Money and Banking

🧭 Overview

🧠 One-sentence thesis

Ignorance of money and banking principles can destroy personal dreams and financial security, as illustrated by individuals who lost homes, businesses, inheritances, and opportunities due to lack of financial knowledge.

📌 Key points (3–5)

• Core claim: Not understanding money, banking, and finance causes real harm—lost homes, failed business dreams, depleted inheritances, and missed opportunities.
• Multiple failure modes: Financial ignorance manifests in different ways—inability to secure financing, predatory lending traps, poor timing due to interest rate changes, currency depreciation, inflation erosion, and lack of diversification.
• Interest rates as a key mechanism: When the Federal Reserve raises interest rates to cool the economy, borrowing becomes more expensive, housing demand falls, and asset prices drop.
• Common confusion: Bonds seem safe but lose value when interest rates rise; inflation erodes purchasing power even when nominal payments arrive on time.
• Why it matters: Financial literacy directly determines whether people can pursue dreams, preserve wealth across generations, and avoid exploitation.

💔 Dreams blocked by lack of financing

🍽️ Ben's restaurant dream

• Ben is a trained chef (hospitality and nutrition degrees) who wants to open a healthy restaurant.
• He lacks personal capital and cannot borrow because of "youthful indiscretions concerning money" (past financial mistakes damaged his credit).
• The stakes: If he gets financing and succeeds, he could revolutionize American eating habits; if he gets financing but fails, backers lose money but at least the idea was tested; if he never gets financing, the world never knows if his idea was good.
• Key insight from the excerpt: "If he cannot obtain financing, however, the world will never know whether his idea was a good one or not."

🏦 Why bankers matter

• The excerpt frames Ben as both an entrepreneur and someone who needs entrepreneurs (bankers/lenders) to lend to him.
• Without access to credit, even good ideas with trained, passionate people behind them cannot be tested in the market.

🏠 Homeownership destroyed by financial traps

🪤 Rose and Joe's predatory mortgage

Negative amortization mortgage with a balloon payment: a loan where monthly payments cover only part of the interest (not even all of it), none of the principal, and the principal grows over time until a large lump sum (balloon) is due.

• Rose and Joe wanted a big house and found a lender offering very low monthly payments.
• They "unwittingly agreed"—they did not understand the loan structure.
• What went wrong: Housing prices in their area fell, and the lender foreclosed even though they had never missed a payment.
• Outcome: Lost their home, lost their credit, now rent a small apartment, and deeply distrust the financial system.
• Don't confuse: Missing payments vs. structural loan traps—they paid on time but still lost everything because the loan was designed to grow the debt.

📉 Rob and Barb's interest rate timing problem

• Rob and Barb bought a new house with a conventional thirty-year mortgage but had trouble selling their old house.
• The mechanism: The Federal Reserve raised interest rates to cool an overheating economy and prevent inflation.
• Higher interest rates → more expensive to borrow → buyers offered less or stopped looking → Rob and Barb had to sell their old house for much less than expected.
• Outcome: Unable to pay two mortgages, they sold at a loss and had to forgo planned purchases (TV, carpeting, playground, mower).
• Key excerpt insight: "That may have been good for the economy by keeping inflation in check, but Rob and Barb... wished they knew more about the economics of money, banking, and interest rates."

💸 Wealth eroded by inflation and currency ignorance

💶 Samantha's currency depreciation

• Samantha studied in France with a $15,000 budget.
• She had only a "vague sense" that other countries use different money.
• What happened: The U.S. dollar depreciated (lost value) against the euro.
• Dollar depreciation → she had to pay more and more dollars to buy each euro → her budget ran out in six months instead of a year.
• Outcome: Unable to work in France, she returned home early, her French still poor, feeling embittered.
• Don't confuse: Exchange rates are not fixed—currency values fluctuate, and a weaker home currency makes foreign expenses more expensive.

📉 Jorge's inheritance wiped out by inflation

• Jorge's father invested his inheritance in U.S. government bonds in the late 1960s.
• The Treasury paid interest on time, but high inflation and high interest rates in the 1970s and early 1980s destroyed the bonds' value.
• The mechanism the excerpt explains:
  • When money supply increases faster than money demand → prices rise → inflation.
  • When inflation increases → nominal interest rates increase.
  • When interest rates rise → prices of bonds (which pay fixed sums) fall.
• Outcome: Instead of a fortune, Jorge received barely enough to buy a midsized car.
• Key point: "Jorge's father didn't lack intelligence... Many people, even some otherwise well-educated ones, do not understand the basics of money, banking, and finance. And they and their loved ones pay for it, sometimes dearly."

🎲 Concentration risk and lack of diversification

🥚 Madison's grandparents and Enron

Portfolio diversification: the principle that you shouldn't put all of your eggs in one basket—spreading investments across multiple assets reduces risk.

• Madison's grandparents invested their entire life savings in a single company, Enron.
• Enron went bankrupt in December 2001 → they lost everything except Social Security.
• Ripple effects: Instead of helping their granddaughter, they became a financial drain on Madison's parents; when they died without life insurance, Madison's parents had to pay for their "final expenses."
• Don't confuse: A single investment, even in a seemingly stable company, carries catastrophic risk if it fails; diversification protects against total loss.

🏛️ Historical example: The American Revolution

💷 Monetary grievances beyond taxation

• The excerpt notes that history textbooks emphasize unjust taxation, but British imperial policies also made it hard for colonists to control money supply or interest rates.
• The cycle: Money became scarce → interest rates spiked → real estate values plummeted → colonists lost property in court → some ended up in debtors' prisons.
• Why this is omitted from textbooks: "Most historians, like many people, generally do not fully understand the principles of money and banking."
• This reinforces the excerpt's thesis that financial ignorance is widespread, even among educated people, and has serious consequences.

🔑 Key takeaway

Principle	What the excerpt shows
Financing access	Without credit, even good ideas (Ben's restaurant) cannot be tested.
Loan structures	Predatory or complex loans (Rose and Joe) can trap borrowers who don't understand terms.
Interest rates	Central bank policy (Fed raising rates) affects borrowing costs, housing demand, and asset prices (Rob and Barb).
Currency risk	Exchange rate fluctuations (Samantha) can exhaust budgets unexpectedly.
Inflation and bonds	Inflation erodes purchasing power; rising rates lower bond prices (Jorge's father).
Diversification	Concentrating wealth in one asset (Madison's grandparents) risks total loss.

The excerpt's conclusion: "People who understand the principles of money and banking are more likely to lead happy, successful, fulfilling lives than those who remain ignorant about them."

🧭 Overview

🧠 One-sentence thesis

Understanding the principles of money and banking enables people to make better personal, business, and civic decisions, potentially improving their lives significantly even if they don't become wealthy financiers.

📌 Key points (3–5)

• Real-world consequences of ignorance: Lack of financial knowledge can lead to devastating losses, such as Madison's grandparents losing everything by failing to diversify their investments in Enron.
• Success through knowledge: Individuals like Henry Kaufman and George Soros built fortunes by understanding interest rates and exchange rates, demonstrating the practical value of financial expertise.
• Challenging but rewarding learning: The study involves mastering unfamiliar terminology and concepts (financial jargon, redefined familiar words), but the effort pays off in personal decisions, business efficiency, and informed citizenship.
• Career opportunities: Knowledge can lead to lucrative careers in banking, including the possibility of starting new banks, though regulatory approval is stringent.
• Scope note: This material focuses on Western financial systems, not Islamic finance (which performs similar functions but in a sharia-compliant manner).

💔 The cost of financial ignorance

💔 Madison's grandparents and Enron

• Madison's grandparents invested their entire life savings in a single company, Enron, violating the principle of portfolio diversification.

Portfolio diversification: the tried-and-true rule that you shouldn't put all of your eggs in one basket.

• When Enron went bankrupt in December 2001, they lost everything except their Social Security checks.
• The consequences cascaded: instead of helping Madison, they drained resources by constantly seeking handouts from her parents; when they died without life insurance, Madison's parents had to pay for their "final expenses."
• Don't confuse: This is not just about one bad investment—it illustrates the systemic impact of not understanding basic financial principles like diversification and insurance planning.

📜 Historical example: American Revolution

• The excerpt notes that British imperial policies made it difficult for colonists to control money supply or interest rates.
• When money became scarce, interest rates increased dramatically, causing the value of homes, farms, and real estate to decrease quickly and steeply.
• Many colonists lost their property in court proceedings; some ended up in debtors' prisons.
• Why history books miss this: Most historians, like many people, do not fully understand the principles of money and banking, so they focus on taxation instead of monetary causes.

💰 Success through financial knowledge

💰 Henry Kaufman's story

• Henry Kaufman fled Nazi persecution as a young Jewish boy in the 1930s.
• He became a billionaire because he understood what made interest rates rise and fall.
• The excerpt notes that understanding interest rates also helps predict "the prices of all sorts of financial instruments."

💰 George Soros's story

• George Soros, another immigrant from Central Europe, made a large fortune by correctly predicting changes in exchange rates.
• Example: Both Kaufman and Soros leveraged specific financial knowledge (interest rates, exchange rates) to build wealth, demonstrating that understanding these mechanisms has concrete economic value.

💰 Broader impact

• Millions of other individuals have improved their lives (though not as dramatically as Kaufman and Soros) by making astute life decisions informed by knowledge of the economics of money and banking.
• The excerpt promises: "if you read this book carefully, attend class dutifully, and study hard, your life will be the better for it."
• Three areas of benefit: personal decisions, business/department efficiency, and informed citizenship.

🗣️ Mastering the language of finance

🗣️ Familiar words, new meanings

The study of money and banking can be daunting because seemingly familiar terms take on new meanings:

Familiar term	Financial meaning (not the everyday meaning)
Derivatives	Financial instruments for trading risks (not calculus)
Interest	A financial concept (not necessarily "interesting")
Stocks	Financial securities (not alive, not holding places for criminals)
Zeroes	Can be quite valuable
CDs	Financial instruments (don't contain music)
Yield curves	Sometimes straight lines
Principal	A sum of money or an owner (not a school administrator)
Returns	A good thing in finance (unlike in retail or publishing)

🗣️ Acronyms and jargon

• The field uses military-style acronyms and jargon extensively.
• Examples listed: 4X, A/I, Basel II, B.I.G., CAMELS, CRA, DIDMCA, FIRREA, GDP, IMF, LIBOR, m, NASDAQ, NCD, NOW, OTS, r, SOX, TIPS, TRAPS, "and on and on."
• Why it matters: Learning this "strange new language" and learning to think like a banker or financier is necessary to gain the promised rewards.

🏦 Career paths in banking

🏦 Importance to business success

• Whether climbing the corporate ladder or starting their own companies, people will discover that interest, inflation, and foreign exchange rates are as important to success as cell phones, computers, and soft people skills.
• A few will find a career in banking to be lucrative and fulfilling.

🏦 Starting a new bank

• Some eager individuals will try to start their own banks from scratch.
• They can do so "provided they are good enough to pass muster with investors and with government regulators charged with keeping the financial system, one of the most important sectors of the economy, safe and sound."
• Regulatory challenge: Gaining regulatory approval has become so treacherous that consulting firms (like Nubank) specialize in helping potential incorporators navigate "regulator-infested waters."
• Why regulations are stringent: Banking is such a complex and important part of the economy that the government cannot allow anyone to do it (similar to surgery or flying commercial airliners).
• Why people bother: Despite the difficulty, establishing a new bank can be extremely profitable and exciting.

🕌 Scope: Western vs Islamic finance

🕌 What this material covers

• This book is about Western financial systems, not Islamic ones.
• Islamic finance performs the same functions as Western finance but tries to do so in a way that is sharia-compliant.

Sharia-compliant: a way that accords with the teachings of the Quran and its modern interpreters, who frown upon interest.

• Islamic finance is currently growing and developing very rapidly.
• For further study: The excerpt refers readers to books in the Suggested Readings section to learn more about Islamic finance.

🧭 Overview

🧠 One-sentence thesis

Financiers are neither innately evil nor infallibly brilliant, but rather ordinary people whose financial systems provide significant economic benefits despite occasional colossal mistakes.

📌 Key points (3–5)

• The negative stereotype: movies and literature portray financiers as evil, powerful monsters bent on profit at any cost (e.g., Sherman McCoy, Shylock, Larry the Liquidator).
• The positive stereotype: some view financiers as brilliant "rocket scientists" or "the smartest guys in the room" who perform complex calculations.
• Reality check: both stereotypes are flawed—financiers are like other occupational groups, containing both decent people and those who have done bad things.
• Common confusion: mathematical sophistication ≠ infallibility; complex formulas work better in astrophysics than in economics and social sciences.
• Why it matters: the financial system benefits many people in wealthier countries, so understanding it objectively (rather than through stereotypes) is essential.

🎭 Cultural stereotypes of financiers

🎬 The evil financier trope

The excerpt traces a long tradition of negative portrayals:

• Literature and film examples: Sherman McCoy in Bonfire of the Vanities (1987) depicted as a slimy, rich, powerful "Master of the Universe"; Shylock in Shakespeare's The Merchant of Venice; Larry the Liquidator vs. the adorable factory owner in Other People's Money; even It's a Wonderful Life contrasts lovable George Bailey against the "ancient and evil financier" Henry F. Potter.
• What the pattern shows: "bashing finance is not a passing fad"—the stereotype persists across centuries and media.
• The implication: viewers and readers absorb the message that financiers are bent on "destroying all that decent folks hold dear for the sake of a fast buck."

Don't confuse: a few individuals doing bad things with an entire occupational group being innately evil.

🚀 The brilliant genius trope

The excerpt also identifies an opposite stereotype:

• Some people believe financiers are "brilliant rocket scientists" or "the smartest guys in the room."
• This positive stereotype suggests that investment bankers, insurance actuaries, and other "fancy financiers" could have worked for NASA.
• Why it's flawed: the excerpt states this stereotype "is as flawed as the negative one."

🧪 Reality: neither evil nor infallible

🧑‍🤝‍🧑 Financiers are ordinary people

• The truth: "some financiers have done bad things. Then again, so have members of every occupational, geographical, racial, religious, and ethnic group on the planet."
• The norm: "most people, most of the time, are pretty decent."
• The principle: "we should not malign entire groups for the misdeeds of a few, especially when the group as a whole benefits others."

Example: Just as one would not judge all college professors or religious leaders by the worst examples, one should not judge all financiers by a few bad actors.

🔢 Mathematical limits in social sciences

The excerpt emphasizes a critical distinction:

• Complex formulas: while financiers use sophisticated mathematics, "complex mathematical formulas are less useful in economics (and other social sciences) than in astrophysics."
• Fallibility: "fancy math does not reality make"—financiers "are far from infallible."
• Historical evidence: "Financiers, like politicians, religious leaders, and, yes, college professors, have made colossal mistakes in the past and will undoubtedly do so again in the future."
• Recent reminder: the financial crisis that began in 2007 demonstrates this fallibility.

Stereotype	Claim	Reality per excerpt
Evil monster	Financiers are innately bad, bent on profit at others' expense	Some have done bad things, but most are decent; the group as a whole benefits others
Brilliant genius	Financiers are infallible rocket scientists	They use complex math but are far from infallible; social science ≠ astrophysics

💡 Why objective understanding matters

🏦 The financial system's benefits

• Economic contribution: "the financial system does so much good for the economy" and "benefit[s] many people in wealthier countries."
• Reason to study objectively: rather than rely on stereotypes, students should "form their own view of the financial system."

📚 Chapter purpose and importance

The excerpt frames this chapter as foundational:

• Goal: help students form an informed view by reviewing "the entire system."
• Content value: "it contains a lot of descriptive information and definitions that will help you later in the text."
• Recommendation: "it's well worth your time and effort to read this chapter carefully."

Don't confuse: understanding the financial system objectively with endorsing every action of every financier—the excerpt calls for balanced judgment, not blind acceptance or rejection.

🧭 Overview

🧠 One-sentence thesis

Financial systems are essential networks that allocate capital, share risks, and facilitate intertemporal trade by efficiently linking borrowers to lenders, enabling the material progress and technological breakthroughs of the last two centuries.

📌 Key points (3–5)

• Three major purposes: allocating capital, sharing risks, and facilitating intertemporal trade.
• Core function: efficiently linking borrowers (those with profitable ideas but limited funds) to lenders (those with excess funds).
• Why specialized intermediaries are needed: lending requires substantial fixed costs and economies of scale that most individuals and non-financial companies cannot achieve.
• Common confusion: internal finance vs external finance—most businesses cannot rely solely on internal finance (plowing back profits) and need external sources.
• Historical impact: the financial system enabled major innovations from steam engines to cell phones by connecting capital to entrepreneurs.

💡 What a financial system is and does

💡 Definition and structure

A financial system is a densely interconnected network of financial intermediaries, facilitators, and markets.

• It is not just banks or stock markets in isolation; it is an entire network of interconnected entities.
• The excerpt emphasizes "densely interconnected," meaning many parts work together.

🎯 Three major purposes

The excerpt identifies three core functions:

Purpose	What it means
Allocating capital	Directing money to where it can be used productively
Sharing risks	Linking risk-averse entities (hedgers) to risk-loving ones (speculators)
Facilitating intertemporal trade	Enabling exchanges across time (borrowing and lending over time)

• These purposes sound "mundane, even boring" according to the excerpt, but they are "important to human welfare."
• Example: An inventor with a good idea today but no money can borrow from someone with excess funds, enabling the invention to be developed.

🔗 Linking borrowers and lenders

🔗 Who are borrowers?

Borrowers are economic agents with potentially profitable business ideas (positive net present value projects) but limited financial resources (expenditures > revenues).

The excerpt lists:

• Inventors and entrepreneurs

• Domestic households

• Governments

• Established businesses

• Foreigners

• Key characteristic: they have more expenditures than revenues at the moment but have profitable opportunities.

🔗 Who are lenders (savers)?

Lenders or savers are entities with excess funds (revenues > expenditures).

The excerpt lists:

• Domestic households

• Businesses

• Governments

• Foreigners

• Key characteristic: they have more revenues than expenditures and can provide capital.

🔗 Why this linking matters

• Without the financial system, "people remain wannabe entrepreneurs and companies cannot complete their projects."
• The excerpt states: "the world is a poorer place for it" when good ideas cannot access funding.
• Historical evidence: material progress and technological breakthroughs "would not have been possible without the financial system."

🏢 Why specialized financial firms are necessary

🏢 Internal vs external finance

Internal finance: plowing back profits—using a company's own wealth and income to fund projects.

External finance: obtaining funds from outside sources.

• Don't confuse: The excerpt notes that "occasionally" people and companies can use internal finance, but "most of the time" they need external finance.
• Small businesses and those in rapidly growing markets especially need external finance because they lack sufficient savings or cash.

🏢 The costs of lending

The excerpt explains why individuals and non-financial companies cannot efficiently lend on their own:

• Fixed costs are substantial: advertising for borrowers, buying and maintaining computers, leasing office space, etc.
• Volume is needed: to recoup fixed costs and "drive them toward insignificance," lenders must do "quite a volume of business."
• Minimum efficient scale: financial companies must exceed a certain scale to be efficient; "little guys usually just can't be profitable."

🏢 Specialists and economies of scale

• Lending is most efficiently conducted by specialists: companies that focus on one thing (or a few related activities) and do it very well.
• Why specialists are better: they have much practice and they tap economies of scale.
• Clarification: "This is not to say, however, that bigger is always better, only that to be efficient financial companies must exceed minimum efficient scale."

Example: A non-financial company trying to lend would face high fixed costs without enough lending volume to make it profitable, whereas a specialized lender can spread those costs across many loans.

🌍 Real-world impact and scope

🌍 Historical breakthroughs enabled

The excerpt lists innovations made possible by the financial system:

• 19th century: steam engines, cotton gins, telegraphs

• 20th century (early-mid): automobiles, airplanes, telephones

• 20th century (late) to 21st century: computers, DNA splicing, cell phones

• These breakthroughs required connecting inventors/entrepreneurs (who had ideas but not money) to lenders (who had money but not necessarily the ideas).

🌍 Everyday involvement

• The excerpt notes that "you are probably already deeply imbedded in the financial system as both a borrower and as a saver."
• This means most people interact with the financial system in multiple roles, not just as one type of participant.

🌍 Linking risk preferences

• The system also connects hedgers (risk-averse entities) to speculators (risk-loving entities).
• This risk-sharing function is separate from the capital allocation function but equally important.

🧭 Overview

🧠 One-sentence thesis

Asymmetric information—when one party knows more than the other—creates adverse selection and moral hazard problems that financial systems must mitigate to enable efficient lending and investment.

📌 Key points (3–5)

• What asymmetric information is: a situation where the seller (borrower) knows more than the buyer (lender/investor), creating fundamental problems in financial transactions.
• Two main problems it causes: adverse selection (before the contract) attracts the worst risks, and moral hazard (after the contract) encourages risky or dishonest behavior.
• Common confusion: adverse selection vs moral hazard—adverse selection happens before signing (who you attract), moral hazard happens after (how they behave once they have your money).
• Why it matters: unmitigated asymmetric information can shut down lending entirely, as lenders would rather keep money "under their mattresses" than risk being exploited.
• Role of financial systems: they reduce (though never eliminate) information asymmetries enough to allow businesses to obtain affordable external finance and grow.

😈 The nature of asymmetric information

😈 What it is and why it's called "the real evil"

Asymmetric information: when one party knows more about an economic transaction or asset than the other party does.

• The excerpt calls it "the devil incarnate" and "another nasty fact that makes life much more complicated."
• Like scarcity and opportunity costs, asymmetric information "inheres in nature"—it is a fundamental problem, not something that can be wished away.
• In finance, it typically means the borrower (seller of securities) knows more than the lender (buyer of securities).
• The metaphor: "Like the devil in Dante's Inferno, this devil has two big ugly heads"—adverse selection and moral hazard.

🔍 Why it's peculiar to finance

• The excerpt notes that finance "suffers from a peculiar problem that is not easily overcome by just anybody."
• Unlike other goods, financial transactions involve promises about future behavior and hidden information about risk.
• This makes specialized financial institutions necessary—they develop expertise in "tangling with those devilish information asymmetries."

🎭 The two heads: adverse selection and moral hazard

🎯 Adverse selection (before the contract)

Adverse selection: the fact that the riskiest borrowers are the ones who most strongly desire loans, which raises problems before a contract is signed.

• The mechanism: lenders attract "sundry rogues, knaves, thieves, and ne'er-do-wells, like pollen-laden flowers attract bees."
• Why it happens: those who know they are bad risks have the strongest incentive to seek loans, while good borrowers may not need to borrow as urgently.
• The consequence: if lenders are unaware of this selection bias, they "will find themselves burned so often that they will prefer to keep their savings under their mattresses rather than risk lending it."
• Timing: this problem occurs before the transaction—it's about who you end up doing business with.

Example: A lender advertises loans. The people most eager to apply are those who know they have risky projects or poor repayment prospects, while safer borrowers may seek smaller amounts or have other options.

🎲 Moral hazard (after the contract)

Moral hazard: sinning after contract consummation—borrowers taking advantage of lenders after the loan has been made.

• The mechanism: "After a loan has been made, even good borrowers sometimes turn into thieves because they realize that they can gamble with other people's money."
• The classic scenario: instead of using the loan as promised (e.g., "setting up a nice little ice cream shop"), borrowers may "try to get rich quick by taking a quick trip to Vegas or Atlantic City for some potentially lucrative fun at the blackjack table."
• Why it happens: borrowers think "if they lose, they think it is no biggie because it wasn't their money."
• The consequence: "Unless recognized and effectively countered, moral hazard will lead to the same suboptimal outcome" as adverse selection—lenders stop lending.
• Timing: this problem occurs after the transaction—it's about how the borrower behaves once they have the funds.

Don't confuse: Adverse selection is about attracting bad risks before lending; moral hazard is about good (or bad) borrowers behaving badly after receiving the loan.

🕵️ The principal-agency problem (mentioned briefly)

• The excerpt notes "a third head, the principal-agency problem, a special type of moral hazard."
• No further detail is provided in this section; it will be covered later.

🛡️ How financial systems fight asymmetric information

🛡️ The major function of financial systems

• "One of the major functions of the financial system is to tangle with those devilish information asymmetries."
• Important limitation: "It never kills asymmetry, but it usually reduces its influence enough..."
• The goal is not perfection but reduction to manageable levels.

💰 What reduction enables

When asymmetric information is sufficiently reduced, financial systems allow:

• Businesses and borrowers to "obtain funds cheaply enough"
• Firms to "grow, become more efficient, innovate, invent, and expand into new markets"
• Entrepreneurs to "test their ideas in the marketplace"

The mechanism: "By providing relatively inexpensive forms of external finance, financial systems make it possible for entrepreneurs and other firms to test their ideas."

🔧 Two major constraints addressed

Financial systems reduce two constraints:

Constraint	What it means	How it's addressed
Liquidity	The need for short-term cash	Financial system provides ways to access cash quickly
Capital	The need for long-term dedicated funds	Financial system channels long-term investment

⏰ Intertemporal trade

• "Another way to think about that is to realize that the financial system makes it easy to trade intertemporally, or across time."
• What this means: "Instead of immediately paying for supplies with cash, companies can use the financial system to acquire what they need today and pay for it tomorrow, next week, next month, or next year."
• Why it matters: "giving them time to produce and distribute their products."

🏦 Two major methods of reducing asymmetry

The excerpt mentions that financial systems reduce constraints "in two major ways":

1. Directly via markets (often with the aid of facilitators)
2. Indirectly via intermediaries

(Details on these methods are not provided in this section.)

🪞 Self-reflection: asymmetric information in everyday life

🪞 The "Stop and Think Box"

The excerpt includes a self-check to help readers recognize asymmetric information in their own behavior:

The premise: "You might think that you would never stoop so low as to take advantage of a lender or insurer. That may be true, but financial institutions are not worried about you per se; they are worried about the typical reaction to asymmetric information."

Examples of taking advantage of asymmetric information:

• Stolen anything from work?
• Taken a longer break than allowed?
• Deliberately slowed down at work?
• Cheated on a paper or exam?
• Lied to a friend or parent?

The point: "If so, you have taken advantage (or merely tried to, if you were caught) of asymmetric information."

Why this matters: Even people who consider themselves honest may exploit information advantages when the opportunity arises—this is why financial institutions must build systems to counter these incentives, not rely on individual virtue.

🧭 Overview

🧠 One-sentence thesis

Financial markets can be categorized by issuance stage, instrument type, maturity length, and market organization, and they increasingly operate on a global scale to connect borrowers and lenders through a variety of specialized securities.

📌 Key points (3–5)

• Primary vs. secondary markets: newly issued securities trade in primary markets; existing securities are resold in secondary markets (most securities are negotiable).
• Money vs. capital markets: money markets handle instruments maturing in less than one year; capital markets handle instruments with one year or more to maturity (some never mature).
• Market organization: secondary markets can be organized as centralized exchanges (like the New York Stock Exchange) or as over-the-counter (OTC) markets run by dealers via telecom.
• Common confusion: "direct finance" is a misnomer—financial markets usually involve facilitators (brokers, dealers, investment banks) rather than direct borrower-lender contact.
• Globalization: financial markets are increasingly international, with foreign bonds, Eurobonds, and cross-border investment now commonplace.

🔄 Primary and Secondary Markets

🆕 Primary markets

Primary markets: where newly created (issued) instruments are sold for the first time.

• This is the initial sale of a security by the issuer (borrower) to investors (lenders).
• Example: a corporation issues new stock or bonds to raise capital—that first sale happens in the primary market.

🔁 Secondary markets

Secondary markets: where existing securities are resold to other investors.

• Most securities are negotiable, meaning they can be sold at will after the initial purchase.
• Stock exchanges are the most well-known type of secondary market, but secondary markets also exist for bonds, mortgages, and derivatives.
• Don't confuse: primary markets create new securities; secondary markets only transfer ownership of existing ones.

🏛️ Market Organization

🏢 Exchanges

• Centralized physical or electronic locations for trading securities.
• Examples mentioned: New York Stock Exchange, Chicago Board of Trade.
• Completely electronic stock markets have gained ground in recent years.

📞 Over-the-counter (OTC) markets

• Run by dealers connected via telecom devices rather than a central location.
• Historical evolution: post and semaphore (flag signals) → telegraph → telephone → computer.
• No single physical trading floor; transactions happen through dealer networks.

⏱️ Money Markets vs. Capital Markets

💵 Money markets

Money markets: used to trade instruments with less than a year to maturity (repayment of principal).

Examples include:

• T-bills (Treasury bills or short-term government bonds)
• Commercial paper (short-term corporate bonds)
• Banker's acceptances (guaranteed bank funds, like a cashier's check)
• Negotiable certificates of deposit (large-denomination negotiable CDs, called NCDs)
• Fed funds (overnight loans of reserves between banks)
• Call loans (overnight loans on the collateral of stock)
• Repurchase agreements (short-term loans on the collateral of T-bills)
• Foreign exchange (currencies of other countries)

🏗️ Capital markets

Capital markets: where securities with a year or more to maturity trade.

• Some instruments, called perpetuities, never mature or fall due.
• Examples of perpetuities: equities (ownership claims) and perpetual interest-only loans.
• Most capital market instruments have fixed maturities ranging from a year to several hundred years, though most issued today mature in thirty years or less.
• Examples: mortgages (loans on real estate collateral), corporate bonds, government bonds, commercial and consumer loans.
• Don't confuse: some interest-only loans mature with a "balloon payment" (principal due all at once at the end), so they are not true perpetuities.

Market Type	Maturity	Examples
Money markets	Less than one year	T-bills, commercial paper, Fed funds, repurchase agreements
Capital markets	One year or more (some perpetual)	Stocks, bonds, mortgages, perpetual interest-only loans

🎲 Derivatives Markets

🎲 What derivatives do

• Derivatives contracts trade in a third type of financial market (distinct from money and capital markets).
• They allow investors to spread and share a wide variety of risks.
• Risk types mentioned: changes in interest rates, stock market indices, and weather conditions (too sunny for farmers, too rainy for amusement parks, too cold for orange growers, too hot for ski resorts).
• The excerpt notes that financial derivatives are "in some ways even more complicated than the derivatives in calculus" and are usually covered in specialized or advanced courses.

🤝 Market Facilitators

🏦 Why "direct finance" is a misnomer

• Financial markets are sometimes called "direct finance," but the term is misleading.
• The functioning of markets is usually aided by one or more market facilitators: brokers, dealers, brokerages, and investment banks.
• These intermediaries stand between borrowers and lenders, so the connection is not truly "direct."

👔 Brokers

Brokers: facilitate secondary markets by linking sellers to buyers of securities in exchange for a fee or a commission (a percentage of the sale price).

• They do not own the securities themselves; they simply connect parties.

💼 Dealers

Dealers: "make a market" by continuously buying and selling securities, profiting from the spread (the difference between the sale and purchase prices).

• Example: a dealer might buy a certain type of bond at $99 and resell it at $99.125, ten thousand times a day.
• Unlike brokers, dealers own the securities temporarily.

🏢 Brokerages

• Engage in both brokering and dealing.
• Usually also provide clients with advice and information.

🏛️ Investment banks

• Facilitate primary markets by underwriting stock and bond offerings, including initial public offerings (IPOs) of stocks, and by arranging direct placements of bonds.
• Sometimes act as brokers (introducing issuers to investors, usually institutional investors).
• Sometimes act as dealers (buying securities themselves for later resale).
• Sometimes provide advice, usually regarding mergers and acquisitions.
• Historical note: investment banks took a beating during the financial crisis that began in 2007; most major ones went bankrupt or merged with large commercial banks. Two large ones and numerous small "boutiques" (niche players) remain.

🌍 International Financial Markets

🌐 Globalization trends

• Financial markets are increasingly international in scope.
• Integration of transatlantic financial markets began early in the nineteenth century and accelerated after the mid-nineteenth-century introduction of transoceanic telegraph systems.
• The process reversed early in the twentieth century due to World Wars I and II, the cold war, the demise of the gold standard, and the rise of the Bretton Woods system (fixed exchange rates, discretionary monetary policy, and capital immobility).
• With the end of the Bretton Woods arrangement in the early 1970s and the cold war in the late 1980s/early 1990s, financial globalization reversed course once again.

🌏 Foreign bonds

Foreign bonds: bonds sold by issuers (borrowers) in a foreign country, denominated in that foreign country's currency.

• Example: the Mexican government can sell dollar-denominated bonds in U.S. markets.

💶 Eurobonds and Eurocurrencies

Eurobonds or Eurocurrencies: bonds issued (created and sold) in foreign countries but denominated in the home country's currency.

• Example: U.S. companies can sell dollar-denominated bonds in London, and U.S. dollars can be deposited in non-U.S. banks.
• Don't confuse: the term "Euro" has nothing to do with the euro (the currency of the European Union); it means "outside." A Euro loan would be a loan denominated in euro but made in London, New York, Tokyo, or Perth.
• Historical example: to purchase the Louisiana Territory from Napoleon in 1803, the U.S. government sold long-term, dollar-denominated bonds in Europe—these were Eurobonds.

📈 Cross-border investment

• It is now quite easy to invest in foreign stock exchanges.
• Many foreign exchanges have grown in size and importance in recent years, even though they struggled through the panic of 2008.

🧭 Overview

🧠 One-sentence thesis

Financial intermediaries link savers to borrowers by transforming assets—buying and selling instruments with different risk, return, and liquidity characteristics—rather than merely brokering the same securities.

📌 Key points (3–5)

• Core function: intermediaries transform assets by buying securities with one set of characteristics (e.g., risky, high-return loans) and selling liabilities with different characteristics (e.g., safe, liquid deposits).
• Key distinction from facilitators: facilitators only broker or trade the same securities; intermediaries change the nature of the instruments.
• Classification methods: intermediaries can be grouped by the type of asset transformations they perform, or by ownership structure, charter terms, and regulatory agencies.
• Common confusion: depositors own claims on the intermediary itself (e.g., the bank), not on the underlying borrowers whose loans the bank holds.
• Historical trend: since World War II, the relative importance of commercial banks and life insurers has declined as new investment options proliferated, though all intermediary types have grown in absolute terms and as a share of GDP.

🏦 How intermediaries transform assets

🔄 The transformation mechanism

Indirect method of finance: intermediaries link investors/lenders/savers to borrowers/entrepreneurs/spenders by transforming assets.

• Intermediaries do not simply pass through the same security from borrower to lender.
• They buy instruments with certain risk, return, and liquidity traits and sell different instruments with other traits.
• This transformation is the defining feature that separates intermediaries from facilitators.

🏦 Bank example

• A bank sells liabilities (demand deposits) that are:
  • Low risk (safe)
  • Low return
  • Highly liquid
• The bank uses those funds to buy assets (loans, mortgages, bonds) that are:
  • Relatively risky
  • High return
  • Nonliquid (illiquid)
• Don't confuse: depositors own claims on the bank, not on the bank's borrowers directly.

Example: A depositor with a checking account has a claim against the bank itself; if the bank's loans default, the depositor's claim is still against the bank, not the borrower.

🏛️ Types of financial intermediaries

🏦 Depository institutions

Three main types traditionally existed, though deregulation has blurred the lines:

Type	Traditional deposits	Traditional assets
Commercial banks	Demand/transaction/checking deposits	Loans to businesses
Savings banks	Time or savings deposits	Mortgage loans to households and businesses
Credit unions	Time deposits	Consumer loans

• Finance companies also make consumer loans but are not depository institutions because they raise funds by selling commercial paper, bonds, and equities instead of issuing deposits.
• After deregulation: the distinctions between depository types have blurred; ownership structure, charter terms, and regulatory agencies are now easier ways to tell them apart.

🏢 Ownership structures

• Joint-stock corporations: owned by stockholders (almost all commercial banks, many savings banks).
• Mutual corporations: owned by depositors or policyholders (some savings banks, all credit unions, some insurance companies).

🛡️ Insurance companies

Insurance policies: contracts that mature or come due when a contingency occurs, serving as a mechanism for spreading and sharing risks.

Types of insurance and their contingencies:

Insurance type	Pays when...
Term life	Insured dies within contract period
Life annuities	Insured is still alive
Health	Insured needs medical assistance
Property/casualty (fire, auto)	Loss occurs (fire, accident)
Liability	Insured is sued for tort damages

💼 Investment matching to risk horizon

• Insurers invest premiums in stocks, bonds, and money market instruments.
• The choice depends on the nature of the contingencies:
  • Life insurance companies: invest in longer-term assets because claims occur much later on average (life insurance has a longer "tail" than property insurance).
  • Auto or health insurers: invest in shorter-term assets because claims happen sooner.

📈 Investment companies

Third major intermediary category:

• Pension and government retirement funds: transform corporate bonds and stocks into annuities.
• Mutual funds: transform diverse portfolios of capital market instruments into nonnegotiable but easily redeemable "shares."
• Money market mutual funds: transform money market instruments into redeemable shares.

📊 Historical trends and growth

📉 Relative decline of traditional intermediaries

• Since World War II, the relative importance of commercial banks and life insurance companies has waned.
• Cause: proliferation of additional investment options (e.g., mutual funds, pension funds).
• Don't confuse relative vs. absolute: their share of total financial assets declined, but their absolute asset values grew rapidly.

📈 Absolute growth across all intermediaries

• Assets of all major intermediary types have grown rapidly over the last six decades (1945–2005).
• Figures are in current dollars (not adjusted for inflation), but growth outpaced inflation.
• Financial intermediary assets have grown steadily as a percentage of GDP (1945–2007).

📊 Financial markets also expanded

Examples of market growth:

• Dow Jones Industrial Average (DJIA): tracks prices of major corporations' shares.
  • End of WWII: < 200
  • 1961 (Kennedy): ~700
  • 1981 (Reagan): ~1,000
  • 1992: > 3,200
  • 1999: > 10,000
• Trading volumes (NYSE and NASDAQ):
  • 1945: rarely > 2 million shares/day
  • 1975: 10 million shares = slow day
  • 2005: regularly > 1 billion shares/day

🌐 Role in economic growth

• The U.S. economy has grown significantly since WWII, in no small part due to the financial system.
• Both intermediaries and markets have contributed to this growth.

🧭 Overview

🧠 One-sentence thesis

Investors choose between markets and intermediaries based on the risk-return-liquidity trade-off that best suits them, while borrowers select whichever channel offers the lowest overall cost and most flexible repayment terms.

📌 Key points (3–5)

• Investor decision criteria: investors primarily trade off among risk (bad), return (good), and liquidity (good), seeking the combination that best fits their needs.
• Borrower decision criteria: borrowers choose markets or intermediaries based on which offers the lowest cost and most flexible repayment terms.
• Why perfect investments are rare: investors bid up the prices of riskless, highly liquid, high-return investments, which reduces their returns—so investors must sacrifice something (liquidity or safety) to maintain higher returns.
• Common confusion: price vs. return—higher investment price means lower return, all else equal; don't assume expensive investments yield more.
• Competition drives variety: competition among investors and borrowers creates a wide range of financial instruments, from safe T-bills to risky derivatives.

💰 What Investors Want

🎯 The core trade-off: risk, return, and liquidity

Risk is a bad thing, while return and liquidity are good things.

• Risk: the possibility of loss or default; investors prefer less risk.
• Return: the gain from an investment; investors prefer higher returns.
• Liquidity: how easily an investment can be sold; investors prefer more liquidity.

Every investor ideally wants:

• Zero risk
• High return
• Easy saleability (high liquidity)

Why this ideal is rare:

• When such opportunities appear, many investors bid up their prices.
• Higher price → lower return (all else equal).
• Competition forces investors to give up something: accept lower liquidity, take on more risk, or settle for lower returns.

🔄 How investors adjust their choices

Investors make trade-offs to keep returns attractive:

• Give up liquidity: buy less easily sold instruments (e.g., mortgages instead of T-bills).
• Take on more risk: buy securities not backed by collateral (no buildings, businesses, or safe assets promised in case of default).

Example: An investor might choose a medium-risk, medium-liquidity mortgage over a safe but low-return T-bill to earn a higher return.

🌈 The resulting variety of instruments

Competition produces a spectrum of financial instruments:

Type	Risk	Liquidity	Return	Example
Very safe, very liquid	Low	High	Low	T-bills, demand deposits
Medium risk/liquidity	Medium	Medium	Medium	Mortgages
High risk, high liquidity	High	High	Potentially high	Derivatives (put options, foreign exchange futures)

🧩 Secondary considerations

Investors care about more than the core three factors, but these are usually less important:

• Certainty of redemption terms: investors prefer fixed redemption dates over callable instruments (which the borrower can repay early), because fixed dates reduce uncertainty.
• Social/environmental factors: investors sometimes pay slightly more for instruments from environmentally or socially conscious issuers, and less for "dirty, rude" ones.

Example from the excerpt:

• In fall 2006, a 30-year mortgage without prepayment penalty: 6.5% per year.
• Same mortgage with a 7-year prepayment penalty: 6.25% per year.
• Why? Investors accepted a lower return in exchange for guaranteed repayment terms (certainty that the loan would not be repaid early).

Don't confuse: "Secondary" does not mean unimportant—it means these factors matter less than risk, return, and liquidity in most decisions.

🏦 What Borrowers Want

💸 Lowest cost and maximum flexibility

Borrowers compete for funds by offering investors better terms:

• Higher returns
• Less risk
• More liquid instruments

Borrower ideal:

• Borrow huge sums
• Forever (no repayment deadline)
• Unconditionally (no collateral or covenants)
• At zero interest

Nobody will lend on those terms, so borrowers must compromise.

🔀 Markets vs. intermediaries: which is cheaper?

Borrowers use whichever part of the financial system, markets or intermediaries, offers them the best deal.

How borrowers decide:

• Large, well-known companies: may sell commercial paper in the money market if they can attract enough investors and market facilitators—often cheaper than a bank loan.
• Smaller, newer companies: may find a bank loan much easier and cheaper to obtain because they lack the size and reputation to access markets efficiently.

Example: A major corporation might issue commercial paper directly to investors; a startup might go to a bank because it cannot attract enough market participants.

Don't confuse: "Best deal" is not just about interest rate—it includes ease of access, transaction costs, and flexibility.

⚖️ How Competition Shapes the System

🔄 Investor competition

• Investors compete with each other for the best opportunities.
• This competition bids up prices of attractive investments, lowering their returns.
• Result: a range of instruments emerges, each offering a different risk-return-liquidity profile.

🔄 Borrower competition

• Borrowers compete with each other for the lowest-cost funds.
• They offer better terms (higher returns, lower risk, more liquidity) to attract investors.
• Result: borrowers choose markets or intermediaries depending on which is cheaper and more accessible.

🌐 The outcome: variety and choice

The financial system offers instruments across the spectrum:

• Safe, liquid, low-return: T-bills, demand deposits
• Medium: mortgages
• Risky, potentially high-return: derivatives

This variety allows both investors and borrowers to find the combination that best fits their needs.

🧭 Overview

🧠 One-sentence thesis

Financial regulators aim to maximize transparency and stability while minimizing investor risk, though their policies—especially those that limit competition—remain controversial and not always effective.

📌 Key points (3–5)

• Who regulates: multiple agencies oversee markets (SEC, NYSE, CFTC) and intermediaries (OCC, FDIC, state commissions).
• Four major regulatory goals: reduce asymmetric information through transparency, protect consumers from fraud, promote competition and efficiency, and ensure financial system soundness.
• How regulation affects borrowers: companies may choose intermediaries over markets to avoid costly direct regulatory scrutiny (e.g., bank loans instead of public stock offerings).
• Common confusion: limiting competition to ensure safety is controversial—it privileges existing institutions and is often supported by the regulated companies themselves, unlike the less-controversial transparency and consumer-protection goals.
• Tools for soundness: lender of last resort, deposit insurance, and restrictions on entry/interest rates.

🏛️ Regulatory structure and scope

🏛️ Who oversees what

The excerpt identifies two broad categories of regulators:

Category	Examples	What they oversee
Market regulators	SEC, NYSE, CFTC	Exchanges, OTC markets, futures markets
Intermediary regulators	OCC, FDIC, state banking and insurance commissions	Banks, depositories, insurance companies

The financial system is relatively heavily regulated compared to most other parts of modern capitalist economies.

💼 Impact on borrower choices

• Companies weigh the total net costs (all costs plus all benefits) of different financing methods, and regulation is a major consideration.
• Direct regulatory scrutiny (e.g., SEC and NYSE rules for public stock sales) can be expensive.
• To avoid these costs, companies may choose intermediaries instead of markets.
• Example: A company might obtain a long-term bank loan or sell bonds directly to institutional investors (a "direct placement") rather than sell shares to the public.

🎯 Four major regulatory functions

🔍 Reducing asymmetric information through transparency

• Regulators encourage transparency: requiring financial markets and intermediaries to disclose accurate information to investors in a clear and timely manner.
• This addresses the problem that one party (e.g., the borrower or issuer) knows more than the other (the investor).

🛡️ Consumer protection

• A second, closely related goal: protect consumers from fraud.
• The excerpt mentions "scammers, shysters, and assorted other grifters."
• This function is generally not controversial.

🚪 Promoting competition and efficiency

• Regulators try to make entry and exit of firms as easy and cheap as possible, consistent with transparency and consumer protection.
• Entry: new banks can form, but founders and executives must be carefully screened first.
• Exit: insurance companies can go out of business, but only after making adequate provision to fulfill promises to policyholders.

🏦 Ensuring financial system soundness

Three tools are mentioned:

1. Lender of last resort: a backstop to provide liquidity in crises.
2. Deposit insurance: protects depositors if a bank fails (mandated by regulators like the FDIC).
3. Limiting competition: restrictions on entry and interest rates.

Don't confuse: the first two tools (lender of last resort and deposit insurance) are "generally not controversial," but many believe the lender of last resort should not be combined with a too big to fail (TBTF) policy.

⚖️ Controversy over limiting competition

⚖️ Why it's controversial

• Limiting competition is a highly controversial means of ensuring safety.
• It extends privileges to existing institutions over new ones.
• The excerpt notes: "Little surprise, then, that the regulated companies themselves are often the strongest supporters of that type of regulation!"
• In other words, incumbents benefit from rules that make it harder for new competitors to enter.

📉 Historical example: interest-rate caps

The excerpt provides a "Stop and Think Box" case:

• For decades, the Federal Reserve capped interest rates banks could pay:
  • Zero on checking deposits.
  • Around 6 percent per year on time or savings deposits.
• Intended effect: limit competition among banks, allowing them to be profitable without assuming too much risk.
• Why existing banks didn't lobby for repeal until the 1970s: they were happy with relatively riskless profits.
• What changed: the Great Inflation of the 1970s pushed inflation above the legal interest-rate caps.
• Result: disintermediation—many people pulled money out of banks and invested directly in markets (money market funds, stock and bond mutual funds).

Don't confuse: this example shows that a policy designed to ensure stability can backfire when economic conditions (like high inflation) change.

🔑 Key takeaways from the excerpt

The excerpt concludes with two summary points:

1. What regulators attempt: maximize macroeconomic stability and transparency; minimize investor risk and loss.
2. The reality: the policies they implement to achieve these goals can be controversial and are not always effective.

🧭 Overview

🧠 One-sentence thesis

Money is perhaps the most important invention of all time because it acts as a force multiplier that facilitates trade by eliminating barter's inefficiencies—the double coincidence of wants and the pricing problem—thereby making humanity happier through easier exchange.

📌 Key points (3–5)

• Why money matters: Money is a force multiplier that allows users to complete much more work (trade) in a given time than barter permits, making trade—the defining human activity—vastly more efficient.
• Barter's two fatal flaws: (1) the double coincidence of wants (both parties must have what the other desires) and (2) the pricing explosion (number of prices equals the number of pairs of goods, not just the number of goods).
• Money's four economic functions: medium of exchange, unit of account, store of value, and standard of deferred payment.
• Common confusion—medium of exchange vs. unit of account: Medium of exchange solves the double coincidence problem (what to trade); unit of account solves the pricing problem (how to measure value). Both are necessary for money to work effectively.
• Historical evidence: When money disappears or fails (hyperinflation, shortages), economies revert to barter briefly, then quickly reinvent or restore money because barter is so inefficient.

💡 Why money is a force multiplier

💡 Money as humanity's defining tool

Money is, perhaps, the most important invention of all time.

• Money belongs alongside other major inventions: the wheel, the hearth (fire control), the atlatl (spear thrower), indoor plumbing, and engines.
• All these inventions are force multipliers: they let users accomplish much more work in the same time than non-users.
  • The wheel moves more stuff.
  • The hearth prepares more food.
  • The atlatl kills more prey.
  • Money facilitates more trade.

🤝 Trade makes us human

• No other animal trades with non-relatives of the same species; trade is uniquely human.
• Trade may explain why humans have relatively large brains and small digestive tracts.
• Trade explains humanity's material comfort advantage over all other species.
• Each fair trade enriches both parties: buyers get consumer surplus, sellers get producer surplus.
• By making trading easy, money increases human happiness overall.
• Don't confuse: this does not claim wealth makes people happy; money is a special form of wealth, not synonymous with it.

🚫 The inefficiencies of barter

🚫 What barter is

Barter: the exchange of one non-money good for another.

• Examples from the excerpt: trading baseball cards, clothes, beers, phone numbers, homework assignments.
• The excerpt provides a real Craigslist example: someone offering a desk lamp, a book, a photo album, a bouncy ball, sunglasses, and a tribal mask, asking for "any fair offer."
  • The problem: what counts as "fair"? A lava lamp and a poster? A ball of yarn as change?
  • This illustrates barter's impracticality in modern economies.

🔄 Problem 1: The double coincidence of wants

• What it means: Party one must have what party two desires, and party two must have what party one desires.
• Example from the excerpt: You want to fill your car's gas tank without money. You must find something the gas station attendant desires—this could take a very long time, possibly forever.
• Money as a medium of exchange eliminates this problem: the attendant accepts money not for its own sake but to trade it away later for something they want.

🔢 Problem 2: The pricing explosion

• In a money economy: number of prices = number of goods (each good has one money price).
• In a barter economy: number of prices = number of pairs of goods.
• The excerpt's calculation:
  • An economy with 1,000 goods (already very poor) requires 499,500 different prices under barter.
  • Barter economies typically produce only about 10 tradable goods, requiring about 45 prices (each good paired with 9 others).
• Money as a unit of account solves this: it provides a single measuring rod of economic value, reducing prices ideally to one per good.

🧩 How money solves both problems

Barter problem	Money's solution	How it works
Double coincidence of wants	Medium of exchange	People accept money not for itself but to trade it away; no need to find someone who wants exactly what you have
Pricing explosion	Unit of account	Money provides one measuring rod for value; each good needs only one price (in money terms) instead of a price for every possible pairing

• The excerpt emphasizes: to be an effective force multiplier, money must eliminate both deficiencies.

🛠️ The four functions of money

🛠️ Overview of the functions

The excerpt identifies four types of work money performs:

1. Medium of exchange
2. Unit of account
3. Store of value
4. Standard of deferred payment

💸 Medium of exchange

Medium of exchange: something that people acquire not for its own sake but to trade away to another person for something of use.

• This is the physical means of payment.
• It solves the double coincidence of wants.
• Examples from the gas station dialogue:
  • Cash: physical currency like Federal Reserve notes or Treasury coins.
  • Check: a paper order for transfer of money from a bank account.
  • Debit: an electronic order for transfer from a bank account or prepaid card.
  • Credit: prearranged transfer from a lender (bank) in exchange for a service fee and the customer's promise to repay.
• Don't confuse: credit cards and loans are not money per se; they are ways of obtaining money.

📏 Unit of account

Unit of account: a measuring rod of economic value; a way of reckoning value.

• This function is more abstract than medium of exchange but equally important.
• It answers the question "How much is that worth?" just as inches answer "How long?" and degrees answer "What temperature?"
• It allows easy comparison of unlike things (apples and oranges, literally and figuratively).
• Example from the gas station dialogue: when the customer asks "How much for a gallon of gasoline?" and the attendant replies "$2.99," money is working as a unit of account—it encapsulates value information quickly.

🏦 Store of value

Store of value: money can store purchasing power over time.

• This means you can hold money today and use it to buy things later.
• Not unique to money: real estate, financial securities, precious metals, and gems also store value.
• The excerpt notes: "Storing value, therefore, is not exclusively a trait of money."
• Example from the Russian ruble case (Stop and Think Box): physical U.S. dollar assets were a good store of value because they could purchase more rubles each day during hyperinflation.

📅 Standard of deferred payment

Standard of deferred payment: money can be used to denominate a debt, an obligation to make a payment in the future.

• This allows contracts and loans to specify repayment amounts.
• Example from the gas station dialogue: when a customer uses credit, they promise to repay the lender the value of the gas at some future point—money is working as a standard of deferred payment.

🔍 Distinguishing the functions in practice

The gas station dialogue illustrates all functions:

Dialogue moment	Function at work	Label in excerpt
"How much for a gallon of gasoline?"	Unit of account	(A)
"$2.99"	Unit of account	(A)
"Great, fill 'er up."	Unit of account (decision based on value comparison)	(A)
"Cash, check, debit, or credit?"	Medium of exchange	(E) for cash/check/debit; (D) for credit
Credit transaction (promise to repay)	Standard of deferred payment	(D)

• The excerpt notes that such conversations rarely occur today because automation (gas pumps handling payments) has made transactions even more efficient—saving humanity untold hours over trillions of exchanges each year.

🌍 What happens when money fails

🌍 Historical evidence: Germany after World War I

• The German government created too much money too quickly, causing hyperinflation (very rapid rise in all prices).
• Workers demanded payment twice daily so they could buy food before wages became worthless.
• Before hyperinflation: "a wheelbarrow full of food with a purse full of cash."
• During hyperinflation: "a wheelbarrow full of cash to purchase a purse full of food."
• At the end: people kept wheelbarrows at home to prevent theft of their most valuable asset—the wheelbarrow itself.
• The economy reverted to barter, but only briefly before currency reforms restored a money economy.

🌍 Argentina's peso crisis (2001–2002)

From the Stop and Think Box:

• Argentina faced a severe shortage of pesos.
• Private firms set up giant flea markets using their own notes called creditós.
• Creditós were priced and used as payment within each firm's flea markets but had very limited circulation outside.
• They could not be used in markets run by other firms.
• As soon as the peso crisis passed, firms stopped honoring creditós.

What this shows:

• A new form of private credit money spontaneously arose to fill the vacuum.
• Creditós were not as liquid or safe as pesos but far superior to barter.
• The end-game default represents seigniorage: the profit issuers extracted for providing money to communities.

🌍 Russia after the Soviet Union

From another Stop and Think Box:

• Inflation caused the ruble to lose value rapidly each day.
• Rubles remained a medium of exchange.
• But prices and debts began to be denominated in "bucks" (essentially U.S. dollars).
• Bucks served as a unit of account and standard of deferred payment—a stable way to reckon value.
• Physical U.S. dollar assets were both a medium of exchange and a good store of value (purchasing more rubles each day).

🌍 Prisons and POW camps

• The excerpt mentions (but does not detail) that in settings where money is unavailable, inmates quickly learn barter's inadequacies.
• They adopt the best available commodity as money.
• This pattern reinforces that humans naturally reinvent money when it disappears because barter is so inefficient.

🎯 Key takeaways from the excerpt

🎯 Summary of barter's problems

• Double coincidence of wants: both parties must have what the other desires.
• Pricing explosion: number of prices equals the number of possible pairs of goods, not the number of goods.
• These make barter extremely inefficient and limit economies to producing very few tradable goods.

🎯 Summary of money's solutions

Money is anything that reduces the transaction costs of barter, anything that is commonly accepted as payment or in exchange.

• Medium of exchange: physical means of payment; eliminates double coincidence problem.
• Unit of account: measure of economic value; reduces number of prices.
• Store of value: method of storing purchasing power over time (not unique to money).
• Standard of deferred payment: basis for repaying debts.

🎯 Why money is indispensable

• Trade is the defining human activity; each fair trade enriches both parties.
• Money makes trade vastly easier, saving enormous amounts of time.
• When money fails or disappears, economies suffer universal distress and quickly revert to or reinvent money.
• The excerpt concludes: money's importance is demonstrated by what happens in its absence—brief chaos, then rapid restoration or reinvention.

🧭 Overview

🧠 One-sentence thesis

When money becomes unavailable or worthless in an economy, people quickly experience the inefficiencies of barter and either reinvent money or adopt substitute forms, demonstrating money's fundamental importance to economic activity.

📌 Key points (3–5)

• What happens without money: economies revert to barter, causing universal distress, but money is quickly reintroduced or reinvented.
• Historical evidence: hyperinflation in post-WWI Germany and the 2001–2002 Argentine peso shortage both led to temporary barter or substitute money systems.
• Commodity money in constrained settings: in prisons and POW camps, inmates spontaneously adopt commodities like cigarettes as money because they best satisfy key monetary properties.
• What makes good commodity money: ease of authentication, uniformity, divisibility, durability, portability, and elasticity of supply.
• Common confusion: not all commodities work as money—hay fails because it's too easy to adulterate, has low portability, and lacks durability; tobacco and cigarettes succeed because they score better on the key properties.

💥 When money disappears

💥 Post-WWI German hyperinflation

• The German government created too much money too quickly after World War I.
• Hyperinflation ensued: a very rapid rise in the prices of all goods.
• Prices increased so fast that workers demanded payment twice daily and ran to stores to buy food before their wages became worthless.
• Before: a purse full of cash bought a wheelbarrow full of food.
• During: a wheelbarrow full of cash bought only a purse full of food.
• At the end: people kept wheelbarrows at home because the wheelbarrow itself became more valuable than the cash.
• The economy reverted to barter, but only briefly—currency reforms stopped inflation and restored a money economy.

💥 Argentine peso shortage (2001–2002)

• Argentina faced a severe shortage of its currency, the peso.
• Private firms responded by setting up giant flea markets where goods were priced and paid for using the firm's own notes, called creditós.
• Creditós could be used in subsequent flea markets run by the issuing firm but not in markets run by other firms—they had very limited circulation outside the flea markets.
• As soon as the peso crisis passed, firms stopped running flea markets and no longer honored the creditós they had issued.
• What happened: a new form of private credit money spontaneously arose to fill the vacuum created by the lack of pesos.
• Although not as liquid or safe as pesos, creditós were far superior to barter.
• The end-game default can be interpreted as seigniorage: the profit the issuers of creditós exacted for providing money to local Argentine communities.

🚬 Commodity money in prisons and POW camps

🚬 Why cigarettes emerge as money

In prisons, prisoner-of-war camps, and other settings where money is unavailable, inmates quickly learn the inadequacies of barter and adopt the best available commodity as money.

Commodity money: a physical good that serves as a medium of exchange, unit of account, store of value, and (to a limited extent) standard of deferred payment.

Packs of cigarettes often emerge as the commodity money of choice for good economic reasons:

✅ Ease of authentication

• Sealed packs of cigarettes are easily authenticated because it would be extremely difficult to counterfeit or adulterate them, especially under prison conditions.
• Example: if you gave up a bar of soap for two packs, you could rest relatively well assured that you were not being cheated.

✅ Uniformity and divisibility

• Cigarettes are relatively uniform in quality, though they differ somewhat from brand to brand.
• Cigarette packs are divisible into twenty individual cigarettes, or "loosies," without giving up much ease of authentication.
• A loosie is easier to adulterate than a sealed pack (e.g., by replacing tobacco with sawdust) but is still not easy to fake.
• Why divisibility matters: supply and demand might dictate an equilibrium price that includes a fraction of a pack, just as prices are often a fraction of a dollar, yen, euro, or pound.
• Individual cigarettes are also somewhat divisible when filterless or when consumed.
• Example: one might sell a good blanket for four packs, two loosies, and five drags or puffs.

✅ Portability and durability

• Cigarettes have relatively high value-to-weight and value-to-bulk ratios—they are relatively valuable given their size and weight.
• Portability is important to their function as a medium of exchange.
• Although they eventually go stale and can be ruined if smashed or drenched in water, sealed cigarette packs are durable enough to serve as an intermediate-term store of value.

⚠️ Elasticity of supply problem

• The elasticity of the supply of cigarette packs is volatile because smokers find it difficult to quit smoking, no matter the price, and the quantity of packs in circulation depends on shipments from the outside world.
• In modern prisons, this is less of a problem.
• In POW camps, sudden gluts caused the prices of goods (noncigarettes) to soar—that is, the value of cigarettes plummeted—only to be followed by long periods of deflation (lower prices for noncigarettes) as the supply of cigarettes dried up and each cigarette gained in purchasing power.

🏛️ Historical commodity money

🏛️ What has served as money

Much stranger commodities than cigarettes have served as money over the ages, and for the most part served well.

Various types have been used at one time and place or another:

• Live animals
• Parts of dead animals
• Grains
• Metals
• Rocks
• Shells (e.g., cowrie money from early China)

🏛️ Why certain commodities succeed or fail

Early societies used available commodities that had the best combination of:

• Ease of authentication
• Uniformity
• Divisibility
• Durability
• Portability
• Elasticity of supply

Commodity	Why it fails or succeeds
Hay	Fails: too easy to adulterate with weeds; low value-to-bulk renders portability very low due to trouble and expense of transporting it; a rainstorm can ruin it until properly baled and stored.
Tobacco	Succeeds: more uniform, durable, portable, and easily authenticated than hay. In colonial Virginia, tobacco served as a commodity money.

Don't confuse: not every available commodity becomes money—only those that score well on the key properties listed above.

🔑 Key takeaways

🔑 What the excerpt concludes

• Where money is absent, an available commodity with the best combination of ease of authentication, uniformity, divisibility, durability, portability, and elasticity of supply may emerge as money.
• In other instances, as in Argentina, private credit money may emerge.
• The historical pattern: when money disappears or becomes worthless, people experience universal distress, then quickly reintroduce or reinvent money—demonstrating that money is indispensable to economic efficiency.

🧭 Overview

🧠 One-sentence thesis

Historically, societies used commodities with the best combination of authentication ease, uniformity, divisibility, durability, portability, and elasticity of supply as money, and modern fiat money succeeds for the same reason historical commodity money did—because people accept it in exchange.

📌 Key points (3–5)

• What makes a good medium of exchange: six key characteristics—ease of authentication, uniformity, divisibility, durability, portability, and elasticity of supply.
• Why strange commodities worked: items like shells, tobacco, and even cigarettes served well when they had the right combination of these six traits.
• Gold's trade-off: gold is uniform, divisible, portable, and durable, but its supply is too inelastic (rare), which is a shortcoming.
• Common confusion: people wonder why "useless" items like shells were money, yet modern paper money (Federal Reserve notes) also has nearly zero use value—both work because they are commonly accepted in exchange.
• Legal tender vs acceptance: declaring something legal tender may help, but simply knowing it is readily accepted works just as well.

💰 The six characteristics of good money

🔍 Ease of authentication

The ability to verify that the money is genuine and not counterfeit or adulterated.

• If a commodity is hard to authenticate, it won't circulate well.
• Example: Diamonds and rare gems seldom become money because they require expensive specialized training and equipment to value properly.
• Contrast: Gold is an element (Au, atomic number 79) and is perfectly uniform in pure form, making it easier to authenticate despite some adulteration risks (clipping, sweating, mixing with cheaper metals).

🟰 Uniformity

Consistency in quality from unit to unit.

• Uniformity reduces disputes and uncertainty in exchange.
• Example: Hay rarely emerges as money because it is too easy to adulterate with weeds, making quality inconsistent.
• Tobacco, by contrast, is more uniform and thus served as commodity money in colonial Virginia.

✂️ Divisibility

The ability to break the money into smaller units without losing much authentication ease.

• Divisibility matters because supply and demand often dictate equilibrium prices that include fractions.
• Example: Cigarette packs divide into twenty individual cigarettes ("loosies"), and loosies are somewhat divisible (e.g., "five drags or puffs"), though a loosie is easier to adulterate than a sealed pack.
• Gold is easily divisible into smaller amounts.

🛡️ Durability

The ability to withstand physical wear and environmental damage over time.

• Durability allows money to serve as a store of value.
• Example: Sealed cigarette packs are durable enough for intermediate-term storage, though they eventually go stale and can be ruined if smashed or drenched.
• Hay is less durable—a rainstorm can ruin it unless properly baled and stored.
• Gold is quite durable, though soft for a metal.

🎒 Portability

High value-to-weight and value-to-bulk ratios, making the money easy to carry and transport.

• Portability is important for a medium of exchange.
• Example: Cigarettes have relatively high value-to-weight and value-to-bulk ratios.
• Hay has very low portability due to its low value-to-bulk ratio and the trouble and expense of transporting it.
• Gold is relatively highly portable for a commodity.

📊 Elasticity of supply

How responsive the supply of money is to changes in demand.

• Money must be scarce (free goods like air and water won't work), but need not be rare—in fact, the best forms of money are not rare.
• Too much rarity (low elasticity) is a shortcoming.
• Example: Gold's elasticity of supply is traditionally quite low due to its rarity, which is its biggest weakness.
• Example: In POW camps, cigarette supply was volatile—sudden gluts caused prices of noncigarettes to soar (cigarettes lost value), followed by long deflation periods as supply dried up and each cigarette gained purchasing power.

Don't confuse: Scarcity (opportunity cost > zero) vs rarity (extremely limited supply). Money should be scarce enough that it can't be freely obtained, but not so rare that supply can't adjust to demand.

🏛️ Historical examples of commodity money

🐚 Strange commodities that worked

• Over the ages, live animals, parts of dead animals, grains, metals, rocks, and shells have all served as money.
• These items worked because early societies used available commodities with the best combination of the six characteristics.
• Example: Cowrie shells (from early China) had the right traits for their context.

🚬 Tobacco as representative money

• In colonial Virginia, tobacco itself was commodity money.
• It was then turned into representative money:
  • Trustworthy inspectors attested to tobacco's quality.
  • They stored it in safe warehouses.
  • They issued paper receipts for it.
• The receipts, rather than the tobacco itself, served as the medium of exchange because they were extremely uniform, durable, divisible, portable, and easily authenticated.

Representative money: paper receipts backed by a stored commodity, circulating in place of the commodity itself.

🥇 Gold's strengths and weaknesses

Characteristic	Gold's performance
Uniformity	Perfectly uniform in pure form (element Au)
Divisibility	Easily divisible
Portability	Relatively highly portable for a commodity
Durability	Quite durable, though soft for a metal
Authentication	Relatively easy ways exist to authenticate bullion and coin forms, despite adulteration risks
Elasticity of supply	Biggest shortcoming: traditionally quite low due to rarity

• Gold can be adulterated (mixed with cheaper metals, clipped, sweated), but authentication methods exist.
• The excerpt emphasizes that gold is not necessarily the best type of money because its supply is relatively inelastic.

💵 Modern fiat money and the acceptance principle

💵 Federal Reserve notes: low use value, high acceptance

• Students often wonder why people used "useless" items like shells as money.
• Yet modern people carry Federal Reserve notes (U.S. paper money) whose use value is nearly nil.
• These notes are fiat money with legal tender status: the face says "legal tender for all debts, public and private," meaning it is illegal to refuse them.

🔄 Why acceptance matters more than legal tender

• Many economists define money as anything commonly accepted in exchange.
• People accept Federal Reserve notes today for the same reason people in the past accepted clamshells or beads: they know they can turn around and successfully exchange them for goods.
• Legal tender status may help a medium of exchange circulate, but simply knowing that something is readily accepted in exchange can work just as well.

Don't confuse: Legal tender laws vs actual acceptance. Historical example: During the American Revolution, Congress declared Continental dollars legal tender, but they soon lost almost all value, giving rise to the expression "Not worth a Continental." Other examples of tender clause failures abound.

🧠 The core insight

• Whether commodity money (gold, tobacco, shells) or fiat money (paper notes), what matters is common acceptance in exchange.
• The six characteristics help ensure acceptance, but ultimately money is what people believe they can exchange for goods.

📋 Summary comparison

Type of money	Example	Key advantage	Key risk
Commodity money	Gold, tobacco, shells, cigarettes	Self-equilibrating (opportunity cost > 0 limits supply naturally)	May have poor elasticity of supply (too rare) or other trait weaknesses
Representative money	Tobacco receipts in colonial Virginia	Combines commodity backing with superior portability and uniformity	Depends on trust in inspectors and warehouses
Fiat money	Federal Reserve notes	Can adjust supply more flexibly	Subject to whims of politicians and bureaucrats, not self-equilibrating

Key takeaway from the excerpt: Commodity monies are self-equilibrating because their opportunity cost limits overproduction, but government fiat monies are not self-equilibrating and may be subject to political forces rather than supply and demand.

🧭 Overview

🧠 One-sentence thesis

Commodity monies self-equilibrate through market forces because their production costs naturally limit supply, whereas credit and representative monies offer superior efficiency as media of exchange but lack automatic supply adjustment and carry default risk.

📌 Key points (3–5)

• Self-equilibration of commodity money: opportunity costs of production naturally stop money creation when it becomes equally profitable to produce other goods, automatically adjusting supply to demand.
• How commodity systems adjust: price changes trigger production shifts—if money becomes easier to find, prices rise until equilibrium is restored; if harder, prices fall.
• Credit money's efficiency advantage: deposits and banknotes are nearly perfect media of exchange (easily authenticated, uniform, divisible, portable, durable, elastic supply) but introduce default risk.
• Common confusion: gold vs. credit money—gold self-regulates but supply is inelastic (slow to adjust), while credit money is highly elastic but requires management and regulation.
• Fractional reserve banking: banks increased gold's effective supply by issuing notes and deposits backed by only partial gold reserves, earning seigniorage on the difference.

🔄 How commodity money self-equilibrates

🔄 The natural stopping point

Commodity monies are self-equilibrating because commodities are scarce and their opportunity costs of acquisition and production are greater than zero.

• At some point, producing non-monetary goods becomes just as profitable as producing money directly.
• Money creation naturally ceases until more is needed.
• This happens automatically through market forces, not government intervention.

🦪 The clam money example

The excerpt provides a detailed scenario:

• Setup: 10 clams can be found in 1 hour; a bow takes 2 hours; an arrow takes 1 hour; a rabbit takes 3 hours.
• Equilibrium prices: arrow = 10 clams, bow = 20 clams, rabbit = 30 clams.
• Why these prices: at these rates, people are indifferent between spending 6 hours collecting clams (60 total), making arrows (60 total), making bows (3 bows × 20 = 60), or hunting rabbits (2 rabbits × 30 = 60).
• Automatic adjustment: if a clambake removes clams from circulation, harvesting clams becomes more profitable than other activities until supply is restored.

Example: If people expect the clambake in advance, the adjustment might be instantaneous—they harvest extra clams beforehand.

⚖️ Adjusting to structural changes

The system automatically responds to changes in production conditions:

Change	What happens	Result
Clams become easier to find (20/hour instead of 10/hour)	Everyone harvests clams	Prices double until equilibrium is restored
Clams become harder to find (5/hour instead of 10/hour)	No one harvests clams (other goods pay better)	Prices drop by half
Bows become easier to make (1.5 hours instead of 2)	Only bow price changes	Bow price drops to 15 clams; other prices unchanged

Don't confuse: a change in money production affects all prices (the price level), but a change in one good's production affects only that good's relative price.

🥇 Why gold failed as commodity money

🥇 Gold's inelasticity problem

• Gold is a very good commodity money in most respects (the excerpt references earlier discussion).
• It fell from grace in the early twentieth century primarily due to competition from superior exchange media and inelastic supply.
• Unlike the clam example, gold production could not quickly adjust to changes in demand.

📉 Prolonged deflation

When gold quantity remained constant but output increased:

• Not enough gold existed to maintain former prices.
• The price level declined (deflation).
• Each ounce of gold became more valuable, able to purchase more goods and services.
• The problem: due to difficulty finding new gold veins, changes in the price level were often prolonged rather than quickly corrected.

The excerpt notes that during the 1930s deep economic troubles, many countries (including the United States) experiencing prolonged deflations abandoned gold in favor of more elastic credit and fiat monies.

🏦 The invention of credit money

🏦 From goldsmiths to proto-bankers

The excerpt traces the evolution:

• By the late seventeenth century, goldsmiths safeguarded gold for customers and issued receipts to depositors.
• Like tobacco receipts, gold receipts could be returned to the issuing goldsmith for gold.
• People preferred holding receipts rather than gold itself—more portable and easily authenticated.
• The receipts began to circulate as a medium of exchange (representative money).

💡 The key discovery

Credit money was born when the goldsmiths, now proto-bankers, discovered that due to the public's strong preference for the receipts, they could issue notes to a greater value than the gold they had on physical deposit.

• This is the foundation of fractional reserve banking.
• By the eighteenth century, banks in Great Britain, the United States, and a few other places increased the elasticity of gold supply through this practice.

📊 How fractional reserve banking works

The excerpt provides a sample bank balance sheet:

Assets:

• Gold: 200
• Public securities: 100
• Loans: 600
• Office and real estate: 100

Liabilities:

• Notes: 400
• Deposits: 500
• Equity: 100

Key insight: Because most people preferred to hold notes and deposits instead of gold, the bank could hold only a small reserve of gold (200) to pay holders of its demand liabilities (notes and deposits = 900 total).

• Only 200 in gold did the work of 900 in circulating money.
• Banks earned seigniorage (profit from the issuance of money) on the difference.
• Bankers made gold less rare and gained control over its elasticity via the reserve ratio (reserves/monetary liabilities = 200/900).
• Bankers could change the ratio as they saw fit, thereby changing the money supply (the total quantity of money in the economy).

Don't confuse: the money supply is not just physical gold; it includes notes and deposits backed by fractional reserves.

✅ Advantages of credit money

✅ Nearly perfect medium of exchange

Credit money has been extremely successful because it is an almost perfect medium of exchange.

Bank deposits are:

• Easily authenticated: just an accounting entry crediting money to a person or organization.
• Perfectly uniform: standardized accounting.
• Divisible to fractions of a penny: no physical constraints.
• Highly portable: via written or electronic orders.
• Extremely durable: accounting entries don't wear out.
• Elastic supply: can be created and destroyed at will.

🔀 Variety of deposit types

The usefulness of deposits is extended by varying characteristics to meet different preferences:

Type	Interest	Withdrawal
Checking/transaction/demand deposit	No or low interest	Anytime via teller, ATM, debit card, or check
Time/savings deposits, certificates of deposit	Relatively high interest	Cannot withdraw before date, or penalty wipes out interest
Hybrids (ATS, sweep accounts, money market mutual funds)	Between the two extremes	Between the two extremes

Most forms of electronic or e-money are just new forms of credit money.

⚠️ The default risk problem

⚠️ Credit money's main weakness

The biggest problem with credit money is that the issuer may default.

• Many banking regulations (referenced in Chapter 11) attempt to minimize this risk.
• Other issuers of credit money are not so closely regulated and constitute serious credit risks for holders of their liabilities.

🏘️ Community currency example (Ithaca Hours)

The excerpt provides a "Stop and Think Box" case:

• In Ithaca, New York, and hundreds of other communities, consortia of businesses issue zero-interest bearer paper notes.
• Denominated in local units (Hours in Ithaca; other names elsewhere).
• Designed to circulate as cash, like Federal Reserve notes.
• In the U.S., the issuer must redeem notes for dollars on demand at a fixed conversion rate (each Ithaca Hour = 10 USD).
• Not legal tender, no intrinsic value, circulate in extremely limited geographical area.

What is really going on:

• Issuers earn seigniorage by issuing Hours in exchange for dollars, which they put out to interest.
• They don't earn much because most people realize this credit money is less liquid and more risky than bank deposits or Federal Reserve Notes.
• No good reason to hold such notes unless one believes the accompanying rhetoric.

Don't confuse: community currencies with bank deposits—the former have much higher default risk and lower liquidity.

📝 Key takeaways from the excerpt

📝 Comparison summary

The excerpt's "Key Takeaways" section states:

Representative money and credit money are more efficient than commodity money because they are superior media of exchange and units of account. Their quality is more uniform and easily ascertained, they have low weight-to-value ratios, they are more divisible and their divisibility is more flexible, and their supply is more elastic.

However, the supply of representative and credit monies generally does not self-equilibrate the way the supply of a commodity money does.

💰 Seigniorage explained

The excerpt provides a footnote defining seigniorage:

• Earned by the positive spread between return on assets and the cost of monetary liabilities.
• Example: the Federal Reserve pays no interest on its notes or deposits but earns interest on Treasury securities and other assets bought with those notes and deposits.
• Another way: mint coins with higher face value than production cost.
• Historically, debasing the coinage (increasing nominal value of a given sum of gold or silver) was highly profitable and "a favorite sport of kings."

🧭 Overview

🧠 One-sentence thesis

Measuring the money supply is complex and requires multiple monetary aggregates because different types of credit money vary in liquidity, and accurate measurement is crucial for determining macroeconomic variables like inflation, unemployment, and interest rates.

📌 Key points (3–5)

• Why measurement is difficult: the profusion of different types of credit money makes measuring the money supply no easy task today.
• Multiple aggregates exist: the Fed developed several monetary aggregates (MB/M0, M1, M2, M3) because their movements are not highly correlated and the appropriate measure varies over time and question.
• What each aggregate includes: narrower aggregates (MB) include only currency and reserves, while broader ones (M2, M3) add various deposit and fund types.
• Common confusion: published data are mere estimates—the Fed often revises figures by as much as 2 or 3 percent, so the numbers are not final or perfectly accurate.
• Why it matters: the money supply helps determine important macroeconomic variables like inflation, unemployment, and interest rates.

💰 What the money supply is

💰 Definition and importance

The money supply: the stock of all money in an economy.

• It is not a single number but a concept measured in multiple ways.
• The excerpt emphasizes that accurate measurement is "so important that monetary economists still search for better ways of doing it."
• Why it matters: the money supply helps determine macroeconomic variables including inflation, unemployment, and interest rates.

📊 The monetary aggregates

📊 Monetary base (MB or M0)

• What it includes: the narrowest aggregate; the unweighted total of Federal Reserve notes and Treasury coins in circulation, plus bank reserves (deposits with the Federal Reserve).
• This is the most basic measure, focusing only on physical currency and reserves.

💵 M1

• What it includes: M0 plus travelers' checks and demand deposits.
• Additional note: banks other than the Fed no longer issue notes; if they did, those notes would be considered components of M1.
• M1 adds the most liquid forms of credit money to the monetary base.

🏦 M2

• What it includes: M1 plus time/savings deposits and retail money market mutual fund shares.
• This is a broader aggregate that captures less-liquid forms of money that people can still access relatively easily.

🌐 M3 (discontinued)

• What it included: M2 plus institutional time deposits, money market mutual fund shares, repurchase agreements, and Eurodollars.
• Status: publication was discontinued by the Fed in 2006.
• The Fed continues to estimate the other three measures (MB, M1, M2) because their movements are not highly correlated.

🔬 Alternative measurement approaches

🔬 Divisia method

Divisia: an approach named after its French inventor, François Divisia (1925), that weighs credit instruments by their liquidity, or in other words, their degree of money-ness, or ease of use as a medium of exchange.

• Unlike the unweighted aggregates, divisia formulas weight different instruments by how easily they function as money.
• Example: the Federal Reserve Bank of Saint Louis tracks the U.S. money supply using various divisia formulas.
• This method recognizes that not all components of the money supply are equally "money-like."

📈 How to access and interpret the data

📈 Where to find the data

• Wall Street Journal: publishes M1 and M2 monetary aggregates each Friday in its "Federal Reserve Data" column.
• Federal Reserve website: data is available at http://www.federalreserve.gov/releases/h6/.
• Other countries: links to other central banks' websites (which also report their monetary aggregates) can be found at http://www.bis.org/cbanks.htm.

⚠️ Data limitations

• Don't confuse published figures with final truth: the excerpt cautions that "the published data are mere estimates."
• The Fed often revises the figures by as much as 2 or 3 percent.
• This means the numbers you see are approximations, not precise measurements, and may change after publication.

🎯 Why multiple aggregates are needed

🎯 Movements are not correlated

• The excerpt states that the Fed continues to estimate MB, M1, and M2 "because their movements are not highly correlated."
• This means the different aggregates can move in different directions or by different amounts at the same time.

🎯 Appropriate measure varies

• "The appropriate monetary aggregate varies over time and question."
• Different policy questions or economic conditions may require looking at different aggregates.
• Example: for some analyses, the narrowest measure (MB) might be most relevant; for others, a broader measure (M2) might be better.

Aggregate	What it includes	Breadth
MB (M0)	Currency in circulation + bank reserves	Narrowest
M1	M0 + travelers' checks + demand deposits	Narrow
M2	M1 + time/savings deposits + retail money market fund shares	Broader
M3	M2 + institutional deposits + other instruments	Broadest (discontinued 2006)

🧭 Overview

🧠 One-sentence thesis

Interest rates—the opportunity cost of money—determine asset prices and macroeconomic conditions like economic growth and employment, making them crucial to understand for both financial decisions and career prospects.

📌 Key points (3–5)

• What interest is: the payment needed to induce a lender to part with money for a period of time, expressed as an annual percentage rate.
• Why interest matters: it determines prices of financial assets (stocks, bonds) and macroeconomic variables like economic growth and hiring.
• Present vs future value: money today is always worth more than money tomorrow; present value (PV) discounts future payments, future value (FV) compounds present investments.
• Common confusion: the relationship between interest rates and bond prices—they move inversely (higher rates → lower bond prices).
• Compounding frequency: more frequent compounding (monthly vs annually) increases the value of an investment, even at the same stated interest rate.

💰 What interest is and why it matters

💰 Definition of interest

Interest: the opportunity cost of money; the payment it takes to induce a lender to part with money for some period of time.

• Interest rates are the price of borrowing money.
• Almost always expressed as an annual percentage rate: dollars paid for the use of $100 per year.
• The excerpt emphasizes yield to maturity as the method economists prefer for accuracy.

🌍 Why interest is important

Interest rates are crucial determinants of:

• Asset prices, especially financial instruments like stocks and bonds.
• Macroeconomic conditions, including economic growth.
• Employment prospects: low rates → businesses borrow more → expand production → hire more; high rates → less expansion → fewer jobs.

Example: If rates are low when you graduate, businesses are more likely to borrow, expand, and hire you. If rates are high, you may be forced to move back home.

⏳ Present value and future value fundamentals

⏳ Why money today is worth more than money tomorrow

• Core principle: money today is always worth more than money tomorrow.
• Reason: you would be foolish to forgo consumption (food, clothes, housing, entertainment) for a year with no compensation.
• Another reason mentioned: in modern economies, prices tend to rise every year (inflation), so $100 tomorrow buys fewer goods than $100 today.

Don't confuse: The excerpt focuses on nominal interest rates for now, not real interest rates (which account for inflation).

📐 The future value formula

FV = PV × (1 + i)ⁿ

Where:

• FV = future value (value of your investment in the future)
• PV = present value (amount invested today)
• i = interest rate (as a decimal: 6% = 0.06, 25% = 0.25)
• n = number of periods (years, months, days, quarters)
• (1 + i)ⁿ = future value factor

What it answers: How much will $x invested today be worth at time y in the future?

Example: $100 at 10% compounded annually:

• After 1 year: $100 × 1.1 = $110
• After 2 years: $110 × 1.1 = $121
• After 3 years: $121 × 1.1 = $131.10
• After 100 years: $100 × (1.1)¹⁰⁰ = $1,378,061

📉 The present value formula

PV = FV / (1 + i)ⁿ

What it answers: How much would you pay today for $x payable at time y in the future?

• You must discount (reduce) a future value to find its present value.
• This is the opposite of compounding—you divide instead of multiply.

Example: What would you pay today for $1,000 payable in 5 years?

• At 5% interest: PV = 1000 / (1.05)⁵ = $783.53
• At 20% interest: PV = 1000 / (1.2)⁵ = $401.88
• At 1% interest: PV = 1000 / (1.01)⁵ = $951.47

🔄 The inverse relationship between interest rates and bond prices

Key insight: As interest rates rise, bond prices fall; as interest rates fall, bond prices rise.

• Algebraically: the interest rate (i) is in the denominator of the PV formula, so as i gets larger, PV must get smaller (holding FV constant).
• Economically: higher interest rates mean higher opportunity cost for money, so a future payment is worth less today when money is more expensive.

Example: $1,000 payable in 5 years:

• At 1% interest: worth $951.47 today
• At 5% interest: worth $783.53 today
• At 20% interest: worth only $401.88 today

Don't confuse: This is about the price of existing bonds changing when market interest rates change, not about the stated interest rate on the bond itself.

⏰ Time and present value

Holding interest rates constant, a payment further in the future is worth less today.

Example: $1,000 at 1% interest:

• Payable in 5 years: PV = $951.47
• Payable in 10 years: PV = $905.29

Why: You're without your money longer and need to be compensated by paying a lower price today.

🔁 Compounding periods

🔁 How compounding frequency affects value

Interest does not always compound annually—it can compound quarterly, monthly, daily, or even continuously.

Key principle: The more frequent the compounding period, the more valuable the investment, all else constant.

🧮 Adjusting the formula for different compounding periods

The formulas remain the same, but you must adjust what you plug in for i and n:

• i = interest rate per period (not per year)
• n = number of periods (not number of years)

Example: $1,000 at 12% for 1 year:

• Compounded annually: $1,000 × (1.12)¹ = $1,120.00
• Compounded monthly: $1,000 × (1.01)¹² = $1,126.83
  • i = 0.12/12 = 0.01 per month
  • n = 12 months
• Compounded quarterly: $1,000 × (1.03)⁴ = $1,125.51
  • i = 0.12/4 = 0.03 per quarter
  • n = 4 quarters

💡 Why compounding frequency matters

The differences can be trivial for small sums and short terms, but become significant for:

• Bigger sums
• Higher interest rates
• More frequent compounding
• Longer terms

Example comparisons:

Scenario	Annual compounding	Quarterly compounding	Difference
$1M at 4% for 1 year	$1,040,000	$1,040,604.01	$604.01
$100 at 300% for 5 years	$102,400	$7,257,064.34	Massive
$1 at 6% for 100 years	$339.30	$397.44	$58.14

Why: Interest is received sooner than the end of the year and is capitalized (earns interest on interest), making it more valuable.

🎯 Practical applications

🎯 Real-world decision-making

The excerpt provides several scenarios where PV/FV calculations matter:

Lottery winnings: $100 million payable as $5 million installments over 20 years is not really worth $100 million today. The final payment of $5 million in 20 years, at 4% interest, has a present value of only $2,281,934.73.

Lawsuit settlements: Choosing between $100,000 today or $75,000 next year depends on interest rates:

• At 5% interest: $75,000 next year is worth $71,428.57 today → take $100,000 today
• At 13.47886% interest: the comparison changes

Insurance settlements: Choosing between $100,000 today or $125,000 in 5 years:

• At 1% interest: $125,000 in 5 years is worth $119,047.62 today → take the future payment
• At 5% interest: $125,000 in 5 years is worth $97,893.53 today → take $100,000 today

🧩 Key takeaways for calculations

• Always identify whether you're solving for PV or FV.
• Adjust i and n for the compounding period (monthly, quarterly, etc.).
• Remember the inverse relationship: higher interest rates → lower present values.
• More frequent compounding → higher future values.

🧭 Overview

🧠 One-sentence thesis

Present and future value formulas allow us to translate money across time by accounting for interest, enabling us to compare payments made at different dates and price financial instruments accurately.

📌 Key points (3–5)

• Core principle: Money today is always worth more than the same amount tomorrow because of opportunity cost and the ability to earn interest.
• Two key formulas: Future value (FV = PV × (1 + i)^n) projects today's money forward; present value (PV = FV / (1 + i)^n) discounts future money back to today.
• Interest rate and price move inversely: When market interest rates rise, the present value of future payments falls; when rates fall, present value rises.
• Common confusion: Compounding frequency matters—monthly compounding yields more than annual compounding at the same stated rate because interest earns interest sooner.
• Practical application: These formulas price all debt instruments (discount bonds, simple loans, fixed-payment loans, coupon bonds) by summing the present value of all promised payments.

💰 The time value of money

💵 Why money now beats money later

• The excerpt establishes that "money today is always worth more than money tomorrow" as a fundamental principle.
• Two reasons given:
  • Opportunity cost: You forgo consumption (food, housing, entertainment) while waiting, so you need compensation.
  • Inflation: Prices tend to rise over time, so the same dollar amount buys less in the future (though the excerpt notes this is discussed separately and focuses on nominal rates).
• Example: No rational person would lend $100 today to receive exactly $100 in a year—you need interest to compensate for the wait.

🔢 Interest as compensation

Interest: the price of money or the price of borrowing it; the payment a borrower needs to make to induce a lender to lend.

• Interest rates determine asset prices (especially financial assets) and influence macroeconomic variables including aggregate output.
• The excerpt uses 10 percent as an example rate: lending $100 at 10% means receiving $110 after one year.

📈 Future value: growing money forward

🌱 The future value formula

FV = PV × (1 + i)^n

Where:

• FV = future value (what your investment will be worth later)
• PV = present value (amount invested today)
• (1 + i)^n = future value factor
• i = interest rate (as a decimal: 6% = 0.06, 25% = 0.25)
• n = number of periods (years, months, quarters, etc.)

🧮 How compounding works

• Annually compounding interest: "paying interest on the interest every year."
• The excerpt shows $100 at 10% grows to:
  • Year 1: $100 × 1.10 = $110
  • Year 2: $110 × 1.10 = $121
  • Year 3: $121 × 1.10 = $131.10
• Quick calculation: $100 × (1.10)^100 = $1,378,061 after 100 years.
• Each year's value is calculated by multiplying the previous year by (1 + interest rate).

📉 Present value: discounting the future

⏪ The present value formula

PV = FV / (1 + i)^n

• This reverses the future value calculation—instead of expanding via multiplication, you "reduce or discount" an FV to find what it's worth today.
• You divide rather than multiply because you're working backward in time.

💡 Example calculations

The excerpt asks: how much would you pay today for $1,000 payable in 5 years?

• At 5% interest: PV = 1000 / (1.05)^5 = $783.53
• At 20% interest: PV = 1000 / (1.20)^5 = $401.88
• At 1% interest: PV = 1000 / (1.01)^5 = $951.47

🔄 The inverse relationship

Key insight: As the interest rate rises, present value falls; as the interest rate falls, present value rises.

• Algebraically: The interest term i is in the denominator, so larger i means smaller PV (holding FV constant).
• Economically: Higher interest rates mean higher opportunity cost for money, so future payments are worth less today.
• Example: The same $1,000 payment is worth $783.53 at 5% but only $401.88 at 20%.

⏳ Time also matters

• Holding interest rates constant, payments further in the future are worth less today.
• At 1% interest, $1,000 in 5 years = $951.47 today, but $1,000 in 10 years = $905.29 today.
• This makes sense: you're without your money longer, so you need greater compensation (lower price today).

🔁 Compounding frequency effects

📅 Beyond annual compounding

Interest can compound at different frequencies: quarterly, monthly, daily, or continuously.

• More frequent compounding = more valuable (all else equal), because interest is received sooner and itself earns interest.
• The formulas remain the same, but you must adjust i and n:
  • i = interest rate per period (e.g., 12% annual ÷ 12 months = 1% per month = 0.01)
  • n = total number of periods (e.g., 1 year × 12 months = 12 periods)

📊 Comparison examples

$1,000 at 12% for one year:

• Annual compounding: $1,000 × (1.12)^1 = $1,120.00
• Monthly compounding: $1,000 × (1.01)^12 = $1,126.83
• Quarterly compounding: $1,000 × (1.03)^4 = $1,125.51

The differences grow larger with:

• Bigger principal amounts
• Higher interest rates
• More frequent compounding
• Longer time periods

Example: $100 at 300% for 5 years compounded annually = $102,400; compounded quarterly = $7,257,064.34.

⚠️ Don't confuse stated vs effective rates

• The same nominal (stated) annual rate yields different effective returns depending on compounding frequency.
• Monthly compounding at 6% annual yields more than annual compounding at 6% because you receive and reinvest interest sooner.

💳 Pricing debt instruments

🎫 Four major debt types

Instrument	Payment structure	Pricing method
Discount bond (zero coupon)	Single payment at maturity (face value only)	Use PV formula once
Simple loan	Principal + interest paid at end	Use FV formula to find total due
Fixed-payment loan (amortized)	Equal periodic payments (principal + interest)	Sum PV of all payments
Coupon bond	Periodic interest + principal at maturity	Sum PV of all payments

🎟️ Coupon bonds in detail

• Named for physical coupons historically clipped and redeemed for interest payments.
• Makes regular interest payments (coupon payments) plus returns principal at maturity.
• Coupon payment = face value × coupon rate (e.g., $10,000 × 5% = $500 annually).

🧾 Pricing example: $10,000 bond, 5% coupon, 5 years

When market interest rate is 6%:

• PV of year 1 payment: $500 / 1.06 = $471.70
• PV of year 2 payment: $500 / (1.06)^2 = $445.00
• PV of year 3 payment: $500 / (1.06)^3 = $419.81
• PV of year 4 payment: $500 / (1.06)^4 = $396.05
• PV of year 5 payment: $10,500 / (1.06)^5 = $7,846.21
• Total price: $9,578.77 (below par)

When market interest rate is 4%, total price = $10,445.18 (above par). When market interest rate equals coupon rate (5%), price = $10,000.00 (at par).

🔑 Coupon rate vs market rate

• Below par: Bond's coupon rate < market rate → people pay less than face value.
• Above par: Bond's coupon rate > market rate → people pay more than face value.
• At par: Bond's coupon rate = market rate → bond sells at face value.

📐 Yield to maturity

🎯 What yield to maturity measures

Yield to maturity: the interest rate that equates the present value of all future payments to the current price.

• It's the effective interest rate earned if you buy at current price and hold to maturity.
• Different from the coupon rate (which is contractual and fixed).

🧮 Easy calculations

One-year discount bond: i = (FV - PV) / PV

Example: Pay $750 for $1,000 due in one year → i = (1000 - 750) / 750 = 0.3333 = 33.33%

Perpetuity (pays forever): i = C / PV (where C = annual payment)

Example: Ground rent pays $50/year, sells for $1,000 → i = 50 / 1000 = 0.05 = 5%

⚠️ Complex instruments

• For coupon bonds and fixed-payment loans, calculating yield to maturity "is mathematically nasty business without a computer."
• The excerpt mentions two manual methods:
  • Current yield (C / PV): quick estimate but "can be wide of the mark" for shorter maturities or prices far from par.
  • Trial-and-error interpolation: tedious but eventually accurate.
• Modern practice: use financial calculators, spreadsheets, or online tools.

📊 Rate of return vs yield to maturity

🔄 The key difference

• Yield to maturity: measures the interest rate only.
• Rate of return: measures actual investment performance, accounting for price changes.

Rate of return formula: R = (C + P_t1 - P_t0) / P_t0

Where:

• C = coupon or other payment received
• P_t0 = purchase price
• P_t1 = sale price or current market price

📉 Interest rate risk

Interest rate risk: the risk that rising interest rates will decrease bond prices, causing losses.

• Even with no default, bondholders can lose money when interest rates rise.
• Example: Buy a bond for $100, receive $5 coupon, but price falls to $65 due to rising rates → R = (5 + 65 - 100) / 100 = -0.25 = -25% return.
• The loss occurs whether you sell or not—your asset's value has declined.

⏱️ Maturity and risk

• Longer maturity = higher interest rate risk (more volatile prices).
• The PV of distant payments shrinks more dramatically when interest rates rise.
• Example: $1,000 in 10 years at 5% vs 10% → 37.2% loss; $1,000 in 30 years → 75.23% loss.

✅ Don't confuse

• Yield to maturity: almost always positive; measures the rate.
• Rate of return: can be negative; measures actual gain/loss including price changes.
• Rising interest rates hurt existing bondholders; falling rates help them.

🔥 Inflation and interest rates

🧮 The Fisher Equation

i = i_r + π

Or rearranged: i_r = i - π

Where:

• i = nominal interest rate (the rates discussed throughout the chapter)
• i_r = real interest rate (purchasing power return)
• π = inflation (actual or expected)

📖 Real vs nominal

• Nominal return: the dollar amount you receive.
• Real return: what you can actually buy with those dollars (purchasing power).
• Example: Lend $100 at 6% when bread, gum, and soda each cost $1. Receive $106 back.
  • If prices stay constant: buy 106 items (real gain of 6).
  • If prices double: buy only 53 items (real loss despite nominal gain).

🔮 Ex ante vs ex post

• Ex ante (before the fact): nominal rate = real rate + expected inflation.
• Ex post (after the fact): nominal rate = real rate + actual inflation.
• If actual inflation exceeds expectations, real returns can be negative even with positive nominal returns.

💡 Observing inflation expectations

• Treasury Inflation Protection Securities (TIPS) are indexed to inflation, revealing real rates directly.
• Example: 10-year Treasury yields 5%, 10-year TIPS yields 2% → inflation expectation = 5% - 2% = 3%.

---

Practice reminder: The excerpt includes multiple exercise sets to drill these calculations. Mastery requires working through problems repeatedly until the mechanics become automatic.

🧭 Overview

🧠 One-sentence thesis

More frequent compounding periods increase the value of an investment because interest earned earlier itself earns interest, making the same nominal rate more valuable when compounded monthly or quarterly than annually.

📌 Key points (3–5)

• What compounding frequency changes: the more often interest compounds, the more valuable the investment becomes, all else equal.
• How the math adjusts: use interest per period for i and total number of periods for n, not years.
• Why frequency matters: interest paid earlier gets capitalized and earns additional interest at the stated rate.
• Common confusion: don't plug annual interest and years directly when compounding is non-annual—you must convert both i and n to match the compounding period.
• When the effect is largest: bigger principal amounts, higher interest rates, more frequent compounding, and longer terms magnify the difference.

💰 Why compounding frequency matters

💰 The core mechanism

Interest does not always compound annually; sometimes it compounds quarterly, monthly, daily, even continuously.

• The more frequent the compounding period, the more valuable the bond or other instrument, all else constant.
• Why: interest received sooner is more valuable because "money now is better than money later."
• Each compounding period, the interest earned is capitalized—it becomes part of the principal and itself earns interest at the stated rate.

📈 Comparing annual vs. more frequent compounding

The excerpt provides a clear example:

• $1,000 at 12 percent for one year compounded annually: $1,000 × (1.12)^1 = $1,120.00
• Same amount, rate, and term compounded monthly: $1,000 × (1.01)^12 = $1,126.83
• Same compounded quarterly: $1,000 × (1.03)^4 = $1,125.51

Difference: about $7 in this case, but the excerpt emphasizes this is "fairly trivial" only for small sums and short terms.

Example: The excerpt notes "I'll take the latter sum over the former any day"—even small differences matter when they're free.

🔧 How to adjust the formula

🔧 Representing i and n correctly

• i = interest paid per period, not per year
  • If annual interest is 12% and compounding is monthly, i = 0.12 ÷ 12 = 0.01
  • If compounding is quarterly, i = 0.12 ÷ 4 = 0.03
• n = number of periods, not number of years
  • For monthly compounding over 1 year: n = 12 × 1 = 12
  • For quarterly compounding over 1 year: n = 4 × 1 = 4

Don't confuse: n is not "how many years"; it is "how many compounding periods in total."

🧮 The formulas remain the same

• Present value: PV = FV / (1 + i)^n
• Future value: FV = PV × (1 + i)^n
• The mathematics remains the same; you must be careful about what you plug in for i and n.

📊 When the effect becomes large

📊 Bigger sums and higher rates

Scenario	Annual compounding	Quarterly compounding	Difference
$1 million at 4% for 1 year	$1,040,000	$1,040,604.01	$604.01
$100 at 300% for 5 years	$102,400	$7,257,064.34	Massive
$1 at 6% for 100 years	$339.30	$397.44 (monthly)	$58.14

• The excerpt shows that $100 at 300% for 5 years compounded annually becomes $102,400, but compounded quarterly it grows to over $7 million.
• Even a single dollar at 6% over a century grows from $339.30 (annual) to $397.44 (monthly).

⏱️ Longer terms amplify the effect

• The excerpt emphasizes: "important for bigger sums, higher interest rates, more frequent compounding periods, and longer terms."
• Over long horizons, the capitalization of interest on interest compounds dramatically.

Example: A mere $1 at 6% compounded monthly for 100 years swells to $397.44, versus $339.30 annually—the difference grows over time.

🔑 Key takeaways from the excerpt

🔑 Adjusting for any compounding period

• Present and future value can be calculated for any compounding period using the same formulas.
• Care must be taken to ensure that i and n terms are adjusted appropriately.

🔑 Why this matters

• The excerpt states: "This all makes good sense because interest is being received sooner than the end of the year and hence is more valuable."
• Understanding compounding frequency is essential for accurately valuing bonds, loans, and other financial instruments.

🧭 Overview

🧠 One-sentence thesis

Debt instruments are priced by calculating the sum of the present value of all their promised future payments, which explains why bonds sell above or below face value depending on how their coupon rate compares to the market interest rate.

📌 Key points (3–5)

• Four major debt types: discount bonds, simple loans, fixed-payment loans, and coupon bonds—each with different payment structures.
• Core pricing principle: the price equals the sum of the present value of all future payments (interest and principal).
• Why bonds trade above or below par: when the coupon rate is below the market rate, the bond sells at a discount; when above, it sells at a premium; when equal, it sells at par.
• Common confusion: the coupon rate (contractual interest the bond pays) vs. the market interest rate (used to discount future payments)—they are different and their relationship determines price.
• Practical calculation: while the math is straightforward, real-world pricing uses financial calculators, software, or spreadsheet functions because of the many payments involved.

💰 The four types of debt instruments

💰 Discount bond (zero coupon bond)

A discount bond makes only one payment—its face value on its maturity or redemption date.

• Also called a "zero coupon bond" or simply a "zero."
• Pricing is the simplest: use the present value formula for a single future payment.
• Example: if a bond pays $10,000 in five years and the market rate is 6%, its price today is $10,000 divided by (1.06) raised to the fifth power.

💰 Simple loan

A simple loan is one where the borrower repays the principal and interest at the end of the loan.

• Use the future value formula to calculate the total sum due upon maturity.
• All payment happens in one lump sum at the end.

💰 Fixed-payment loan (fully amortized loan)

A fixed-payment loan is one in which the borrower periodically repays a portion of the principal along with the interest, and all payments are equal.

• Includes most auto loans and home mortgages.
• No large balloon payment at the end because the principal shrinks over time.
• The excerpt shows a sample thirty-year mortgage: $500,000 borrowed at 6% annual interest, with 360 monthly payments of $2,997.75 each.
• The principal shrinks slowly at first, then more rapidly as the final payment approaches.
• To price this instrument: sum the present value of each remaining monthly payment.
• Don't confuse: the payment amount stays the same, but the split between interest and principal changes over time.

💰 Coupon bond

A coupon bond makes one or more interest payments periodically until its maturity or redemption date, when the final interest payment and all of the principal are paid.

• Historically, owners received interest by clipping physical coupons and remitting them to the borrower or its paying agent.
• The excerpt shows historical examples: a Malden & Melrose Railroad coupon from 1860 and a Michigan Central Railroad bond from 1902 with coupons still attached.
• Even without physical coupons today, the structure remains: periodic interest payments plus principal at maturity.
• To price: sum the present value of each future payment (both interest and principal).

🧮 How to price a coupon bond

🧮 The calculation method

• Calculate the present value of each future payment separately, then add them all together.
• Each interest payment is the bond's face value multiplied by its coupon rate.
• The final payment includes both the last interest payment and the full principal repayment.

🧮 Worked example: $10,000 bond at 5% coupon, 5 years to maturity, 6% market rate

The bond pays $500 interest annually (because $10,000 × 0.05 = $500).

Year	Payment	Present Value Calculation	PV Amount
1	$500	$500/(1.06)	$471.70
2	$500	$500/(1.06)²	$445.00
3	$500	$500/(1.06)³	$419.81
4	$500	$500/(1.06)⁴	$396.05
5	$10,500	$10,500/(1.06)⁵	$7,846.21

• The final payment is $10,500 because it includes the last $500 interest plus the $10,000 principal.
• Total price: $9,578.77 (sum of all PV amounts).

🧮 Why the bond sells below face value

• The bond's coupon rate is 5%, but the market interest rate is 6%.
• Because the bond pays at a rate lower than the going market rate, people are not willing to pay as much for it.
• Result: the price sinks below par (below $10,000).

📊 The relationship between coupon rate, market rate, and price

📊 Three scenarios

Market Rate	Coupon Rate	Bond Price	Reason
6%	5%	$9,578.77 (below par)	Bond pays less than market → discount
4%	5%	$10,445.18 (above par)	Bond pays more than market → premium
5%	5%	$10,000.00 (at par)	Bond pays exactly market rate → par value

📊 When market rate is 4% (below coupon rate)

• People should be willing to pay more than face value because the bond pays better than the market.
• Calculation for the same bond at 4% market rate:
  • PV₁ = $500/(1.04) = $480.77
  • PV₂ = $500/(1.04)² = $462.28
  • PV₃ = $500/(1.04)³ = $444.50
  • PV₄ = $500/(1.04)⁴ = $427.40
  • PV₅ = $10,500/(1.04)⁵ = $8,630.23
  • Total: $10,445.18

📊 When market rate equals coupon rate (5%)

• The bond will sell at exactly its par value ($10,000).
• Calculation:
  • PV₁ = $500/(1.05) = $476.19
  • PV₂ = $500/(1.05)² = $453.51
  • PV₃ = $500/(1.05)³ = $431.92
  • PV₄ = $500/(1.05)⁴ = $411.35
  • PV₅ = $10,500/(1.05)⁵ = $8,227.02
  • Total: $10,000.00

📊 Don't confuse

• Coupon rate: the contractual interest rate the bond pays, fixed at issuance (5% in the examples).
• Market interest rate: the current rate used to discount future payments, which changes with market conditions (4%, 5%, or 6% in the examples).
• The coupon rate determines the payment amounts; the market rate determines the present value and thus the price.

🛠️ Practical tools for pricing

🛠️ Why tools are needed

• Calculating the price of a bond with many payments (e.g., quarterly payments over thirty years = 120 payments) becomes tedious by hand.
• Historically, people used special bond tables to speed up calculations.

🛠️ Modern methods

Today, most people use one of the following:

• Financial calculators: specialized devices for finance calculations.
• Specialized financial software: programs designed for bond pricing.
• Spreadsheet functions: Excel functions like PRICEDISC or PRICEMAT, or custom formulas.
• Web-based calculators: online tools that automate the calculation process.

The excerpt mentions specific websites (calculatorweb.com, investinginbonds.com) as examples.

🛠️ The underlying principle remains the same

• Regardless of the tool, the method is always: sum the present value of all future payments.
• The tools simply automate the repetitive calculation steps.

🔑 Key takeaways

🔑 Definition of debt instruments

Debt instruments—like discount bonds, simple loans, fixed payment loans, and coupon bonds—are contracts that promise payment in the future.

🔑 Universal pricing principle

They are priced by calculating the sum of the present value of the promised payments.

• This principle applies to all debt instruments, regardless of type.
• The excerpt assumes no default risks or transaction costs in all examples.
• You need to know: the rate of interest, the compounding period, and the size and timing of the payments.

🧭 Overview

🧠 One-sentence thesis

Yield to maturity is the most economically accurate measure of nominal interest rates, and while it is easily calculated for one-year discount bonds and perpetuities, it requires specialized tools for more complex instruments like coupon bonds and fixed-payment loans.

📌 Key points (3–5)

• What yield to maturity measures: the interest rate earned when you know the present value (price paid) and future value (amount received) of a financial instrument.
• Easy calculations: one-year discount bonds use i = (FV − PV)/PV; perpetuities use i = C/PV (where C is the annual payment).
• Hard calculations: coupon bonds and fixed-payment loans require financial calculators, spreadsheets, or bond tables because the math is complex.
• Common confusion: current yield (a quick estimate using the perpetuity formula) can be inaccurate, especially for bonds with short maturities or prices far from par value.
• Why it matters: yield to maturity lets investors compare returns across different instruments and make informed investment decisions.

🔄 Reversing the calculation

🔄 From price and future value to interest rate

• Previously, the excerpt assumed a market interest rate and calculated the price (PV) of an instrument, or given PV and an interest rate, calculated FV.
• Now the goal is the opposite: calculate the interest rate (yield to maturity) when given PV and FV.
• This reversal is useful when you observe a transaction and want to know what rate of return the buyer is earning.

🧮 One-year discount bond formula

Yield to maturity for a one-year discount bond: i = (FV − PV) / PV

Derivation (from PV = FV/(1 + i)):

• Multiply both sides by (1 + i): (1 + i) × PV = FV
• Expand: PV + PVi = FV
• Subtract PV: PVi = FV − PV
• Divide by PV: i = (FV − PV) / PV

Example: Someone paid $750 for a zero coupon bond with a $1,000 face value due in one year.

• i = (1000 − 750) / 750 = 250 / 750 = 0.3333 or 33.33 percent
• Check: PV = 1000 / 1.3333 = $750 ✓

Stop and Think scenario: You have $1,000 to invest for a year. Option A: a discount bond with $1,000 face value selling for $912. Option B: a bank account at 6.35 percent compounded annually.

• Bond yield: (1000 − 912) / 912 = 0.0965 or 9.65 percent
• Choose the bond (higher yield) and invest the leftover $88 in the bank account to maximize returns.

💰 Perpetuities

💰 What a perpetuity is

• A perpetual debt with no maturity or repayment date.
• Examples mentioned: Consol, ground rent, perpetual interest-only mortgage.
• Pays a fixed amount every year forever.

💰 Pricing a perpetuity

Price of a perpetuity: PV = FV / i (where FV is the yearly payment and i is the interest rate in decimal form)

Example: A $1,000 ground rent paying $50 per year (5 percent coupon rate):

• If interest rates are 5 percent: PV = 50 / 0.05 = $1,000
• If interest rates are 10 percent: PV = 50 / 0.10 = $500
• If interest rates are 1 percent: PV = 50 / 0.01 = $5,000

Key insight: Higher interest rates → lower present value; lower interest rates → higher present value.

💰 Yield to maturity of a perpetuity

Solving for i:

• Start with PV = FV / i
• Multiply both sides by i: PVi = FV
• Divide by PV: i = FV / PV

Example: A ground rent pays $60 per year and currently sells for $600.

• i = 60 / 600 = 0.10 = 10 percent

Historical example: A ground rent contract from Philadelphia (1756) still pays $23.17 annually; someone recently paid $455 for it.

• Yield to maturity: i = 23.17 / 455 = 0.05092 = 5.09 percent
• If interest rises to 10 percent: PV = 23.17 / 0.1 = $231.70
• If interest falls to 2 percent: PV = 23.17 / 0.02 = $1,158.50

🧩 Complex instruments and workarounds

🧩 Why coupon bonds and fixed-payment loans are hard

• Calculating yield to maturity for these instruments is "mathematically nasty business" without a computer or bond table.
• The formulas involve multiple future payments discounted at different periods, making manual calculation tedious and error-prone.

🧩 Historical methods (before computers)

Method 1: Current yield (quick estimate)

Current yield: uses the perpetuity formula i = FV/PV to estimate yield to maturity

• Treats the bond as if it were a perpetuity.
• Limitation: Can be "wide of the mark," especially for:
  • Bonds with maturities less than twenty years
  • Bonds whose prices are far from par value
• Why it's inaccurate: The more a bond differs from a perpetuity (shorter maturity, price far from par), the worse the approximation.
• When it works better: The closer a bond's price is to par, the better current yield approximates yield to maturity (because yield to maturity equals the coupon rate when the bond is at par).

Method 2: Trial-and-error interpolation

• Make successive guesses about i and plug them into the PV formula.
• "Not fun" but eventually gets the right answer.
• Laborious and time-consuming.

🧩 Modern tools

• Most people today use:
  • Financial calculators
  • Specialized financial software
  • Spreadsheet functions (e.g., Excel's PRICEDISC or PRICEMAT)
  • Web-based calculators

Don't confuse: Current yield (erroneous shortcut) vs. yield to maturity (accurate but complex calculation).

📋 Summary table

Instrument type	Yield to maturity formula	Calculation difficulty
One-year discount bond	i = (FV − PV) / PV	Easy (by hand or simple calculator)
Perpetuity	i = C / PV (C = annual payment)	Easy (by hand or simple calculator)
Coupon bond	Complex (multiple discounted payments)	Hard (requires financial calculator/software)
Fixed-payment loan	Complex (multiple discounted payments)	Hard (requires financial calculator/software)

🎯 What you should be able to do

🎯 By-hand calculations

• Calculate yield to maturity for one-year discount bonds using i = (FV − PV) / PV
• Calculate yield to maturity for perpetuities using i = C / PV
• These can be done "by hand, or at worst with the aid of a simple (nonfinancial) calculator"

🎯 Practice exercises (from excerpt)

1. A $100 bond payable in a year sells for $97.56. What is the yield to maturity?
2. Sam promises to pay Joe $1,904 in a year if Joe gives him $1,498 today. What interest rate is Sam paying and Joe earning?
3. The U.S. government pays a tribe $10,000 per year forever. Mr. Trump offered $143,500 for this stream. What yield to maturity did Trump offer?
4. What is the yield to maturity of a British Consol paying £400 per year that sold for £27,653?

🧭 Overview

🧠 One-sentence thesis

Rate of return differs from yield to maturity by accounting for changes in bond prices, making it possible to earn negative returns even when bonds pay as promised, due to interest rate risk.

📌 Key points (3–5)

• What rate of return measures: the actual gain or loss from holding a bond, including both coupon payments and price changes.
• How it differs from yield to maturity: YTM measures only the interest rate; rate of return captures how lucrative the investment actually is by including price movements.
• Interest rate risk: when market interest rates rise, bond prices fall, creating losses for bondholders even if no default occurs.
• Common confusion: YTM is almost always positive, but returns can be negative; losses occur whether or not you sell the bond because your net worth has decreased.
• Maturity matters: longer-maturity bonds have more volatile prices and higher interest rate risk because distant future values shrink more when interest rates rise.

🧮 Rate of return vs yield to maturity

🧮 What rate of return measures

Rate of return: a measure of how lucrative an investment is because it accounts for changes in the price of the bond (or other asset).

• The formula is: R = (C + P_t1 − P_t0) / P_t0
  • R = return from holding the asset from time t0 to time t1
  • P_t0 = the price at time t0 (purchase price)
  • P_t1 = the price at time t1 (sale or current market price)
  • C = coupon (or other) payment
• Unlike YTM, which is "merely a measure of the interest rate," rate of return captures the full investment outcome.

🔄 The key difference

• Yield to maturity: measures the interest rate only; does not account for price changes.
• Rate of return: includes both coupon income and any gain or loss from price movements.
• Example: You buy a 5 percent coupon bond with $100 face value for $100 when the interest rate is 5 percent. If interest rates decrease and the bond price rises to $103 after one year, your return is R = (5 + 3)/100 = 0.08, or 8%—higher than the 5% YTM.
• Don't confuse: YTM tells you the interest rate; return tells you what you actually earned or lost.

📉 Interest rate risk

📉 How rising rates hurt bondholders

• Bond prices and interest rates are inversely related.
• When market interest rates increase, the present value of the bond's future payments decreases, making the bond less valuable.
• When rates decrease, the PV of future payments increases, making the bond more valuable.
• Example: You purchased the bond for $100. If interest rates soar and drive the market price down to $65 after two years, your return (from purchase) is R = (10 − 35)/100 = −0.25, or negative 25%.

💸 Losses without default

It is quite possible to lose wealth by investing in bonds or other fixed-rate financial instruments, even if there is no default (i.e., even if payments are punctually made as promised).

• Default risk: the risk of nonpayment.
• Interest rate risk: the risk of loss due to rising interest rates, distinct from default risk.
• The loss occurs whether or not you actually sell the bond, because the value of your assets (and your net worth) has shrunk.
• One way to think about it: the rate of return formula calculates the return if the bond were sold.
• Another way: even if you don't sell, you are poorer because your bond is now worth less.

⏳ Maturity and volatility

• Interest rate risk is higher the longer the maturity of a bond.
• More future values are affected by an interest rate increase, and the most distant ones are the most highly affected.
• Example comparison:
  • PV of $1,000 in 10 years at 5% = $613.91; at 10% = $385.54 → loss of 37.2%
  • PV of $1,000 in 30 years at 5% = $231.38; at 10% = $57.31 → loss of 75.23%
• Algebraically: PV = FV / (1 + i)^n. The interest rate i is in the denominator, so as i gets bigger, PV must get smaller.
• Bonds with longer periods to maturity have more volatile prices because the PV of their distant FV shrinks more.

🔍 Historical example

🔍 U.S. government bonds in the 1790s

The excerpt includes a "Stop and Think Box" scenario:

• The U.S. federal government issued three bond types in the early 1790s:
  • A 6 percent coupon bond
  • A 3 percent coupon bond
  • A zero coupon bond that became a 6 percent coupon bond in 1801
• For most of the 1790s and early 1800s, the 6 percent bonds traded around par.
• What this tells us: The yield to maturity on government debt was about 6 percent, because the 6 percent coupon bonds traded at around par.
• Price of the 3 percent bond: must have been well below par—no one would pay $100 to get $3 a year when they could pay $100 and get $6 a year.
• Price of the zero coupon bond: must have appreciated toward the price of the 6 percent coupon bonds as the conversion date (1801) neared.

📊 Summary table

Concept	Definition	Key characteristic
Yield to maturity	Measure of the interest rate	Does not account for price changes; almost always positive
Rate of return	Measure of investment gain/loss	Includes coupon payments + price changes; can be negative
Interest rate risk	Risk of loss due to rising rates	Distinct from default risk; higher for longer maturities
Default risk	Risk of nonpayment	Not the focus of this section

🧭 Overview

🧠 One-sentence thesis

Inflation drives a wedge between nominal and real interest rates, meaning lenders can receive more dollars yet lose purchasing power if nominal rates fail to keep pace with rising prices.

📌 Key points (3–5)

• The Fisher Equation: nominal interest rate equals real interest rate plus inflation (or inflation expectations).
• Real vs nominal: nominal rates are the rates discussed in earlier sections; real rates adjust for inflation and reflect actual purchasing power.
• Why the distinction matters: if inflation exceeds expectations, lenders can suffer negative real returns even when nominal returns are positive.
• Common confusion: ex ante (before the fact) uses expected inflation; ex post (after the fact) uses actual inflation—the two can differ.
• Observing inflation expectations: Treasury Inflation Protection Securities (TIPS) allow market participants to infer expected inflation by comparing TIPS yields with regular Treasury yields.

🔢 The Fisher Equation

🔢 Three equivalent forms

The Fisher Equation (named after early twentieth-century U.S. economist Irving Fisher) can be rearranged in three ways:

• i = i_r + π
  Nominal interest rate equals real interest rate plus inflation.
• i_r = i − π
  Real interest rate equals nominal interest rate minus inflation.
• π = i − i_r
  Inflation equals nominal interest rate minus real interest rate.

Where:

• i_r = real interest rate
• i = nominal interest rate (the type discussed earlier in the chapter)
• π = inflation (or expected inflation)

📖 Plain-language interpretation

• Ex post (after the fact): the nominal rate equals the real rate plus actual inflation.
• Ex ante (before the fact): the nominal rate equals the real rate plus the expectation of inflation.
• Don't confuse: the same equation applies, but the inflation term changes from expected to actual depending on timing.

💸 Real vs nominal returns

💸 What real return means

Real return: what you can actually buy with the money you receive, adjusted for changes in the price level.

• Nominal return is the dollar amount you get back.
• Real return is the purchasing power of those dollars.
• If prices rise faster than your nominal return, your real return can be negative.

🍞 Purchasing power example

The excerpt provides a concrete scenario:

• You lend $100 for one year at 6 percent interest.
• At the start, a loaf of bread, pack of gum, and bottle of Mountain Dew each cost $1.
• At the end, you receive $100 × 1.06 = $106.
• If prices stay constant: you can buy 106 items (an extra 6 items compared to your original $100).
• If prices double: each item now costs $2, so $106 buys only 53 items—far fewer than the original 100.
• Your nominal return is positive (+$6), but your real return is steeply negative (you lost purchasing power).

⚠️ When nominal rates don't adjust

• The excerpt notes that nominal rates "often don't, or can't" rise to match inflation.
• Result: lenders receive more nominal dollars but less purchasing power.
• This is why the real/nominal distinction is critical for understanding actual investment outcomes.

📊 Observing inflation expectations with TIPS

📊 What TIPS are

Treasury Inflation Protection Securities (TIPS): bonds indexed to inflation that provide real interest rate information.

• Traditionally, inflation expectations were unobservable, so real rates were known only ex post.
• TIPS allow market participants to observe ex ante inflation expectations.

🔍 How to infer expected inflation

The excerpt gives a step-by-step method:

Bond type	Yield to maturity	Interpretation
Regular 10-year Treasury	5%	Nominal interest rate (i)
10-year TIPS	2%	Real interest rate (i_r)
Implied inflation expectation	5% − 2% = 3%	π = i − i_r

• Example: if the regular Treasury yields 5 percent and TIPS yields 2 percent, the market expects 3 percent inflation over the next ten years.
• The excerpt references a figure showing how inflation expectations have changed since TIPS were introduced in 1997.

🧭 Ex ante vs ex post again

• TIPS let you see expected inflation before it happens (ex ante).
• After the period ends, you can compare expected inflation to actual inflation (ex post).
• If actual inflation exceeds expectations, real ex post returns on regular bonds can be negative.

🎒 Stop and Think Box: the lost wallet

🎒 The scenario

• A man lost his wallet in France during World War II (over sixty years earlier, around the 1940s).
• In early 2007, the wallet was returned with an unspecified sum of cash, his original Social Security card, and a picture of his parents.
• Question: was losing the wallet a good investment?

🎒 Why the answer is no

The excerpt lists two reasons:

1. High risk: the chance the wallet would never be returned was very high.
2. Inflation and no interest: the dollar lost significant purchasing power over sixty years, and the cash earned no interest.

🎒 Opportunity cost illustration

The excerpt calculates what $100 would have grown to if invested at compound interest:

• At 3% annually for 60 years: $100 × (1.03)^60 = $589.16

• At 6% annually for 60 years: $100 × (1.06)^60 = $3,298.77

• The cash in the wallet earned zero interest and lost purchasing power to inflation.

• Even a modest interest rate would have multiplied the original sum many times over.

• Don't confuse: this is not about the sentimental value of the wallet or photos; it's purely about the financial return on the cash.

🔑 Key takeaways from the excerpt

🔑 The core distinction

• Real interest rate: adjusts for inflation; reflects actual purchasing power.
• Nominal interest rate: the rate discussed in earlier sections; does not adjust for inflation.
• The difference between the two is literally inflation or inflation expectations.

🔑 The Fisher Equation in practice

• Nominal interest equals real interest plus inflation (or inflation expectations).
• Real interest equals nominal interest minus inflation (expectations).
• This relationship holds both ex ante (with expected inflation) and ex post (with actual inflation).

🔑 When expectations miss the mark

• If actual inflation exceeds inflation expectations, real ex post returns on bonds can be negative.
• Lenders receive the promised nominal dollars but find those dollars buy less than anticipated.
• This risk is why understanding the real/nominal distinction is essential for investors and policymakers.

🧭 Overview

🧠 One-sentence thesis

Interest rates fluctuate constantly because the supply and demand curves for bonds shift in response to economic conditions, causing the equilibrium price (and thus the interest rate) to change.

📌 Key points (3–5)

• Why interest rates matter: interest rate changes profoundly affect the value of bonds, loans, equities, and derivatives, and rates fluctuate monthly, weekly, daily, and even by the nanosecond.
• What determines "the" interest rate: the general level of interest rates is determined by supply and demand for bonds in the market, where equilibrium price and quantity occur at the intersection of the curves.
• How supply and demand work: the demand curve for bonds slopes downward (lower prices/higher yields → more demand); the supply curve slopes upward (higher prices/lower yields → more supply from borrowers).
• Common confusion: bond price vs. interest rate—when bond prices rise, yields (interest rates) fall, and vice versa; they move in opposite directions.
• What causes rate changes: shifts in the supply or demand curves (not just movements along them) change the equilibrium price and quantity, thereby changing the interest rate.

📊 Bond market mechanics

📊 Supply and demand curves

The demand curve for bonds slopes downward; the supply curve slopes upward.

• Supply curve (borrowers/sellers of bonds):

  • When bond prices are high (yields are low), borrowers supply more bonds because they can borrow cheaply.
  • When bond prices are low (yields are high), borrowers supply fewer bonds because borrowing is expensive.
  • Example: if a bond fetches a high price, borrowers will issue more bonds; if the price is low, they won't sell as many.

• Demand curve (investors/buyers of bonds):

  • When bond prices are high (yields are low), investors demand fewer bonds because they are not good deals.
  • When bond prices are low (yields are high), investors demand more bonds because they offer better returns.
  • Example: as bond prices fall and yields increase, bonds become increasingly attractive to buyers.

⚖️ Market equilibrium

• The market price (p*) and quantity (q*) are determined where the supply and demand curves intersect.
• If price is temporarily above p*:
  • Quantity supplied exceeds quantity demanded (glut).
  • Sellers lower their asking price until equilibrium is restored.
• If price is temporarily below p*:
  • Quantity demanded exceeds quantity supplied (excess demand).
  • Investors bid up the price until equilibrium is reached.

🔄 How shifts change interest rates

🔄 Supply curve shifts

Shift direction	Effect on bond price	Effect on interest rate	Effect on quantity
Supply increases (shifts right)	Price decreases	Interest rate increases	Quantity increases
Supply decreases (shifts left)	Price increases	Interest rate falls	Quantity decreases

• Don't confuse: a movement along the supply curve (caused by a price change) vs. a shift of the entire curve (caused by other factors).

🔄 Demand curve shifts

Shift direction	Effect on bond price	Effect on interest rate	Effect on quantity
Demand increases (shifts right)	Price increases	Interest rate falls	Quantity increases
Demand decreases (shifts left)	Price decreases	Interest rate increases	Quantity decreases

• The excerpt emphasizes that shifts in the curves—not just movements along them—are what cause interest rate changes.

🔍 Why this framework matters

🔍 Constant fluctuation

• The excerpt shows that interest rates change at multiple time scales: long-term secular trends and short-term ups and downs.
• Figures in the excerpt illustrate yields on one-month U.S. Treasury bills from 2001–2008 and a zoomed-in view of March 2008, demonstrating both patterns.
• Because rates fluctuate so frequently, understanding the supply-demand mechanism is essential for predicting and explaining rate movements.

🔍 Focus on "the" interest rate

• The excerpt explains that this chapter focuses on the general level of interest rates, ignoring differences across security types.
• Interest rates on different securities tend to track each other, so understanding one interest rate helps make sense of thousands of rates in the real world.
• Example: by analyzing what moves "the" interest rate, we gain insight into movements across the entire interest rate landscape.

🔍 Theoretical foundation

• The keys to understanding interest rate changes are:
  • Simple price theory (supply and demand).
  • The theory of asset demand.
  • The liquidity preference framework of economist John Maynard Keynes.
• The excerpt notes that determining why the curves shift is the interesting part, not just shifting them around mechanically.

🧭 Overview

🧠 One-sentence thesis

Interest rates change because shifts in bond supply and demand curves—driven by wealth, expected returns, risk, liquidity, government budgets, inflation expectations, and business conditions—move the equilibrium price and quantity of bonds.

📌 Key points (3–5)

• Supply and demand shifts move interest rates: rightward supply shifts or leftward demand shifts lower bond prices (raise interest rates); leftward supply shifts or rightward demand shifts raise bond prices (lower interest rates).
• Three main demand drivers: wealth (overall level), expected relative return (including expected interest rate changes), risk (default, interest rate, liquidity risks), and liquidity itself.
• Three main supply drivers: government budgets (deficits increase supply, surpluses decrease it), inflation expectations (higher expected inflation makes borrowing cheaper in real terms), and general business conditions (favorable conditions encourage borrowing).
• Common confusion—business cycle effects: expansions shift both supply (right, lowering prices) and demand (right, raising prices); empirically, supply shifts dominate, so interest rates usually rise during expansions and always fall during recessions.
• Expected inflation has a double effect: it shifts supply right (borrowers issue more) and demand left (investors expect lower real returns), unambiguously lowering bond prices and raising yields.

📊 How supply and demand shifts affect bond prices and interest rates

📊 Basic mechanics

• Like any market, bond prices and quantities adjust when supply or demand curves shift.
• Supply increases (curve shifts right) → bond prices fall, interest rates rise, quantity traded rises.
• Supply decreases (curve shifts left) → bond prices rise, interest rates fall, quantity traded falls.
• Demand increases (curve shifts right) → bond prices rise, interest rates fall, quantity traded rises.
• Demand falls (curve shifts left) → bond prices fall, interest rates rise, quantity traded falls.

🔄 The inverse price-yield relationship

• Remember: bond prices and interest rates (yields) always move in opposite directions.
• When the excerpt says "prices decrease," it always adds "(the interest rate will increase)" and vice versa.
• Example: if bond supply increases, more bonds are available at any given price, so prices must fall to clear the market, which means yields rise.

💰 What shifts the demand curve for bonds

💰 Wealth: the overall level

Wealth determines the overall demand for assets.

• Wealth must be stored in some asset (bonds, stocks, real estate, precious metals, etc.).
• As wealth increases, the quantity demanded of all types of assets increases, though to different degrees.
• The reasoning is nearly circular: if wealth is to be maintained, it must be invested somewhere.
• Wealth sets the general level of demand; the next three factors determine which assets investors choose.

📈 Expected relative return

Expected relative return is the ex ante (before the fact) belief that the return on one asset will be higher than the returns of other comparable (in terms of risk and liquidity) assets.

• Positive relationship: as expected relative return on bonds increases, quantity demanded of bonds increases.
• This can happen because:
  • Expected return on bonds themselves rises, or
  • Expected return on comparable assets falls, or
  • A combination of both.

📈 How expected interest rates affect demand

• If interest rates are expected to rise, bond prices are expected to fall → quantity demanded of bonds decreases (demand curve shifts left).
• If interest rates are expected to fall, bond prices are expected to rise → quantity demanded of bonds increases (demand curve shifts right).
• Expected inflation affects this through the Fisher Equation: higher expected inflation typically means higher expected nominal interest rates.

⚠️ Risk (inverse relationship)

Risk is the uncertainty of an asset's returns.

• Inverse relationship: as risk increases, quantity demanded of an asset decreases, all else equal.
• Risk comes in several types, all undesirable:
  • Default risk (credit risk): chance that a financial contract will not be honored.
  • Interest rate risk: chance that interest rates will rise and decrease a bond's price.
  • Reinvestment risk: the offsetting risk that interest rates will fall, forcing reinvestment at lower yields.
  • Liquidity risk: chance that an asset cannot be sold as quickly or cheaply as expected.

⚠️ Risk tolerance and required returns

• To accept more risk, rational investors must expect a higher relative return.
• Risk-averse investors require much higher returns for a little extra risk.
• Risk-tolerant (risk-loving, risk-seekers) investors will take on much risk for a little higher return.
• Risks can be:
  • Idiosyncratic: specific to one company.
  • Sectoral: affecting an entire industry.
  • Systemic: economy-wide.

⚠️ Real-world example from the excerpt

• During the 2007 financial crisis, subprime mortgage-backed bonds (asset-backed securities, ABS) collapsed in price.
• Investors realized these bonds had much higher default rates and much lower liquidity than previously believed.
• Their yields had to increase markedly to induce investors to hold them.

💧 Liquidity (positive relationship)

Liquidity [is] the ability to sell an asset quickly and cheaply.

• Positive relationship: the more liquid an asset is, the higher the quantity demanded, all else equal.
• Investors often need to change their investment portfolio or dis-save (spend wealth on consumption).
• Being able to sell quickly and cheaply is valuable.
• Don't confuse: liquidity is relative to other assets; it's not an absolute property.

📋 Summary table: demand shifters

Factor	Direction of relationship	Why
Wealth	Positive	More wealth → more of all assets demanded
Expected relative return	Positive	Higher expected return → more attractive
Risk	Inverse	More uncertainty → less attractive
Liquidity	Positive	Easier to sell → more attractive

🏛️ What shifts the supply curve for bonds

🏛️ Government budgets

• Deficits → governments borrow by selling bonds → supply curve shifts right → bond prices fall (yields rise).
• Surpluses → governments redeem/buy back bonds → supply curve shifts left → bond prices rise (yields fall).
• Example: when governments run deficits, they issue more bonds to finance spending, increasing the quantity of bonds available at any given price.

📉 Inflation expectations

• Higher expected inflation → borrowers issue more bonds → supply curve shifts right → bond prices fall (yields rise).
• Lower expected inflation or deflation expectations → opposite effect.

📉 Why inflation expectations matter: the Fisher Equation

• The Fisher Equation: real interest rate = nominal interest rate – expected inflation.
• Written as: i_r = i – π^e (where i_r is real rate, i is nominal rate, π^e is expected inflation).
• If expected inflation (π^e) increases while nominal interest rate (i) stays the same, the real interest rate (i_r) must decrease.
• From borrowers' perspective: the real cost of borrowing falls, making borrowing more attractive.
• So they sell more bonds, shifting supply right.

🏢 General business conditions

• Favorable conditions → businesses borrow more → supply curve shifts right → bond prices fall (yields rise).
• Favorable conditions include:
  • Tax decreases.
  • Regulatory cost reductions.
  • Economic expansion (boom).

🏢 Why businesses borrow

• Most borrowing comes from strength, not weakness.
• Businesses borrow to finance expansion and engage in new projects they believe will be profitable.
• When economic prospects are good, taxes are low, and regulations are not too costly, businesses are eager to borrow.
• Conversely, higher taxes, more costly regulations, and recessions shift the bond supply curve left.

📋 Summary table: supply shifters

Factor	Effect on supply	Effect on bond prices	Effect on yields
Government deficits	Increase (shift right)	Fall	Rise
Government surpluses	Decrease (shift left)	Rise	Fall
Higher expected inflation	Increase (shift right)	Fall	Rise
Lower expected inflation	Decrease (shift left)	Rise	Fall
Favorable business conditions	Increase (shift right)	Fall	Rise
Unfavorable business conditions	Decrease (shift left)	Rise	Fall

🔀 Combined effects: when both curves shift

🔀 Expected inflation: unambiguous effect

• Expected inflation shifts both curves:
  • Supply shifts right: borrowers want to issue more bonds (real borrowing cost falls).
  • Demand shifts left: investors expect lower real returns on bonds.
• Both shifts work in the same direction: bond prices fall, yields rise.
• This is an unambiguous result.

🔀 Business cycle expansion: ambiguous effect

• A business expansion shifts both curves:
  • Supply shifts right: businesses borrow more to take advantage of opportunities → bond prices fall (yields rise).
  • Demand shifts right: economic expansion increases wealth → more demand for bonds → bond prices rise (yields fall).
• The net effect on interest rates depends on which curve shifts more.

🔀 Empirical reality

• Usually during expansions: the supply curve shifts much further than the demand curve → interest rates rise.
• Always during recessions: interest rates fall.
• Historical examples:
  • Interest rates fell to very low levels during the Great Depression.
  • Interest rates fell during Japan's extended economic downturn in the 1990s.

🔀 Don't confuse

• Theoretical ambiguity vs. empirical regularity: in theory, either curve could dominate; in practice, supply shifts dominate during expansions.
• The excerpt emphasizes: "In reality, the first scenario is the one that usually wins out."

🧪 Practice scenarios (from the excerpt)

🧪 Stop and Think Box question

Question: "Recent increases in the profitability of investments, inflation expectations, and government surpluses will surely lead to increased bond supplies in the near future."

What's wrong?

• Government surpluses lead to decreased bond supplies, not increased.
• Deficits, not surpluses, cause governments to issue more bonds.
• The other two factors (profitability increases and inflation expectations) do correctly lead to increased bond supply.

🧪 Sample exercise logic

The excerpt includes exercises (without answers for most). Here's the logic for a few:

• Stock trading commissions decrease → stocks become more attractive relative to bonds → demand for bonds falls → bond prices fall.
• Bond trading commissions increase → bonds become less liquid → demand for bonds falls → bond prices fall.
• Government tax increases → businesses less eager to borrow → bond supply decreases → bond prices rise.
• Government revenues drop (with constant expenditures) → larger deficit → more bonds issued → bond prices fall.
• Government guarantees bond payments → default risk eliminated → demand for bonds increases → bond prices rise.

🎯 Key takeaways from the excerpt

🎯 Demand curve shifts

• Driven by changes in: wealth, expected relative returns, risk, and liquidity.
• Wealth, returns, and liquidity are positively related to demand.
• Risk is inversely related to demand.
• Wealth sets the general level; investors then trade off risk for returns and liquidity.

🎯 Supply curve shifts

• Driven by: government budgets, inflation expectations, and general business conditions.
• Deficits → supply increases; surpluses → supply decreases.
• Expected inflation → supply increases (real borrowing costs fall).
• Favorable business conditions → supply increases.

🎯 Business cycle effects

• Theoretically: whether expansion raises or lowers interest rates depends on relative shifts.
• Empirically: bond supply curve typically shifts much further than demand curve.
• Result: interest rates usually rise during expansions, always fall during recessions.

🧭 Overview

🧠 One-sentence thesis

Keynes's liquidity preference framework explains interest rate movements by analyzing the supply and demand for money, showing that inflation expectations and income changes shift money demand while monetary authority actions shift money supply, both affecting the equilibrium interest rate.

📌 Key points (3–5)

• The model's structure: only two assets exist—money (earning zero interest) and bonds (earning positive interest)—and equilibrium in the money market determines the interest rate.
• How equilibrium works: the intersection of money supply (vertical line) and money demand (downward-sloping curve) reveals the market interest rate.
• What shifts money demand: income and price level both positively affect money demand—higher income or inflation expectations shift the demand curve right, raising the interest rate.
• Common confusion: the model studies the money market to learn about interest rates, not the bond market directly, because both markets are in equilibrium.
• The liquidity effect: increasing the money supply shifts the supply curve right and lowers the interest rate, ceteris paribus.

💰 The two-asset framework

💰 What the model assumes

In this model there are but two assets: money, which earns no interest, and bonds, which earn some interest greater than zero.

• Economic models deliberately simplify reality to concentrate on what is most important.
• The two-asset assumption allows us to focus on the trade-off between liquidity (money) and returns (bonds).
• Because both money and bond markets are in equilibrium, studying the money market reveals what happens to interest rates.

🔄 Why study money instead of bonds

• The excerpt states we can "study the latter [money market] to learn about the former [bond market]" because both are in equilibrium.
• This approach differs from directly analyzing bond supply and demand but reaches the same conclusions about interest rates.
• Don't confuse: the interest rate is still determined by supply and demand forces, just viewed through the lens of money rather than bonds.

📈 Money supply and demand curves

📊 The money demand curve

• Slopes downward: as the interest rate increases, the quantity of money demanded decreases.
• Why it slopes down:
  • Higher interest rates mean higher opportunity cost of holding cash instead of bonds.
  • "Why hoard cash when you can buy bonds with it and make beaucoup bucks?"
  • Lower interest rates reduce the opportunity cost: "Why own bonds, which of course aren't as liquid as money, if they pay squat?"
• The vertical axis is the interest rate (not price), but the graph works exactly like a traditional supply and demand graph.

📏 The money supply curve

• Represented by a vertical line: the quantity supplied does not vary with changes in the interest rate.
• In technical terms, the supply of money is perfectly inelastic.
• The curve can shift left or right if the monetary authority (like a government central bank) decreases or increases the money supply.
• The position is controlled by policy, not by the interest rate itself.

⚖️ Reaching equilibrium

The intersection of the money supply and demand curves reveals the market rate of interest (i*).

How the market self-corrects:

Situation	What happens	Result
Interest rate above i*	Quantity of money demanded < quantity supplied → people use excess money to buy bonds	Bond prices rise, yields fall toward equilibrium
Interest rate below i*	Quantity of money demanded > quantity supplied → people sell bonds for cash	Bond prices fall, yields rise toward equilibrium

Example: If the interest rate is too high, people hold less cash than is available. They take their excess cash and buy bonds, driving bond prices up and interest rates down until equilibrium is restored.

🔀 What shifts the curves

💵 Money supply shifts

• Increase in money supply (curve shifts right) → interest rate falls, ceteris paribus.
  • Makes sense: more money to lend means lower cost of borrowing.
• Decrease in money supply (curve shifts left) → interest rate rises.
  • Less money to lend while demand stays the same.

📊 Money demand shifts

• Demand curve shifts right (money supply constant) → interest rate rises.
  • Higher demand for money with the same supply means higher "price" (interest rate).
• Demand curve shifts left → interest rate falls.
  • Lower money demand causes the interest rate to decrease.

The excerpt emphasizes: "The interesting issue here is why the curves move, not what happens when they do."

🎯 Why money demand shifts

💼 Income effects

Income is positively related to money demand.

• As income increases, the demand for money increases (shifting the money demand curve right, thus increasing the interest rate).
• Two reasons income matters:
  1. Money is an asset, so demand for it increases with wealth (as described in asset demand theory).
  2. Economic entities transact more as incomes rise, so they need more money to make payments.
• Example: During an economic expansion, people and businesses earn more and conduct more transactions, requiring more money at any given interest rate.

💸 Price level and inflation expectations

Inflation increases money demand because people care about real balances, not nominal ones.

• As the price level rises, the same sum of money cannot buy as much.
• People demand more money at any given interest rate to maintain their purchasing power.
• This shifts the money demand curve to the right, raising the interest rate.
• Connection to Fisher Equation: the interest rate rises in accord with the Fisher Equation when inflation expectations increase.

Don't confuse: people don't want more nominal money for its own sake—they want to maintain real balances (purchasing power).

🔥 The inflation scenario

📰 How inflation expectations affect interest rates

The excerpt provides a detailed scenario about inflation concerns:

When expected inflation rises:

• In the liquidity preference framework: expectations of higher prices cause the demand for money to shift right, raising the interest rate.
• In the bond market view (Fisher effect):
  • Higher expected inflation reduces the expected return on bonds relative to real assets.
  • Bond demand curve shifts left.
  • Real cost of borrowing decreases, so bond supply increases (supply curve shifts right).
  • Both reduced demand and increased supply lead to lower bond prices (higher yields).

Example: A company considering issuing bonds learns that economists expect inflation to rise. According to the analysis, the company will have to pay a higher yield on its bonds than anticipated because inflation expectations will increase the interest rate through multiple channels.

🔄 Deflation effects

• If prices actually decline (deflation), the opposite occurs.
• The demand for money decreases (people need less nominal money to maintain real balances).
• The money demand curve shifts left, causing the interest rate to decrease.

📉 Business cycles and interest rates

📈 Business expansion effects

A business expansion will cause interest rates to increase by increasing the demand for money (causing the money demand curve to shift right).

• During expansions, income rises and transaction volume increases.
• Both factors increase money demand.
• With money supply constant, higher demand raises the equilibrium interest rate.

📉 Recession effects

A recession will cause interest rates to decrease by decreasing the demand for money (causing the money demand curve to shift left).

• During recessions, income falls and transaction volume decreases.
• Money demand decreases.
• With money supply constant, lower demand reduces the equilibrium interest rate.

Example: If a steep recession sets in, the interest rate will fall because people and businesses need less money for transactions and have lower incomes.

🌊 The liquidity effect

💧 What the liquidity effect predicts

The liquidity preference framework predicts that increasing the money supply will decrease the interest rate. This liquidity effect, as it is called, holds if...

• When the monetary authority increases the money supply, the money supply curve shifts right.
• With money demand unchanged, the equilibrium interest rate falls.
• This is called the "liquidity effect" because it describes how changes in money availability (liquidity) affect interest rates.

🔍 Summary of determinants

The excerpt provides a comprehensive summary of what affects money supply and demand:

Factor	Effect on	Direction	Result on interest rate
Monetary authority increases money	Supply	Shifts right	Decreases
Monetary authority decreases money	Supply	Shifts left	Increases
Income rises	Demand	Shifts right	Increases
Income falls	Demand	Shifts left	Decreases
Price level/inflation expectations rise	Demand	Shifts right	Increases
Price level/inflation expectations fall	Demand	Shifts left	Decreases

Don't confuse: the liquidity effect specifically refers to money supply changes, not to all factors that affect interest rates through the liquidity preference framework.

🧭 Overview

🧠 One-sentence thesis

When the money supply increases, the interest rate may fall (liquidity effect), rise immediately, or rise with a lag, depending on whether inflation expectations and actual inflation overwhelm the initial downward pressure.

📌 Key points (3–5)

• The liquidity effect: increasing the money supply decreases the interest rate if income, actual inflation, and expected inflation remain constant.
• Three countervailing effects: income effect, price level effect, and expected inflation effect all push interest rates upward when money supply increases.
• Historical context matters: under commodity money (gold standard), liquidity effect dominated; under modern fiat money, inflation expectations often overpower it.
• Common confusion: the direction of interest rate change depends on which effect wins—liquidity effect vs. the three inflationary effects—not just on money supply growth itself.
• Forecasting difficulty: even professional forecasters struggle to predict interest rate changes, often getting direction wrong half the time.

💧 The liquidity effect and its conditions

💧 What the liquidity effect predicts

Liquidity effect: the prediction that increasing the money supply will decrease the interest rate.

• This is the direct, mechanical result from the liquidity preference framework.
• The money supply increases → more money available → interest rate falls.
• Critical condition: this holds only if all other factors remain the same (ceteris paribus).

🔒 The ceteris paribus requirement

The liquidity effect requires that three factors stay constant:

• Income levels
• Actual inflation
• Expected inflation

Historical example: In the early 1800s, these conditions actually held:

• The world used commodity money (gold/silver standard).
• Money supply was self-equilibrating—it expanded and contracted automatically.
• When money per capita increased from $1 to $25, interest rates fell from 20-30% down to 3-4%.
• No permanent price increases occurred; people expected zero net inflation over time.

⚔️ Three countervailing effects

📈 Income effect

• When money supply expands prudently, it increases economic growth and employment.
• Higher incomes → increased demand for money → interest rate rises.
• This effect works against the liquidity effect.

💰 Price level effect

• Expanding money supply causes prices to rise in modern economies.
• Unlike the commodity standard era, prices rise almost every year with no reversion to earlier levels.
• Higher price level → increased demand for money → interest rate rises.

🔮 Expected inflation effect

• When money supply increases today, people begin to expect inflation.
• Expected inflation causes both:
  • Bond supply curve to shift right
  • Bond demand curve to shift left
• Both shifts push interest rates upward.

⚖️ The battle of effects

When money supply increases, four effects compete:

• Downward pressure: liquidity effect (lowers interest rate)
• Upward pressure: income effect + price level effect + expected inflation effect (all raise interest rate)

The final outcome depends on which side wins.

🌍 Three scenarios in different economic contexts

🏛️ Scenario 1: Distant past (commodity money systems)

Context: Gold/silver standard, self-equilibrating money supply, zero expected inflation

What happens:

• Liquidity effect wins outright.
• Interest rate declines and stays below the previous level.
• No inflation expectations to counteract the liquidity effect.

Example: The early 1800s data showing steady interest rate decline as money per capita increased.

🏭 Scenario 2: Modern industrial economies with independent central banks

Context: Fiat money, credible monetary institutions, moderate inflation expectations

What happens (sequence):

1. Initially: liquidity effect wins → interest rate declines
2. Then: incomes rise, inflation expectations increase, price level actually rises
3. Eventually: interest rate increases above the original level

The liquidity effect is temporary; the three countervailing effects dominate over time.

🌐 Scenario 3: Undeveloped countries with weak central banks

Context: Weak monetary institutions, strong and immediate inflation expectations

What happens:

• Expected inflation effect is so strong and quick that it overwhelms the liquidity effect immediately.
• Interest rate rises right away (no initial decline).
• Later: after incomes and price level increase, interest rate soars even higher.

Don't confuse: This is not "no liquidity effect exists"—it's "inflation expectations are so powerful they dominate from the start."

📊 Comparison of outcomes

Economic context	Initial interest rate response	Later response	Why
Commodity money (past)	Falls and stays low	Stays low	No inflation expectations; ceteris paribus holds
Modern industrial (independent central banks)	Falls initially	Rises above original level	Liquidity effect wins first, then inflation effects dominate
Weak institutions (undeveloped countries)	Rises immediately	Rises even higher	Inflation expectations overwhelm liquidity effect instantly

🎯 Practical implications

🔮 Forecasting is extremely difficult

• Professional interest rate forecasters are rarely accurate.
• They often miss by large margins.
• Half the time they don't even get the direction (up or down) right—no better than flipping a coin.

📚 Post-diction vs. prediction

What you should be able to do:

• Post-dict: explain why past interest rate changes occurred using appropriate graphs and reasoning.
• Predict with ceteris paribus: make conditional forecasts assuming other factors remain constant.

What you should NOT expect:

• Accurate unconditional forecasts of future interest rate movements.
• The real world rarely holds other factors constant.

🧩 Milton Friedman's insight

His concern: Both inflation and deflation are harmful.

His proposal: Increase money supply at a known, constant rate (not fix it permanently).

Why not fix money supply permanently?

• As income and population grow, demand for money increases.
• Fixed money supply → interest rates would rise higher and higher.
• Only deflation could counter this, but deflation is as harmful as inflation.
• Constant growth rate would keep price level relatively stable and reduce interest rate fluctuations.

🔑 Key takeaways

🪙 Under commodity money systems

• Increase in money supply → interest rate decreases
• Decrease in money supply → interest rate increases
• The relationship is straightforward because inflation expectations remain stable.

💵 Under fiat money systems (modern)

• Increase in money supply might cause interest rates to:
  • Rise immediately (if inflation expectations are strong), or
  • Rise with a lag (as actual inflation takes place)
• The relationship is complex because multiple effects compete.

🧭 Overview

🧠 One-sentence thesis

Interest rates in the United States have moved together over time, trending downward from 1920 to 1945, rising until the early 1980s, then falling again through 2005, driven by shifts in business conditions, inflation expectations, and geopolitical events.

📌 Key points (3–5)

• Interest rates track each other: different types of financial instruments have different rates, but their movements are highly correlated—they move together closely.
• Three major trend periods: downward 1920–1945, upward 1945–early 1980s, downward early 1980s–2005.
• Business conditions shift bond demand: favorable conditions increase bond demand (curve shifts right), raising prices and lowering yields; unfavorable conditions reduce bond supply (curve shifts left), also raising prices and lowering yields.
• Inflation drives rates up: higher price levels push nominal interest rates higher through the Fisher Equation and Keynes's real nominal balances mechanism.
• Common confusion: bond supply vs. demand—both can raise bond prices and lower yields, but through different mechanisms (supply reduction vs. demand increase).

📈 Why interest rates move together

📊 High correlation across instruments

• The excerpt notes that "interest rate movements are highly correlated"—they track each other closely.
• This means that although different financial instruments (corporate bonds, government bonds, municipal bonds) have different interest rates, they all tend to rise and fall together.
• The figures referenced show this pattern clearly over nearly a century.
• Why this matters: it allows economists to talk about "the" interest rate or the general level of interest rates without losing too much accuracy.

🔍 Three distinct trend periods

The excerpt identifies three major phases:

Period	Direction	Key drivers
1920–1945	Downward	Favorable business conditions (1920s), then Great Depression supply shock (1930s)
1945–early 1980s	Upward	Post-war inflation, "creeping inflation," then "Great Inflation" of the 1970s
Early 1980s–2005	Downward	Federal Reserve controlled inflation, end of cold war, globalization

🏢 How business conditions affect rates

📈 Favorable conditions → lower rates

When general business conditions were favorable, demand for bonds increased (the demand curve shifted right), pushing prices higher and yields lower.

• The 1920s example: President Coolidge said "The business of America is business"—this favorable climate increased bond demand.
• Mechanism: more demand → bond prices rise → yields fall (remember: bond prices and yields move inversely).
• Example: when businesses see profit opportunities, they want to invest, so they demand more bonds (to raise capital or as investments).

📉 Unfavorable conditions → also lower rates (via supply)

When general business conditions were unfavorable, profit opportunities for businesses dried up, shifting the supply curve of bonds left, further increasing bond prices and depressing yields.

• The 1930s Great Depression example: "an economic recession of unprecedented magnitude that dried up profit opportunities."
• Mechanism: fewer profit opportunities → businesses issue fewer bonds → supply curve shifts left → bond prices rise → yields fall.
• Don't confuse: both favorable and unfavorable conditions can lower yields, but through different mechanisms—demand increase vs. supply decrease.
• The excerpt notes that if the federal government hadn't run budget deficits (adding bond supply), rates would have fallen even further during the Depression.

🔥 How inflation drives rates up

💰 The inflation-interest rate link

During inflationary periods, interest rates rose per the Fisher Equation and Keynes's real nominal balances.

• Post-World War II: the government used monetary policy to keep rates low during the war, but "that policy came home to roost as inflation began."
• The excerpt describes inflation becoming "a perennial fact of life" for the first time in American history—called "creeping inflation."
• Mechanism: higher price level → upward pressure on interest rates.

📊 The Great Inflation of the 1970s

• The excerpt mentions "unprecedented increase in prices during the 1970s"—called both "creepy inflation" and "the Great Inflation."
• This drove nominal interest rates "higher still"—the peak of the upward trend.
• Only when the Federal Reserve "mended its ways" and "brought inflation under control" in the early 1980s did rates begin to fall.

🌍 Geopolitical factors and the modern decline

🕊️ End of cold war and globalization

The end of the cold war and the birth of globalization helped to reduce interest rates by rendering the general business climate more favorable (thus pushing the demand curve for bonds to the right, bond prices upward, and yields downward).

• Late 1980s and early 1990s: positive geopolitical events improved business conditions.
• Mechanism: more favorable climate → increased bond demand → higher prices → lower yields.
• This contributed to the downward trend from the early 1980s through 2005.

🔄 The complete picture

The excerpt emphasizes that understanding these trends requires applying concepts from earlier chapters:

• Fisher Equation (linking nominal rates to inflation expectations)
• Keynes's real nominal balances (how price levels affect money demand and interest rates)
• Bond supply and demand curves (how shifts affect prices and yields)

Example: if you see interest rates rising in a period, check whether inflation is increasing (Fisher effect) or whether bond supply is increasing faster than demand (supply-demand imbalance).

🧭 Overview

🧠 One-sentence thesis

The risk structure of interest rates explains why bonds with the same maturity but issued by different entities have different yields, primarily because investors demand higher returns to compensate for differences in default risk, liquidity, and tax treatment.

📌 Key points (3–5)

• What the risk structure explains: why bonds of the same maturity issued by different entities (corporations, governments, municipalities) have different yields.
• Three major risks drive yield differences: default risk (probability of non-payment), liquidity (ease of trading), and after-tax return (tax treatment).
• Rank ordering pattern: Baa corporate bonds yield most, then Aaa corporates, then Treasuries, then municipal bonds (due to tax exemption).
• Common confusion: municipal bonds yield less than Treasuries despite higher default risk—tax exemption overcomes the risk premium.
• Flight to quality: during crises, spreads widen dramatically as investors sell risky bonds and buy safe ones, driving prices and yields in opposite directions.

💰 The three forces behind yield differences

🎲 Default risk

Default risk: the probability that a bond issuer will fail to make promised payments.

• U.S. government bonds: virtually no default risk because the government can always create money to meet nominal obligations (even if that causes inflation, it's not technically a default).
• Municipal bonds: moderate risk—municipalities can tax but cannot create money; some have defaulted historically (e.g., during the Great Depression).
• Corporate bonds: highest risk—companies depend on business conditions and management; no taxing or money-creation power.
• Bond ratings: agencies like Moody's and Standard & Poor's grade bonds (Aaa is highest, down to C/D for junk bonds); lower-rated bonds default more frequently.

Example: During the Great Depression, Baa-rated companies "went belly-up left and right," causing Baa bond yields to spike while safer Aaa and Treasury yields rose only slightly.

💧 Liquidity

Liquidity: how easily a bond can be bought or sold without affecting its price.

• Treasuries: most liquid bond markets.
• Corporate and municipal bonds: liquidity depends on issuer size and amount of bonds outstanding.
• Less liquid bonds require higher yields to attract investors.

Example: New Jersey state bonds might be more liquid than a small corporation's bonds but less liquid than General Electric's bonds.

🧾 Tax treatment

• Treasuries and corporates: fully taxable.
• Municipal bonds: exempt from most income taxes.
• Tax exemption makes munis more valuable to investors in high tax brackets (over 30%), allowing them to offer lower yields.

Don't confuse: Before income taxes became significant, munis yielded more than Treasuries (as expected given higher default risk and lower liquidity). Tax considerations reversed this relationship during and after World War II.

📊 Understanding the yield hierarchy

📈 Why the rank ordering exists

Bond Type	Yield Level	Reason
Baa Corporate	Highest	Highest default risk + limited liquidity + fully taxable
Aaa Corporate	High	Lower default risk than Baa + may be liquid + fully taxable
U.S. Treasury	Moderate	Extremely safe + extremely liquid + fully taxable
Municipal	Lowest	Tax exemption overcomes moderate default risk + limited liquidity

• Investors require a risk premium (also called credit/default risk premium, liquidity premium, and tax premium) to hold riskier or less liquid bonds.
• Another way to state this: investors accept lower yields on Treasuries because they don't need as much compensation for risk.

🔄 How the hierarchy changed over time

• Before WWII: Munis yielded more than Treasuries (expected pattern based on risk and liquidity alone).
• During WWII: Wealthy investors bought large quantities of munis for tax-exempt income, driving prices up and yields down.
• Since WWII: Tax considerations have "overcome the relatively high default risk and illiquidity of municipal bonds," keeping muni yields below Treasury yields most of the time.

📏 Bond spreads and their movements

📐 What spreads measure

Spread: the difference between yields of bonds of different types.

• Visually, spreads are "the distance between the lines" on yield charts.
• Spreads reflect how much extra return investors demand for taking on additional risk, illiquidity, or unfavorable tax treatment.

🌊 Why spreads change: the Great Depression example

• Early 1930s: Baa bond yields spiked dramatically while other bond yields rose only slightly.
• Cause: Baa-rated companies had much higher default rates; Aaa companies, municipalities, and the federal government were "more likely to default in that desperate period, but not nearly as likely."
• Result: The spread between Baa corporates and other bonds "increased considerably."
• Better times: Spreads narrowed as default risk declined.
• 1937–1938 Roosevelt Recession: Spreads widened again as economic conditions deteriorated.

✈️ Flight to quality

Flight to quality: during a crisis, investors simultaneously sell risky assets (driving prices down) and buy safe assets (driving prices up).

• Mechanism:
  • Investors sell riskier bonds (e.g., Baa corporates) → prices fall → yields rise.
  • Investors buy safe bonds (e.g., Treasuries) → prices rise → yields fall.
  • Spreads widen rapidly.

Example: After the September 2001 terrorist attacks, someone with advance knowledge could have profited by selling corporate bonds and buying Treasuries before the flight to quality occurred.

Don't confuse: A flight to quality is not just rising risk premiums—it's a simultaneous two-way movement where safe asset prices rise while risky asset prices fall, amplifying the spread change.

🧪 Predicting spread changes

🔮 Using the three-risk framework

By focusing on default risk, liquidity, and after-tax return, you can:

• Understand why some bonds are more or less valuable than others (holding maturity constant).
• Predict or explain changes in rank ordering.
• Predict or explain changes in spreads between bond types.

🎯 Scenario analysis

Scenario 1: Federal government makes Treasuries tax-exempt and raises income taxes considerably.

• Treasury yields would fall (tax exemption increases value).
• Spreads between Treasuries and other bonds would widen (Treasuries become even more attractive relative to taxable bonds).

Scenario 2: Supreme Court declares a major municipal tax revenue source illegal.

• Municipal default risk increases.
• Municipal bond yields would rise (investors demand higher return for increased risk).

Scenario 3: Brokers reduce fees for trading Baa corporate bonds.

• Baa bond liquidity improves.
• Baa bond yields would fall (lower liquidity premium needed).
• Spreads between Baa bonds and other bonds would narrow.

Scenario 4: A major corporation (like Enron) collapses.

• Perceived default risk for all corporate bonds increases.
• Corporate bond yields rise (especially for lower-rated bonds).
• Spreads between corporate bonds and Treasuries widen.

🧭 Overview

🧠 One-sentence thesis

The term structure of interest rates explains why bonds from the same issuer but with different maturities have different yields, and the yield curve reveals the market's prediction of future short-term interest rates based on investor expectations and liquidity preferences.

📌 Key points (3–5)

• What term structure explains: why bonds from the same issuer (e.g., U.S. Treasury) have different yields depending on their maturity dates, even when default risk, liquidity, and taxes are identical.
• The yield curve as a tool: a snapshot plotting yield against maturity that reveals market expectations about future interest rates and economic conditions.
• Why the curve usually slopes upward: investors prefer short-term bonds (liquidity preference) and demand a premium to hold long-term bonds due to greater interest rate risk.
• Common confusion—curve shapes: an upward slope means rates are expected to rise or stay stable; a flat curve suggests rates will fall moderately; an inverted curve predicts sharp rate declines (often signaling recession).
• Bonds as partial substitutes: bonds of different maturities are not perfect substitutes, so their yields differ, but they are related enough that expectations about future rates drive current long-term yields.

📊 What the term structure measures

📊 Holding risk constant, maturity matters

Term structure of interest rates: the variability of bond returns due to differing maturities, holding default risk, liquidity, and taxes constant.

• Even bonds issued by the same entity (e.g., U.S. government) can have different yields depending on how long until repayment.
• The excerpt shows that short-term Treasuries sometimes yield less than long-term ones, sometimes the same, and sometimes more.
• This variability cannot be explained by default, liquidity, or tax differences—those are identical for all Treasuries.

🔍 The yield curve snapshot

• A yield curve is a graph showing yields of bonds with different maturities at a single point in time.
• It is published daily (e.g., in the Wall Street Journal, Bloomberg, U.S. Treasury website).
• The curve's shape changes over time, reflecting shifts in investor expectations and preferences.

🔄 Why yield curves take different shapes

🔄 Bonds of different maturities are partial substitutes

• Investors do not treat a 1-year bond and a 10-year bond as identical, but they are related.
• Generally, investors prefer short-term bonds because they carry less interest rate risk (as discussed in an earlier chapter).
• To hold long-term bonds, investors demand a liquidity premium (or term premium)—a higher yield to compensate for the extra risk.

⬆️ The usual upward slope

• Most of the time, the yield curve slopes upward: short-term yields are lower than long-term yields.
• This reflects liquidity preference: investors' preferred habitat is short-term bonds, so they need extra compensation (a premium) to hold long-term bonds.
• Example: if short-term rates are 4% and the liquidity premium is 0.5%, a 5-year bond might yield 4.5%.

📉 When the curve flattens or inverts

• Sometimes the curve is flat (yields are nearly identical across maturities) or inverted (short-term yields exceed long-term yields).
• This happens when investors expect interest rates to fall in the future.
• If current short-term rates are high but expected to drop, investors will accept lower yields on long-term bonds because they view them as the average of future short-term rates.
• Investors may also anticipate that long-term bond prices will rise when rates fall, making them attractive even at lower current yields.

🧮 The expectations model formula

🧮 How investors think about long-term yields

The excerpt presents a formula (rewritten in words):

Long-term bond yield = (average of expected future short-term rates) + liquidity premium

• i_n = interest rate today on a bond maturing in n years
• i_e_x = expected interest rate in year x (0, 1, 2, ..., n−1)
• ρ_n = liquidity (term) premium for an n-period bond (always positive, increases with n)

📐 Numerical examples from the excerpt

1. Upward-sloping curve (stable expectations):

   • Expected rates each year: 4, 4, 4, 4, 4
   • Liquidity premium: 0.5%
   • 5-year bond yield = (4+4+4+4+4)/5 + 0.5 = 4.5%
   • Since 4 < 4.5, the curve slopes upward.

2. Steeper upward slope (rising expectations):

   • Expected rates: 4, 5, 6, 7, 8
   • Liquidity premium: 0.5%
   • 5-year bond yield = (4+5+6+7+8)/5 + 0.5 = 6.5%
   • Since 4 < 6.5, the curve slopes upward more steeply.

3. Inverted curve (falling expectations):

   • Expected rates: 12, 10, 8, 5, 5
   • Liquidity premium: 0.5%
   • 5-year bond yield = (12+10+8+5+5)/5 + 0.5 = 8.5%
   • Since 12 > 8.5, the curve is inverted (short-term yield exceeds long-term yield).

🔑 Why this matters

• The yield curve embeds the market's forecast of future short-term interest rates.
• To extract the forecast, subtract the liquidity premium from the observed yield curve.
• Don't confuse: the curve itself includes both expectations and the premium; the pure expectation is the curve minus the premium.

🔮 Using the yield curve for forecasting

🔮 The curve as a prediction tool

• Where the curve slopes sharply upward → market expects future short-term rates to rise.
• Where it slopes slightly upward → market expects rates to stay roughly the same.
• Where the curve is flat → rates expected to fall moderately.
• Where the curve inverts → rates expected to fall sharply.

📈 Implications for the economy

• Flat or inverted curve: signals lower future short-term rates, consistent with a recession but also with lower inflation.
• Steeply upward-sloping curve: signals higher future rates, which might result from rising inflation or an economic boom.

⚠️ Limitations of the forecast

• Empirical research shows the yield curve predicts well in the very short term (next few months) and the long term, but not in between.
• The liquidity premium (ρ_n) is not well understood, not easily observable, and may change over time.
• It may not increase much from one maturity to the next on the short end of the curve.

📜 Historical context: the 19th-century yield curve

📜 Why the curve was often flat in the 1800s

The excerpt includes a "Stop and Think Box" noting that in the nineteenth century, the yield curve was usually flat under normal conditions (it inverted only during financial panics).

Two possible explanations:

1. No liquidity premium: investors faced high reinvestment risk—difficulty reinvesting principal when bonds or mortgages were repaid. Lenders sometimes urged borrowers not to repay. This reinvestment risk may have offset interest rate risk, eliminating the need for a liquidity premium.

2. Stable long-term price level: the specie standard (gold/silver backing) made the interest rate less volatile. Investors expected rates to revert to a long-term mean, so short-term and long-term rates did not differ much.

🔄 Don't confuse: then vs. now

• Today, reinvestment risk is lower (more investment opportunities), so interest rate risk dominates, and investors demand a liquidity premium.
• In the 1800s, the balance of risks was different, leading to a flatter curve.

📝 Practice exercises (from the excerpt)

The excerpt includes two exercises asking students to interpret actual Treasury yield curves:

📝 Exercise 1: January 20, 2006

Maturity	Yield (%)
1 month	3.95
3 months	4.35
6 months	4.48
1 year	4.44
2 years	4.37
3 years	4.32
5 years	4.31
7 years	4.32
10 years	4.37
20 years	4.59

What it tells us: The curve rises steeply at the short end, then flattens and even dips slightly in the middle, then rises again at the long end. This suggests mixed expectations—perhaps stable or slightly falling rates in the near term, then rising in the distant future.

📝 Exercise 2: July 31, 2000

Maturity	Yield (%)
1 month	(missing)
3 months	6.20
6 months	6.35
1 year	(missing)
2 years	6.30
3 years	6.30
5 years	6.15
7 years	(missing)
10 years	6.03
30 years	5.78

What it predicts: The curve is inverted—yields decline as maturity increases. This suggests the market expected short-term interest rates to fall, possibly signaling an anticipated economic slowdown or recession.

🎯 Key takeaways (from the excerpt)

• The term structure of interest rates explains why bonds from the same issuer but different maturities have different yields.
• Plotting yield against maturity creates the yield curve, an important analytical tool.
• The yield curve is a snapshot of the term structure for a single class of bonds (e.g., Treasuries) and reveals the market's prediction of future short-term interest rates.
• By extension, the curve can be used to make inferences about inflation and business cycle expectations.

🧭 Overview

🧠 One-sentence thesis

Rational expectations and transparency can help mitigate asymmetric information problems by enabling investors to anticipate biases and discount misleading information when making decisions.

📌 Key points (3–5)

• Asymmetric information reduces financial market efficiency and harms the real economy by limiting funds to entrepreneurs.
• Two types of asymmetric information: adverse selection (precontractual) and moral hazard (postcontractual), each requiring different mitigation strategies.
• Principal-agent problems are a specific subcategory of moral hazard where agents (employees/managers) do not act in the best interest of principals (owners).
• Common confusion: adverse selection vs. moral hazard—adverse selection occurs before a contract (screening applicants), while moral hazard occurs after a contract (monitoring behavior).
• Rational expectations as a solution: when investors know that information providers have conflicts of interest, they can adjust their expectations and discount biased reports accordingly.

🔍 Types of asymmetric information

🔍 Adverse selection (precontractual)

Adverse selection is precontractual asymmetric information.

• Occurs before a contract is signed, during the applicant screening phase.
• The problem: high-risk applicants may hide their true risk level to gain approval.
• Mitigation strategy: screening out high-risk members of the applicant pool.
• Financial intermediaries can become expert specialists and achieve minimum efficient scale, but face the free-rider problem.
• The free-rider problem: few firms find it profitable to produce information because others can easily copy and profit from it; banks and intermediaries solve this by creating proprietary information about borrowers and insured parties.

🔍 Moral hazard (postcontractual)

Moral hazard is postcontractual asymmetric information.

• Occurs after a contract is signed, when the borrower or insured entity engages in behaviors not in the lender's or insurer's best interest.
• Examples from the excerpt:
  • A borrower uses a bank loan to buy lottery tickets instead of Treasuries as agreed.
  • An insured person leaves doors unlocked or lets candles burn unattended.
  • A borrower fails to repay a loan when able to do so, or an insured driver fakes an accident.
• Why it happens: people are tempted to put other people's money at risk—more risk means more reward, and if rewards don't materialize, the borrower defaults and suffers little.
• The excerpt notes that thinking of moral hazard as a character flaw does not help mitigate it; instead, practical mechanisms are needed.

🔍 Principal-agent problems

The principal-agent problem is an important subcategory of moral hazard that involves postcontractual asymmetric information of a specific type.

• Occurs when principals (owners) appoint agents (employees/managers) to conduct business on their behalf.
• The problem: agents may not act in the principal's best interest.
• Examples from the excerpt:
  • Stockholders hire professional managers who may steal, slack off, act rudely toward customers, or otherwise cheat the company's owners.
  • Investment banks underprice IPOs through "spinning" to create excess demand, then ration shares to favor certain investors rather than maximizing value for the issuing company.
• Don't confuse: this is still moral hazard, but specifically involves the owner-employee relationship rather than borrower-lender or insured-insurer relationships.

🛡️ Mitigating moral hazard

🛡️ Monitoring (costly state verification)

Monitoring is just a fancy term for paying attention.

• Lenders and insurers cannot "contract and forget"—they must ensure customers do not exploit their information advantage.
• Banks' monitoring advantage: watching checking accounts.
  • Banks rarely provide cash loans because the temptation to run off with money would be too high.
  • Instead, they credit the loan to a checking account and watch to ensure appropriate use.
  • This also creates "compensatory balances"—the loan doesn't leave the bank at once, raising the effective interest rate.

🛡️ Restrictive covenants

Most loans contain restrictive covenants, clauses that specify in great detail how the loan is to be used and how the borrower is to behave.

• If the borrower breaks one or more covenants, the entire loan may fall due immediately.
• Examples of covenants:
  • Require borrower to obtain life insurance.
  • Keep collateral in good condition.
  • Maintain business ratios within certain parameters.
  • Provide audited financial reports to minimize lender monitoring costs.

🛡️ Aligning incentives (skin in the game)

Another powerful way of reducing moral hazard is to align incentives.

• Make sure the borrower or insured will suffer if a loan goes bad or a loss is incurred.
• This induces the borrower or insured to behave in the lender's or insurer's best interest.

Collateral:

Collateral, property pledged for the repayment of a loan, is a good way to reduce moral hazard.

• Borrowers don't want to lose their homes or other assets.
• The more equity they have, the harder they will fight to keep from losing it.
• Higher net worth (market value of assets minus liabilities) makes default less likely.
• This explains why "you have to have money to borrow money"—owning assets free and clear makes borrowing much easier.

Deductibles and co-insurance:

• Insurers insure only part of the value of a ship, car, home, or life.
• Example: if an accident costs you $500 (deductible) or 20% of damage costs (co-insurance), you will think twice before doing something risky with your car.
• Without any personal loss, you might attempt risky behavior like late-night trips on icy roads or entering a demolition derby.

🛡️ Financial intermediaries' advantages

Why intermediaries are better at monitoring than individuals:

Advantage	Explanation
Economies of scale	Monitoring is not cheap ("costly state verification"); intermediaries can spread costs across many contracts
Specialization and expertise	Monitoring is not easy; intermediaries develop specialized skills
Legal resources	Intermediaries can hire the best legal talent to deter scammers; borrowers can go to prison for fraud even if not for defaulting

Why intermediaries are better than markets:

• In bond markets, free-rider problems arise: Bondholder A tries to free-ride on Bondholder B, who hopes Bondholder C will bear verification costs, and all hope the government will do the work.
• Result: nobody may monitor the bond issuer.
• Intermediaries solve this by taking direct responsibility for monitoring.

💡 Rational expectations and transparency as solutions

💡 The investment bank conflict of interest case

The problem:

• Investment banks engage in both research (for investors) and underwriting (for bond issuers), creating a conflict of interest.
• Investors want unbiased information; bond issuers want optimistic reports.
• During the late 1990s Internet stock mania, ibank managers forced research departments to avoid negative comments about clients.
• Example: Jack Grubman of Citigroup made outrageous claims about high-tech companies publicly, while private emails showed he thought they were extremely weak.

How it injured the economy:

• This is an example of moral hazard: investors contracted for unbiased research but received extremely biased advice.
• Result: investors paid too much for securities, particularly weak tech companies' equities.
• Financial market efficiency decreased as resources went to firms that did not deserve them and could not put them to their most highly valued use.
• This injured economic growth.

💡 Potential solutions

Separation of activities:

• Allow ibanks to engage in underwriting or research, but not both.
• Drawback: makes ibanks less profitable because doing both creates economies of scope.

Chinese walls:

• Create a barrier within each ibank between research and underwriting departments.
• The excerpt notes the irony: the Great Wall of China was repeatedly breached by invaders with help from insiders.
• Problem: if the wall is impenetrable, economies of scope vanish; if the wall is low or porous, the conflict of interest can arise again.

Rational expectations and transparency:

Rational expectations and transparency could help here. Investors now know (or at least could/should know) that ibanks can provide biased research reports and hence should remain wary.

• When investors understand that information providers have conflicts of interest, they can adjust their expectations accordingly.
• Government regulations can mandate that ibanks completely and accurately disclose their interests in the companies they research and evaluate.
• Extra transparency allows investors to discount rosy prognostications driven by ibanks' underwriting interests.

The Global Legal Settlement of 2002:

• Brokered by Eliot Spitzer (then New York State Attorney General).
• Bans spinning (underpricing IPOs to create excess demand for rationing to favored investors).
• Requires investment banks to sever links between underwriting and research.
• Imposed a $1.4 billion fine on the ten largest ibanks.

💡 How rational expectations work

• Investors who understand the incentive structure of information providers can anticipate biases.
• Rather than taking reports at face value, they discount information that appears driven by conflicts of interest.
• This mechanism relies on transparency: investors must know about the conflicts to adjust their expectations.
• Example: if an investor knows an ibank underwrites for a company, the investor can discount the ibank's overly optimistic research report on that company.

📉 Economic impact of asymmetric information

📉 Overall effects

Asymmetric information decreases the efficiency of financial markets, thereby reducing the flow of funds to entrepreneurs and injuring the real economy.

• When financial markets cannot efficiently allocate capital due to information problems, entrepreneurs receive less funding.
• Resources go to the wrong firms—those that do not deserve them and cannot put them to their most highly valued use.
• This reduces economic growth overall.

📉 The free-rider problem in information production

• Few firms find it profitable to produce information because it is easy for others to copy and profit from it.
• This market failure means less information is produced than would be socially optimal.
• Solution: Banks and other intermediaries create proprietary information about their borrowers and insured parties that cannot be easily copied.

📉 Historical note

Classical economists like Adam Smith recognized adverse selection and asymmetric information more generally, but they did not label or stress the concepts.

• The formal analysis of asymmetric information is relatively recent, even though the underlying phenomena were observed long ago.

🧭 Overview

🧠 One-sentence thesis

The principal-agent problem and asymmetric information create conflicts of interest in corporate governance that require monitoring, aligned incentives, and regulation to protect shareholders and ensure efficient markets.

📌 Key points (3–5)

• Principal-agent problem: agents (employees, managers) may not act in the best interest of principals (owners), leading to theft, slacking, or other harmful behaviors.
• Incentive alignment: efficiency wages, commissions, bonuses, and stock options can reduce agency problems, but poorly designed incentives create perverse outcomes.
• Free-rider problem in monitoring: individual shareholders lack incentive to monitor management because others benefit from their costly efforts without contributing.
• Common confusion: aligning incentives sounds simple, but people do precisely what they're incentivized to do—unintended consequences are common (e.g., collectors becoming bankruptcy counselors).
• Why governance matters: weak monitoring allows managers to raise salaries excessively, slack off, or empire-build, explaining why stock sales are a relatively unimportant form of external finance worldwide.

🚨 The principal-agent problem

🚨 What it is and how it arises

The principal-agent problem arises when agents do not act in the best interest of the principal.

• In corporations, owners (principals) hire managers, who hire supervisors, who hire employees (agents).
• Agents may steal, slack off, act rudely toward customers, or otherwise cheat the company's owners.
• The excerpt notes that both authors admit to having been guilty of such activities as employees and victims as owners.

Example: One author's brother told him their childhood lemonade stand had revenues of only $1.50 when it actually brought in $10.75—an early agency problem.

🏦 Investment bank spinning case

The excerpt describes a specific conflict of interest called spinning:

• Investment banks systematically underpriced initial public offerings (IPOs), as evidenced by large first-day price "pops" in the aftermarket.
• Underpricing was too prevalent to be honest errors (which should be too high half the time, too low the other half).
• Investment banks purposely underpriced IPOs to create excess demand, then rationed the "hot shares" to friends, family, and executives of other companies in return for future business.

Who it hurts:

• Owners of the company going public receive less money than they could have.
• Investors in companies whose executives received underpriced shares, because those executives might not use the best investment bank later in reciprocation.

Who it helps:

• The investment bank gains a tool to acquire more business.
• Whoever receives the underpriced shares.

🛠️ Solutions to agency problems

🛠️ Monitoring

• Supervisors, cameras, and corporate informants help mitigate the principal-agent problem.
• Direct observation and oversight reduce opportunities for agents to act against principals' interests.

💰 Aligning incentives

A more powerful way of reducing agency problems is to align the incentives of employees with those of owners by paying efficiency wages, commissions, bonuses, stock options, and the like.

Critical warning from the excerpt:

• People will do precisely what they have incentive to do.
• Failure to recognize this universal human trait has had adverse consequences for organizations.

⚠️ Perverse incentives: ice cream retailer

• A major ice cream retailer allowed employees to consume mistakes free of charge (meant as an environmentally sensitive perk).
• Hungry employees found it easy to make "delicious frozen mistakes."
• Employee waistlines bulged and profits shrank.

Example dialogue: "Oh, you said chocolate. I thought you said my favorite flavor, mint chocolate chip. Excuse me because I am now on break."

⚠️ Perverse incentives: debt collection agency

Original incentive scheme:

• Collectors received bonuses based on dollars collected divided by dollars assigned.
• Example: $250,000 collected / $1,000,000 assigned = 0.25 bonus ratio.

Revised scheme (after complaints about bankrupt accounts):

• Managers deducted bankrupt accounts from the denominator.
• Example: $100,000 collected / ($1,000,000 - $800,000 bankrupt) = $100,000 / $200,000 = 0.5 bonus ratio.

Unintended consequence:

• Collectors transformed themselves into bankruptcy counselors.
• The new scheme inadvertently created a perverse incentive diametrically opposed to the collection agency's interest (collecting as many dollars as possible).

📈 Stock options and accounting manipulation

• When managers are paid with stock options, they have an incentive to increase stock prices.
• They sometimes do this by making companies more efficient.
• But sometimes, as investors in the U.S. stock market in the late 1990s learned, they use accounting manipulation ("legerdemain").

🔍 The free-rider problem in corporate governance

🔍 Why monitoring fails

A free-rider problem makes it difficult to coordinate the monitoring activities that keep agents in line.

The dynamic:

• If Stockholder A watches management, Stockholder B doesn't have to but still reaps the benefits.
• Stockholder A sits around hoping Stockholder B will do the costly work of monitoring executive pay and perks.
• Often, nobody ends up monitoring managers.

Consequences when monitoring fails:

• Managers raise their salaries to obscene levels.
• Managers slack off work.
• Managers go empire-building.
• Or all three.

🏢 Why stock sales are unimportant globally

This governance conundrum helps to explain why the sale of stocks is such a relatively unimportant form of external finance worldwide.

• Governance becomes less problematic when the equity owner is actively involved in management.
• This explains alternative approaches to equity investment.

🤝 Solutions through active involvement

Historical and modern examples:

Approach	How it works	Why it reduces free-riding
J.P. Morgan's method	Put "his people" (principals in J.P. Morgan and Company) on boards of companies with large stakes	Direct principal involvement in management
Warren Buffett's Berkshire Hathaway	Similar approach of active board participation	Aligned ownership and oversight
Venture capital firms	Insist on taking management control; startup equity cannot trade until IPO/DPO	Other investors cannot free-ride on costly monitoring; no secondary market
Private equity funds	Invest in privately owned (versus publicly traded) companies	Avoids free-rider problem and costly regulations like Sarbanes-Oxley

📋 Government regulation and conflicts of interest

📋 Accounting firm conflicts

The problem:

• Accounting firms both audited corporate financial statements and provided tax, business strategy, and other consulting services.
• Auditors were too soft in hopes of winning or keeping consulting business.
• They could not criticize plans put in place by their own consultants.

Arthur Andersen collapse:

• One of the big five accounting firms collapsed after the market and SEC discovered its auditing procedures had been compromised.

📋 Why simple disclosure doesn't work

• Financial statements have to be correct.
• The free-rider problem ensures no investor would have incentive to verify them individually.
• The traditional solution was the auditor, and no better one has yet been found.
• But the question remains: How to ensure auditors do their jobs?

📋 Sarbanes-Oxley Act of 2002 (SOX/Sarbox)

Key provisions:

Provision	Purpose
Public Company Accounting Oversight Board (PCAOB)	New regulator to oversee auditor activities
Increased SEC budget	More enforcement capacity (though still tiny compared to the grand scheme)
Separation requirement	Made it illegal for accounting firms to offer audit and nonaudit services simultaneously
Increased criminal charges	Stronger penalties for white-collar crimes
CEO/CFO certification	Executive officers must certify accuracy of financial statements
Audit committees	Corporate boards must establish unpaid audit committees composed of outside directors (not members of management)

Controversy and assessment:

• The most controversial provision is the CEO/CFO certification and audit committee requirement.
• The jury is still out on SOX.
• The consensus so far: it is overkill—it costs too much given the benefits it provides.

📋 Government regulation generally

Government regulators try to reduce asymmetric information. Sometimes they succeed. Often, however, they do not.

• Asymmetric information is such a major problem that regulatory efforts will likely continue, whether all businesses like it or not.
• Some regulations, like laws against fraud, are clearly necessary and highly effective.
• Others, like parts of Sarbanes-Oxley, may add to the costs of doing business without much corresponding gain.

🎯 Key takeaways from the excerpt

• Agency problems are a special form of moral hazard involving employers and employees or other principal-agent relationships.
• Mitigation strategy: Agency problems can be reduced by closely aligning the incentives of agents (employees) with those of principals (employers).
• Caution required: Incentive design must account for the fact that people do precisely what they're incentivized to do—unintended consequences are common.
• Regulations are essentially attempts by the government to subdue asymmetric information problems.
• Regulation effectiveness varies: some are clearly necessary and highly effective (e.g., fraud laws); others may add costs without corresponding gains (e.g., parts of Sarbanes-Oxley).

🧭 Overview

🧠 One-sentence thesis

Banks must simultaneously manage liquidity, profitability, and capital adequacy while facing credit risk and interest rate risk, making bank management a complex balancing act closely monitored by regulators.

📌 Key points (3–5)

• Three core management challenges: liquidity (enough reserves but not too many), profitability (asset and liability management), and capital adequacy (sufficient cushion but not excessive).
• Two major risks: credit risk (borrower defaults) and interest rate risk (rate changes affecting returns/costs).
• The fundamental trade-off: banks "borrow short and lend long," transforming short-term deposits into long-term loans, which creates inherent management difficulties.
• Common confusion: reserves vs profitability—holding too many reserves ensures liquidity but kills profits; holding too few risks inability to meet withdrawals.
• Why regulation matters: the 2008 panic showed banks also face liquidity seizure risk in financial markets; regulators close banks before equity reaches zero to prevent failures.

🏦 What banks do and how they transform assets

🏦 Core function in five words

Banks lend long and borrow short.

• This is the essence of what commercial banks do.
• They are financial intermediaries that engage in asset transformation.

🔄 Asset transformation explained

Asset transformation: selling liabilities with certain liquidity, risk, return, and denominational characteristics and using those funds to buy assets with a different set of characteristics.

• Banks link investors (who buy the bank's liabilities) to entrepreneurs (who sell assets to the bank) in a more sophisticated way than simple market facilitators.
• Specifically for banks: they turn short-term deposits into long-term loans.
• This is more complex than other intermediaries:
  • Finance companies borrow long and lend short (easier management).
  • Life insurance companies sell contingent contracts (policies that pay if the insured dies).
  • Property and casualty companies sell policies that pay if specific events occur.
• Example: A depositor puts money in a checking account (short-term, liquid liability for the bank); the bank uses that money to fund a 30-year mortgage (long-term, illiquid asset).
• Why this matters: This mismatch between short-term liabilities and long-term assets creates the specific management problems banks face.

📊 Bank balance sheets and T-accounts

📊 Balance sheet structure

A balance sheet lists what a bank owns (assets, uses of funds) and what it owes (liabilities, sources of funds).

Major bank assets:

• Reserves (cash and deposits with the Fed)
• Secondary reserves (government and other liquid securities)
• Loans (to businesses, consumers, other banks)
• Other assets (buildings, computer systems, physical infrastructure)

Major bank liabilities:

• Deposits (transaction and nontransaction)
• Borrowings (from other banks, the Fed, corporations)
• Shareholder equity (net worth)

💰 Asset side details

💰 Reserves

• Allow banks to pay transaction deposits and other liabilities.
• Required reserves: minimum level mandated by regulators.
• Excess reserves: anything held above the requirement.
• American bankers keep excess reserves to a minimum because reserves pay no interest.
• Instead, they prefer secondary reserves (U.S. Treasuries and other safe, liquid, interest-earning securities).

💰 Loans

• The bank's "bread-and-butter asset"—most income comes from loans.
• Banks must be very careful about who they lend to and on what terms.
• Types:
  • Loans to other banks (federal funds market, check clearing).
  • Loans to nonbanks (most loans).
  • Uncollateralized loans.
  • Collateralized loans: mortgages (backed by real estate), factorage (backed by accounts receivable), call loans (backed by securities).

🏛️ Liability side details

🏛️ Transaction deposits

• Include NOW accounts, MMDAs, and checkable deposits.
• Banks like these because they pay little or no interest.
• Some depositors even pay fees for the liquidity convenience.
• Banks justify fees by pointing to costs: bookkeeping, money transfers, maintaining cash reserves.

🏛️ Nontransaction deposits

• Range from passbook savings accounts to negotiable certificates of deposit (NCDs) over $100,000.
• Passbook savings: can withdraw or add at will, but no checks; more liquid, so lower interest rates.
• Time deposits (CDs): impose stiff penalties for early withdrawal; less liquid, so higher interest rates.

🏛️ Borrowings

• Overnight borrowing from other banks via the federal funds market.
• Direct borrowing from the Federal Reserve via discount loans (advances).
• Borrowing from corporations, including parent companies (if part of a bank holding company).

🏛️ Bank net worth (equity capital)

Net worth: the difference between the value of a bank's assets and its liabilities.

• Originally comes from stockholders in IPO or DPO.
• Later comes mostly from retained earnings; sometimes from seasoned stock offerings.
• Why regulators watch this closely: more equity = less likely to fail.
• U.S. regulators close banks well before equity reaches zero (if they catch it in time).
• Even well-capitalized banks can fail very quickly, especially if trading derivatives.

📝 T-accounts for tracking changes

T-accounts: simplified balance sheets that list only changes in liabilities and assets.

• Called T-accounts because they look like a T (horizontal and vertical rules crossing).
• Used to analyze the dynamic changes constantly occurring in banks.

Example: Someone deposits $17.52 cash in a checking account:

Some Bank Assets	Some Bank Liabilities
Reserves +$17.52	Transaction deposits +$17.52

Example: Someone deposits a check for $4,419.19 drawn on Another Bank:

Initial T-account for Some Bank:

Assets	Liabilities
Cash in collection +$4,419.19	Transaction deposits +$4,419.19

After collection (Some Bank):

Assets	Liabilities
Cash in collection −$4,419.19
Reserves +$4,419.19

Another Bank:

Assets	Liabilities
Reserves −$4,419.19	Transaction deposits −$4,419.19

⚖️ The three management challenges

⚖️ Liquidity management

Liquidity management: ensuring the bank has enough reserves to pay for any deposit outflows (net decreases in deposits) but not so many as to render the bank unprofitable.

• The trade-off: Too many reserves = safe but unprofitable (reserves pay no interest). Too few reserves = profitable but risky (can't meet withdrawals).
• Deposit outflows: net decreases in deposits that require the bank to pay out reserves.
• Example: Big Apple Bank has $10 million in reserves and $30 million in transaction deposits. If it experiences a $5 million net outflow, reserves drop to $5 million and transaction deposits to $25 million. The bank must ensure it still has enough reserves to operate.

⚖️ Profitability management

Banks must earn profits through two channels:

Asset management:

• The bank must own a diverse portfolio of remunerative (income-generating) assets.
• This means choosing the right mix of loans and securities that earn returns.

Liability management:

• The bank must obtain its funds as cheaply as possible.
• This means minimizing interest paid on deposits and borrowings.

⚖️ Capital adequacy management

Capital adequacy management: ensuring the bank has sufficient net worth or equity capital to maintain a cushion against bankruptcy or regulatory attention but not so much that the bank is unprofitable.

• The second tricky trade-off: Too little capital = risk of failure and regulatory intervention. Too much capital = unprofitable (equity is expensive).
• Regulators watch bank capital closely because more equity reduces failure risk.

🎲 The two major risks

🎲 Credit risk

Credit risk: the risk of borrowers defaulting on the loans and securities the bank owns.

• If borrowers don't repay, the bank loses money on its assets.
• Banks must carefully assess who they lend to and on what terms.

🎲 Interest rate risk

Interest rate risk: the risk that interest rate changes will decrease the returns on the bank's assets and/or increase the cost of its liabilities.

• Example: If interest rates rise, the bank may have to pay more on deposits (increasing liability costs) while its existing loans still earn the old, lower rates (decreasing asset returns).
• This risk is especially acute because banks borrow short and lend long.

🎲 Additional risks revealed in 2008

The financial panic of 2008 reminded bankers of additional risks:

• Liability risk: if financial markets become less liquid.
• Capital adequacy risk: if financial markets seize up completely (quantity demanded/supplied = 0).
• These risks can materialize even for well-capitalized banks, especially those trading derivatives.

🕰️ Historical perspective: early U.S. banking

🕰️ Reserve practices in the 19th century

In the first half of the 19th century:

• Bank reserves consisted solely of full-bodied specie (gold or silver) coins.
• Banks pledged to pay specie for notes and deposits immediately upon demand.
• The government did not mandate minimum reserve ratios.

🕰️ Why early banks kept high reserves (20–30%)

Early banks kept reserves much higher than today's required reserves for several reasons:

No fast borrowing:

• Unlike today, no fast, easy, cheap way to borrow from the government or other banks.
• Borrowing was essentially closed to them.

Limited secondary reserves:

• Banks in major cities (Boston, New York, Philadelphia) could keep secondary reserves.
• Before the telegraph, hinterland banks couldn't be certain they could sell bonds quickly into thin local markets.
• For most banks, secondary reserves were of little use.

Higher outflow risk:

• Early bankers sometimes collected rivals' liabilities and presented them all at once, hoping to catch the other bank with inadequate reserves.
• Runs by depositors were much more frequent.

Prudent strategy:

• Only one option for prudent early bankers: keep vaults brimming with coins.

🕰️ Wildcat banks exception

• Some notorious exceptions were "wildcat banks"—basically financial scams.
• These were not representative of typical banking practice.

🏥 Comparison: savings banks and life insurance companies

🏥 Why they hold fewer reserves

Savings banks and life insurance companies hold significantly fewer reserves than commercial banks.

Reason:

• They do not suffer large net outflows very often.
• People do draw down savings (withdrawals, cashing in life insurance, policy loans).
• But: one advantage of large intermediaries is they can meet outflows from inflows.
• They can usually pay customer A's withdrawal from customer B's deposit or premium payment.
• Therefore, no need for large reserves, which are expensive in opportunity costs.

Don't confuse with commercial banks:

• Commercial banks face frequent transaction deposit outflows and must maintain higher reserves.
• Savings banks and life insurance companies have more predictable, offsetting flows.

🧭 Overview

🧠 One-sentence thesis

Banks must actively manage liquidity, capital, assets, and liabilities while balancing trade-offs between profitability and safety, using specialized screening and monitoring techniques to minimize credit risk and prevent failures.

📌 Key points (3–5)

• Core trade-offs: Banks face liquidity management (holding enough reserves) and capital adequacy management (holding enough equity buffer), both of which reduce profitability but increase safety.
• Credit risk management: Banks reduce asymmetric information through screening (applications, verification, credit reports), specialization, long-term relationships, collateral requirements, and credit rationing.
• Risk-return in capital structure: Higher leverage (less capital relative to assets) increases return on equity but also increases bankruptcy risk when loans default.
• Common confusion: Return on assets (ROA) vs return on equity (ROE)—ROE measures profitability per dollar of shareholder capital and rises with leverage, while ROA measures profitability per dollar of total assets regardless of capital structure.
• Liability management evolution: Since the 1960s, large banks shifted from passively accepting deposits to actively managing liabilities by attracting deposits, selling negotiable certificates of deposit, and borrowing in the federal funds market.

💧 Liquidity management

💧 What liquidity risk means

Liquidity management: ensuring the bank has enough reserves to meet withdrawal demands and regulatory requirements.

• Banks hold reserves (cash and deposits at the central bank) to handle deposit outflows.
• The reserve ratio = reserves ÷ transaction deposits.
• When net deposit outflows occur (withdrawals exceed deposits), reserves fall and the reserve ratio drops.
• If the ratio falls below the legal minimum or reaches zero, the bank faces a liquidity crisis.

🔧 How banks restore liquidity

When reserves fall too low, banks choose the least expensive method to increase reserves:

Method	How it works	Trade-off
Sell securities	Convert "secondary reserves" to cash	Lose interest income; quickest option
Borrow funds	Borrow from Fed or other banks (federal funds market)	Pay interest; increases liabilities and bank size
Attract deposits	Offer higher rates, lower fees, better service	Takes time; may be costly
Call in loans	Demand repayment or sell loans	Angers borrowers; high adverse selection if selling loans
Sell real estate	Liquidate physical assets	Very slow; disrupts business operations

Example: Big Apple Bank starts with $10 million reserves and $30 million transaction deposits (reserve ratio = 0.33). After $5 million net outflow, reserves drop to $5 million and deposits to $25 million (ratio = 0.20). After another $5 million outflow, reserves hit $0 and deposits fall to $20 million (ratio = 0.00). The bank must act immediately—selling $10 million in securities restores reserves to $10 million and raises the ratio to 0.50.

🔄 Liabilities drive bank size

• Changes in liabilities (deposits and borrowings) are called "sources of funds" because they determine total bank size.
• When deposits shrink, total assets shrink unless the bank borrows to replace them.
• When the bank borrows, total assets and liabilities both grow.

Don't confuse: Selling assets (e.g., securities) to buy reserves does not change bank size—it only reshuffles the asset side. Borrowing or attracting deposits changes the size of the balance sheet.

🏛️ Capital adequacy management

🏛️ Why banks hold capital

Capital (equity, net worth): the buffer that absorbs losses and keeps the bank solvent.

• Capital = Assets − Liabilities.
• If losses exceed capital, capital becomes negative and the bank is bankrupt.
• Regulators impose capital requirements (minimum capital levels) because banks would otherwise hold too little capital to protect depositors and the financial system.

⚖️ The profitability trade-off

Banks face a tension between safety and profitability:

• Return on assets (ROA) = net profit ÷ total assets.
• Return on equity (ROE) = net profit ÷ capital.
• Higher leverage (more assets per dollar of capital) increases ROE but also increases bankruptcy risk.

Example: Safety Bank and Shaky Bank both have $100 billion in assets and $10 billion in profit, so both have ROA = 10%. But Safety Bank has $10 billion in capital (ROE = 1.0) while Shaky Bank has only $1 billion in capital (ROE = 10.0). If $5 billion in loans default, Safety Bank survives with $5 billion in capital remaining, but Shaky Bank's capital becomes −$4 billion (bankrupt).

🛠️ How banks manage capital

Banks adjust capital in three ways:

1. Buy or sell their own stock: Buying back shares reduces outstanding shares and increases ROE; selling shares increases capital and decreases ROE.
2. Pay or withhold dividends: Paying dividends reduces capital and increases ROE; retaining earnings increases capital and decreases ROE.
3. Change asset size: Increasing assets (with capital constant) increases ROE; decreasing assets decreases ROE.

Don't confuse: Capital management is not the same as asset management. Banks can change ROE by adjusting either the numerator (profit) or the denominator (capital or assets).

🎯 Credit risk management

🎯 What credit risk is

Credit risk: the risk that borrowers will default on loans and securities the bank owns.

• Credit risk is the primary threat to bank profitability—poor loan decisions lead to nonperforming loans and losses.
• Banks must combat asymmetric information: adverse selection (lending to risky borrowers) and moral hazard (borrowers behaving riskly after receiving the loan).

🔍 Screening to reduce adverse selection

Banks create information about applicants to avoid lending to risky borrowers:

• Applications: Ask detailed questions; make the application a binding part of the contract so fraud voids the loan.
• Verification: Check information with third parties—call employers, conduct medical exams, hire appraisers.
• Credit reports: Buy reports from Equifax, Experian, Trans Union; insurers share information with each other.
• Specialization: Focus on one or a few types of borrowers to develop expertise in spotting risky applicants.

Example: An applicant claims to be "Supreme Commander of XYZ Corporation"—the bank calls the employer to verify. An applicant claims a small house is worth $1.2 million—the bank hires an appraiser to check.

Don't confuse: Screening happens before the loan is made (to reduce adverse selection). Monitoring happens after (to reduce moral hazard).

👁️ Monitoring to reduce moral hazard

Banks watch what borrowers do after receiving loans:

• Restrictive covenants (loan covenants): Contract terms that limit risky behavior—require financial reports, maintain working capital, allow onsite inspections, restrict withdrawals, include call options if performance deteriorates.
• Insurance covenants: Prohibit risky activities (e.g., turning a home into a brothel voids homeowner's insurance).
• Claims investigation: Insurers investigate suspicious claims (e.g., a car crash the day after increasing coverage).

🤝 Long-term relationships

• Banks study checking and savings accounts over years or decades to assess creditworthiness.
• Borrowers cooperate because they expect future business—the relationship is a repeated game (tit-for-tat strategy) rather than a one-off prisoner's dilemma.
• Loan commitments (lines of credit): Promises to lend a certain amount at a specified rate for a set period; most commercial loans are structured this way.

🔒 Collateral and credit rationing

• Collateral: Assets pledged by the borrower for repayment; when the collateral is cash left in the bank, it's called compensating balances.
• Credit rationing: Refusing to lend at any interest rate (to avoid adverse selection—high rates attract risky borrowers) or lending less than requested (to reduce moral hazard—smaller loans reduce incentive to abscond or cheat).

Don't confuse: Credit rationing is not the same as charging a higher interest rate. Banks sometimes refuse to lend at any rate because high rates signal high risk.

⚠️ Limits of screening

• Banks are not perfect screeners—competitive pressure, individual banker incentives, or external political/societal pressure can lead to lending to risky borrowers.
• When screening fails, banks suffer from high levels of nonperforming loans (loans in default).
• Example: In 2007, subprime mortgage lenders (specializing in high-risk borrowers) experienced soaring default rates, triggering fears of a financial crisis.

🔄 Asset and liability management

📊 Asset management

Asset management: choosing the mix of loans, securities, and other assets to balance risk and return.

• Banks want safe, high-interest loans, but few exist—they must choose between lower interest or higher default rates.
• Diversification: Lend to a variety of borrowers in different sectors and regions to avoid concentration risk (if one sector or region fails, the bank doesn't fail with it).
• Secondary reserves: Hold some easily sold assets (securities) to quickly raise reserves if needed.

📈 Liability management

• Historically, banks passively accepted deposits and adjusted assets accordingly.
• Since the 1960s, money center banks (large banks in New York, Chicago, San Francisco) began actively managing liabilities:
  • Attract deposits with higher rates and better service.
  • Sell large negotiable certificates of deposit (NCDs) to institutional investors.
  • Borrow in the federal funds market (overnight loans between banks).
• Today, if a bank has a profitable loan opportunity, it raises funds by borrowing, attracting deposits, or selling NCDs rather than waiting for deposits to arrive.

Don't confuse: Passive liability management = taking deposits as given and adjusting assets. Active liability management = raising funds on demand to fund profitable opportunities.

⚖️ Specialization trade-offs

• Benefits: Specialization improves screening and monitoring, reducing credit risk.
• Costs: Over-specialization increases systemic risk—too many loans in one place or to one group means the bank fails if that sector or region fails.
• Banks must decide how much to specialize, balancing credit risk reduction against systemic risk increase.

🏦 Regulatory and systemic context

📏 Why regulation exists

• Banks would hold some reserves and capital even without regulation (for safety and business operations).
• However, they might not hold enough to prevent bank failures at a socially acceptable rate.
• Regulators impose reserve requirements and capital requirements to protect depositors and the financial system.

💸 Opportunity costs

• Reserves: Pay no interest, so holding them reduces profitability.
• Capital: Must share profits, so holding more capital reduces return on equity.
• These opportunity costs create pressure on banks to minimize reserves and capital, which is why regulation is necessary.

🌐 Systemic risk and government intervention

• When many banks make bad loans (e.g., subprime mortgages in 2007), the risk of a financial crisis rises.
• The government must balance supporting the financial system against creating moral hazard—if banks expect bailouts, they may take excessive risks.
• The excerpt notes that in 2007, people debated whether the government should guarantee subprime mortgages to prevent crisis, but warns that such intervention could encourage future risky lending.

Don't confuse: Individual bank failure (credit risk) vs systemic failure (many banks fail together, threatening the entire financial system). Regulators care more about systemic risk because it affects the whole economy.

🧭 Overview

🧠 One-sentence thesis

Banks manage credit risk and interest-rate risk through screening, monitoring, collateral requirements, and balancing rate-sensitive assets and liabilities to protect profitability.

📌 Key points (3–5)

• Credit risk management tools: screening applicants, monitoring borrowers, requiring collateral (including compensating balances), and using restrictive covenants in loan agreements.
• Loan commitments and lines of credit: arrangements where banks commit to lend at pre-agreed rates for a set period, beneficial to both lenders and borrowers.
• Credit rationing as an information tool: refusing loans at any rate (to reduce adverse selection) or lending less than requested (to reduce moral hazard).
• Interest-rate risk: arises when the value of rate-sensitive liabilities exceeds rate-sensitive assets—rising rates hurt profitability; the reverse situation creates opposite effects.
• Common confusion: More lending or higher rates don't always mean better outcomes—risky borrowers willing to pay high rates signal danger, and excessive lending increases moral hazard.

🛡️ Managing credit risk

🔍 What is credit risk

Credit risk: the chance that a borrower will default on a loan by not fully meeting stipulated payments on time.

• This is the fundamental risk banks face when lending money.
• Default means the borrower fails to pay back according to the agreed schedule.
• Banks must actively manage this risk or face losses from nonperforming loans.

🧰 Screening and monitoring tools

Banks use multiple techniques to combat asymmetric information:

• Screening: taking applications and verifying the information they contain before approving loans.
• Monitoring: tracking loan recipients after the loan is made to ensure compliance.
• Collateral: assets pledged by the borrower for repayment of a loan.
  • When the collateral is cash left in the bank, it's called compensating or compensatory balances.
• Restrictive covenants: various conditions included in loan agreements to limit borrower behavior.

✂️ Credit rationing

Credit rationing: refusing to make a loan at any interest rate (to reduce adverse selection) or lending less than the sum requested (to reduce moral hazard).

Two forms of rationing:

1. Complete refusal: not lending at any rate to certain applicants.
2. Partial lending: lending less than the borrower requested.

Why rationing works:

• People willing to pay very high rates are likely risky (adverse selection signal).
• The more that is lent, the higher the likelihood the customer will abscond or cheat (moral hazard).
• Insurers use the same logic for the same reasons.

Don't confuse: Higher interest rates don't always compensate for risk—they may attract exactly the wrong borrowers.

⚠️ When screening fails

Banks are not perfect screeners, and lending mistakes happen:

• Competitive pressure: banks lend to borrowers they should not have.
• Individual banker incentives: individual bankers may profit handsomely from risky loans even though their actions endanger their banks' existence.
• External pressures: political or societal pressures induce bankers to make loans they normally wouldn't.
• Result: high levels of nonperforming loans that eventually force corrections.

Example: In 2007–2008, banks and mortgage companies in the subprime market (catering to high-risk borrowers) experienced soaring default rates, triggering fears of a financial crisis.

💳 Loan commitments and lines of credit

💳 How loan commitments work

Loan commitments: arrangements where a bank commits to lend up to a certain amount at a pre-agreed rate for a specified period.

• Also called lines of credit, especially when extended to consumers.
• The excerpt mentions lending "x dollars at y plus some market rate for z years."
• Why beneficial: both lenders and borrowers gain from the certainty and pre-agreed terms.
• Most commercial loans are actually loan commitments rather than one-time loans.

📈 Interest-rate risk

📊 What is interest-rate risk

Financial intermediaries face risk from changes in interest rates based on their balance sheet structure:

Balance Sheet Component	Type
Rate-sensitive assets	Variable rate and short-term loans, short-term securities
Rate-sensitive liabilities	Variable rate CDs and MMDAs
Fixed-rate assets	Reserves, long-term loans and securities
Fixed-rate liabilities	Checkable deposits, CDs, equity capital

The key: comparing the value of rate-sensitive assets versus rate-sensitive liabilities.

📉 When rising rates hurt

If rate-sensitive liabilities exceed rate-sensitive assets, rising interest rates reduce profitability:

Example scenario from the excerpt (Some Bank with $10 billion rate-sensitive assets, $20 billion rate-sensitive liabilities):

• Initially: Pays 3% on $20B = $0.6B; earns 7% on $10B = $0.7B → profit of $0.1B.
• After 1% rate increase: Pays 4% on $20B = $0.8B; earns 8% on $10B = $0.8B → zero profit.
• After another 1% increase: Pays 5% on $20B = $1.0B; earns 9% on $10B = $0.9B → loss of $0.1B.

Why this happens: The bank has more liabilities that reprice with interest rates than assets, so costs rise faster than revenues.

📈 When falling rates hurt

If rate-sensitive assets exceed rate-sensitive liabilities, falling interest rates reduce profitability:

Example: Bank has $10 billion rate-sensitive assets at 8%, only $1 billion rate-sensitive liabilities at 5%:

• Initially: Earns 8% on $10B = $0.8B; pays 5% on $1B = $0.05B → gross profit of $0.75B.
• After rates decrease: Earns 5% on $10B = $0.5B; pays 2% on $1B = $0.02B → gross profit of $0.48B.

The opposite situation: More assets reprice downward than liabilities, so revenues fall faster than costs.

Don't confuse: The same interest rate change can help or hurt a bank depending on its balance sheet structure—there's no universal "good" or "bad" direction for rates.

🔥 Historical example: 1970s–1980s crisis

The excerpt provides a real-world case:

• 1970s: Unexpectedly high inflation occurred.
• Effect via Fisher Equation: Nominal interest rates increased.
• Impact on banks: Profitability sank because banks were earning low rates on long-term assets (like thirty-year bonds) while having to pay high rates on short-term liabilities.
• Result: Many banks, especially savings and loans (S&Ls), went under.
• Desperate measures: Mounting losses induced many bankers to take on added risks, including derivatives risks; a few succeeded, but others destroyed all their bank's capital.

🚨 Moral hazard and government intervention

🚨 The bailout dilemma

The 2007 subprime crisis raised a policy question: Why didn't the government immediately guarantee subprime mortgages to prevent a financial crisis?

The government's reasoning:

• Must support the financial system without giving succor to those who have screwed up.
• Moral hazard concern: Directly bailing out subprime lenders by guaranteeing mortgage payments would cause moral hazard to skyrocket.
  • Borrowers might rationalize defaulting as a victimless crime (though all taxpayers would suffer).
  • Lenders would learn they can make crazy loans to anyone because the government will cushion or prevent their fall.

Economic principle: There is no such thing as a free lunch—bailouts have costs borne by taxpayers.

Don't confuse: Supporting the financial system is not the same as protecting individual institutions that made bad decisions; the distinction matters for future incentives.

🧭 Overview

🧠 One-sentence thesis

Banks and lenders use screening, monitoring, collateral, and credit rationing to combat asymmetric information, but imperfect screening and external pressures can lead to excessive lending and financial crises.

📌 Key points (3–5)

• Core problem: Asymmetric information creates adverse selection (risky borrowers willing to pay high rates) and moral hazard (borrowers behaving riskily after receiving loans).
• Key tools: Loan commitments, collateral (including compensating balances), and credit rationing help lenders manage information problems.
• Credit rationing works two ways: refusing loans at any rate (to reduce adverse selection) or lending less than requested (to reduce moral hazard).
• Common confusion: More willingness to pay ≠ better borrower—high rates attract riskier borrowers, so lenders must screen carefully.
• Real-world failure: Competitive pressure, individual banker incentives, and external political/societal pressures can induce banks to make loans they shouldn't, leading to high nonperforming loans and crises.

🛠️ Tools to combat asymmetric information

📋 Loan commitments and lines of credit

Loan commitments: arrangements where a bank agrees to lend up to a certain amount at a specified rate for a defined period.

• Also called "lines of credit," especially for consumers.
• The excerpt emphasizes these are "so beneficial for both lenders and borrowers that most commercial loans are in fact loan commitments."
• Why beneficial: Reduces uncertainty for borrowers (they know credit is available) and gives banks ongoing relationships with screened customers.

🔒 Collateral and compensating balances

Collateral: assets pledged by the borrower for repayment of a loan.

Compensating (or compensatory) balances: collateral in the form of cash left in the bank.

• Collateral reduces the lender's risk because the bank can seize assets if the borrower defaults.
• Cash balances are particularly safe collateral because they are already in the bank's possession.
• Example: A borrower might be required to keep 10% of a loan amount in a deposit account as a condition of the loan.

✂️ Credit rationing

Credit rationing: refusing to make a loan at any interest rate (to reduce adverse selection) or lending less than the sum requested (to reduce moral hazard).

Two types and their purposes:

Type	What it means	Why it works
Refusing loans at any rate	Won't lend even if borrower offers high interest	People willing to pay very high rates are likely very risky (adverse selection signal)
Lending less than requested	Approve only part of the loan amount	Smaller loans reduce the borrower's temptation to abscond or cheat (moral hazard control)

• Insurers use the same logic: "the more that is lent or insured (ceteris paribus) the higher the likelihood that the customer will abscond, cheat, or set aflame."
• Don't confuse: Rationing is not about the bank lacking funds; it's a deliberate strategy to avoid bad borrowers.

⚠️ When screening fails

💥 Why banks lend to risky borrowers

The excerpt identifies three main pressures:

1. Competitive pressure: Banks compete for business and may lower standards to win customers.
2. Individual banker incentives: Individual bankers can "profit handsomely by lending to very risky borrowers, even though their actions endanger their banks' very existence."
3. External political or societal pressures: Outside forces "induce bankers to make loans they normally wouldn't."

• Result: "Banks and other lenders are not perfect screeners."
• The excerpt notes that "as the world learned to its chagrin in 2007–2008," these failures can be severe.

📉 Nonperforming loans

Nonperforming loans: loans on which borrowers are not making stipulated payments on time (i.e., defaults).

• "Such excesses are always reversed eventually because the lenders suffer from high levels of nonperforming loans."
• High default rates force banks to recognize their screening failures and tighten standards again.

🏦 Case study: The subprime mortgage crisis

🔥 What happened in 2007

• "Banks and other intermediaries specializing in originating home mortgages (called mortgage companies) experienced a major setback in the so-called subprime market."
• Subprime market: the segment catering to high-risk borrowers.
• Default rates "soared much higher than expected," causing extensive losses.
• Many feared (correctly) this could trigger a financial crisis.

🚫 Why the government didn't immediately guarantee mortgages

The excerpt explains the moral hazard dilemma:

• Direct bailout problem: "Directly bailing out the subprime lenders by guaranteeing mortgage payments would cause moral hazard to skyrocket."
• Borrower moral hazard: Borrowers might default more easily, "rationalizing that the crime is a victimless one (though, in fact, all taxpayers would suffer)."
• Lender moral hazard: "Lenders would learn that they can make crazy loans to anyone because good ol' Uncle Sam will cushion, or even prevent, their fall."
• Government's dilemma: "The government must be careful to try to support the financial system without giving succor to those who have screwed up."

Don't confuse: Supporting the financial system ≠ bailing out individual bad actors. The government must balance systemic stability against creating future moral hazard.

🎯 Key takeaways on credit risk management

📊 Summary of banker strategies

The excerpt lists the main tools:

• Screening applicants: Taking applications and verifying the information they contain.
• Monitoring loan recipients: Ongoing oversight after the loan is made.
• Requiring collateral: Real estate, compensatory balances, etc.
• Restrictive covenants: Contract terms that limit borrower behavior.
• Portfolio management: Trading off between specialization (knowing certain industries well) and diversification (spreading risk across different types of loans).

⚖️ The fundamental trade-off

Credit risk: the chance that a borrower will default on a loan by not fully meeting stipulated payments on time.

• Bankers cannot eliminate credit risk entirely.
• They must balance the costs of screening and monitoring against the benefits of making profitable loans.
• Too little screening → high defaults; too much screening → lost business and high costs.

🧭 Overview

🧠 One-sentence thesis

Banks must guarantee or repurchase loans they sell to investors because otherwise investors would fear adverse selection—that the bank is offloading its worst loans onto unsuspecting third parties.

📌 Key points (3–5)

• What adverse selection means in loan sales: the risk that a bank might sell only its poorest-quality loans to outside investors.
• Why investors worry: without guarantees, investors cannot tell whether they are buying good or bad loans, so they assume the worst.
• How banks address it: banks sell loans with a guarantee or agreement to buy them back if the borrower defaults.
• Common confusion: loan sales generate fee income for banks, but they do not eliminate credit risk—the bank often retains the risk through buyback clauses.

🏦 Why banks sell loans

💰 Fee income from loan origination

• Banks earn approximately 0.15 percent (15 basis points) when they sell a loan.
• This fee compensates the bank for originating the loan: finding and screening the borrower.
• Example: A bank discounts a $100,000 one-year note at 8 percent, worth $92,592.59 on the day it is made, then sells it for $92,721.37 and pockets the difference.

📊 Off-balance-sheet activity

• Loan sales are part of banks' off-balance-sheet activities—they generate revenue without appearing as assets on the balance sheet.
• These activities help banks manage interest rate risk by providing income not tied to holding assets.

⚠️ The adverse selection problem

🔍 What investors fear

Adverse selection: the risk that the bank is "pawning off their worse loans on unsuspecting third parties."

• When a bank offers to sell loans, outside investors cannot easily judge loan quality.
• Rational investors assume the bank knows more about loan quality than they do.
• Without credible signals, investors fear they will end up with the bank's worst loans—those most likely to default.

🛡️ How banks solve the problem

• Banks sell loans with a guarantee or stipulation that they will buy them back if the borrower defaults.
• This commitment reassures investors: the bank retains some of the credit risk, so it has an incentive to sell only decent loans.
• Don't confuse: even though the loan leaves the balance sheet, the bank does not fully escape the risk—buyback clauses mean the bank may have to absorb losses later.

🔄 Implications for bank risk management

📉 Loan sales do not eliminate credit risk

• Although loan sales and fee income help keep up revenues when interest rates rise, they do not absolve the bank of the necessity of carefully managing its credit risks.
• The excerpt emphasizes that banks must still monitor and control credit risk, even when loans are sold.

🧩 Relationship to other off-balance-sheet activities

• Loan sales are one type of off-balance-sheet activity; others include loan guarantees, backup lines of credit, and derivatives trading.
• All these activities carry risks: loan guarantees can become very costly if the guaranteed party defaults, just as buyback clauses can force the bank to repurchase defaulted loans.

🧭 Overview

🧠 One-sentence thesis

U.S. banks innovated slowly for two centuries under light regulation and unit-banking monopolies, but the Great Inflation of the 1970s–1980s triggered rapid innovation through new products, loophole mining, lobbying, and technology adoption, ultimately reshaping the industry through consolidation, conglomeration, and increased concentration.

📌 Key points (3–5)

• Why innovation happens: Bankers innovate in response to changes in competition, regulation, technology, and macroeconomic volatility to maintain profitability.
• Unit banking's dual effect: Branching restrictions created local bank monopolies with little incentive to innovate, but spurred innovation in financial markets as borrowers and investors bypassed banks.
• Great Inflation as catalyst: Rising and volatile interest rates (1968–1982) forced banks to develop adjustable-rate mortgages, derivatives, sweep accounts, and other risk-shifting tools.
• Common confusion—loophole mining vs lobbying: Loophole mining works within existing rules (e.g., nonbank banks, sweep accounts); lobbying seeks to change the rules themselves (e.g., ending Regulation Q interest caps).
• Industry transformation: Technology, deregulation, and competitive pressure drove consolidation (fewer banks), conglomeration (broader activities), and concentration (larger market shares for big banks).

🏦 The era of traditional banking

🏦 Unit banking and local monopolies

• From 1782 until the late 20th century, most U.S. banks were unit banks: small, branchless institutions restricted to a single location.
• State and federal laws prohibited interstate branching and most intrastate branching.
• Result: thousands of tiny banks, each enjoying a near-monopoly in its local area.
  • Customers had little choice—banking elsewhere might require "a full day's trek away by horse."
  • Banks faced minimal competitive pressure.

💤 The 3-6-3 rule

Traditional banking: bankers earned profits from the spread between the cost of their liabilities and the earnings on their assets.

• The 3-6-3 rule summarized the staid business model: borrow at 3 percent, lend at 6 percent, golf at 3 p.m.
• Light regulation and sparse competition meant stable, comfortable profits with little innovation.
• Example: A local bank could charge high loan rates and pay low deposit rates because customers had no practical alternative.

🌐 Market innovation as a response

• Near-monopoly in banking led to innovation in financial markets instead.
• Investors sought higher returns by lending directly to entrepreneurs; borrowers sought cheaper funds by selling bonds.
• The U.S. developed the world's largest markets for commercial paper (short-term business IOUs) and junk bonds (high-yield, risky bonds).
• Trade-off: Markets suffer from higher asymmetric information and free-rider problems than intermediaries, leading to fraud and eventually to securities regulation.

Don't confuse: Unit banking stifled bank innovation but accelerated market innovation—the two are complementary channels of external finance.

🔥 The Great Inflation and forced innovation

🔥 Macroeconomic volatility (1968–1982)

• Inflation rose steadily and erratically from the late 1960s, exceeding 110 percent cumulatively over fifteen years.
• Nominal interest rates rose via the Fisher Equation.
• Interest rate risk became acute: banks holding fixed-rate, long-term assets faced rising costs on short-term liabilities.

🛡️ Shifting risk to borrowers

Bankers responded by inducing others to assume interest rate risk:

• Adjustable-rate mortgages (ARMs): Borrowers promise to pay a market rate (e.g., six-month Treasury rate) plus a spread.

  • When rates rise, the borrower pays more; when rates fall, the borrower pays less.
  • Banks offer lower initial rates to compensate borrowers for taking on the risk.
  • Fixed-rate mortgages remained popular because many borrowers dislike uncertainty; they can refinance if rates drop (though high closing costs limit this).

• Financial derivatives: Options, futures, and swaps markets revived in the 1970s to help banks hedge interest rate risk.

Example: A bank issues an ARM at Treasury + 3%. If Treasury rates jump from 5% to 10%, the borrower's rate rises from 8% to 13%, protecting the bank's spread.

💸 Disintermediation and regulatory workarounds

• Regulation Q capped interest on checking deposits at 0% and time deposits at ~6%.
• During high inflation, depositors pulled funds out of banks (disintermediation) to buy higher-yielding assets.
• Banks tried gimmicks (toasters as gifts) but failed to retain deposits.
• Financiers created money market mutual funds (MMMFs): checking-like liquidity with market interest rates, investing in T-bills and commercial paper.

🔧 Loophole mining and lobbying

🔧 What is loophole mining?

Loophole mining: a process where bankers and financiers look for creative ways to circumvent regulations.

• Works best in permissive regulatory systems (anything allowed unless explicitly forbidden), like the U.S.
• Bankers exploited technicalities to offer competitive products despite restrictive rules.

🔧 Examples of loophole mining

🔧 Nonbank banks

• Regulations defined banks as institutions that "accept deposits and make loans."
• Banks created entities that did one function or the other, but not both, to establish de facto branches across state lines.
• Less efficient than real branches but profitable within legal constraints.

🔧 Sweep accounts

• Checking accounts invested overnight in loans; interest credited the next morning.
• Allowed banks to pay above official deposit rate ceilings.
• Also reduced reserve requirements (cash and Fed deposits earning no interest), making reserve regulations "largely moot."

🔧 Bank holding companies (BHCs)

• Parent companies owning multiple banks and banking-related services.
• Faced more liberal regulation than unit banks.
• Could circumvent branching restrictions and offer investment advice, data processing, credit cards.
• Today, J.P. Morgan Chase, Bank of America, and Citigroup are all BHCs.

📢 Lobbying for regulatory change

Lobbying: a type of innovation where bankers and financiers try to change regulations.

• When loophole mining was too costly, bankers pushed for reform.
• The Great Inflation and banking crisis aided their efforts.
• Success: interest rate caps (Regulation Q) ended in the 1980s; Glass-Steagall (separating commercial and investment banking) eroded and was repealed in 1999.

Don't confuse: Loophole mining = working within existing rules; lobbying = changing the rules themselves.

💻 Technology-driven transformation

💻 Pre-digital era: limited impact

• Telegraph, telephone, automobiles (drive-up windows in the 1950s), and mechanical computers made incremental improvements.
• None fundamentally transformed banking.

💻 Digital revolution after WWII

Cheap electronic computing and digital telecommunications eventually spurred significant innovation.

💳 Credit and debit card networks

• Credit cards emerged to solve retail credit inefficiencies:

  • Before: stores issued cards to known customers; clerks verified creditworthiness manually.
  • Problem: consumers needed separate cards per store; screening was inefficient.

• Diners Club (post-WWII) applied the concept to restaurants but was costly.

• Late 1960s: computer and telecom advances enabled point-of-sale and card-issuer transaction processing.

• Win-win-win system:

  • Retailers: assured payment; pay small fixed fee + percentage.
  • Consumers: convenience, safety (max $50 liability if lost/stolen), credit line access; avoid interest by paying in full monthly.
  • Issuers: earn fees from vendors; some charge annual fees (now rare due to competition); offer rewards to encourage use.

• Debit cards: tap checking accounts instantly; can't bounce like checks; higher liability if lost/stolen; provide firm budget constraints.

🏧 ATMs and online banking

• ATMs (automatic teller machines): smaller, cheaper, more convenient than branches; favorable regulatory treatment before branching restrictions lifted.
  • Over 250,000 in the U.S. today, linked via telecom networks.
• ABMs (automated banking machines): ATMs + websites + phone lines for deposits, transfers, complex transactions.
• Online/home/e-banking: customers bank from computers; much cheaper for banks, who sometimes charge fees for in-person teller service.
• Virtual banks: completely online, no physical branches; less viable than "click-and-mortar" hybrids because depositors still value physical presence for confidence.

📦 Securitization

Securitization: transforming illiquid financial assets (mortgages, auto loans, receivables) into marketable securities.

• Computers made bundling loans, selling to investors, and passing through payments cheap and easy.
• Bundles are diversified against default risk; sold in large sums institutional investors prefer.
• Banks specialize in originating loans rather than holding assets; sell loans, use cash to fund new loans.
• Downside: opened the door to smaller competitors (finance companies, specialized mortgage lenders) that originate and sell without managing deposits or sophisticated ALM.

🏗️ Industry restructuring

🏗️ Declining market share, rising profitability

• Banks' share of loans to nonfinancial borrowers fell from 60% (1970s) to ~33% today.
• Absolute loan volume grew, so decline is relative only.
• Banks remain extremely profitable, but traditional banking (3-6-3 rule) is gone.
• Fees and off-balance-sheet activities now ~50% of income (up from 7% in 1980).

🏗️ Erosion of traditional profit sources

Pressure	Cause	Effect
Deposit costs	End of Regulation Q; competition with MMMFs	Banks pay more for deposits
Loan revenues	Competition from commercial paper, junk bonds, securitization	Banks charge less for loans

• Smaller, riskier companies can now sell bonds directly or borrow from specialized lenders.
• Finance companies and mortgage lenders ate into banks' market share.

🏗️ Consolidation

Consolidation: the process where the number of banks declines due to mergers and bankruptcies exceeding new bank formation.

• 1980s banking crisis + deregulation (eased branching restrictions, ended Glass-Steagall) enabled mergers.
• Fewer but larger, more profitable banks.
• Benefits: economies of scale (lower per-unit costs at higher volume); geographic diversification; ability to invest in expensive technology.
• Risks: banks may be too big, complex, and politically powerful to regulate; may increase risk-taking to justify mergers; may not perform diverse activities well.

🏗️ Conglomeration

Conglomeration: banks entering nonbanking financial activities (e.g., insurance, investment banking).

• Glass-Steagall (1933) separated commercial and investment banking.
• Gradual erosion (via BHCs and Fed support) and formal repeal (1999) allowed mergers and cross-activities.
• Benefits: economies of scope (use one resource for multiple products, e.g., borrower information for loans or underwriting; branches for insurance sales).
• Risks: conglomerates may be too large/complex to regulate; may not excel at all activities, increasing failure risk.

🏗️ Concentration

Industry concentration: the degree to which a few large firms control market share (assets, deposits, capital).

• Measured by:

  • N-firm concentration ratio: sum of market shares of top N firms (e.g., top 5 banks).
  • Herfindahl index: sum of squared market shares of all firms; ranges 0–1 (or 0–10,000); low = many small firms; high = near-monopoly; >1,800 triggers antitrust scrutiny.

• U.S. banking concentration has increased markedly but remains lower than most countries (Canada ~1,600; Colombia/Chile top 5 banks >60% of loans).

• 2006: 7,402 U.S. commercial banks; 3,246 <$100M assets; 3,662 $100M–$1B; 494 >$1B.

  • Top 500 control vast bulk of assets.
  • Top 10 banks rapidly gaining share.

• Regional concentration may be high enough to allow quasi-monopoly rents.

• Mitigating factor: easy bank entry—scores to hundreds of de novo banks form annually (~$50k/incorporator; ~$1M capital; consultants assist).

• Outlook: competitive sector with numerous small banks, megabanks, and regional players; small banks exploit niches (personal service, small business lending).

Don't confuse: Consolidation = fewer banks; conglomeration = broader activities; concentration = market share distribution.

🌍 Internationalization

• Foreign banks hold >10% U.S. bank assets, >16% corporate loans; can buy U.S. banks or establish branches; regulations converged since 1978.

• U.S. banks abroad: ~100 have foreign branches (up from 8 in 1960); driven by international trade, foreign investment, diversification, larger spreads, Eurodollar market access.

  • Eurodollars: dollar-denominated deposits in foreign banks; help trade, avoid reserve requirements/capital controls.
  • Main centers: London, Singapore, Cayman Islands.

• Trend: convergence toward European (especially British) model—commercial + investment banking; some universal banks (Germany, Switzerland) offer insurance too.

• Implication: increasingly unified global financial system—more efficient but raises systemic risk concerns.

🏦 Other depository institutions

• Savings and loan associations, mutual savings banks (few new; many converted to commercial banks).
• Credit unions: mutual (depositor-owned), organized around common bond (e.g., employer); tax-exempt; historically small; regulators allowed expansion for scale/diversification; new formation fairly brisk.

🧭 Overview

🧠 One-sentence thesis

The excerpt provided does not contain substantive content about agency problems; it consists only of chapter references, suggested readings, and introductory material about banking innovation and structure.

📌 Key points (3–5)

• The excerpt does not discuss agency problems as indicated by the title "8.5 Agency Problems."
• The text includes bibliographic references for bank asset and liability management.
• The main content covers Chapter 10 on innovation and structure in banking and finance, not agency problems.
• The excerpt explains early financial innovations driven by unit banking restrictions in the United States.
• No information about principal-agent relationships, conflicts of interest, or agency costs is present in the provided text.

📋 Content Assessment

📋 What the excerpt contains

The provided source material does not address the topic indicated by the title "8.5 Agency Problems." Instead, it contains:

• End-of-chapter suggested reading citations (Chapter 9.7)
• Chapter 10 opening material on "Innovation and Structure in Banking and Finance"
• Learning objectives for Chapter 10
• Historical discussion of U.S. banking structure and unit banking
• Explanation of financial innovation drivers

⚠️ Missing content

No definition, explanation, or discussion of agency problems appears in this excerpt.

The excerpt does not cover:

• Principal-agent relationships
• Conflicts of interest between parties
• Agency costs or mechanisms to reduce them
• Monitoring or incentive alignment strategies
• Any application of agency theory to banking or finance

🏦 Actual Content: Early U.S. Banking Structure

🏦 Unit banking system

The excerpt describes a historical banking structure in the United States:

• What it was: Most U.S. banks were small, single-location (unit) banks without branches
• Why it existed: State and federal regulations forbade or severely restricted branching—both within states (intrastate) and across state lines (interstate)
• When: From the first commercial bank in 1782 through approximately two centuries

🗺️ Geographic restrictions

Type of restriction	Description
Intrastate branching	Most states forbade banks from opening branches within the same state
Interstate branching	Banks could not branch across state lines (except small private banks)
National banks	Despite the name, these federally-chartered banks faced the same branching restrictions as state banks

💰 Consequences of unit banking

• Local monopolies: Each unit bank served a small geographic area with little competition
• Customer lock-in: Customers faced high costs to bank elsewhere (might require "a full day's trek away by horse")
• The 3-6-3 rule: "borrow at 3 percent, lend at 6 percent, and golf at 3 p.m."—indicating stable, comfortable profits with little competitive pressure
• Stagnant innovation: Light regulation and sparse competition meant banks had little incentive to innovate

Don't confuse: "National banks" did not mean nationwide banks; the term referred only to federal chartering, not geographic scope.

💡 Innovation Response

💡 Market innovation instead of banking innovation

Because unit banks were uncompetitive and offered poor terms, innovation shifted to financial markets:

• Investors' response: Sought higher returns by lending directly to entrepreneurs instead of depositing in local banks
• Borrowers' response: Sought cheaper funds by selling bonds directly into markets instead of borrowing from expensive local banks
• Result: The United States developed "the world's largest, most efficient, and most innovative financial markets"

📊 New market instruments

The excerpt mentions specific innovations that emerged:

• Commercial paper: Short-dated business IOUs
• Junk bonds (also called BIG bonds—below investment grade): High-yielding but risky bonds issued by relatively small or weak companies

Example: An entrepreneur needing funds could issue commercial paper directly to investors rather than paying high rates at the local monopoly bank.

⚖️ Trade-offs of market finance

• Advantage: More competitive pricing and innovation than monopolistic unit banks
• Disadvantage: Markets suffer from higher asymmetric information and free-rider problems than financial intermediaries
• Consequence: Instances of fraud and overvalued or fraudulent securities, leading to securities regulation and further innovation

🏢 Comparison: Life Insurance vs. Banking

🏢 Different competitive environments

The excerpt includes a "Stop and Think Box" comparing life insurers to banks:

| Feature | Life insurers | Commercial banks | | --- | --- | | Branching restrictions | Could establish branches/agencies anywhere, including foreign countries | Severely restricted by state and federal law | | Size | America's largest financial institutions (late 19th–mid 20th century) | Mostly small, local unit banks | | Competition | Fierce competition among major companies | Local monopolies with little competition | | Innovation pace | More rapid; adopted data-processing innovations earlier | Glacial; little incentive to innovate |

🔧 Technology adoption

Life insurers adopted innovations before banks:

• Punch-card tabulating machines
• Automated mechanical mailing address machines
• Mainframe computers

Why the difference: Intense competition among life insurers (Massachusetts Mutual, MetLife, Prudential, New York Life, Equitable) drove innovation, while monopolistic unit banks faced no such pressure.

🔄 Drivers of Financial Innovation

🔄 Four key drivers

The excerpt identifies what drives innovation in the financial system:

1. Macroeconomic volatility: Changes in economic stability and inflation
2. Technology: New tools and systems for processing information and transactions
3. Competition: Pressure from rivals to offer better products and services
4. Regulation: Rules that constrain behavior and create incentives to find workarounds

📈 Innovation as response

Innovation is "new ideas, products, and markets" created in response to changes in the financial environment.

• Bankers and financiers innovate "to continue to earn profits despite a rapidly evolving financial environment"
• The excerpt notes that Chapter 10.2 will explain "Why did the Great Inflation spur financial innovation?" but this content is not included in the provided text
• Innovation can occur in banking institutions or in financial markets, depending on where competitive and regulatory pressures are strongest

🧭 Overview

🧠 One-sentence thesis

During the Great Inflation, bankers used loophole mining to circumvent restrictive regulations and lobbied for regulatory reforms when workarounds became too costly, ultimately reshaping the banking industry.

📌 Key points (3–5)

• Loophole mining: bankers creatively circumvent regulations by exploiting gaps in the rules, especially effective in permissive regulatory systems where anything not explicitly forbidden is allowed.
• Lobbying: when loophole mining is too costly or ineffective, bankers push for direct regulatory changes.
• Great Inflation context: interest rate caps on deposits caused massive disintermediation, forcing banks to innovate with products like money market mutual funds, sweep accounts, and bank holding companies.
• Common confusion: permissive vs restrictive regulatory systems—loophole mining works better where "anything is allowed unless explicitly forbidden" rather than "only what is permitted is allowed."
• Why it matters: these innovations allowed banks to compete for profits despite regulatory constraints, but sometimes created less efficient solutions than direct regulatory reform would have.

💡 What loophole mining and lobbying are

💡 Loophole mining definition

Loophole mining: a process where bankers and other financiers look for creative ways of circumventing regulations.

• It is a type of innovation driven by competition for profits.
• Works best in permissive regulatory systems where anything is allowed unless explicitly forbidden.
• Contrast: in restrictive systems, only what is explicitly permitted is allowed, leaving fewer gaps to exploit.

🗣️ Lobbying definition

Lobbying: a type of innovation where bankers and other financiers try to change regulations.

• Used when loophole mining is too costly or cannot effectively circumvent a regulation.
• During the Great Inflation, bankers successfully lobbied to change the regulatory regime they faced.
• The banking crisis aided their lobbying efforts.

🏦 Great Inflation innovations through loophole mining

🏦 The disintermediation problem

• The regulatory constraint: banks could not legally pay any interest on checking deposits or more than about 6 percent on time deposits—both far below market rates.
• Failed workaround: banks tried giving depositors toasters and other gifts to sweeten the pot without violating interest rate caps.
• Result: few depositors bit; massive disintermediation occurred as depositors pulled money out of banks to buy assets offering market rates of return.

💰 Money market mutual funds (MMMFs)

• Financiers developed MMMFs to offer checking-account-like liquidity while paying interest at market rates.
• MMMFs invested in short-term, high-grade assets like Treasury Bills and AAA-rated corporate commercial paper.
• This innovation aided the growth and development of commercial paper markets.

🔄 Sweep accounts

• What they are: checking accounts that were invested each night in overnight loans.
• How they worked: interest earned on those loans was credited to the account the next morning.
• Two benefits:
  1. Allowed banks to pay rates above official deposit rate ceilings.
  2. Allowed banks to circumvent reserve requirements (legal minimums of cash and Federal Reserve deposits).
• Why reserve requirements mattered: banks earn no interest on reserves, so they wished to hold fewer reserves than required, especially when interest rates were high.
• Impact: by using computers to sweep checking accounts at close of business each day, banks reduced their de jure deposits and reserve requirements to the point that reserve regulations today are largely moot.

🏢 Nonbank banks

• The regulatory constraint: interstate banking was prohibited; the law defined banks as "institutions that accept deposits and make loans."
• The loophole: banks established de facto branches that did one function or the other, but not both.
• Why it mattered: this innovation was much less economically efficient than establishing real branches would have been.
• Trade-off: the banks that created nonbank banks likely profited, but not as much as they would have without resorting to such a technicality; customers were also more inconvenienced.

Example: A bank operating across state lines might create one branch that only accepts deposits and another that only makes loans, technically avoiding the definition of a "bank" while still serving both functions.

🏛️ Bank holding companies (BHCs)

• What they are: parent companies that own multiple banks and banking-related service companies.
• The advantage: regulation of BHCs was, for a long time, more liberal than unit bank regulation.
• How they circumvented regulations:
  • Could circumvent restrictive branching regulations.
  • Could earn extra profits by providing investment advice, data processing, and credit card services.
• Today: bank holding companies own almost all of the big U.S. banks, including J.P. Morgan Chase, Bank of America, and Citigroup.

🔀 When loophole mining isn't enough

🔀 The shift to lobbying

• Not all regulations can be circumvented cost-effectively via loophole mining.
• When loophole mining is too costly, bankers and other financiers push for regulatory reforms.
• The Great Inflation and the decline of traditional banking induced bankers to lobby to change the regulatory regime they faced.
• Outcome: the bankers largely succeeded, aided in part by a banking crisis.

⚖️ Comparing the two strategies

Strategy	When used	Example from excerpt
Loophole mining	When regulations can be circumvented creatively	Sweep accounts, nonbank banks, BHCs
Lobbying	When loophole mining is too costly or ineffective	Pushing for regulatory reforms during Great Inflation

Don't confuse: loophole mining works within the existing regulatory framework by exploiting gaps; lobbying seeks to change the regulatory framework itself.

🧭 Overview

🧠 One-sentence thesis

The excerpt does not contain substantive content related to assets, liabilities, or T-accounts; instead, it discusses banking innovation, technology, and industry structure.

📌 Key points (3–5)

• The provided excerpt covers banking innovation strategies (loophole mining and lobbying), technological advances in banking, and banking industry profitability—not the accounting concepts suggested by the title.
• Loophole mining vs lobbying: two distinct strategies bankers use to deal with regulations—one circumvents existing rules, the other changes them.
• Technology's role: digital computers and telecommunications transformed banking by enabling credit cards, ATMs, online banking, and securitization.
• Market share decline: banks have lost relative market share in loans to nonfinancial borrowers (from over 60% in the 1970s to about one-third today) but remain profitable.
• Common confusion: the excerpt does not address assets, liabilities, or T-accounts as the title suggests; the content focuses on banking industry evolution and innovation.

⚠️ Content mismatch notice

⚠️ Title vs actual content

The title "9.2 Assets, Liabilities, and T-Accounts" suggests accounting concepts, but the excerpt contains no discussion of:

• What assets or liabilities are
• How T-accounts work
• Double-entry bookkeeping
• Balance sheet structure

Instead, the excerpt covers three unrelated banking topics: regulatory innovation strategies, technological advances, and industry structure changes.

🔧 Banking innovation strategies

🔧 Loophole mining

Loophole mining: a type of innovation where bankers and other financiers look for creative ways of circumventing regulations.

• This is about working around existing rules without formally breaking them.
• The excerpt mentions the Great Inflation induced bankers to use loophole mining, such as using bank holding companies.
• Example: finding legal structures or methods that achieve desired outcomes while technically complying with restrictive regulations.

🗣️ Lobbying

Lobbying: a type of innovation where bankers and other financiers try to change regulations.

• This is about working to change the rules themselves.
• When loophole mining became too costly, bankers lobbied to change the regulatory system.
• The goal was generally to make regulations less restrictive.
• Don't confuse: loophole mining circumvents rules; lobbying seeks to rewrite them.

💻 Technology and banking transformation

💻 Early technology had limited impact

• Telegraph and telephone in the nineteenth century did little to change banking fundamentally.
• Mechanical computers made some data storage and calculations faster.
• Automobiles led to drive-up teller windows in the 1950s.
• None of these technologies transformed the business model.

💳 Credit and debit card networks

Why credit cards needed technology:

• Retail credit existed before, but stores issued individual cards—inefficient because consumers needed different cards for each store.
• Screening borrowers is difficult and requires high minimum efficient scale.
• Economies of scale could be exploited if one company determined creditworthiness and provided a universal payment system.

How technology enabled modern cards:

• After World War II, Diners Club applied the concept to restaurants.
• Credit card systems did not spread successfully until the late 1960s.
• Improvements in computer technology and telecommunications made it possible for machines to conduct transactions at both point-of-sale and card issuer sides.

The win-win-win structure:

Party	Benefit	Cost
Retailers	Assured payment (cards verified before goods given; checks can bounce later)	Small fixed fee plus percentage points per transaction
Consumers	Easier and safer than cash; limited liability ($50 max if lost/stolen and reported timely); smooth consumption via credit line; avoid interest if paid in full monthly	Potentially high interest rates if balance carried
Card issuers	Fees from vendors; sometimes annual fees from cardholders	Must compete by offering rewards (cash back, points) to attract users

Debit cards:

• Look like credit cards but tap directly into checking accounts (like instantaneous checks).
• Retailers prefer them over checks because debit cards cannot bounce.
• Consumers who struggle with spending control find them useful because they provide firm budget constraints (limited to checking account balance).
• Important difference: if lost or stolen, cardholder liability is generally much higher than with credit cards.

🏧 ATMs and automated banking

ATM development:

• ATM cards allow customers to withdraw cash from automatic teller machines.
• Many debit cards are also ATM cards, linked directly to checking (and sometimes savings) accounts.
• ATMs are much smaller, cheaper, and more convenient than full-service branches.
• Before branching restrictions were lifted, ATMs received more favorable regulatory treatment than branches.
• Today there are more than 250,000 ATMs in the United States, all linked to bank databases via telecommunications.

Evolution to ABMs and online banking:

• ABMs (automated banking machines): combinations of ATMs, websites, and dedicated customer service phone lines that allow deposits, fund transfers, and sophisticated transactions without visiting the bank.
• Online banking (home banking, e-banking): customers bank from home or work computers.
• Banks found online banking so much cheaper that some charge fees for the privilege of talking to a teller.

Virtual vs click-and-mortar banks:

• A few banks are completely virtual with no physical branches.
• Click-and-mortar (hybrid) banks appear more viable at present.
• Virtual banks seem too ephemeral, like the wildcat banks of old—a grand physical edifice still inspires confidence in depositors.

📦 Securitization

Securitization: the process of transforming illiquid financial assets like mortgages, automobile loans, and accounts receivable into marketable securities.

How technology enabled it:

• Computers make it relatively easy and cheap to bundle loans together, sell them to investors, and pass payments through to the new owner.
• Securitized loans are diversified against default risk.
• Sold in large round sums that institutional investors prefer.

Benefits for banks:

• Allows bankers to specialize in originating loans rather than holding assets.
• Banks can improve balance sheets by securitizing and selling loans, using the cash to fund new loans.
• Trade-off: securitization has opened the door to smaller competitors.

📊 Banking industry structure and profitability

📊 Market share decline (relative, not absolute)

• In the 1970s, commercial banks and other depository institutions (thrifts—credit unions, savings and loans, savings banks) controlled over 60 percent of the market for loans to nonfinancial borrowers.
• Today, they have only about one-third.
• Important context: this decline is relative only—the market for loans to nonfinancial borrowers grew very quickly over the last quarter century.
• Banks are still extremely profitable; many new banks form each year.

💰 Changing profit sources

The end of the 3-6-3 rule:

• The good old days of traditional banking and the 3-6-3 rule are long gone.
• Bankers have to work harder than ever for profits.

Shift in income sources:

• Fees and other off-balance-sheet activities now account for almost half of bank income.
• This is up from about 7 percent in 1980.
• The traditional source of profit—the spread between cost of liabilities and returns on assets—has steadily eroded from both ends.

📉 Regulation Q and competition for deposits

What Regulation Q did:

• Interest rates banks could pay on deposits were capped at 0 for checking deposits and about 6 percent on time deposits.
• Until the Great Inflation, bankers loved the caps because they limited competition for deposits.

Why it ended:

• When interest rates rose enough, disintermediation occurred—funds flowed out of banks to higher-yielding investments like money market mutual funds.
• Bankers lobbied for an end to interest rate restrictions; their request was granted in the 1980s.
• Since then, banks have had to compete with each other and with money market mutual funds for deposits.
• Result: banks have had to pay more for deposits, eroding profit margins.

🧭 Overview

🧠 One-sentence thesis

Despite losing market share in lending, banks remain profitable by adapting through consolidation, conglomeration, and diversification, though these changes raise concerns about market power and systemic risk.

📌 Key points (3–5)

• Market share decline but continued profitability: Banks dropped from 60% to about one-third of the nonfinancial lending market since the 1970s, yet remain highly profitable through fees and off-balance-sheet activities.
• Competitive pressures from both sides: Banks face higher deposit costs (after Regulation Q ended) and lower loan revenues (due to commercial paper, bonds, and securitization competitors).
• Consolidation and conglomeration as responses: Deregulation allowed banks to merge (consolidation), enter new activities like insurance (conglomeration), and combine commercial and investment banking (Glass-Steagall repeal in 1999).
• Common confusion—concentration vs. consolidation: Consolidation means fewer banks through mergers; concentration means a few large banks control most assets; both have increased but the U.S. still has thousands of small banks.
• Trade-offs of the new structure: Larger banks gain economies of scale and scope and geographic diversification, but may become too big to regulate, take excessive risks, or exercise market power.

💰 Erosion of Traditional Banking Profits

💰 The end of the 3-6-3 rule era

• Traditional banking relied on a comfortable spread: pay low rates on deposits (capped by Regulation Q at 0% for checking, ~6% for time deposits) and earn higher rates on loans.
• The "good old days" ended when competitive pressures squeezed profits from both the liability and asset sides.
• Fees and off-balance-sheet activities now account for almost half of bank income, up from about 7% in 1980.

📉 Higher deposit costs

• What changed: Regulation Q interest rate caps were eliminated in the 1980s after the Great Inflation caused disintermediation (funds flowing out of banks to higher-yielding investments like money market mutual funds).
• Banks initially loved the caps because they limited competition, but high inflation made the caps unsustainable.
• Result: Banks now compete with each other and money market funds for deposits, paying more than ever before (holding general interest rate levels constant).
• Deposits have become relatively less important as funding sources.

📉 Lower loan revenues

• Competition from securities markets: Companies can now issue commercial paper and bonds (including junk bonds) directly to investors instead of borrowing from banks.
• Smaller and riskier companies that once had to "cozy up to a bank" can now access bond markets.
• Securitization impact: Numerous small lenders originate loans and immediately sell them to investors, avoiding the need to attract deposits or manage assets and liabilities.
  • Example: Finance companies gained market share in commercial lending; specialized mortgage lenders made inroads into home mortgages.
• These competitors can operate efficiently at smaller scale because they focus only on loan origination, not the full banking model.

🏗️ Structural Changes: Consolidation and Conglomeration

🏗️ Consolidation—fewer but larger banks

Consolidation: The process of banks merging in large numbers, reducing the total number of institutions.

• Drivers: The 1980s banking crisis, competitive pressures, and regulatory easing of branch banking restrictions.
• Scale: Figures 10.4 and 10.5 (referenced in excerpt) show the nation now has fewer but larger and more profitable banks.
• Why it helps banks:
  • Tap economies of scale (important as minimum efficient scale increased due to high costs of computer and telecommunications technology).
  • Diversify risks geographically.
  • Achieve greater efficiency.

🏢 Conglomeration—broader activities

Conglomeration: The process of banks entering nonbanking financial activities, such as insurance.

• Glass-Steagall repeal: The 1933 law strictly separated commercial banking (deposits and loans) from investment banking (securities underwriting).
  • Gradual erosion in the late 1980s–1990s through bank holding companies and Federal Reserve support.
  • Formal elimination in 1999 allowed commercial and investment banks to merge and engage in each other's activities.
• Economies of scope: Banks can now use a single resource for multiple products.
  • Example: Use information about borrowers to offer both loans and securities underwriting; use branches to sell insurance.

🏦 Large, complex banking organizations (LCBOs/LCFIs)

• The Federal Reserve labels merged entities as "large, complex banking organizations" or "large, complex financial institutions."
• Benefits: Can engage in many activities, diversifying revenues and risks.
• Costs and risks:
  • May be too big, complex, and politically powerful to regulate effectively.
  • Some banks increased profitability by taking on higher risk rather than becoming more efficient.
  • Conglomerates may not excel at any single activity, potentially increasing failure risk.
  • Helped trigger the 2007–2008 financial crisis (referenced for later chapters).

📊 Market Concentration and Competition

📊 Measuring concentration

Herfindahl index: A measure of market concentration calculated by summing the squares of the market shares of each firm in an industry; ranges from near 0 (many small firms) to 1 or 10,000 (monopoly).

Measure	What it shows	U.S. banking trend
Herfindahl index	Overall concentration	Increased markedly but still below 1,800 (Justice Department antitrust threshold)
N-firm concentration ratio	Share held by top N banks	Top 10 banks rapidly gaining market share (Figure 10.7)
Number of banks	Industry consolidation	Thousands of small banks remain (3,246 under $100M; 3,662 between $100M–$1B; only 494 over $1B in 2006)

📊 U.S. vs. international concentration

• U.S. banking is less concentrated than most other countries:
  • Canada: Herfindahl index around 1,600; top 5 banks make over 60% of loans in Colombia and Chile.
  • The U.S. is large and banking remains local, so national concentration is lower.
• Regional concentration concerns: Some U.S. regions have high enough concentration that banks may earn quasi-monopoly rents (high profits from oligopolistic market structures).
• Competitive check: Bank entry is fairly easy, so if profits become excessive, new banks (de novo banks) will form—scores to hundreds start each year since the mid-1980s.

🏦 Market power concerns

• What it means: A few large banks controlling most assets may give them the ability to charge more for loans and pay less for deposits.
• Current state: The top ~500 banks control the vast bulk of industry assets, liabilities, and capital.
• Don't confuse: High national Herfindahl index with regional monopoly power—thousands of small banks keep the national index moderate, but local markets may be more concentrated.

🌱 Bank Entry and Diversity

🌱 Starting a new bank

• Not as difficult as it sounds: About 20 incorporators each risk ~$50,000 for 1–2 years to gain regulatory approval, then subscribe at least the same amount in a private stock placement for capital.
• New banks typically begin with two branches: one in an asset-rich area, one in a deposit-rich area.
• Consultants help new banks form and begin operations.

🏘️ Small banks and niches

• Survival strategy: Small and regional banks exploit geographical and specialized niches.
  • Example: Cater to depositors who prefer interacting with people instead of machines.
  • Lend to small businesses, where they have advantages over large banks.
• Why small banks excel at small business lending: Better knowledge of local markets and borrowers allows better assessment of business plans.
• Large banks also lend to small businesses, but community banks are often better at it.

🏦 Other depository institutions

• Savings and loan associations and mutual savings banks: Few new ones created; many have converted to commercial bank charters or merged with commercial banks.
• Credit unions: New formation is fairly brisk.
  • Mutual institutions (owned by depositors, not shareholders).
  • Organized around people sharing a common bond (e.g., same employer).
  • Tax-exempt and historically small.
  • Regulators recently allowed expansion to maintain minimum efficient scale and diversify portfolios.

🌍 Internationalization of Banking

🌍 Foreign banks in the U.S.

• Foreign banks can enter the U.S. market relatively easily by buying U.S. banks or establishing branches.
• Hold more than 10% of total U.S. bank assets and make more than 16% of loans to U.S. corporations.
• Previously subject to less stringent regulations than domestic banks; changed in 1978.
• Bank regulations worldwide have increasingly converged.

🌍 U.S. banks abroad

• About 100 U.S. banks have branches abroad, up from just 8 in 1960.
• Drivers: Growth of international trade and foreign direct investment.
• Benefits: Diversify assets, tap markets with larger spreads than the U.S., access the Eurodollar market.
• Eurodollars: Dollar-denominated deposits in foreign banks that help international businesses conduct trade and banks avoid reserve requirements, regulations, and capital controls.
• Key locations: London, Singapore, and the Cayman Islands (main Eurodollar centers); also strong presence in East Asia and Latin America.

🌍 Convergence toward a global model

• Banking worldwide is converging, apparently toward the European (especially British) model.
• Continental Europe (Germany, Switzerland): Universal banks offering commercial banking, investment banking, and insurance.
• Great Britain and commonwealth: Full conglomerates less common, but most banks engage in both commercial and investment banking.
• Foreign securities markets are modeling themselves after American markets, growing larger and more sophisticated.
• Result: The world's financial system is increasingly becoming one, which should improve efficiency but also raises fears of financial catastrophe.

🔮 Future Industry Structure

🔮 Expected composition

Many observers predict the U.S. banking sector will remain competitive with:

• Numerous small banks: Serving local and specialized niches.
• Hundreds of large regional players: Mid-tier institutions.
• A few megabanks: Handful with over $1 trillion in assets.
• Regulatory caps: Regulations effectively limit the size of the largest banks.

🔮 Why this structure persists

• Ease of creating new banks provides competitive pressure.
• Small banks have advantages in certain markets (local knowledge, personal service, small business lending).
• America has many small businesses that prefer community banks.
• Geographic and product diversity allows different bank types to coexist.

🧭 Overview

🧠 One-sentence thesis

Government officials may pursue their own private interests rather than the public good, and asymmetric information creates multiple layers of principal-agent problems that prevent effective regulation even when regulators have good intentions.

📌 Key points (3–5)

• Two competing models: the public interest model assumes government works for the people; the private interest model assumes officials act in their own interests.
• Why government can't legislate problems away: budget constraints, opportunity costs, and the profitability of illegal activities mean enforcement is limited.
• Asymmetric information pervades regulation: creates principal-agent problems between public and politicians, politicians and regulators, and regulators and banks.
• Common confusion: don't assume "public interest rhetoric" means "public interest outcome"—regulations clothed in noble language may actually serve private interests.
• Regulatory capture: regulators are often "captured" by the industry they regulate, writing rules that protect incumbents rather than the public.

🏛️ Two models of government behavior

🎭 The public interest model

The public interest model posits that government officials work in the interests of the public, of "the people."

• This is what many people learn in school—the idea that government serves citizens.
• Lincoln's Gettysburg Address exemplifies this view: "government of the people, by the people, for the people."
• It's effective political rhetoric but may not accurately describe reality.
• If you believe this model, you're more likely to support government regulation as a solution to problems.

💰 The private interest (public choice) model

According to the private interest model, politicians and bureaucrats often behave in their own interests rather than those of the public.

• Officials don't openly admit self-interest; instead they use public-interest language (protecting widows and orphans, stopping bad actors, etc.).
• This model is more accurate in "predatory" countries where corruption is open.
• Even in wealthy countries, many regulations appear to follow the private interest model upon close inspection.
• Example mechanism: regulatory capture—the industry influences or controls its own regulators.
• If you believe this model, you'll be more skeptical of regulation.

Don't confuse: Public interest rhetoric with public interest reality—the language used to justify a regulation tells you nothing about whose interests it actually serves.

🚫 Why government can't simply ban bad things

💸 Resource constraints

• Government faces budget constraints and opportunity costs like everyone else.
• Cannot monitor everyone all the time.
• Must choose which activities to enforce against.

📈 Supply and demand for illegal activities

• What's bad for some is often good for others.
• People willingly supply illegal goods or activities when there's profit.
• Result: many illegal activities remain commonplace (the excerpt lists sodomy, drug use, reckless driving, music piracy as examples).

Example: Simply making an activity illegal does not mean it will stop—enforcement is costly and incomplete, and demand persists.

🕸️ The asymmetric information problem

🔗 Multiple layers of principal-agent problems

The excerpt identifies at least three principal-agent relationships where asymmetric information interferes:

Level	Principal	Agent	Information gap
1	Public	Elected officials	Politicians know more about their actions and motivations
2	Elected officials	Regulators	Regulators know more about their enforcement activities
3	Regulators	Banks/firms	Banks know more about their own risk-taking and activities

• At each level, the agent (the one with more information) can act against the principal's interests.
• The public's interest can be "stymied" at any of these three points.
• This makes effective regulation extremely difficult even with good intentions.

🏢 Agency problems within organizations

Beyond the three main levels, additional complications exist:

• Within banks: traders and loan officers may take excessive risks to earn bonuses; shareholders, managers, and depositors may have conflicting risk preferences.
• Within regulatory bureaucracies: regulators have incentives to hide mistakes and claim credit for good outcomes.
• Within government: different branches may withhold information or spread disinformation to discredit each other's policies.

Don't confuse: The number of information problems—there are at least three major layers plus internal agency problems within each organization.

🎯 Implications for regulation

🌍 Geography matters

• The private interest model "clearly holds sway" in predatory countries.
• In wealthy countries, the public interest model becomes "more plausible" but private interest still operates.
• Corruption in predatory governments gives politicians, regulators, and financiers incentives to perpetuate suboptimal systems.

🔍 The Blue Sky Laws example

Example: In the 1910s–1920s, U.S. states passed "Blue Sky Laws" ostensibly to protect widows and orphans from fraudulent securities dealers.

• The public interest story: preventing scams.
• The private interest reality: unit bankers wanted to protect their monopolies from competition by securities markets.
• Unable to gain sympathy for their own profits, bankers used public-interest rhetoric instead.
• Some states gave officials power to forbid most securities issuances.

Lesson: Regulations presented as consumer protection may actually protect incumbent businesses from competition.

⚖️ The need for aligned incentives

• Past regulatory failures will continue unless interests are better aligned.
• The excerpt suggests empowering market forces to "do most of the heavy lifting."
• Simply trusting regulators' good intentions is insufficient given the multiple information problems.

Don't confuse: Good intentions with good outcomes—asymmetric information can thwart well-meaning regulation just as easily as self-interested regulation.

🧭 Overview

🧠 One-sentence thesis

Interest-rate risk arises when changes in interest rates alter the profitability of banks by affecting the gap between their rate-sensitive assets and liabilities, and bankers manage this risk through gap analysis, duration analysis, and strategic balance-sheet positioning.

📌 Key points (3–5)

• What interest-rate risk is: the chance that interest rate changes will decrease bank profitability or asset values.
• How the gap matters: when rate-sensitive liabilities exceed rate-sensitive assets, rising rates hurt profits; when rate-sensitive assets exceed liabilities, falling rates hurt profits.
• Common confusion: banks naturally borrow short and lend long, so they thrive when rates fall but struggle when rates rise—yet they cannot easily reverse this structure because few borrowers want callable loans and few depositors want long-term checking accounts.
• Tools to measure risk: basic gap analysis compares dollar amounts of rate-sensitive assets vs. liabilities; duration analysis accounts for different maturities and estimates percentage changes in market value.
• Why it matters: interest-rate risk can destroy bank capital (as happened to savings and loans in the 1980s), so bankers must predict rate movements and adjust their balance sheets accordingly.

💰 How interest rates affect bank profits

💰 The basic mechanism

• Banks earn money on the spread between what they pay for liabilities (deposits, CDs) and what they earn on assets (loans, securities).
• When interest rates change, rate-sensitive assets and liabilities adjust, altering gross profits.
• Rate-sensitive means the interest rate can change (variable-rate loans, short-term securities, variable-rate CDs, money market deposit accounts).
• Fixed-rate means the rate is locked in (reserves, long-term loans, long-term bonds, checkable deposits, equity capital).

📉 When rising rates hurt

Example from the excerpt:

• Some Bank has $10 billion in rate-sensitive assets and $20 billion in rate-sensitive liabilities.
• Initially: pays 3% on liabilities (20 × 0.03 = $0.6 billion cost) and earns 7% on assets (10 × 0.07 = $0.7 billion revenue) → profit of $0.1 billion.
• Rates rise 1%: pays 4% (20 × 0.04 = $0.8 billion) and earns 8% (10 × 0.08 = $0.8 billion) → zero profit.
• Rates rise another 1%: pays 5% ($1 billion) and earns 9% ($0.9 billion) → loss of $0.1 billion.
• Why: the bank has more rate-sensitive liabilities than assets, so its costs rise faster than its revenues.

📈 When falling rates hurt

Example from the excerpt:

• Some Bank has $10 billion in rate-sensitive assets at 8% and $1 billion in rate-sensitive liabilities at 5%.
• Initially: earns 10 × 0.08 = $0.8 billion, pays 1 × 0.05 = $0.05 billion → gross profit of $0.75 billion.
• Rates fall: earns 10 × 0.05 = $0.5 billion, pays 1 × 0.02 = $0.02 billion → gross profit of $0.48 billion, a loss of $0.27 billion.
• Why: the bank has more rate-sensitive assets than liabilities, so its revenues fall faster than its costs.

🔢 Basic gap analysis

🔢 The formula

Basic gap analysis: Change in profitability = (Rate-sensitive assets − Rate-sensitive liabilities) × Change in interest rates

Written as: Cρ = (Ar − Lr) × Δi

Where:

• Cρ = change in profitability
• Ar = risk-sensitive assets
• Lr = risk-sensitive liabilities
• Δi = change in interest rates (in decimal form, e.g., 2% = 0.02)

🧮 How to interpret the gap

Gap condition	Interest rates rise	Interest rates fall
Positive gap (Ar > Lr)	Profits increase	Profits decrease
Negative gap (Ar < Lr)	Profits decrease	Profits increase

• Positive gap: more rate-sensitive assets than liabilities → bank benefits when rates rise, suffers when rates fall.
• Negative gap: more rate-sensitive liabilities than assets → bank suffers when rates rise, benefits when rates fall.

🎯 Strategic positioning

Bankers want to have more interest-sensitive assets than liabilities if they think that interest rates are likely to rise and they want to have more interest rate-sensitive liabilities than assets if they think that interest rates are likely to decline.

• This requires predicting interest rate movements.
• Example: if a banker expects rates to rise, she should increase rate-sensitive assets (e.g., make more variable-rate loans) or reduce rate-sensitive liabilities (e.g., lock in fixed-rate deposits).

⏱️ Duration analysis

⏱️ What duration measures

Duration (Macaulay's Duration): the average length of a security's stream of payments.

• Duration is used to estimate how sensitive a security's or portfolio's market value is to interest rate changes.
• It accounts for the fact that not all rate-sensitive assets and liabilities have the same maturities.

📐 The duration formula

Δ%P = −Δ%i × d

Where:

• Δ%P = percentage change in market value
• Δ%i = change in interest rates (as a whole number, e.g., 5% is written as 5, not 0.05)
• d = duration in years
• The negative sign reflects the inverse relationship between interest rates and prices (from Chapter 4).

🧪 Duration examples from the excerpt

Scenario 1: Interest rates increase 2%, bank has $100 million in assets with 3-year duration

• Asset value falls: −2 × 3 = −6%, or $6 million loss.
• If liabilities ($95 million) also have 3-year duration: they fall 95 × 0.06 = $5.7 million.
• Net effect on equity: 6 − 5.7 = $0.3 million loss.

Scenario 2: Same assets, but liabilities have only 1-year duration

• Liabilities fall: −2 × 1 = −2%, or 95 × 0.02 = $1.9 million.
• Net effect on equity: 6 − 1.9 = $4.1 million loss (worse).

Scenario 3: Same assets, but liabilities have 10-year duration

• Liabilities fall: −2 × 10 = −20%, or $19 million.
• Net effect: the bank profits from the rate rise (liabilities fall more than assets).

🔄 Duration strategies

Expected rate movement	Asset duration	Liability duration	Why
Rates expected to fall	Keep long	Keep short	Bank earns old higher rates on assets, pays new lower rates on liabilities
Rates expected to rise	Keep short	Keep long	Bank earns new higher rates on assets, pays old lower rates on liabilities

Don't confuse: The second strategy (short assets, long liabilities) runs against banks' natural structure—banks normally borrow short and lend long—so it is harder to implement because few borrowers want callable loans and few depositors want long-term checking accounts.

🏦 Banks' natural structure and interest-rate risk

🏦 Why banks naturally suffer when rates rise

• Banks' core business is borrowing short and lending long: they take short-term deposits and make long-term loans.
• This means they naturally have:
  • More rate-sensitive liabilities (short-term deposits, variable CDs).
  • More fixed-rate, long-term assets (30-year mortgages, long-term bonds).
• Result: banks tend to thrive when interest rates go down (they pay less on deposits while still earning the old higher rates on long-term loans).
• But when rates rise, they suffer (they must pay more on deposits while still earning the old lower rates on long-term loans).

📚 Historical example: the 1980s savings and loan crisis

From the "Stop and Think Box":

• In the 1970s, inflation was unexpectedly high.
• Via the Fisher Equation (from Chapter 5), inflation caused nominal interest rates to increase.
• Banks (especially savings and loans) were earning low rates on long-term assets (like 30-year bonds) while having to pay high rates on short-term liabilities.
• Result: bank profitability sank; many S&Ls went under.
• Some bankers took on added risks (including derivatives) to try to restore profitability; a few succeeded, but others destroyed all their bank's capital.

🚧 Limits to repositioning

• Banks cannot easily reverse their natural structure because:
  • Few people want to borrow if loans are callable (short-duration assets).
  • Fewer still want long-term checkable deposits (long-duration liabilities).
• This structural constraint limits how much banks can adjust their duration gap.

🛡️ Managing interest-rate risk

🛡️ More sophisticated analyses

The excerpt mentions three approaches:

1. Basic gap analysis: compares dollar amounts of rate-sensitive assets vs. liabilities (covered above).
2. Maturity bucket approach: groups assets and liabilities by maturity ranges (not detailed in excerpt).
3. Standardized gap analysis: (not detailed in excerpt).
4. Duration analysis: accounts for different maturities and estimates percentage changes in market value (covered above).

🔀 Off-balance-sheet activities

The excerpt notes that bankers also hedge interest-rate risk by:

• Trading derivatives (swaps, futures).
• Engaging in other off-balance-sheet activities.
• (Details are in the next section, 9.6, not fully covered in this excerpt.)

🎲 The prediction challenge

• All these tools require bankers to predict interest rate movements.
• If predictions are wrong, the bank can suffer large losses.
• Example: if a bank positions for rising rates (short assets, long liabilities) but rates fall instead, it will lose money.

🧭 Overview

🧠 One-sentence thesis

Banks engage in off-balance-sheet activities—such as charging fees, selling loans, and trading derivatives—to generate income and manage interest rate risk without relying solely on traditional assets and liabilities.

📌 Key points (3–5)

• What off-balance-sheet activities are: transactions that generate revenue or manage risk but do not appear on the bank's balance sheet (though they are still accounted for elsewhere).
• Why banks do them: to protect against interest rate increases and maintain income streams that are not tied to traditional assets.
• Main types: fees (loan guarantees, backup credit lines, foreign exchange), loan sales, and derivatives trading (futures, interest rate swaps).
• Common confusion: derivatives can be used to hedge (reduce risk) or to speculate (increase risk)—the same tool serves opposite purposes depending on intent.
• Risk trade-off: off-balance-sheet activities can help manage interest rate risk, but excessive speculation or poor controls can endanger the bank's capital and survival.

💰 Fee-based income and loan sales

💰 Fee income sources

Banks charge customers fees for various services that do not involve holding assets or liabilities on the balance sheet:

• Loan guarantees
• Backup lines of credit
• Foreign exchange transactions

These fees provide revenue that is independent of interest rate movements on the bank's traditional assets.

📄 Loan sales and origination fees

Loan sales: banks sell loans to investors and earn a fee (typically around 0.15 percent) for originating the loan—finding and screening the borrower.

How it works:

• A bank makes a loan (e.g., discounts a $100,000 note at 8 percent for one year).
• The present value of that loan is $92,592.59 (calculated as 100,000 divided by 1.08).
• The bank sells it for slightly more, say $92,721.37, and pockets the difference as an origination fee.

Risk caveat:

• Loan guarantees can become costly if the guaranteed party defaults.
• Banks often sell loans with a buyback guarantee—they promise to repurchase the loan if the borrower defaults.
• Without such guarantees, investors would pay less due to adverse selection (fear that the bank is offloading its worst loans).

⚠️ Limitations

• Fees and loan sales help maintain revenue when interest rates rise, but they do not eliminate the need for careful credit risk management.

🔄 Derivatives for hedging

🔄 Using derivatives to hedge interest rate risk

Hedging: using derivatives to earn income if the bank's main business suffers a decline (e.g., when interest rates rise).

Banks and other financial intermediaries take positions in derivatives markets to offset losses from interest rate changes.

📈 Futures contracts example

• Bankers sell futures contracts on U.S. Treasuries (e.g., at the Chicago Board of Trade).
• If interest rates increase:
  • Bond prices decrease.
  • The bank can buy bonds in the open market at a lower price than the contract price.
  • The bank fulfills the contract and pockets the difference.
  • This profit helps offset damage to the bank's balance sheet from rising rates.

🔁 Interest rate swaps

Interest rate swap: an agreement where two parties exchange interest payment streams—one fixed, one variable—based on a notional principal.

Example scenario:

• A bank agrees to pay a finance company a fixed 6 percent on $100 million notional principal ($6 million per year) for ten years.
• In exchange, the finance company pays the bank a market rate (e.g., LIBOR plus 3 percent).
• Initially (market rate = 3%): 6% fixed = (3% LIBOR + 3% contractual) → wash, no net payment.
• If market rate rises to 5%: Finance company pays (3 + 5 = 8%) minus 6% fixed = 2% on $100 million = $2 million net to the bank. The bank uses this to cover balance sheet damage from higher rates.
• If market rate falls to 2%: Bank pays (6% − [3 + 2] = 1%) on $100 million = $1 million per year to the finance company, but the bank can afford it because lower rates improve its balance sheet.

Don't confuse:

• Swaps are not bets on direction alone; they are structured to provide income precisely when the bank's main business is hurt by rate changes.

🎲 Speculation and risk

🎲 Speculative use of derivatives

Banks sometimes use derivatives and foreign exchange markets to speculate—hoping to make large profits.

Risk trade-off:

• High potential returns come with high levels of risk.
• Several established banks have gone bankrupt from assuming too much off-balance-sheet risk.

🚨 Causes of failure

The excerpt identifies two main causes:

Cause	Explanation
Principal-agent problem	Rogue traders bet their jobs and their banks' capital, and lost.
Management instruction	Traders were scapegoats; they were instructed to behave riskily by the bank's managers or owners.

Sympathy and accountability:

• The excerpt states it is difficult to have sympathy for bankers in either case—they were either deliberate risk-takers or incompetent.

🛡️ Risk controls

Banks can prevent excessive risk through:

• Basic internal controls to limit how much capital traders can risk.
• Value at risk (VaR): a technique to assess the bank's derivative risk exposure.
• Stress testing: another technique to evaluate how the bank would perform under adverse conditions.

📋 Summary of off-balance-sheet activities

📋 What "off the balance sheet" means

Off-balance-sheet activities: transactions that do not appear on the bank's list of assets and liabilities, though they are accounted for in revenue statements, cash flow analyses, etc.

• The term does not imply anything illegal or unethical.
• It simply means the activity is not recorded as an asset or liability on the balance sheet.

📋 Why they matter for interest rate risk

• Off-balance-sheet income (fees, loan sales) is not based on assets, so it provides revenue even when interest rate changes hurt traditional asset values.
• Derivatives can be used to hedge (reduce) interest rate risk by generating offsetting income when rates move unfavorably.
• However, derivatives can also be used to speculate, which increases risk and can endanger the bank's capital cushion and economic survival.

🧭 Overview

🧠 One-sentence thesis

Unit banking regulations in the United States dampened banking innovation but spurred financial market innovation because local bank monopolies drove investors and borrowers to meet directly in markets instead.

📌 Key points (3–5)

• Why financiers innovate: to continue earning profits despite changes in competition, regulation, technology, and the macroeconomy.
• Unit banking structure: most U.S. states forbade branching, creating thousands of tiny, branchless banks that enjoyed local monopolies.
• The 3-6-3 rule: traditional banking was stodgy—borrow at 3%, lend at 6%, golf at 3 p.m.—because spreads were large and stable with little competition.
• Market innovation vs. banking innovation: unit banks had little incentive to innovate, but investors and borrowers sought better terms by bypassing banks and meeting directly in markets.
• Common confusion: the U.S. developed innovative financial markets (commercial paper, junk bonds) precisely because its banks were less innovative, unlike other countries that developed large branching banks.

🏦 The unit banking system and its constraints

🏦 What unit banking meant

Unit banks: branchless banks that could not establish branches within or across state lines.

• Before the Civil War, almost all incorporated banks were state-chartered, and most states forbade intrastate branching.
• After the Civil War, Congress authorized national banks, but these could not branch across state lines and faced state-level branching restrictions within their home state.
• State governments continued chartering banks; when the national government taxed state bank notes heavily, state banks responded by issuing deposits instead.
• Result: the United States had thousands of tiny unit banks spread evenly throughout the country, unlike most countries that developed a few large banks with extensive branch systems.

🗺️ Local monopolies and lack of competition

• Because banking was a local retail business, most unit banks enjoyed near-monopolies.
• Customers who disliked the local bank could bank elsewhere, but that might require traveling a full day's trek by horse.
• Most people were reluctant to travel, so the local bank got their business even if terms were not particularly good.
• Little regulation and light competitive pressure made American banks "stodgy affairs."

💤 Traditional banking: the 3-6-3 rule

💤 How traditional banking worked

Traditional banking: bankers earned profits from the spread between the cost of their liabilities and the earnings on their assets.

• The 3-6-3 rule summarized this staid business model:
  • Borrow at 3 percent
  • Lend at 6 percent
  • Golf at 3 p.m.
• Spreads between sources of funds and uses of funds were large and stable.
• This model persisted for nearly two centuries because regulations were relatively light, technological changes were few, and competition was sparse.

🔍 Why innovation was glacial in banking

• Near-monopoly conditions removed the incentive to innovate.
• Unit banks faced minimal competitive pressure and light regulation.
• The financial environment (macroeconomic volatility, technology, competition, regulation) changed slowly, so there was little external pressure to adapt.

🚀 Financial market innovation as a response

🚀 Why markets innovated instead

• Near-monopoly in banking led to innovation in financial markets.
• Investors sought higher returns by lending directly to entrepreneurs instead of depositing money in the local bank.
• Entrepreneurs sought cheaper funds by selling bonds directly into the market instead of paying high rates at the bank.
• Result: the United States developed the world's largest, most efficient, and most innovative financial markets.

📄 New market instruments

Instrument	Description
Commercial paper	Short-dated business IOUs
Junk bonds (BIG bonds)	Below investment grade bonds—high-yielding but risky bonds issued by relatively small or weak companies

• These innovations allowed investors and borrowers to bypass unit banks and meet directly.
• Example: An entrepreneur needing funds could issue commercial paper to investors rather than borrow from the local bank at 6%.

⚠️ Trade-offs: asymmetric information and fraud

• Markets suffer from higher levels of asymmetric information and more free-rider problems than financial intermediaries do.
• Along with innovative securities markets came instances of fraud—people issuing overvalued or fraudulent securities.
• This led to several layers of securities regulation and, inevitably, yet more innovation.
• Don't confuse: market innovation solved one problem (bypassing monopolistic banks) but created another (higher information asymmetry and fraud risk).

🏢 Contrast: life insurance companies

🏢 Why life insurers were different

• Unlike banks, U.S. life insurance companies could establish branches or agencies wherever they pleased, including foreign countries.
• Life insurers must maintain massive accumulations of assets to pay claims when an insured person dies.
• From the late nineteenth century until the middle of the twentieth, America's largest financial institutions were not its banks but its life insurers.
• Competition among the biggest life insurers (Massachusetts Mutual, MetLife, Prudential, New York Life, and the Equitable) was fierce.

💡 Innovation in life insurance

• Innovation in life insurance was more rapid than in commercial banking because competition was more intense.
• Data-processing innovations occurred in life insurers before they did in most banks:
  • Punch-card-tabulating machines
  • Automated mechanical mailing address machines
  • Mainframe computers
• Example: A life insurer facing fierce competition adopted new technology to process claims faster and reduce costs, while a unit bank with a local monopoly had no such pressure.

🔑 Drivers of financial innovation

🔑 Four key environmental changes

Innovation is driven by changes in the financial environment:

1. Macroeconomic volatility: changes in inflation, interest rates, and economic stability.
2. Technology: new tools for data processing, communication, and transaction handling.
3. Competition: pressure from rivals to offer better terms or services.
4. Regulation: rules that constrain or enable certain activities, spurring workarounds or new products.

🔄 The innovation feedback loop

• Bankers and financiers innovate to continue earning profits despite a rapidly evolving financial environment.
• Regulation often leads to innovation (e.g., state banks issuing deposits instead of notes when notes were taxed).
• Innovation can lead to new problems (e.g., fraud in markets), which leads to more regulation, which spurs further innovation.
• Don't confuse: innovation is not always "progress"—it can be a response to constraints or a way to exploit loopholes.

🧭 Overview

🧠 One-sentence thesis

The Great Inflation of 1968–1982 spurred dramatic financial innovation as bankers responded to unprecedented macroeconomic volatility and rising interest rates by shifting risks to borrowers and developing new products, techniques, and technologies.

📌 Key points (3–5)

• What drove innovation: increased competition in the 1970s–1980s combined with unprecedented macroeconomic volatility (inflation rose over 110% during 1968–1982).
• How bankers responded to interest rate risk: they induced others to assume the risk through derivatives, adjustable-rate products, and off-balance-sheet activities.
• Key innovation—adjustable-rate mortgages: shifted interest rate risk from banks to borrowers by tying payments to market rates instead of fixed rates.
• Common confusion: fixed vs. adjustable mortgages—fixed-rate loans keep the bank exposed to rising rates, while adjustable-rate loans transfer that risk to the borrower (who pays more when rates rise but less when rates fall).
• Why it matters: innovation allowed banks to manage interest rate risk during a period when rising rates threatened their profitability, fundamentally changing how financial products worked.

📈 The Great Inflation context

📈 What happened in 1968–1982

• Beginning in the late 1960s, inflation rose steadily and grew increasingly erratic.
• The aggregate price level rose over 110% during the fifteen-year period from 1968 to 1982—more than any comparable period before or since.
• Nominal interest rates rose as well, following the Fisher Equation.
• This created unprecedented macroeconomic volatility that forced financial institutions to adapt.

😰 Why this kept bankers awake

• As covered in Chapter 9, interest rate risk—particularly rising interest rates—is a major concern for bank management.
• Banks faced a severe gap problem: they held long-term fixed-rate assets (like mortgages at 6%) but had to pay rising rates on short-term liabilities.
• When rates rose, banks earned well below what they had to pay depositors, squeezing profits.
• The combination of high inflation and volatile rates made traditional banking models unsustainable.

🔄 Shifting interest rate risk

🛡️ The core strategy

Bankers responded to increased interest rate risk by inducing others to assume it.

• Instead of bearing all the risk themselves, banks developed ways to transfer interest rate risk to other parties.
• This was not about eliminating risk but about reallocating who bears it.
• Two main approaches emerged: financial derivatives and adjustable-rate products.

📊 Financial derivatives revival

• Bankers used financial derivatives—options, futures, and swaps—to hedge their interest rate risks.
• It is no coincidence that the modern revival of such markets occurred during the 1970s.
• These tools allowed banks to manage exposure without changing their core loan products.

🏠 Adjustable-rate mortgages (ARMs)

Traditional fixed-rate mortgages:

• The borrower promised to pay a set rate (e.g., 6%) over the entire fifteen-, twenty-, or thirty-year term.
• Great for banks when interest rates declined or stayed the same.
• Disastrous when rates rose—banks got stuck earning below-market returns while paying market rates on deposits.

The adjustable-rate innovation:

• Banks began making adjustable-rate mortgage loans in the 1970s.
• Borrowers promised to pay some market rate (like the six-month Treasury rate) plus a spread (2, 3, 4, or 5 percent).
• When interest rates rise, the borrower pays more to the bank, helping with its gap problem.
• When rates decrease, the borrower pays less to the bank.

Key realization:

• With adjustable-rate loans, interest rate risk—as well as reward—falls on the borrower rather than the bank.
• To induce borrowers to accept this risk, banks must offer a more attractive (lower) initial interest rate than on fixed-rate mortgages.

⚖️ Why fixed-rate mortgages survived

Despite the innovation of ARMs, fixed-rate mortgages remained popular:

• Many people don't like the risk of possibly paying higher rates in the future.
• Borrowers with no prepayment penalty clauses (most don't have them) can refinance when rates drop—getting a new loan at the lower rate and using proceeds to pay off the higher-rate loan.
• However, refinancing involves high transaction costs (closing costs like loan application fees, appraisal costs, title insurance), so interest rates must decline substantially before refinancing is worthwhile.

Don't confuse: Refinancing is not free—it only makes sense when rate drops are large enough to offset transaction costs.

🏢 Life insurance innovations

🏢 Similar pressures, similar solutions

Life insurance companies faced the same macroeconomic pressures and sought regulatory approval for parallel innovations in the 1970s–1980s:

Product	Traditional form	Innovation	Why it mattered
Policy loans	Fixed at 5–6%	Adjustable-rate policy loans	Stopped arbitrage where policyholders borrowed at 5–6% and re-lent at double-digit market rates
Annuities	Fixed annual payments	Variable annuities	Maintained purchasing power when inflation eroded the real value of fixed payments

💡 The arbitrage problem

• Whole life insurance policyholders can take loans against the cash value of their policies.
• Most policies stipulated a 5 or 6 percent fixed rate.
• During the Great Inflation, policyholders astutely borrowed at 5–6% then re-lent the money at going market rates (often in double digits).
• By making policy loans variable, life insurers could adjust rates upward when market rates increased, limiting such arbitrage.

📉 The annuity problem

• Fixed annuities were a difficult sell during the Great Inflation.
• Annuitants saw the real value (purchasing power) of their annual payments decrease dramatically as inflation rose.
• By promising to pay annuitants more when interest rates and inflation were high, variable-rate annuities helped insurers attract customers.

🔧 Broader innovation landscape

🔧 New products

• Adjustable-rate mortgages (detailed above)
• Sweep accounts (mentioned as an innovation)
• Money market mutual funds (MMMFs) offering checking-like liquidity while paying market rates

🔧 New techniques

• Derivatives (options, futures, swaps) for hedging
• Off-balance-sheet activities to manage risk without expanding the balance sheet

🔧 New technologies

• Credit card payment systems
• Automated banking facilities
• Online banking facilities

Context: These innovations emerged because the Great Inflation increased macroeconomic instability, nominal interest rates, and competition between banks and financial markets, forcing bankers and other financiers to innovate to survive.

🧭 Overview

🧠 One-sentence thesis

Competition for profits drives bankers to circumvent regulations through loophole mining and, when that becomes too costly, to lobby for regulatory changes that make the system less restrictive.

📌 Key points (3–5)

• Loophole mining: bankers search for creative ways to work around regulations without breaking them explicitly.
• When loophole mining works best: in permissive regulatory systems (anything allowed unless explicitly forbidden) rather than restrictive ones.
• Lobbying as an alternative: when loophole mining is too costly or ineffective, bankers push for regulatory reforms instead.
• Common confusion: loophole mining vs lobbying—mining works within existing rules by exploiting gaps; lobbying tries to change the rules themselves.
• Historical context: the Great Inflation pressured banks to innovate through both loophole mining (e.g., sweep accounts, bank holding companies) and lobbying for deregulation.

🔍 What loophole mining is

🔍 Definition and mechanism

Loophole mining: a process where bankers and other financiers look for creative ways of circumventing regulations.

• It is a type of innovation driven by competition for profits.
• The key is finding gaps or ambiguities in existing rules and exploiting them legally.
• It does not involve breaking laws; instead, it involves interpreting rules in ways regulators may not have anticipated.

🌍 Where it works best

• Loophole mining is more effective in permissive regulatory systems.
• In permissive systems, anything is allowed unless explicitly forbidden.
• In restrictive systems (where only explicitly permitted activities are allowed), there are fewer gaps to exploit.
• Example: The United States has a permissive system, which made loophole mining a viable strategy for banks.

💡 Examples of loophole mining

💡 Money market mutual funds (MMMFs)

• The problem: During the Great Inflation, banks could not legally pay interest on checking deposits or more than about 6 percent on time deposits—both far below market rates.
• Failed attempts: Banks tried giving depositors toasters and other gifts to attract them, but few depositors responded.
• The result: Massive disintermediation—depositors pulled money out of banks to buy assets offering market rates.
• The innovation: Financiers developed MMMFs, which offered checking-account-like liquidity while paying market interest rates by investing in short-term, high-grade assets (Treasury Bills, AAA-rated commercial paper).
• Don't confuse: MMMFs were not banks; they were a workaround that provided bank-like services without being subject to bank deposit rate caps.

💡 Nonbank banks

• The problem: Regulations against interstate banking prevented banks from establishing branches across state lines.
• The loophole: The law defined banks as institutions that "accept deposits and make loans."
• The innovation: Banks established "nonbank banks" that did one function or the other, but not both, allowing them to operate de facto branches.
• The downside: This was less economically efficient than real branches would have been; banks profited less, and customers were more inconvenienced.
• Example: An organization could set up one entity that only accepts deposits and another that only makes loans, technically avoiding the legal definition of a "bank."

💡 Sweep accounts

• The problem: Banks could not pay interest above official deposit rate ceilings and had to hold reserve requirements (cash and Federal Reserve deposits that earn no interest).
• The innovation: Banks created sweep accounts—checking accounts that were invested each night in overnight loans.
• How it worked: Interest earned on those loans was credited to the account the next morning, allowing banks to pay rates above the official ceilings.
• Additional benefit: By sweeping checking accounts at the close of business each day, banks reduced their de jure deposits and thus their reserve requirements, making reserve regulations largely moot today.

💡 Bank holding companies (BHCs)

• The loophole: Regulation of BHCs was more liberal than unit bank regulation for a long time.
• How banks used it: BHCs could circumvent restrictive branching regulations and earn extra profits by providing investment advice, data processing, and credit card services.
• Today: Bank holding companies own almost all of the big U.S. banks (e.g., J.P. Morgan Chase, Bank of America, Citigroup).

🏛️ Lobbying as an alternative strategy

🏛️ When lobbying becomes necessary

• Not all regulations can be circumvented cost-effectively via loophole mining.
• When loophole mining is too costly or ineffective, bankers and other financiers push for regulatory reforms instead.

Lobbying: a type of innovation where bankers and other financiers try to change regulations.

🏛️ Historical example: the Great Inflation

• The Great Inflation and the decline of traditional banking induced bankers to lobby to change the regulatory regime they faced.
• Bankers largely succeeded in their lobbying efforts, aided in part by a banking crisis.
• The goal was generally to make the regulatory system less restrictive.

🔄 Comparing loophole mining and lobbying

Strategy	What it does	When it's used	Example from excerpt
Loophole mining	Works within existing rules by exploiting gaps or ambiguities	When regulations can be circumvented cost-effectively	Sweep accounts, nonbank banks, BHCs
Lobbying	Tries to change the rules themselves	When loophole mining is too costly or ineffective	Bankers pushing for deregulation during the Great Inflation

• Don't confuse: Both are responses to regulation, but mining accepts the rules and finds workarounds, while lobbying seeks to rewrite the rules.
• Both are driven by competition for profits and the desire to reduce regulatory constraints.

🧭 Overview

🧠 One-sentence thesis

Digital electronic computers and telecommunications after World War II transformed banking by enabling innovations like credit card networks, ATMs, and securitization, which reduced costs and allowed banks to specialize but also opened the door to new competitors.

📌 Key points (3–5)

• Earlier technologies had little impact: telegraph, telephone, automobiles, and mechanical computers did not fundamentally transform banking.
• Digital computing enabled major innovations: credit/debit card networks, ATMs, online banking, and securitization all depend on cheap electronic computing and digital telecommunications.
• How technology changed bank operations: ATMs, ABMs, and online banking reduced expenses; securitization allowed banks to originate loans and sell them rather than hold assets.
• Common confusion: debit cards vs credit cards—debit cards tap checking accounts directly (can't bounce, higher liability if stolen), while credit cards provide a line of credit (lower cardholder liability, can avoid interest by paying in full).
• Why it matters: technology made banking cheaper and more convenient, but also increased competition and changed how banks earn profits.

📜 Pre-digital era: limited technological impact

📞 Telegraph, telephone, and mechanical computers

• Nineteenth-century telegraph and telephone allowed bankers in remote places to place orders with brokers more quickly and cheaply.
• Customers could perform limited transactions by phone rather than in person.
• Mechanical computers made data storage and number crunching faster.
• None of these technologies transformed the face of the business.

🚗 Automobiles and drive-up windows

• Widespread automobile use led to drive-up teller windows in the 1950s.
• This was a convenience feature, not a fundamental change in banking operations.

💳 Credit and debit card networks

💳 The credit problem before cards

• Retail-level credit was a major component of the American economy.
• In late nineteenth and early twentieth centuries, urban growth created problems:
  • People no longer knew their neighbors.
  • Store clerks left jobs frequently.
• Stores began issuing credit cards (literally identification cards showing the customer had a credit account).
• Inefficiency: consumers needed a different card for each store; even large department store chains were not efficient at screening borrowers (minimum efficient scale is high).

🍽️ Early credit card systems

• Observers realized economies of scale could be exploited if one company decided creditworthiness and provided a payment system for many retailers.
• After World War II, Diners Club applied the idea to restaurants: it paid customers' bills and later collected from customers.
• The service was very costly and did not spread successfully until the late 1960s.
• Key breakthrough: improvements in computer technology and telecommunications made it possible for machines to conduct transactions at both point of sale and card issuer sides.

🏆 Modern credit card networks: a win-win-win system

Visa and MasterCard created private payment systems that benefit retailers, consumers, and card issuers.

Retailers win:

• Assured of getting paid (credit/debit cards can be verified before goods are given; checks can bounce days later).
• Pay a small fixed fee plus a few percentage points per transaction.
• Believe customers like to pay by credit card.

Consumers win:

• Easier and safer than carrying cash.
• Cardholder liability limited to no more than $50 if card is lost or stolen (if reported timely).
• Small and light; eliminate need for small change.
• Allow consumption smoothing by tapping a line of credit on demand.
• Can avoid interest charges by paying the bill in full each month.

Banks and card issuers win:

• Receive fees from vendors.
• Some charge cardholders an annual fee (though competition has largely ended this).
• Refund some fees to cardholders as cash back, rewards, frequent flier points to induce people to use their cards.

💰 Debit cards: direct account access

Debit cards look like credit cards but tap into the cardholder's checking account like an instantaneous check.

Why retailers prefer them over checks:

• Cannot bounce or be returned for insufficient funds days after the customer has left.

Why some consumers prefer them:

• Useful for consumers who find it difficult to control spending.
• Provide firm budget constraints (limited to sums in checking accounts).

Don't confuse with credit cards:

• Debit cards have generally much higher cardholder liability if lost or stolen.
• Credit cards provide a line of credit; debit cards access existing funds.

🏧 ATMs and automated banking

🏧 Automatic Teller Machine (ATM) cards

• Allow customers to withdraw cash from ATMs.
• Linked directly to each cardholder's checking (and sometimes savings) accounts.
• Many debit cards are also ATM cards.

🏦 Why banks adopted ATMs

• Much smaller, cheaper, and more convenient than full-service branches.
• Many banks established networks of ATMs instead of branches.
• Before bank branching restrictions were lifted, ATMs received more favorable regulatory treatment than branches.
• Scale: more than 250,000 ATMs in the United States today, all linked to bank databases via telecommunications.

🖥️ Automated Banking Machines (ABMs) and online banking

ABMs:

• Combinations of ATMs, Web sites, and dedicated customer service telephone lines.
• Allow customers to make deposits, transfer funds, or engage in sophisticated banking transactions without stepping foot in the bank.

Online banking (home banking, e-banking):

• Allows customers to bank from home or work computers.
• So much cheaper than traditional in-bank methods that some banks charge fees for talking to a teller to encourage online use.

🏛️ Virtual banks vs click-and-mortar

• A few banks are completely virtual, having no physical branches.
• Problem: virtual banks seem too ephemeral, like the wild cat banks of old.
• Click-and-mortar (hybrid) banks appear more viable because a grand physical edifice still inspires confidence in depositors.
• Example: the excerpt contrasts a grand bank building with "a bank in a trailer" to illustrate confidence differences.

📦 Securitization: transforming illiquid assets

📦 What securitization is

Securitization: the process of transforming illiquid financial assets like mortgages, automobile loans, and accounts receivable into marketable securities.

How it works:

• Computers make it relatively easy and cheap to bundle loans together.
• Sell them to investors and pass the payments through to the new owner.
• Securitized loans are diversified against default risk (composed of bundles of smaller loans).
• Sold in large round sums that institutional investors crave.

🔄 How securitization changes banking

• Allows bankers to specialize in originating loans rather than holding assets.
• Banks can improve their balance sheets by securitizing and selling loans, using the cash to fund new loans.
• Trade-off: securitization has opened the door to smaller competitors.

📊 Summary of technology's impact

Innovation	What it does	Main benefit
Credit/debit card networks	Private payment systems for retailers, consumers, and issuers	Convenience, safety, consumption smoothing; assured payment for retailers
ATMs/ABMs	Automated transaction machines	Reduced bank expenses; more convenient than branches
Online banking	Banking from home/work computers	Much cheaper than in-bank methods
Securitization	Transform illiquid loans into marketable securities	Allows banks to specialize in loan origination; improves balance sheets

Overall result:

• Technology reduced bank expenses (ATMs, ABMs, online banking).
• Enabled new revenue streams (credit card issuance often lucrative).
• Allowed specialization (securitization lets banks focus on originating loans).
• But also increased competition (securitization opened door to smaller competitors).

🧭 Overview

🧠 One-sentence thesis

Despite losing market share to non-bank lenders, banks remain profitable by shifting from traditional interest-spread income to fee-based activities, while consolidation, conglomeration, and concentration have reshaped the industry into fewer, larger, and more complex institutions that may pose both efficiency gains and systemic risks.

📌 Key points (3–5)

• Traditional banking profit model has eroded: banks now earn almost half their income from fees and off-balance-sheet activities (up from 7% in 1980) because both deposit costs and loan pricing have become less favorable.
• Market share decline is relative: banks controlled over 60% of loans to nonfinancial borrowers in the 1970s but only about a third today, yet absolute loan volume grew, keeping banks profitable.
• Three structural shifts: consolidation (fewer banks via mergers), conglomeration (banks entering insurance and investment banking after Glass-Steagall repeal), and concentration (larger banks holding bigger market shares).
• Common confusion—concentration vs. consolidation: consolidation means fewer total banks; concentration means a few large banks control most assets; both have increased, but the U.S. still has thousands of small banks keeping the national Herfindahl index below monopoly thresholds.
• Trade-offs of the new structure: larger banks may be more efficient and diversified, but they may also be too big to regulate, take on excessive risk to justify mergers, and wield market power that harms consumers.

💸 Erosion of traditional banking profits

💸 The old 3-6-3 rule is gone

• The excerpt notes "the good old days of traditional banking and the 3-6-3 rule are long gone."
• Traditional profit came from the spread between what banks paid on deposits and what they earned on loans.
• This spread has "steadily eroded from both ends," forcing banks to work harder for profits.

📉 Rising deposit costs

• Regulation Q capped deposit interest rates: 0% on checking, about 6% on time deposits.
• During the Great Inflation, high market interest rates caused disintermediation—funds flowed out of banks into higher-yielding investments like money market mutual funds.
• Banks lobbied to end interest rate caps; restrictions were lifted in the 1980s.
• Result: banks now compete with each other and money market funds, paying more for deposits than before (holding general interest rates constant).
• Deposits have become "relatively less important as sources of funds for banks."

📉 Falling loan revenues

• Banks face "increasingly stiff competition from the commercial paper and bond markets, especially the so-called junk bond market."
• Smaller and riskier companies can now sell bonds directly to investors instead of borrowing from banks.
• Issuing bonds has costs (mandatory disclosure, constant investor feedback via bond prices), but companies accept these if they get better rates than banks offer.
• Securitization enabled small lenders to originate loans and sell them immediately, without needing deposits or sophisticated asset-liability management.
  • Finance companies ate into commercial lending market share.
  • Specialized mortgage lenders made "major inroads into the home mortgage market."
• Example: A lender originates a home loan, sells it to investors, and uses the proceeds to make new loans—competing with banks without holding deposits.

💼 Shift to fee income

• "Fees and other off-balance-sheet activities now account for almost half of bank income, up from about 7 percent in 1980."
• This shift compensates for the shrinking interest-rate spread.
• Banks innovate to generate non-interest revenue (credit cards, sweep accounts, securitization services).

🏛️ Regulatory changes and industry restructuring

🏛️ Glass-Steagall and its repeal

Glass-Steagall (1933): legislation that strictly separated commercial banking (deposits and loans) from investment banking (securities underwriting).

• Enacted "at the nadir of the Great Depression."
• Gradually eroded in the late 1980s and 1990s via bank holding companies and a sympathetic Federal Reserve.
• Formally eliminated in 1999 (de jure repeal).
• Result: commercial and investment banks could merge and engage in each other's activities.
• This change, along with other deregulation, enabled conglomeration (banks entering nonbanking activities like insurance).

🔗 Consolidation

Consolidation: the process by which banks merge in large numbers, reducing the total number of banks.

• Driven by competitive pressures, the 1980s banking crisis, and regulatory reforms easing branch banking restrictions.
• Many banks exited via bankruptcy or merger with larger institutions.
• The excerpt references Figure 10.4 showing the decline in the number of FDIC commercial banks from 1980 to 2007.
• Result: "fewer but larger and more profitable (and ostensibly more efficient) banks."

🏢 Conglomeration

Conglomeration: the process by which banks enter into nonbanking financial activities (e.g., insurance, securities underwriting).

• Enabled by Glass-Steagall repeal and other regulatory changes.
• Banks can now "tap economies of scope"—using a single resource to supply multiple products.
  • Example: banks use information about borrowers to offer both loans and securities underwriting; branches sell insurance.
• Consolidation also allows banks to:
  • Diversify risks geographically.
  • Tap economies of scale (important because minimum efficient scale may have increased due to high costs of computer and telecom technology).

⚠️ Costs of the new regime

• The Federal Reserve calls the merged entities large, complex banking organizations (LCBOs) or large, complex financial institutions (LCFIs).
• Potential problems:
  • May be "too big, complex, and politically potent to regulate effectively."
  • Some banks increased profitability "not by becoming more efficient, but by taking on higher levels of risk" to justify mergers to shareholders.
  • Conglomerates may diversify activities but "may not do any of them very well, thereby actually increasing the risk of failure."
• The excerpt notes that "a combination of consolidation, conglomeration, and concentration helped to trigger a systemic financial crisis acute enough to negatively affect the national and world economies" (referring to the 2007–2008 crisis in later chapters).

📊 Measuring industry concentration

📊 What concentration means

Concentration: the degree to which a few large banks hold a large share of assets, deposits, and capital.

• "The U.S. banking industry is far more concentrated than during most of its past."
• High concentration may give large banks market power—the ability to charge more for loans and pay less for deposits.

📐 Herfindahl index

Herfindahl index: a measure of market concentration calculated by summing the squares of the market shares of each firm in an industry.

• Scaled between 0 and 1 (or 0 and 10,000).
• Low (near zero): many small firms → competitive industry.
• High (near 1 or 10,000): close to monopoly (1 × 1 = 1; 100 × 100 = 10,000).
• The U.S. banking Herfindahl index has "increased markedly in recent years" but remains below 1,800, the threshold for greater antitrust scrutiny by the Justice Department.
• Thousands of small banks keep the national index low: at end-2006, 3,246 of 7,402 commercial banks had assets under $100 million; another 3,662 had $100 million–$1 billion; only 494 had over $1 billion.

📈 Top-bank market share

• The excerpt references Figure 10.7 showing "the nation's ten largest banks are rapidly gaining market share."
• Those ~500 big banks "control the vast bulk of the industry's assets (and hence liabilities and capital too)."
• Don't confuse: a low national Herfindahl index does not mean no concentration problem—certain regions may have high enough concentration that banks earn "quasi-monopoly rents."

🌍 International comparison

• "U.S. banking is still far less concentrated than the banking sectors of most other countries."
• Examples:
  • Canada: commercial bank Herfindahl index around 1,600.
  • Colombia and Chile: the biggest five banks make more than 60% of all loans.
• The U.S. is large, and banking remains "such a local business" that regional concentration varies.

📘 Worked example: Canadian concentration (2003)

The excerpt includes a "Stop and Think Box" with Canadian bank data (Figure 10.8) and calculations:

Measure	Calculation	Result
Five-firm concentration ratio	Sum of market shares of five largest banks	86%
Herfindahl index	Sum of squares of all banks' market shares	1,590

• The five-firm ratio is straightforward: add the top five banks' shares.
• The Herfindahl sums the square of each bank's share (including smaller banks).

🏦 New bank entry and industry dynamics

🏦 Ease of entry

• "Bank entry is fairly easy."
• If banks become too profitable in a region, new banks will form, bringing concentration ratios and profits back in line.
• Since the mid-1980s, "scores to hundreds of new banks, called de novo banks, began operation in the United States each year."

🛠️ How to start a new bank

• About twenty incorporators each put ~$50,000 at risk for the year or two needed to gain regulatory approval.
• They subscribe at least the same amount in a private stock placement to provide capital.
• The new bank begins with "usually two branches, one in an asset-rich area, the other in a deposit-rich one."
• Consultants (e.g., Dan Hudson of NuBank.com) help new banks form and operate.

🔮 Future structure

• Regulations effectively cap the size of megabanks (the handful with over $1 trillion in assets).
• Many observers expect the U.S. banking sector to remain competitive, composed of:
  • Numerous small banks.
  • A few (dozen or score) megabanks.
  • Hundreds of large regional players.
• Why small banks survive:
  • Exploit geographical and specialized niches (e.g., customers who prefer live interaction over machines).
  • Better at lending to small businesses because they know local markets and borrowers better.
• Large banks also lend to small businesses, but "smaller, community banks are often better at it."

🏛️ Other depository institutions and internationalization

🏛️ Other U.S. depository types

• Savings and loan associations and mutual savings banks: few new ones created; many have taken commercial bank charters or merged with commercial banks.
• Credit unions:

  Mutual (owned by depositors) depository institutions organized around a group sharing a common bond (e.g., same employer).

  • Tax-exempt and historically small.
  • Regulators recently allowed expansion to maintain minimum efficient scale and diversify portfolios.
  • New credit union formation is "fairly brisk."

🌐 Foreign banks in the U.S.

• "Foreign banks can enter the U.S. market relatively easily."
• Today, foreign banks hold more than 10% of total U.S. bank assets and make more than 16% of loans to U.S. corporations.
• They can buy U.S. banks or establish branches.
• Used to face less stringent regulations, but this was changed in 1978.
• "Increasingly, bank regulations worldwide have converged."

🌐 U.S. banks abroad

• About 100 U.S. banks have branches abroad (up from eight in 1960).
• Reasons for international banking:
  • Grew with international trade and foreign direct investment.
  • Diversify assets.
  • Tap markets with larger spreads than in the U.S.
  • Access the Eurodollar market.

    Eurodollars: dollar-denominated deposits in foreign banks that help international businesses conduct trade and banks avoid reserve requirements, regulations, and capital controls.

• Main Eurodollar centers: London, Singapore, Cayman Islands.
• U.S. banks also have strong presence in East Asia and Latin America to finance trade.

🌍 Convergence toward European models

• Banking in the U.S. and abroad is "apparently converging on the European, specifically the British, model."
• Continental Europe (Germany, Switzerland): universal banks offer commercial and investment banking plus insurance.
• Great Britain and commonwealth: full conglomerates less common, but most banks do both commercial and investment banking.
• Foreign securities markets are modeling themselves after American markets, growing larger and more sophisticated.
• "Increasingly, the world's financial system is becoming one."
  • Should make it more efficient.
  • Raises fears of financial catastrophe (a point the excerpt says will return later).

🎯 Key takeaways (from the excerpt)

🎯 Consolidation

• Measured by the number of banks at a given time.
• As mergers and bankruptcies exceed new bank formation, the industry becomes more consolidated.
• Why it matters:
  • A more consolidated industry may be safer and more profitable (smaller, weaker institutions absorbed by larger, stronger ones).
  • But can also lead to higher costs for consumers/borrowers and poorer service.
  • Bigger banks may be more diversified but might also take on higher risk, threatening financial system stability.

🎯 Conglomeration

• Refers to the scope of activities a bank or financial intermediary can engage in.
• Traditionally, U.S. banks did commercial banking or investment banking, not both, and could not sell/underwrite insurance.
• Recent regulatory changes allow banks, brokerages, and other intermediaries to merge or exist under the same holding company.
• Why it matters:
  • May increase competition and drive innovation.
  • Could create conglomerates "too large and complex to regulate adequately."

🎯 Concentration

• Proxy for competition; measured by:
  • n-firm concentration (e.g., share of assets held by top 1, 3, 5, 10, 25, 50 firms).
  • Herfindahl index (sum of squares of market shares).
• Why it matters:
  • High concentration may mean less competition → less innovation, higher borrower costs, outsized bank profits, more fragile banking system.
  • On the other hand, more concentrated banking means individual banks are more geographically diversified, which may help them weather economic downturns.