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宏观代写-ECO 2307
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Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
1
Chapter 10: CREDIT MARKETS
Learning objectives
- How a credit market matches borrowers and lenders (savers).
- How the credit market equilibrium determines the real
interest rate.
- The three key functions of banks.
- How banks can become insolvent, and the effects of bank
insolvency to the economy.
10.1 What is the Credit Market?
The credit market (also known as the loanable funds market) is
where borrowers obtain funds from savers. As always the case, a
market requires two sides to function, supply and demand. A
credit market consists of credit supply (savers/lenders) and
credit demand (borrowers), and institutions such as banks which
bring the two together.
Hence, credit markets are institutions that match the savers and
borrowers:they bring together savers and borrowers.
Credit markets perform the essential economic function of
channeling funds from savers to borrowers.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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(a) Borrowers and the Demand for Loans
Debtors: economic agents (borrowers) who borrow funds either to
invest or to consume.
Creditors: economic agents (lenders/savers) who lend the funds
to earn an interest.
Credit: the funds that debtors borrow (loans).
(b) Nominal and real interest rates
When businesses and individuals receive credit from banks, they
don’t use this credit for free. Debtors have to pay a price for
use of borrowed funds in the form of an interest rate (nominal
interest rate) per period of time, on the “principal”, that is,
on the original loan amount borrowed.
Nominal Interest ($) is the amount in dollar terms by which the
money paid back exceeds the principal loan (original money
borrowed). For example, let the principal be $1000, and the
payback $1100. The nominal interest is $100.
Nominal interest rate (i) is the percent by which the payback
exceeds the loan per period of time, without making any
adjustment for the change in the purchasing power of money
(inflation or deflation). The nominal interest rate is often
simply referred to as the interest rate. A “rate” is a percent.
In the above example the nominal interest rate is 10 percent,
that is,
$ଵ
$ଵ
∗ 100 = 10
Hence the payback in dollars is:
($) = + = (1 + ) = (1 + 0.10) ∗ 1000 = $1100
Businesses and households are optimizers, they seek to maximize
their profits. Thus, when interest rates are high, they borrow
less because fewer projects are likely to produce enough revenue
to cover the interest cost of borrowing, in addition to the
other project costs. When interest rates are low, they borrow
more (obtain more credit).
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
3
Real Interest ($): is computed by dividing the nominal interest
by the CPI. This adjusts the dollars of nominal interest to
remove the effect of inflation.
Real interest =
($)
∗ 100
The term “real” means that the nominal dollar value has been
adjusted for (controlled/protected from)inflation (price
changes). The inflation rate measures the speed at which the
general price level (Consumer Price Index) is changing in the
economy. It captures how much less valuable a dollar is becoming
because of the increase in the overall price level.
Real interest rate (r): This is the “true” cost of borrowing
money (obtaining credit). It is computed by subtracting the
inflation rate from the nominal interest rate as follows:
() = () – ()
This is also known as the Fisher equation: = ( – )
If you borrow a dollar at the beginning of the year, your
payback at the end of the year is ($1 + ∗ $1), that is,
(1 + ) ∗ $1
If there was an inflation rate (π), a dollar borrowed at
the beginning of the year has the same purchasing power as
($1 + ∗ $1) at the end of the year, that is, (1 + ) ∗ $1
Therefore, the real gain, which is the real interest rate
(r) from the loan is the difference between the payback
($1 + ) and the inflation adjusted value of the dollar
($1 + ), which is:
= ($1 + ) − ($1 + ∗ $1) = –
If banks don’t factor in inflation when calculating the
cost of lending (borrowing), it implies that a dollar
borrowed today has same purchasing power as a dollar year
from now. This can be true only if the inflation rate is
zero (0) percent.
Example: if the inflation rate is 3 percent, each dollar
borrowed and lent at the beginning of the year will have
same purchasing power as ($1 + ), that is, 1 + 0.03 = $1.03 at
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
4
the end of the year. If inflation is not factored in, and
the borrower simply pays back $1, the payback would have
the same purchasing power as $0.97 one year ago. Implying
a loss of $0.03 per dollar to the lender.
For the lender to have a real gain in purchasing power,
which is the real interest rate, the lender would have to
charge a nominal interest rate greater that the inflation
rate of 3 percent, for instance, 4.5 percent.
Real interest (rate) is, therefore, the transfer of
purchasing power from the borrower to the lender for the
benefit of borrowing.
c) The Credit Demand Curve
The credit demand curve represents the relationship between the
quantity of credit demanded and the real interest rate, other
things constant. Where the real “price” of credit is the “real
interest rate”. It is the cost of the loan (borrowing).
Other things constant, when the real interest rate increases,
the quantity of credit demanded decreases, and vice versa. This
change in “quantity of credit demanded” is illustrated by a
movement along the same credit demand curve.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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The steepness of the credit demand curve tells us about the
sensitivity or responsiveness (elasticity) of the relationship
between the real interest rate and the quantity of credit
demanded. It also represents how responsive borrowers are to
changes in the real interest rate.
If, for instance, the credit demand curve is almost flat, then a
small increase in the real interest rate results into a large
decrease in the quantity of credit demanded.
Shifts in the credit demand curve: at any possible level of the
real interest rate more or less credit is demanded.
Causes of shifts in the credit demand curve:
i. Changes in perceived business opportunities for firms.
Business borrow to fund their expansions, for instance,
when sales and/or when profitability increase over time.
If many businesses experience similar expansion trends and
increase their demand for credit at a given real interest
rate, then the aggregate demand curve for credit will shift
to the right, and vice versa. For example, since the late
1990s oil prices have had an upward trend. Accordingly, oil
companies invested in more exploration, drilling, and
transportation equipment, all of which required additional
demand for credit.
ii. Changes in household preferences or expectations.
Households borrow money to finance purchases of big-ticket
items: cars, furniture, TVs, etc. Any changes to their
Baylor University ECO 2307
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by Ssozi
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preferences that lead them to consume more or less of such
items will shift the credit demand curve. Moreover, if
they have reason to expect that they will be in a better
financial position in the future, they may increase their
borrowing today knowing that they will be able to pay back
the loan in the future, and vice versa. An increase in
expected future income shifts the credit demand curve to
the right.
iii. Changes in government policy. When government spends more
than it collects in taxes, it runs a deficit. To cover the
deficit, the government borrows money from the credit
market, that is, the credit demand curve shifts to the
right. Also, in order to incentivize business to invest
more, the government may opt to lower taxes on corporate
profits. If firms respond positively to this government
policy, they will increase their desired borrowing at any
given interest rate, causing the credit demand curve to
shift to the right.
d) The Credit Supply Curve: the relationship between quantity of
credit supplied and the real interest rate, other things
constant. For dollar households consume today, they give up the
real interest they could have earned if they had saved and
invested the dollar. The higher the real interest rate, the
higher the opportunity cost of current consumption. When the
real interest rate rises, an optimizing household is encouraged
to consume less today and save more (increasing the quantity of
credit supplied) and invest.
An increase in savings leads to an increase in credit supply.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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Shifts in the credit supply curve: This is determined by changes
in the saving motives of the optimizing economic agents,
assuming the real interest rate is held constant.
i. Changes in the saving motives of households. Households
save money for many reasons, which change over time
shifting the credit supply curve. For example, if they
expect hard times ahead, they may increase the amount of
money they save, and vice versa. As households approach
the retirement age tend to save at a higher rate.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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ii. Changes in the saving motives of firms. Typically, firms
pay some of their profits as dividends to shareholders and
retain some of the earnings. The magnitude of retained
earnings changes over time. When firms want to expand or
are nervous about their ability to fund future business
activities they may retain more of the earnings. Thus,
would increase the supply of credit, shift the curve
outwards.
e) Equilibrium in the credit market
This brings together the credit demand curve and credit supply
curve. In the equilibrium, the quantity of credit demanded is
equal to the quantity of credit supplied at (Q*,r*).
At any real interest rate above r*, there is a surplus of
credit, which typically puts downward pressure on the real
interest rate.
On the other hand, if the real interest rate below r*,
there is a shortage of credit, and the credit market will
bid up the real interest rate.
Effect of a shift in the credit demand curve on the real
interest rate and credit.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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Any of these curves can be shifted to create a new equilibrium
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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10.2: Banks and Financial Intermediation: Putting Supply and
Demand Together
What is a bank? A bank is a financial institution which accepts
deposits and makes loans. Banks play the role of financial
intermediation by channeling funds from suppliers of financial
capital (savers) to the users of financial capital (borrowers).
Notice: The types of financial intermediaries on page 238 are much better covered in Finance
courses. For now, we skip them.
Financial capital takes many forms. The most common ones are
credit and equity.
Credit (debt): When savings are turned into credit, loans
are made with the expectation of interest. It also includes
credit instruments such as mortgages, bonds, T-bills, etc.
Equity (shareholders): When savings are turned into equity,
shareholders acquire ownership in corporations and a claim
on the future profits (dividends).
Assets and Liabilities on the Balance Sheet of a
Bank
To understand how banks function, it is important to understand
the balance sheet of the bank.
A balance sheet is a way of listing and recording the value of a
bank’s assets and liabilities. A balance sheet is a statement
(list) of the assets and liabilities of a firm (bank), where
total assets equal to total liabilities plus shareholder equity
(capital). Both sides of a “balance sheet” must be equal. Hence,
the word “balance”.
= + ℎ’
Liabilities: what the bank owes. These are the sources of money
to the bank.
Assets: what the bank owns. These are the uses of the money by
the bank.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
11
The following are the key features of a bank balance sheet:
ASSETS LIABILITIES and STOCKHOLDERS’
EQUITY
- Reserves
- Cash Equivalents
- Long-term Investments
Liabilities
- Demand deposits
- Short-term borrowing
- Long-term debt
Stockholders’ Equity
Assets:
i. Bank reserves: Vault cash and deposits at the Federal
Reserve Bank. Commercial Banks hold a percent of the
clients’ deposits in their vaults and a percent with the
Fed as reserves. All National commercial banks have
accounts with the Fed. The Fed is the bank of banks. For
instance, Citibank’s reserves at the Fed are deposits that
Citibank has made at the Fed. These deposits are owned by
Citibank, and it can even loan some its excess reserves to
other banks. Cash in their vaults serves to cover cash
withdrawals by clients.
ii. Cash equivalents. These are low-risk and liquid financial
assets that a bank can access at any time, such as
deposits at other banks and U.S. Treasury securities,
especially Treasury Bills. Cash equivalent assets are
liquid because they can easily and quickly be converted
into cash, with little or no loss in value. An asset is
low risk if its value doesn’t change from day to day, for
example the hard currencies (e.g. dollars, pounds, euro)
are low risk.
iii. Long-term investments. This category includes most of the
loans that a bank makes to individuals and banks. Loans
with term to maturity of at least a year. It also
includes all buildings, real estate, and structures that
the bank owns.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
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Liabilities and Stockholders’ Equity:
i. Demand deposits. These are funds that depositors can
access, on demand (anytime), by withdrawing money at
teller windows, using ATMs, writing checks, or using their
debit cards to make a store purchase. Demand deposits have
zero maturity because they can be withdrawn anytime.
Maturity is the time until a debt/money must be repaid.
Even though demand deposits are “cash in the bank”, they
are a liability from the perspective of the bank because
it owes this money to its depositors.
ii. Short-term borrowing. These are loans that a bank gets
from other banks to support its day-to-day operations.
They are short-term in nature, i.e., for less than a year.
In fact, most of these loans are overnight loans. Usually
overnight loans are rolled over from one day to the next.
This means that a bank pays its overnight loans and then
instantly arranges new overnight loans with the same
lenders. Maturity < 1 year
iii. Long-term debt. This type of debt is due to be repaid in a
year or more. Maturity ≥ 1 year. The size of the long-
term debt on the liability side is often compared to the
size of the long-term investments on the asset side to get
an idea about the riskiness of the bank. Illiquid assets
lock away money that a bank may need to give back to
depositors or other creditors on short notice. If the
long-term assets are greater than the long-term
liabilities, it may appear good, but it exposes a bank to
some risk especially if the money invested in long-term
assets comes from short-term liabilities. A bank may find
itself having accumulated a lot of illiquid assets but
unable to pay its short-term liabilities.
iv. Shareholders’ equity. This is simply the value of the bank
to its owners, which is calculated by subtracting its
total liabilities from total assets. Notice that if assets
equal liabilities, shareholders’ equity is zero. If assets
are greater than liabilities, then the value of the
company is positive. In other words, it is the
shareholders’ equity that ensures that the two columns in
the balance sheet are equal. If the assets are less than
the liabilities, a bank is said to be insolvent, and
cannot pay its debts. Regulators will move to close it.
Baylor University ECO 2307
Class Notes, SUMMER 2022
by Ssozi
13
10.3 What do Banks do?
We use the bank balance sheet to identify three interrelated
functions that banks perform as financial intermediaries:
- Identifying profitable lending opportunities
- Maturity transformation
- Management of risk
(a) Identifying profitable lending opportunities: The main
function of banks is to channel funds from savers to
borrowers. For this to be efficient and profitable, banks have
to assess the creditworthiness of the borrowers (ensure they
will be able to repay their loans).
- Banks employ loan officers and investment analysts to
scrutinize the loan applications to distinguish the
profitable from the unprofitable lending opportunities.
- How? Loan officers examine the following about a loan
applicant: Credit scores, feasibility, collateral, level of
firm equity, loans with other banks, etc.
(b) Maturity transformation: This is the process of converting
short-term liabilities such as demand deposits into long-term
assets such as mortgages/loans payable in more than a year.
Maturity is the time until a debt must be repaid.
Qn. Why is maturity transformation important for the economy? It
is important for two main reasons:
It enables banks to make profits. Long-term investments
such as mortgages make more profits than cash equivalents.
It enables the economy to undertake significant long-term
investments that require large amounts of money, and whose
returns take long.
The maturity mismatch: between the liabilities and assets. For
instance, “demand deposits” and “loans” when bank X borrows from
bank Y are liabilities and often cases have zero maturity and
short-term maturity respectively. If a bank uses these funds to
issue mortgages, these mortgages are an asset for the bank have
long-term maturity. Hence the maturity mismatch between assets
(mortgages) and liabilities (demand deposits).
Baylor University ECO 2307
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by Ssozi
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The Downside of maturity transformation:
- Maturity mismatch could get a bank in trouble.
- How? Maturity transformation creates a maturity mismatch
between the liabilities and assets, creating illiquid
assets which can cause a problem (bank run or loss of
confidence in the banking system) if lots of depositors and
other creditors were to ask for withdrawals at a short
notice/simultaneously. The bank may not have enough
liquidity (cash) at hand to meet the withdrawals.
- For example, a mortgage is an illiquid asset of the bank
because it cannot quickly convert it into cash to pay
depositors and creditors at short notice. Banks cannot
simply recall their long-term loans if their short-term
depositors want their money back.
To avoid the problems of maturity mismatch, banks do the
following:
Banks hold a fraction of the deposits as reserves or some
other form of cash-like security which is easily
convertible into cash. To ensure that they can fulfill
demands for withdrawals, banks do not lend out all their
deposits.
Banks need to have a large number of depositors. Typically,
only a few demand a small fraction of their deposits on any
given day. This may help withdrawals and inflows to offset
on most days. This also enables a bank to maintain a
smaller pool of reserves for the daily withdrawals, and to
commit a significant amount of deposits to long-term
investment.
(c) Management of risk: Bank investments such as mortgages are
risky (have uncertain returns). They can end up in total
defaults or late payments, causing losses to banks and
depositors. Banks manage risks in a couple of ways:
- Holding a diversified portfolio of assets: different types
of assets
- Narrow banking
Baylor University ECO 2307
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- Shifting the risk to stockholders, and ultimately to the
FDIC
i. Holding a diversified portfolio of assets is useful because
all the assets are unlikely to underperform at the same
time. e.g., business loans, government loans, mortgages,
stock, bonds, etc. Diversification implies holding assets
whose returns are not significantly correlated.
ii. Narrow banking: matching the short-term liabilities with
the short-term assets. It reduces the risk/likelihood of
liquidity shortages and bank runs when depositors want to
make withdrawals. However, narrow banking reduces bank
profitability, because long-term assets, such as mortgages,
bring higher returns than short-term assets such as the
Cash Equivalents (T-bills).
iii. Shifting the risk to the stockholders, and to the Federal
Deposit Insurance Corporation (FDIC). During a financial
crisis, such as the 2007-2009 recession, even a well-
diversified set of assets may underperform.
When a bank makes losses, the bad loans are written off the
value of assets. This means that stockholder equity falls,
while the liabilities remain unchanged.
Example: Initially, let total assets be $100b, liabilities
$90b. Therefore, stockholder equity is $10b.
o Case 1: Stockholders bear all the risk if Assets remain
greater than liabilities after the losses are incurred,
that is, if equity remains positive. If a bank loses $6b,
assets fall to $94b and equity falls to $4b ($94b minus
$90b equals $4b). The bank remains solvent. Hence,
stockholder equity is the cushion against which loans are
made. A well-capitalized bank minimizes the probability of
failure. As long as stockholder equity is greater than
zero, stockholders bear all the risk which the bank faces.
o Case 2: The Federal Deposit Insurance Corporation (FDIC)
bears the risk if assets fall below the liabilities after
Baylor University ECO 2307
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the losses are incurred. For instance, if the bad loans
amount to $13b. Assets fall to $87b but liabilities remain
$90b. Hence equity is negative ($87b minus $90b equals -
$3b). The bank owes more than it owns, it cannot pay its
debts, and stockholder equity goes to zero. In this case,
the bank is declared insolvent. The FDIC, which is the
Federal government regulator, takes over the bank either to
close it or transfer it to a new ownership. In the event
of closure, the FDIC pays depositors up to $250,000, and
stockholder equity is wiped out.
Deposit Insurance: The FDIC charges an insurance premium to all
bank deposits. When bank failures occur, the FDIC may raise the
premium on all bank deposits, not just those at the failed
banks. The buck ends with the depositors. During the 2007-2009
recession, bank failures cost the FDIC about $100 billion.
10.4 Bank runs, Failures, and Regulations
(a) Bank runs: A bank run occurs when extraordinarily large
value of cash withdrawals occurs to a bank driven by a concern
that the bank will run out of liquid assets (cash) to pay future
withdrawals and creditors. It is a rush by depositors to
withdraw before it is too late.
Three main causes of bank runs:
- Insolvency
- Illiquid assets
- Pessimism
Insolvency: if the value of assets is less than the value
of liabilities, the bank does not have enough money to pay
depositors withdrawals and other creditors.
Illiquid assets: this is often a result of maturity
transformation, when short-term liabilities are turned into
long-term illiquid assets (investments) which cannot be
easily converted into cash to pay withdrawals and mature
loans. Hence, even a solvent bank can run out of cash to
pay, and this may trigger a bank run.
Pessimism: a bank panic can be self-fulfilling-it feeds on
itself. If there is a bank panic, that is, simultaneous
Baylor University ECO 2307
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runs at many individual banks, people lose confidence in
the whole banking system. If people expect a run, a run can
occur. This can trigger massive withdrawals/runs in other
banks even if there was nothing wrong at those other banks.
It usually starts with big banks in the big cities.
Economic costs of bank runs
i. A bank may be forced to liquidate (fire-sell) its long-term
illiquid assets prematurely to generate cash needed for
withdrawals. Fire sales often involve losses because the bank
does not have enough time to find buyers willing to pay the
highest prices e.g. for real estate. Hence, the value of
assets falls, and stockholder equity also falls, while
liabilities remain unchanged. If the losses are high enough, a
bank can become insolvent and fail.
ii. Bank runs/withdrawals disrupt the flow of credit from savers
to borrowers, making borrowing and investment very costly.
Large withdrawals decrease the supply of credit (supply curve
shifts inwards). Real interest rate rises, for a given demand
curve. Such financial crises reduce economic efficiency and
can cause a recession.
(b) Bank Regulation and Bank Solvency
If bank runs, were a frequent occurrence, the banking system
would be quite unstable, and bank runs frequent. During the
Great Depression 1929-1933 bank failures were very frequent.
The FDIC was established in 1933, and since then the rate of
bank failures in the U.S. significantly declined.
Exhibit 10.9.
The FDIC has two functions:
i. Insure deposits up to $250,000 (currently).
ii. Enforce banking regulations to uphold the solvency and
integrity of the banking system.
However, the FDIC may not prevent institutional bank runs
because corporations make deposits and short-term loans that are
too large to be fully insured by the FDIC.
An institutional bank run occurs when firms and other banks
withdraw their deposits and short-term loans from a weak bank.
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When the general business community starts feeling uneasy about
a particular bank, an institutional bank run may occur.
In this case, the FDIC may not be able to cover large firm’s
deposits which often exceed the cap of $250,000. Moreover,
investment banks are not covered by FDIC because they are not
depository financial institutions.
If an institutional bank run occurs to a bank, that bank
involved would fail unless it receives a bail out from the
government. These bails are a reserve of the SIFI’s
(Systemically Important Financial Institutions).
(c) Too Big to Fail
The Too Big to Fail is the doctrine that SIFIs facing insolvency
must be bailed out to protect the financial system.
The failure of one megabank could bring down the whole financial
system. Failure of large banks may cause a ripple effect
throughout the entire financial system and drag down other
banks.
Why? Because they have many liabilities from many other
corporations and small banks. If the SIFIs fail, all those other
corporations and banks will also surfer losses. Due to this
systemic risk regulators pay special attention to the SIFIs, may
even bail them out of financial trouble.
Systemic risk: are economy-wide risks created by failure of one
mega or several financial institutions
Bail out: involves giving financial assistance (emergency
credit/loans) to a failing SIFI to save it from collapse.
Bailouts can save a financial system from collapsing but they
have a downside.
The FDIC cannot observe all the risks an SIFI bank is
undertaking, but the SIFIs know that they are too big to fail.
This information asymmetry between the SIFIs and FDIC may give
rise to moral hazard problems.
Moral hazard implies that an economic agent may choose to do
something undesirable (immoral), aware that if one incurs heavy
losses someone else will take the responsibility (bail the agent
out).
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For instance, after an SIFI has acquired the license to operate,
it may undertake huge risky (hazardous) investments, which are
undesirable (immoral) to the FDIC, aware that if it is in danger
of failing the U.S. government/FDIC will bail it out.
It is a “Heads I win, tails you lose” or “We either win or they
lose” situation.
The winners in the bailout are the bank shareholders; the losers
are the taxpayers who indirectly bear the losses when the
government lends cheap money to SIFIs.
Regulatory measures to avoid/reduce moral hazard among SIFIs
i. Large banks are required to write their living wills, that is,
a plan of how they would wind down their portfolios in an
orderly fashion, that is, sell their assets and pay off
creditors in case of insolvency. These wills are also meant
to help government shutdown failing banks.
ii. Stress-tests: SIFIs are required to show how to survive
potential economic shocks, for instance, deep recessions or
sharp fall in housing prices. The tests have the effect of
encouraging large banks to offer less risky loans (risky
assets), and to hold more stockholder equity, that is, to be
well capitalized.
iii. Regulators directly require the SIFIs to be well capitalized,
A>L, to hold more stockholders’ equity, take on less risky
loans, thus reducing the likelihood that a large bank will
become insolvent (and helping banks to pass their stress
tests).
Notice: Systemic risk is not only brought about by large banks
like SIFIs. Sometimes many small banks fail at the same time
and create systemic problems for the entire financial system.
E.g., during the great depression
(d) Asset price fluctuations and bank failures
Question 1: What makes banks fail?
Banks fail when they invest in long-term assets which
subsequently fall in value (market price), e.g., Mortgages,
homes, stock, etc.
Since liabilities remain unchanged despite the losses, a fall in
the value of assets can eventually make a bank insolvent and
fail, that is, make < .
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Question 2: Why do many banks fail at the same time?
Since different banks tend to invest in the same types of long-
term assets (stock, mortgages, business loans), their fortunes
often rise and fall together. Hence many banks may fail at the
same time.
Question 3. Why do asset prices fluctuate so much?
Two theories:
The First, the theory of efficient markets, proposed by Eugene
Fama. Fluctuations in stock prices reflect rational appraisals
(updates/ forecasts) using new information about expected future
income/returns/profits (economic fundamentals), and future value
of interest rates. For instance, new information about the
future profitability of the firms traded on the stock exchange
is associated with a change in the value of their stock:
Increase in future expected profits is associated with an
increase in stock prices, and vice versa.
The Second, asset bubbles. An asset-price bubble is a rapid rise
in asset prices that is not justified by rational forecasts of
the fundaments (returns/profits), but by overly optimistic
expectations (irrational exuberance) partly driven by
psychological factors and biases during economic expansions.
e.g. When a credit boom begins it can spillover into an asset-
price bubble. Easier credit can be used to buy particular assets
such as homes and stock, and thereby raise their prices.
Once a bubble is identified, subsequent market crashes would be
predictable.
An asset-price crash is a large rapid fall in asset prices,
often to below the true present value. This can lead to
insolvency and bank failure when the assets they invested in
rapidly fall in value relative to the liabilities. <
Solutions: Sound bank regulation can play a key role in helping
the banking sector survive asset-price crashes, particularly, by
requiring banks to hold more stockholder equity (be well-
capitalized) and watching the asset versus liabilities maturity
mismatch (Narrow banking). A well-capitalized bank can write off
bad loans and remain solvent.
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Chapter 10: CREDIT MARKETS
Learning objectives
- How a credit market matches borrowers and lenders (savers).
- How the credit market equilibrium determines the real
interest rate.
- The three key functions of banks.
- How banks can become insolvent, and the effects of bank
insolvency to the economy.
10.1 What is the Credit Market?
The credit market (also known as the loanable funds market) is
where borrowers obtain funds from savers. As always the case, a
market requires two sides to function, supply and demand. A
credit market consists of credit supply (savers/lenders) and
credit demand (borrowers), and institutions such as banks which
bring the two together.
Hence, credit markets are institutions that match the savers and
borrowers:they bring together savers and borrowers.
Credit markets perform the essential economic function of
channeling funds from savers to borrowers.
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(a) Borrowers and the Demand for Loans
Debtors: economic agents (borrowers) who borrow funds either to
invest or to consume.
Creditors: economic agents (lenders/savers) who lend the funds
to earn an interest.
Credit: the funds that debtors borrow (loans).
(b) Nominal and real interest rates
When businesses and individuals receive credit from banks, they
don’t use this credit for free. Debtors have to pay a price for
use of borrowed funds in the form of an interest rate (nominal
interest rate) per period of time, on the “principal”, that is,
on the original loan amount borrowed.
Nominal Interest ($) is the amount in dollar terms by which the
money paid back exceeds the principal loan (original money
borrowed). For example, let the principal be $1000, and the
payback $1100. The nominal interest is $100.
Nominal interest rate (i) is the percent by which the payback
exceeds the loan per period of time, without making any
adjustment for the change in the purchasing power of money
(inflation or deflation). The nominal interest rate is often
simply referred to as the interest rate. A “rate” is a percent.
In the above example the nominal interest rate is 10 percent,
that is,
$ଵ
$ଵ
∗ 100 = 10
Hence the payback in dollars is:
($) = + = (1 + ) = (1 + 0.10) ∗ 1000 = $1100
Businesses and households are optimizers, they seek to maximize
their profits. Thus, when interest rates are high, they borrow
less because fewer projects are likely to produce enough revenue
to cover the interest cost of borrowing, in addition to the
other project costs. When interest rates are low, they borrow
more (obtain more credit).
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Real Interest ($): is computed by dividing the nominal interest
by the CPI. This adjusts the dollars of nominal interest to
remove the effect of inflation.
Real interest =
($)
∗ 100
The term “real” means that the nominal dollar value has been
adjusted for (controlled/protected from)inflation (price
changes). The inflation rate measures the speed at which the
general price level (Consumer Price Index) is changing in the
economy. It captures how much less valuable a dollar is becoming
because of the increase in the overall price level.
Real interest rate (r): This is the “true” cost of borrowing
money (obtaining credit). It is computed by subtracting the
inflation rate from the nominal interest rate as follows:
() = () – ()
This is also known as the Fisher equation: = ( – )
If you borrow a dollar at the beginning of the year, your
payback at the end of the year is ($1 + ∗ $1), that is,
(1 + ) ∗ $1
If there was an inflation rate (π), a dollar borrowed at
the beginning of the year has the same purchasing power as
($1 + ∗ $1) at the end of the year, that is, (1 + ) ∗ $1
Therefore, the real gain, which is the real interest rate
(r) from the loan is the difference between the payback
($1 + ) and the inflation adjusted value of the dollar
($1 + ), which is:
= ($1 + ) − ($1 + ∗ $1) = –
If banks don’t factor in inflation when calculating the
cost of lending (borrowing), it implies that a dollar
borrowed today has same purchasing power as a dollar year
from now. This can be true only if the inflation rate is
zero (0) percent.
Example: if the inflation rate is 3 percent, each dollar
borrowed and lent at the beginning of the year will have
same purchasing power as ($1 + ), that is, 1 + 0.03 = $1.03 at
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the end of the year. If inflation is not factored in, and
the borrower simply pays back $1, the payback would have
the same purchasing power as $0.97 one year ago. Implying
a loss of $0.03 per dollar to the lender.
For the lender to have a real gain in purchasing power,
which is the real interest rate, the lender would have to
charge a nominal interest rate greater that the inflation
rate of 3 percent, for instance, 4.5 percent.
Real interest (rate) is, therefore, the transfer of
purchasing power from the borrower to the lender for the
benefit of borrowing.
c) The Credit Demand Curve
The credit demand curve represents the relationship between the
quantity of credit demanded and the real interest rate, other
things constant. Where the real “price” of credit is the “real
interest rate”. It is the cost of the loan (borrowing).
Other things constant, when the real interest rate increases,
the quantity of credit demanded decreases, and vice versa. This
change in “quantity of credit demanded” is illustrated by a
movement along the same credit demand curve.
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The steepness of the credit demand curve tells us about the
sensitivity or responsiveness (elasticity) of the relationship
between the real interest rate and the quantity of credit
demanded. It also represents how responsive borrowers are to
changes in the real interest rate.
If, for instance, the credit demand curve is almost flat, then a
small increase in the real interest rate results into a large
decrease in the quantity of credit demanded.
Shifts in the credit demand curve: at any possible level of the
real interest rate more or less credit is demanded.
Causes of shifts in the credit demand curve:
i. Changes in perceived business opportunities for firms.
Business borrow to fund their expansions, for instance,
when sales and/or when profitability increase over time.
If many businesses experience similar expansion trends and
increase their demand for credit at a given real interest
rate, then the aggregate demand curve for credit will shift
to the right, and vice versa. For example, since the late
1990s oil prices have had an upward trend. Accordingly, oil
companies invested in more exploration, drilling, and
transportation equipment, all of which required additional
demand for credit.
ii. Changes in household preferences or expectations.
Households borrow money to finance purchases of big-ticket
items: cars, furniture, TVs, etc. Any changes to their
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preferences that lead them to consume more or less of such
items will shift the credit demand curve. Moreover, if
they have reason to expect that they will be in a better
financial position in the future, they may increase their
borrowing today knowing that they will be able to pay back
the loan in the future, and vice versa. An increase in
expected future income shifts the credit demand curve to
the right.
iii. Changes in government policy. When government spends more
than it collects in taxes, it runs a deficit. To cover the
deficit, the government borrows money from the credit
market, that is, the credit demand curve shifts to the
right. Also, in order to incentivize business to invest
more, the government may opt to lower taxes on corporate
profits. If firms respond positively to this government
policy, they will increase their desired borrowing at any
given interest rate, causing the credit demand curve to
shift to the right.
d) The Credit Supply Curve: the relationship between quantity of
credit supplied and the real interest rate, other things
constant. For dollar households consume today, they give up the
real interest they could have earned if they had saved and
invested the dollar. The higher the real interest rate, the
higher the opportunity cost of current consumption. When the
real interest rate rises, an optimizing household is encouraged
to consume less today and save more (increasing the quantity of
credit supplied) and invest.
An increase in savings leads to an increase in credit supply.
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Shifts in the credit supply curve: This is determined by changes
in the saving motives of the optimizing economic agents,
assuming the real interest rate is held constant.
i. Changes in the saving motives of households. Households
save money for many reasons, which change over time
shifting the credit supply curve. For example, if they
expect hard times ahead, they may increase the amount of
money they save, and vice versa. As households approach
the retirement age tend to save at a higher rate.
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ii. Changes in the saving motives of firms. Typically, firms
pay some of their profits as dividends to shareholders and
retain some of the earnings. The magnitude of retained
earnings changes over time. When firms want to expand or
are nervous about their ability to fund future business
activities they may retain more of the earnings. Thus,
would increase the supply of credit, shift the curve
outwards.
e) Equilibrium in the credit market
This brings together the credit demand curve and credit supply
curve. In the equilibrium, the quantity of credit demanded is
equal to the quantity of credit supplied at (Q*,r*).
At any real interest rate above r*, there is a surplus of
credit, which typically puts downward pressure on the real
interest rate.
On the other hand, if the real interest rate below r*,
there is a shortage of credit, and the credit market will
bid up the real interest rate.
Effect of a shift in the credit demand curve on the real
interest rate and credit.
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Any of these curves can be shifted to create a new equilibrium
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10.2: Banks and Financial Intermediation: Putting Supply and
Demand Together
What is a bank? A bank is a financial institution which accepts
deposits and makes loans. Banks play the role of financial
intermediation by channeling funds from suppliers of financial
capital (savers) to the users of financial capital (borrowers).
Notice: The types of financial intermediaries on page 238 are much better covered in Finance
courses. For now, we skip them.
Financial capital takes many forms. The most common ones are
credit and equity.
Credit (debt): When savings are turned into credit, loans
are made with the expectation of interest. It also includes
credit instruments such as mortgages, bonds, T-bills, etc.
Equity (shareholders): When savings are turned into equity,
shareholders acquire ownership in corporations and a claim
on the future profits (dividends).
Assets and Liabilities on the Balance Sheet of a
Bank
To understand how banks function, it is important to understand
the balance sheet of the bank.
A balance sheet is a way of listing and recording the value of a
bank’s assets and liabilities. A balance sheet is a statement
(list) of the assets and liabilities of a firm (bank), where
total assets equal to total liabilities plus shareholder equity
(capital). Both sides of a “balance sheet” must be equal. Hence,
the word “balance”.
= + ℎ’
Liabilities: what the bank owes. These are the sources of money
to the bank.
Assets: what the bank owns. These are the uses of the money by
the bank.
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The following are the key features of a bank balance sheet:
ASSETS LIABILITIES and STOCKHOLDERS’
EQUITY
- Reserves
- Cash Equivalents
- Long-term Investments
Liabilities
- Demand deposits
- Short-term borrowing
- Long-term debt
Stockholders’ Equity
Assets:
i. Bank reserves: Vault cash and deposits at the Federal
Reserve Bank. Commercial Banks hold a percent of the
clients’ deposits in their vaults and a percent with the
Fed as reserves. All National commercial banks have
accounts with the Fed. The Fed is the bank of banks. For
instance, Citibank’s reserves at the Fed are deposits that
Citibank has made at the Fed. These deposits are owned by
Citibank, and it can even loan some its excess reserves to
other banks. Cash in their vaults serves to cover cash
withdrawals by clients.
ii. Cash equivalents. These are low-risk and liquid financial
assets that a bank can access at any time, such as
deposits at other banks and U.S. Treasury securities,
especially Treasury Bills. Cash equivalent assets are
liquid because they can easily and quickly be converted
into cash, with little or no loss in value. An asset is
low risk if its value doesn’t change from day to day, for
example the hard currencies (e.g. dollars, pounds, euro)
are low risk.
iii. Long-term investments. This category includes most of the
loans that a bank makes to individuals and banks. Loans
with term to maturity of at least a year. It also
includes all buildings, real estate, and structures that
the bank owns.
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Liabilities and Stockholders’ Equity:
i. Demand deposits. These are funds that depositors can
access, on demand (anytime), by withdrawing money at
teller windows, using ATMs, writing checks, or using their
debit cards to make a store purchase. Demand deposits have
zero maturity because they can be withdrawn anytime.
Maturity is the time until a debt/money must be repaid.
Even though demand deposits are “cash in the bank”, they
are a liability from the perspective of the bank because
it owes this money to its depositors.
ii. Short-term borrowing. These are loans that a bank gets
from other banks to support its day-to-day operations.
They are short-term in nature, i.e., for less than a year.
In fact, most of these loans are overnight loans. Usually
overnight loans are rolled over from one day to the next.
This means that a bank pays its overnight loans and then
instantly arranges new overnight loans with the same
lenders. Maturity < 1 year
iii. Long-term debt. This type of debt is due to be repaid in a
year or more. Maturity ≥ 1 year. The size of the long-
term debt on the liability side is often compared to the
size of the long-term investments on the asset side to get
an idea about the riskiness of the bank. Illiquid assets
lock away money that a bank may need to give back to
depositors or other creditors on short notice. If the
long-term assets are greater than the long-term
liabilities, it may appear good, but it exposes a bank to
some risk especially if the money invested in long-term
assets comes from short-term liabilities. A bank may find
itself having accumulated a lot of illiquid assets but
unable to pay its short-term liabilities.
iv. Shareholders’ equity. This is simply the value of the bank
to its owners, which is calculated by subtracting its
total liabilities from total assets. Notice that if assets
equal liabilities, shareholders’ equity is zero. If assets
are greater than liabilities, then the value of the
company is positive. In other words, it is the
shareholders’ equity that ensures that the two columns in
the balance sheet are equal. If the assets are less than
the liabilities, a bank is said to be insolvent, and
cannot pay its debts. Regulators will move to close it.
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10.3 What do Banks do?
We use the bank balance sheet to identify three interrelated
functions that banks perform as financial intermediaries:
- Identifying profitable lending opportunities
- Maturity transformation
- Management of risk
(a) Identifying profitable lending opportunities: The main
function of banks is to channel funds from savers to
borrowers. For this to be efficient and profitable, banks have
to assess the creditworthiness of the borrowers (ensure they
will be able to repay their loans).
- Banks employ loan officers and investment analysts to
scrutinize the loan applications to distinguish the
profitable from the unprofitable lending opportunities.
- How? Loan officers examine the following about a loan
applicant: Credit scores, feasibility, collateral, level of
firm equity, loans with other banks, etc.
(b) Maturity transformation: This is the process of converting
short-term liabilities such as demand deposits into long-term
assets such as mortgages/loans payable in more than a year.
Maturity is the time until a debt must be repaid.
Qn. Why is maturity transformation important for the economy? It
is important for two main reasons:
It enables banks to make profits. Long-term investments
such as mortgages make more profits than cash equivalents.
It enables the economy to undertake significant long-term
investments that require large amounts of money, and whose
returns take long.
The maturity mismatch: between the liabilities and assets. For
instance, “demand deposits” and “loans” when bank X borrows from
bank Y are liabilities and often cases have zero maturity and
short-term maturity respectively. If a bank uses these funds to
issue mortgages, these mortgages are an asset for the bank have
long-term maturity. Hence the maturity mismatch between assets
(mortgages) and liabilities (demand deposits).
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The Downside of maturity transformation:
- Maturity mismatch could get a bank in trouble.
- How? Maturity transformation creates a maturity mismatch
between the liabilities and assets, creating illiquid
assets which can cause a problem (bank run or loss of
confidence in the banking system) if lots of depositors and
other creditors were to ask for withdrawals at a short
notice/simultaneously. The bank may not have enough
liquidity (cash) at hand to meet the withdrawals.
- For example, a mortgage is an illiquid asset of the bank
because it cannot quickly convert it into cash to pay
depositors and creditors at short notice. Banks cannot
simply recall their long-term loans if their short-term
depositors want their money back.
To avoid the problems of maturity mismatch, banks do the
following:
Banks hold a fraction of the deposits as reserves or some
other form of cash-like security which is easily
convertible into cash. To ensure that they can fulfill
demands for withdrawals, banks do not lend out all their
deposits.
Banks need to have a large number of depositors. Typically,
only a few demand a small fraction of their deposits on any
given day. This may help withdrawals and inflows to offset
on most days. This also enables a bank to maintain a
smaller pool of reserves for the daily withdrawals, and to
commit a significant amount of deposits to long-term
investment.
(c) Management of risk: Bank investments such as mortgages are
risky (have uncertain returns). They can end up in total
defaults or late payments, causing losses to banks and
depositors. Banks manage risks in a couple of ways:
- Holding a diversified portfolio of assets: different types
of assets
- Narrow banking
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- Shifting the risk to stockholders, and ultimately to the
FDIC
i. Holding a diversified portfolio of assets is useful because
all the assets are unlikely to underperform at the same
time. e.g., business loans, government loans, mortgages,
stock, bonds, etc. Diversification implies holding assets
whose returns are not significantly correlated.
ii. Narrow banking: matching the short-term liabilities with
the short-term assets. It reduces the risk/likelihood of
liquidity shortages and bank runs when depositors want to
make withdrawals. However, narrow banking reduces bank
profitability, because long-term assets, such as mortgages,
bring higher returns than short-term assets such as the
Cash Equivalents (T-bills).
iii. Shifting the risk to the stockholders, and to the Federal
Deposit Insurance Corporation (FDIC). During a financial
crisis, such as the 2007-2009 recession, even a well-
diversified set of assets may underperform.
When a bank makes losses, the bad loans are written off the
value of assets. This means that stockholder equity falls,
while the liabilities remain unchanged.
Example: Initially, let total assets be $100b, liabilities
$90b. Therefore, stockholder equity is $10b.
o Case 1: Stockholders bear all the risk if Assets remain
greater than liabilities after the losses are incurred,
that is, if equity remains positive. If a bank loses $6b,
assets fall to $94b and equity falls to $4b ($94b minus
$90b equals $4b). The bank remains solvent. Hence,
stockholder equity is the cushion against which loans are
made. A well-capitalized bank minimizes the probability of
failure. As long as stockholder equity is greater than
zero, stockholders bear all the risk which the bank faces.
o Case 2: The Federal Deposit Insurance Corporation (FDIC)
bears the risk if assets fall below the liabilities after
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the losses are incurred. For instance, if the bad loans
amount to $13b. Assets fall to $87b but liabilities remain
$90b. Hence equity is negative ($87b minus $90b equals -
$3b). The bank owes more than it owns, it cannot pay its
debts, and stockholder equity goes to zero. In this case,
the bank is declared insolvent. The FDIC, which is the
Federal government regulator, takes over the bank either to
close it or transfer it to a new ownership. In the event
of closure, the FDIC pays depositors up to $250,000, and
stockholder equity is wiped out.
Deposit Insurance: The FDIC charges an insurance premium to all
bank deposits. When bank failures occur, the FDIC may raise the
premium on all bank deposits, not just those at the failed
banks. The buck ends with the depositors. During the 2007-2009
recession, bank failures cost the FDIC about $100 billion.
10.4 Bank runs, Failures, and Regulations
(a) Bank runs: A bank run occurs when extraordinarily large
value of cash withdrawals occurs to a bank driven by a concern
that the bank will run out of liquid assets (cash) to pay future
withdrawals and creditors. It is a rush by depositors to
withdraw before it is too late.
Three main causes of bank runs:
- Insolvency
- Illiquid assets
- Pessimism
Insolvency: if the value of assets is less than the value
of liabilities, the bank does not have enough money to pay
depositors withdrawals and other creditors.
Illiquid assets: this is often a result of maturity
transformation, when short-term liabilities are turned into
long-term illiquid assets (investments) which cannot be
easily converted into cash to pay withdrawals and mature
loans. Hence, even a solvent bank can run out of cash to
pay, and this may trigger a bank run.
Pessimism: a bank panic can be self-fulfilling-it feeds on
itself. If there is a bank panic, that is, simultaneous
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runs at many individual banks, people lose confidence in
the whole banking system. If people expect a run, a run can
occur. This can trigger massive withdrawals/runs in other
banks even if there was nothing wrong at those other banks.
It usually starts with big banks in the big cities.
Economic costs of bank runs
i. A bank may be forced to liquidate (fire-sell) its long-term
illiquid assets prematurely to generate cash needed for
withdrawals. Fire sales often involve losses because the bank
does not have enough time to find buyers willing to pay the
highest prices e.g. for real estate. Hence, the value of
assets falls, and stockholder equity also falls, while
liabilities remain unchanged. If the losses are high enough, a
bank can become insolvent and fail.
ii. Bank runs/withdrawals disrupt the flow of credit from savers
to borrowers, making borrowing and investment very costly.
Large withdrawals decrease the supply of credit (supply curve
shifts inwards). Real interest rate rises, for a given demand
curve. Such financial crises reduce economic efficiency and
can cause a recession.
(b) Bank Regulation and Bank Solvency
If bank runs, were a frequent occurrence, the banking system
would be quite unstable, and bank runs frequent. During the
Great Depression 1929-1933 bank failures were very frequent.
The FDIC was established in 1933, and since then the rate of
bank failures in the U.S. significantly declined.
Exhibit 10.9.
The FDIC has two functions:
i. Insure deposits up to $250,000 (currently).
ii. Enforce banking regulations to uphold the solvency and
integrity of the banking system.
However, the FDIC may not prevent institutional bank runs
because corporations make deposits and short-term loans that are
too large to be fully insured by the FDIC.
An institutional bank run occurs when firms and other banks
withdraw their deposits and short-term loans from a weak bank.
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When the general business community starts feeling uneasy about
a particular bank, an institutional bank run may occur.
In this case, the FDIC may not be able to cover large firm’s
deposits which often exceed the cap of $250,000. Moreover,
investment banks are not covered by FDIC because they are not
depository financial institutions.
If an institutional bank run occurs to a bank, that bank
involved would fail unless it receives a bail out from the
government. These bails are a reserve of the SIFI’s
(Systemically Important Financial Institutions).
(c) Too Big to Fail
The Too Big to Fail is the doctrine that SIFIs facing insolvency
must be bailed out to protect the financial system.
The failure of one megabank could bring down the whole financial
system. Failure of large banks may cause a ripple effect
throughout the entire financial system and drag down other
banks.
Why? Because they have many liabilities from many other
corporations and small banks. If the SIFIs fail, all those other
corporations and banks will also surfer losses. Due to this
systemic risk regulators pay special attention to the SIFIs, may
even bail them out of financial trouble.
Systemic risk: are economy-wide risks created by failure of one
mega or several financial institutions
Bail out: involves giving financial assistance (emergency
credit/loans) to a failing SIFI to save it from collapse.
Bailouts can save a financial system from collapsing but they
have a downside.
The FDIC cannot observe all the risks an SIFI bank is
undertaking, but the SIFIs know that they are too big to fail.
This information asymmetry between the SIFIs and FDIC may give
rise to moral hazard problems.
Moral hazard implies that an economic agent may choose to do
something undesirable (immoral), aware that if one incurs heavy
losses someone else will take the responsibility (bail the agent
out).
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For instance, after an SIFI has acquired the license to operate,
it may undertake huge risky (hazardous) investments, which are
undesirable (immoral) to the FDIC, aware that if it is in danger
of failing the U.S. government/FDIC will bail it out.
It is a “Heads I win, tails you lose” or “We either win or they
lose” situation.
The winners in the bailout are the bank shareholders; the losers
are the taxpayers who indirectly bear the losses when the
government lends cheap money to SIFIs.
Regulatory measures to avoid/reduce moral hazard among SIFIs
i. Large banks are required to write their living wills, that is,
a plan of how they would wind down their portfolios in an
orderly fashion, that is, sell their assets and pay off
creditors in case of insolvency. These wills are also meant
to help government shutdown failing banks.
ii. Stress-tests: SIFIs are required to show how to survive
potential economic shocks, for instance, deep recessions or
sharp fall in housing prices. The tests have the effect of
encouraging large banks to offer less risky loans (risky
assets), and to hold more stockholder equity, that is, to be
well capitalized.
iii. Regulators directly require the SIFIs to be well capitalized,
A>L, to hold more stockholders’ equity, take on less risky
loans, thus reducing the likelihood that a large bank will
become insolvent (and helping banks to pass their stress
tests).
Notice: Systemic risk is not only brought about by large banks
like SIFIs. Sometimes many small banks fail at the same time
and create systemic problems for the entire financial system.
E.g., during the great depression
(d) Asset price fluctuations and bank failures
Question 1: What makes banks fail?
Banks fail when they invest in long-term assets which
subsequently fall in value (market price), e.g., Mortgages,
homes, stock, etc.
Since liabilities remain unchanged despite the losses, a fall in
the value of assets can eventually make a bank insolvent and
fail, that is, make < .
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Question 2: Why do many banks fail at the same time?
Since different banks tend to invest in the same types of long-
term assets (stock, mortgages, business loans), their fortunes
often rise and fall together. Hence many banks may fail at the
same time.
Question 3. Why do asset prices fluctuate so much?
Two theories:
The First, the theory of efficient markets, proposed by Eugene
Fama. Fluctuations in stock prices reflect rational appraisals
(updates/ forecasts) using new information about expected future
income/returns/profits (economic fundamentals), and future value
of interest rates. For instance, new information about the
future profitability of the firms traded on the stock exchange
is associated with a change in the value of their stock:
Increase in future expected profits is associated with an
increase in stock prices, and vice versa.
The Second, asset bubbles. An asset-price bubble is a rapid rise
in asset prices that is not justified by rational forecasts of
the fundaments (returns/profits), but by overly optimistic
expectations (irrational exuberance) partly driven by
psychological factors and biases during economic expansions.
e.g. When a credit boom begins it can spillover into an asset-
price bubble. Easier credit can be used to buy particular assets
such as homes and stock, and thereby raise their prices.
Once a bubble is identified, subsequent market crashes would be
predictable.
An asset-price crash is a large rapid fall in asset prices,
often to below the true present value. This can lead to
insolvency and bank failure when the assets they invested in
rapidly fall in value relative to the liabilities. <
Solutions: Sound bank regulation can play a key role in helping
the banking sector survive asset-price crashes, particularly, by
requiring banks to hold more stockholder equity (be well-
capitalized) and watching the asset versus liabilities maturity
mismatch (Narrow banking). A well-capitalized bank can write off
bad loans and remain solvent.
