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18. Monetary Policy
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18. Monetary Policy

Introduction to Central Banks

In this section, Professor Robert Shiller introduces the topic of central banks and their role in managing a country's currency.

What are Central Banks?

  • Central banks are special government banks responsible for the currency and money of a country.
  • Every country has paper money with the name of its central bank on it.

Importance of Financial Innovation

  • Financial innovation is similar to engineering invention, where successful ideas get copied worldwide.
  • The same principle applies to central banks, as successful models are replicated globally.

History of Central Banks

In this section, Professor Shiller discusses the history of central banks, starting from the first central bank and leading up to modern times.

Origins of Banking System

  • Modern banking institutions trace back to goldsmith bankers who accepted gold deposits and issued paper receipts.
  • These receipts started circulating as paper money, creating an unregulated system backed by gold or silver until the 1970s.

Problems with Early Banking System

  • Goldsmith bankers sometimes failed to redeem paper receipts for gold, causing trust issues in the system.

Bank of England - First Central Bank

  • Founded in 1694, the Bank of England became the dominant bank in the United Kingdom.
  • It had a special charter from the British government that gave it a monopoly on joint stock banking.
  • The Bank of England used its power to put other banks out of business if they didn't keep a deposit with them.

Role and Influence of Bank of England

This section explores how the Bank of England operated as a government-like institution and influenced other central banks around the world.

"Live and Let Live" Policy

  • The Bank of England required other banks in the UK to keep a deposit with them.
  • This policy created stability in the banking system, as troubled banks could rely on the Bank of England for support.

Model for Central Banks Worldwide

  • The Bank of England's model became the basis for central banks worldwide.
  • Many countries adopted similar practices, including requiring deposits from other banks and providing assistance during financial crises.

Suffolk Bank - Early Example in the United States

This section discusses an early example of a central bank-like institution in the United States called the Suffolk Bank.

Suffolk System

  • The Suffolk Bank, founded in 1819, required all New England banks to keep a deposit with them.
  • It stabilized New England from bank runs and served as an influential private bank.

Conclusion

In this final section, Professor Shiller concludes by highlighting how central banks are inventions of people rather than government creations.

Role of Individuals in Central Banking

  • Central banks were not initially government inventions but rather initiatives taken by individuals or private institutions.
  • The history of central banking demonstrates how innovative ideas and practices shaped their development over time.

New Section

This section discusses the banking system in Boston and the Suffolk Bank's role as a model. It also mentions the two banks in the United States, The Bank of the United States and the Second Bank of the United States.

Boston's Banking System

  • The Suffolk Bank in Boston had a good record and was held up as a model for banking systems.
  • Other states had worse banking systems compared to Boston.

Banks in the United States

  • The United States had two banks: The Bank of the United States and the Second Bank of the United States.
  • These banks were not functioning like central banks and were not renewed, disappearing in 1836.

New Section

This section explains why it took a long time for the United States to establish a central bank. It also introduces the National Banking Act passed in 1863.

Reluctance to Establish a Central Bank

  • The United States was reluctant to involve the government in private business, which delayed setting up a central bank.
  • In 1863, the U.S. passed the National Banking Act as an alternative approach to achieve some advantages of central banks without actually founding one.

New Section

This section discusses how national banks were created under the National Banking Act. It explains that each city created its own bank with specific requirements set by the government.

Creation of National Banks

  • In 1863, every city created a bank called "First National Bank of something" under the National Banking Act.
  • These national banks issued currency known as National Bank Notes, which were printed by the government but had different names based on each bank.
  • The government required these banks to keep deposits with Treasury to back their currency.

New Section

This section highlights the success of the National Banking Act in resolving paper money problems. It also mentions that it did not create a stable currency system.

Success of National Bank Notes

  • The United States no longer had problems with its paper money after implementing the National Banking Act.
  • All national banks honored each other's notes at par, eliminating issues with discounts.
  • However, banking crises and credit expansions still occurred, leading to the idea of copying the Bank of England's system.

New Section

This section discusses major banking crises in the late 19th and early 20th centuries and how they led to the creation of the Federal Reserve System.

Banking Crises and Need for Reform

  • The United States experienced severe banking crises in 1893 and 1907, which prompted calls for reform.
  • These crises resulted in the establishment of a system similar to the Bank of England, known as the Federal Reserve System.
  • The Federal Reserve System was created by an act of Congress in 1913 and opened its doors in 1914.

New Section

This section explains how the Federal Reserve System was structured differently from the Bank of England. It introduces the concept of regional banks and describes their oversight by a central agency.

Structure of the Federal Reserve System

  • The Federal Reserve System consists of 12 regional banks spread across different parts of the country.
  • In addition to these regional banks, there is a headquarters called the Federal Reserve Board or Board of Governors in Washington, DC.
  • The Board oversees all 12 regional banks, including Boston's region.

New Section

This section discusses how banks are required to have deposits or collateral with their respective Federal Reserve Banks. It introduces concepts like the lender of last resort and the discount window.

Deposits and Collateral

  • Banks in the Federal Reserve System are required to have deposits or collateral with their respective Federal Reserve Banks.
  • The Federal Reserve can provide assistance to banks in trouble by using their deposits or going beyond that to help them, acting as a lender of last resort.
  • The system also includes a "discount window" where troubled banks can bring collateral for loans.

New Section

This section explains the concept of the discount window and its purpose in providing loans to troubled banks.

The Discount Window

  • The discount window is a metaphorical term used for a special window at the Federal Reserve Bank where troubled banks can seek loans.
  • Banks must bring securities as collateral when accessing the discount window.
  • The teller behind the discount window would evaluate the collateral brought by the bank and lend money based on it.

New Section

This section mentions President Wilson's optimism about the Federal Reserve System's ability to prevent banking crises and promote prosperity.

President Wilson's Optimism

  • When the Federal Reserve was founded in 1913, President Wilson expressed great optimism about putting banking crises behind forever.
  • He believed that this system would lead to prosperity and stability.

New Section

In this section, the speaker discusses the importance of central bankers in modern society and their role in maintaining stability in the banking system.

The Role of Central Bankers

  • Central bankers are crucial in ensuring sensible lending and preventing over-lending by banking systems.
  • They are responsible for maintaining stability and good sense in the banking system.
  • Central bankers control the system through reserve requirements, which dictate how much banks must hold in reserves at the central bank or as currency.

Reserve Requirements and Capital Requirements

  • Reserve requirements have been imposed by state banking regulators even before the establishment of the Federal Reserve.
  • Capital requirements also emerged around 1900, with both terms flourishing under state banking regulators. After 1913, the Federal Reserve took over setting these requirements.

New Section

This section delves into a historical breakdown of the banking system, including its breakdown in 1933 and subsequent measures taken to prevent future crises.

Banking Crisis of 1933

  • The banking system faced a crisis after 1929, leading to numerous bank failures. The Federal Reserve had an opportunity to bail out banks but did not intervene effectively.
  • President Roosevelt shut down all banks as soon as he took office to address the catastrophic bank run that was causing panic among depositors. This period was known as a "banking holiday."

Introduction of Deposit Insurance

  • To prevent future crises like those experienced during the Great Depression, deposit insurance was introduced with the establishment of the Federal Deposit Insurance Corporation (FDIC) in 1933.
  • Deposit insurance played a significant role in preventing banking crises, as evidenced by the absence of major banking crises in the United States since 1933.

New Section

This section explores how the Federal Reserve shifted its focus from solely preventing banking crises to stabilizing the economy and preventing recessions.

The Role of the Federal Reserve

  • The Federal Reserve began to see itself as a stabilizer of the economy, aiming to prevent recessions and control inflation. It achieved this by adjusting interest rates.
  • The Fed's function of stabilizing the economy dates back even before 1933, with economists comparing it to a regulator on a steam engine.

Central Banks Worldwide

  • Almost every country now has a central bank, including communist countries. The European Central Bank is mentioned as a relatively new addition to this global network of central banks.

New Section

This section provides an overview of the euro currency and the European Central Bank.

Euro Currency and European Central Bank

  • The euro currency was introduced in 1999, with actual currency issuance starting in 2002. It is a relatively recent invention.
  • The European Central Bank (ECB) was founded in 1998, before the introduction of the euro currency.
  • Not all European Union countries participate in the euro zone. The United Kingdom, Sweden, Lithuania, Latvia, Estonia, Poland, Czech Republic, Hungary, Romania, Bulgaria, and Malta are not part of the euro zone. However, some of these countries use the euro unofficially.
  • The European Central Bank in Frankfurt is considered the real central bank for the euro zone.

New Section

This section discusses the importance of independent central banks.

Importance of Independent Central Banks

  • Many countries have moved towards making their central banks independent to ensure stability.
  • Independent central banks bring in individuals with long banking careers and reputations for integrity to maintain a stable currency.
  • The U.S. Federal Reserve has had a stable price level due to its independence from government influence.
  • There has been a global trend to copy the model of an independent central bank.

New Section

This section explains the role of central banks and focuses on the Federal Reserve System.

Role of Central Banks - Federal Reserve System

  • The Federal Reserve System has a committee called the Federal Open Markets Committee (FOMC) that meets monthly. They decide on the range for an interest rate called the federal funds rate.
  • The federal funds rate is an overnight interest rate charged on loans between banks and some financial institutions.
  • The current federal funds rate in the United States is 0.13% as of April 1, 2011. The FOMC sets this rate to stabilize the economy.

New Section

This section discusses changes in interest rates and reserve accounts at the Federal Reserve.

Changes in Interest Rates and Reserve Accounts

  • Traditionally, banks did not receive interest on their reserve accounts at the Federal Reserve.
  • In 2008, banks started receiving interest on their deposits at the Federal Reserve.

Timestamps are provided for each section to help locate specific information in the video transcript.

New Section

This section discusses the policy of paying interest on reserve balances by the Federal Reserve and its impact on member banks.

Interest on Reserves

  • The Federal Reserve now pays interest on reserve balances held by member banks.
  • Member banks receive an interest rate when they deposit money with the Federal Reserve.
  • The current interest rate can be found on the Federal Reserve website, which is currently 0.25%.
  • This policy change encourages member banks to hold reserves.

Difference between Federal Funds Rate and Interest on Reserves

  • Some people question why the federal funds rate is not the same as the interest on reserves.
  • Banks may prefer holding reserves at the Federal Reserve instead of investing in the federal funds market due to higher interest rates.
  • Government-sponsored enterprises like Fannie Mae and Freddie Mac have taken over lending in the federal funds market since they are not eligible for interest on reserves.

Purpose of Interest on Reserves

  • The addition of interest on reserves by the Fed serves as a new tool for monetary policy.
  • It provides a means to contract the economy rapidly if there is a surge of inflation after a crisis.
  • The Fed traditionally controls the federal funds rate through buying and selling Treasury bills, indirectly affecting short-term credit supply and demand.

New Section

This section explains reserve requirements set by the Federal Reserve and distinguishes them from capital requirements.

Reserve Requirements vs Capital Requirements

  • The Federal Reserve has authority over setting the amount of reserves banks must hold.
  • Reserve requirements are different from capital requirements.

Regulation D and Reserve Requirements

  • Regulation D specifies the percentage of reserves banks must hold based on their liabilities.
  • As of April 2011, reserve requirements for transaction accounts are set at 10%.
  • Transaction accounts include checking accounts, NOW accounts, and ATS accounts that allow instant withdrawals.

Time Deposits vs Transaction Accounts

  • Time deposits refer to savings accounts where banks do not have to provide immediate withdrawal.
  • Reserve requirements focus on transaction accounts to prevent bank runs.
  • No reserve requirement is imposed on time deposits as they have longer terms for repayment.

New Section

This section discusses the concept of the money multiplier and how it has become irrelevant due to banks holding excess reserves.

Money Multiplier and Reserve Requirements

  • The money multiplier theory suggests that the total amount of deposits a bank can issue is determined by the reserve requirement.
  • Under old theories, high-powered money was determined by currency plus deposits at the Federal Reserve, with a multiplier effect based on reserve requirements.

Excess Reserves and Changing Dynamics

  • Banks now hold excess reserves due to changes in policies and lack of interest earnings on them in the past.
  • The money multiplier theory is currently irrelevant as banks no longer rely solely on reserve requirements to determine their lending capacity.

New Section

This section discusses the changes in reserve requirements and the shift towards capital requirements in the banking industry.

Reserve Requirements

  • Reserve requirements are no longer binding for most banks.
  • Banks now hold reserves well above the required amount.
  • The focus has shifted from preventing bank runs to other regulatory measures.

Capital Requirements

  • Capital requirements are different from reserve requirements.
  • Basel III emphasizes capital requirements, which are more likely to be binding.
  • Basel III is an international agreement that is being phased in gradually.

Credit Ratings and Basel III

  • Basel III refers to credit ratings in many places.
  • The Dodd-Frank Act of 2010 abolished credit ratings in US regulations.
  • Moody's and Standard & Poor's are well-known credit rating agencies.

Challenges with Risk Assessment

  • The recent financial crisis exposed flaws in relying solely on credit ratings.
  • Congress prohibits regulations based on credit ratings from NRSROs (Nationally Recognized Statistical Rating Organizations).
  • There is a need to find alternative ways to assess risk without relying on credit ratings.

New Section

This section explores the implementation challenges of Basel III and the role of risk committees in assessing risk.

Implementation of Basel III

  • Each country must decide on the implementation of Basel III.
  • The United States faces difficulties due to its abolishment of credit ratings under Dodd-Frank Act.

Role of Risk Committees

  • Banks may need to establish their own risk committees for assessing risk.
  • They will be responsible for their own assessments, but they may still rely on Moody's and S&P ratings.

New Section

This section highlights the importance of understanding capital requirements and acknowledges a lack of public awareness about them.

Importance of Capital Requirements

  • Capital requirements are increasingly important in the banking industry.
  • Basel III introduces new capital requirements, including common equity requirements.

Lack of Public Understanding

  • The general public has limited understanding of capital requirements.
  • These requirements have a long history but are not well-known outside the finance field.

New Section

This section emphasizes the need for simplifying complex financial concepts and discusses the over-simplification of Basel III common equity requirements.

Simplifying Financial Concepts

  • There is a need to simplify complex financial concepts for better understanding.
  • Basel III is a complicated agreement with many intricacies.

Over-Simplification of Basel III Common Equity Requirements

  • The focus is on over-simplifying the Basel III common equity requirements for easier comprehension.

Starting a Bank and Capital Requirements

This section discusses the process of starting a bank and complying with capital requirements.

Applying for a Charter and Opening the Bank

  • To start a bank, one needs to apply for a charter.
  • The type of bank (e.g., national bank) needs to be decided before obtaining the charter.
  • After getting the charter, the bank can open its doors.

Complying with Capital Requirements

  • Once the bank is open, it must comply with capital requirements.
  • Finding an empty building downtown, renting it, and setting up the bank is part of this process.

Deposits and Assets/Liabilities

  • When someone deposits $100 in cash to the newly opened bank, it becomes an asset.
  • The liability also increases by $100.
  • Different types of accounts have different reserve requirements.

Risk-weighted Assets and Capital Requirements

  • Cash has zero risk, so it has zero risk-weighting.
  • Risk-weighted assets need to be calculated based on different asset types.
  • Basel III requires banks to hold 4.5% of their risk-weighted assets as capital.

Need for Capital

  • Although reserve requirements are satisfied, there is no initial capital in this scenario.
  • Shares need to be issued to raise capital.

Raising Capital and Capital Conservation Buffer

This section explains how banks raise capital and introduces the concept of a capital conservation buffer.

Issuing Shares for Capital

  • To raise capital, shares in the business can be sold.
  • Selling $20 worth of shares brings in additional cash ($120 total).

Common Equity Requirement and Capital Conservation Buffer

  • Basel III requires a 4.5% common equity requirement for banks.
  • There is also a 2.5% capital conservation buffer that banks are encouraged to hold.
  • Holding the capital conservation buffer is not mandatory, but failure to do so may result in restrictions.

Importance of Common Equity

  • Regulators distinguish between liabilities like transactions accounts and common equity.
  • Shareholders have no demand on the bank and cannot run it.
  • Shareholders only receive dividends if approved by the board of directors.

Making Money through Corporate Loans

This section explores how banks can generate income by providing corporate loans.

Transitioning from Cash to Corporate Loans

  • To start making money, the bank decides to lend out its cash as corporate loans.
  • The cash on hand becomes corporate loans, which earn interest.

Risk-weighted Assets with Corporate Loans

  • Corporate loans are considered risky assets and have a 100% risk-weighting under Basel regulations.
  • Risk-weighted assets increase with the transition to corporate loans.

Satisfying Reserve Requirements and Capital Requirements

  • Despite the increase in risk-weighted assets, reserve requirements (10%) are still satisfied due to sufficient cash reserves.
  • Basel III's capital requirement (7% of risk-weighted assets) is also met.

Conclusion: Generating Profit for the Bank

This section concludes by emphasizing the need for banks to generate profit through various means.

Need for Profit Generation

  • While satisfying regulatory requirements, banks must focus on generating profit.

Lending as a Source of Income

  • Providing corporate loans allows banks to earn interest income and make money.

Timestamps provided above indicate when each section starts in the video.

The Impact of a Crisis on Business

In this section, the speaker discusses the consequences of a crisis on business operations and loans.

Corporate Loan Defaults

  • During a crisis, 20% of corporate loans default.
  • This leads to a reduction in corporate loans from $100 to $80.

Maintaining Balance between Assets and Liabilities

  • As a result of loan defaults, assets need to equal liabilities.
  • With $100 in assets and $120 in liabilities, common equity is marked down to zero.
  • This adjustment ensures that assets and liabilities match.

Capital Requirements and Reserve Requirements

  • While reserve requirements are met with excess reserves ($20 in cash), capital requirements are not satisfied.
  • Failure to meet capital requirements can lead to bank closure.

Raising Capital during Crisis

  • Selling corporate loans or issuing new shares are common methods for raising capital during a crisis.
  • However, selling loans is not feasible when common equity is reduced to zero.
  • Issuing more shares becomes the only option for raising capital.

Challenges with Capital Requirements during Crisis

This section highlights the challenges faced by banks when trying to raise capital or sell assets during a financial crisis.

Difficulties in Raising Capital

  • Raising new equity during a crisis is challenging as investors may be reluctant due to the bank's recent losses.

Challenges with Selling Loans

  • In times of crisis, multiple banks attempt to sell their loans simultaneously, causing system collapse.

Role of Central Banks in Crisis Management

  • Central banks play a crucial role as lenders of last resort by providing loans to banks and companies during crises.

Basel III and Improving Capital Requirements

This section discusses the motivation behind Basel III and its approach to improving capital requirements.

Analyzing the Financial Crisis

  • Basel III aims to analyze how the financial crisis occurred and identify areas for improvement.

Challenges with Capital Raising Timing

  • Requiring banks to raise capital during a crisis is problematic.
  • Reliance on central banks as lenders of last resort may not always be feasible or desirable.

Basel III's Solution: Additional Capital Buffer

  • Basel III allows regulators to add an additional buffer of 2.5% if they anticipate a bubble or crisis.
  • This raises the common equity requirement to 9.5% in advance, reducing reliance on central banks.

Dodd-Frank Act and Constraints on Central Banks

This section explores the constraints placed on central banks by the Dodd-Frank Act in the United States.

Public Reaction and Constraints on Central Banks

  • The Dodd-Frank Act of 2010 was enacted due to public backlash against bailouts.
  • It restricts the discretion of the Federal Reserve in deciding which institutions to bail out.

Fairness in Bailout Operations

  • The Federal Reserve can operate a discount window but must ensure fairness and equal treatment for all institutions.

Conclusion

The transcript provides insights into how crises impact business operations, loan defaults, challenges with raising capital, and regulatory measures like Basel III and the Dodd-Frank Act. It emphasizes the importance of maintaining balance between assets and liabilities, meeting capital requirements, and addressing systemic risks during times of crisis.

New Section The Instability of the Financial System

In this section, the speaker discusses the instability of the financial system and the challenges faced in finding solutions. The roles of central banks and regulatory authorities are also mentioned.

The Instability of the Financial System

  • The example is given where everyone is short on capital and selling loans simultaneously, leading to a collapse of the entire system.
  • Different solutions have been proposed but implementation issues remain.
  • Central banks and regulatory authorities are experiencing changes in their roles.
  • It will take many years before we can fully understand where the system is heading.

New Section Next Lecture on Investment Banking

The next lecture will focus on investment banking, with a guest speaker who is a former student.

Next Lecture on Investment Banking

  • The next lecture will cover investment banking.
  • A former ECON 252 student named Jon Fougner will be speaking, returning after nine years.
Playlists: Financial Markets (2011) with Robert Shiller
Video description

Financial Markets (2011) (ECON 252) To begin the lecture, Professor Shiller explores the origins of central banking, from the goldsmith bankers in the United Kingdom to the founding of the Bank of England in 1694, which was a private institution that created stability in the U.K. financial system by requiring other banks to have deposits in it. Turning his attention to the U.S., Professor Shiller outlines the evolution of its banking system from the Suffolk System, via the National Banking era, to the founding of the Federal Reserve System in 1913. After presenting approaches to central banking in the European Union and in Japan, he emphasizes the federal funds rate, targeted by the Federal Open Market Committee, as well as the recent change to pay interest on reserve balances at the Federal Reserve, enacted by the Emergency Economic Stabilization Act from 2008, as important tools of U.S. monetary policy. After elaborating on reserve requirements, which are liability-based restrictions, and capital requirements, which are asset-based, he provides a simple, illustrative example that delivers an important intuition about the difficulties that banks have faced during the recent crisis from 2007-2008. This leads to Professor Shiller's concluding remarks about regulatory approaches to the prevention of future banking crises. 00:00 - Chapter 1. The Origins of Central Banking: The Bank of England 06:27 - Chapter 2. The Suffolk System and the National Banking Era in the U.S. 12:08 - Chapter 3. The Founding of the Federal Reserve System 25:46 - Chapter 4. The Move to Make Central Banks Independent 30:49 - Chapter 5. U.S. Monetary Policy: Federal Funds Rate and Reserve Requirements 45:23 - Chapter 6. Capital Requirements, Basel III and Rating Agencies 52:34 - Chapter 7. Capital Requirements and Reserve Requirements in the Context of a Simple Example 01:05:30 - Chapter 8. Capital Requirements to Stabilize the Financial System in Crisis Times Complete course materials are available at the Yale Online website: online.yale.edu This course was recorded in Spring 2011.