Money, Banking and Financial Markets

Primers

Primers

 
 
Posts tagged Capital
A Primer on Private Sector Balance Sheets

Double-entry bookkeeping is an extremely powerful concept. Dating at least from the 13th century (or possibly much earlier), it is the idea that any increase or decrease on one side of an entity’s balance sheet has an equal and opposite impact on the other side of the balance sheet. Put differently, whenever an asset increases, either another asset must decrease, or the sum of liabilities plus net worth must increase by the same amount.

In this post, we provide a primer on the nature and usefulness of private sector balance sheets: those of households, nonfinancial firms, and financial intermediaries. As we will see, a balance sheet provides extremely important and useful information. First, it gives us a measure of net worth that determines whether an entity is solvent and quantifies how far it is from bankruptcy. This tells us whether an indebted firm or household is likely to default on its obligations. Second, the structure of assets and liabilities helps us to assess an entity’s ability to meet a lender’s immediate demand for the return of funds. For example, how resilient is a bank to deposit withdrawals?

After discussing how balance sheets work, we show how to apply the lessons to the November 2007 balance sheet of Lehman Brothers—nearly a year before its collapse on September 15, 2008….

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Steve Cecchetti and Kim SchoenholtzBalance sheet, Assets, Liabilities, Net worth, Equity, Capital, Gearing ratio, Leverage, Leverage ratio, Liquidity, Household balance sheet, Nonfinancial firms balance sheet, Banks balance sheet, Lehman, Financial crisis, Credit risk, Default risk, Credit transformation, Maturity risk, Maturity transformation, Liquidity risk, Liquidity transformation, Financial fragility, Regulation, Supervision, Government safety net, Lender of last resort, Deposit insurance, Primer
Understanding Bank Capital: A Primer

Over the past 40 years, U.S. capital markets have grown much faster than banks, so that banks’ share of credit to the private nonfinancial sector has dropped from 55% to 34% (see BIS statistics here).  Nevertheless, banks remain a critical part of the financial system. They operate the payments system, supply credit, and serve as agents and catalysts for a wide range of other financial transactions. As a result, their well-being remains a key concern. A resilient banking system is, above all, one that has sufficient capital to weather the loan defaults and declines in asset values that will inevitably come.

In this primer, we explain the nature of bank capital, highlighting its role as a form of self-insurance providing both a buffer against unforeseen losses and an incentive to manage risk-taking. We describe some of the challenges in measuring capital and briefly discuss a range of approaches for setting capital requirements. While we do not know the optimal level of capital that banks (or other intermediaries) should be required to hold, we suggest a practical approach for setting requirements that would promote the safety of the financial system without diminishing its efficiency....

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Steve Cecchetti and Kim SchoenholtzAssets, Liabilities, Net worth, Capital, Capital adequacy, Capital requirements, Loss-absorbing capacity, Exposure, Leverage ratio, Debt-equity ratio, Self-insurance, Incentives, Solvency, Liquidity, Risk-weighted assets, Derivatives, Balance sheet, Off-balance sheet, Debt overhang, Gamble for redemption, Skin in the game, Too big to fail, Time consistency, Adverse selection, Goodwill, Intangible capital, Deferred tax assets, Credit conversion factor, US GAAP, IFRS, Hypothetical portfolio exercise, Modigliani-Miller theorem, Minneapolis Plan, Narrow banking, De factor bank, Credit supply, De facto bank, Primer
Time Consistency: A Primer

The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.

For simplicity, we will define a time consistent policy as one where a future policymaker lacks the opportunity or the incentive to renege. Conversely, a policy lacks time consistency when a future policymaker has both the means and the motivation to break the commitment.

In this post, we describe the conceptual origins of time consistency. To emphasize its broad importance, we provide three economic examples—in monetary policy, prudential regulation, and tax policy—where the impact of the idea is especially notable....

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Steve Cecchetti and Kim SchoenholtzPrimer, Time consistency, Dynamic inconsistency, Strategy, Policy commitment, Credibility, Rules vs. discretion, Constrained discretion, Institutional design, Policy framework, Transparency, Communications, Monetary policy, Central bank independence, Inflation targeting, Inflation, Inflation expectations, Too big to fail, TBTF, Bailout, Capital requirements, Resolution, Stress test, Taxation, Capital, Tax treaty, Fiscal sustainability, Investment treaty