Money, Banking, and Financial Markets

Understand the principles, understand the future
 
Commentary

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....

When most people think of investment, what comes to mind is the purchase of new equipment and structures. A restaurant might start with construction, and then fill its new building with tables, chairs, stoves, and the like. This is the world of tangible capital.

We still need buildings and machines (and restaurants). But, over the past few decades, the nature of business capital has changed. Much of what firms invest in today—especially the biggest and fastest growing ones—is intangible. This includes software, data, market analysis, scientific research and development (R&D), employee training, organizational design, development of intellectual and entertainment products, mineral exploration, and the like.

In this post, we discuss the implications of this shift for the structure of finance. Tangible capital can serve as collateral, providing lenders with some protection against default. As a result, firms with an abundance of physical assets can finance themselves readily by issuing debt. By contrast, a company that focuses on software development, employee training, or improving the efficiency of its organization, will find it more difficult and costly to borrow because the resulting assets cannot easily be re-sold. That means relying more on retained earnings or the issuance of equity....

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Further commentary, click here.

 
Welcome to MoneyandBanking.com ...

... the site where you can learn about finance and economics. We provide commentary on events in the news and on questions of more lasting interest. Because the financial system is constantly evolving, our analysis is informed by a set of core principles: understand the principles, understand the future. The opening excerpts of our two most recent posts appear above. For prior posts, click on the Commentary link to the left, or on the month-by-month Archives to the right. Alternatively, if you are interested in a specific topic, use the tags.

The site also provides material related to our textbook, Money, Banking and Financial Markets, 5th edition, 2017. The Five Core Principles on which the book is based are highlighted here. In addition, Cecchetti and Schoenholtz 5e systematically integrates the use of economic and financial data from FRED, the online database provided by the Federal Reserve Bank of St. Louis. Click on FRED Lessons on the left to access help on how to use this incredible resource.

Steve Cecchetti and Kim Schoenholtz
 

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