Banking
Summary and Teaching Tips
Banking Summary and Teaching Tips
This module allows the student to determine the effects of the (three) policy tools used by the FED, including both macroeconomic effects and the effects on the balance sheets and profit and loss statements of banks. Students can learn the effects of each policy tool including the impacts on banks with different asset mixes. The objective is to allow students to realize the relationships between the tools of monetary policy and the status of the economy and of its financial institutions.
- After the initial conditions, the module begins with the student choosing which of the FED’s policy tools will be used to alter monetary policy. The three tools shown are the discount rate, the required reserve ratio, and open market operations. Only one of the tools can be used at a time.
- Use of each tool is restricted. The reserve ratio has a default value of 0.1 (ten percent) and students can change it by no more than +0.01 (the highest is 11% and the lowest 9%). Since the FED virtually never changes this policy value, this range is quite large. The restrictions on all the tools are both to maintain some realism and to prevent students from crashing the monetary system. Attempts to make changes larger than those permitted give the user an error message and they must enter another value.
- The discount rate has a default value of 0.05 (five percent). Students can change the discount rate only by +0.015 (one and one-half percent). Since the FED generally makes changes in the range of +0.005 to +0.0025 (one-half or one-quarter of one percent), this is a generous range compared to the real policy changes.
- The open market operation default value is zero, since in open market operations there must be a decision to buy or sell securities. The limit on this tool is in total amount of securities bought or sold. The limit is $85 billion bought or sold.
- Whichever policy is changed, the student is provided with the results for the aggregate money market: old and new values for the money supply, the amount of bank deposits, and the level of interest rates. They are also reminded which policy they changed and by how much.
- At this point the emphasis of the module changes from the overall effects on the money markets to the effects of the policy changes on individual banks. The student can see the impacts on two different banks, one run as a “high risk” bank and the other as a “low risk” bank.
- The degree of risk is defined in terms of the relative proportions of fixed and variable rate assets the banks hold. The high-risk bank holds a high proportion of long-run assets whose returns do not adjust when the general level of interest rates change. As a result, if the policy chosen by the student raises interest rates, the
high-risk bank suffers a substantial capital loss. The low risk bank holds a lower proportion of such assets and receives a smaller capital loss. Of course, if the student’s policy change lowers interest rate the high- risk bank receives a large capital gain, while the low risk bank gets a smaller gain. When there is no policy change the high-risk bank is more profitable than the low- risk bank because fixed rate assets pay higher returns than variable (and short term) assets do. This permits discussion of portfolio choice and risk-return tradeoffs.
- If the student employs a policy change that raises interest rates, causing capital losses to banks, the results cause the banks “capitalization ratio” to fall. This ratio (in simplest terms the ratio of the bank’s equity to total assets) is of concern to regulators and has, in recent years, been the subject of international agreements. Attention to this ratio allows discussion of the importance of regulating banks equity in order to give owners more incentive to follow lower risk banking practices.
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Banking
Summary and Teaching Tips
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