Lecture Materials

Topic 1

ECONOMICS, MONEY MARKETS AND BANKING

Todd Patrick Senior Vice President - Capital Markets

CenterState Bank Atlanta, Georgia

tpatrick@centerstatebank.com 770-850-3403

August 1, 2017

Economics, Money Markets and Banking

James M. Johannes UW-Madison

DO THREE THINGS TODAY

I. Give you an outline for this course

II. Show where you actually use economics, probably without realizing it in day to day banking

III. Show you some myths and realities in conventional economic wisdom

Approach

1. There is a lot of material.

2. Go through it as one big lecture.

3. Since some of you know all of thisand some know none of this material,we will shoot for a middle ground.

4. Try to keep graphs/equations to a minimum because “economists use statistics like drunks use lamp posts…for support rather than illumination.”

5. Try not to get lost in all the details because “it is usually better to be roughly correct than precisely wrong.”

The course will not

1) create economists.

2) argue that economics is all that matters.

3) take a political stance

Lots of things matter and we all have a roleMarketing, HR, Operations/Compliance

I. Course Outline: Economics, Money Markets and Banking

• Financial Markets, Economics and the Banker

• Interest Rates and Interest Rate Mechanics

• Yield Curves, Banking and Interest Forecasts

• The Federal Reserve, The Treasury and Monetary Policy

Basically one BIG lecture!

II. Let’s Talk About Where You Use Macroeconomics in the Bank either Implicitly or Explicitly

1. CAPITAL PLANNING and BANK BUDGETINGWhich situation would you vote for as a Director?

Asset Growth Return on Assets Change in K/A

.10 .005 .0600 → .0625

.10 .0075 .0600 → .0650

.08 .0100 .0700 → .0800

.05 .0075 .0700 → .0800

.10 .0100 .0800 → .0850

.15 .0125 .0800 → .0825

Most Beautiful and Useful Equation in Finance and Accounting:

This equation shows many valuable things

• How Balance Sheet & Income Statement are linked• What you need to do to adjust capital structure• Keys to capital planning in banking• A framework for budgeting• Importance of Dividend policy• The basis for Prompt Corrective Action

Capital Budgeting: The Formula for Internally Generated CapitalLet K = Book Value of Capital A = Book Value of Assets

ROA = Return on Assets ρ = Percent of income not paid out to stockholders

)( GrowthAssetAKROAratio

AKinChange

−=

ρ

Shows • Balance Sheet/Income Statement are Linked

• Cannot Pick any old Target for K/A, ROA, Dividend Payout, growth.

MANAGEMENT PICKS TARGET FOR CHANGE IN K/A RATIOMANAGEMENT CHOOSES PROFIT RETENTION RATEACCOUNTANTS TELL US OUR CURRENT K/A RATIOTHENONCE WE ESTIMATEASSET GROWTH, THEN WE KNOW WHAT ROA

WE MUST BUDGET TO MAKE IT ALL HAPPEN

Summary of Prompt Corrective Action Provisions of FDICIA, 1991 Capital Ratios (%) Zone Mandatory provisions Discretionary provisions Total Tier 1 Leverage 1. Well capitalized >10 >6 >5 2. Adequately Capitalized 1. No brokered deposits, Except with FDIC approval >8 >4 >4 3. Undercapitalized 1. Suspend dividends and mgmt fee 1. Order recapitalization 2. Require capital restoration plan 2. Restrict inter-affiliate transactions 3. Restrict asset growth 3. Restrict deposit interest rates 4. Approval required for acquisitions, 4. Restrict certain other activities Branching, and new activities 5. Any other action that would better 5. No brokered deposits carry out prompt corrective action 4. Significantly undercapitalized 1. Same as for Zone 3 1. Any Zone 3 discretionary actions 8>4 >4

3. Undercapitalized

1. Suspend dividends and mgmt fee 1. Order recapitalization

2. Require capital restoration plan 2. Restrict inter-affiliate transactions

3. Restrict asset growth

3. Restrict deposit interest rates

4. Approval required for acquisitions, 4. Restrict certain other activities

Branching, and new activities 5. Any other action that would better

5. No brokered deposits

carry out prompt corrective action

4. Significantly undercapitalized1. Same as for Zone 3

1. Any Zone 3 discretionary actions

SENSITIVITY OF BUDGET TO GROWTHTo highlight impact of the asset growth assumption

[.10].08.5[.01].003-[.05].08.5[.01].001

AΔA

AKROAρ

AKΔ

−=−=

−=

Says that if bank’s growth rate goes from 5% to 10%, its capital ratio will FALL!

Two ways to offset this.

•Raise the ROA to .018

•Raise the retention rate to .9, that is pay out much less in dividends.

Two very important lessons to be learned from this simple example:

1) if your bank’s asset growth depends on economic conditions in your community then economics affects your bank’s budgeting decisions.

2) there are always tradeoffs (more asset growth requires a higher ROA or a lower dividend payout to maintain capital levels)

ONCE YOU HAVE A BUDGET, YOUR GOAL SHOULD BE

TO ACHIEVE THE BUDGET AND ADD VALUE TO THE BANK AND YOUR COMMUNITY.

To accomplish this we must …

• Keep Customers

• Manage liquidity risk

• Manage default risk

• Manage interest risk

ECONOMICS PLAYS A KEY ROLE IN EACH OF THESE.

2. Keep Customers: The Banker as Local Economist in Residence

• What’s going to happen to interest rates?

• What’s the Fed Funds Rate?

• Is this a good time to refinance?

• Should I put my money into a short term or long term CD?

• What do you make of current Federal Reserve policy?

• Are deficits really a problem?

• Why is everybody worried about inflation or deflation ?

• What is “forward guidance” and who cares?

3. How Does Economics Help us Manage Liquidity

The Bank’s “Liquidity” Constraint

Bank’s Net Deposit Outflow Asset SaleLiquidity = + = +Need New Net Loans Borrowing

or Securities +New Capital

Things that happen that require the bank to have cash (could addBranch purchases, etc. but those are not everyday events)

Where the bank gets the cash

So, suppose you think the economy will improve. Typically strong economic growth causes loan demand will rise.

This means you will need liquidity to make the new loans.

Suppose further you get a bunch of new deposits. What should you do with the new deposits while you wait for loan demand to rise?

If you invest the new deposits in Short Term investments, they will mature quickly and you will have the $$ you need to make loans.

If you invest Long Term, they will not mature and you will not have the $$ you need for the new loan growth unless you sell the Long Term investments or borrow. But, you could lose a lot of $$ selling LT investments if interest rates rose (which they probably did since interest rates are pro-cyclical!) or borrowing could become expensive.

So knowing where the economy will go helps guide your Bank’s investment decisions!

4. Using Economics to Help Manage Default Risk

PricingTo make both prime and non prime loans, it must be the case that the expected profit from both types of loans (after adjusting for loan losses) is identical.

Prime loan =(1+prime rate) •$ LOANED Risky loan = (1+risky rate) • $ LOANED • % recovered

Pricing Risky Loans

So, to make both Risky loans and riskless loansReturn on “Riskless” Loan = Return on “Risky” Loan

(1+P)($ LOANED) = (1+R)($ LOANED)(%recovered)

Now just solve for the Risky Rate R since you know Prime (P) and have an idea about what you can recover (% recovered)

1%rec

P1R −+=

ExampleSuppose prime = 10% and % recovered = .9, then

- if you invest $100 in prime loan you get back 1.1 ($100) = $110 for a return of 10%

- If you invest $`100 in non-prime loan you get 1.222 ($100) (.9) = $110 for a return of 10%

Moral: to know what to charge on nonprime loans you must know the prime rate, and the % recovered from risky customers. Both of these depend on economic conditions.

1%rec

P1R −+= = (1.10/.9) -1 = .222 = 22.2%

Rates Rise 2%

Matched Funding

Bank 1 Bank 1

1 month loans 1 month CD’s 1 month loan 1 month CD’s

$100 $100 $100 $100

8% 5% 10% 7%

$8 $5 $10 $7

NII $3 NII $3

5. MANAGING INTEREST RISK

All rates rise 2%

Rates Rise 2%

Positive “GAP”

Short term assets funded by long term deposits

Bank 2 Bank 21 month loans 3 yr CD’s 1 month loans 3 yr CD’s$100 $100 $100 $1008% 5% 10% 5%$8 $5 $10 $5

NII $3 NII $5

Locked In on Long Term CD So Remain Constant

Rates Rise 2%Negative “GAP”

Long term assets funded by short term deposits

Bank 3 Bank 33 yr loans 1 month CD’s 3 yr loans 1 month CD’s$100 $100 $100 $1008% 5% 8% 7%$8 $5 $8 $7

NII $3 NII $1

Now assets are long term and so asset rates are locked and remain constant

This Says

1. Impact changing rates has on your net interest income (NII) depends on the maturity structure of your balance sheet.

2. In textbook world• If maturity matched (a ZERO GAP), NII will not change if rates go

up

• If maturity of assets < maturity of liabilities (a POSITIVE OR ASSET SENSITIVE GAP), NII goes up if rates rise

• If maturity of assets > maturity of liabilities (a NEGATIVE OR LIABILITY SENSITIVE GAP), NII goes down if rates rise.

3. Therefore, to determine the best maturity structure of assets (loans) and liabilities (deposits), you have to predict which way rates are going and that is economics!

Credit & IRR Alignment

25

Risk

RewardReward

Liability Sensitive ProfileAsset Sensitive Profile

http://www.google.com/url?sa=i&rct=j&q=&esrc=s&source=images&cd=&cad=rja&uact=8&ved=0ahUKEwj82tCW5M_UAhVMQCYKHYMUAdMQjRwIBw&url=http://itknowledgeexchange.techtarget.com/IT-watch-blog/opportunity-cost-the-real-way-to-measure-cloud-roi/&psig=AFQjCNFOHVIxFmLukscP5bX5bl26pQKVIw&ust=1498163508520654http://www.google.com/url?sa=i&rct=j&q=&esrc=s&source=images&cd=&cad=rja&uact=8&ved=0ahUKEwj82tCW5M_UAhVMQCYKHYMUAdMQjRwIBw&url=http://itknowledgeexchange.techtarget.com/IT-watch-blog/opportunity-cost-the-real-way-to-measure-cloud-roi/&psig=AFQjCNFOHVIxFmLukscP5bX5bl26pQKVIw&ust=1498163508520654

Portfolio Management• A Top Down Approach - Economy

http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=GIS-W7oHnseDHM&tbnid=vkic9L1qZ935CM:&ved=0CAUQjRw&url=http://zeitgeistnbstyle.wordpress.com/tag/economy-2/&ei=UfBBUozRAuSy2gWWtYDICA&bvm=bv.52434380,d.b2I&psig=AFQjCNE1igh4-9ZZ17ER1mP523Zrvw7eKg&ust=1380139367381141http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=GIS-W7oHnseDHM&tbnid=vkic9L1qZ935CM:&ved=0CAUQjRw&url=http://zeitgeistnbstyle.wordpress.com/tag/economy-2/&ei=UfBBUozRAuSy2gWWtYDICA&bvm=bv.52434380,d.b2I&psig=AFQjCNE1igh4-9ZZ17ER1mP523Zrvw7eKg&ust=1380139367381141

Portfolio Management• A Top Down Approach – Interest Rates

http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=e4W8SlKM-WVtJM&tbnid=WhU47EC4v9WclM:&ved=0CAUQjRw&url=http://blog.besthomesbc.com/2011/10/19/bank-of-canada-predicted-to-keep-interest-rate-hike-on-hold/&ei=2PFBUpfsLMXT2wX4l4HYBw&bvm=bv.52434380,d.b2I&psig=AFQjCNFUYeRDlNYbaYFFhelwpj3dXbvJag&ust=1380139755793704http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=e4W8SlKM-WVtJM&tbnid=WhU47EC4v9WclM:&ved=0CAUQjRw&url=http://blog.besthomesbc.com/2011/10/19/bank-of-canada-predicted-to-keep-interest-rate-hike-on-hold/&ei=2PFBUpfsLMXT2wX4l4HYBw&bvm=bv.52434380,d.b2I&psig=AFQjCNFUYeRDlNYbaYFFhelwpj3dXbvJag&ust=1380139755793704

Portfolio Management• A Top Down Approach – Your Interest Rate Risk

Portfolio Management• A Top Down Approach – Your Asset Allocation

http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=xXDZNIJycg3tOM&tbnid=BdstmTLbaZlyAM:&ved=0CAUQjRw&url=http://www.lancs.ac.uk/%7Ejamest/Group/finance1.html&ei=QPRBUp-oLerx2QXcx4GoCQ&psig=AFQjCNEMKS4gqU5j8cb0JprNF1HGFR8PXg&ust=1380140343642465http://www.google.com/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&docid=xXDZNIJycg3tOM&tbnid=BdstmTLbaZlyAM:&ved=0CAUQjRw&url=http://www.lancs.ac.uk/%7Ejamest/Group/finance1.html&ei=QPRBUp-oLerx2QXcx4GoCQ&psig=AFQjCNEMKS4gqU5j8cb0JprNF1HGFR8PXg&ust=1380140343642465

III. Economic Myths and Realities• You always want positive GAPs when

rates are rising

• Pegging interest rates is stabilizing

• Deficits are financed by printing money

• Easy Money means lower interest rates

• Deficits raise interest rates

• All business cycles are the same

• Easy to forecast inflation

“It is amazing what foolish things one can temporarily believe if one thinks too long alone, particularly in economics.”

Modern Library Top 100 Non-Fiction Books of the 20th Century

A. What Kind of GAP Do You Want in a Rising Interest Rate Environment?

Suppose1 Yr Rate .102 Yr Rate .123 Yr Rate .14

Further, suppose we know rates will rise1 Yr Rate next year .131 Yr Rate two years from now .15

Further, we pay 2% less than market on deposits (i.e. we markdown deposits).

$GAP Income Expense ProfitPositive (.10 + .13 + .15) (.12 + .12 + .12) .02Zero (.10 + .13 + .15) (.08 + .11 + .13) .06Negative (.14 + .14 + .14) (.08 + .11 + .13) .10

Positive GAP means borrow long term, invest short term.Negative GAP means borrow short term, invest long term.

B.“Pegging” Interest Rates Stabilizes Interest Rates and the Economy

• “Pegging” means trying to keep interest rates constant

• Econ ↑ → Loan ↑ → i ↑ → Money ↑ → Econ ↑

√ Great Depression

√ Vietnam

√ Late 70sSo “pegging rates” actually means that rateswill get pro-cyclical and UNSTABLE, notmore stable

C. Deficits are Financed by Printing Money.

• Illegal in the US

• Then why does money stock rise when deficits rise? Because Fed (historically) tried to peg rates.Deficit ↑ → interest rate ↑ → Money supply ↑

• How does Fed “Monetize” debt created by deficit? By buying debt from the public with “cash”.

MONEY GROWTH AND INTEREST RATES

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SIX-

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NTH

T-B

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M2 GROWTH SIX MONTH T-BILL

D. More Money means Lower Interest Rates

Chart1

59'MON-INT'!$a$4:$a$47

600.00056926

61-0.0060550459

62-0.0121367521

63-0.0077795786

64-0.0088989442

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68-0.02766191

690.0032586558

70-0.0027027027

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80-0.0265086207

81-0.0253530167

82-0.0394818014

83-0.0591180654

84-0.0475140953

85-0.050777326

86-0.0500226142

87-0.0319266837

88-0.0307326733

89-0.0280382423

90-0.0385445682

91-0.0455467298

92-0.0464766176

93-0.0388990546

94-0.029250036

95-0.0225447043

96-0.0137591194

97-0.0026385542

980.0079004453

990.0133707138

000.024

010.013

02-0.01

Six Month T-Bill

Federal Deficit/GDP

YEAR

T-Bill Rate

Fed Deficiit/GDP

DEFICITS AND INTEREST RATES

3.8

-0.0252465483

3.2

2.6

2.9

3.3

3.7

4.1

5.1

4.6

5.5

6.9

6.6

4.5

4.5

7.2

7.9

6.1

5.3

5.5

7.6

10

11.3

13.8

11

8.8

9.8

7.7

6

6

6.9

8

7.5

5.5

3.54

3.14

4.66

5.6

5.1

5.18

4.85

4.76

5.92

3.39

1.69

MON-INT

yearm2tbill6defgdpdef/gnpm2 growthM1GNP/M1GNP/M2

592983.8-12.8507-0.0251403.62142857141.7013422819

603123.20.35270.0010.04697986581413.73758865251.6891025641

613362.6-3.3545-0.0060.07692307691453.75862068971.6220238095

623632.9-7.1585-0.0120.08035714291483.95270270271.6115702479

633933.3-4.8617-0.0080.08264462811534.03267973861.5699745547

644253.7-5.9663-0.0090.08142493641604.143751.56

654594.1-1.4719-0.0020.081684.27976190481.5664488017

664805.1-3.7788-0.0050.0457516341724.58139534881.6416666667

675254.6-8.6834-0.0100.093751834.55737704921.5885714286

685675.5-25.2911-0.0280.081984.6010101011.60670194

695886.93.29820.0030.0370370372044.81372549021.6700680272

706276.6-2.81036-0.0030.06632653062154.81860465121.6523125997

717104.5-231125-0.0200.13237639552284.93421052631.5845070423

728024.5-23.41237-0.0190.12957746482494.96787148591.542394015

738567.2-14.91383-0.0110.06733167082635.25855513311.6156542056

749037.9-6.11497-0.0040.05490654212745.46350364961.657807309

7510176.1-53.21631-0.0330.12624584722885.66319444441.6037364798

7611535.3-73.71819-0.0410.1337266473065.94444444441.5776235906

7712725.5-53.72027-0.0260.10320901993316.12386706951.5935534591

7813687.6-59.22291-0.0260.07547169813586.39944134081.6747076023

79147610-40.22557-0.0160.07894736843836.67624020891.7323848238

80160111.3-73.82784-0.0270.08468834694096.80684596581.7389131793

81175613.8-793116-0.0250.09681449094377.13043478261.7744874715

82191111-1283242-0.0390.08826879274756.82526315791.6964939822

8321288.8-207.83515-0.0590.11355311365216.74664107491.6517857143

8423129.8-185.43902-0.0480.08646616545537.05605786621.687716263

8524987.7-212.34181-0.0510.0804498276206.74354838711.6737389912

8627356-221.24422-0.0500.09487590077256.09931034481.6168190128

8728346-149.84692-0.0320.03619744067506.2561.6556104446

8829986.9-155.25050-0.0310.05786873687876.4167725541.6844563042

8931648-152.55439-0.0280.05537024687946.85012594461.7190265487

9032827.5-221.45744-0.0390.03729456388266.95399515741.7501523461

9133845.5-269.55917-0.0460.03107861068986.58908685971.7485224586

9234393.54-290.26244-0.0460.016252955110256.09170731711.8156440826

9334943.14-255.16558-0.0390.015993021211285.81382978721.8769318832

9435094.66-203.26947-0.0290.004293073811486.05139372821.9797663152

9535755.6-163.97270-0.0230.018808777411256.46222222222.0335664336

9637475.1-107.57813-0.0140.04811188811077

9739315.18-21.98300-0.0030.0491059514

9842064.8569.287590.0080.069956754

9945244.7612492740.0130.0756062767

0047995.9298250.0240.0607869142

0152183.39100820.0130.0873098562

0256211.6910445-0.010.0772326562

Current

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0101

0202

M2 GROWTH

SIX MONTH T-BILL

Year

M2 GROWTH

SIX-MONTH T-BILL

MONEY GROWTH AND INTEREST RATES

0.0469798658

3.2

0.0769230769

2.6

0.0803571429

2.9

0.0826446281

3.3

0.0814249364

3.7

0.08

4.1

0.045751634

5.1

0.09375

4.6

0.08

5.5

0.037037037

6.9

0.0663265306

6.6

0.1323763955

4.5

0.1295774648

4.5

0.0673316708

7.2

0.0549065421

7.9

0.1262458472

6.1

0.133726647

5.3

0.1032090199

5.5

0.0754716981

7.6

0.0789473684

10

0.0846883469

11.3

0.0968144909

13.8

0.0882687927

11

0.1135531136

8.8

0.0864661654

9.8

0.080449827

7.7

0.0948759007

6

0.0361974406

6

0.0578687368

6.9

0.0553702468

8

0.0372945638

7.5

0.0310786106

5.5

0.0162529551

3.54

0.0159930212

3.14

0.0042930738

4.66

0.0188087774

5.6

0.0481118881

5.1

0.0491059514

5.18

0.069956754

4.85

0.0756062767

4.76

0.0607869142

5.92

0.0873098562

3.39

0.0772326562

1.69

Early 70’sDeficit BiggerRates Down

Early 90’sDeficit SmallerRates Up

Great RecessionDeficits largerRates Down

E. Deficits and Interest Rates? Not so clear!

F.All Business Cycles are the Same“Still, the odds of a further slowing of economic activity outweigh the odds for a resurgence of growth, if for no other reason than the age of the current recover. Sanwa Securities in New York notes that December marked the 57thmonth of this economic expansion, compared with an average duration of 50 months for economic expansions in the postwar period.”

0

20

40

60

80

100

120

140

Recovery Months Trough to Peak

1854-2009 (33 cycles) 38.7

1854-1919 (16 cycles) 26.6

1919-1945 (6 cycles) 35.0

1945-2009 (11 cycles) 58.4

Std Dev All Recoveries 27 monthsStd Dev Post WW2 Recoveries 34 months

Inflation takes off

whenever CapacityUtilization rises above 82%

G. It Is Easy To Forecast Inflation

Inflationary periods

…or whenever the unemployment rate falls below 6%Oops! What happened toour rule here

Unemployment Rate

Inflation periods

Different Now

1. Foreign trade keeps prices ↓

2. Less unionization to push wages ↑

3. Productivity rising keeps prices down

4. Fed not feeding the business cycle

Highlights how changes in Federal Reserve Policy can change theWay the world/economy works and therefore why it is so Important to understand what the Fed’s current policy really is!

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