The analytical apparatus is largely balance sheets, there's other stuff too that we'll get to in the class. But I just want to signal right now, students that have some background in accounting or might find this a little bit easier than others, but sometimes not because usually accounting classes teach you what the law is. What is GAAP accounting and so forth. And we're not concerned here with what the law is. We're using balance sheets as an analytical structure to help us think rigorously about the economy. So let me just show you what I mean by that. We start with, A bank. On the left hand side is assets, on the right hand side is liabilities. Why don't I just write that in here for the first time, so that we remind ourselves. In general, I won't be writing it in. You'll just get used to knowing that assets are on the left and liabilities are on the right. Okay. And we could think of a bank as having some loans, some securities. So, that might be like a treasury bill and some cash reserves. It's more complicated than that, but. And on the liabilities side, you can think of this bank as having deposit accounts. I'm going to put in other borrowing, because they might issuing bonds or other kinds of short term money market borrowing. In fact, that's going to be a very big part of this course, is understanding other borrowing. And then a balancing item here, net worth. Okay? This is what the balance sheet of a generic bank sort of looks like. And I'm drawing this to draw your attention to two sorts of issues that arise when we're thinking about banks. One is the issue of solvency. Is this bank solvent or not? We've been having some issues with that in the last few years, and Europe is having its issues now. Perhaps entire national banking systems are bankrupt in any literal, solvent way. Solvency just means, is the value of the assets greater than the value of the liability so that the net worth is greater than zero? This being a balancing item, is the net worth greater than zero? So this is about the market value of assets versus the market value of liabilities. A lot of the discussion about banking systems is about that. But in this course we're going to focus most attention, actually, on what is very specific about banking that makes them different from other corporations, okay. Which is the issue of liquidity. Okay, and that's here. Cash reserves, okay? If a depositor transfers their deposit to somebody else, tries to make a payment to somebody else, does the bank have liquidity? Does it have cash reserves in order to make that payment. These are demand deposits. They can be withdrawn at any moment, okay? Does it have its reserves? And if it doesn't, can it acquire them? Can it borrow them, in the money markets? Can it go to the Fed ultimately, to the window? Can it sell a security or repo a security? These are words you haven't heard, but you're going to know what these are pretty soon. Or does it have to liquidate these loans? Sell them at a fire sale price, and if it does, what happens to solvency? If it sells them at a fire sale price, you know the assets are sold below their value. So, there is a link between the liquidity and the solvency. Most economists approach banking by thinking first about solvency. We're going to approach banks by thinking first about liquidity and see where that leads us, and that's how bankers think. They face this liquidity constraint every day. They have to clear their accounts. The first two weeks of this course is about the payment system, oddly enough, but you'll see why. It will all connect up. This is a balance sheet of a traditional bank. But we're also going to be talking about shadow banks. I'm involved in a research team that's just finished a paper on shadow banking, which I'm going to be talking about at the end of the course. I wasn't sure I would finish it in time so I put it at the end of the course. So this is assets and liabilities here, and when I talk about a shadow bank, I mean an entity that is holding, let's say residential mortgage bank securities. So these are loans that are turned into a bond of a kind. This is all just to give you an impression. By the way, all this lecture is all sort of written down, and it's going to be posted in CourseWorks, too. You're going to get used to that, so that you don't have to necessarily write everything down. But if you feel if that helps you, by all means do. Residential mortgage bank securities, and then they strip out some of the risk as much risk as possible from this maybe with something called an interest rate swap. Okay, getting rid of the interest rate risk involved. Something like a credit default swap. Getting rid of some of the credit risk, selling that off to somebody else so that what you have left is a short term, relatively risk free thing that you can use as collateral for borrowing in the wholesale money market. So there's money market borrowing here. They're not borrowing from you and me, but they're borrowing from money market mutual funds. They're borrowing from big corporate investors and the instruments they're using are things like repurchase agreements, RP, Euro dollars, your LIBOR, your dollar borrowing. Asset backed commercial paper, okay? We're going to understand what all these things are. It's not rocket science, but the point is that what has happened in the world is that this model became the dominant one. Now the amount of credit in the United States that ran through this sort of method became larger than that kind of method. The textbooks are all about that, okay? But reality is increasingly about that, and we need to bring that into our minds. Again, there's an issue of solvency. Again there's an issue of solvency. And an issue of liquidity. But it's not so easy as it is in the regular banking system. The issue of liquidity is really about being able to roll over this funding. Okay, if using this as collateral for the funding, this is short term funding. So if the money markets freeze up, you can't roll it over. You have to liquidate, okay. This is what a lot of the financial crisis is about, okay. Is exactly this kind of problem, okay. And I'm waving my hands now, okay, because I don't want to get in it too deep. But in a few weeks, you'll understand all this stuff. This is not rocket science, it can be understood. And it's my mission to help people understand it. I think we're in a teaching moment in history where we need to understand this. The general population needs to understand how this stuff works. Because we need to make some big decisions about how to regulate this new system. The regulatory system we have, is all about that kind of banking. Okay? And we don't really know what we're doing about regulating this? Dodd Frank doesn't touch it. So this is what the issue is about. So we're talking about banking, and we're also talking about the final thing here, I want to show you another. This is a bank, the Central Bank is a bank. This is the balance sheet of the Fed, okay, that's from, what does it say there? August 30th, 2012. Factors affecting reserve balances of depository institutions. What you see there, can you see it if I point here? Yeah, you can see that. So here this is actually they list on this page, this is all assets. So it's just the left-hand side of my balance sheet there. And you see what the Fed has there. US treasury securities are $1.6 trillion. Bills are short term trip [INAUDIBLE] securities, they sold them all off. They have no short term securities anymore. Maybe you were notice, maybe you heard about this that they were moving into long term debt, and they have that notes and bonds so forth. Federal agency debt securities, that's like Fannie Mae and Freddy Mac. Mortgage backed securities, these are private mortgage backed securities, okay? The Fed has bought mortgage backed securities itself. For the very first time ever in history. Okay, it never imagined it was ever going to do that. This is part of the legacy of the crisis. If you look down, and look, it's not like there's a small amount there. There's $852 billion. These are big numbers. The Central Bank here. These things here Maiden Lane all this, this is left over from the AIG and Lehman and all those sorts of things that we can talk about. They are small numbers now, they where large numbers. Central Bank liquidity swaps, these are the Fed lending to other central banks for the ECB. To the Swiss National Bank, to the Bank of Japan. The point I want to emphasize, in many economics classes you've had, you talk about this and you talk about MD equals MS, money demand equals money supply okay? Now we're saying what the actual things that are behind the scenes there are banks, okay? And the Central Bank is a bank. It's not printing money. It has liabilities and assets. It's just not correct to say that it's printing money. When it's expanding the money supply, it's expanding both sides of the balance sheet. Asset and liabilities at the same time. This is a classic banking operation. It happens at all levels. The Central Bank and also farther down. It's something we're going to pay a lot of attention to. So, there you see the total size of the balance sheet is, they're $2.8 trillion. By the way, before the crisis it was less than 1 trillion. So when I say that the size of the balance sheet tripled, that's about right. And here's the liability side. So you can see that the liabilities of the Central Bank are about 1 trillion of currency in circulation. That's green pieces of paper. Okay, there's also a bunch of other small numbers then there's this other big number. $1.5 trillion reserve balances with Federal Reserve banks. This is excess reserves, okay. The banks have to hold reserves, cash reserves, these are held as deposits at the Fed. They're holding $1.5 trillion worth of those. $1.5 trillion worth of those. Before the crisis that number was $50 billion, okay. It's an order of magnitude change. The system has changed very dramatically. This sort of thing is when people talk about QE1, QE2, QE3, they're talking about the transformation of the Fed's balance sheet that I'm showing you here. This is stuff that we are going to try to understand in this course.
