54 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
date. This makes bonds relatively safe investments. No investment is risk-free, and sometimes bonds aren't repaid (credit risk) and there can be considerable interest rate risk, especially with a long-term bond. That is, if you hold a 30-year bond at a 5% interest rate, the value of that bond will drop precipitately if interest rates rise to 6%. 
Banks have a special position in the bond market, as it is often a bank who acts as the underwriter of a bond. (This is usually an investment bank's function, rather than a commercial bank's.) The underwriter (or underwriters, as the case may be) buys the bonds from the issuing company or government, and then offers them for resale to other buyers. The underwriter assumes the risk of selling the bond, so usually it only does so if it is also involved in other market activity, like trading securities, that bring it into contact with bond buyers. 
Underwriters are often part of a syndicate, especially for bond issues that might be too large for an individual bank. 
Sometimes a bank will buy an entire bond offering and just keep it. This is known as a private placement and is considered to be different from just a bank loan, though how exactly it differs is a matter of fine philosophical distinctions. The issuance costs are different, so there is a practical distinction, but that's a result, not a cause, or so they say. 
To a significant extent, a fair amount of the evolution of banking over the past 40 years has been a reaction to the increasing accessibility of the bond market. Back when bonds were only available through the mediation of big banks, banks weren't really in competition with bond buyers to fund investment. Today, when a universe of bond dealers is out there, only some of whom are associated with banks, a bank is in direct competition with buyers in the bond market. Because there is so much money available for investment in bonds, this is no small part of the downward pressure on loan yields and bank profits. 
Money market lending 
As we saw in the example balance sheets back in chapter 2, bankoriginated loans are hardly the only items on the asset side of a bank's balance sheet. There is a universe of assets banks can earn money with out there. 
Banks make up the largest part of the worldwide money mar- 
LENDING 
55 
keto This is the name we use to refer to the market for relatively short-term sources of money. It's not a physical marketplace, and it encompasses a lot of different kinds of borrowing and lending, mostly between financial institutions, but governments and nonfinancial corporations also playa role, as do customers of moneymarket funds, a kind of mutual fund that invests in these highly liquid short-term securities. 
The money market instruments used for lending from one bank to another are also used by banks to borrow from each other, so they are described in "Borrowing" on page 58. But banks are not the only players in the money market. Quite a bit of money market activity is on behalf of corporations and governments. 
Short-term loans to companies are usually called commercial paper. These are unsecured bonds, sold on the open market, with a fixed maturity of less than nine months. Despite the lack of collateral, commercial paper is generally quite a good bet, since it's usually only the really credit-worthy customers who use this method of financing. A company with a poor credit rating will find commercial paper to be a very expensive way to get a loan, so they rely on other means to finance operations. 
Governments use the money market to manage their cash flow, since tax funds ebb and flow during the course of a fiscal year, and the fluctuations don't necessarily coincide with the ebb and flow of their expenses. Governments will use the money market to cover short-term finance gaps. For example, a tax anticipation note (TAN) is a short-term bond issue, meant to provide cash before some tax payment is due. (A note is just jargon for a short-term bond.) A city that expects a surge of property-tax payments in August might issue a TAN in May to cover a few months' cash flow needs. 
The federal government is a big user of short-term securities, which it uses to iron out the differences between getting and spending the funds it runs on. A Federal bond with a maturity of less than a year is called a Treasury bill or run» 
There is more about bonds, bonding, and the bond markets in Chapter 6. 
48 A medium-term bond is a Treasury note and only the long-term stuff is actually called bonds. Who knows why? It's just jargon; do you feel like an insider yet? 

56 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
Secondary markets 
A bank that has loaned all the money it feels safe to lend can make no more loans without securing some more money, somehow. It can increase its capital by selling stock or refraining from distributing profits. Depending on its capital ratios, it could choose instead to increase its liabilities, by increasing deposits or borrowing from other banks. (More to come about that in "Borrowing" on page 58.) Also depending on the regulatory ratios, a bank can seek to transform assets that cannot readily be loaned-like a loan already on the books-into assets that can be loaned, like cash. 
For example, a bank managing $100 mllion dollars worth of mortgage loans might sell someone the right to receive the payments on those mortgages for $100 million minus some profit for the buyer. Assuming the borrowers continue to pay their mortgages, the buyer will get a prof t in exchange for taking the risk of default off the bank's books. The bank, in turn, will get almost $100 million it can lend again.49 
The loans can also be used to back up a bond: the bank establishes a trust of some kind to receive the mortgage payments from all the homeowners, and distribute them to the owners of the security. This is an asset-backed bond, or a mortgage-backed bond, and the process is called securitization. You'll also see bonds like this called a collateralized debt obligation or CDO. 
The secondary market for mortgages in the US is dominated by the quasi-public government-sponsored enterprises (GSE) called Fannie Mae, Freddie Mac, and the government-owned Ginnie Mae50 These are institutions whose purpose is to set standards 
49 As with most of these transfers of risk, it's fairly important that the buyer understand that they are assuming some risk and that risk means occasionally you lose. The 2008 crisis was largely due to the fact that very risky bonds were being sold as risk-free, and they found their way into places where the level of risk was inappropriate to the level of being, well, stupid. 
50The names come from their acronyms, more or less. Fannie Mae is the Federal Natonal Mortgage Association (FNMA), and Ginnie Mae is the Government National Mortgage Association (GNMA), and if you try to pronOlmce both of those acronyms, you'll get a rough approximation of their nicknames. Freddie Mac is actually the Federal Home Loan Mortgage Corporation (FHLMC) and its origin is a bit more mysterious. "Mac" is longtime industry shorthand for a mortgage corporation, but how the "FHL" part came to be pronounced "Freddie" is a mys~ tery that awaits further investigation by linguistic historians. One theory is that it had to do with the original acronym in the 1970 enabling legislation. There are doubtless other theories, equally accurate. 

LENDING 
57 
and use bond market money to buy mortgages that conform to those standards, and roll them into guaranteed bonds. Fannie Mae was founded as a government entity as part of the National Housing Act of 1934, part of the New Deal, but was privatized in 1968. Freddie Mac was founded in 1970 more or less as a private competitor to the now-private Fannie. Ginnie Mae was created in 1968, essentially to be the repository of Fannie Mae's loans that were awkward to privatize. Their private state lasted until the financial crisis, when they were caught up in the madness of the real estate bubble. The government bailed them out, and they are run by a conservator now, with their future the subject of ongoing debate. Before the financial crisis, Fannie and Freddie saw significant and increasing competition from private issuers of mortgage bonds, which is partly what drove them to join their private-sector brethren in the mortgage madness. They were hardly innocents in that debacle, though they were late to the party. The fallout from the events of 2007 discouraged most of the other mortgage-bond issuers, and as of the end of 2012, t~e GSEs issue plus Ginnie Mae issue almost all the mortgage bonds Issued in the country. 
As we saw in the 2008 financial crisis, there are lots of ways for mortgage bonds to go wrong, but the bond market is a very large source of funds. Through misuse, fraud, and customer abuse, mortgage bonds have acquired a bad reputation, but there are several perfectly valid policy reasons to admire using that market to strengthen the position of local banks, the original purpose to the GSEs. 
One of the gotchas involved in secondary markets is that the stuff that circulates is likely to be the least desirable for a bank to keep. This is essentially the banking equivalent of Gresham's Law, that predicts that only the least valuable examples of some commodity will circulate.P! In a world of floating interest rates, it does not pay to be the bank holding the low-interest loan when rates rise, so those are often the ones banks sell first. The result is that the loans a bank tries to keep on its books are likely to be 
51 Gresham's law, among the only "laws" of economics that really merits the name, says that bad money drives out good, so that if you have two coins of the same face value, but one has more intrinsic value than the other, that one will disappear from circulation. This is why YOLI can't find dimes older than 1964 in your pocket change, but there are still plenty of pennies older than that. The dimes were silver before 1964, so they've vanished from circulation and live in private hoards of silver coins, never to be spent. 

CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
less-risky floating rate loans, while the ones they try to sell will be fixed rate or floating-rate loans to poor credit risks.52 
Loan insurance 
One way to reduce the credit risk of a loan is for a bank to get insurance for it, and have the risk assumed by (or at least shared with) the insurance company. In the US, a great number of residential mortgages are insured by the federal government, either through the Federal Housing Administration (FHA) or through the Veterans Administration (VA). There is also private mortgage insurance, which you'll see as PMI on loan documents. These all work more or less the same way. The insurance is paid for with either a monthly premium, or a premium amortized over the life of the loan, which comes to more or less the same thing. The rates differ depending on the insurer, as well as who and where the borrower is. In the event of a default, the insurer pays the bank the unpaid portion of the principal on the loan. 
Mortgage insurance has an impact on the secondary market. 
Fannie Mae was set up to buy FHA-insured mortgages. Banks who make FHA mortgages know they can get them off their books by selling them to Fannie.53 Even if the bank has no intention of doing so, a portfolio of FHA-insured loans would be significantly more liquid in the event of trouble down the road than a portfolio without the insurance. 
Borrowing 
In order to lend money, you must have some. Banks start their operation with capital-money they own and don't owe to anyone-but leveraging that capital with other people's money is what 
:':lNot that they always succeed; see also the sad tale of Lehman Brothers, in "Subdividing bonds" on page 135. 
53This is more than just a detail. An innovative plan to finance energy-efficiency improvements to homes called Property Assessed Clean Energy loans, (PACE loans) was seriously wounded when the FHA said it would not insure mortgages on properties with PACE liens on them. Without FHA insurance, a bank can't sell to Fannie, and thus must either keep the loan on their books, or find some other route to sell it. In other words, such lending is significantly more risky than it would be if FHA would insure them. Some states have changed their laws to make PACE lending acceptable to the FHA, but Fannie and Freddie remain reluctant participants, as of 2014. 

BORROWING 
59 
banking is all about. There are several different ways banks borrow money: from depositors, in the repo market, from (or through) the Fed, and several more. All of these together constitute the money market. Each source has different advantages and disadvantages, and the cost of funds to a bank varies Significantly, too. 
The different sources of funding also have different levels of interest rate risk and liquidity risk. Customer deposits, for example, flow inexorably, but slowly, toward higher interest rates. Repo loans react much more quickly to interest rate changes. Banks with a small number of sources of money will also suffer from a kind of concentration risk, where a single depositor pulling out might conceivably cause a catatrophic liquidity crisis. 
Some of the sources for bank funding are only available to the biggest banks. A credit union, for example, isn't going to be trolling the deposit note market looking for million-dollar CD purchases, and a community bank is not likely to be a securities dealer. Still, these are the ways that banks find money to lend, and because opportunity presents itself to prepared minds, it behooves even the smallest bank to understand what the possibilities actually are. 
Managing deposits 
A depositor trusting a bank with their money is among the most fundamental transactions a bank makes. A decent body of deposits is also about the most stable source of funding for a bank's operation. 
A bank's deposits come in different forms. A term deposit, like a CD, is just like a loan, where you give the bank some money and they promise it back on some date in the future. A demand deposit, like a checking or savings account, is essentially also a loan to the bank, though with unusually demanding terms where the lender can get some or all of their money back whenever they want54 
54Some people make a point of the fact that it's not really "your II money after you put it into the bank. This is technically true, but doesn't matter much in the context of running a bank. You can think of a deposit as a loan to the bank, or you can think of it as a purchase of a liability. In truth, it doesn't really matter; what matters is that the depositor can get the money back, either when he or she wants it, or at the end of the deposit term, depending on the kind of account. 

60 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
Deposits, of course, are not free for the bank. A bank pays interest to its depositors, and the cost of maintaining branches, tellers, the ATM network, all those toasters, and the rest have to be included in the cost to the bank of depositors' funds. Depending on how they do the analysis of their customers, a bank might conclude that the cost of funds from some branch is too high. A branch in a poor neighborhood, for example, might not attract many deposits, but will cost just as much to operate as a branch in a rich neighborhood. A branch in a neighborhood near some big employer might attracts lots of customers who will arrange for direct-deposit of their paychecks. That branch will cost less to staff than a branch where no one does. There are a lot of variables, and for many banks, the only w?, they discover them is by opening (and often closing) branches.f 
Beyond the simple cost of the funds, the other important fact about deposits is that they are short-term money. People put money into a bank with the intention of taking it out again relatively soon. Banks can make long-term loans against money like this only because collectively, a body of deposits might not be as volatile as any individual's account. The volatility of customer accounts varies a lot between banks and even between the kinds of customers at a bank. A bank needs to keep around the reserves it needs to service its accounts or the regulatory minimum, whichever is greater. The regulatory minimum a bank needs to keep around in reserves is, after all, a minimum, and certain classes of customers might force a bank to keep around much more cash. 
Imagine an employee credit union at some large company in Sunnydale. Let's call it the Acme Credit Union. Acme might see all its accounts surge 20% when paychecks are issued every Friday. Suppose it usually has a million dollars in deposits on Thursday, and then $1.2 million on Friday. Acme would be foolish to think that it only has to keep around 10% of the deposits it has on payday because more than that is going to flow out of its customers' accounts during the march to the next payday. If they only keep $120,000 around in reserves (10%), they'll be scram- 
55This is not to say that a bank cannot work against these pressures. In a better world, banks would do exactly that, and there are plenty of strategies available for doing so: cooperating with commercial or non-profit entities already present in targeted neighborhoods, for example. The people who hope to create banks that do so need to understand what they are undertaking and whence come the headwinds they will face. 

BORROWING 
6] 
bling for another $80,000 in cash to meet customer demand before next Thursday. More likely they set their reserve requirements to handle the low ebb of their weekly fluctuation and manage from there. 
Specialized consulting companies exist whose business is analyzingthe ebb and flow of a bank's accounts and advising management on the optimal ways to manage their cash and customer accounts. These are difficult problems, and are part of the reason CDs are popular with banks. CDs have a term, so banks know the customer isn't going to demand their money before the term completes. CDs originated in the 1960s for large deposits with a rate that companies would negotiate with their local bank. The development was largely due to an exemption for large deposits in the interest-rate limits legally imposed on banks at the time. It was only in the 1980s that they began to be offered at smaller denominations to the general pubic. Though CDs are available to anyone with the minimum deposit now, the market for large CDs persists and is still an important part of the world's money market. 
Another source of deposits is called brokered deposits. This is where a securities broker makes a large deposit in a bank, and sells shares of that deposit to its clients. With so little overhead (the broker is doing the marketing), this is a relatively inexpensive source of deposits to a bank, even if the interest rate is commonly somewhat higher than on normal consumer accounts. There is, however, a certain amount of concentration risk, since the broker winds up in control of a large block of deposits. In the US, FDIC rules restrict brokered deposits to well capitalized banks. Brokered deposits are central to some banks' business strategy: Morgan Stanley gets almost all its deposits in this fashion, and Goldman Sachs gets a high proportion that way, too. These banks don't have branches, but they still have deposits. Even banks with lots of branches and a broad customer base sometimes turn to them as a useful source of funds: BankAmerica and Citigroup make substantial use of them, though they represent only 5-7% of their deposits. 
A growth in reliance on brokered deposits can be a sign of trouble in a bank, and this is more or less what sank IndyMac, who used brokered deposits for more than a third of their deposit base by 2008. Unfortunately for them, in early 2008, a ratings downgrade of bonds based on their loans dramatically affected their CRAR by increasing the risk weights used to value their assets. A 

62 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
bank has to be "well-capitalized" by FDIC standards to participate in the brokered deposit market, and the downgrade threatened to cut them off from this source of funding. Losing access to this market would have bled them for around $500 million per month. Insolvency threatened to follow. IndyMac, with the cooperation of their regulator, found a borderline-fraudulent fix by backdating a transfer of capital from their parent company. But, as frequently happens when insolvency threatens a bank, the threat was made good shortly thereafter by a good old-fashioned bank run, complete with crowds of angry depositors in the bank lobbies. 
Fed funds and the discount window 
Too much money on reserve can be as much of a burden as too little. Let's look at Acme Credit Union again. Remember they have deposits of $1 million every Thursday and $1.2 million on Friday, payday at Acme Manufacturing, the company for whose employees the credit union was formed. 
Acme's troubles aren't over if it just arranges to have 10% of its deposits on reserve on Thursday. Suppose they do that, and have a reserve of $100,000 in cash and reserve deposits available on Thursday. What do they do with the excess $200,000 they get on Friday? Remember, reserves bear no (or little) interest, so not investing this surge of funds is sort of like wasting it. Acme could use it to buy some liquid investment like T-bills and then sell them the next week, or time the maturities to align to its needs, but that's complicated, and the commissions on the sales would be expensive. Also, T-bills pay almost nothing in interest and really are not very different from cash. Buying a CD from another bank isn't really an option, since those are usually longer terms than a few days. 
The Fed funds market is where a bank first turns to cover reserve problems like Acme's. Fed funds are the reserve funds that banks kee€ on deposit at the Federal Reserve, or at Fed member banks. 6 Loans of these funds to each other are the goods of the Fed funds market. Loans are short-term and uncollateralized, and regulators don't count them against a bank's reserve requirements, so they can be used to meet those requirements. 
56 Acme, being a credit union, is not (1. Fed member, but it probably has relationships with one or more partner banks who are. 

BORROWING 
63 
A bank in Acme's position might arrange to have around $100,000 on reserve (cash and deposits at other banks) at any time, and manage the ebb and flow by lending in the Fed funds market. On Friday, when Acme expects $200,000 to flow into its accounts, Acme can offer almost all of that money immediately to other banks who might have a reserve shortfall. They'll keep around $20,000 to make sure they have 10% of their deposits on reserve at the end of the day, but can loan the other $180,000. During the course of the week, they'll spend down the $20,000 and the $180,000 will be repaid and that, too, will be paid out to customers making withdrawals. And they'll earn a little interest income from the banks to whom they've loaned the funds. 
Acme could do it slightly differently, and keep only $80,000 on reserve, and make up the difference by lending and borrowing on the Fed funds market. They wouldn't have as much to lend each Friday, and they would probably have to borrow each Wednesday, but they'd have 20% less money in cash and reserve accounts. If they can find good investments for that money, it might be worth the added risk of the lower reserves. You might call this a more aggressive way to run a bank, but it's not an unusual one57 
A bank facing a reserve shortfall can also borrow at the Fed's discount window, where a member bank can borrow at very low interest rates. discount window loans are short-term, with terms ranging from overnight to a month or so. They are different from Fed funds loans by being secured loans, with collateral pledged in the form of securities of various kinds, or loans the bank has made. A bank can get primary credit if it is healthy, with minimal overhead. A less well-capitalized bank will get secondary credit, which comes with a bit more analysis and paperwork and a slightly higher interest rate. The Fed can also extend longer-term 
57 Aggression, you'll be shocked to learn, is not a trait unheard of in the executive suites of our nation's leading financial institutions. At an IMF meeting in 2011, Jamie Dimon, the CEO of JPMorgan Chase who was said to be known as "Mad Dog" on the high school soccer field, berated the governor of the Bank of Canada so thoroughly that the president of Goldman Sachs felt compelled to apologize on his behalf. The Canadian banker's offense? Suggesting that increasing capital requirements would be good for the banking system. Dick Fuld, CEO of Lehman Brothers when it expired, was called "The Gorilla" for his rampaging style. Kenneth Lewis, ex-CEO of BankAmerica, Angelo Mozilo, formerly of CountryWide Financial, and Franklin Raines, once head of Fannie Mae, are all frequently described as aggressive and competitive, and all three brought their banks low in the 2008 crisis due to serious overreach. 

64 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
seasonal credit to banks that have seasonal fluctuations in their reserves, like a bank in a farm or resort community might. The primary credit rate is called the discount rate.58 Because of the collateral, even though the interest rate is low, the cost of those funds is not zero. The discount window sounds good, but there are lower rates available in Fed funds, so it is really just where a bank goes when it needs to. Fed policy more or less discourages its use. 
Repo market 
A bank has other sources of funds. A repurchase agreement, or repo is essentially a short-term collateralized loan, framed as two sales. (You'll also see it in banking documents as RP sometimes.) I borrow money from you by selling you some securities with an agreement that tomorrow you'll sell them back to me at a slightly higher price. I get the use of your money for a while and you get the securities as collateral. The higher price is calculated by adding the repo rate, the interest rate, to the original sale price. The borrower is sometimes said to be "doing a repo" while the lender is "doing a reverse." 
A repurchase agreement can be for any term, but lots of them are just for overnight, or to cover some settlement deadline when reserve requirements have to be met. They can be, and often are, rolled over, sometimes indefinitely (an open repo). From the lender's perspective, there is very little credit or liquidity risk in a repo transaction, because the collateral is good and the terms are short. It's not a bad way to invest surplus funds, and attractive for loans substantially larger than might be appropriate for the Fed funds market. 
From the borrower's perspective, it looks a little different. The loan is secured, so it's not the cheapest source of funds, even if the repo rate is typically a bit below the Fed funds rate. Also, there is a healthy amount of interest rate risk for the borrower, since the interest rate will float freely each time the loan is rolled over. On the other hand, repo transactions are available to anyone with collateral, such as money market funds, while Fed funds loans are only 
58There is also emerge,!cy credit which is what the Fed used to bailout AIG with an $85 billion loan in 2008. Dodd-Frank curtailed the ability of the Fed to offer this kind of credit to individual companies, though it still has the power to establish an emergency credit program to aid a sector of the economy. The details of this will doubtless be worked out during the next such crisis. 

BORROWING 
65 
available to Fed member banks. In addition to covering larger transactions, the repo market is also somewhat more private, so to speak. With the Fed funds market, everyone knows your business; with repo transactions, only the two parties really need to understand what's going on. 
More money markets for borrowing 
Bank deposits, Fed funds loans, the discount window, and the repo market are all components of the world money market, but they do not make up the whole thing. There are more exotic ways for a bank to borrow funds, including currency swaps59 and futures or issuing some kind of asset-backed security. These last typically have much longer maturities than most money market instruments, but for some reason are frequently considered to be part of the money market. 
One important money market practice is the interest rate swap, a way banks relieve themselves from interest rate risk. Interestrate risk is one of the important risks faced by banks, and remains on the minds of many bankers. The S&L crisis of the 1980s was largely brought about by the deregulation of interest rates in 1980. Suddenly banks could compete for customer deposits by paying higher rates, and the rates small banks were forced to pay to keep their customers rose much faster than the rates they were receiving from their long-term loans. A bank might have only been getting 6% on their 30-year loans, but suddenly found themselves having to pay that much or more in order to keep their depositors from moving their money to money-market funds, or to larger banks. This is a recipe for going out of business quickly. Small banks found themselves pursuing much more risky lending opportunities than they had had experience with, and it ended badly for many. This was a quarter-century ago, but well within the careers of many people still working in banking, both within banks as well as the bank regulators.s'' 
59 A swap is just an exchange agreement. A credit default swap, for example, is an agreement to exchange money for the risk that some obligation will default. A currency swap is an agreement to exchange two debts denominated in different currencies. 
60In truth there wasn't much choice about deregulating interest rates. Inflation during the 19705 had climbed to levels much higher than the regulated interest rates, so banks were bleeding depositors desperate not to lose the value of their money by getting the interest they would earn by putting it in banks. 

66 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
With an interest rate swap, a bank that has borrowed at a fixed rate can convert it to a floating rate by persuading someone else (paying them, cajoling them, lying to them, whatever) to assume the interest rate risk. Despite the extra risk, this may be appealing to organizations whose budgets are tightly planned years in advance, like governments whose credit isn't good enough to borrow at decent fixed rates. A bank that manages to secure a large multi-year CD, and then swap that fixed-rate debt with someone, now has a long-term, floating-rate, source of funds for which there are no reserve requirements. This is more or less a banker's holy grail. 
Of course, legend has it that lots of knights perished in the search for the grail, and in this case, it's worth remembering that the only way banks can reach the grail is by finding someone else to assume risk they don't want. And there's a reason they don't want it: it's risky. This is what has happened to the Philadelphia school district. There are bankers prowling city halls and state houses all over the country looking for other people to assume interest rate risk they don't want. Philadelphia took the bait, like many others, and when interest rates plunged in the 2008 financial crisis, they all found themselves on the losing end of interest rate swaps+' 
Again, many of the transaction possibilities are routinely available only to the biggest banks, but even a smaller bank might find ways to use the knowledge of what's possible to its benefit. 
Using the bond market 
If your bank is big enough and stable enough to merit a decent bond rating, the bond market isn't a bad place to look for funds. There is a lot of money there, and a wide variety of appetites for different items on the interest rate and terms menu. This is not 
61 Let's look at Philadelphia's swap a bit more closely. Before the swap, Philadelphia had floating-rate debt funded by relatively fixed income (the taxes it collects). The banks, on the other hand, had fixed rate debt funded by what was very likely floating-rate income (the loans they'd made). Philadelphia feared rates going up, and increasing the cost of servicing their debt. The banks feared rates going down and decreasing their income. After the swap, Philadelphia feared rates going down. The banks, however, created a situation where they are making floating-rate debt payments with income from what are probably floating-rate loans. They no longer cared which way the rates went. Philadelphia exchanged one kind of risk for another, but the banks no longer had any at all. A nice deal for the banks, but not so nice for the students. 

THE BANKING UNIVERSE 	67~ 
so very different from trolling for large CDs, but a bond is usu- 
ally a longer-term investment, so will merit a bit higher interest 
rate. Also, the pool of buyers is far larger, so the terms can be relatively favorable to the issuing bank. Big banking institutions use 
the bond market extensively. The World Bank is funded almost exclusively through bonds. 
An interesting player in the bond market is the Federal Home Loan Bank (FHLB), which was founded to be a conduit between the money markets and small mortgage lenders, supplying them with liquidity specifically for home finance lending. More about them on page 69. 
One thing to remember is that a bond creates a liability on the bank's balance sheet, in addition to the asset of the bond proceeds. You can't add to a bank's capital via a bond, though the owner of a bank can do that. That is, if you own a bank, you can borrow to increase the bank's capital because it's you, not the bank, that owesit back. Your balance sheet will have matching assets to the liability for the loan you took out, but the bank you own will only see the capital. 
The banking universe 
Every bank in America (the world, actually) is part of a network of other banks, each dependent on the others around it for credit, liquidity, and much more. Banks borrow from each other all the time, either in unsecured Fed funds loans, secured repo agreements, or just in deposits into accounts at their correspondent banks. Often this lending is in service of liquidity. For example, a bank running close to running out of cash on Tuesday may expect a whole bunch of customers to purchase CDs. on Friday because that happens most Fridays. Those CD purchases mean the bank acquires cash, but first the bank has to get past Wednesday and Thursday, so they might borrow from a friendly bank to do that. The most likely way to deal with this is one of: an unsecured Federal funds loan (which doesn't change either bank's reserve requirement); a secured repo loan; or a secured loan from the Federal Reserve discount window (slightly longer term, but more expensive). There are other ways to address this kind of shortfall, but these are the most likely. 
I 

68 
CHA PTER 3. BANK OPERA TION MADE SIMPLE(R) 
In other words, every bank depends on a network of other banks and financial institutions around it. Here, then, is a brief description of the important institutions, and kinds of institutions, that any bank will see as important parts of its network. 
The Federal Reserve 
The Federal Reserve system is a bank-owned, public-private hybrid consisting of twelve branches around the country run by a network of boards appointed by the President62 All nationallychartered banks are members, and state-chartered banks may apply to be. A member bank will keep some large fraction of its reserves on account at the Fed (with the rest in cash), and a great deal of the processing of checks and electronic payments in the country has to do with shuffling account entries among these reserve accounts. So, for example, the First National Bank of Louisiana will send a payment to the First National Bank of Montana by asking the Fed to move some money from the Louisiana reserve account to the Montana account. 
In addition to this, a bank can buy Treasury securities directly from the Fed, or sell them back. It can get and redeem coins and bills in exchange for reserve account funds, and it has accessAithe discount window, which we met in "Fed funds and the discolmt window" on page 62. The Fed is also the primary regulator of some banks, and sets accounting rules for all US banks, but those effects are sometimes a bit abstract compared to the day-to-day issues for any particular bank. 
The Fed controls the Fed funds rate, not by setting it directlythese are transactions between one bank and another and the Fed is not a party to them, even if it holds the funds-but by managing the supply of Fed funds through open market operations. When the Fed wants the rate to go up, it sells Treasury bonds and collects reserve funds in exchange, often through repa agreements. This reduces the total amount of Fed funds out there and so increases the cost of borrowing those funds. When it wants to make the 
62The geography of Fed branches is something of a relic of the economic state of the US in 1913. It was supposed to be dividing the country into more or less economic equivalents, but today the balance is fairly lopsided. There are, for example, two branches in the state of Missouri, and the San Francisco branch covers nine states, pretty much everything west of the Rockies. The branches are in Boston, New York City, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Dallas, Kansas City, and San Francisco. 

THE BANKING UNIVERSE 
69 
rate go down, it buys bonds instead. This usually works, but not always. The Fed funds rate target is usually a bit lower than the discount rate63 
Beyond even that, the Federal Reserve is, of course, central to the US monetary system, and there is a world of controversy surrounding it. The Fed's every move is watched by legions of commentators and analysts for what it portends for the economic future of the United States and the world. There are lots of books about the Fed and its control of the money supply. This is not one of them, though, since almost none of that is relevant to the Fed's interaction with any particular bank. 
Federal Home Loan Bank 
A similar institution with very different purpose is the Federal Home Loan Bank (FHLB). Structured as a mutual bank owned by its members, the FHLB also has twelve branches around the country, though they mostly don't correspond to the Fed branch locations64 Membership in the FHLB is much less restrictive than the Fed, and includes banks, credit unions, thrifts, insurance companies, and community development financial institutions (CDFls). 
The point of the FHLB is to supply funds to be loaned out for long periods. Indeed, the institution was the key player in creating and promoting the concept of a long-term fixed-rate mortgage, back in the 1930s. Before that, most mortgages were five-year loans, with a balloon payment that would typically be refinanced. You can see the 30-year mortgage as a big step in democratizing finance, because it involved a huge shift in risk from the mortgagor (owner) to the mortgagee (bank). FHLB members can borrow from it for much longer terms than they can get either from the Fed or the Fed funds markets. FHLB loans (they call them advances) are 
63Prior to the financial crisis of 2008, it was ioo basis points lower, but once the Fed funds rate hit rock bottom it wasn't possible to maintain that difference due to downward pressure on the discount rate. As of this writing, the difference is about 50 paints, and will likely go back to 100 as rates rise again. 
64These are also a relic of an earlier economic epoch, but the FHLB was chartered in 1932, a different epoch than the Fed, so its center of mass is considerably further west. The branches are in Atlanta, Boston, Chicago, Clncinatti, Dallas, Des Moines, Indianapolis, New York City, Pittsburgh, San Francisco, Seattle, and Topeka. Apparently there was a desire at the time to make sure that the FI~ILB cities were different from the Fed cities, but gravity will out and after a while, the original FHLB branches in Newark, NJ, Cambridge, MA, and Evanston, IL, moved to New York, Boston, and Chicago. . 

70 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
fully collateralized, so borrowing institutions must put up at least as much collateral as the loan amount, making the cost of funds fairly substantial. The collateral rules are quite strict, but much broader than at the Fed, though, so residential mortgages count, as do other kinds of lending. This makes FHLB into a conduit to the international financial markets for small institutions, which can make loans backed by FHLB funds. 
The Bank of Sunnydale, for example, can borrow from its customers, but at least at first, it's probably too small to borrow at good rates in the bond market. The FHLB has an excellent credit rating,65 so it can borrow at low rates in the bond market, and lend what they get to Sunnydale, along with the low rates. Sunnydale bankers can add a percent or so to the mortgage rate and lend that money out. And if they do a good job with the underwriting, they can use the resulting loans as collateral for more lending from FHLB. 
Correspondent banks 
The Fed is not the only bank that other banks keep accounts with. Almost all banks have what are called correspondent accounts with other banks. Often this is a case of a small bank opening an account with a larger bank, usually in order to have access to some service the small bank does not offer66 Lots of smaller statechartered banks are not Fed members, and those small banks can use big ones in the same way the big ones use the Fed, to hold reserves, and as a quick source of liquidity. 
A bank can also join its neighbors and cooperate in lending. 
This will often happen when a lending opportunity arises that is just a little too big for a single bank to take on. Perhaps it's a case of avoiding concentration risk, perhaps the bank is almost tapped out, perhaps it's something else. In this case, a bank will often seek to syndicate a loan, sharing it with cooperating banks. (It's 
65 Apparently well-deserved. The FHLB came through the 2008 financial crisis with only relatively minor bruising. Of course part of their excellent rating is the implicit guarantee they enjoy from the federal government, something that was tested in the S&L crisis of the 19805, when the FHLB was hit hard. 
66Uke money laundering, where big banks are much more efficient than little ones. In 2012, UBS, the giant Swiss bank, was found to have facilitated tax evasion for customers of Wegelin, a very small Swiss bank. There is some evidence that global drug money may have kept the international banking system afloat during 2008 and 2009. One of the lessons of the crisis might be that money laundering is a good strategy for reducing concentration risk. 

THE BANKING UNIVERSE 
71 
also called participation lending.) One bank is typically the lead, and handles processing the actual loan payments, but the risk is shared. The Bank of North Dakota does a fair amount of participation lending like this, backing up North Dakota banks who want to make a loan to a valued customer, for example, but can't quite afford to do it solo. 
Banker's bank 
There are banks whose purpose is to serve other banks. Sometimes characterized as a wholesale bank-to contrast with a retail bank serving customers directly-a banker's bank provides services that smaller banks need: liquidity management, investment advice, access to the bond market, and much more. The economies of scale mean that some services, like credit cards, lease financing, or access to the foreign currency markets are much easier to provide in the setting of a larger institution than a small community bank. Some other services, like cash management, work better as the pool of cash invested grows. And a banker's bank can be the way a smaller bank accesses the Fed's services, like the Fed funds market or buying currency, too. 
A wholesale bank can also provide extra capital, chipping in when a lending opportunity is too big for a community bank, or provide a vehicle for syndicating loans among a group of banks. In a case like this, the community bank would be the lead in securing and working out the loan opportunity, but the banker's bank or other banks would supply some of the loaned funds and share in the resulting interest payments. The Bank of North Dakota is largely a wholesale operation, allowing small banks in its state to operate as if they were somewhat larger. 
A related concept is a private-label bank. This is a bank willing to act as a bank on behalf of another organization that wants to offer banking services, but doesn't want to be a bank. When Paypal wanted to offer a debit card to its customers, they didn't become a bank, they contracted with a private-label bank willing to offer a debit card that says "Paypal" on it. The bank deals with the regulatory hassle and operates a lending operation, neither of which were important to Paypal's goal of offering a payment option to its customers. 

CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
Investment banks 
Unlike retail and commercial banks, an investment bank does not take deposits67 They have capital and find sources of funding, to be sure, but they have them in service of the underwriting and trading of securities. They underwrite bond sales, help companies acquire capital through stock sales, buy and sell the resulting securities, and about a thousand other financial services. Whereas at least some of a commercial bank's activities can be construed as making money for its depositors as well as for itself, an investment bank has no such shared goals. Certainly some of its activities are services for customers (underwriting, bond trading, dispensing financial advice), but the functions are in service to profit to the partners or shareholders. 
One important function of the nation's investment banks is to be the backbone of the bond market. There is no centralized bond exchange, and bonds are traded directly from buyers to sellers, in what are called over the counter (OTC) transactions. Not all investment banks are bond dealers, and not all bond dealers are investment banks, but the two categories overlap significantly. 
Investment banks are creatures of the securities industry, and as such, are regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FlNRA), a non-government regulator, set up by Congress, but run by the firms it regulates. 
Several of the big banks you think of when you think of big banks-Goldman Sachs, Morgan Stanley, JPMorgan Chase-are investment banks. Actually several of them are officially bank holding companies, a switch permitted during the meltdown in 2008, when Goldman Sachs, Morgan Stanley, Citigroup, and some others, were permitted to become bank holding companies in order to get access to emergency credit from the Fed. 
72 
Investment company 
An investment company is a very different beast from an investment bank, but they can also be useful to a bank. An investment company manages assets on behalf of a collection of partners or customers, depending on how it's incorporated. A mutual fund 
67That's the official line, anyway. Investment banks often take brokered deposits. See "Managing deposits" on page 59. 

THE BANKING UNIVERSE 
73 
is a kind of investment company, called an open ended investment company since it is intended to last indefinitely, with shareholders joining and leaving the pool at will. A closed-end investment company is basically the same thing, but with a fixed number of shares, so the only way to join is to find someone who wants to leave and buy their shares. (Some of these are traded in the stock exchanges. ) 
There are a few different kinds of investment companies you hear a lot about: 
•	A money market [und is an open-ended investment company that specializes in investing in highly liquid short-term securities like T-bills and commercial paper. They try to manipulate their share price to be a dollar, so that entering and exiting the fund is relatively simple. The interest a shareholder earns is awarded in more shares. They are considered to be quite secure.68 
•	A mutual fund is an investment company that generally implies a fairly low threshold for investors. They can invest in stocks and bonds, and there are funds out there that invest in commodities and real estate and probably in cucumber futures, too. They can be open-ended or closed-end. By being open to the general public, and with a low threshold for investors, they are subject to SEC regulations governing disclosure, insider information, and all the rest. 
68 Relatively speaking. The failure of Reserve Primary, a large money market fund, in the fall 2008 was probably the beginning of the real panic phase of that crisis. In the aftermath of the Lehman Brothers failure in 2008, Reserve Primary, which held a lot of Lehman paper, saw its share price drop to 97 cents. This precipitated a run on the fund and on several other funds who madly tried to sell all their commercial paper to deal with the demand for cash. The run destroyed Reserve Primary, and severely damaged the others. Lots of big corporations use commercial paper to finance purchases of parts and materials, and they were suddenly cut off, unable to sell notes at alL They couldn't tum to banks because lots of them rely on the short-term market for liquidity, and suddenly it wasn't liquid. The resulting plunge in the short-term bond market was the real source of panic among bank regulators that fall, when they realized the Lehman failure would become much more than simply teaching errant bankers the sins of their ways, and that it would have real repercussions on the real economy. Lehman closed on September 15, a Monday, Reserve Primary dropped on Tuesday, other funds were hammered on Wednesday. On Friday morning, chastened Treasury Department officials announced it would guarantee deposits in money market funds. 

74 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
•	A hedge [und is (usually) a closed-end investment company that invests however it pleases. These funds are open only to accredited investors, the SEC's term for "rich and supposedly sophisticated investors." The idea is that only savvy investors should be let into this jungle, and so they wash their hands of regulating the jungle. Hedge fund fees tend to be high, the industry standard is what they call "2-and- 20." They charge an annual management fee of 2% of assets under management and take 20% of the investment gainsthough not the losses.P" 
•	A private equity fund is an investment company, also usually closed-end and exempt from many SEC rules regarding investment companies. A private equity fund's purpose is to make equity investments in existing companies. There's a lot to say about the private equity industry, but in a book about banks, it will suffice to say that private equity companies have been the primary device through which industry in the US has been financialized over the past 40 years. That is, through the private equity industry, financial managers without a deep connection to the business of some company have supplanted the people who came to management through years of experience in that particular business. The value supplied by the new managers remains controversial, to say the least. Private equity funds also typically use the 2-and-20 formulation for fees. 
•	A special-purpose private equity fund, designed to help startup businesses with their capital investment, is called a venture capital fund. 
69The fee structure and the unregulated nature of these funds is partly why YOll hear so much about hedge fund and private equity managers who have become incredibly wealthy through their hedge funds. Curiously, one has a much harder time finding hedge fund customers who have become incredibly wealthy through their hedge fund activities. One would cry few tears for these supposedly savvy investors being so exploited, except that many of them are actually our municipal comptrollers, pension fund managers, or county treasurers. 

PAYMENTS 
75 
Payments 
When you get right down to it, money is a pretty ethereal concept. It's possible to talk forever about what it actually is without coming to a conclusion. However ethereal money itself is, the representation of money is pretty straightforward. It might be pieces of paper or metal, and it might be electrons or some molecules of iron oxide on the back of a bank card. Whatever it is, a system that moves money or a representation of money from one person to another (or one bank to another, as the case may be) is a payment system. Since it all connects together, some people will say the world has just one payment system, but calling the whole big crazy quilt a Single "system" seems kind of a stretch. 
A payment system is not only the technology, but the rules and procedures that make it work, and make it secure. C.E. Beckman Co., a 100-year-old ship's chandlery in New Bedford, MA, had an interesting payment system. Clerks would write up your order on a slip and tuck the slip into a pneumatic tube that would take it down the block to the cashier's office. You'd then have to follow it there to pay for your order, and the cashier would use another pneumatic tube to send back permission for you to pick up the order. The result was they could keep the cash in a single secured room and didn't have to walk it down the street at closing in what was a pretty tough dockfront neighborhood. They could also hire clerks they couldn't trust with money, something else important in a neighborhood where sailors needed work for a few months when they were on shore, but then would ship out for a year or more at a time. 
Beckman's payment system consisted of the pneumatic tubes, the cashier's office, and the rules and procedures people used to operate it. It was designed to be secure against the risks they faced. Other payment systems are designed with similar concerns to protect against different risks. This is why your debit card requires a PIN number and your checks require a signature. 
There is, as you might imagine, an endless variety of payment systems beyond the simple exchange of cash. This section describes some of the more important systems in the US. 

76 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
Checks 
A check is a familiar payment system to most people. It is the most common form of what's called a draft, an order from you that your bank pay another party. Some checks are presented at the bank that issued them and exchanged for cash, but most are deposited in some other bank. 
When one bank winds up with a check written on another bank, it has to arrange for the check to be returned to the issuing bank, in exchange for money. This is check clearing. Many banks have arrangements with correspondent banks to return checks directly, while a check written on some distant bank has to be submitted to a clearing house. Transferring money incurs charges, so a bank doesn't want to make a transfer for every single check. The clearing house accumulates all the checks issued over some period, usually a day, and consolidates the transactions they represent.70 If at the end of the day, Bank A has $5,000 in checks from Bank B, who has $4,000 checks from Bank A, the transfers cancel out a little and result in only a single transfer of $1,000 from Bank B to Bank A. 
Once the transactions are consolidated, the clearing house still has to make the transfers happen, and that involves creating instructions for them and issuing them to some settlement bank where each of the banks involved has an account. The Fed operates the largest clearing house, and also operates the National Settlement Service (NSS) that executes a whole set of account transfers at once, for its clearing house, and others. Of course, it can only provide that service for banks that have an account at the Fed. 
Check payment has several security features, ranging from the signature on the check itself to the lists of bad-check passers stuck in a folder next to the grocery store cash register. One important security feature, widely used by big companies or governments is called positive pay. With positive pay, the company sends the bank a list of the checks it has written and the bank agrees to honor only checks on that list. This allows an account's checks to be under the control of several different offices within that business or government. 
700bviouslya dearing house can only dear checks (rom banks it knows about. 
Other checks have to be forwarded to another clearing house that might have better luck with them. 
PAYMENTS 
77 
Some banks offer an elaboration of the check payment system, a lockbox service, which is an address, with a bunch of people there to open envelopes containing bill payments and deposit what's inside. This can be a more secure option for many offices, and makes the funds available much more quickly. Some lockbox services will offer the ability to print and mail the bills, too. There are also courier companies doing roughly the same thing by planting an actuallockbox-a steel box with a lock on it--on your premises and emptying it on some regular schedule." 
Electronic payments 
Electronic payments are quickly growing in importance. There are well over 80 billion such transactions in the US each year, with a value of over $50 trillion. By the time you read this, the numbers will be greater since they appear to be growing each year at an annual rate of about 5%. Electronic payments are supplanting both payments by check and payment by cash. 
There are two important variants of electronic payments: instant and netting. An instant system, also called a real-time gross settlement transfer (RTGS) makes the transaction happen right away. A wire transfer is an RTGS transaction. In the US, the Fedwire system, operated by the Fed, carries the bulk of these transactions, which produce a transfer from one account at the Fed to another. There is a substantial charge for these transactions, so they are typically only used for large transfers of funds. 
An example of a netting system with a much smaller membership is the Clearing House Interbank Payment System (CHIPS). CHIPS has a bit less than 50 members, as opposed to the 9,000 or so Fed members. However, its members are quite large, and most of them are not based in the US, so it makes a very good route for large international transfers of money. CHIPS members pre-fund a fraction of their anticipated transactions for a day as security, and then make up the balances at the end of the day. CHIPS is a netting engine, that accumulates a day's transactions, composes them into a set of final payments, and settles them all at once. 
71 For those who enjoy debating what money really is, consider that some of these companies will credit your account for money you've put into the box before they send their armored truck out to get it. A business or government using this service can spend money while it is still locked inside a small steel box in their offices. If you can spend the money, then what, exactly, is in the box? 

78 
CHAPTER 3. BANK OPERATION MADE SIMPLE(R) 
For smaller transactions, the most important system (in the US) is called ACH which stands for automated clearing house. ACH transactions include things like direct-deposit of payroll and government benefits, direct bill-pay from consumer bank accounts, and direct-pay business-to-business payments. It's not a bad approximation to think of ACH as just an electronic check. In the same way that a bank forwards its checks to a clearing house, a bank will transmit ACH payment requests to an ACH operator, who accumulates those payments into a set of consolidated payments over some time, like a day. There are several different ACH operators out there, though again the Fed operates the biggest by far, handling billions of transactions every year. 
Credit and debit cards 
Bank cards have, in the past forty years, gone from being a novelty to an integral part of the flow of funds in the economy. They have proliferated in variety, too, but come in two main varieties: credit cards and debit cards. 
You can think of a credit card as representing two different payments, from the bank to the merchant and from you to the bank. When you buy a doughnut with a credit card, the baker swipes your card through their machine, which notifies their bank (the acquiring bank) that you're hungry for a doughnut. They check with your bank, who authorizes the transaction, and so the baker releases the doughnut and you eat it. (Some merchants might skip this authorization step, for a variety of different reasons having to do with the size of the transaction and the relationship between the merchant and the bank.) 
Later that day, the baker collects all the credit card slips collected during the day and submits them in a batch to their bank, who sends them along to the credit card association. This is the governing body for that brand of card: Visa, MasterCard, Discover, and the rest. The association clears the transactions, sorting and consolidating them into payment instructions and debiting the account of your issuing bank (the one who issued the card to you) and crediting the merchant's bank, who then pays the merchant. It's now the issuing bank's problem to get the money from you, and they send a bill. Money flows from your bank to the association to the baker's bank to the baker, and then from you to your issuing bank when you pay the bill. The issuing bank may not be 

PAYMENTS 
79 
the bank where you have a checking account, so there is a bank transfer involved there, too. 
As you can imagine, there is a certain amount of settling and consolidation done throughout the process. The merchant accumumlates a day's worth of credit card receipts before submitting them to their bank. The credit-card association settles transactions among all the customer and merchant banks they deal with, and the customer's payment is settled through the usual checkclearing process. There is quite a lot of money in the pipeline at any time. 
There is a certain amount of credit risk a bank takes on when it issues credit cards. Most credit card debt is unsecured, and there is a bit of a mismatch between the date the debt is incurred and the date interest begins to accrue. For example, if you paid for that doughnut on the first day of the billing month, the merchant will get their money for it a couple of days later, but it's still almost a month before the bank issues the bill and another few weeks before you pay it. The bank is earning no interest unless you put off paying the bill and start to accumulate a balance. Despite this, banks have found credit cards to be quite a profitable business, partly through fee income (from both the consumer and merchant) and partly because in 1978, the Supreme Court ruled that state-bystate usury limits (interest rate limits) only applied to the banks within those states, not to the customers. Issuing banks proceeded to move en masse to Delaware, Nevada, and South Dakota, where there are no interest rate limits, and have lived happily ever after, charging interest rates that would have made Pierpont Morgan himself blanch. 
A debit card is quite a bit simpler than a credit card, because the money flows directly from the bank account associated with the card to the merchant's bank account. Like credit cards, debit card transactions also undergo a settling and clearing process, to minimize the number of transactions the banks have to pay for. (The process differs, depending on whether you Signed for the debit transaction, or entered a PIN into a pas terminal.) Some lag is thus built into all these systems, time to let the transactions accumulate with the goal being to economize on the cost of the actual transactions. 
There are also pre-pay debit cards now, where instead of the card being an accessory to the account, it represents the account. A customer pays some money and gets a card that "contains" the