FNCE 4102 Week 11 Financial System Final Paper Example

Following $10,000 Around the Financial System: From a Household Deposit Through a Bank, a Corporate Loan, a Payroll and a Money Market Fund and Back, With the Fee Taken at Each Hop and Three Places the Circuit Could Break

Student Name

Walden University

FNCE 4102: Financial Institutions and Markets

Instructor Name

Month Day, Year

Following $10,000 Around the Financial System: From a Household Deposit Through a Bank, a Corporate Loan, a Payroll and a Money Market Fund and Back, With the Fee Taken at Each Hop and Three Places the Circuit Could Break

The Starting Point

On the first of the month, a nurse in Columbus, Ohio, deposits a $10,000 bonus into a checking account at a composite regional bank. This paper follows that money through the financial system as it is lent, spent and saved again, naming the institution, the instrument and the fee or spread taken at each hop. All institutions are composite, and the rates are illustrative of the mid-2020s. The purpose is to show the system as a connected circuit rather than as separate markets, and then to examine where the circuit could break, using material from earlier assignments.

The Circuit

The nurse's deposit becomes part of a loan within days. The bank keeps a fraction as reserves and lends the rest; the loan funds the manufacturer's payroll; a machinist's paycheck lands at a credit union; the machinist, wanting a better return, moves savings into a money market fund; and the fund lends the cash overnight to a dealer bank through a repurchase agreement, which finances Treasury securities. The money has passed through five institutions and returned to the banking system.

Table 1

The Path of $10,000 and the Cost Taken at Each Hop

Composite institutions; rates illustrative.

The Cost of the Circuit

The largest single cost is the bank's spread at hops 1 and 2, about 7 percentage points between what the nurse earns and what the manufacturer pays. Part of that spread covers expected loan losses and the bank's operating costs; part is profit and a return on capital. The payroll processor, the credit union and the money market fund each take far smaller amounts. Philippon (2015) measured what American finance charges per dollar it intermediates, the sector's total income over the assets it handles, and found the figure has stayed around 2 percent for over a century despite large advances in technology, a finding that suggests the circuit has not become much cheaper.

Who Bears the Risk at Each Hop

The fees and spreads in the table are payment for bearing risk as well as for doing work. At hop 1, the nurse bears almost no risk, because federal deposit insurance covers her balance up to $250,000. At hop 2, the bank bears the credit risk of the manufacturer, and its shareholders absorb any loss beyond what the loan rate priced in. At hop 3, the payroll processor bears operational risk, the chance that a file fails and employees go unpaid for a day. At hop 4, the credit union bears the risk of its own lending, and its members are insured in the same way as the nurse. At hop 5, the machinist bears the small risk that the money market fund's assets lose value, though a government fund holds only Treasury and agency paper. At hop 6, the fund is protected by Treasury collateral on its repurchase agreement, while the dealer bears the risk of the securities it finances. Risk ends up concentrated where capital is meant to absorb it, in the banks.

What Would Make the Circuit Cheaper

Two developments could narrow the costs. Instant payment systems such as the Federal Reserve's FedNow service shorten the time money sits in transit between hops, which matters more to businesses than to households. And competition for deposits, of the kind that briefly appeared when money market fund yields rose above bank savings rates in 2023, pressures banks to share more of their spread with depositors. The nurse's 0.5 percent checking rate is the clearest sign that this pressure was weak at hop 1.

Where the Circuit Could Break

Three points, each studied earlier in the course, could stop the flow.

The funding side. If depositors at the regional bank began withdrawing at once, as happened at Silicon Valley Bank in March 2023, the bank could not call in the manufacturer's loan fast enough. Diamond and Dybvig (1983) explained why such runs can happen even at a sound bank; deposit insurance covers the nurse's $10,000, but large uninsured depositors may run anyway.

The credit side. If the manufacturer's sales collapsed and it defaulted, the bank would absorb the loss through its capital. The credit assessment and risk pooling covered in Week 8 are meant to keep such losses within what the bank's pricing and capital can absorb.

The short-term funding market. If money market funds pulled back from repo lending, as funds did from commercial paper in September 2008, dealer banks would lose overnight funding for their securities, and the Treasury market itself could become disorderly. Federal Reserve facilities and the 2023 money market fund reforms are designed to prevent that link from failing (Mishkin & Eakins, 2018).

What the Circuit Shows

Viewed as a whole, the system turns one household's short-term deposit into a business's working capital, a worker's wages, another household's savings and overnight funding for the government bond market, all within weeks. Each institution earns something for the function it performs. The circuit is efficient in normal times and fragile at the points where short-term money funds long-term or risky assets. Those are the points regulators watch most closely.

References

Diamond, D. W., & Dybvig, P. H. (1983). Bank runs, deposit insurance, and liquidity. Journal of Political Economy, 91(3), 401-419. https://doi.org/10.1086/261155

Mishkin, F. S., & Eakins, S. G. (2018). Financial markets and institutions (9th ed.). Pearson.

Philippon, T. (2015). Has the US finance industry become less efficient? On the theory and measurement of financial intermediation. American Economic Review, 105(4), 1408-1438. https://doi.org/10.1257/aer.20120578