2. Financial Markets & Monetary Policy - Commercial & Investment Banks

Question 1

What are commercial banks?

Answer 1

Commercial banks are financial intermediaries - high street banks.

Question 2

What are the functions of a commercial bank?

Answer 2

They accept savings and give out loansThey allow payments from one agent to another - you can transfer funds to other accounts.They provide financial advice to clients.

Question 3

What is the nature of commercial banking?

Answer 3

It is fairly simple, and not particularly risky but then it is not massively profitable either.

Question 4

What are investment banks?

Answer 4

Investment banks are financial intermediaries that engage in proprietary trading - banks like JP Morgan Chase.

Question 5

What is proprietary trading?

Answer 5

This is when banks take excess capital that they’re sitting on and invest it in an attempt to get better returns.

Question 6

What are the functions of an investment bank?(NOT CRUCIAL - NOT RLLY ON SPEC)

Answer 6

They ensure markets exist - provide a place where bonds and shares can be bought and soldAdvice on mergers & acquisitions - they provide banks with advice on when to merge, the paperwork, due diligence and media management of mergersPublicising new issue bonds - they publicise bonds on the half of the issuerUnderwriting - the bank may buy a companies bonds (bc no one else will) then sells them on in the secondary market - then charge the company a % of the costs.

Question 7

What is a balance sheet?

Answer 7

A balance sheet is a financial record of all assets, liabilities and capital at a given point in time.

Question 8

What are assets?

Answer 8

Anything of value that the commercial bank owns.

Question 9

What are liabilities?

Answer 9

Anything of value that the commercial bank owes.

Question 10

What is capital?

Answer 10

A section within the the liabilities part of the balance sheet - made up of 2 parts;1. Shareholder funds2. Retained profits (reserves)

Question 11

Why are balance sheets important?

Answer 11

Because they give an idea of the health of the business and liquidity of assets etc.

Question 12

Why must balance sheets always balance?

Answer 12

It must always balance because Assets = Liabilities + Capital - if a banks assets were < Liabilities + Capital the bank would owe more than it owns meaning it will fail.

Question 13

What would a commercial banks balance sheet look like?(complete)

Answer 13

Assets: Liabilities:Reserves DepositsLoans Bonds Capital

Question 14

What are the objectives of commercial banks?

Answer 14

There are three key aims for commercial banks:1. Profitability2. Liquidity3. Security

Question 15

How does the bank attempt to achieve profitability?

Answer 15

The bank will engage in fractional reserve banking. They will charge borrowers at a greater rate of interest than they will give savers in the form of returns for deposits. The difference therefore becomes profits.

Question 16

How does the bank attempt to achieve liquidity?

Answer 16

The banks will purchase financial assets that are fairly easy to convert into cash - s-term bonds for instance.Most liquid asset = cashMost illiquid asset = l-term bonds or other investments.

Question 17

How does the bank attempt to achieve security?

Answer 17

The bank will balance the assets it purchases so that it has a balance of liquid and illiquid assets and a certain level of reserves - protects against large, unpredicted withdrawals being made. The bank will also balance the returns on financial assets with the risk associated with them.

Question 18

What is the reserve ratio?

Answer 18

The reserve ratio is the required quantity of deposits banks must hold as cash reserves, the rest they can lend out. This only exists in the US and is at 10% currently, it acts to help banks achieve security.

Question 19

What is the concept of systemic risk?

Answer 19

In todays banking system investment and commercial banking are usually done together by one institution. This creates the possibility of systemic risk, if an institution starts taking money made from commercial banking and investing it to make money any risky investments that don’t work will negatively effect both the commercial and investment banking areas. This is systemic risk.

Question 20

What possible conflicts are there between the objectives of commercial banks?

Answer 20

Banks want security and profitability - this is a conflict bc the riskiest investments are the ones with the highest yields.Banks want liquidity and profitability - this is a conflict bc the most liquid assets like cash are the ones that offer the lowest yields.

Question 21

How do banks create credit?

Answer 21

Through the money multiplier effect.

Question 22

What is the money multiplier effect and how does it work?

Answer 22

This is the process in which a single deposit to a bank actually increases the money supply by proportionally more than original deposit itself.It works in the following way:1. If £100 is deposited £10 is kept and £90 is loaned out2. The £90 lent out is is eventually deposited by someone else, £81 is loaned out and £9 kept3. This process continues, as you can see the combined increase in money supply is £90 + £81 …4. So a £100 deposit actually leads to a proportionally greater increase in the money supply5. The formula for the money multiplier effect is;(1 / Reserve Ratio) x 100 (10% rr = 0.1 in equation)NOTE: IF CALCULATING INC. DICARD INITIAL DEPOSIT

Question 23

Is the money multiplier effect sustainable?

Answer 23

The mm effect is sustainable and will continue to work while people have faith in the financial system - if everyone goes to the bank demanding their money at once the banks will fail as they don’t have the money to give out - known as a bank run - happened to Northern Rock.