banking Flashcards
Benefits of banks (4)
- One major reason is that they act as intermediaries between people who save money and people who need to borrow money.
- Value of Financial Intermediaries: Financial intermediaries, like banks, provide several benefits. They help spread out risks (diversification) and can gather and process information more efficiently due to their scale.
- Maturity Transformation: This is about how banks handle different time frames for money. Savers can deposit money into banks and can withdraw it whenever they need (short-term). Banks, in turn, use these deposits to fund loans for longer-term projects by firms.
- Bank Deposits vs. Direct Equity: Bank deposits offer savers more immediate access to their money compared to investing directly in companies through stocks (equity). This ease of access is valuable to society.
Tell me about short-term liquid investments
- This type of investment has a zero rate of return, meaning it doesn’t earn any extra money.
- It’s available between periods 0 and 1, and periods 1 and 2.
- Examples include holding onto cash, reserves, or government bonds ( for safety and stability)
Tell me about long-term illiquid investment
- This investment offers a positive return over a long period.
- Investing one unit of wealth in period 0 gives a payoff of 1 + R in period 2, where R > 0 represents the total return over the two time periods.
- If you abandon the investment in period 1, you only get back the initial funds, resulting in a zero return.
- In reality, you might not recover everything if you abandon the investment in period 1, but for simplicity, the model assumes full recovery.
what do central banks do
- CB is banker to commercial banks and financial institutions
- Clearing house for inter-bank payments, settled with CB money
- CB has regulatory/supervisory role for commercial banks
- Can impose reserve requirements (minimum ratio of reserves to customer deposits), or a minimum liquidity coverage ratio (sufficient
liquid assets to cover deposit outflows for some time) - Most prominent role of CB is conducting monetary policy
- Raising/lowering interest rates, quantitative easing/tightening (QE/QT)
What are the effects of open-market operations?
When the central bank (CB) buys assets, it pays banks with newly created reserves, expanding both sides of its balance sheet.
For example, quantitative easing (QE) involves outright purchases of assets like mortgage-backed securities in the US.
The CB’s balance sheet shrinks when assets mature and it receives repayment, reducing outstanding liabilities.
Quantitative tightening (QT), as implemented by the Federal Reserve, involves selling assets before maturity and receiving payment in CB money.
Some open-market operations, like repos (repurchase agreements), reverse faster than outright purchases. Repos involve selling an asset (e.g., government bond) with an agreement to buy it back later at an agreed price. This effectively functions as a secured loan, with the difference between the repurchase price and the sale price serving as the interest rate. In these operations, the central bank buys an asset and pays with new reserves, agreeing to sell the asset back later and receive payment in reserves.
What are standing facilities
Through the “discount window” or borrowing facility, banks can borrow reserves from the central bank at an interest rate denoted 𝑖𝑏.
Loans are backed by collateral, typically government bonds.
The interest rate 𝑖𝑏 is set by the central bank and is usually higher than market rates, acting as a penalty.
These facilities serve as a liquidity source during shortages, making the central bank the “lender of last resort.”
They may be designed for regular or emergency use, with emergency loans often carrying a stigma.
Additionally, central banks may pay interest, denoted 𝑖𝑟, on banks’ reserve balances. Traditionally, no interest was paid (𝑖𝑟 = 0), but this has changed in recent decades.
The central bank then provides the loan, with the government bonds serving as security. If the commercial bank fails to repay the loan, the central bank can seize and sell the government bonds to recover the outstanding amount.
overnight reverse repo meaning
Central bank operations are generally similar across institutions like the Federal Reserve (Fed) and the European Central Bank (ECB), but there are some differences in terminology and practices.
For the U.S. Federal Reserve, there are specific aspects to note:
Not all institutions with reserve accounts are eligible to receive interest.
Some financial institutions cannot hold reserve accounts.
To address this, there’s an overnight reverse repo (ON RRP) facility available to a wider range of financial institutions.
Through ON RRP, the Fed sells government bonds to a counterparty with an agreement to repurchase them the next day. If the repurchase price is higher, it’s effectively like earning interest.
The U.S. government also has an account at the Fed called the Treasury General Account (TGA), which can hold large and volatile funds, especially during events like the Covid pandemic or debt ceiling negotiations.
what does the interbank market do
The interbank market involves unsecured short-term loans of reserves between banks, with an interest rate
Tell me how inter banking transactions work
There may also be regulatory requirements like reserve requirements and liquidity coverage ratios.
If a bank anticipates insufficient reserves, it can borrow more from other banks in the money markets. Conversely, if reserves are excessive, it can lend to others.
Overnight loans of reserves come with an interest rate denoted 𝑖.
Banks avoid borrowing if the market interest rate 𝑖 is higher than the central bank’s lending rate (𝑖𝑏), as borrowing from the central bank is cheaper, assuming there’s no stigma.
Banks aim to borrow as much as possible if 𝑖 is lower than the interest rate paid by the central bank (𝑖𝑟), to take advantage of arbitrage opportunities.
Banks only lend reserves if the market interest rate 𝑖 is higher than the interest rate paid by the central bank (𝑖𝑟), as they need to be compensated for giving up control of liquid assets that might be needed before the loan matures.
The total demand for reserves falls as the borrowing cost (interest rate 𝑖) increases.
what is arbitage opportunities
Arbitrage opportunities refer to situations where an investor can simultaneously buy and sell assets in different markets or forms to profit from differences in prices or interest rates. The goal is to exploit these differences to make risk-free profits. In the context of banking and financial markets:
Interest Rate Arbitrage: This involves borrowing at a lower interest rate and lending at a higher interest rate, taking advantage of the interest rate differential. For example, a bank might borrow funds at a lower overnight rate and then lend those funds at a higher rate in the interbank market, profiting from the spread.
How does the traditional system work
here’s no interest paid on reserves, so 𝑖𝑟 = 0.
Changes to the market interest rate (𝑖∗) are achieved through open-market operations, which shift the reserve supply curve (𝑅𝑠).
The exact shape and position of the reserve demand curve (𝑅𝑑) are not precisely known, making it harder to control the market interest rate (𝑖∗).
The use of the discount window is discouraged due to the associated stigma.
corridor system
Reserve demand depends on the market interest rate (𝑖) relative to the interest rates paid on reserves (𝑖𝑟) and charged on loans of reserves (𝑖𝑏).
Changes to the market interest rate (𝑖∗) are achieved by making equal changes in the administered standing-facility interest rates (𝑖𝑟 and 𝑖𝑏).
This causes a parallel vertical shift of the reserve demand curve.
The administered standing-facility interest rates are typically set at 𝑖𝑟 + 0.25% and 𝑖𝑏 + 0.25%, creating a corridor around the target market interest rate (𝑖∗).
These adjustments precisely change 𝑖∗ without the need for open-market operations.
The central bank saturates money markets with reserves, ensuring abundant liquidity.
The reserve supply curve (𝑅𝑠) is shifted to the right, intersecting the reserve demand curve (𝑅𝑑) close to or at the interest rate paid on reserves (𝑖𝑟).
The central bank typically sets the interest rate on reserves (𝑖𝑟) slightly above the lower bound of the corridor, such as 𝑖𝑏 + 0.25%.
When the market interest rate (𝑖∗) needs adjustment, it can be implemented by changing 𝑖𝑟 directly.
