Chapter 14 Flashcards
4 parts of a financial system
- money
- financial martkets
- banks
- financial institutions and instruments
Factors that increase effectiveness of financial system
- Greater investor participation
- Competition amongst institutions
- Lower costs
- Correct security pricing
- Fair play in trading
Financial markets
Trade instruments to determine prices of securities and enable allocation of capital
Financial instruments
Share and bonds transfer resources from savers to investors
Financial institutions
Financial products and services that act as financial intermediaries
Regulatory authorities
Protect investors by enforcing rules and encourage participation in financial markets
4 changes to Western financial systems
- Financial integration - financial markets in neighbouring, regional, or global economies are closely linked.
- Globalisation - countries are interconnected by trade links
- Deregulation - increasing competition by decreasing intervention
- Financial innovation - creating new investment products
5 services provided by financial intermediaries
- Expert advice
- Expertise in channelling funds
- Maturity transformation (tranfering funds from short-term savers to long-term borrowers)
- Risk transformation (spreading risk)
- Transmission of payments (cheques/ATMs etc)
Role of retail banks
Banking for individuals at published rates of interest and charges
Role of wholesale banks
Large scale deposits and loans - often with other banks/companies. Interest rates can be negotiable
Role of building societies
Specialise in mortgages - also provide retail banking services for customers
Retail bank liabilities
- Sight deposits (money that can be withdrawn immediately without consequence)
- Time deposits (notice of withdrawal is required)
- Certificates of deposits CDs (issued by banks, tradeable, interest bearing deposits)
- Sale and repurchase agreements Repos (agreement between two institutions, one to borrow by selling assets to the other, then the other will buy them back at a fixed date and price)
- Capital and other funds
Retail bank assets
- Cash
- Deposits at central bank (reserve balances and cash ratio deposits
- Short term loans (market loans/bank and treasury bills/reserve repos)
- Long-term loans (overdrafts, mortgages, credit cards)
- Investments (government bonds or gilts)
Liquidity
Ease by which an asset can be converted to cash without loss
Liquidity ratio
Proportion of a banks assets held in liquid form
Maturity gap
Difference in average maturity of loans and deposits
- -Big gap big profit
- -Big gap small liquidity
Bank and liquidity conflict
Banks want to lend long-term (more profitable)
Customers want cash (so they need liquid assets)
Must balance profitability (low liquid) and avoiding being unable to meet demand (high liquid)
Secondary marketing
Sale of assets before maturity
Securitisation
Pooling assets (eg mortgages and loans) and selling securities (e.g. bonds) backed by the assets
Special purpose vehicle
legal entity created by financial institutions for a specific function (e.g. securitisation)
Collateralised debt obligation
Fixed-income bond backed by range of assets (eg corp bonds, mortgage debt, credit card debt)
Sub-prime debt
debt with high risk of default by borrowers (sub-prime mortgages)
Capital adequacy
Measure of banks capital relative to assets (assets weighted according to risk)
Capital adequacy ratio
Banks capital (ie reserves and shares) divided by risk-weighted assets
Why can securitisation lead to moral hazard
Securitisation reduces cash flow risk facing investors. It enables originator banks to pass risk of default onto buyers of CDOs. Encourages banks to offer higher income multiples, and/or higher loan values, increasing the over all risk of default
Potential negatives of securitisation
- Lower liquidity ratio - expansion of credit therefore asset bubbles
- moral hazard - banks take greater risk for lending
- Systemic risk of banking collapse - fortunes of banks are intertwined
Functions of the central bank
- Issuer of notes
- Banker to government
- Operator of gov monetary policy
- Acts as liquidity backstop (provides liquidity)
- Overseer - ensures other banks and financial institutions maintain adequate liquidity
- Operator of country’s exchange rate policy
Capital market
Long-term debt instruments can be bought and sold here
Money market
short-term loans between banks, government and industry. Contains: discount and repo markets (treasury bills and corp bills), and parallel money markets (CDs, foreign currency)
Lender of last resort
BoE. - Guarantor of sufficient liquidity in the monetary system. Banks can sell gilts to the BoE (in exchange for cash) and buy them back at a later date (repo agreement)
Or sell BoE treasury bills before they mature (at a price below face value) (rediscounting)
Asset bubble
Asset price increases rapidly over a short period of time (normally because of speculation) - these bubbles can burst and the asset price falls dramatically.
Banking crisis
Occurs when a bank (or a number of) fail or are close to failure.
What causes a banking crisis
Asset bubbles. Banks lend to investors in the asset expecting the rise to continue. This is not the case and the bubble collapses. Falling prices lead to losses for investors and undermine confidence in the banks. Consumers will then remove their money from banks causing collapse.
Financial Market Contagion
Spread of financial difficulties between banks (one has it and the others sort of catch it). Banks sell assets to pay back investors, which forces the price of the asset down (as there is large supply.) This has a knock on effect because each banks that also hold these assets are forced to sell them at reduced rates and then run into difficulties.
Factors affecting a country’s ability to respond to a banking crisis
Having good economic conditions. Healthy government finances. This is only effective because it allows normal economic policy to minimise economic shocks.
Failings of classic economic policy
Assumes humans make decisions rationally.
Four main functions of money
- A medium of exchange
- A means of storing wealth
- A means of evaluation
- A means of establishing the value of future claims and payments
Monetary base
(Or narrow money) is notes in circulation outside the central bank
Broad money
Cash in circulation plus retail and wholesale bank and building society deposits
Bank deposit multiplier
Number of times greater the expansion of banks is than the additional liquidity in banks that causes it (1/L where L is the liquidity ratio)
Money multiplier
Number of times greater the expansion of money supply is than the expansion of the monetary base that caused it
