Chapter 18 Flashcards
The main purpose of money is for buying and selling goods, services and assets. Four other important functions:
Medium of exchange = something that is acceptable in exchange for goods and service.
A means of storing wealth.
A means of evaluation.
A means of establishing the value of future claims and payments.
Financial intermediaries
the general name for financial institutions which act as a means of channeling funds from depositors to borrowers.
Financial intermediaries, Five services:
Expert advice.
Expertise in channeling funds. (return rate, risks, increase allocative efficiency)
Maturity transformation = the transformation of deposits into loans of a longer maturity.
Risk transformation = the process whereby banks can spread the risks of lending by having a large number of borrowers.
Transmission of funds.
Two types of banks:
Retail banking
Wholesale banking
Retail banking
branch, telephone, postal and internet banking for individuals and businesses at published rates of interest and charges. Retail banking involves the operation of extensive branch networks.
Wholesale banking
where banks deal in large-scale deposits and loans, mainly with companies and other banks and financial institutions. Interest rates and charges may be negotiable: wholesale deposits and loans = large-scale deposits and loans made by and to firms at negotiated interest rates.
In the past there were many wholesale banks that were known as investment banks.
Functional separation
the ring-fencing of retail and wholesale banking. The core activities of retail banking needed isolating from the potential contagion from risky wholesale banking activities.
Monetary financial institutions (MFIs)
deposit-taking institutions including banks, building societies and the Bank of England. MFIs also lend and borrow wholesale funds to and from each other, and deposit with and borrow from the central bank.
Money market
the market for short-term debt instruments, such as government bills, in which financial institutions are active participants.
Banks and building societies provide a range of financial instruments
financial products resulting in a financial claim by one party over another.
Liabilities
all legal claims for payment that outsiders have on an institution.
Liabilities, Five types:
Sight deposits
Time deposits
Certificates of deposits
Sale and repurchase agreements (repos)
Capital and other funds.
Sight deposits
deposits that can be withdrawn on demand without penalty. (current accounts)
Time deposits
deposits that require notice of withdrawal or where a penalty is charged for withdrawals on demand.
Certificates of deposits
certificates issued by banks for fixed-term interest-bearing deposits. They can be resold by the owner to another party.
Sale and repurchase agreements (repos)
an agreement between two institutions whereby one in effect borrows from another by selling its assets, agreeing to buy them back at a fixed price and on a fixed date.
One of the major assets to use in this way are government bonds > gilt-edged securities or simply gilts.
Assets
possessions or claims made on others.
Short term loan
Market loans
Money lent at call (reclaimable on demand or 24 hours)
Money lent for periods up to one year
CDs
Bills of exchange
Bank bills
Reverse repos
Market loans
made primarily to other financial institutions.
Bills of exchange
certificates promising to repay a stated amount on a certain date, typically three months from the issue of the bill. Bills do not pay interest as such but are sold at a discount and redeemed at face value, thereby earning a rate of discount for the purchaser > discount market.
To companies are called commercial bills.
To the government are called treasury bills.
Bank bills
bills that have been accepted by another financial institution and hence insured against default.
Reverse repos
gilts or other assets that are purchased under a sale and repurchase agreement. They become an asset to the purchaser.
Gearing or leverage
the ratio of debt capital to equity capital.
Co-ordination failure
when a group of firms acting independently could have achieved a more desirable outcome if they had coordinated their decision making.
Long-term loans
Fixed term
Overdrafts
Outstanding balances on credit card accounts
Mortgages.
Bank levy
a tax on the liabilities of banks and building societies operating in the UK.
Liquidity
the ease with which an asset can be converted into cash without loss.
Maturity gap
the difference in the average maturity of loans and deposits.
Liquidity ratio
the proportion of bank’s total assets held in liquid form.
The most common method for the sale of assets has been through a process known as securitization
where future cash flows are turned into marketable securities, such as bonds. The sellers get cash immediately rather than having to wait and can use it to fund loans to customers. The buyers make a profit by buying below the discounted value of the future income. Such bonds can be very risky, however, as the future of cash flows may be less than anticipated.
Special purpose vehicle
legal entity created by financial institutions for conducting specific financial functions, such as bundling assets together into fixed interest bonds and selling them.
These bonds are known as collateralized debt obligations
these are a type of security consisting of a bundle of fixed income assets.
Dangers of secondary marketing:
Lead to lower national liquidity ratio > an excessive expansion of credit in times of economic boom.
Increased danger of banking collapse.
Sub-prime debt = debt where there is a high risk of default by the borrower.
Macro-prudential regulation
regulation which focuses not on a single financial institution but on the financial system as a whole and which monitors its impact on the wider economy.
Liquidity coverage ratio
requires that financial institutions have high quality liquid assets to cover the expected cash flow over the next 30 days
Net stable funding ratio
the ration of stable liabilities to assets likely to require funding.
Liability side > stable funding
Assets side > required funding
Banks will need to hold a NSFR of at least 100%.
Central bank
banker to the banks and the government. It oversees the banking system, implements monetary policy and issues currency.
Operational standing facilities
central banks facilities by which individual banks can deposit reserves or borrow reserves. They are designed to provide banks with excess or surplus reserves an incentive to trade them with other banks.
Reserve averaging
the process whereby individual banks manage their average level of overnight reserves between MOC meetings using the Bank of England’s operational standing facilities and/or the inter-bank market.
Quantitative easing
a deliberate attempt by the central bank to increase the money supply by buying large quantities of securities through open-market operations. These securities could be securitized mortgage and other private-sector debt or government bonds
Discount market
the market for corporate bills and treasury bills whose initial price is below the redemption value. The rate of discount depends on demand and supply in the discount market.
Rediscounting
buying bills before they reach maturity.
Lender of last resort
the role of the BoE as the guarantor of sufficient liquidity in the monetary system.
The monetary base
notes and coin outside the central bank. It gives us very poor indication of the effective money supply.
The most usual measure that countries use for money supply is broad money
cash in circulation plus retail and wholesale bank and building society deposits.
Bank deposits multiplier
the number of times greater the expansion of bank deposits is than the additional liquidity in banks that causes it: 1/l (the universe of the liquidity ratio).
There are four major complications to the creation of credit:
- Bank’s liquidity ratio may vary
Banks may choose a different liquidity ratio.
Customers may not want to take up the credit on offer - Banks may not operate a simple liquidity ratio. Near money assets = highly liquid assets (other than cash)
- Some extra of the extra cash may be withdrawn by the public. If extra cash comes into the banking system, and as a result extra deposits are created, part of them may be held by households and non-bank firms (known as non-bank private sector = households and non-bank firms. In other words, everyone in the country other than banks and the government) as cash outside the banks.
So, some extra cash leaks out of the banking system. This resuts in an overall multiplier effect which is known as the money multiplier = the number of times greater the expansion of money supply is than the expansion of the monetary base that caused it: ΔMs/ΔMb. - The broad money multiplier in the UK.
ΔM4/ΔMb, where Mb in this case is defined as cash in circulation with the public plus banks’ interest-bearing deposits at the BoE.
Another indicator is the ratio of the level of M4 relative to the level of cash in circulation with the public and banks’ reserve accounts at the central banks.
Money supply can change for a number of reasons:
Central bank action: i.e. create extra money when stock of money is too low, and this is keeping up interest rates and restraining spending in the economy.
Banks choose to hold a lower liquidity ratio > surplus liquidity.
The non-bank private sector chooses to hold less cash. The extra cash held in deposits allow banks to create more credit.
An inflow of funds from abroad
A public-sector deficit. It is the difference between public-sector expenditure and public-sector receipts. Public-sector net cash requirement (PSNCR) = the annual deficit of the public sector and thus the amount that the public sector must borrow. In general the bigger the deficit, the greater will be the growth in money supply.
Flow-of-funds equation
the various items making up an increase (or decrease) in money supply.
Three reasons why people want to hold their assets in the form of money
The transaction motive.
The precautionary motive
The speculative or asset motive.
In a free foreign exchange market, equilibrium will be achieved by changes in the exchange rate. Assume that the money supply increases. This has three direct effects:
Part of the excess money balances will be used to purchase foreign assets. This will lead to an increase in the supply of domestic currency coming on to the foreign exchange markets.
The excess supply of money in the domestic money market will push down interest rates. This will reduce the return on domestic assets below that on foreign assets. This will lead to an increased demand for foreign assets and thus an increased supply of the domestic currency on the foreign exchange rate. It will reduce the demand for domestic assets by those outside the country.
Speculators will anticipate that the higher supply of the domestic currency will cause the exchange rate to depreciate. They will therefore sell domestic currency and buy foreign currencies before the expected depreciation takes place.
