Lecture 2b - Basic Concepts And Ideas

Question 1

Confidence

Answer 1

“The whole basis of all these banking operations rests on confidence on the part of the general public”

Risk adverse households allow their funds to be banked when confident in the security on these funds. Such savings need to be more secure than hoarding.
It was argued that if households lack confidence there would be no funds available for industry.

Question 2

Continued…

Answer 2

Firms seek confidence for future investment plans

Firms must be confident in the integrity of the payments mechanism

Households and firms want to know that they will be able to get access to funds when it suits them.

Question 3

Continued again…

Answer 3

Financial institutions have far less funds actually available in cash then would be necessary if everyone wanted their funds withdrawn.

There has to be a balance between liquid and illiquid funds.

Bank runs.

Question 4

Contagion

Answer 4

“A bank run is obviously bad for the bank involved, but it need not have much effect on the economy.
However, a banking panic - a run on the banking system as a whole is another matter.”

Question 5

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Answer 5

“Given the way bank runs work, there is a tendency for a run on one bank to precipitate runs on others. In addition, a failure or a run in a single bank can heighten awareness of potential problems, causing depositors to jump ship more readily, just as drivers are more careful after passing an accident.”

Question 6

Assets

Answer 6

So that households feel secure and confident in the access to their funds, these are presented as assets held on the households behalf by the financial intermediaries

As opposed to their funds simply being given over directly to the firms

Question 7

Asset

Answer 7

“Any object, tangible or intangible, that is of value to its possessor.”

“Any piece of property, the ownership of which provides a flow of benefits over time.”

Question 8

Assets as Liabilities

Answer 8

Financial intermediaries create assets for household funds placed with them

• by depositors or investors

These funds are assets for depositors & investors, but are liabilities for the financial institutions

“Liability: a debt owed to someone else”

Question 9

Deposits

Answer 9

Funds placed with a financial institution become a debt owed by that institution to the original funds holders

The issue of confidence relates to the belief that the institution can pay its debts when required to, possibly on demand

Question 10

Institutions’ Assets

Answer 10

The money or funds deposited with an institution are its liabilities

It’s assets, from our devious definition provide “a flow of benefits over time”

Thus we need to identify where institutions gain these “benefits”

Question 11

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Answer 11

As intermediaries, they would take funds in from households and give funds out to firms,

The difference between these two flow of funds could then be equated to their income

However, this difference between flows would not itself be an asset.

Question 12

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Answer 12

An institution needs assets to balance against the liabilities it has created

Therefore the funds it lends are seen as assets considered against the liabilities of the funds it receives

Question 13

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Answer 13

Funds lent to firms are repaid with interest in the original sums

These are viewed as income and thereby assets for the lender

Initially, there will be a balance between institutions’ liabilities and assets

Question 14

The creation of assets

Answer 14

Once a financial system becomes relatively sophisticated

• so that payments can be made by non- money means,

Institutions can lend more than they have borrowed

Assets > Liabilities

Question 15

The creation of assets

Answer 15

The overall balance of liabilities tends to remain at a constant level

Loans given out are mostly repaid into other chequing accounts

Loans are given out for which there is no direct corresponding borrowing by the institution

An asset is created for which there is no direct corresponding liability

Question 16

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Answer 16

“The final stage is reached when the banker, in view of his accumulated notes and gold, lends, by placing in his books the name of someone who has made no deposit, with a definite sum to his credit, as if he were a depositor”

Question 17

The balance sheet

Answer 17

A financial institution creates a balance sheet that accounts for its assets and liabilities

As it makes loans and creates money the balance sheet expands

“But the ratio of operational balances to total assets/liabilities is falling”