Money and Banking Flashcards
Money =
- Assets that people are generally willing to accept in exchange for goods and services or for payment of debts.
- Money is an asset that can be used as a medium of exchange, unit of account, store of value (& standard of deferred payment).
Asset =
- Anything of value owned by an entity (a person, a firm, or an organization).
- Money is one of many types of (financial) assets.
Narrow definition of money:
Currency & M1.
- Currency: Notes and coins held by the non-bank private sector (i.e. excluding banks, the RBA, the state and federal governments).
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M1: Currency + the value of all demand deposits with banks operating in Australia.
- Demand deposits: deposits in financial institutions (FIs) that are transferrable by cheque, by debit card and via electronic transfers between accounts.
Broad definitions of money:
- M3: M1 + all other deposits (e.g. term deposits) with banks operating in Australia.
- Broad money: M3 + deposits into non- bank deposit-taking institutions less holdings of currency and deposits of non- bank depository corporations, such as finance companies, money market corporations and cash management trusts.
Bank’s balance sheet:
For our purpose, the five most relevant items on a bank’s balance sheet are: equity, deposits, loans, reserves and securities.
- Reserves: The cash that a bank keeps in its vault or its deposits with the central bank (CB).
- Reserve Ratio: A bank’s reserves to deposits ratio.
Liquidity =
Liquidity refers to how easy it is for an asset to be sold for or converted into cash without a price cut.
- Cash is, by definition, the most liquid asset.
- Saving deposits are highly liquid as people can withdraw them as cash at any time.
- Term deposits are less liquid than saving deposits.
- Governmen__t bonds (especially short term bonds) are typically more liquid than corporate bonds.
Why Reserves?
- Banks hold reserves because they are the most liquid assets amongst all bank assets.
- hey can be used by banks to meet their obligations when funds are withdrawn.
- If a bank does not have enough cash to meet fund outflows, it will be forced to sell its (non-liquid) assets quickly even when the prices are not good, or to borrow from the CB or other banks at a cost.
- So maintaining sufficient reserves is important for banks’ liquidity management.
Bank Vulnerability:
Fractional banking system: banks only keep a small fraction of deposits as liquid assets to meet daily withdraw demand.
- Banks are inherently vulnerable to bank run even if they are solvent.
- A bank run happens when many of the bank’s depositors want their money back at the same time.
- This happens when depositors think the bank is insolvent, and try to be the first one to get their money out.
Equity and Solvency:
Total assets = total liabilities + shareholders’ equity
Shareholders’ equity = the bank’s net worth
- If total assets < total liabilities
- bank’s net worth < 0
- the bank is insolvent and should enter bankruptcy.
Bail-out and Bail-in:
When banks become insolvent there are basically three options:
- Bankrupt: e.g. Lehman Brother in 2008.
- Bail-out: external investors inject new capital, (e.g. the UK government injected a total of £37bn into Royal Bank of Scotland, Lloyds TSB and HBOS in 2008).
- Bail-in: banks’ creditors (i.e. bond holders and depositors) convert their loans into shares.
Reserve Ratio & Deposits:
- Reserve-to-deposit ratio is also known as reserve ratio.
- These formulas apply to individual bank as well as the banking sector as a whole
Central Banks can influence money supply through:
- Open market operations
- Reserve requirement ratio (but no all CBs impose it on banks)
Reserve-to-Deposit Ratio:
- When the CB lowers the required reserve-to-deposit ratio, banks can keep less of its deposits as reserves and make more loans; as a result, investment and consumption increase.
- When the CB raises the reserve-to- deposit ratio, banks have to keep more of its deposits as reserves and make less loans; as a result, investment and consumption decrease.
Financial institutions (FIs) create money when…
They make loans (or credit in general).
- Since the simple deposit multiplier is bigger than one, making loans is how most money was created.
Simple Deposit Multiplier:
An initial injection of liquidity (i.e. reserves) by a CB into the banking sector will eventually lead to a much larger increase in deposits and thus money supply.
- This is called money multiplication.
Quantity Theory of Money (QTM):
The QTM connects between the quantity of money and the price level:
