Topic 2: Banking, Money & Economic Growth

Question 1

Target rate of growth:

Achieved by:

Answer 1

• Grow total value of assets (goods and services) at least as fast as the population
• Achieving that requires innovation and specialisation, and therefore trade

Question 2

Money exists to..

Money is:

Answer 2

1. Money exists to facilitate trade
2. Money is:
   • Unit of Account – relative worth of different assets
   • Medium of Exchange – widely accepted in exchange for assets
   • Store of Value – scale (price) is stable and does not fluctuate materially over time
   • Money continues to evolve

Question 3

Money as a unit of account:

Answer 3

• Not a currency, just a pure bookkeeping measure
• Value is still in the physical assets (goods or services)
• Inflation / deflation in the measure is not an issue
• Market will arbitrage away inconsistency
• Trade may still be via swaps of physical assets

Question 4

Units before current form of money

Answer 4

1. Barter (friction - time & energy)
2. Commodities (friction falls vs barter, but need to agree on which commodity; quality standards, consider scarcity)
3. Coins (multiple units - change is easier, promotion (emporer), govts make money (seigniorage), bulky, require storage)

Question 5

Issues: money supply & inflation

Answer 5

1. Need sufficient currency to support trading activity and cover wealth “in transit”
2. Money supply (MS) must grow with economy and level of economic activity
3. Increasing MS faster than needed by the economy means excess inflation
4. Inflation undermines key purpose of money – to store of value
   • eg govt “printing money” to make up for a shortfall in tax revenues
   • Inflation can be brought under control, requires economic discipline and political will
   • Thus many Central Banks are independent from government

Question 6

Deflation

Answer 6

• Economic activity (trade) shrinks → profits fall → salaries are cut → prices driven downward
• If prices are falling, consumers act rationally and delay non‐essential purchases
• That reduces trade further, “death spiral” into deep recession
• Increasing MS often one part of treatment to boost the economy
• Periods of deflation less frequent than those of inflation, but often harder to solve

Question 7

Changing Money Supply (MS)

Answer 7

• Changing MS = useful tool to manage economy

* Target is a small positive inflation rate as a buffer to deflation and an incentive to invest

Question 8

Promissory Notes - origin

Answer 8

1. Merchants rented secure storage for precious metals with goldsmiths, who issued promissory notes (receipts) for these deposits
2. Traders realised the receipts were good as gold, and more convenient
3. Asset]backed paper money was born, but this was different to today’s currency:
   . Each goldsmith had their own design of receipt and there were no standard notes
   . Notes were not technically legal tender, hence could be refused
   . So some friction remained

Question 9

Fractional Reserve Banking

Answer 9

• Goldsmiths realised they could issue more receipts than total gold held
• As long as depositors didn’t demand gold back at same time, this worked
• These excess receipts were lent to borrowers (traders) for a fee, and banking was born
• Moving from a repository model to a bank model means accepting some risk, specifically the risk of a mass withdrawal (a run on the bank)
• Key is not to print too many notes, and always stay within a reserve ratio to physical assets
• These “excess” receipts are real money – commercial banks can create money from nothing
• However the friction of non‐standardised, purely private forms of money still present

Question 10

Bank Accounts

Answer 10

1. As bank notes became accepted, they too became risky to hold in bulk (fire, theft, etc.)
2. Banks were originally merchants, skilled at keeping records of transactions and balances
3. Network of trusted banks could settle transactions bank]to]bank (cheques), reducing risk
4. More like modern banking, but still a loose collection of independent private institutions

Question 11

Central Banking via Gold Standard

Answer 11

1. Central Bank oversees commercial banks, standardises design and production of currency
2. However most money no longer in physical form ] it exists only as numbers on bank records
3. A prescribed fraction of total money (cash plus account balances) held centrally as gold
4. Interbank transfer = credit + debit on corresponding banks stocks of IOUs at central bank

Question 12

Problems with Gold Standard

Answer 12

• Gold‐standard currencies will have fixed exchange rates to each other (if gold transportable)
• That reduces the options available for economic management (example: euro region!)
• Growth in stocks of gold may not match economy’s need for growth in money supply
• Periodically, the Central Bank will need to adjust the reserve ratio
• Can be a problem when more money needed quickly, for instance to combat recession
• Not specific to gold ‐ same for any currency backed by a physical asset

Question 13

Fiat Money

Answer 13

1. Cut the link to gold
2. USA dropped the gold standard in 1971,
3. In a modern economy, money is money simply because the Central Bank says that it is
4. Money still has value, but now that value is purely the result of:
   . Its legal tender status (recognised under law for the settlement of debts)
   . The economic management credibility of the Central Bank (not to create too much)
   . Central Banks can now expand and contract money supply quickly when needed

Question 14

Where does money come from?

Answer 14

1. Customer A borrows money from a commercial bank to purchase an asset from Customer B
2. Customer B then deposits the proceeds of that transaction back into the banking system
3. Collectively, the banking system repeats this process for Customers C & D, E & F, G & H, etc.
4. Each credit ]driven trade grows the system’s liabilities + assets (IOUs), and money is created

Question 15

What limits the creation of money? (4)

Answer 15

1. Demand for credit in the economy
2. Permitted levels of bank leverage
3. Risk adjusted profitability, compared with holding excess funds at the Central Bank
4. Central Bank interest rates (monetary policy) therefore helps to manage the money supply

Question 16

Negative Real Interest Rates

Answer 16

1• CBs pay interest on the reserves placed by commercial banks
2• Reserves are risk‐free as the CB can always create money to repay them
3 Lowering this rate encourages banks to “put their money to work” increasing credit supply
4• But there is a lower bound – zero per cent – or at least there was a lower bound
5• As of mid‐2016, negative depository rates in Sweden, Switzerland, Japan, and EU
– It costs banks money if they do not use surplus funds to underwrite more loans

Question 17

Risks of negative interest rates (3)

Answer 17

1– More risky lending by banks, and by other investors looking for yield
2– Asset price bubbles with social consequences (housing)
3– Outflow of retail deposits from the banking system and a “dash to cash”

Question 18

Quantitative Easing

Answer 18

1. Central Banks depository rates mostly influence short term interest rates
2. LT rates reflect long duration asset prices, and driven by economic expectations
3. QE: CBs creates new money on its books (credits) to buy LT low-risk assets (govt bonds) directly from commercial investors

Question 19

Aims of QE (3)

Answer 19

1. Increase price of assets purchased by CBs making them less attractive as investments
2. Steer funds toward more risky real economy assets of similar duration
3. Depresses LT interest rates, so increasing current spending (hopefully)

Question 20

Challenges of QE (4)

Answer 20

1. Inflationary
   - Argument is that inflation is a lesser problem than a deep recession,
   . Assets can (eventually) be sold back to private market, removing excess money
2. Creates asset bubbles
   . Price of some asset classes (real property, equities) become artificially inflated
3. Social consequences (housing), or building up for damaging correction (equities)?
4. Push to invest in riskier assets runs against the direction of post]crisis banking regulation

Question 21

1. QE = ?
2. How?
3. Why?
4. Aim to…
5. How to reverse QE

Answer 21

1. QE is the creation of new money to boost the economy. It is not the printing of money.
2. How: Purchase assets and credit the bank account of the seller with new money.
3. Why: keeps rates low to stimulate the economy
4. Aim to encourage investors to leave safe assets like bonds for riskier assets; and to stimulate lending by keeping rates low
5. Reverse QE: (ie if infl rises): central bank could sell the assets to withdraw $$

Question 22

QE: Pros
QE: Cons

Answer 22

Pro
- prevented recession: commercial banks were shrinking as balance sheets withdrew cash. Normally commercial banks would be lending. Money supply would otherwise be shrinking

Con:
- More money chasing fewer goods should create inflation

Question 23

Bank Funding Costs article

WHy are bank funding costs important

Answer 23

1. Bank funding costs are integral to the transmission of MP and the outlook for growth and inflation.
2. Financial stability (monitored as part of micro-pru supervision of indiv banks; fed into stability reviews, implications for macro-pru)

Question 24

Bank Funding Costs article
1. Pre crisis: bank funding costs moved _______ official rates
2. Post crisis: funding costs?___________
Why?

Answer 24

1. Pre crisis: bank funding costs moved in line with official rates
2. Post crisis: funding costs rose sharply relative to RF rates
   Why? Some sources of fudning evaporated

Question 25

Bank Funding Costs article

1. Structure of Balance Sheet:
2. Accounting rule

Answer 25

1. Structure of Balance Sheet: Asset stack & liability stack; or sources of funds + capital (liabilities); and use of funds (assets)
2. Assets = liabilities + capital

Question 26

Bank Funding Costs article

1. Retail vs wholesale funding
2. Secured vs unsecured funding
3. Types of secured funding

Answer 26

1. Retail vs wholesale funding
   - banks channel retail savers deposits ti HH & Cos that wish to borrow
   - wholesale investors generally demand sharper return
2. Secured vs unsecured funding
   - secured: backed by collateral - investor has recourse to collateral in event of bank failure
3. Types of secured funding
   - repo: sale and repurchase agreement. Sell govt bond, agree to buy back later at a higher price. Same as a secured loan.
   - securitisation - pooling of illiquid assets and transforming into tradeable securities

Question 27

Bank Funding Costs article

Bank costs

1. Cost of funding = ?
2. Marginal cost of funding = ?
3. Average funding cost ?

Answer 27

1. Cost of funding = price it must pay to replace its liabilities
2. Marginal cost of funding = cost of an additional unit of funding
3. Average Funding Cost = Cost on existing stock = accumulation of past flows of funding that have yet to mature

Question 28

Bank Funding Costs article

1. Net interest margin = ?
2. NIM depends on ?

Answer 28

1. Net interest margin = difference between the average price of lending and the average cost of funding
2. NIM depends on how much the marginal cost of funding rises, and how great the flow of new funding is relative to the stock of existing

Question 29

Bank Funding Costs article

Implications of 3 scenarios if funding costs increase:

1. bank absorbs higher costs
2. bank passes on higher funding
3. attempts to pass on increased cost, but there is no demand for loans at higher interest rate

Answer 29

1. bank absorbs higher costs
   - loss on all new lending. Overtime, erode capital base, threatening bank insolvency and financial stability
2. bank passes on higher funding
   - higher cost of credit reduces HH & Co income; -> lower ec activity, implications for MP. Could lead to credit losses / impact financial stability
3. attempts to pass on increased cost, but there is no demand for loans at higher interest rate
   - lower lending -> lower C, I and ec activity. MP stability impacted. Borrowers have difficulty repaying loans; profits lower as BS shrinks, capital eroded, implications for financial stability

Question 30

Bank Funding Costs article

1. Bank cost of funding reflects:
2. Decompose bank funding as:

Answer 30

1. Bank cost of funding reflects: compensation that investors and depositors demand for financing a bank’s activities
2. Decompose bank funding as:
   a) risk free component
   b) credit risk and liquidity risk premia
   c) other factors/costs (eg cross currency swaps, cost of programmes etc

Question 31

Bank Funding Costs article

How does CB policy affect bank funding costs?

Answer 31

How does CB policy affect bank funding costs?

• MP determines RF rate
• MP and macro-prudential policy affect other components of funding costs

Question 32

Bank Funding Costs article

1. Credit risk premium =
2. Liquidity risk premium =
3. Term liquidity premium =

Answer 32

1. Credit risk premium = compensation for risk that bank defaults on debt
2. Liquidity risk premium = risk that asset may not be readily converted to cash
3. Term liquidity premium = premium for the inconvenience of not being able to access funds for a longer period of time