Week 1: Banks, Money And The Credit Market Flashcards
Why is Chambar relevant?
Months have passed since they sold the last harvest, the only way farmers can buy inputs (tools) is to borrow, promising to repay at the next harvest
Farmers prefer local moneylenders vs traditional commercial bank such as JS Bank because money
lenders do not usually require farmers to set aside collateral (e.g. land)
Getting credit from a bank is not easy: more than half applications are rejected.
What is money?
Money = medium of exchange used to purchase goods or services (bank notes, deposits, crypto?)
What is Unit Of Account?
Money offers a standard measure for pricing goods and services (easy to compare)
What is Standard of Deferred Payment?
Money allows purchasing power to be transferred among people
even when payment takes place at a later date (cheque, credit card or trade finance).
What is Store of Value?
Money may preserve purchasing power over time, allowing individuals to save and defer consumption.
What is wealth?
Wealth = stock of assets owned (the value of such stock)
Example: buildings, land, machinery, debts owed to you,
capital goods – debts owed to others
What is income?
Income = The amount of money one receives over some
period of time (flow)
Example: salary, market earnings, investments (after paying
tax, it is called disposable income
Does wealth decline overtime?
Wealth declines over time due to depreciation/consumption
What is depreciation?
Reduction in the value of a stock of wealth over time (due to inflation or
market fluctuations).
What is net income?
The maximum amount that one could consume without running down wealth.
What is the formula for net income?
Net income = gross income – depreciation (assuming no tax)
What are earnings, savings and investment?
Earnings = Wages, salaries and other income from labour
Savings = Income not consumed, added to wealth via investment (bonds, shares)
Investment = Expenditure on capital goods (machinery, buildings).
What does borrowing and lending allow us to do?
Borrowing and lending allow us to rearrange our capacity to buy goods and services. There is a trade-off between consuming goods now and later, where
the opportunity cost of having more goods now is having fewer goods later
across time but constrains us to buy less later.
Time plays a crucial role in money, wealth, consumption, savings and investment
What is the interest rate?
Interest rate (r) = The price of bringing some buying power forward
in time. If r is 10% Julia can only borrow up to $91 today
Ø Repayment = principal + interest ($100 = $91 + $9)
The repayment is: Future value / (1+r) and r is the percentage of interest which is where the $91 comes from. And then the 9 comes from 100-91.
What is the Marginal Rate Of Transformation (MRT)?
MRT= Tradeoff between current and future consumption (feasible
frontier slope). The lender benefits from interest rate, if loan is repaid.
What does bringing consumption forward depend on?
Borrowing allows to bring consumption forward
How much consumption Julia will bring forward depends on:
1. Consumption smoothing
2. Impatience.
How would you smooth consumption?
Julia smoothes her consumption to avoid consuming a lot in one period and little in the other (e.g. eating a lot
today but starve tomorrow).
What is Diminishing marginal returns to consumption?
The value of an additional unit of consumption declines the
more consumption the individual has. So the interest rate causes loss of money over time.
How is slope of indifference curve and slope of feasible frontier linked?
Point F: Highest attainable indifference curve where
slope of the indifference curve = slope of feasible frontier
What is slope of indifference curve?
Slope of the indifference curve: the rate at which a consumer is willing to trade one good for another while
maintaining the same level of utility
What is Pure Impatience, Myopia and Prudence. (All linked)
Pure impatience is being impatient as a person and myopia is that people experience the present satisfaction aka consuming more now than later. And this happens due to prudence where people consume now as they might think they might not be around in the future.
Pure impatience = being impatient as a person
Myopia (short-sightedness): people experience the present satisfaction more strongly
than the same satisfaction later
Prudence: people know that they may not be around in the future so they want to
consume now
What is a discount rate?
Discount rate (ρ) = ”Rho” is a measure of a person’s impatience
How much an individual values an extra unit of consumption now over
an extra unit of consumption later
What are the alternate names for:
Slope of indifference curve
Marginal rate of substitution
Discount rate
Impatience
Slope of the indifference curve = slope of feasible frontier
Marginal rate of substitution = Marginal rate of transformation
1+ρ = 1+r
ρ = r
discount rate = interest rate
impatience = desire to smooth consumption
What does lending do?
Lending expands the saver’s feasible set, compared to
simply storing it for the future
What does investment do and what combination increases consumption in both periods?
Investment is another way to move consumption to the future.
Market risk plays a crucial role
Combination of investing and borrowing can further increase consumption in both periods. Wealth and income determine the opportunities to engage in these activities and their interest rates
What is a balance sheet?
Balance sheet as a tool to track wealth
A balance sheet summarises what the household
or firm owns and what it owes to others
Assets = Anything of value that is owned
Liabilities = Anything of value that is owed
Net worth = assets – liabilities
A loan creates both an asset and a liability on your balance sheet
How do balance sheet and wealth interlink?
Wealth or net worth does not change when you
lend or borrow
A loan adds both assets and liabilities to the
balance sheet:
- the borrowed money (cash) is an asset
- the debt is an equal liability (to be repaid)
What is a bank, and how does it make profits?
A bank is a firm that makes profits by supplying credit, investing in financial markets, and managing assets for clients. Banks borrow from households (deposits), other banks, and the central bank. They offer a variety of financial services and products. Banks make profits by paying lower interest on deposits than they charge on loans.
What is the role of a central bank?
- The central bank is the only bank that creates legal tender, money that must be accepted by law. cash (notes, coins) + commercial banks reserves (also
called base money) - The central bank is usually owned or controlled by the government through treasury/finance ministry, ensuring alignment with national economic policy goals
- Acts as the “the bank of banks” as commercial banks need to hold accounts at the central bank.
- It facilitates interbank payments, liquidity management, and monetary policy implementation
How do commercial banks make money?
Commercial banks create money through lending (making loans)
- This is called bank money ≠ legal tender
- Loans are considered a liability to the bank, not an asset
- Banks earn profits by charging interest on bank money
What’s the formula for Broad money?
Broad Money = Base Money + Bank Money
The bank physically only has 20 dollars but puts 180 into ginos bank account which he pays back so the bank ends up with 200.
Maximum deposit = 20/0.10 =200
Maximum credit = 200-20=180
What is maturity transformation?
By taking deposits and making loans, banks provide the economy with maturity
transformation (short-term borrowing vs long-term lending):
- Deposits can be withdrawn at any time
- But loans are repaid after a pre-agreed time (typically years)
What is liquidity and liquidity transformation?
Liquidity is how quickly an asset can be turned into cash.
Banks also provide liquidity transformation:
Ø Deposits are liquid
Ø Loans to borrowers are illiquid
The above exposes two risks affecting banks:
1. Default risk: loans will not be repaid
2. Liquidity risk: an asset cannot be exchanged for cash rapidly enough to prevent a
financial loss
How do banks make money, and what can cause them to fail?
Banks make money by lending more than they hold in legal tender, following central bank rules on reserves. A bank run happens when all depositors demand their money at once, and if the bank runs out of money, it may go bankrupt. Banks can also fail by making bad investments or offering loans that aren’t repaid. If a bank fails, the government may intervene with bailouts because a banking crisis can affect the entire financial system.
How do banks handle daily transactions and base money needs?
Banks make many transactions with each other daily, most of which cancel out, and settle up at the end of the day. Each bank transfers or receives the net amount of transactions. Banks need enough base money to cover these transactions. If they don’t have enough, they can borrow base money on the money market at the short-term interest rate. The demand for base money depends on transaction volumes, and the central bank controls the total supply of base money through monetary policy.
What is the policy interest rate and the bank lending rate?
Policy interest rate = interest rate on base
money set by the central bank
Bank lending rate = average interest rate
charged by commercial banks to firms and
households who borrow
How does the policy rate affect the economy?
The central bank’s policy rate affects the level of spending in the economy via the interest rate
The more it costs to borrow, the less household and firms will borrow to spend and invest
Higher interest rate → lower level of investment/spending today
What are a bank’s costs and revenue sources, and how is expected return calculated?
Bank’s costs:
• Operational costs: salaries, IT infrastructure, branch rents
• Cost of money: determined by policy interest rates via the money market
• Interest on liabilities: paying interest on deposits and other borrowings
Bank’s revenue:
• Interest and repayments from loans
• Financial products (structuring and sales)
• Transaction fees and other fees
• Investments
Expected return: The return on loans, investments, and transactions, considering default risk, market fluctuations, and transaction volumes.
What is leverage, net worth, and how does leverage apply to banks?
Leverage = Total assets / Net worth.
Net worth (or equity) = Assets - Liabilities. It’s what’s owed to shareholders and includes shares and retained profits. For banks, net worth is a small portion of the balance sheet. A negative net worth means the bank is insolvent (liabilities exceed assets).
Leverage describes a company’s reliance on debt. For banks, it’s the ratio of assets to equity (net worth). For companies, leverage is total liabilities divided by total assets.
Why is lending risky?
The relationship between the lender and the borrower is a principal–agent problem
Principal-agent = a conflict of interest between principal (lender) and agent (borrower),
about some hidden action or attribute of the agent that cannot be enforced or guaranteed in
a binding contract
Screening & monitoring are difficult: lender cannot ensure that the borrower will use the
funds in a prudent way or is going to put a lot of effort in a business project
A loan is made now and has to be repaid in the future.
How can you reduce the conflict of interest between the principal and the agent?
To reduce the conflict of interest between the principal (lender) and the agent (borrower):
Ø Equity: the lender may require the borrower to put some of her wealth into the project
1. This creates incentive to work hard to ensure the project’s success
2. It signals that the borrower thinks that the project is of sufficient quality to succeed
Ø Collateral: the borrower has to set aside assets that will be transferred to the lender if the
loan is not repaid (e.g. land, house, factory, car, yacht, arts)
House as collateral: In the UK, a 10% rise in value of real estate increases the number of start-
up businesses by 5%
What happens in a situation where someone doesn’t have equity or collateral? (Credit rationing)
Those with little or no wealth cannot provide equity nor collateral (e.g. farmers in Chambar)
Credit rationing = when those with less wealth find it difficult to borrow
Ø Credit-constrained: borrow on unfavourable terms compared with those with more wealth
(1 in 8 US families had their request for credit rejected by a financial institution)
Ø Credit-excluded: are refused loans entirely (impossible to get a loan at any interest rate)
Why would someone say there’s an inequality in lending?
People with limited wealth are credit-constrained, which limits their ability to profit from the
investment opportunities that are open to those with more assets
Inequality increases when few people are in a position to profit by lending money to others
(their wealth will grow at higher pace)
Credit-rationing increases inequality: people with limited wealth do not have the same level
of access to investment opportunities compared to those with more assets
