Financial Intermediation and Banking Theoretical Foundations

Financial Intermediation and BankingTheoretical Foundations
Prof. Santosh Sangem

XLRI, Finance Area
Commercial Banking Sessions 1-8, BM 2011-13.
Why Study Commercial Banks?

Most regulated of all financial entities Bank deposits a widely used form for settling economic obligations. Also widely misunderstood
Banks are Dinosaurs .(Bill Gates, quoted in O Sullivan, 1996) The banking industry is dead, and we ought to just bury it (Dick Kovacevich (CEO, Norwest), quoted in Davis,1999) The Banking Sector is becoming irrelevant economically and its almost irrelevant politically (William Isaac, Former Chairman, FDIC; quoted in Boyd and Gertler (1994))

Prominent role of banks in almost all major financial crises during twentieth century
The U.S. Banking Panic of 1907 The Great Depression Savings & Loan Crisis of the 1980s Continental Illinois Bank Failure of 1984 Asian Financial Crisis of 1997-98 The Sub-Prime crisis/Credit crisis of 2007-

Costs of Banking Crises
Direct costs of restructuring banking sector Lowered GDP growth Estimates of impact from 5% of GDP to 300% of GDP Banking crises accompanied by crises in other parts of financial system and currency crises
A Paradox
Economic booms and claims of growing irrelevance of banks in modern economies
Some Typical Issues

Are banks special or not??? Banks and external macro-environment Regulation as the provider of incentives/disincentives Deposit Insurance and Capital Maintenance requirements Liquidity Maintenance & Management Risk Management & Financial Innovation Off- Balance Sheet Activities of Banks & Securitization Excessive Risk Taking and Bank Failures
Banks are Financial Intermediaries

Banks and Non-Financial Firms

Both finance themselves through equity and borrowed funds Both invest funds raised in income generating assets Surplus over expenses paid to providers of capital Too many similarities on the surface. But are they really similar? A closer look at balance sheet composition

Assets Manufacturing Banks Firms (% of Total Assets) 50%-60% 10%-20% 20%-40% (incl. in Current Assets) 3%-5% 25%-30% 40%-60% 3%-5% 5%-10%
Net Fixed Assets Investments Current Assets Loans & Advances Reserve Balances with Central Bank Inter-Bank Balances

Liabilities Manufacturing Firms Banks (% of Total Assets) 40%-50% 5%-10% 30%-40% 10%-25% 15%-20% 0%-5% 0%-10% 75%-90% 200%-400%
Net Worth Long-Term Borrowed Funds Short-Term Borrowed Funds & Current Liabilities Deposits from Customers Contingent Liabilities

Financial Assets as Major Component of Bank Assets Loans as Primary Assets High Financial Leverage Low Net Worth Deposits as Primary Source of Bank Funds Typically interest cost of deposits is much lower than cost of borrowed funds for manufacturing firms Inter-Bank Balances and Reserve Balances

Much higher financial risks of banks relative to other firms Business of Banking Taking up a variety of financial risks to make profits Reducing Financial Risks through reduction of leverage Reduction of Profitability Importance of Off-Balance Sheet Transactions for Banks
What is Financial Intermediation

Intermediaries as third parties Financial intermediaries (FIs) intermediate between providers and users of capital Some FIs use their resources to borrow from the providers of capital and lend to users of capital FIs as providing valuable services to both providers and users of capital Which services do they provide? Why are they able to provide these services? Are these really useful for both providers and users of capital?
Direct Finance
Direct finance a transaction between provider and end-user of capital Both meet and exchange funds for financial assets
Flow of Funds Lenders (surplus budget unit) Primary Security Borrowers (deficit budget unit)
Issues with Direct Finance

Direct finance an expensive means of transacting for savers and borrowers Total information collection and processing = 2N2 Lesser extent of diversification for savers and borrowers Liquidity risk for savers An intermediary to collect, process, and match requirements (A broker) Total number of transactions = 2N Savings equivalent to 2(N2 N) * cost per transaction The screening function of financial intermediaries
Issues with Direct Finance

When would such brokers come ahead? Private nature of information Re-usability of information Specialization and scale economies over time Role of profitability and entry barriers Asymmetric information and ex-post screening?? Liquidity risk for savers?? Portfolio diversification for savers??
Indirect Finance
Financial Intermediary
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Savers (surplus budget unit)
Borrowers (deficit budget unit)
Indirect finance as risk-taking by Financial Intermediaries Portfolio diversification benefits, liquidity creation, and ex-post monitoring
Qualitative Asset Transformation

Demand from savers for liquidity risk management services Risk aversion of providers of capital Risk of default of borrower replaced with risk of default of Financial Intermediary Liquidity creation and provision Maturity transformation and mismatched balance sheets Business of managing financial risks Interest spread as primary source of income
Issues in QAT
Characteristics of the Financial Intermediary Capitalization Ability to manage financial risks, especially liquidity risk Resources for ex-ante screening and ex-post monitoring Transaction costs for savers in monitoring the financial intermediary ?? Reducing this element of transaction costs?? Total costs of screening and information collection = N Make the liabilities of FIs risk-free for savers Insured deposits Characteristic of only banks
What else do Financial Intermediaries do?

Functions performed by FIs The brokerage function Adverse Selection, Screening, and Information Collection Scale economies & reusability of information Moral hazard and post-funding monitoring Providing funds just one activity of financial intermediaries Other services provided by FIs Transaction services Financial advisory Issuances Guarantees and so on
Definitional Issues
Lack of clear and well-accepted definitions of bank
Definition by functions Definition by services Definition by legal basis
Definition by functions/services as inadequate

Changing nature of functions & services provided by banks
Definition by legal basis

Issue demand deposits and making business loans Qualified for deposit insurance
Definitional Issues
Banks are financial institutions that are privileged by the laws of a nation to have the power to issue deposits that are payable on demand and which deposits are also generally accepted by economic agents in final settlement of transactions between them Emphasis on payments/transaction services Regulations as laying down boundaries on activities of banks
But why do banks exist

Debate on rationale for existence of banks Transaction cost & Asymmetric information based theories Scale economies in information collection, monitoring, and liquidity provision Debt as a contract brings forth optimal behavior from users of funds Agency Costs Banks exist to deal with ex-ante & ex-post information asymmetries Industrial Organization based theories Banks as portfolio managers for depositors Arguments equally applicable to other financial intermediaries

Incomplete Markets Theories
Typical providers of capital are risk averse Need to manage liquidity risks across time Bank deposits as a risk-free liquid asset Banks (and other FIs) provide a variety of risk management services to providers and users of capital
Understand banks in terms of their role in the functions of a financial system

Providing a payments system for the exchange of goods and services Pooling of funds for undertaking large-scale indivisible enterprise Transfer economic resources across time, industries and geographical locations Managing uncertainty and controlling risk Provide price information Provide a way to deal with asymmetric information

Other rationales Banks as providing a means of payment Banks as the central players in transmission of monetary policy actions Banks as having ability to create liquidity to business through provision of funds Why the unique role of banks in payments and provision of risk free liquid asset? History of banks and bank regulation
A brief history of banking

The Medici Bank (1397) as the first formal bank Early banks serving the needs of merchants Money changer banks and merchant banks Large number of failures in Continental Europe driven by bad debts Charters to deposit banks - primarily transaction services Another objective of charters to finance the governments needs Banks also as safe-keepers of money Banks as universal banks

The growth of fractional reserve banking
Logic of un-coordinated withdrawal requirements of depositors Wider reach and accessibility
Large number of bank failures in 19th century and early 20th century Bank failures attributed to liquidity problems and undue risk taking US banking panic of 1907 and the creation of the federal reserve
Lender of last resort
The Great Depression

Deposit Insurance Glass-Steagall Act

Deposit insurance and risk-free deposits Commercial banking under Glass-Steagall Act
Banks to provide only loans to business and governments Banks as sole entities to issue deposits
Competition among banks as a destabilizing factor

Interest rate controls Restrictions on geographical expansion
The introduction of reserve requirements Payment of deposit insurance premium Capital Maintenance The early forms

The US Scenario
Competition from foreign banks for customer deposits Rise in interest rates since the late 1950s
The response financial innovation

Eurodollar deposits, inter-bank repos, commercial paper, etc Financial innovation driven by demand of depositors and borrowers
Increasing competition from non-bank financial intermediaries

Declining profitability and viability of banks Dangers of losing monopoly position in payments function
The regulatory response leveling the playing field

Deregulation
Lender of Last Resort

Objective of ensuring stability of banking sector Liquidity problems as the primary cause of bank failures Lack of liquidity when needed the most during crises Essentially a government set-up agency Provision of short-term loans to banks facing temporary liquidity problems Principles of LOLR function Lend only against good collateral Accept all good collateral Penal rate of interest on loans Policies as public knowledge
Deposit Insurance
Objective of Deposit Insurance
Protection of savings of depositors
Banking failures and bank runs primarily a result of liquidity problems Early private solutions like mutual agreements, own deposit insurance schemes, etc. The credibility problem breakdown of the pooling arrangements Provision of liquidity post failure The solution - governments to provide deposit insurance
Deregulation of banking
Removal of administered interest rate regimes Removal of portfolio restrictions on banks Increasing scope and nature of activities allowed to banks Setting up of financial markets and introducing a wider range of financial instruments Allowing a greater variety and number of non-bank financial intermediaries to be setup Allowing easier entry to foreign banks
Continental Bank & Thrifts

A common problem with all deposit insurance schemes
Moral Hazard
Continental Illinois Bank the first post-war failure of a large bank Multiple failures in the S&L industry Some common features Excessive risk taking on the asset side Short-term non-deposit funds and maturity mismatches The regulatory response Risk-based capital requirements (Basel-I) Innovations in payments systems and short-term liquidity markets
Moral Hazard and the Too-Big-To-Fail Problem

Moral hazard as the taking on of more risk than warranted in the absence of a safety net Deposit insurance and moral hazard in banking More acute moral hazard problem for large banks Creditors of large bank with an implicit government guarantee as to repayment in event of failure
Contagion effect of large bank failures Better safe than sorry approach of regulators
Basel Norms
Basel-1 introduced in developed economies in early 1990s Objective of ensuring sufficient capital maintenance Leveling global playing field Capital Requirements Risk-Weighted Assets Tier 1 and Tier 2 Capital Instruments Basel-1 and Credit Risk Standardized Risk Weights Basel 1.5 and Market Risk Growing importance of market traded securities Tier 3 Capital Instruments
Basel Norms
Basel 2 Standardized risk weights not reflecting true risks Portfolio diversification benefits not reflecting in lower capital requirements Pro-cyclical behavior of capital requirements Basel 3 More of the same? Liquidity Maintenance Book Value of Leverage as well Higher Capital Adequacy requirements Counter-cyclical buffer Seasonal variation requirement
Repeal of Glass Steagall Act

Growing size of investment banks and other non-bank financial intermediaries Scope for profitability and risk diversification for banks Glass-Steagall Act as final set of restrictions on banks Repealed in 1999 US Commercial banks free to provide all kinds of financial services The universal bank model Some reservations Conflicts of interest Higher risks with securities activities
Services offered by Modern Banks

Traditional Services Safekeeping of assets Currency exchange Providing business loans Discounting commercial bills Demand deposit & Savings deposit accounts Financing governments Providing guarantees
Services offered by Modern Banks

Relatively recent trends Consumer lending Financial advisory Equipment leasing Cash management Venture capital finance Mutual funds & Portfolio management services Selling insurance & Retirement policies Securitization Investment banking Risk management And so on
Banking Structures
Competition as a driver of change

Increasing activities of banks driven by competition
Search for higher profits Exploiting economies of scale and scope
Asset-side competition
Investment (Merchant) banks, Venture capital funds, Financial markets, Mutual funds, Pension funds, Hedge funds, etc
Liability-side competition
Money market mutual funds Investment banks Insurance companies
Other Financial Services

Securities Brokers Investment banks
Competition and Consolidation

19 95 19 97 19 99 20 01 20 03 20 04 N me o u br f Bn s ak 1 ,2 2 0 4 9 5 ,4 1 8 8 ,5 0 8 8 ,0 0 7 6 ,7 9 7 3 ,6 0 <$ 0 M 10 7 2 ,1 3 (6 .5 % 9 5 ) 6 4 ,1 7 (6 .0 % 5 4 ) 5 5 ,1 7 (6 .1 % 0 0 ) 4 8 ,4 6 (5 .5 % 5 2 ) 3 1 ,9 1 5 .3 % 0 4 3 5 ,6 5 (4 .9 % 7 0 ) A s ts se $0M 10 -$B 1 2 4 ,7 1 (2 .7 % 6 6 ) 2 0 ,9 0 (3 .6 % 0 8 ) 3 2 ,0 9 (3 .3 % 5 0 ) 3 9 ,1 4 (3 .5 % 9 3 ) 3 3 ,4 4 4 .2 % 4 0 3 3 ,5 0 (4 .2 % 6 6 ) S e iz $B 1 -$0 1B 31 3 (3 3 ) .2 % 31 3 (3 0 ) .5 % 38 1 (3 1 ) .7 % 30 2 (3 6 ) .9 % 31 4 4 9 .3 % 30 6 (4 2 ) .7 % >$ 0 1B 6 3 (0 2 ) .6 % 7 3 (0 7 ) .7 % 7 6 (0 9 ) .8 % 8 0 (0 9 ) .9 % 8 3 1 7 .0 % 8 5 (1 1 ) .1 %
19 95 19 97 19 99 20 01 20 03 20 04
T ta o l A s ts se $ ,1 6 4 1 $ ,6 2 4 4 $ ,7 5 5 3 $ ,5 9 6 6 $ ,6 3 7 0 $ ,4 3 8 1
<$ 0 M 10 $1 30 (7 4 ) .5 % $7 27 (5 7 ) .9 % $4 23 (4 3 ) .2 % $2 22 (3 7 ) .3 % $0 21 (2 4 ) .6 % $8 19 (2 5 ) .2 %
A s tS e s e iz $0M 10 -$B 1 $B -$0 1 1B $6 68 $ ,0 7 1 7 (1 .2 % 6 2 ) (2 .1 % 6 7 ) $1 71 $9 95 (1 .3 % 5 2 ) (2 .4 % 1 5 ) $5 75 $1 95 (1 .1 % 3 6 ) (1 .9 % 5 6 ) $1 89 $1 95 (1 .4 % 2 7 ) (1 .9 % 3 3 ) $1 90 $4 97 (1 .9 % 1 7 ) (1 .4 % 2 6 ) $5 93 $7 93 (1 .3 % 1 3 ) (1 .5 % 1 7 )
>$ 0 1B $ ,0 1 2 6 (5 .0 % 0 7 ) $ ,6 8 2 5 (5 .2 % 7 7 ) $ ,8 3 3 2 (6 .6 % 6 5 ) $ ,6 3 4 1 (7 .2 % 0 2 ) $ ,5 5 5 4 (7 .9 % 2 3 ) $ ,2 7 6 9 (7 .8 % 4 5 )
Competition and Consolidation

M&A activity in banking on rise since the 1990s Driven by competition and the exploitation of scale economies
Tendency of banks to grow larger (e.g. Number of German banks reduced by 35% between 1997 and 2008 ) Dismantling of Glass-Steagall and the rise in Mega-Mergers
Providing greater product diversity to customers Greater efficiency in risk management, liquidity and capital management Stability and bank size changing regulatory trends Removal of geographical expansion restrictions
Sources of Scale Economies

Cost indivisibility
Higher share of fixed costs Indivisibility of reputation
Financial economies of scale

Netting and liquidity requirements Portfolio diversification and equity requirements
Claimed benefits of consolidation on banking sector efficiency

Lowered costs for customers Competitive pricing of deposits and loans Broader access to banking services
Sources of Scope Economies

The growth of Universal Banks since the 1990s
Provide a broad range of financial services and products Dominant structure of banks in Continental Europe
Claimed Benefits
Cross-Selling of Products Better resource utilization for common activities Information re-use
From Bank Holding Companies (BHCs) to Financial Holding Companies (FHCs)

BHCs restricted from carrying on most non-banking activities Repeal of Glass Steagall Act & removal of restrictions on M&A Difference in type of M&A transactions since 1999-00.
Financial Innovation
The financial innovation cycle
Development of a new product Selling product to existing clientele Duplication of product by other banks & FIs Widespread use and active trading on financial markets
Key drivers of financial innovation

Search for profits by banks Competition Regulatory restrictions Low and stable interest rate environment
Financial Innovation
Two post-war eras of financial innovation
1950-mid 1980s Mid 1980s onwards
High Return vs. Risk Sharing Products Demand driven financial innovation vs. Supply push financial innovation Rapid growth of non-bank financial intermediaries
A clientele for new financial products Sophisticated clientele searching for better yields Shift towards developing risk sharing financial products
Risk Sharing Innovations

Creating stable return distributions for clients Demand Side Factors Managerial Self-Interest Bankruptcy Costs Capital Market Imperfections Participation Costs Increased Cross-border Transactions Supply Side Factors Technology Transaction Costs Competition & First Mover Advantage
Off-Balance Sheet Activities of Banks

Rapid growth in off-balance sheet transactions of banks
Fee-based incomes Trading profits
Increasing importance of derivative contracts

Nominal Amt of outstanding derivative contracts nearly USD 700 trillion
Banks and other FIs as dominant counterparties

Risk reducing transactions?
Clientele effect and Market segmentation

Risk appetites differ across different investor categories Better risk sharing
Increased liquidity risks

Bank Regulation : Shifts in Thought

Frequent occurrence of banking crises and greater instability of banking sectors
Liquidity problems as primary driving forces of bank failures Increased concerns with bank solvency since the mid1980s Belief of solvency problems as an outcome of undue risk taking Adequate maintenance of capital by banks as a solution to limit undue risk taking Regulatory separation of liquidity problems and solvency risks
Shift of regulatory approaches from micro-management to supervisory Re-Recognition of Contagion post East Asian Crisis
Systemic Crises & Contagion

Systemic risk as the risk of failures in a set of financial markets/ financial intermediaries
Macroeconomic Factors & Systemic Risk Asset Markets & Systemic Risk
Contagion as the spread of problems from one intermediary/market to other intermediaries/markets Bank Runs? Banking sector most prone to systemic crises & contagion
Loss of depositor confidence Inter-linkages between banks Inter-bank markets Inter-linkages between banks Counterparties in financial markets
Bank Regulation : Some Rationales

Moral hazard effect of deposit insurance
Risk taking by banks needs to be monitored and restrained
Preventing disruptions in payments and settlement systems

Bank deposits as money Banks as largest players in payments & settlement systems Systemic Risk & Contagion
Opacity of risks taken up by banks

Depositor Safety
Monitoring the monitor

Banks as agencies monitoring behavior of borrowers
Enhanced efficiency of banks

Maintenance of competitive conditions
Consumer Protection
Bank Regulation- Prudential Regulation

Shift to prudential regulation principles
Safety and soundness of financial system as a whole Depositor protection Regulators as not micro-managers Regulatory costs and financial system efficiency Creation of an enabling operating environment Reducing regulatory disparities Capital adequacy norms Risk measurement practices Sectoral credit limits Disclosure & accounting practices Shift towards self-regulatory organizations
Some prudential regulation measures

Regulation and Social Benefits???

Traditional view of regulation as a solution to negative externalities Regulation as the outcome of a bargaining process between regulators and interested entities Pervasive regulation as an outcome of rational self-interest of powerful interest groups Regulation formulation as an optimal solution to the claims of all interested parties
Doubts on the efficacy of regulation Regulation as more of a satisfactory give and take solution
Theories of Interest Rate Term Structure

Term structure as the schedule of interest rates across different maturities Interest rate for a risky asset = Interest rate on risk-free asset + risk premium Government securities as risk-free assets default risk free Some general observations about interest rate behavior
Yield curves almost always slope upwards When short term rates are very high, yield curves likely to have a negative slope Interest rates on bonds of different maturities move together over time
An important point
Each yield curve has an underlying set of assumptions about default risks at different maturities

Expectations hypothesis
Long-term interest rates as expected values of future short-term rates No specific preference for a particular maturity by bond investors (i.e. all maturities as perfect substitutes) Explains only downward sloping yield curves and co-movement of bond interest rates Cannot explain typical observation of upward sloping yield curves
Market segmentation hypothesis

Investors concerned with both interest rates & maturities Different categories of investors with different maturity preferences & interest rate risk tolerance Smaller maturities with very low interest rate risk Explains only upward sloping behavior of yield curves

Liquidity Premium Theory
Explains all 3 observations Key assumption that different maturities as imperfect substitutes Investors as risk averse need increasing reward for bearing higher levels of interest rate risk Interest rate as comprising two components expectation of future shortterm interest rates and liquidity premium for the corresponding maturity Rise in current short-term interest rates as a signal of higher future shortterm rates. So interest rates on different maturities move together. Inverted yield curve an abnormal occurrence only when expectations of a very sharp fall in future interest rates
Banks & Monetary Policy

Monetary policy as the regulation of interest rates & money supply by central banks Special role of banks as conduits of monetary policy actions
Reserve maintenance requirement of banks The use of reserve balances for inter-bank settlements
Monetary policy actions as attempts to influence the extent and cost of liquidity provision by banks and FIs
Banks & Monetary Policy

The Monetary Policy Framework Goals Targets
Operating Targets Intermediate Targets
Operating Instruments Monetary policy targets

Money Supply Interest Rates Exchange Rates Inflation
Monetary Policy Interest Rate Targets

On the very short-end of the yield curve
Domestic inter-bank interest rates Overnight repo rate Overnight call money interest rates
Central banks typically as short-term lenders of reserve balances

intra-day overnight short-term
Provision of reserve balances against collateral

Government securities as accepted collateral
Other Monetary Policy Targets

Money supply targeting
Very commonly used until mid-late1980s Monetary policy instruments to change the amount of money supply Breakdown due to financial innovation & money multiplier instability Definitional issues for money supply High powered money (M0), Narrow money (M1), Broad money (M3), and so on. Not much used in practice
Exchange rate targeting

Adopted by economies heavily dependent on international trade Economies must be small relative to global economy Fewer options for central banks
Inflation targeting
Extremely popular since late 1990s Monetary policy instruments design to control inflation
Monetary Policy Tools

Changes in Money Supply
Reserve Requirements Open Market Operations Discount Window Loans
Temporary Liquidity Provision

Repos & Reverse Repos Standing Facilities
Other instruments
Inflation forecasts Credible Signaling Moral Suasion
Market-based operations through g-sec markets

Alternative classification of monetary policy instruments

Portfolio Restrictions
Reserve balance requirements Sectoral lending floors and ceilings
Interest Rates and Liquidity Provision

Discount window & the Bank rate Standing facilities loan and deposit of reserves Interest rates on reserve balances Repos & Reverse Repos Outright purchase transactions
Interest rate changes by central banks

Feed through inter-bank interest rates and other short-term money market instruments
Monetary Policy Impact on the EconomySome Facts

Unanticipated changes in monetary policy have only transitory effects on interest rates Unanticipated tightening of monetary policy is followed by sustained declines in real GDP and the price level Aggregate demand changes relatively quickly compared to changes in production.
Inventories change quickly in the short-run
The earliest and sharpest changes in aggregate demand occur in residential investment Spending on consumer goods lags changes in residential investment Capital investment by business lags changes in consumer goods spending
Unconventional Monetary Policy Measures in Emerging Economies during the Credit Crisis
The IS-LM Model :A Quick Refresher

Two sets of markets
Goods Markets Financial Markets
The Goods Market Equilibrium Condition

Investment = Savings
The Financial Markets Equilibrium Condition

Demand for Money = Supply of Money
Central role of interest rates

Liquidity Preference
Monetary policy as operating upon the financial markets equilibrium

IS-LM: Financial Markets Equilibrium

Why do people demand money?
To meet their day-to-day transactions (transactions motive) To meet unforeseen future liquidity requirements (precautionary motive) To take advantage of expected profitable avenues (speculative motive)
Demand from first two motives relatively stable Two sets of assets in financial markets
Money & Financial Securities
Increasing interest rates on securities lower demand for money

Supply of Money & Financial Securities unchanged
Increase in money supply lower rates of interest on securities

Supply of financial securities unchanged

LM curve construction assumes unchanged supply of money and financial securities
One LM curve per money supply-financial securities supply configuration
Suppose the supply of financial securities increases

Interest rates would increase
Suppose the supply of money decreases

Interest rates would increase
Inflation in IS-LM model

Some part of money supply increase as higher transaction balances More money chasing same amount of goods Inflation as the result

IS-LM model as the basic logic for explaining effects of monetary policy actions But why only banks as conduits for monetary policy? The role of reserve balances
Reserve balances akin to minimum deposit balances Central banks as monopoly creator of reserve balances Increase the cost to banks of expanding their balance sheets? Resort to other mechanisms by banks e.g. inter-bank lines of credit
Central banks as having power over money supply

Definitions of Money Supply Reduced over time money multiplier instability Switch to targeting interest rates Money Supply the adjusting variable
Other Monetary Policy Channels

Credit channel
Credit rationing is a pervasive phenomenon Always some fringe borrowers Monetary policy actions & interest rate on all credit
Monetary policy as influencing the size of this fringe

Reduction of interest rates & decline in size of fringe Increase in interest rates & increase in size of fringe
Two different sub-channels

Balance Sheet Channel Bank Lending Channel

Balance Sheet Channel
Net-Worth, Adverse Selection, & Moral Hazard Asymmetric Information & External Finance Premium Borrowers having short-term/floating rate debt Value of Collateral
Bank Lending Channel

A set of borrowers solely dependent upon banks for credit Monetary policy as primarily influencing cost of credit for such borrowers Same logic as for Balance Sheet Channel

Bank Balance Sheet Channel & Bank Capital Channel
Recent developments Credit channel implications Monetary policy actions as not restricting bank asset growth Portfolio reallocations and change in risk aversion of banks the outcome Capital levels of banks an important consideration in the nature of portfolio reallocations
Interest Rate Channel
Money Supply
Expected Inflation
Real Interest Rates
Investment
GDP
Balance Sheet Channel / Bank Lending Channel

Money Supply Expected Inflation Borrower Net Worth
Adverse Selection Bank Loans
Moral Hazard
Investment
GDP
Exchange Rate Channel

Money Supply Short-Term Interest Rate
Expected LongTerm Interest Rate
Expected Exchange Rate
Investment
Net Trade Balance GDP

Tobins q Channel
Money Supply
Expected Inflation
Tobins q
Investment
GDP
Unanticipated Price Level Changes Channel

Money Supply Adverse Selection Moral Hazard Bank Loans Unanticipated Price Level Change
Windfall Business Profits
Investment
GDP
Cash Flow Effects Channel

Money Supply Adverse Selection Moral Hazard Business Cash Flows Bank Loans Nominal Interest Rates
Investment
GDP
Wealth & Debt Effects Channel

Money Supply Expected Price Levels
Wealth
Financial Asset Prices Consumer Debt Capacity
Likelihood of Financial Distress
GDP
Consumer Durables & Hsg Exp

Liquidity Effects Channel

Money Supply Financial Asset Prices Borrowing Capacity Likelihood of Financial Distress Investment; Consumer Durables & Hsg Exp Expected Price Levels
GDP
Bank Balance Sheet Channel

Money Supply Expected Inflation
Adverse Selection Bank Loans
Moral Hazard (Bank)
Investment
GDP
Bank Capital Channel

Money Supply Interest Rates Capital Gains on Securities Portfolio
Govt. Securities Capital Adequacy Levels
Loans
Investment
GDP
Bank Liquidity Preference (Risk Aversion) Channel

Money Supply Interest Rates Cost of Bank Funds
Loans
Bank Risk Aversion
Investment
GDP
Bank Liquidity Preference (Risk Aversion) Channel

Money Supply Interest Rates Expected Interest Rates
Loans
Bank Risk Aversion
Investment
GDP
Monetary Policy Transmission Channels A Summary
Monetary Policy Transmission Some Key Lessons

Monetary policy actions will not always lead to a change in long-term interest rates Prices & conditions in other short-term debt markets are critical to the efficient transmission of monetary policy Financial health and risk aversion of banks critical to the efficient transmission of monetary policy Unanticipated fluctuations in inflation are to be avoided as they have significant impact on economic activity Central bank policies will be most effective only when they are not anticipated by economic agents
Monetary Policy in India Mandates of RBI

to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage Multiple objectives for RBI
Regulate the issue of currency Monetary Stability Operating credit system
Monetary Policy in India Mandates of RBI

Monetary Stability
Price stability External value of rupee exchange rate Banking sector stability
Operating credit system

Adequate credit to productive sectors Accelerate economic growth
Policies of the RBI

Monetary Policy Credit Policy Problems in balancing conflicting requirements
Monetary Policy Instruments in India

Portfolio Restrictions
Cash Reserve Ratio Statutory Liquidity Ratio Priority Sector Lending Selective Credit Control Discount window - Term Loans, Bank rate, Marginal Standing Facility Standing facilities Liquidity Adjustment Facility Repos & Reverse Repos Outright purchase transactions Market Stabilization Scheme
Interest Rates and Liquidity Management

Monetary Policy Targets in India

Pre 1984
Inflation as a result of supply shocks Selective credit control
1984-1998
Monetary Targeting Reserve requirements as operating instruments M3 as intermediate target
Shift to Interest Rate Targeting

Call money rate as the operating target Introduction of Liquidity Adjustment Facility Development of money markets
Monetary Policy Decision Making Process
CRR & SLR

Portfolio Restrictions - low yield assets Not much used post liberalization Changes affect interest rates and bank asset expansion No fine-tuning - for large changes only
Used sparingly by RBI
Decreasing trend since liberalization

Primarily used for sterilizing expansionary effect of government borrowings
Currently CRR = 6% ; SLR = 24%

CRR
CRR as a percentage of net demand and time liabilities
Excludes inter-bank deposits & foreign currency deposits Basis of average fortnightly deposits (Saturday-Friday) To be maintained in full by next reporting Friday (i.e. after one more fortnight) Interim 70% daily maintenance Penal interest First day(bank rate + 3% p.a.); Subsequent days (bank rate + 5% p.a.) No Interest on CRR balances Only Reserve Balances with RBI as qualified assets
SLR
SLR as a percentage of net demand and time liabilities
Excludes inter-bank deposits & foreign currency deposits Basis of average fortnightly deposits (Saturday-Friday) To be maintained in full each day until next reporting Friday (i.e. after one more fortnight) Penal interest First day(bank rate + 3% p.a.); Subsequent days (bank rate + 5% p.a.) No interest by RBI on SLR balances Cash balances (after meeting CRR), Gold, Government Securities as qualified assets
Liquidity Adjustment Facility (LAF)

Provision of overnight & intra-day liquidity to banks
Repurchase transactions in government securities
Daily LAF Auctions Repo rate as signal of short-term liquidity cost

The operating target of RBIs monetary policy Repos to provide intra-day liquidity Repos only for g-sec holdings over SLR
Reverse Repos to absorb excess liquidity

Repo rate 100 bps
Marginal Standing Facility to provide distress liquidity

Max limit -1% of NDTL Repo rate + 100 bps
Liquidity Adjustment Facility (LAF)
Other Monetary Policy Instruments

Priority Sector Lending Norms
40% of total advances
Market Stabilization Scheme (MSS)

For long-term liquidity position Special Dated Securities & T-Bills issued by GOI Money raised from banks kept in a separate account MSS securities qualified for SLR maintenance
Multiple Indicator Approach
Monetary Policy of RBI & Other Central Banks
Payments & Settlement Systems

Central role of payments and settlement systems (PSS) for banks and central banks
The means to settle obligations to counterparties Financial stability as a mandate of central banks
Central bank objectives for PSS

Risk reduction Systemic Risk , Credit Risk, Liquidity Risk Increasing efficiency
Settlement with finality

A key feature of PSS Point at which payment transaction deemed complete, legally enforceable and irrevocable
Risks in a PSS
Credit Risks Liquidity Risks Legal Risks Operational Risks Security Risks Market Risks Systemic Risk & Contagion
Value of payments settled Number of participants Interaction between banks
Importance of PSS
Smooth functioning of economy A carrier of systemic risk
Liquidity problems a main cause of bank failures
Enormous amounts of transaction flows (nearly USD 4 trillion daily in Forex markets alone) Transaction processing as a source of fee-based revenue for banks Most PSS operated by central banks
Provision of intra-day reserve loans
Some relatively recent trends

Reduction of time for transaction settlement Adoption of RTGS Debates on netting or gross settlements
Evolution of PSS Instruments

Fixed costs of processing payments and their settlements Scale economies for processing large transactions
Most innovation in payment systems Clearing houses and transaction aggregators e.g. CHIPS, ACH, LCH Clearnet, MEPS+, CHAPS, Fedwire, ECS, etc
Technological Advances Delivery versus payment systems

Collateralized transactions Popular due to growth of repo transactions
Levels of PSS
Two Levels of PSS
Entities other than banks Inter-bank PSS
Corresponding PSS
Small Value Transfer Systems Large Value Transfer Systems
Large Value Transfer Systems operated by Central Banks
Customer PSS & Inter-bank PSS-An Example

Bank 1 200 Loans to customers 50 Reserve balances 50 Loans to other banks 300 Total Bank 2 200 Loans to customers 50 Reserve balances 50 Loans to other banks 300 Total
Customer deposits Equity Loans from other banks Total
100 100 100 300
100 100 100 300

100 100 100 300
100 100 150 350

100 50 100 250
100 150 100 350
Types of PSS
Cash based settlement systems Non-Cash settlement systems Netting Systems
Bilateral Netting Novation Netting Close-Out Netting Multilateral Netting
Gross Settlement Systems

Real-Time Gross Settlement
Bilateral Netting
Multiple transactions during the day Obligations netted out at end of day Lowered liquidity requirements & liquidity costs Risk of large unwanted exposures to a single counter-party Is the netting arrangement legally enforceable?
Novation Netting
Multilateral Netting
Further reduction of transactions
Number of transactions under bilateral netting [0,(n2 -n)/2] Number of transactions under multilateral netting [0,n]
Smaller amount of final settlement transfers

Lowered liquidity requirements
From whom to collect and how much??

Credit risks at least as high as under bilateral netting
Central clearing-house as counterparty

Credit risk reduction
Managing/Reducing Credit Risks

Insolvency laws & procedures Bilateral exposure limits Shortening Netting Intervals Restricting access to PSS Clearing Houses Collateral Pools How to compute each members contribution Close-Out Procedures
Dealing with counterparty default
RTGS
Each transaction settled on a gross basis in real time Number of transfers very large Zero credit risk Higher liquidity requirements/liquidity risk
Continuous requirements of liquidity Requires support from central bank for intra-day liquidity provision
Incentive Issues in RTGS

Delaying Payments
Trade-off between expected revenue losses from customers & cost of liquidity Incentive weaker when liquidity costs are very low
Delaying payments is optimal only if all other banks do the same Synchronization of payments by all banks Price for intra-day credit Collateralized system for intra-day credit
Standards for PSS (Lamfalussy Report)

Well founded legal basis under all relevant jurisdictions Participants have clear understand of system on each of the risks affected by the netting process System should have clearly defined procedures of management of credit and liquidity risks that specify the responsibilities of the system and the participants
Standards for PSS (Lamfalussy Report)

System capable of timely completing of daily settlements even if the participant with the largest position fails System should have objective and disclosed criteria for admission that permit fair and open access System must ensure operational reliability of systems and availability of back-up facilities
Netting vs. RTGS

Risks & Costs
Credit Risks Liquidity Requirements & Liquidity Risk Legal Risks Costs of Customer Payment Delays Interest cost on liquidity funding Nature of liquidity requirements Transfer/Payment Processing Costs
Netting Systems
Higher Lower Higher High Lower Lumpy Lower
RTGS
Negligible Higher Minimal Negligible/Nil Higher Continuing Higher
Netting vs. RTGS

Netting based settlement systems
Netting as a more efficient means of settlement End of day final transfer of reserve balances Exposure to credit risk on intra-day transactions Bilateral Netting vs. Multilateral Netting
RTGS
Greater requirement of intra-day reserve balances Improved ability of central banks to influence interest rates Reduced credit risk
Drivers of PSS choice

Credit risk vs. transfer cost trade-off Credit risk vs. liquidity risk Customer benefits vs. liquidity cost
Implicit & Explicit liquidity costs
PSS in India
Board for Regulation and Supervision of Payment and Settlement Systems as the primary regulator Governed by the Payment & Systems Act, 2007 & Payment & Systems Rules 2008 Multiple Systems All operated by RBI Electronic Clearing System National Electronic Funds Transfer RTGS based systems for inter-bank transactions RBI as providing standby intra-day credit facilities through repos.
Dimensions of the modern operating environment

Increased focus on transparency Management of risk exposures Competition for customers Capital adequacy Technological developments Financial innovation

Financial Intermediation and Banking Theoretical Foundations

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Financial Intermediation and BankingTheoretical Foundations

Prof. Santosh Sangem

Commercial Banking Sessions 1-8, BM 2011-13.

Why Study Commercial Banks?

Commercial Banking Sessions 1-8, BM 2011-13.

Why Study Commercial Banks?

Commercial Banking Sessions 1-8, BM 2011-13.

Why Study Commercial Banks?

Commercial Banking Sessions 1-8, BM 2011-13.

Some Typical Issues

Banks are Financial Intermediaries

Banks and Non-Financial Firms

Commercial Banking Sessions 1-8, BM 2011-13.

Banks and Non-Financial Firms

Commercial Banking Sessions 1-8, BM 2011-13.

Banks and Non-Financial Firms

Commercial Banking Sessions 1-8, BM 2011-13.

Banks and Non-Financial Firms

Commercial Banking Sessions 1-8, BM 2011-13.

Banks and Non-Financial Firms

Commercial Banking Sessions 1-8, BM 2011-13.

What is Financial Intermediation

Commercial Banking Sessions 1-8, BM 2011-13.

Issues with Direct Finance

Issues with Direct Finance

Commercial Banking Sessions 1-8, BM 2011-13.

Savers (surplus budget unit)

Borrowers (deficit budget unit)

Qualitative Asset Transformation

Commercial Banking Sessions 1-8, BM 2011-13.

What else do Financial Intermediaries do?

Definition by functions/services as inadequate

Definition by legal basis

Commercial Banking Sessions 1-8, BM 2011-13.

Commercial Banking Sessions 1-8, BM 2011-13.

But why do banks exist

But why do banks exist

Understand banks in terms of their role in the functions of a financial system

But why do banks exist

Commercial Banking Sessions 1-8, BM 2011-13.

A brief history of banking

A brief history of banking

The Great Depression

Commercial Banking Sessions 1-8, BM 2011-13.

A brief history of banking

Competition among banks as a destabilizing factor

A brief history of banking

The response financial innovation

Increasing competition from non-bank financial intermediaries

The regulatory response leveling the playing field

Commercial Banking Sessions 1-8, BM 2011-13.

Lender of Last Resort

Commercial Banking Sessions 1-8, BM 2011-13.

Commercial Banking Sessions 1-8, BM 2011-13.

Continental Bank & Thrifts

Moral Hazard and the Too-Big-To-Fail Problem

Commercial Banking Sessions 1-8, BM 2011-13.

Repeal of Glass Steagall Act

Services offered by Modern Banks

Commercial Banking Sessions 1-8, BM 2011-13.

Services offered by Modern Banks

Commercial Banking Sessions 1-8, BM 2011-13.