Money, Banking & Interest Rates

1. The global financial system

The global financial system is comprised by a set of market-related institutions that includes
financial markets, financial institutions, laws, procedures and regulations, as well as the set of
techniques through which securities of all types of financial products and/or services are
bought and sold (e.g., bonds, stocks, futures, options, and other hybrid securities are some of
the most commonly exchanged financial products) (Mishkin, 2004).

1.1. The global financial system as a marketplace for the

demand and supply of capital.
The global financial system also encompasses sub-categories within financial markets, such
as the money markets (where global interest rates such as the London Interbank Offered Rate,
or LIBOR, are determined), and also multiple financial market segments where financial
services are produced and delivered around the world (e.g., either in an offshore or offshore
jurisdiction).

It could be argued that the financial system is one of the most fundamental products of
modern societies, insofar as it reflects an interplay between the demand to financially service
the needs of global financial consumers, taking into consideration the wider context of the
financial markets’ role in providing for these needs with a specific range of financial products
and/or services. That is, the financial markets are the meeting point of a given individual’s
financial needs (when addressed within certain bounded and reasonable limits), as well as
society’s ability to provide a similar or equivalent product or service. For example, in the
credit markets, the need felt by an individual consumer to fund the purchase of her/his
residential property through mortgage financing is met by the ability of a given financial
institution to fund the said purchase through a specific mortgage product that the financial
institution might offer within its product or service catalogue.

In essence, the financial system’s main task is to serve as a meeting point between the
lending of scarce loanable funds from investors seeking a given rate of return, and the need to
move the said loans to the hands of those investors interested in borrowing these amounts in
order to buy goods and services, or to make investments in new equipment, facilities, or other
productive assets. These asset purchases and/or investments typically foster investment
schedules in order to help grow the economy, and expand the standard of living enjoyed by a
given economy’s citizens. In the absence of the global financial system, and without the
ability to allocate funds from lenders to borrowers, the significant diffusion of financial
products and/or services would not be available to fully service the wide range of financial
consumers at a global level. That is, without access to mass-market credit (from loans lent by
banks to buy a house, to the availability of credit to fund specific consumer purchases), the
structured pipeline of loanable funds the financial system provides would not be available,
thus rendering our life in society much less enjoyable (from a strictly materialistic
perspective, at least).
1.2. The global financial system and the occurrence of
market failures: the importance of the credit channel
The financial system essentially determines both the cost/return and the quantity associated
with the provision of funds between parties in the financial markets. This provision is also
frequently associated with a given schedule of return and risk, which are typically associated
with a given financial operation. These operations are an integral part of the millions of goods
and services purchased every day through multiple markets, and whose payments indelibly
pass through some payment gateway associated with a certain segment of the financial
industry.

Nevertheless, it should be observed that financial markets are periodically prone to market
failures, insofar as the events (however extreme) occurring within the financial industry
might also have important repercussions on the overall health of the global economy. For
example, the latest global financial crisis is an example of a market failure that compromised
the major goals associated with the basic general mechanisms associated with the financial
markets. In the aftermath of the global financial crisis, the credit channel became
compromised due to the liquidity shock occurring in the global financial markets. Although
the crisis originated in the U.S.A., the financial shock rapidly spread globally, affecting the
performance of each and every segment of the financial markets, thus forcing monetary
authorities to intervene. In sum, financial markets are thus also exposed to the occurrence of
severe market failures that can strongly condition and impact the underlying real economies
these markets are supposed to serve in ‘normal’ (i.e., non-crisis) times (Hull, 2009).

Discussion Point: But what is the link between the onset of a given financial shock and the
subsequent impact on the underlying real economy?

One obvious shock transmission mechanism is the credit channel. When liquidity becomes
constrained in the aftermath of a systemic shock, funds become less available and more
costly. The scarcity of loanable funds subsequently affects, for example, personal
consumption expenditures, as well as investment - this constitutes the essence of the
economic underperformance associated with a liquidity shock (Gambacorta and Marques-
Ibanez, 2011). This impact thus depresses the overall spending for goods and services,
severely impacting the performance of real economies. As a direct consequence,
unemployment rises and the economic growth stalls, as businesses cut back on their
production schedule and dismiss their workforce. Quite the contrary, when the cost of
financing declines, as loanable funds are more easily available, the opposite mechanism
holds, as spending in the economy strikingly increases, enabling the growth in both economic
output and in the number of created jobs. In essence, the global financial system is an integral
part of the global economic system, and its appropriate functioning is thus essential to the
stability of the world economy, as it constitutes an important pillar upon which global
economic uncertainty is averted.

1.3. The decentralisation of the global financial system

Furthermore, it should be observed that that are several types of financial markets within the
highly decentralised structure of the global financial system. That is, within the global
financial system, there are several specific markets that are bound by a particular set of
financial operations that share common characteristics. These distinct types of markets may
be characterised as quite structured channels through which a vast pipeline of loanable funds
is continually transferred between those who supply funds to those who seek to use those
funds to finance a set of economic activities to which capital financing is crucial. The
‘meeting point’ (i.e., the market equilibrium) between the demand and supply of loanable
funds is thus the capital and interest rate earned by providers of available funds on the
amount of capital lent, which is billed to those who seek to use the said capital for their
economic activities. These specific financial market segments typically move a vast flow of
loanable funds that continually replenish these specific segments. Some of the basic types of
markets will be hereinafter described.

Definitions: The distinct segments of the financial markets that serve the global financial
system may be classified in multiple forms. One of the most widely use definitional
frameworks involves the distinction between the money markets vs. the capital markets
(Mishkin, 2004). The former is mainly concerned with the supply of short-term loans with an
average maturity of less than a year; while the capital markets are essentially concerned with
supplying long-term possessing an average maturity superior to one year. A second major
categorisation involves the distinction between open markets (where financial agents, either
seeking or borrowing funds, may participate as buyer or seller), as opposed to the existence
of negotiated markets (where only a few bidders seek to acquire assets, such as in the case of
financial auctions) (Mishkin, 2004). A third major categorisation involves the definitional
framework involving the primary versus secondary markets (Mishkin, 2004). The primary
markets are mainly concerned with the issuance and promotion of newly minted financial
instruments, whereas the secondary markets are essentially concerned with the trading
activities involving existing financial instruments that have already been issued and initially
traded in the corresponding financial marketplace. A fourth major categorisation involves the
distinction between the spot markets and the futures, forward, or options markets (Hull,
2006). In the spot markets, financial products are typically exchanged through financial
transactions associated with the immediate purchase/ sale of financial products or services.
Whereas, in the futures, forward, or options markets (which by themselves deal in quite
distinctive financial products or services), emphasis is put on the future delivery of the
underlying products or services, at a mutually agreed date, and under certain market
conditions.

1.4. The global financial system as the marketplace for

savings and investment
Overall, it should be noted that the key role associated with a proper functioning of the global
financial system is to harness an adequate pipeline of savings(i.e., capital available for
lending purposes once personal consumption expenditures by households and the earnings
retained by businesses are accounted for) and channel those funds into an adequate pool of
investments (i.e., involving the purchase, by borrowers, of capital goods and/or the
accumulation of inventories of products to sell) (Krugman, et al., 2011). Subsequently,
investment in itself further stimulates the economy by generating new products and/ services,
by creating new jobs, and by stimulating the establishment of new businesses, giving rise to
further economic growth, job creation, and a higher standard of living. By virtue of the
determination of interest rates within the global financial system, the money and capital
markets increase the pipeline of savings generated by households and firms, augmenting the
volume of new investment into new plant and equipment, and into inventories of products
which become subsequently available for sale, in furtherance of the supply side of the
markets.

Money thus becomes a vehicle for the satisfaction of the financial needs of both lenders and
borrowers.

1.5. A brief definition of money

Prior to addressing the main determinants associated with the demand and supply for money,
a brief definition of money should be presented. Money is a financial asset that can readily be
used to purchase goods and services available in the marketplace. Broadly viewed, money
encompasses a set of highly ‘liquid’ financial assets comprising cash, as well as other highly
liquid assets (e.g., such as the monies easily available through checking accounts) (Mishkin,
2004). In the absence of money, the transaction of goods and services might have to be made
through barter exchange (whereby a good would be sold in exchange for another good),
which requires extensive ‘matching’ between the needs of buyers and sellers alike (Banerjee
and Maskin, 1996). Money thus becomes the common denominator between the two parties
involved in any transaction for goods and services, as it constitutes a common yardstick for
both of these parties, eschewing the need for both buyers and sellers to match their needs
through lengthy bargaining processes, thus avoiding cumbersome and otherwise lengthy
exchange processes.

As with any other commodity, money is also subjected to the laws of demand and supply,
insofar as the former is linked to the reasons why financial agents should hold this type of
asset, while the latter is associated with the issuance of this type of asset by the relevant
monetary authorities.

The following sub-section addresses the most pertinent aspects associated with the demand
for money by financial agents.

2. The demand for money

The demand for money reflects the amount of financial assets associated with a high degree
of liquidity that a given economic agent may want to hold. The main reasons for holding
these positions are to be described hereinafter, but it should be pointed out that these
positions are associated with a non-negligible economic cost (i.e., the opportunity cost for
holding money).

2.1. The opportunity cost of holding money

This is due to the fact that, when a given financial agent opts to hold cash, this financial
position carries a cost insofar as the said amount of money might be earning interest, but the
economic agent has decided to forego that marginal income on the referred amount in order
to use this position for some specific non-savings related purpose. For example, a given
consumer may need to make a purchase requiring payment on demand. The said consumer
might use the balance of her/his checking account to make that purchase, instead of using
her/his accumulated savings. Notwithstanding, it should be observed that this decision is
sensitive to the overall level of interest rates in place in the markets, as higher interest rates
imply a higher cost of holding capital than when the rates at a lower level.

2.2. Reasons for holding money

Discussion point: But what are the reasons for holding money (regardless of the type of
definition used)?

Economists have pointed out to the fact that economic agents might want to hold money due
to three (3) different reasons (Mishkin, 2004). First, taking into consideration that economic
agents need to use cash in order to settle frequent purchases of goods and services, these
consumers might need to hold a sufficient amount of liquid assets in order to conduct these
operations. That is, the economic agent needs to hold cash for transaction purposes. Second,
economic agents might want to hold money to settle for uncertain events. That is, economic
agents might face an uncertain situation that might require them to settle a purchase of goods
and/or services, the amount of which is unbeknownst to them beforehand. Thus, these agents
might opt to secure money in the event they might face this (uncertain) settlement, a
motivation fuelled by liquidity purposes as a precautionary (i.e., pre-emptive) reason. Third,
economic agents may want to hold liquid assets in order to rebalance her/his financial
portfolios. In this specific case, economic agents might hold a portfolio comprising several
types of securities (such as stocks, bonds, or hybrid securities), and holding money (e.g.,
cash) might alter the portfolio’s financial profile (e.g., in terms of risk and return) associated
with the set of financial investment options. Thus, economic agents might be holding money
due to portfolio rebalancing purposes, in order to adjust the composition of their financial
portfolios to existing financial market conditions (e.g, as in the aftermath of a financial crisis,
where financial positions have to be re-evaluated) (Mishkin, 2004).

Essentially, demand for money is established by either families (households) and/or firms,
and might be viewed as the total sum associated with the three previous motives previously
described (i.e., the transaction, the liquidity, and the portfolio rebalancing purposes). This
does not exclude the fact that these motivations may vary over time, or that a given
motivation might be more relevant than the remaining ones (the determinants of the
corresponding empirical estimations are beyond the present guide).

Definitions: The Quantity Theory of Money states that the overall price level associated with
the goods and services produced by a given economy is directly proportional to the amount of
money in circulation (typically defined as the money supply). In numerical terms, the
relationship is thus given by the equation of exchange:

M x V = P x Y,

where M represents the money supply, V the velocity of money, P the overall price level, and
Y the aggregate income (P x Y is also known as total spending, or nominal GDP).  A major
implication associated with this theory is that inflation is essentially linked to the money
supply, as both sides of the equation must balance (i.e., when M suddenly increases, both
sides of the equation above must also increase, giving rise to inflation) (Mishkin, 2004).

Notwithstanding, their corresponding decisions about holding money are conditioned by

multiple variables, such as the prevailing interest rate, income, and/or wealth, etc. One of the
most important determinants for holding money is thus the level of interest rate, as economic
agents and firms who hold money typically pay a price which is reflected in the opportunity
cost of holding money (Krugman, et al., 2011). This opportunity cost is the foregone interest
rate that could be obtained should the said money be earning interest. That is, the opportunity
cost for holding money is reflected in the lost interest when the money is not used as a saving
instrument over time. Notwithstanding, it should be observed that the higher the overall level
of interest rates, the higher the opportunity cost (which is foregone) associated with the
option of holding money.

2.3. The demand for money curve

A demand for money schedule can thus described, using the overall level of interest rates as a
main determinant.  Because the overall level of interest rates typically conditions the
opportunity cost of holding money, the overall quantity of money economic agents and
businesses might want to hold is, other things being held constant, negatively related to the
interest rate.

Where the importance of demand for money is concerned, this topic is of the utmost
importance to macroeconomic policy analysts, insofar as estimating the demand for money
plays a pivotal role in the pursuit and implementation of appropriate monetary policy tools,
and in the selection of appropriate monetary policy actions. This is especially relevant in the
context of the onset of economic and/or financial crises, which necessarily prompt the
intervention of the relevant monetary authorities in the aftermath thereof (Mishkin, 2009).
Thus it is vital for these policy analysts to have estimations regarding this important
macroeconomic topic, in order to facilitate their interventions in the appropriate markets (e.g.,
in the monetary markets). As a consequence, both empirical and theoretical research has been
devoted on this topic.

A simple curve depicting this relationship between money and interest rate can be drawn
based on the negative association between these variables. Accordingly, the curve
representing the money demand curve depicts the negative relationship between the interest
rate offered by the financial markets and the quantity of money demanded by economic
agents. The curve thus has a negative slope, insofar as a higher level of interest rates offered
by the market is associated with a higher opportunity cost related to holding money. That is, a
higher interest rate also reduces the overall quantity of money demanded by economic agents
(Krugman, et al., 2009).

Thus, a typical representation is presented in the following figure:

FIGURE 1. THE MONEY DEMAND CURVE

 Interest rate (r)

r*

q*Quantity of money demanded (q)

As can be observed in this figure, the higher the overall level of interest rates, the lower the
quantity of money demanded, as economic agents prefer to hold more money in savings, than
to have it readily available and forego the corresponding interest earned.

2.4. Shifts in the money curve

Nevertheless, it should be observed that certain economic circumstances may dictate that the
demand for money curve might shift over time. This is an important point to retain, especially
in the context of the influence of other unaccounted variables over the said negative
relationship between interest rates and the quantity of money demanded.

Accordingly, a change in the demand for money may occur when there are changes in the
aggregate price level, or in real GDP, or even within the banking industry and the
corresponding technology it promotes. For example, the ubiquity of ATM machines and pay
terminals for debit cards may strongly curtail the need to physically hold cash in order to pay
for purchases, as transactions might be conducted solely using electronic means of payment,
thus affecting the amount of money demanded.
FIGURE 2. THE MONEY DEMAND CURVE AND CORRESPONDING CURVE SHIFTS

Interest rate (r)

r*

D0  D1    D2
            q***      q**Quantity of money demanded (q)

When economic agents demand more money, the corresponding money demand curve shifts
to the right (D1 to D2), and the quantity of money demanded rises for any given interest rate.
Reciprocally, when economic agents demand less money, the corresponding money demand
curve shifts to the left (from D1 to D0) for any given level of interest rate, as the quantity of
money demanded falls for any given level of the interest rate.

Lastly, the following section will deal with the supply for money side of the economic
equation, insofar as the demand for money schedule is obviously constrained by the
availability of the several concepts that might be associated with money (bank notes, coins,
etc.).

3. The supply of money

The money supply is essentially defined as a set of liquid and safe set of assets that
businesses and households and businesses can use in order to make their payments, or even to
use as a financial instrument for short-term investments. For example, the U.K.’s currency (£)
and corresponding balances held in checking accounts and/or money savings accounts are
typically included in many of the most basic measures associated with the money supply
(Sloman, 2006). Notwithstanding, there are multiple technical monetary measures associated
with the money supply. For example, there are several standard (i.e., universally accepted)
measures of the money supply that reflect these type of assets. Amongst others, these
measures include, for example, the monetary base, as well as the monetary aggregates such as
M1 and M2.

Types of money
Definitions: The monetary base is essentially defined as the sum of a given economy’s
currency in circulation and the balances associated with the deposits held by banks and other
depository and financial institutions in their corresponding accounts located at the
corresponding central bank (Krugman, et al. 2011). In turn, M1 is defined as the sum of
currency in circulation held by the public and the deposits at depository institutions. The
latter are financial institutions that accept funds essentially through deposits from the general
public, and might encompass commercial banks, retail banks, savings banks, or even building
societies. M2 is further defined as M1 plus the savings deposits, as well as other safe and
liquid assets, including some money market funds (Federal Reserve Bank, 2016).

Typically, these concepts of money are quite well documented by a given economy’s central
bank, and information on the existing categories is quite readily available. This is in stark
contrast to the information concerning the money demand (and the corresponding curve),
which has to be estimated using advanced mathematical techniques of econometric
extraction, as information on the distinct components of the money demand curve is not
easily observed. Another important contrast to the demand for money framework is
associated with the fact that the money supply framework is essentially determined by
financial institutions, such as the central bank or other financial institutions concerned with
the process of ‘money creation’. In fact, under the money supply curve, the most important
agents are the following: i) the economy’s central bank (i.e., the government agency that
oversees the whole banking system and is responsible for the conduct and proper
implementation of monetary policy (e.g., the Bank of England); ii) the banks(e.g. retail
banks, as the financial intermediaries that collect deposits from businesses and individuals
and subsequently provide commercial or individual loans); iii) depositors (e.g., the
individuals and businesses that hold deposits in financial institutions; and iv) borrowers from
banks (e.g., individuals and businesses that borrow from the lending financial institutions).

3.1. The ‘creation’ of money: the institutions

In essence, money is not only created by the central banks (e.g., the coins and notes in
circulation), but is also ‘created’ through the concession of credit by financial institutions that
are willing to take depositors’ monies and ‘farm’ them out to borrowers that will
subsequently apply these funds for productive- or personal consumption-related investments
and assets. The borrowers can then pay the initial capital plus the accrued interested to the
financial institutions involved as the money lenders, and these proceeds can then cover the
financial institutions’ obligations towards their financing sources (e.g., deposit holders).

In the past, the most common measures associated with the money supply had exhibited close
relationships with a given country’s most important economic variables, such as the nominal
gross domestic product (GDP), or the price level. That is, these measures were actively used
as monetary policy instruments in order to attain certain macroeconomic goals established
under a given central bank’s mandate (e.g., low inflation, sustainable economic growth
trajectories, etc.). Notwithstanding, in more recent times, these correlations have broken
down, so that the evolution of the money supply is no longer a good harbinger of the
evolution of the GDP, although the link between some more evolved monetary aggregates
(such as M2) and inflation might still observable in certain economies.

The most important financial institution in the money supply side is thus the central bank, but
banking institutions also play an important part in the ‘creation’ of money. For example,
banks can create money through their financial intermediation function. Banks elicit financial
assets such as cash and other liquid assets from deposits holders, and subsequently ‘farm’ this
money out to those seeking business and/or consumer loans. These activities are for-profit
banking activities conducted in order to generate revenues and profits for these financial
market participants.

3.2. The creation of money: the process and the credit

multiplier
In order to initiate the process of money creation, central banks typically deal with each
financial institution (banks) under their supervision, generally through a specific type of
financial account. When central banks wish to deal with the financial institutions under their
supervision, they typically conduct open market operations by buying/selling securities (e.g.,
bonds) to banks. When central banks buy bonds, they inject liquidity (i.e., money) in the
banks and into the financial system in the form of deposits. Quite the contrary, when they sell
bonds, they typically withdraw liquidity from banks and the financial system through the said
account. Banks thus receive or support financing through this special relationship with their
corresponding central bank. In an expansionary monetary phase, that is, when central banks
want to stimulate economic growth by facilitating the concession of credit by banks, they
tend to buy securities from banks, thus injecting liquidity into the financial system through a
specific set of banks. In turn, banks can subsequently use these deposits to the benefit of
credit concession to their corresponding clients. That is, banks constitute a very important
financial intermediary in the credit concession channel, insofar as they are the recipient of
funds from central banks, and are thus in a position to lend those funds to their retail client
base. However, a small portion of these deposits is retained by the financial institution in
order to guarantee the said bank’s solvability, while the remaining funds (essentially, the
bulk) are lent. In turn, when the monies lent are, for example, applied in a given investment
project, these funds not only stimulate economic growth (as investment is a fundamental
determinant of GDP), but these monies are then deposited at another financial institution by
these funds’ recipients. The money creation process thus continues at this second bank (and
the funds, minus the required reserves, are lent for another entirely different purpose). This is
the essence of an expansion of the money supply, as the process continues indefinitely,
although the multiplier effect decreases with each round. Expansion of the money supply thus
stimulates the underlying real economy, as well as the banking activities associated with
these financial activities. Lastly, when monetary policy becomes contractionary, that is, when
central banks wish to cool an ‘overheating’ economy (because it leads to excessive inflation,
for example), they pursue the opposite macroeconomic policy by systematically selling
securities in open market operations, and withdrawing monies from banks and the financial
system as a whole. In this scenario, there is a contraction of the money supply (Mishkin,
2004).

3.3. The money supply curve

Overall, it should be observed that the money supply process is not very sensitive to the
overall level of interest rates. Taking into consideration that the money supply essentially
encompasses the currency in circulation and liquid bank deposits, the said money supply is
not deemed to respond to the overall level of interest rates. In this case, the money supply is
the same whether interest rates are low or high, suggesting that the money supply curve is the
same for each and every level of interest rates. The following figure is typical of the money
supply curve:

FIGURE 3. THE MONEY SUPPLY CURVE

Interest rate (r)

q****Quantity of money supplied (q)

This above-mentioned figure depicts the money supply curve, which is insensitive to the
overall level of interest rates. That is, the money supply is typically the same regardless of the
level of interest rates prevailing in the economy. The quantity of the money supply is thus
established at q****.

4. The market equilibrium between the

demand and supply of money
In any market where demand and supply meet, a market equilibrium ensues determining the
overall quantity of goods (in the present case, the amount of money), as well as the
corresponding price (in this case, the overall level of interest rates). This is the essence of the
market clearing mechanism whereby the two sides of the market are confronted in order to
arrive at a satisfactory solution to both parties - the equilibrium level. Typically, this
equilibrium point satisfies both sides of the market through a bargaining process. The
following figure depicts the overall market clearing mechanism and the ensuing market
equilibrium.

FIGURE 4. THE DEMAND AND SUPPLY FOR MONEY: THE MARKET

EQUILIBRIUM

Interest rate (r)      MS

 r*

(market clearing rate)

    MD

q*Quantity of money in equilibrium (q)

4.1. The equilibrium between demand and supply

The market clearing mechanism thus confronts both the money demand curve and the money
supply curve. The money demand curve represents the segment of economic agents that
require money for a number of motives, while the money supply curve depicts the overall
level of currency and deposits available, as issued by the central bank, as well as through
financial institutions that participate in the money creation process within the financial
system.

The equilibrium point is thus attained through the intersection of the demand and supply
curves at (r*,q*). It should be observed that this is a unique point. Should the market interest
rate be above r*, the money demand curve would suggest a demand for money lower that q*.
In this case, the supply of money would still be q* (higher than the demanded quantity).
Given that there would be excess liquidity in the system (as the money demanded would be
lower than the supplied), the interest rate would fall until r* was reached, matching demand
and supply. The market would then clear at (r*,q*).

On the other hand, should the market interest rate be above r*, the money demand curve
would suggest a demand for money higher that q*. In this case, the supply of money would
still be q* (lower than the demanded quantity). Given that there would be a liquidity shortage
in the system (as the money demanded would be higher than the supplied), the interest rate
would rise until r* was reached. The market would again then clear at (r*,q*), matching
demand and supply.

4.2. Changes in the equilibrium through the money supply

Lastly, it should be observed that monetary policy might be either expansionary or
contractionary. Where expansionary monetary policy is concerned, the central bank seeks to
expand economic growth by expanding the money supply through, for example, open market
operation. This necessarily expands the money supply curve (to the right, in the above-
mentioned figure), lowering interest rates and stimulating the economy. Reciprocally, where
contractionary monetary policy is concerned, the central bank seeks to contract excessive
economic growth (which might lead to higher inflation) by contracting the money supply
through, for example, open market operations. This necessarily contracts the money supply
curve (to the left, in the above-mentioned figure), raising interest rates and cooling off the
economy (Samuelson and Nordhaus, 2009). The above-mentioned reasoning assumes that the
demand for money stays constant in both cases. Notwithstanding, the central bank thus
becomes a major decision maker in the financial markets, in view of the fact that its actions
can swiftly condition the performance of the financial markets through the manipulation of
the overall level of interest rates. This central bank intervention is particularly important in
the context of the fulfillment of the central bank’s mandate, as the interest rate instrument has
become a decisive tool in the central banking toolkit.

REFERENCES
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Bank of Mingo, 2016. Bank of Mingo. [Online]. Bank of Mingo. [viewed 15 October 2016].
Available: https://www.thebankofmingo.com/

Board of Governors of the Federal Reserve System, 2015. What is the money supply? Is it
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2016]. Available from: https://www.federalreserve.gov/faqs/money_12845.htm

Gambacorta, L., and Marques-Ibanez, D., 2011. The bank lending channel: Lessons from the
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Hull, J., 2006. Options, Futures and Other Derivatives. Sixth Edition. United States of
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Hull, J.C., 2009. The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can
Be Learned? [Online]. Available: http://www-
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2016].

Krugman, P., Wells, R., and Graddy, K., 2011. Essentials of Economics. Second edition.
United States of America: Worth Publishers.

Mishkin, F.S., 2004. The Economics of Money, Banking, and Financial Markets. Seventh
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Mishkin, F.S., 2009. Is monetary policy effective during financial crises? Available:
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Samuelson, P.A., and Nordhaus, W.D., 2009. Economics. Nineteenth edition. Asia: McGraw-
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Sloman, J., 2006. Economics. Sixth edition. England: Pearson Education Limited.

CASE STUDY
We are presently living in a post-recessionary economic environment, after having gone
through one of the worst global financial crisis the world has ever known. Moreover, the said
crisis’ global impact has attained truly pandemic proportions, as its consequences will be
undoubtedly felt throughout the following years. The crisis’ impact was compounded by
three major banking failures, namely, Bear Sterns, Lehman Brothers, and Northern Rock. The
first two banking failures constituted a direct consequence of the ‘Subprime’ financial crisis
in the U.S.A., especially in the context of the demise of the subprime segments in this
country, as well as the failure in the U.S. money markets; lastly, Northern Rock was a
significant U.K. banking demise associated with the global collapse in property prices in the
U.K. and international financial contagion processes in the global banking industry.

Bear Stearns
This U.S. financial institution was a major brokerage firm, investment bank, and securities
trader that operated at a truly global scale. Prior to its demise, the bank had been active in the
financial markets for more than 85 years. Before the onset of the U.S. Subprime crisis, the
bank had a massive financial position in subprime mortgages (excessive residential credit
held in its balance sheet). Most obviously, the bank’s stakeholders (its clients, counterparties,
and investors) started to raise serious questions concerning the state of the bank’s balance
sheet and the real quality of its financial assets. In 2007, when a failed hedge fund sponsored
by a subsidiary of Bear Stearns brought about unwanted questions about the quality of the
subprime loans the bank held, the bank’s stock market price started to collapse, in line with
the retraction in U.S. house prices. Moreover, the bank had a reputation as an aggressive
trading institution quite willing to undertake significant risks, and the firm was quite proud of
its reputation as a top bank, with a stellar management team, as well as good management
practices. The bank was recognized as one of the market leaders operating in its segment,
especially in the run-up to the crisis from 2005 to 2007. Notwithstanding, and due to the
massive scale of its subprime business, the bank became one of the most highly leveraged
financial institutions on Wall Street. The bank collapsed in March 2008, and was later sold to
JPMorgan. The bank’s demise constituted a key moment in the financial watershed that
ensued, especially taking into consideration the weaknesses of risk management procedures
in the financial industry that ultimately led to the global financial crisis and ensuing recession
(Ryback, n.d.).

Lehman Brothers
This U.S. financial institution was a financial giant with more than 209 registered subsidiaries
in twenty-one countries (Fleming and Sarkar, 2014). This giant financial conglomerate filed
for bankruptcy on September 15, 2008, while its subsidiaries also started to collapse in the
wake of the initial U.S. bankruptcy.
Central to the Bank’s demises was the Bank’s ‘Repo 105’ program, which transformed a
financing transaction mechanism into a massive asset disposal mechanism. In a typical repo
operation (which stand for ‘sale and repossession’), a given financial institution borrows
funds against highly liquid securities (usually treasuries), so that the latter are used as
collateral. For example, if a bank has securities for £105, it might borrow £100 from another
financial institution, by presenting the securities as collateral for the short term loan. The £5
difference between the value of the posted collateral and the loan is called the ‘haircut’, and
constitutes the price for both the liquidity of the security and subsequent risk attached to the
financing operation. Loans in the repo markets are typically short-term, lasting from one
night to three months. Lehman Brothers allegedly used repos for financing reasons, but
accounted for these operations as asset disposals, so that the Bank effectively used the repo
proceeds to decrease its leverage (at least officially), thus avoiding any regulatory scrutiny
that would otherwise be required. This ultimately led to the Lehman’s demise. The Bank
extensively used this short-term financing model, in order to fund its multi-billion dollar
operations in aggressive real estate-related assets. The Bank thus collapsed under its
significant exposures to subprime mortgages, in the wake of the real estate collapse of 2007-
2008 (IMD, 2010).

Northern Rock
In September 2007, the U.K. witnessed its first bank run in more than a century, as deposit
holders of Northern Rock patiently waited in line outside the Bank’s branch offices to
withdraw their money. Northern Rock’s collapse stemmed from the fact that the Bank relied
heavily on non-retail funding, through a complex combination of short-term financing in the
capital markets, and through securitized notes and other longer-term funding sources.
Northern Rock used this financing mechanism in order to fund the expansion of its balance
sheet acquisition of mortgage assets, which overwhelmingly outgrew the Bank’s traditional
funding source of branch-based retail deposits. On the eve of its demise, Northern Rock - a
building society that should have heavily relied on mutually owned savings and the Bank’s
mortgage business and clients - had a coverage of liabilities to retail deposits in the vicinity of
23 percent (as a % of total liabilities). In the summer of 2007, this ratio degraded even more
considerably, especially after the bank run by the deposit holders. Although Northern Rock
had virtually no subprime lending of its own (the Bank was essentially in the business of
prime mortgage lending to U.K. households), it was nevertheless tapped on financing
mechanisms that heavily relied on short-term funding processes (quite a similar situation to
Northern Rock’s counterparts in the U.S., as these institutions were quite heavily exposed to
the subprime debacle). In the summer of 2007, when the global short-term funding and
interbank lending markets all but froze, Northern Rock’s financing model suddenly
collapsed. The quality of the balance sheet of any mortgage bank is vulnerable to a sharp
decline in house prices and rising unemployment, insofar as it heavily affects the quality of
its banking assets, as well as its balance sheet, especially once an economic and financial
shock occurs. Although the Bank of England tried to step in in order to save the bank,
Northern Rock ultimately collapsed, and was placed under public ownership in 2008 (Shin,
2009).

References (Case Study)

Fleming, M.J., and Sarkar, A., 2014. The Failure Resolution of Lehman Brothers. [Online].
Available: https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf
[viewed 15 October 2016].
IMD, 2010. The Lehman Brothers Case - a corporate governance failure, not a failure of
financial markets. [Online]. Available:
http://www.imd.org/research/challenges/upload/TC039-10PDF.pdf [viewed 15 October
2016].

Ryback, W., n.d. Case study on Bear Stearns. [Online]. Available:

http://siteresources.worldbank.org/FINANCIALSECTOR/Resources/02BearStearnsCaseStud
y.pdf [viewed 15 October 2016].

Shin, H.S., 2009. Reflections on Northern Rock: The Bank Run that Heralded the Global
Financial Crisis. Journal of Economic Perspectives, Volume 23 (Number 1), pp. 101-119.