CH 18 / BANKING, MONEY AND INTEREST RATES

The meaning and functions of money:

-Money supply and aggregate demand.

The functions of money:

- Medium of exchange: Means of payment for goods and services
and as a means of payment for labour and other factor services.
- Means of storing wealth: today’s labour can be used to purchase
goods and services in the future.
- A means of evaluation: The value of goods is expressed in terms of
prices, and prices are expressed in money terms. Money thus
serves as a ‘unit of account’.
- Means of establishing the value of future claims and payments:
wage agreements, supplier contracts.

What should count as money?

- Narrow definition of money includes just cash (e.g., notes and
coins). / Cash in circulation

- Broad definition of money includes various of bank account,

financial assets. / Highly liquid assets (house, car, shares)

The ideal attributes of money:

¡ durability
¡ divisibility
¡ transportability
¡ non-counterfeit ability
The evolution of bank deposit money:
¡ evolution of coinage
¡ goldsmiths and the origins of bank notes
¡ bank deposit money

18.2 / The financial system

The role of the financial sector:

Financial intermediaries are the general name for financial institutions
(banks, building societies, etc.) which act as means of channeling funds
from depositors to borrowers.

In this process they provide five important services:

1) Expert advice: Financial intermediaries who advice their customers

on financial matters such as best way of investing their funds and
alternative ways of obtaining finance.
- Encourages the flow of savings and the efficient use of the savings.

2) Expertise in channelling funds: Financial intermediaries have the

specialist knowledge to be able to channel funds to those areas that
yield the highest return. They also have the expertise to assess risks
and to refuse loans for projects considered too risky or to charge a
risk premium to others.
- Encourages the flow of savings as it gives savers the confidence that
their savings will earn a good rate of interest.
- Ensures that projects that are potentially profitable will be able to
obtain finance
- They help to increase allocative efficiency.

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 3) Maturity transformation: The transformation of deposits into
loans of a longer maturity.
- Maturity transformation implies a maturity mismatch between the
liabilities and assets on institutions’ balance sheets.

4) Risk transformation: The process whereby banks can spread the

risks of lending by having a large number of borrowers.

5) Transmission of funds: This is to provide a means of transmitting

payments.

- Use of debit cards, credit cards, the internet, telephone banking,

cheques, direct debits etc.,

The banking system (Types of banks):

1) Retail banks: Branch, telephone, postal and internet banking for

individuals and businesses at published rates of interest and
charges. Retail banking involves the operation of extensive branch
networks.

2) Wholesale banking: Where banks deal in large-scale deposits and

loans, mainly with companies and other banks and financial
institutions. Interest rates and charges may be negotiable.

- Wholesale deposits and loans: Large-scale deposits and loans

made by and to firms at negotiated interest rates.
- Universal banks: conducting retail and wholesale banks

Building Societies:

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 - Financial deregulation: The removal of or reduction in legal rules
and regulations governing the activities of financial institutions.

- Monetary financial institutions (MFIs): Deposit-taking institutions

including banks, building societies and the Bank of England.

- Money market: The market for short-term debt instruments, such

as government bills (Treasury bills), in which financial institutions
are active participants.

Deposit taking and lending (Balance sheets):

- Financial instrumetns: Financial products resulting in a financial

claim by one party over another.

- Liabilities: All legal claims for payment that outsiders have on an

institution.

- Types of liabilities:

1) Sight deposits: Deposits that can be withdrawn on demand without

penalty.
- Current accounts at banks. (Chequebooks and debit cards)
2) Time deposits: Deposits that require notice of withdrawal or where
a penalty is charged for withdrawals on demand. (Saving accounts)
3) Certificates of deposit (CDs): Certificates issued by banks for fixed-
term interest-bearing deposits. They can be resold by the owner to
another party.
4) Sale and repurchase agreements (repos): An agreement between
two financial institutions whereby one in effect borrows from
another by selling its assets, agreeing to buy them back (repurchase
them) at a fixed price and on a fixed date. (Government bonds)

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 5) Capital and other funds: This consist largely of the share capital in
banks.

Assets: Possessions or claims on others.

There are three main categories of assets.

1) Market loans: Short-term loans (e.g., money at call and short

notice).
- Short-term loans: These are in the form of market loans, bills of
exchange or reverse repos. The market for these various types of
loan is known as the money market.

2) Bills of exchange: Certificates promising to repay a stated amount

on a certain date, typically three months from the issue of the bill.
Bills pay no interest as such but are sold at a discount and
redeemed at face value, thereby earning a rate of discount for the
purchaser.

- Commercial bills: Bills of exchange issued by firms.

- Treasury bills: Bills of exchange issued by the Bank of England on
behalf of the government. They are a means whereby the
government raises short-term finance.
- Discount Market: An example of a money market in which new or
existing bills, such as Treasury bills or Commercial bills, are bought
and sold at a discount below their face value: i.e., the value at
which they will be redeemed on maturity.
- Bank bills: Bills that have been accepted by another financial
institution and hence insured against default.

3) Reverse repos: Gilts or other assets that are purchased under a sale
and repurchase agreement. They become an asset to the
purchaser.

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Longer-term loans:
- Fixed term loan (repayable in instalments over a set number of
years typically, six months to five years).
- Overdraft (Unspecified term).
- Outstanding balances on credit card accounts, and mortgages
(typically for 25 years).

Taxing the banks:

Bank Levy:
÷ balance sheet tax
÷ full rate and half rate
÷ certain liabilities excluded
÷ offset specific highly liquid assets against taxable
liabilities

bank corporation tax surcharge:

÷ taxing banks’ profits

Profitability: Profits are made by lending money out at a higher rate of

interest than that paid to depositors. The average interest rate received
by banks on their assets is greater than that paid by them on their
liabilities.

Liquidity: The ease with which an asset can be converted into cash
without loss.

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Maturity gap: The difference in the average maturity of loans and
deposits.
- For profitability the larger the gap, larger the profits are.
- For liquidity banks will want a relatively small gap: if there is a
sudden withdrawal of deposits, banks will need to be able to call in
enough loans.

Liquidity ratio: The proportion of a bank’s total assets held in liquid form.

Secondary marketing and securitization:

Secondary Marketing: Where assets are sold before maturity to another

institution or individual. The possibility of secondary marketing
encourages people or institutions to buy assets/grant loans in the primary
market, knowing that they can sell them if necessary, in the secondary
market. The sale of existing shares and bond on the stock market is an
example of secondary marketing.

- Certificates of deposit are a good example of secondary marketing.

Securitisation: Where future cash flows (e.g., from interest rate or

mortgage payments) are turned into marketable securities, such as
bonds. The sellers (e.g., banks) get cash immediately rather than having
to wait and can use it to fund loans to customers. The buyers make a
profit by buying below the discounted value of the future income. Such
bonds can be very risky, however, as the future cash flows may be less
than anticipated.

-Securitization occurs when a financial institution pools some of its assets,

such as residential mortgages, and sells them to an intermediary known
as a special purpose vehicle (SPV).

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Special Purpose vehicle (SPV): Legal entity created by financial
institutions for conducting specific financial functions, such as bundling
assets together into fixed-interest bonds and selling them.

Colleteralised debt Obligations(CDOs): These are a type of security

consisting of a bundle of fixed-income assets, such as corporate bonds,
mortgage debt and credit card debt.

Dangers of secondary marketing:

- Banks feel that they can operate with a lower liquidity ratio hence,
this leads to a lower national liquidity ratio.
- Failure of one bank will have a knock-on effect on those banks
which have purchased its assets.
Sub-prime debt: Debt where there is a high risk of default by the
borrower (e.g., mortgage holders who are on low incomes facing higher
interest rates and falling house prices).

Capital adequacy ratio (CAR): The ratio of a bank’s capital (reserves and
shares) to its risk-weighted assets.

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Strengthening international regulation of capital adequacy and liquidity:

Basel III minimum capital requirements:

Macro-prudential regulation: Regulation which focuses not on a single

financial institution but on the financial system as a whole and which
monitors its impact on the wider economy.

Global systemically important banks (SIBs): Bank identified by a series of

indicators as being significant players in the global financial system.

Liquidity coverage ratio: Requires that financial institutions have high

quality liquid assets (HQLAs) to cover the expected net cash flow over the
next 30 days.

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Net stable funding ratio: Takes a longer-term view of the funding profile
of banks by focusing on the reliability of liabilities as source of funds,
particularly in circumstances of extreme stress. The NSDR is the ratio of
stable liabilities to assets likely to require funding (i.e., assets where there
is a likelihood of default).

The central bank: Banker to the banks and the government. It oversees
the banking system, implements monetary policy and issues currency.

It issues notes:
The number of banknotes issued by the central banks depends largely on
the demand for notes from general public. If people draw more cash from
their bank accounts, the banks will have to draw more cash from their
balances in the Bank of England (or any other central bank).

Thus, the banking department will have to acquire more notes from the
Issue department, which will simply print more in exchange for extra
government or other securities supplied by the banking department.

It acts as a bank:
- To the government. It keeps two major government accounts: the
‘Exchequer’ and the ‘National Loans Fund’. Taxation and
government spending pass through the Exchequer. Government
borrowing and lending pass through the National Loans Fund.

- To banks. Bank’s deposits in the Bank of England consist of reserve

balances and cash ratio deposits.

- To overseas central banks. These are deposits of sterling (or euros

in the case of the ECB) made by overseas authorities as part of their
official reserves and/or for purposes of intervening in the foreign

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 exchange market in order to influence the exchange rate of their
currency.

It operates the government’s monetary policy:

Open-market operations (OMOs): The sale (or purchase) by the

authorities of government securities in the open market in order to
reduce (or increase) money supply and thereby affect interest rates.

Operational standing facilities: Central bank facilities by which individual

banks can deposit reserves or borrow reserves.

Reserve averaging: The process whereby individual banks manage their

average level of overnight reserves between MPC meetings using the
Bank of England’s operational standing facilities and/or the inter-bank
market.

Quantitative easing (QE): A deliberate attempt by the central bank to

increase the money supply by buying large quantities of securities
through open-market operations. These securities could be securitized
mortgage and other private-sector debt or government bonds.

It provides liquidity, as necessary, to banks:

Financial institutions engage in maturity transformation. While most
customer deposits can be withdrawn instantly, financial institutions will
have a variety of lending commitments, some if which span many years.
Hence, central banks act as a ‘liquidity backstop’ for the banking system.
It attempts to ensure that there is always an adequate supply of liquidity
to meet the legitimate demands of depositors in banks.

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