Money & Banking Notes PDF

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Summary

Week 1 – Money Money supply is defined as anything that is generally accepted as payment for goods and services or in the repayment of debts Money as a concept is different to wealth & income: Wealth = total collection of pieces of property that serve to store value Income = flow of earnings...

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Week 1 – Money -

Money supply is defined as anything that is generally accepted as payment for goods and services or in the repayment of debts Money as a concept is different to wealth & income: Wealth = total collection of pieces of property that serve to store value Income = flow of earnings per unit of time

Functions of Money 1. Medium of Exchange: -

Eliminates the trouble of finding a double coincidence of needs (reduced transaction costs) Promotes specialisation MofE must be:

2. Unit of Account: -

Used to measure value in the economy Reduces transactions costs

3. Store of Value: -

Used to save purchasing power over time Other assets also serve this function

4. Other functions: -

A means of anonymous payments As a means of deferred payments

Liquidity -

Is the relative ease and speed with which an asset can be converted into a medium of exchange Money is the most liquid of all assets but loses value during inflation

Evolution of Payment System -

Is the method of conducting transactions in the economy: Commodity money: valuable, easily standardised & divisible commodities (eg. Precious metals) Representative money: money whose value arises from an underlying commodity which it represents Fiat Money – paper money decreed by governments as legal tender

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Cheques – an instruction to your bank to transfer money from your account Electronic payment E-money

Measuring Money

UK’s Total Money Supply (M4)

Central Bank Digital Currency (CBDC) -

With money & payment systems evolving, debates of a CBDC are on the rise CBDC is an electronic form of central bank money that could be used by households and businesses to make payments Increasingly likely that CBDC will be created by central banks worldwide (China is currently testing one they have created in major cities)

Avoids the risks of new forms of private money creation

Any significant deposit balances moved from banks to CBDC could lead to implications for the balance sheets

Supporting competition, efficiency & innovation in payments

Possibility of affecting the amount of credit provided by banks to the wider economy

Improving the availability & usability of central bank money

Could impact how BoE implements monetary policy and supports financial stability

Meeting future payment needs in the economy Addressing the consequences of a decline in cash

CBDC Positives & Negatives

CBDC Risks with the BoE

Week 2 – Cryptocurrencies -

These are becoming the evolutionary step of fiat money since their existence in 2009 Virtual monetary units and hence no physical representation Currently over 60m active trade investors in cryptocurrencies on more than 100 exchanges worldwide

Major Cryptocurrencies -

Bitcoin unveiled by Satoshi Nakamoto in 2009 post financial crisis Fundamental tech behind cryptocurrencies is blockchain

Blockchain -

Is a computer protocol enabling distributed ledgers & promising almost instantaneous & near free transactions It allows money and assets to be moved without a centralised custodian (ie bank/financial institution) Verification is performed via a peer to peer network

Types of Blockchain

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Centralised blockchain relies on at least one trusted authority

Major Cryptocurrencies Cont -

The Initial coin offering (ICO) boom in 2017 enabled anyone who created a digital currency to raise capital without the administrative burden of an IPO Resulted in the release of several alternatives to bitcoin commonly referred to as altcoins

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Decision to look at the above is based on market cap & type of blockchain system Market Cap is good indicator to know how a cryptocurrency is performing

Bitcoin - Bitcoin (BTC) was created to serve as a viable alternative to fiat money issued by -

central banks Bitcoin is still the most traded cryptocurrency in terms of market cap To transact, users need a BTC wallet Transactions can be made anonymous Bitcoin is created by decentralised users using their computer power to ‘mine’ and verify/process transactions

Bitcoin vs Gold

This graph shows that the quantity of bitcoin is meant to level off at 21million units by 2040. Compared to Gold, this is not similar as in modern times the production of gold is actually increasing Relative to other assets, how did Bitcoin perform at the height of the Covid-19 Pandemic?

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During a crisis, central banks are cautious and investors run to safe assets such as gold Financial markets did rally behind Bitcoin until late February before the stock market crashes in March On 12th March, rate of return on BTC sharply declined

Major Cryptocurrencies – Ethereum -

Ethereum is run on its platform specific cryptographic token, called Ether Transactions are much faster on the Ethereum network than on Bitcoins. Main driver of the 2017 ICO boom In 2016, the Ethereum network went through a crisis with the DAO investment fund hack – split into Ethereum without the hack (ETH) & Ethereum Classic (with the hack)

Ripple -

Ripple uses a consensus ledger validation method which is more centralised than most other cryptocurrencies It uses a digital payment platform called RippleNet The needed tokens were already minted at Ripple’s inception Ripple’s structure doesn’t require mining so reduces computer power usage and minimises network latency It is governed by Ripple Labs

Litecoin

Bitcoin Cash -

Split from Bitcoin in 2017 due to scalability issues of the Bitcoin blockchain Bitcoin has a strict one megabyte limit on the size of blocks Bitcoin cash increases the block size from 1 MB to 8 MB allowing for faster transaction times

Stable Coins -

Are pegged to a paper currency (Eg. US$) More promising in terms of large scale adoption but they too have weaknesses: Perceived more as assets rather than currencies The issuers needs to have enough reserve of fiat money to back up the coin

SC – Tether (USDT) -

USDT is the stable coin with the highest market cap It claims to be 100% backed by its USD reserves but continuously refuses to be audited, breaking user trust Holds its value at $1 per Tether

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On March 12th, BTC lost 40% of its value On the same day, investors rushed to Tether as BTC was being sold off Tether traded at 1 Tether to $1.08 which is extremely rare for a stable coin Shows a clear liquidity event in the cryptocurrency markets Movement of BTC & USDT shows that perhaps the movement of cryptocurrency is independent of financial markets movements around the world

Facebook Libra -

In June 2019, Facebook announced it plans to launch Libra coin in 2020 but it is yet to be issued Is the most promising stable coin but has faced a lot of regulatory challenges – in particular from US congress

Regulatory Responses Of Governments To Cryptocurrencies & Stable Coins -

With the growth of cryptocurrencies & the risk they pose to financial system, regulators have taken various actions to protect the investing public Some countries have banned crypto assets while others have been more liberal

Week 3 – Banking & the Management of Financial Institutions - Banks are vital financial institutions in any economy whose principal activities are: 1. Borrowing money from customers 2. Lending money to customers -

Other financial institutions & companies do the above as well

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Banks do facilitate the flow of funds through the economy but banks are also: 1. Intermediaries 2. Agents 3. Provide a venue for borrowers & lenders 4. Act as a principal for their own account

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Banks have promoted economic mobility and pushed the global economy to greater heights But a meltdown in the banking sector has catastrophic effects in an economy & global financial markets

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The Bank Balance Sheet - Is a statement of what a financial institution or company owns and owes at a given point in time – used to understand the principal activity of borrowing and lending

- Golden rule of balance sheets: total assets = total liabilities Bank Balance Vs Company Balance - A bank balance sheet is applicable only on the banks which are prepared to reflect the trade-off between the profit of the bank and its risk - A company balance sheet is applicable on all types of companies which are prepared to reflect the financial status of the business Understanding Bank Balance Sheets – We need to:

Assets Financial Assets - Are spilt into liquidity Assets & customer assets 1. Liquidity Assets - Reserves (includes vault cash) – includes required reserves and excess reserves - Cash items in process of collection - Deposits at other banks - Securities 2. Customer Assets (loans) – the largest section - Commercial & industrial assets – real estate and other commercial assets - Retail assets – mortgages & other retail assets

Physical Assets - Branches, call centres, buildings, computers etc - Banks own few physical assets in relation to their total assets

Liabilities -

Wholesale funding Customer deposits:

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Bank capital (equity) = leftover funds from Assets – liabilities Sits on liabilities because it is owed to shareholders Cushion against a drop in the value of assets which could force the bank into insolvency

Bank Equity & Net Interest Margin -

Shareholders are first in line to absorb the losses from a bank’s bad debt thanks to the bank’s Net Interest Margin (NIM) NIM = difference between the interest rate a bank pays on its liabilities & interest rate it generates from its financial assets

Basic Banking -

Changes on banks assets & liabilities occur all the time Basic operation of a bank is asset transformation Banks also provide services such as: Foreign exchange, payments, insurance policies & investment services

Bank Management -

A bank manager has 4 primary concerns: 1. Liquidity management 2. Asset management 3. Liability management 4. Capital adequacy management

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In addition we need to understand how financial institutions manage: 5. Credit risk 6. Interest rate risk

Liquidity management & role of reserves

2. Shortfall

Ways Of Eliminating Shortfall 1. Borrowing -

Cost incurred is in the interest rate paid on borrowed funds From the interbank or corporations (eg, by selling negotiable certificate of deposits)

2. Securities Sale -

The cost of selling securities is the brokerage & other transaction costs

3. Central Bank -

Borrowing from the central bank (CB) also incurs interest payments: In the US, the cost of borrowing from the Federal reserve is called the discount rate Other countries have different technologies

4. Reduce Loans -

Reduction of loans is the most costly way of acquiring reserves Calling in loans antagonises customers Other banks may only agree to purchase loans at a substantial discount

Asset Management Goals: - Seek the highest possible returns on loans and securities - Reduce risk - Have adequate liquidity Tools

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Find borrowers who will pay high interest rates and have low possibility of defaulting Purchase securities with high returns and low risk Lower risk by diversifying Balance need for liquidity against increased returns from less liquid assets

Liability Management -

The decision made by a bank in order to maintain liquid assets to meet the bank’s obligation to depositors Recent phenomenon due to rise of money centre banks in 1960s Expansion of overnight loan markets and new financial instruments (such as negotiable CDs) Checkable deposits have decreased in importance as a source of bank funds

Capital Adequacy management Banks hold bank capital for 3 main reasons: 1. Helps prevent bank failure 2. The amount of capital affects return for the owners (equity holders) of the bank 3. As a regulatory requirement

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Suppose during the 2008 global financial crisis, £5 million of their housing loans go bad – therefore they are written off The balance sheet therefore changes to look like this:

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A bank maintains bank capital to reduce the possibility of becoming insolvent Insolvency could lead to a bank run

Therefore:

Trade-off between safety & returns to equity -

Benefits the owners of a bank by making their investment safe Costly to owners of a bank because the higher the bank capital, the lower the return on equity Choice depends on the state of the economy & levels of confidence \

Regulatory Requirement -

Banks hold bank capital because it is a requirement by regulatory authorities Due to the high costs of holding bank capital, banks prefer to hold less bank capital relative to assets than is required by authorities Therefore the amount of bank capital is determined by the bank capital requirements which takes a global approach The setting of capital adequacy standards are coordinated at a global level by organisation called the Basel committee on Banking supervision

Week 4 – Banking & The Management of Financial Institutions Managing Credit Risk - This is the risk that a contracted payment will not be made - Markets put a price on this risk & it is included in the market’s purchase price for the contracted payment - Part of the price due to credit risk is called credit spread - Various models used to measure such risk

Estimating Economic Capital needed to support Credit Risk - To estimate capital needed to support credit risk activities, banks can employ an analytical framework that relates: - Required economic capital for credit risk to their portfolio’s probability density function (pdf) of credit losses - PDF are used by banks’ to gauge the potential risk to reward of including a security/fund in their portfolio – are plotted on a graph (typically bell curve) and the probability of outcomes lie below the curve. -

Generally assumed that PDF for economic capital against credit risk can be estimated by mean and standard deviation of portfolio losses

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Modelling credit risks differs between banks but generally a credit risk model is used by a bank to estimate a credit portfolio’s PDF

To manage Credit Risk, banks need to overcome: 1. Adverse selection

2. Moral Hazard

Methods to manage credit risk: 1. Screening & Monitoring: - Screening borrowers - Specialise in lending - Monitor & enforce restrictive covenants 2. Long-term customer relationships: - Build such relationships to reduce costs of information collection - Makes it easier to screen bad credit risks 3. Loan commitments: - Promotes long term relationships - Good for info gathering

4. Collateral & Compensating Balances: - Property promised in compensation if borrower defaults - Compensating balances often required (min deposit required)

Gap Analysis - Is a method of measuring the sensitivity of a bank’s profit to changes in interest rates (interest rate risk)

2. Maturity Bucket Approach: - Addresses the weakness of the basic gap analysis - Measures the gap for several maturity subintervals , called maturity buckets 3. Standardised Gap Analysis: - Accounts for different degrees of rate sensitivity among rate sensitive assets and liabilities

Duration Analysis -

Measures the sensitivity of the market value (MV) of the bank’s total assets & liabilities to a change in interest rates

Summary - Both gap & duration analysis suggest that banks will suffer if interest rates rise and gain if they fall - Both analyses are important tools for a bank manager to know the bank’s degree of exposure to interest rate risk

Off-Balance Sheet Activities -

These generate income for the bank but don’t appear on the balance sheets:

Internal controls to reduce the principal agent problem: - Separation of trading activities & bookkeeping - Limits on exposure - Value at risk - Stress testing Rogue traders can bankrupt their banks if internal controls are not properly maintained:

Potential Risks & Solutions

Summary -

Concepts of adverse selection & moral hazard explain many credit risk management principles Increased volatility of interest rates from 1980s meant banks & FIs became more concerned with interest rate risk Gap & duration analyses enable banks to know if it has more rate sensitive liabilities than assets Off balance activities include trading financial instruments, generating income fees & loan sales which all affect bank profits

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Off balance activities expose banks to increased risk that management must account for

Week 5 – Central Banks Introduction -

Central banks are important players in financial markets These authorities in charge of monetary policy Central bank actions affect interest rates, amount of credit available & money supply These factors have direct impact on financial markets, aggregate output & inflation

Central Bank Roles Monetary Policy - Implements policies to meet monetary objectives such as price stability, employment etc - Sets monetary policy instruments to achieve its monetary objective Supervisor for Banking System - Helps ensure stability - Licencing & liquidity rules & capital adequacy standards Banker for Banking System - Banks hold accounts with CB for reserves on deposits and day to day activities Banker for Government - Holds government’s bank account & performs some banking operations for the government

Manager of National Debt

Issuer of National Currency - Controls the issue of bank notes & coins (legal tender) Manager of currency reserves - A government’s reserves of gold & foreign exchange are held at the CB Lender of Last Resort to - The banking system to provide emergency liquidity to banks - The government to provide liquidity in a crisis

- This helps to stabilise expectations in the economy Relationship between banks, CB & government

- Government is responsible for solvency of the banking system - CB is lender of last resort (LOLR) to both banks & governments:

- Mutual confidence between the government & CB is important for the governance system – confidence that CB acts as LOLR to government helps stabilise expectations

- Monetary unions such as the Eurozone did not have this governance structure at its -

formation – US did have one in place This meant that during the global financial crisis of 2007-2009 the European Central Bank provided liquidity to banks but bank insolvency was dealt with by each member countries’ government

- Member countries cannot rely on European Central Bank as LOLR to support gov -

bond sales if required To bailout Eurozone banks, gov debt was issued in Euro

- ECB was prevented by mandate to act as LOLR - Fear of government illiquidity - Gov bond interest rate increased - Eurozone banks are major holders of gov bonds - If gov bond price falls, bank solvency problems may arise – called the doom loop problem

- Resulted in the Eurozone crisis – high levels of public debt for Eurozone members compared to the US states

- US debt is mainly federal – The Fed is LOLR to federal governmen...