FINA 1001 Lecture3_2024 PDF

Elements of Banking and Finance (FINA 1001) Semester 1 (2024/2025) Money and Introduction to Risks 1 Topics — Introduction to Money — Barter – “the double coincidence of wants” — From commodity to digital money — Role of money...

Elements of Banking and Finance (FINA 1001) Semester 1 (2024/2025) Money and Introduction to Risks 1 Topics — Introduction to Money — Barter – “the double coincidence of wants” — From commodity to digital money — Role of money — Cryptocurrencies — De-risking of financial institutions — Bank management (its main responsibilities) 2 1  Introduction to Money In previous lectures, we learned of the financial system and its components. In this lecture we will look at another important component of the modern financial system. We all know what it is - its what we need to get what we want - and its what most of us don't have nearly enough of! We all know that MONEY is the cash and coins that we have in our pockets. True - but is that all there is to MONEY? From an economic viewpoint, money is anything that is generally accepted as final payment for goods and services or for the repayment of debt - cash/currency, cheques, gold, tobacco, salt, etc. In order to understand the relationship between money and banking, need to understand the role of money within the economic system. 3 Introduction to Money To start our discussion of money, its function. First imagine what the economy would be like if we didn't have money. Trade would still take place, but how would we execute a trade? First, do you think that it is OK if I paid for a new outfit at Cave Shepherd by offering the people there lessons in banking and finance? They might not be interested in banking and/or may not want my services, but I know that I want the outfit!! Note the “double coincidence of wants”? This condition needs to be satisfied in order to consummate the transaction. The transaction may occur, but the system may not be an efficient system. 4 2  Barter – A Means of Exchange Why exchange goods in a barter economy? In an economy with different resources, the division of labour tends to provide a number of benefits: Absolute Advantage – An entity is proficient at something, another entity something else. Comparative Advantage – Everyone is a specialist in the area of greatest competence. In order for two entities to exchange, each must have a particular good that the other wants With perfect knowledge (no asymmetric information/certainty), all exchanges could operate on a barter system. In the real world, imperfect knowledge (uncertainty) exists. e.g., Entity A (Cave Shepherd) has something that Entity B (me) wants, but Entity B has nothing that Entity A wants. How do you solve this? MONEY!! 5 Features of Money in a Monetary Economy — What can serve as money? The commodity that develops as money must be valuable in the first place. — Commodities? — Advantage (commodity money) – the limited supply of precious metal can prevent inflation and stabilize the price level. — BUT it uses up scarce resources, and there is a high opportunity cost, since gold/silver/copper have other uses besides coins. 6 3  Short History of Paper Money The Chinese were the real monetary pioneers, issuing their paper currency in the 7th century, 1000 years before the Europeans. Europe ’ s first paper money was issued in 1661 in Sweden where copper ingots initially were utilized. Copper worked poorly as money owing to its low value per unit of weight. The bills issued were redeemable on demand for metal. However, too much money was printed and the Stockholm Banco failed. This situation also ensued for “continentals” issued by the US and “ assignats ” by France. Both currencies became worthless after huge quantities were printed to facilitate wars. 7 The Advent of Money The introduction of money removed the need for participants to be satisfied/limited with/to specific goods offered by the other party. Something else could be exchange…. Commodities as a medium of exchange have been used throughout history until the last century - gold, silver, copper, beads, salt, shells, etc Advent of gold and silver coins 8 4  The Concept of Money — Naturally, large quantities were bulky and difficult/unsafe to be transported. — There was a finite amount of commodity resource — The obvious solution therefore was to: Find a better mode of exchange Deposit the coins with the goldsmith for safekeeping Issued a “promise to pay” – a goldsmith’s receipt – a precursor to money 9 Evolution of Global Money From early periods there was an acceptance that the division of labour is beneficial, which should encompass the entire globe. There are different commodity moneys/currencies, therefore there was a need for an international currency. As the global market in trade began to expand there was, as one expects the evolution of a global standard to better facilitate exchange. So what happened? That is exactly what happened with the Gold Standard. 10 5  The Death of the Gold Standard Up until 1971 the currency of the United States had value - based on the gold and silver reserves of the Federal Reserve Banking System. The "Gold Standard”. Barbados had gold reserves as well Ever heard of Fort Knox in Kentucky? It is the storage facility of the gold that belongs to the United States’ Federal Reserve Central banks sold much of their gold reserves in the 1990s The amount of US currency was limited to the gold reserves at Fort Knox. President Nixon in 1971 announced that the US will no longer be redeeming US dollars for gold – seen as a constraint in expanding economies NO longer the case - and now, the currency of the United States has value - simply because the world believes it does. 11 The Value of Money — Like other assets or goods, its value is directly related to the supply of and demand for dollars. The greater the supply of dollars, the less valuable a $1 bill is. More money and higher prices reduce the purchasing power of money. — Therefore, money's value (purchasing power) is inversely related to the supply of dollars and the price level. — If money grows faster than the rate of real output, prices will rise, inflation will rise, and the value of money will fall. Inflation is caused by "too much money chasing too few goods." "Inflation is always and everywhere a monetary phenomenon." 12 6  The Value of Money — In Germany during the 1920ʼs, it was indeed useless pieces of paper. Photos of children flying “money kites”. — Dateline Sept 2006 - Zimbabwe inflation: 1204%. — In extreme cases – hyperinflation - money is worthless. Example: 1922-23, German govt. printed so much money that inflation was 250% per month. — 80 marks for an egg and 200 marks for a loaf of bread. Wages were paid in suitcases. Shops closed at lunchtime to change price tags. 13 The Value of Money — Remember what non-commodity money is from its origins – a promise to pay. — Governments issue money and therefore promise to pay — But whatever the form “ money ” must satisfy the following properties to serve as money 14 7  Properties of Money Must be a valuable at the outset Divisible/Standardized Transportable/Portable (Easy to carry) High value per unit weight Easily recognizable / Widely accepted Durability: does not deteriorate easily Stability 15 The Role of Money — Money is what we use to make payments for our debts, goods, services, products, and financial assets. — Unlike gold or silver money, modern money has no real value - it is coloured paper with no intrinsic value and is no longer backed by a commodity. — Paper money, metal coins and cheques are now used globally and this is fiat money. 16 8  The Role of Money Fiat/fiduciary/paper money simply means that the government has issued a decree or fiat, that for example Barbados dollars are legal tender - for all debts, public and private. Illegal for a bank or private company to issue legal tender. Is it illegal to deface a currency note? No value, but everyone wants more of it. Why? Because a) it is the generally accepted as payment for real goods and services and b) in most cases it is a source of purchasing power. Money is an asset that performs three very important functions in the economy 17 The Role of Money — Medium of exchange/means for deferred payment — Can be used as the basis for agreements and for repayment in future dates since, but unlike many other assets its value remains relatively stable and predictable (except in the cases of?) — As a medium of exchange, facilitates trade, eliminates "double coincidence of wants". — Money is generally used to make final payment in transactions settlement. 18 9  The Role of Money — Unit of account/Measure of Worth: — Used to measure goods and services in objective comparison and for the purposed of trade. — In Barbados, everything is priced in dollars, i.e. a standard unit of measurement (dollars) to measure value in the Barbadian economy, similar to the use of standard units to measure weight (lbs, kilos). Money is a measuring cup of value. With the use of a common unit of account (measurement), comparing prices and values become easy since the economic value of a good is stated at a value in dollars. — As a unit of account, reduces information costs. 19 The Role of Money Store of value Purchasing Power As a store of wealth, it is the most liquid asset Hence money helps to: Lower transaction costs In a barter economy, there is greater transaction costs associated with finding an individual to trade with. Increase liquidity in an economy Money is used as a financial asset to transfer/defer purchasing power from the current period to some period in the future. Wealth can also be stored in other assets such as equity stocks, bonds, mutual funds, real estate, etc. § BUT money has some special advantages!! 20 10  Advantages/Disadvantages of Money — Advantages of money as an asset (vs. stocks, bonds, real estate): — Cash is more liquid than any other asset — (Liquidity refers the degree to which an asset can be converted to cash quickly without loss of value.) Equity and debt instruments (bonds) are not as liquid as cash. — Cash has a fixed nominal value — A $100 bill will always be $100 - unlike stocks/bonds/real estate which could fluctuate in value. — Cash has no stated owner (anonymous) — Disadvantages of money as an asset: — Cash pays no interest, and will lose value (purchasing power) when inflation is rising 21 Uses of Money Compared to barter, a monetary system is extremely efficient. No longer a need to find a clothing store, whose operators require banking lessons. Money eliminates the need to satisfy the "double coincidence of wants”, and therefore assists the economy in operating much more efficiently. Why can such a claim be made? When is the barter system efficient? Card/comic book convention and coin/stamp trading. Black market - to avoid high taxes. During hyperinflation. 22 11  How Has Payments Evolved? — Precious metals like gold and silver (commodity money) — Paper currency (fiat/fiduciary money) — Cheques — Electronic means of payment – ATMs, etc. — Electronic money: Debit cards, Stored-value cards — Smart cards — Visa debit, Mastercard debit — E-cash — Cryptocurrency 23 Is a Cashless Society Likely? Sooner than we think. However… There is a cost to setting up computers, card readers, network, telecommunication, etc. Notably, that cost is getting lower. In Barbados, the Central Bank and commercial banks are tackling the digitisation of cheques, that will allow for the clearing of cheques within one day. However, the current challenge is the print quality of the cheques. Privacy and security concerns about digital cash, etc. Fears of hackers getting into bank accounts and siphoning funds. Also, your personal data, buying habits may not be totally private on the Internet. Further fears of the Government, marketers, etc. getting information about you. 24 12  Definition of Money — Basic definition - Money: Anything that is generally accepted in payment for goods and services. — So with all these 'new' methods of storing and moving MONEY - how does one actually go about 'measuring' the supply of money? — For the central bank to regulate the money supply (MS), it would be helpful to know how much money is in circulation. There is no clear definition of exactly what money is. For example, you have $1000 cash, that is definitely money, but what if you have a $1000 Certificate of Deposit (CD) or a $1000 T-bill? You can't use the CD or T-Bill to pay for goods and services, but they fit the definition of money as a store of value 25 Definition of Money — Money is a financial asset that provides us with current or future purchasing power. Credit cards serve this purpose, but are not part of the money supply, why? 26 13  Measurement of Money In Barbados: — M0 = Currency (Notes and coins in circulation) + cash and liquid assets held at the central bank (narrow money) — M1 = M0 + Demand Deposits held with commercial banks in domestic currency (includes all physical money) — M2 = M1 + Savings deposits and money market deposit accounts + call and term deposit balances in domestic currency (broad money – includes time related money) — Accuracy of Measurement - just how much MONEY is out there. — In some countries this is difficult because some lost, burned, buried and forgotten in the back yard and so on. 27 Short Notes on Cryptocurrencies — What are cryptocurrencies? — Some benefits to the usage of cryptocurrencies — Some disadvantages to the usage of cryptocurrencies 28 14  What are cryptocurrencies? A cryptocurrency is a digital token produced by cryptographic algorithms. This token is then transported across cyberspace using protocols such as peer-to-peer networking. e.g: the blockchain Its value is mainly derived from the demand and supply for such tokens and an important part of their appeal resides in the decentralisation of the system of which they exist. 29 Some benefits to the usage of cryptocurrencies — The main benefits cited are: — the security features; — transparency — ease of use on mobile devices; — relatively cheap costs of production and transmission via the Blockchain transmission protocol. 30 15  Some disadvantages to the usage of cryptocurrencies — The main issues with the adoption of cryptocurrencies include: — an early track record of illiquidity, — high volatility and — potentially nebulous uses — e.g. buying illegal goods on the deep and/or dark web 31 What is de-risking? The financial action task force (FATF) definition: “The phenomenon of financial institutions terminating or restricting business relationships with clients to avoid, rather than manage risk in line with the FATF’s risk – based approach... The risk – based approach should be the cornerstone of an effective AML/CTF system, and is essential to properly managing risks.” AML – Anti-Money Laundering CTF – Counter-Terrorism Financing See https://www.fatf-gafi.org/ 32 16  Primary Reasons for de-risking — Increased regulation & pressure to demonstrate compliance with AML/CTF regulations — Divergence of regulatory approaches drive up costs across jurisdictions — Imposition of increased sanctions and fines — Low profitability of customer — Know Your Customers’ Customer (KYCC) is vital…increased risk for banks engaging in correspondent banking relationships 33 Implications of de-risking — De-link Caricom from the Global payments & financial system — Downside for Caricom growth prospects — Leads to financial and social exclusion — Legitimate international financial transactions hampered — Development of “shadow banking sector” 34 17  Banking Business - Responsibilities Like all business - Banks are organized to maximize the profits for their stockholders. In that process - Bank Management has four very basic responsibilities. They are: Liquidity management (withdrawal risk) Asset management Liability management Capital adequacy management 35 Banking Business - Liquidity Management The financial needs of either depositors or borrowers cannot always be predicted. Large depositor issue If a VERY large depositor needed to withdraw his deposit. If unanticipated what might be the outcome…Liquidity issues Management has a number of different options Increasing deposit interest rates to attract new deposits Borrowing from other financial institutions (inter-bank market) Borrow from the central bank through the discount window if it is expected to be a short term situation. 36 18  Asset Management In terms of asset management, bank management attempts to : Make loans at high enough interest rates with minimal chances of default Invest in securities with high returns and low risk (Note however, the risk/return relationship) Manage liquidity to just about meet reserve requirements to avoid incurring the expenses of borrowing to meet reserves. Reserves are non-earning assets. Therefore, the amount of reserves should be as close to the requirement as possible. 37 Liability Management Liability management is essential in banking so to facilitate lending and allow for asset growth In the 1960’s through the issuance of negotiable CDs, banks were able to acquire other funds Banks needed to manage depositors’ funds as well as funds secured from other institutions. At present, most banks manage both sides of the balance sheet This involves controlling the gap between the maturities of assets and liabilities 38 19  Capital Adequacy Management — It is critical that a bank manage its capital so to: — Prevent bank failure (bank cannot satisfy its depositorsʼ obligations as well as its creditors) — Pacify its equity holders- the amount of capital affects returns for the owners — Satisfy the minimum requirement set by central bank 39 20