Principles of Banking PDF 2024

Principles of Banking Jari-Mikko Meriläinen September 2024 Jari-Mikko Meriläinen JSBE September 2024 1 / 76 Principles of Banking Jari-Mikko Meriläinen [email protected] Denis Davydov...

Principles of Banking Jari-Mikko Meriläinen September 2024 Jari-Mikko Meriläinen JSBE September 2024 1 / 76 Principles of Banking Jari-Mikko Meriläinen [email protected] Denis Davydov (digital banking) Jari-Mikko Meriläinen JSBE September 2024 2 / 76 Course requirements A take-home exam, and an EXAM exam The exams cover all the themes of the course One must pass the exams to pass the course In addition, there are weekly quizzes, which give you extra points for the EXAM exam Jari-Mikko Meriläinen JSBE September 2024 3 / 76 Home assignments There were two home assignments (essays) last year Home assignments are not included this year Jari-Mikko Meriläinen JSBE September 2024 4 / 76 Excursion Traditionally, we have made an excursion to Helsinki at the end of the course We visited OP Group and the Financial Services Authority in 2023 More details in the future Jari-Mikko Meriläinen JSBE September 2024 5 / 76 The main course book Last year, the content also included material from ’Microeconomics of Banking’ (by Freixas & Rochet) Jari-Mikko Meriläinen JSBE September 2024 6 / 76 Contents Part 1: Banks as institutions Mishkin: chapters 1–6, 9–11 I: Jari-Mikko: Introduction Introduction to money, banking and financial markets Description of financial markets, especially markets for interest-yielding assets Zero lower bound and negative interest rates The banking industry and its regulation II: Denis Davydov: New forms of banking Digital banking, disruption and financial intermediation FinTech regulation and financial stability, policy responses to FinTech activities FinTech and market structure: New Banking and new risks Impact of Covid-19 on digital banking Digital banks and monetary policy Jari-Mikko Meriläinen JSBE September 2024 7 / 76 Contents Part 2: Banking and the aggregate economy Mishkin: chapters 14–17, 20–24 III: Jari-Mikko: Central banking and monetary policy Quantity theory of money IS curve Monetary policy curve and aggregate demand Monetary policy in action Extreme actions and special case of negative interest rates International and European banking regulation The global financial crisis and the regulatory reforms Jari-Mikko Meriläinen JSBE September 2024 8 / 76 Our learning objectives Recognize the importance of financial markets in the economy Describe how financial intermediation and financial innovation affect banking and the economy Familiarize the different forms of banks as institutions Recognize the importance of regulation in banking and financial mar- kets Identify the basic links among monetary policy, the business cycle and economic variables; how do negative interest rates affect to these links Describe the meaning and the role of regulation in modern banking and the channels of monetary policy Jari-Mikko Meriläinen JSBE September 2024 9 / 76 Failed banks Jari-Mikko Meriläinen JSBE September 2024 10 / 76 Bank balance sheet Assets Liabilities Cash Equity Loans Customer deposits Interbank loans Interbank deposits Securities Issued debt Fixed assets Jari-Mikko Meriläinen JSBE September 2024 11 / 76 Bank balance sheet Assets Liabilities Cash Equity ? ? ? ? ? Issued debt (?) Fixed assets (?) Banks’ balance sheets contain risks Both sides.. A risk-free bank has equity and cash Jari-Mikko Meriläinen JSBE September 2024 12 / 76 Bank income statement Income statement Net interest income Net fee and commission income (Other income) Administrative expenses Loan loss provisions Profit before tax Income taxes Profit after tax A bank’s income statement differs from other companies’ income state- ments Jari-Mikko Meriläinen JSBE September 2024 13 / 76 Debt markets and interest rates A security (aka financial instrument) is a claim on the issuer’s future income or assets. A bond is a debt security that promises to make payments periodically for a specified period of time. An interest rate is the cost of borrowing or the price paid for the rental of funds. Jari-Mikko Meriläinen JSBE September 2024 14 / 76 Interest rates FRED = Federal Reserve Economic Data fred.stlouisfed.org/ Jari-Mikko Meriläinen JSBE September 2024 15 / 76 Interest rates and inflation Jari-Mikko Meriläinen JSBE September 2024 16 / 76 Stock markets Common stock represents equity ownership in a corporation A share of stock is a claim on the residual earnings and assets of the corporation This is the unit of ownership The shares of stock are traded on the stock market (Note that we know stock markets very well, but we know little about debt markets) Jari-Mikko Meriläinen JSBE September 2024 17 / 76 Jari-Mikko Meriläinen JSBE September 2024 18 / 76 S&P500 (Jan 1928–Jul 2024) Source: macrotrends.net Jari-Mikko Meriläinen JSBE September 2024 19 / 76 S&P500 (log) (Jan 1928–Jul 2024) Source: macrotrends.net Jari-Mikko Meriläinen JSBE September 2024 20 / 76 Why study financial institutions and banking? Financial system is fundamental to the economy Financial intermediaries: institutions that borrow funds from people who have saved, and in turn, make loans to other people who need money Banks: accept deposits and make loans Other financial institutions: insurance companies, finance companies, pension funds, mutual funds, and investment companies Financial innovation: the development of new financial products and services Can be an important force for good by making the financial system more efficient Financial crises: major disruptions in financial markets that are charac- terized by sharp declines in asset prices and failures of many financial and non-financial firms Jari-Mikko Meriläinen JSBE September 2024 21 / 76 Why study money and monetary policy? Evidence suggests that money plays an important role in generating business cycles Recessions (unemployment) and expansions affect all of us Monetary theory ties changes in the money supply to changes in ag- gregate economic activity and the price level Jari-Mikko Meriläinen JSBE September 2024 22 / 76 Money, business cycles, and inflation The aggregate price level is the average price of goods and services in an economy A continual rise in the price level (i.e., inflation) affects all economic players Life becomes (at least nominally) more expensive Our savings lose value Property prices increase Data shows a connection between the money supply and the price level Jari-Mikko Meriläinen JSBE September 2024 23 / 76 Growth of M3 Jari-Mikko Meriläinen JSBE September 2024 24 / 76 M3 and inflation Jari-Mikko Meriläinen JSBE September 2024 25 / 76 Growth of money and inflation (Mishkin, p. 58) Jari-Mikko Meriläinen JSBE September 2024 26 / 76 Money and interest rates An interest rate is the price of money Prior to 1980, the rate of money growth and the interest rate on long- term Treasury bonds (T-bonds) were closely tied Since then, the relationship is less clear but the rate of money growth is still an important determinant of interest rates Note that interest rates are forbidden in some religions Jari-Mikko Meriläinen JSBE September 2024 27 / 76 Growth of money and interest rates (Mishkin, p. 59) Jari-Mikko Meriläinen JSBE September 2024 28 / 76 Monetary policy Monetary policy is the management of the money supply and interest rates Conducted in the U.S. by the Federal Reserve System (Fed) and in the euro area by the European Central Bank (ECB) Similarly, in Sweden, it is conducted by the Sveriges Riksbank, in Norway by the Norges Bank, in Switzerland by the Swiss National Bank, etc. Jari-Mikko Meriläinen JSBE September 2024 29 / 76 Fiscal policy Fiscal policy deals with government spending and taxation Budget deficit is the excess of expenditures over revenues for a particular year Budget surplus is the excess of revenues over expenditures for a particular year Any deficit must be financed by borrowing Jari-Mikko Meriläinen JSBE September 2024 30 / 76 Fiscal balance (deficit) Jari-Mikko Meriläinen JSBE September 2024 31 / 76 Budget (deficit) Jari-Mikko Meriläinen JSBE September 2024 32 / 76 Foreign exchange markets For funds to be transferred from one country to another, they have to be converted from one currency into another This is done by the foreign exchange market The foreign exchange rate is the price of one currency in terms of another currency The foreign exchange market determines the foreign exchange rate Jari-Mikko Meriläinen JSBE September 2024 33 / 76 U.S. dollars to euro spot exchange rate Jari-Mikko Meriläinen JSBE September 2024 34 / 76 Why study international finance? Financial markets have become increasingly integrated throughout the world The international financial system has a tremendous impact on domes- tic economies: How a country’s choice of exchange rate policy affects its monetary policy? How capital controls impact domestic financial systems and therefore the performance of the economy? Which should be the role of international financial institutions like the IMF? Jari-Mikko Meriläinen JSBE September 2024 35 / 76 Money, banking, and financial markets and Your career Understanding monetary policy may help you predict when interest rates will rise or fall help you make decisions about whether it is better to borrow now or to wait until later help you know how banks and other financial institutions are managed, which may help you get a better deal when you need to borrow from them enable you to make better investment decisions, whether for yourself or for the company you work for Jari-Mikko Meriläinen JSBE September 2024 36 / 76 How we will study money, banking, and financial markets? A simplified approach to the demand for assets The concept of equilibrium Basic supply and demand model to explain behavior in financial markets Aggregate supply and demand analysis Jari-Mikko Meriläinen JSBE September 2024 37 / 76 Aggregate output and income The most commonly reported measure of aggregate output, the gross domestic product (GDP), is the market value of all final goods and services produced in a country during the course of a year Aggregate income, the total income of factors of production (land, labor, and capital) from producing goods and services in the economy during the course of the year, is equal to aggregate output Jari-Mikko Meriläinen JSBE September 2024 38 / 76 Real versus nominal magnitudes Nominal GDP is the total value of final goods and services in (nominal implies using current prices) A more reliable measure of economic production is real GDP Real GDP values are calculated in terms of prices for an arbitrary base year such, e.g., 2020 It is the GDP measured with constant (fixed) prices Jari-Mikko Meriläinen JSBE September 2024 39 / 76 Real vs. nominal magnitudes Country Million $ 1. United States 28,781,083 2. China 18,532,633 3. Germany 4,591,100 4. Japan 4,110,452 5. India 3,937,011 6. United Kingdom 3,495,261 7. France 3,130,014 8. Brazil 2,331,391 9. Italy 2,328,028 10. Canada 2,242,182 11. Russia 2,056,844 Table: Nominal GDP 2023 (World Bank) Jari-Mikko Meriläinen JSBE September 2024 40 / 76 Real vs. nominal magnitudes Country Million $ 1. China $31,227,000 2. United States $24,662,000 3. India $13,104,000 4. Russia $5,816,000 5. Japan $5,761,000 6. Germany $5,230,000 7. Brazil $4,016,000 8. Indonesia $3,906,000 9. France $3,764,000 10. United Kingdom $3,700,000 11. Italy $3,097,000 Table: Real GDP 2023 (CIA) Jari-Mikko Meriläinen JSBE September 2024 41 / 76 Aggregate price level Aggregate price level is the measure of average prices in the economy Three different measures: The GDP deflator: Nominal GDP Real GDP Nominal PCE The PCE deflator (personal consumption expenditures): Real PCE The Consumer Price Index (CPI) Jari-Mikko Meriläinen JSBE September 2024 42 / 76 The function of the financial markets What do we need the financial markets for? Financial markets perform the essential function of channeling funds from those economic players that have saved surplus funds to those that have a shortage of funds Often, funds are channeled by a financial intermediary Indirect finance Borrowers may also borrow funds directly from lenders in financial mar- kets by selling them securities This is called direct finance In both cases, there is a borrower and a lender Or a debtor and a creditor Jari-Mikko Meriläinen JSBE September 2024 43 / 76 The function of the financial markets The financial markets promote economic efficiency by producing an efficient allocation of capital, which increases production It also directly improves the well-being of consumers by allowing them to time purchases better Jari-Mikko Meriläinen JSBE September 2024 44 / 76 Flows of funds through the financial system Jari-Mikko Meriläinen JSBE September 2024 45 / 76 Structure of the financial markets Exchanges are a very visible part of the financial markets Stock exchanges: NYSE, Frankfurt Futures exchange: CME Group Over-the-counter (OTC) markets Trading is done directly between two parties In exchanges, futures etc. are standardized Foreign exchange, Federal funds Also commodities are traded in the OTC markets Money and capital markets: Money markets deal in short-term debt instruments (maturity ≤ one year) Capital markets deal in longer-term debt and equity instruments Jari-Mikko Meriläinen JSBE September 2024 46 / 76 Structure of the financial markets Capital markets divide into debt and equity markets Debt markets Debt instruments have a (fixed) interest rate and a maturity Investors get their money (the loan) back Equity markets Equities do not have maturities or interest rates Equities pay dividends that have no upper limit The capital is not returned Primary and secondary markets Investment banks underwrite securities in primary markets Typically, brokers and dealers work in secondary markets Secondary markets do not (directly) affect the issuer Jari-Mikko Meriläinen JSBE September 2024 47 / 76 Internationalization of financial markets The issuer and the investor may locate in different countries or even on different continents Foreign bonds are sold in a foreign country and denominated in that country’s currency Eurobond is a bond denominated in a currency other than that of the country in which it is sold Even if the name is eurobond, they are not tied to Europe or the euro currency The first eurobonds were issued in the 1960s The key benefit is that the issuer can raise capital in many currencies Jari-Mikko Meriläinen JSBE September 2024 48 / 76 Internationalization of financial markets Eurocurrencies are foreign currencies deposited in banks outside the home country For example, eurodollars are U.S. dollars deposited in banks outside the U.S. That is, in foreign banks outside the U.S. or in foreign branches of U.S. banks World stock markets Today, even an ordinary person can invest in almost any listed company Global stock markets provide funds for companies Mishkin, p. 81: ”Also help in financing the general governments because foreign funds create economic growth” Jari-Mikko Meriläinen JSBE September 2024 49 / 76 Global financial markets 2018 Source: The Global Financial Centres Index (GFCI 23), March 2018 Jari-Mikko Meriläinen JSBE September 2024 50 / 76 The function of the financial intermediaries: indirect finance Financial intermediaries have lower transaction costs Less time and money spent for each financial transaction Intermediaries benefit from the economies of scale They can provide immediate liquidity services because transaction costs are low Financial intermediaries reduce the exposure of investors to risk Risk sharing (aka asset transformation): a bank’s assets are riskier than its liabilities Diversification benefits Since transaction costs are low, intermediaries can easily diversify Diversification lowers the overall risk because returns of different assets do not always move together Jari-Mikko Meriläinen JSBE September 2024 51 / 76 The function of the financial intermediaries: indirect finance Financial intermediaries deal with asymmetric information problems Adverse selection (before the transaction): try to avoid selecting a risky borrower by gathering information on him/her Moral hazard (after the transaction): ensure the borrower will not engage in activities that will prevent him/her to repay the loan Sign a contract with restrictive covenants Financial intermediaries are well capable of screening & monitoring Screening for adverse selection, monitoring for moral hazard Jari-Mikko Meriläinen JSBE September 2024 52 / 76 The function of the financial intermediaries: indirect finance Conclusion: financial intermediaries allow savers and borrowers to ben- efit from the existence of financial markets Direct finance is the privilege of big players Jari-Mikko Meriläinen JSBE September 2024 53 / 76 Types of financial intermediaries Type of intermediary Primary assets Primary liabilities (Uses of funds) (Sources of funds) Depository institutions (banks) Commercial banks Business and consumer loans, mortgages, U.S. Deposits government securities, and municipal bonds Savings and loan associations Mortgages Deposits Mutual savings banks Mortgages Deposits Cooperative banks Mortgages Deposits Credit unions Consumer loans Deposits Jari-Mikko Meriläinen JSBE September 2024 54 / 76 Types of financial intermediaries Type of intermediary Primary liabilities (Sources of funds) Primary assets (Uses of funds) Investment intermediaries Finance companies Commercial paper, stocks, bonds Consumer and business loans Mutual funds Shares Stocks, bonds Money market mutual funds Shares Money market instruments Hedge funds Partnership participation Stocks, bonds, loans, foreign curren- cies, and many other assets Investment banks Stocks, bonds Not a bank, instead, offers services such as underwriting and mergers Jari-Mikko Meriläinen JSBE September 2024 55 / 76 Types of financial intermediaries Type of intermediary Primary assets (Uses of funds) Primary liabilities (Sources of funds) Specialized commercial banks Business loans, government loans Deposits, equity, money market instruments Development banks Loans to businesses, governments, Equity, deposits? households Jari-Mikko Meriläinen JSBE September 2024 56 / 76 Meaning of money Money (or the ”money supply”) is anything that is generally accepted as payment for goods or services or in the repayment of debts A rather broad definition Money (a stock concept) is different from: Wealth is the total collection of pieces of property that serve to store value Besides money, wealth includes many other things Income is the flow of earnings per unit of time (a flow concept) Jari-Mikko Meriläinen JSBE September 2024 57 / 76 Functions of money Money is the medium of exchange Eliminates the trouble of finding a double coincidence of needs, which reduces transaction costs Promotes specialization A medium of exchange must: be easily standardized be widely accepted be divisible be easy to carry not deteriorate quickly Jari-Mikko Meriläinen JSBE September 2024 58 / 76 Functions of money Unit of account: Used to measure value (prices) in the economy Reduces transaction costs Store of value: Money is used for saving purchasing power over time Many other assets serve this function. Money is the most liquid of all assets but loses value during inflation. Jari-Mikko Meriläinen JSBE September 2024 59 / 76 Evolution of the payments system Commodity money: valuable, easily standardized and divisible com- modities (e.g. precious metals, cigarettes) Commodity money has intrinsic value Fiat money: paper money decreed by governments as legal tender Fiat money is not backed by any commodity Possibly (?) the last currency backed by gold was Swiss franc (until 2000) Jari-Mikko Meriläinen JSBE September 2024 60 / 76 Evolution of the payments system A check is an instruction to your bank to transfer money from your account to someone A check is an easy way to transfer a large amount of money Even today, they are commonly used but much less than before ”Since late 2003, the Reserve Banks have reduced the number of loca- tions where paper checks are processed from 45 offices to a single site in Cleveland1.” 1 www.federalreserve.gov/newsevents/pressreleases/ other20100302a.htm Jari-Mikko Meriläinen JSBE September 2024 61 / 76 Evolution of the payments system Electronic payments ”Home computers” and the Internet made online payments easy Compared to checks, the costs and the effort needed are minimal Electronic money substitutes cash A debit card transfers money directly from your bank account A stored-value card is a prepaid or a smart card E-cash means Internet money such as, e.g., Paypal Jari-Mikko Meriläinen JSBE September 2024 62 / 76 https://www.washingtonpost.com/business/2023/09/15/ paper-checks-who-uses/ Jari-Mikko Meriläinen JSBE September 2024 63 / 76 A 17th century money changer Jari-Mikko Meriläinen JSBE September 2024 64 / 76 Are we headed for a cashless society? Predictions of a cashless society have been around for decades, but they have not come to fruition Although e-money might be more convenient and efficient than a pay- ments system based on paper, several factors work against the complete disappearance of the paper system However, the use of e-money will still increase, and due to the increas- ing role of crypto currencies and introduction of Central Bank Digital Currencies (CBDC), we will experience strong changes in the near fu- ture Jari-Mikko Meriläinen JSBE September 2024 65 / 76 Will Bitcoin (or some other crypto) become the money of the future? Bitcoin is type of electronic money created in 2009 By ”mining”, Bitcoin is created by decentralized users when they use their computing power to verify and process transactions Although Bitcoin nowadays functions also as a medium of exchange, it is unlikely to become the money of the future because it performs less well as a unit of account and a store of value More like a speculative asset (see also e.g. Corbet et al (2018); Bitcoin Futures—What use are they?, Economics Letters 172 (2018), 23-27 Jari-Mikko Meriläinen JSBE September 2024 66 / 76 A 21st century money changer? Jari-Mikko Meriläinen JSBE September 2024 67 / 76 Measuring (standard fiat) money How do we measure money? Which particular assets can be called ”money”? The measures of money supply, i.e., monetary aggregates, are con- structed using the concept of liquidity The narrowest definition of money supply is M1 M1 = most liquid assets = currency + demand deposits + other check- able deposits Jari-Mikko Meriläinen JSBE September 2024 68 / 76 Measuring money M2 = M1 + small denomination time deposits + savings deposits and money market deposit accounts + money market mutual fund shares Less liquid than M1 M1 ⊂ M2 Jari-Mikko Meriläinen JSBE September 2024 69 / 76 The Fed’s monetary aggregates Jari-Mikko Meriläinen JSBE September 2024 70 / 76 The Fed’s monetary aggregates June 2024: M2 = $21,024,700,700,700 Jari-Mikko Meriläinen JSBE September 2024 71 / 76 The Fed’s monetary aggregates Jari-Mikko Meriläinen JSBE September 2024 72 / 76  The Fed tracks M1 and M2 The Fed’s M3 is discontinued The ECB tracks M1, M2, and M3! M1 is the sum of currency in circulation and overnight deposits M2 is the sum of M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months M3 is the sum of M2 (that includes M1), repurchase agreements, money market fund shares/units and debt securities with a maturity of up to two years https://www.ecb.europa.eu/stats/money_credit_banking/monetary_aggregates/html/index.en.html Jari-Mikko Meriläinen JSBE September 2024 73 / 76 M1 versus M2: Does it matter which measure of money is considered? M1 and M2 can move in different directions in the short run (see the figure) The choice of the monetary aggregate may matter for policymakers Jari-Mikko Meriläinen JSBE September 2024 74 / 76 The Fed’s monetary aggregates Jari-Mikko Meriläinen JSBE September 2024 75 / 76 Where are all the U.S. dollars? The more than $7,000 held per person in the USA is a surprisingly large number Where are all these dollars and who is holding them? Foreigners Criminals Jari-Mikko Meriläinen JSBE September 2024 76 / 76