Banking and Finance Fundamentals of Money and Banking PDF

Banking and Finance Fundamentals of money and banking  Evolution of value exchange 6000 BC 2000 BC 600 BC 0 845 1950 Bartering Physical goods Gold and coins F...

Banking and Finance Fundamentals of money and banking  Evolution of value exchange 6000 BC 2000 BC 600 BC 0 845 1950 Bartering Physical goods Gold and coins Fiat money Credit cards 1972 1984 1995 2009 ? Automated Clearing ATMs Online House (ACH) payments Banking and Finance 2  Three functions of money Store of value: Money can be used to transfer purchasing power from present to future. Unit of account: Money is the standard unit or agreed measure of quoting or stating prices. Medium of exchange: Money is accepted as means of payment. Economizes on time & effort spent in barter economy. Banking and Finance 3  The origins of modern banking Banks played a crucial role offering liquidity and payment services It is more efficient to exchange goods and services for money rather than for other goods or services, as in barter operations. Money evolved from a system in which the medium of exchange is itself a commodity (i.e. gold coins) to a system in which the medium of exchange has a value that is guaranteed by some institutions, and therefore is accepted as a means of payment. Money exchange The Moneylender and his wife, Quentin Metsys (1514) Provision of payment services Banking and Finance 4  The origins of modern banking Casa delle compere e dei banchi di San Giorgio, the world's first modern bank,1407, Repubblica di Genova. The world's first modern, public bank (FT); The Genoa connection (Economist) Banking and Finance 5  The origins of modern banking Monte dei Paschi di Siena, 1472, the world's oldest bank still operating Banking and Finance 6  Banks’ special role in the economy Banks play a crucial role in the allocation of capital in the economy They have four major functions: 1. Offering liquidity and payment services 2. Transforming assets 3. Managing risk 4. Processing information Banking and Finance 7  Financial intermediation Financial intermediaries are entities that intermediate between providers and users of financial capital, i.e., households and corporations. Financial Corporations Intermediaries Households Investments Securities Securities Savings Brokerage Qualitative Asset Transformation Banking and Finance 8  Financial intermediation A bank is a special type of financial intermediary whose current operations consist in granting loans and receiving deposits from the public: Financial Corporations Intermediaries Households Investments Securities Securities Savings Brokerage Qualitative Asset Transformation Bank Loans Deposits Banking and Finance 9  The fractional reserves banking model Fractional reserve banks fund themselves with liabilities that are convertible into cash on demand, but they hold only a fraction of such liabilities in the form of cash assets. From the bank standpoint client’s deposits are liabilities and loans (credit) are assets. There is always some probability that withdrawals will exceed the cash available. Places enormous power in the hands of bankers to jeopardize the stability of the system in the pursuit of personal gains. Banks Cash reserves Deposits Loans Banking and Finance 10  The fractional reserves banking model The Goldsmith anecdote: Think of a primitive simplified setting in which gold is used as money – i.e., by social convention all debts are settled with gold and all purchases are made with gold. But holding and transporting gold is costly Security problem Market response is to provide Convenience problem warehousing service for gold Emergence of goldsmiths that provide secure storage facilities for gold in exchange of a fee Goldsmith Gold Receipts Banking and Finance 11  The fractional reserves banking model The Goldsmith anecdote: The owner of gold would receive a warehouse receipt in exchange for gold, with the understanding that the owner could present the receipt at any convenience to redeem gold from the goldsmith As confidence in the goldsmith increases and gold flows in and out of the coffers, the warehouse receipts increasingly pass from buyers to sellers with gold undisturbed in the vault The willingness to accept warehouse receipts in lieu of gold rests on the belief that gold would be available on demand Goldsmith Gold Receipts Banking and Finance 12  The fractional reserves banking model The Goldsmith anecdote: As the use of receipts gradually replaces gold, goldsmiths’ inventories become less and less volatile The goldsmiths then realize it is not necessary to have a unit of gold for each outstanding receipt Extra receipts can be lent to borrowers at an interest Goldsmith Gold Receipts Loans Banking and Finance 13  The fractional reserves banking model The Goldsmith anecdote: By issuing extra receipts indistinguishable from their more authentic counterparts backed by gold, goldsmiths provide a liquidity transformation service as: They issue liquid claims to depositors that are backed by illiquid loans to merchants Risk of bankruptcy becomes endogenous, depending on how many extra receipts the bank prints Fear of loss of reputation being the only limit 🡪 Vulnerability of the system to bank runs! Remedy: banks runs could be avoided if banks could make their loans liquid or their deposits safer Central bank that lends against collateral in situation of extraordinary redemptions (lender of last resort) Deposit insurance scheme The introduction of such a central bank with virtually unlimited capacity together with a commitment to the continuity of the system introduces moral hazard in the system 🡪 Need for prudential regulation and supervision! Cash asset reserve requirements, capital requirements, and portfolio restrictions. Banking and Finance 14  The fractional reserves banking model Modern banks produce fiat money on the basis of fractional reserves Money has value only because of its universal acceptance as a form of payment or means of exchange, which ultimately is a social convention supported by the legal system that recognizes money as an instrument for the legal discharge of debts The money multiplier The pace at which banks produce money and the maximum amount of money they can produce depends on the money multiplier. Money multiplier = 1/Reserve Requirements Banking and Finance 15  The fractional reserves banking model Example: A national central bank pays you $100 on behalf of the government. You then take the banknotes to Bank One and deposits them there, receiving a deposit slip. Assuming, for the sake of simplicity that this bank operates a 10% reserve ratio (that is, it is required to maintain the ratio of its reserves to its total liabilities at 10%), it deposits $10 with the central bank and lends the other 90 to one of its clients. While this client decides what to do with its loan, he deposits the money in Bank Two. This bank also has a 10% reserve rule, so it deposits 9 at the central bank and lends out the remaining 81 to another of its clients, who then deposits the money at Bank Three and so on….. Bank One Bank Two Bank Three Cash 10 100 Deposit Cash 9 90 Deposit Cash 8.1 81 Deposit Loans 90 Loans 81 Loans 72.9 Banking and Finance 16  The fractional reserves banking model Bank One Bank Two Bank Three Cash 10 100 Deposit Cash 9 90 Deposit Cash 8.1 81 Deposit Loans 90 Loans 81 Loans 72.9 [After just three rounds] How much is the increase in the money supply? M0, also known as monetary base or high-powered money, which is equal to the total liabilities of the central bank, that is, cash plus the reserve of private sector banks on deposits at the central bank; - By the time money has been deposited at three different banks, M0 is equal to $100 M1, also known as narrow money, which is equal to money in circulation plus demand or ‘sight’ deposits. - By the time money has been deposited at three different banks, M1 is equal to $271 ($100+$90+$81) Banking and Finance 17  The fractional reserves banking model A primer on monetary policy: Central banks determine the availability and cost of money and credit by controlling money supply and/or the level and structure of interest rates. How? Reserve Requirements Key policy rates: main refinancing operations, marginal lending and deposits facilities Open market operations: asset purchase programs and quantitative easing [Print banknotes and mint coins] Central bank needs to be independent from political influence Single (inflation) or dual (inflation + employment) mandate Banking and Finance 18  News: Sep. 8, 2022 - ECB Monetary Policy Decision Source: FT, ECB Banking and Finance 19  Extra reading: MakerDAO Capital Structure Source: https://dirtroads.substack.com/p/-37-capital-structures-for-stablecoin Banking and Finance 20