MB Lecture 5 - 2024-2025 PDF

Lecture 5 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- Topics The...

Lecture 5 Money and Banking Dirk Veestraeten References to figures and tables The references to the figures and tables that are used in this lecture can be found at the end of this presentation. -1- Topics The main functions, structure and instruments of the financial system. The important role of financial intermediaries in the functioning of the financial system. Banking and the management of financial institutions. -2- Flow of funds in the financial system -3- Function of the Financial System The financial system allows to channel funds from economic agents with saved surplus funds (the lender-savers) to those with a shortage of funds (the borrower-spenders). Advantages: Promotes efficient allocation of capital: capital is channelled from economic agents that lack productive investment opportunities to economic agents that have such opportunities. This leads to higher production and higher economic growth; Improves directly the well-being of consumers by allowing them to time their purchases better (e.g., young people can buy a house notwithstanding that they have limited savings); Allows firms to bridge the time gap between incurring production costs and obtaining the revenues of the sale of their products. -4- Flow of funds in the financial system. First channel: direct finance via financial markets -5- Structure of Financial Markets Debt Markets => debt instruments (e.g., bonds and mortgages): short- (1 year and 10 years). Equity Markets => (common) stocks, a.k.a. shares, equity. Primary Market => issuance of new securities (bonds, stocks, etc.). Secondary Market => securities previously issued are resold in two ways on: (1) exchanges (e.g., NYSE, Euronext, etc.); (2) over-the-counter (OTC) markets (e.g., government bond market). Money Market => Short-term (< 1 year) debt instruments. Capital Market => Long-term (> 1 year) debt instruments + stocks. -6- Financial Market Instruments 1. Main Money Market Instruments in the US (similar elsewhere): US Treasury bills Negotiable Bank Certificates of Deposit (CD) Commercial paper Repurchase agreements (repos) Federal (FED) Funds -7- Table 1 Principal Money Market Instruments in the US Amount ($ billions, end of year) Type of Instrument 1990 2000 2010 2019 U.S. Treasury bills 527 647 1,767 2,416 Negotiable bank certificates of deposit (large 547 1,053 1,923 1,859 denominations) Commercial paper 558 1,602 1,058 1,045 Federal funds and security repurchase agreements 372 1,197 3,598 4,356 -8- Financial Market Instruments 2. Main Capital Market Instruments in the US (similar elsewhere): (Corporate) Stocks Mortgages and Mortgage-Backed Securities (MBS) Corporate Bonds US Government Securities US Government Agency Securities State and Local Government Bonds (a.k.a. Municipal Bonds) Consumer and Bank Commercial Loans -9- Table 2 Principal Capital Market Instruments in the US Amount ($ billions, end of year) Type of Instrument 1990 2000 2010 2019 Corporate stocks (market value) 3,530 17,628 23,567 54,624 Residential mortgages 2,676 5,205 10,446 11,159 Corporate bonds 1,703 4,991 10,337 14,033 U.S. government securities (marketable long-term) 2,340 3,171 7,405 14,204 U.S. government agency securities 1,446 4,345 7,598 9,431 State and local government bonds 957 1,139 2,961 3,068 Bank commercial loans 818 1,497 2,001 3,818 Consumer loans 811 1,728 2,647 4,181 Commercial and farm mortgages 838 1,276 2,450 3,230 - 10 - Flow of funds in the financial system. Second channel: indirect finance via financial intermediaries - 11 - Function of Financial Intermediaries Why are financial intermediaries important in the financial system? They: 1. Lower transaction costs They reduce transaction costs by developing expertise and economies of scale. 2. Reduce exposure to risk They create and sell assets with low risk and use the funds that they obtain that way to buy assets with more risk: risk sharing and asset transformation. E.g., create and sell deposits in order to give loans to corporations. Help people to diversify their asset portfolio. 3. Deal with/reduce asymmetric information (see below). - 12 - Asymmetric information Adverse Selection (AS) Takes place before the transaction occurs. The borrowers that are most likely to produce adverse outcomes (“the bad credit risks”) are also the ones most likely to seek loans => lenders provide fewer/no loans and/or buy fewer/no securities. Moral Hazard (MH) Takes place after the transaction occurs. The borrowers have incentives to engage in undesirable (immoral) and risky (hazard) activities that make it more likely that they will not be able to pay back the loan => lenders provide fewer/no loans and/or buy fewer/no securities. - 13 - Function of Financial Intermediaries AS and MH are important (potential) impediments to the well-functioning of financial markets (bonds/stocks), i.e., to direct finance. Financial intermediaries reduce these problems. How? Adverse selection: financial intermediaries are better equipped than private individuals to screen (ex ante) and distinguish the bad from the good credit risks. Moral hazard: financial intermediaries have developed strong expertise in monitoring (ex post) the parties they lend to. - 14 - Table 3 Primary Assets and Liabilities of Financial Intermediaries in the US Type of Intermediary Primary Liabilities Primary Assets (Uses of (Sources of Funds) Funds) Depository institutions Blank Blank (banks) Commercial banks Deposits Business and consumer loans, mortgages, U.S. government securities, and municipal bonds Savings and loan Deposits Mortgages associations Mutual savings banks Deposits Mortgages Credit unions Deposits Consumer loans - 15 - Table 3 Primary Assets and Liabilities of Financial Intermediaries in the US (continued) Type of Intermediary Primary Liabilities Primary Assets (Uses of (Sources of Funds) Funds) Contractual savings Blank Blank institutions Life insurance companies Premiums from policies Corporate bonds and mortgages Fire and casualty Premiums from policies Municipal bonds, corporate insurance bonds and stocks, and U.S. companies government securities Pension funds, Employer and employee Corporate bonds and stocks government contributions retirement funds - 16 - Table 3 Primary Assets and Liabilities of Financial Intermediaries in the US (continued) Primary Liabilities Primary Assets (Uses of Type of Intermediary (Sources of Funds) Funds) Investment Blank Blank intermediaries Finance companies Commercial paper, Consumer and business loans stocks, bonds Mutual funds Shares Stocks, bonds Money market mutual Shares Money market instruments funds Hedge funds Partnership Stocks, bonds, loans, foreign participation currencies, and many other assets - 17 - Table 4 Primary Financial Intermediaries and Value of Their Assets in the US Value of Assets ($ billions, end of year) Type of Intermediary 1990 2000 2010 2019 Depository institutions (banks) Blank Blank Blank Blank Commercial banks, savings and loans, and mutual savings banks 4,744 7,687 12,821 18,518 Credit unions 217 441 876 1,534 Contractual savings institutions Blank Blank Blank Blank Life insurance companies 1,367 3,136 5,168 8,508 Fire and casualty insurance companies 533 866 1,361 2,650 Pension funds (private) 1,619 4,423 6,614 10,919 State and local government retirement funds 820 2,290 4,779 9,335 Investment intermediaries Blank Blank Blank Blank Finance companies 612 1,140 1,589 1,528 Mutual funds 608 4,435 7,873 17,660 Money market mutual funds 493 1,812 2,755 3,634 - 18 - Economic Analysis of Financial Structure The financial system plays a key role in promoting economic efficiency. But how important is indirect finance relative to direct finance? What are the main basic facts regarding the financial systems in different parts of the world? - 19 - External vs Internal Funds for Investment - 20 - Sources of External Funds for Nonfinancial Businesses - 21 - Basic Facts of Financial Structure 1. Stocks are not the most important source of external finance for businesses. 2. Issuing marketable debt and equity securities (bonds and stocks) is not the primary funding source for businesses. 3. Indirect finance is more important than direct finance. 4. Financial intermediaries and in particular banks are the most important source of external finance. - 22 - Basic Facts of Financial Structure 5. The financial system is amongst the most heavily regulated sectors of the economy. 6. Only large, well-established firms have easy access to financial markets to finance their activities. 7. Collateral (assets that guarantee payment in the case the borrower is unable to make debt payments) is a prevalent feature of debt contracts. 8. Debt contracts are extremely complicated legal documents that place substantial restrictions on the behaviour of the borrower (restrictive covenants). - 23 - Asymmetric Information Problem Tools to Solve It Explains Fact Number Adverse selection Private production and sale of information 1, 2 Blank Government regulation to increase information 5 Blank Financial intermediation 3, 4, 6 Blank Collateral and net worth 7 Moral hazard in equity contracts Production of information: monitoring 1 (principal–agent problem) Blank Government regulation to increase information 5 Blank Financial intermediation 3 Blank Debt contracts 1 Moral hazard in debt contracts Collateral and net worth 6, 7 Blank Monitoring and enforcement of restrictive 8 covenants Blank Financial intermediation 3, 4 - 24 - Economics of Banking Financial intermediaries and more in particular banks play a central role in the financial system. Therefore, we need to examine: (i) The structure of the balance sheet of banks; (ii) How banks manage their liquidity, assets, liabilities and capital. This analysis will also help in understanding the: importance of regulation of the banking sector and the Global Financial Crisis of 2007-2008 (lectures week 5); role of banks in the money supply process (lectures week 6). - 25 - Table 1 Balance Sheet of All Commercial Banks in the US, June 2020 Assets (Uses of Funds)* Blank Liabilities (Sources of Funds) Blank Reserves and cash items 15% Checkable deposits 14% Securities Blank Nontransaction deposits Blank U.S. government and agency 16 Savings deposits 52 State and local government and other securities 4 Small denomination time deposits 2 Loans Blank Large-denomination time deposits 9 Commercial and industrial 14 Borrowings 10 Real estate 23 Bank capital 13 Consumer 7 Other 8 Other assets (for instance, physical capital) 13 Total 100 Total 100 - 26 - Balance Sheet: Assets 1. Reserves and cash items: Required Reserves (RR) and Excess Reserves (ER) 2. Securities: corporate, bank and government bonds 3. Loans: o Commercial and industrial, i.e., loans to firms o Real estate, i.e., mortgages o Consumers (e.g., for the purchase of durable consumer goods, overdrafts and credit card loans) o Interbank loans, i.e., loans to other banks 4. Other Assets: physical capital (e.g., buildings) - 27 - Balance Sheet: Liabilities 1. Checkable deposits (aka sight deposits, transaction deposits) 2. Nontransaction deposits: savings accounts and time deposits 3. Borrowings: from banks (interbank borrowing), corporations and the central bank 4. Debt and other securities 5. Foreign currency deposits 6. Bank capital (or “equity” or “net worth”): = Total assets – liabilities - 28 - Basic Banking: Making a Cash Deposit T-account analysis: a T-account is a simplified balance sheet that lists only the changes that occur in the balance sheet of the bank: each operation always affects two items of the balance sheet. Example: You open a deposit of €100 with cash at ING Assets Liabilities Cash + € 100 Deposits + € 100 or Assets Liabilities Reserves + € 100 Deposits + € 100 - 29 - Basic Banking: Payment Transaction You then purchase a book of € 60 paid by PIN (debit card) from SEFA (which holds an account at the Rabobank). ING: Assets Liabilities Reserves - € 60 Deposits - € 60 Rabobank: Assets Liabilities Reserves + € 60 Deposits + € 60 When a bank receives a deposit, reserves  by an equal amount and when a bank loses a deposit, reserves  by an equal amount. - 30 -  Basic Banking: Making a Profit After a new deposit of €100 has been received, the bank is obliged to keep a fraction of the deposit as required reserves at the central bank (assume that the required reserve ratio r = RR / D = 10%). Assets Liabilities Required Reserves + € 10 Deposits + € 100 Excess Reserves + € 90 To make a profit, the bank will use the excess reserves to make loans: Assets Liabilities Required Reserves + € 10 Deposits + € 100 Loans + € 90 This is asset transformation: the bank borrows short and lends long. Assume that the interest rate on loans is 10%, the interest rate on deposits is 5%. that other costs are 3% of deposits and that the central bank pays no interest on the Required Reserves. The profit then will be 1 (= 9-5-3). - 31 - Principles of Bank Management 1. Liquidity Management 2. Asset Management Managing Credit Risk Managing Interest-Rate Risk 3. Liability Management 4. Capital (Adequacy) Management - 32 - Liquidity Management Assume: required reserve ratio r = 10%. The initial balance sheet (in € millions): Assets Liabilities Reserves 20 Deposits 100 Loans 80 Capital 10 Securities 10 => The bank thus has 10 in Excess Reserves Assume: a deposit outflow of €10 million Assets Liabilities Reserves 10 Deposits 90 Loans 80 Capital 10 Securities 10 After the outflow of deposits, the bank still has excess reserves of €1 million (€10 million - 10% of €90 million). Or, with ample initial excess reserves, no further actions are needed. - 33 - Liquidity Management Assume on the contrary an initial balance sheet with no excess reserves: Assets Liabilities Reserves 10 Deposits 100 Loans 90 Capital 10 Securities 10 Then a deposit outflow of €10 million occurs: Assets Liabilities Reserves 0 Deposits 90 Loans 90 Capital 10 Securities 10 The bank now has no reserves and thus also has not the required reserves that are at €9 million (10% of €90 million). To eliminate this shortfall, the bank has 4 basic options (the exercises in the tutorial explore further options). - 34 - Liquidity Management: Options 1. Borrow from other banks (e.g., interbank market) or corporations Assets Liabilities Reserves 9 Deposits 90 Loans 90 Borrowing from banks or corp. 9 Securities 10 Capital 10 2. Sell Securities Assets Liabilities Reserves 9 Deposits 90 Loans 90 Capital 10 Securities 1 - 35 -  Liquidity Management: Options 3. Borrow from the central bank Assets Liabilities Reserves 9 Deposits 90 Loans 90 Borrowing from CB 9 Securities 10 Capital 10 4. Call in or sell loans Assets Liabilities Reserves 9 Deposits 90 Loans 81 Capital 10 Securities 10 Fundamental roles of maintaining a “healthy” level of liquidity: 1. Reduces costs associated with deposit outflows and the subsequent need to quickly replenish reserves when initially insufficiently large reserves were held: may be (very) costly. 2. Reduces the probability of bank runs or bank panics (link to financial regulation). 3. With sufficiently large excess reserves, new clients can immediately be given a loan. 4. Holding large excess reserves is costly, since lending them brings a larger reward. - 36 - Asset Management Four main challenges: 1. Find borrowers who pay high interest rates and have low default risk, i.e., that are unlikely to halt interest payments and/or repayment of the borrowed amount. 2. Purchase securities with high returns and low risk. i.e., diversifying between different types of securities. 3. Lower the credit risk (i.e., the default risk) of their asset portfolio by diversifying and also lower the interest-rate risk of their asset portfolio. 4. Balance the need for liquidity against the larger returns from less liquid assets. - 37 - Managing Credit Risk Strategies to Manage Credit Risk 1. Screening and information collection (“credit score”). 2. Specialise in lending (trade-off with diversification). 3. Monitoring and enforcement of restrictive covenants. 4. Establishing long-term customer relationships. 5. Loan commitments (to increase information collection). 6. Collateral and compensating balances. - 38 - Managing Credit Risk 7. Credit rationing: credit rationing implies that no credit is given or that the credit does not cover 100% of the desired sum, but for instance 90%. The latter should encourage careful and more thrifty use of the funds; limits the involvement of the bank; co-financing is an example of credit rationing: the remainder, for instance, 10% must come out of the private funds of the owner(s) of the company. The use of private funds should lead to more caution (“more skin in the game”). - 39 - Managing Interest-Rate Risk Example of exposure to interest-rate risk (in € millions): Assets Liabilities Rate-sensitive assets 20 Rate-sensitive liabilities 50 Variable-rate loans Variable-rate CDs Short-term securities Fixed-rate assets 80 Fixed-rate liabilities 40 Long-term bonds Sight deposits Long-term securities Savings deposits Long-term loans Long-term CDs Capital 10 - 40 - Managing Interest-Rate Risk: Gap Analysis The gap analysis focusses on the effect of interest rate changes on profits. Assume: i  5%-points: GAP = (rate-sensitive assets) – (rate-sensitive liabilities) = € 20 million – € 50 million = – € 30 million 1. Income on assets = + € 1 million (= 5%  € 20 million) 2. Costs of liabilities = + € 2.5 million (= 5%  € 50 million) 3. Profits = € 1 million – € 2.5 million = – € 1.5 million = 5%  (€ 20 million – € 50 million) = 5%  GAP Profits = i  GAP - 41 - Managing Interest-Rate Risk: Duration Analysis The duration analysis focusses on the effect of interest rate changes on the balance sheet: Duration = average lifetime of a security’s stream of payments. Duration analysis: measures sensitivity of the market value of the bank’s total assets and liabilities to changes in the interest rate. Indeed, changes in the market value of assets and liabilities affect the capital of bank. Remember: the longer the maturity of an asset or liability, the stronger its market value changes with interest rate changes. Percentage change in the market value of a security ≈ (- percentage point change in interest rate) x (duration in years) - 42 - Managing Interest-Rate Risk: Duration Analysis E.g., assume that the duration of assets = 3 years and that the duration of liabilities = 2 years. Percentage change in market value of assets = -5% x 3 = -15% Percentage change in market value of liabilities = -5% x 2 = -10% The assets’ value declines by € 15 million (-15% x € 100 million), whereas the liabilities’ value declines by € 9 million (-10% x € 90 million)  bank capital decreases by € 6 million - 43 - Strategies for Managing Interest-Rate Risk Strategies to reduce the interest-rate risk: 1. Rearrange the balance sheet in order to have a balance between rate-sensitive assets and rate-sensitive liabilities (gap analysis) and ensure that assets and liabilities have the same duration (duration analysis). 2. Use financial derivatives (e.g., interest-rate swaps, options, forwards and futures). - 44 - Liability Management Banks no longer only depend on sight and time deposits as primary bank funds, i.e., they have increasingly also access to other sources of funding such as borrowing from other banks. When banks see lending opportunities, they may borrow from other banks in the interbank market and/or issue certificates of deposit (CD) to raise additional funds. Goal of Liability Management: Minimise the cost of funding. Banks manage the asset and the liability sides of the balance sheet together: Asset- Liability Management (ALM). - 45 - Capital (Adequacy) Management Capital (= assets – liabilities) acts as a cushion to prevent bank failure (insolvency) in the presence of adverse developments (e.g., a non-performing loan must be written off which decreases capital). However, there is trade-off between safety with high levels of capital and the return on equity (ROE) for holders of bank capital (see next slides for the argument). Moreover, banks are subjected to international agreements on capital adequacy (the so- called capital requirements in the Basel Accords). Indeed, international interdependencies can cause bank problems to spread across nations (see week 5). - 46 - Capital Management Strategies for managing capital (in relation to assets): Buy back stocks or issue new stocks; Pay higher or lower dividends to stockholders; Increase or decrease the assets of the bank (given a certain amount of capital). This alters the ratio of bank capital relative to assets: this ratio is at the centre of the Basel Accords (see week 5). - 47 - Capital Management ROE = Return On Equity = P / E where P = net profits after taxes E = equity (i.e., capital) ROA = Return On Assets = P / A where A = assets EM = Equity Multiplier = A / E Hence: ROE = ROA x EM For a given ROA, if E ↓ then ROE ↑ and if E ↑ then ROE ↓ - 48 - Off-Balance-Sheet Activities Not booked on the balance sheet. Generation of profits from activities that do not appear on the balance sheet: o Loan sales (with guarantees); o Fees from specialised services linked to securitisation, derivatives and foreign- exchange transactions, guarantees of securities and backup credit lines, etc. These activities and services do not appear on the balance sheet, but can dramatically affect the risk that the bank faces. See week 5 for more detail as OBS-guarantees were central to the Global Financial Crisis of 2007-2008. - 49 - References to tables and figures All figures, tables, diagrams, etc. are made by Dirk Veestraeten unless stated otherwise. 1. Slide 3: Figure 1 on p. 71 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 2. Slide 5: Figure 1 on p. 71 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 3. Slide 8: Table 1 on p. 75 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 4. Slide 10: Table 2 on p. 77 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 5. Slide 11: Figure 1 on p. 71 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 6. Slide 15: Table 3 on p. 87 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 7. Slide 16: Table 3 on p. 87 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 8. Slide 17: Table 3 on p. 87 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 9. Slide 18: Table 4 on p. 88 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 10. Slide 20: Mishkin (2015), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 11. Slide 21: Figure 1 on p. 213 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 12. Slide 24: Table 1 on p. 229 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. 13. Slide 26: Table 1 on p. 237 of Mishkin (2022), “The Economics of Money, Banking, and Financial Markets”, Pearson Education. - 50 -