Post on 25-Dec-2015
Finance 110631-1165
THE BANKING SYSTEM
Finance 110631-1165
Lecture outline
The types and functions of banking
Central banking
Commercial and investment banks
Finance 110631-1165
Types of banking
The central bank
Commercial banks
Investment banks
Finance 110631-1165
The central bank’s functions (1)
A bank for the state
A bank for banks
Money issuance
Monetary policy
The lender of last resort
Foreign reserves managament
Financial supervisory functions
Finance 110631-1165
The central bank’s functions (2)
The bank for the state- it manages the
state accounts with other countries
The bank for banks- all the commercial
banks have accounts in the central banks
Finance 110631-1165
The central bank’s functions (3)
The central bank has the exclusive right to issue cash
It is responsible for controlling the monetary base and money supply
To fulfill these functions the central bank is provided with several monetary policy tools
The goal of monetary policy
The general goal of monetary policy is inflation stabilization
To achieve this goal central banks can pursue different monetary policy strategies
Finance 110631-1165
Finance 110631-1165
Monetary policy strategies
Exchange rate target e.g. during the Bretton Woods system,
Monetary base target- a popular strategy in the 80-ties
Direct inflation targeting- currently the most popular strategy
Finance 110631-1165
Monetary policy tools
The interest rate Open market transactions Reserve requirements Exchange requirements
Finance 110631-1165
What are interest rates for?
Through setting the interest rates the central bank wants
to influence market interest rates
It setting of interest rates leads to series of lending or
borrowing money until the targeted market rate is
reached
These transactions take place between the central bank
and a limited number of qualified banks
The same target can be reached by purchasing and
selling bonds
Finance 110631-1165
What are open market operations?
Open market operations are aimed at direct influencing
of the money supply
The central bank carries out open market operations by
buying and selling securities on the open market
Each purchase of securities increases the money
supply, each sell of securities decreases the money
supply
Finance 110631-1165
Finance 110631-1165
What’s the purpose of reserve requirements?
Commercial banks have to hold cash reserves for the
case of bank-runs
The reserves constitute usually only a fraction of the
deposits
The central bank sets the level of the required reserves
in order to influence the amount of loans granted by
commercial banks
This way it influences monetary creation, economic
activity and the level of inflation
Finance 110631-1165
What role do exchange requirements play?
The role of exchange requirements depends on the convertibility of the currency
If the currency is only partially convertible the central bank has to purchase the foreign currency from the domestic enterprises who own the foreign currency
The purchase of foreign currency leads an increase of money supply
If the currency is convertible there can be constraints on bank foreign exchange operations e.g. central bank permits are necessary to transfer money abroad
The central bank as the lender of last resort (1)
The lender of last resort is an institution willing to extend credit when no one else will
The function of the lender of last resort is triggered in the case of financial difficulties of important institutions
In order to avoid their bankruptcy the central bank may grant credit to the failing institution
Finance 110631-1165
Finance 110631-1165
The central bank as the lender of
last resort (2)
The purpose of this function is to protect
depositors in times of crises
It constitutes an insurance against the default
risk
It is aimed at preventing panic withdrawals in the
time of crisis
Finance 110631-1165
Foreign reserves managament
The foreign reserves constitute a part of central
banks assets held in foreign currency
The foreign reserves are an important element
of backing the central banks liabilities
Central banks assets and liabilities
Assets Gold Foreign assets
(foreign exchange reserves)
Domestic assets
Liabilities Domestic money
supply Other domestic
liabilities Foreign liabilities
Finance 110631-1165
Finance 110631-1165
Financial supervisory functions of the central bank
Financial supervisory systems differ from
country to country
The financial supervision function van be
divided between institutions or consolidated
Central bank play a crucial role as supervisory
institutions
Finance 110631-1165
Financial supervisory functions of the central bank
Entry into banking regulation
Banking activity regulation
Capital requirements
Deposit insurance schemes
The functions of commercial banks (1)
The commercial banks can issue money in the form of loans but not in the form of cash
Commercial banks like every enterprise pursue the goal of profit maximizing
The profit derives from the interest earned from loans and deposits
Finance 110631-1165
Finance 110631-1165
The functions of commercial banks (2)
Commercial banks process payment transfers
They are involved in financing trade They are involved in brokerage (securities
trade) as market makers Large banks fulfill the function of
underwriters in bond issuance
Finance 110631-1165
The notion of credit (1)
One of the basic functions of banks is issuing credit
Credit is a relation between the debtor and the creditor
It is based on an agreement according to which the creditor provides resources to the debtor and the debtor is obliged to return the resources
Finance 110631-1165
The notion of credit (2)
Credit itself can relate to monetary or non-
monetary resources
The banking credits refer to monetary resources
Banking credits are usually: current credits,
investment credits or consumption credits
Finance 110631-1165
Current credits
Credits granted for financing the current
activity needs of enterprises e.g. production,
supply, warehousing, sales
Short term credits
The largest fraction of banking credits
Finance 110631-1165
Investment credits
Credits aimed at financing investmentsThe investments may be aimed
modernizing, restitution or creation of new estate of the debtor
Medium and long term credits
Consumption credits
Usually granted for householdsAimed at financing consumption e.g the
purchase of a car Paid off in installments
Finance 110631-1165
Finance 110631-1165
Credit vs. loans
A loan refers to monetary resources onlyThe loan is a type of debtThe borrower initially receives monetary
resources from the lender, and is obligated to pay back an equal amount of money to the lender at a later time
Bank loans
The banks grant loans in the form of credit at the cost of specified interest
Simple interest=interest rate* initial balance* duration of the loan
Real interest- accounting for inflationCummulative interest=
interest1*interest2*…*interestn
Finance 110631-1165
Investment banks functions
Primarily the function of investment banks was to act as brokers and market makers for securities trading, especially derivatives and foreign exchange
The introduction of electronic brokerage systems led to the decrease of their role as intermediary
Currently they act mainly as a consultant, provide assistance in raising capital by underwriting and assist companies involved in mergers and acquisitions,
Finance 110631-1165
International banking
Banks can act internationally as branches or subsidiaries of the bank based in the home country
A branch is bank which is a part of the parent corporation
A subsidiary is a separate legal entity Implications for the lender of last resort-
which central bank should support a branch and which one a subsidiary?
Finance 110631-1165
„Special” central banks
The European Central BankThe Bank for International Settlements
Finance 110631-1165
The European Central Bank
Responsible for the monetary policy in the whole euro area
The reserves created from the contributions of national central banks
According to the Treaty the ECB can not act as the lender of last resort- the no bail out principle
Finance 110631-1165
The Bank for International Settlements
The bank for the central banksIt provides banking services to central
banks and international institutionsBroadly involved in banking regulation The BIS is not accountable to any
national government
Finance 110631-1165
Finance 110631-1165
Literature
R.W.Melicher, E.A.Norton, Introduction to Finance. Markets, Investments and Financial Management, John Wiley&Sons,2007