Comm Bkg, Sessions 1-8

7/31/2019 Comm Bkg, Sessions 1-8

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Commercial Banking Sessions 1-8, BM 2011-13.

Financial Intermediation and Banking-Theoretical Foundations

Prof. Santosh SangemXLRI, Finance Area


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Most regulated of all financial entities Bank deposits a widely used form for settling economic

obligations.

Also widely misunderstood

Banks are Dinosaurs .(Bill Gates, quoted in O Sullivan,1996)

The banking industry is dead, and we ought to just bury it(Dick Kovacevich (CEO, Norwest), quoted in Davis,1999)

The Banking Sector is becoming irrelevant economically andits almost irrelevant politically (William Isaac, FormerChairman, FDIC; quoted in Boyd and Gertler (1994))

Why Study Commercial Banks?


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Prominent role of banks in almost all major financialcrises during twentieth century The U.S. Banking Panic of 1907

The Great Depression

Savings & Loan Crisis of the 1980s Continental Illinois Bank Failure of 1984

Asian Financial Crisis of 1997-98

The Sub-Prime crisis/Credit crisis of 2007-


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Costs of Banking Crises Direct costs of restructuring banking sector

Lowered GDP growth

Estimates of impact from 5% of GDP to 300% of GDP

Banking crises accompanied by crises in other parts of financialsystem and currency crises

A Paradox

Economic booms and claims of growing irrelevance of banks inmodern economies


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Some Typical Issues

Are banks special or not??? Banks and external macro-environment

Regulation as the provider of incentives/disincentives

Deposit Insurance and Capital Maintenance requirements

Liquidity Maintenance & Management

Risk Management & Financial Innovation

Off- Balance Sheet Activities of Banks & Securitization

Excessive Risk Taking and Bank Failures

Banks are Financial Intermediaries


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Banks and Non-Financial Firms

Both finance themselves through equity and borrowed funds Both invest funds raised in income generating assets

Surplus over expenses paid to providers of capital

Too many similarities on the surface. But are they really similar?

A closer look at balance sheet composition


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Assets ManufacturingFirms Banks

(% of Total Assets)

Net Fixed Assets 50%-60% 3%-5%

Investments 10%-20% 25%-30%Current Assets 20%-40% -

Loans & Advances (incl. in CurrentAssets)

40%-60%

Reserve Balances with CentralBank - 3%-5%

Inter-Bank Balances - 5%-10%




Liabilities ManufacturingFirms

Banks

(% of Total Assets)

Net Worth 40%-50% 5%-10%

Long-Term Borrowed Funds 30%-40% 0%-5%

Short-Term Borrowed Funds &Current Liabilities

10%-25% 0%-10%

Deposits from Customers - 75%-90%

Contingent Liabilities 15%-20% 200%-400%




Financial Assets as Major Component of Bank Assets Loans as Primary Assets

High Financial Leverage

Low Net Worth

Deposits as Primary Source of Bank Funds Typically interest cost of deposits is much lower than cost of

borrowed funds for manufacturing firms

Inter-Bank Balances and Reserve Balances




Much higher financial risks of banks relative to other firms Business of Banking

Taking up a variety of financial risks to make profits

Reducing Financial Risks through reduction of leverage

Reduction of Profitability

Importance of Off-Balance Sheet Transactions for Banks



What is Financial Intermediation

Intermediaries as third parties Financial intermediaries (FIs) intermediate between providers and

users of capital

Some FIs use their resources to borrow from the providers of

capital and lend to users of capital

FIs as providing valuable services to both providers and users ofcapital

Which services do they provide?

Why are they able to provide these services?

Are these really useful for both providers and users of capital?



Direct Finance

Direct finance a transaction between provider and end-user ofcapital

Both meet and exchange funds for financial assets

Borrowers

(deficit budget unit)Lenders

(surplus budget unit)

Flow of Funds

Primary Security



Issues with Direct Finance

Direct finance an expensive means of transacting for savers andborrowers

Total information collection and processing = 2N2

Lesser extent of diversification for savers and borrowers

Liquidity risk for savers

An intermediary to collect, process, and match requirements (Abroker)

Total number of transactions = 2N

Savings equivalent to 2(N2 N) * cost per transaction

The screening function of financial intermediaries


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Issues with Direct Finance

When would such brokers come ahead? Private nature of information

Re-usability of information

Specialization and scale economies over time

Role of profitability and entry barriers

Asymmetric information and ex-post screening??

Liquidity risk for savers?? Portfolio diversification for savers??


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Indirect Finance

Savers

(surplus budget unit)

FlowofFunds

PrimarySe

curity

Financial Intermediary

Flow

ofF

unds

Borrowers

(deficit budget unit)

PrimarySecurity

Indirect finance as risk-taking by Financial Intermediaries

Portfolio diversification benefits, liquidity creation, and ex-postmonitoring


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Qualitative Asset Transformation

Demand from savers for liquidity risk management services Risk aversion of providers of capital

Risk of default of borrower replaced with risk of default ofFinancial Intermediary

Liquidity creation and provision

Maturity transformation and mismatched balance sheets

Business of managing financial risks

Interest spread as primary source of income


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Issues in QAT

Characteristics of the Financial Intermediary

Capitalization

Ability to manage financial risks, especially liquidity risk

Resources for ex-ante screening and ex-post monitoring

Transaction costs for savers in monitoring the financial intermediary??

Reducing this element of transaction costs??

Total costs of screening and information collection = N Make the liabilities of FIs risk-free for savers

Insured deposits

Characteristic of only banks


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What else do Financial Intermediaries do?

Functions performed by FIs The brokerage function

Adverse Selection, Screening, and Information Collection

Scale economies & reusability of information

Moral hazard and post-funding monitoring Providing funds just one activity of financial intermediaries

Other services provided by FIs

Transaction services

Financial advisory Issuances

Guarantees

and so on


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Lack of clear and well-accepted definitions of bank Definition by functions

Definition by services

Definition by legal basis

Definition by functions/services as inadequate Changing nature of functions & services provided by banks

Definition by legal basis Issue demand deposits and making business loans

Qualified for deposit insurance

Definitional Issues


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Banks are financial institutions that are privileged by the laws of anation to have thepower to issue deposits that are payable ondemand and which deposits are also generally accepted by economicagents in final settlement of transactionsbetween them

Emphasis on payments/transaction services

Regulations as laying down boundaries on activities of banks

Definitional Issues


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But why do banks exist

Debate on rationale for existence of banks Transaction cost & Asymmetric information based theories

Scale economies in information collection, monitoring, andliquidity provision

Debt as a contract brings forth optimal behavior from users offunds Agency Costs

Banks exist to deal with ex-ante & ex-post informationasymmetries

Industrial Organization based theories Banks as portfolio managers for depositors

Arguments equally applicable to other financial intermediaries


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But why do banks exist Incomplete Markets Theories

Typical providers of capital are risk averse

Need to manage liquidity risks across time

Bank deposits as a risk-free liquid asset

Banks (and other FIs) provide a variety of risk management servicesto providers and users of capital

Understand banks in terms of their role in the functions of afinancial system

Providing a payments system for the exchange of goods and services

Pooling of funds for undertaking large-scale indivisible enterprise

Transfer economic resources across time, industries and geographicallocations

Managing uncertainty and controlling risk

Provide price information

Provide a way to deal with asymmetric information


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But why do banks exist

Other rationales Banks as providing a means of payment

Banks as the central players in transmission of monetary policyactions

Banks as having ability to create liquidity to business throughprovision of funds

Why the unique role of banks in payments and provision of risk freeliquid asset?

History of banks and bank regulation


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A brief history of banking

The Medici Bank (1397) as the first formal bank Early banks serving the needs of merchants Money changer banks

and merchant banks

Large number of failures in Continental Europe driven by bad

debts

Charters to deposit banks - primarily transaction services

Another objective of charters to finance the governments needs

Banks also as safe-keepers of money

Banks as universal banks


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The growth of fractional reserve banking Logic of un-coordinated withdrawal requirements of depositors Wider reach and accessibility

Large number of bank failures in 19th century and early 20th century

Bank failures attributed to liquidity problems and undue risk taking

US banking panic of 1907 and the creation of the federal reserve Lender of last resort

The Great Depression Deposit Insurance

Glass-Steagall Act


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Deposit insurance and risk-free deposits Commercial banking under Glass-Steagall Act

Banks to provide only loans to business and governments

Banks as sole entities to issue deposits

Competition among banks as a destabilizing factor Interest rate controls

Restrictions on geographical expansion

The introduction of reserve requirements

Payment of deposit insurance premium

Capital Maintenance The early forms


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A brief history of banking The US Scenario

Competition from foreign banks for customer deposits

Rise in interest rates since the late 1950s

The response financial innovation Eurodollar deposits, inter-bank repos, commercial paper, etc

Financial innovation driven by demand of depositors and borrowers

Increasing competition from non-bank financial intermediaries Declining profitability and viability of banks

Dangers of losing monopoly position in payments function

The regulatory response leveling the playing field Deregulation


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Lender of Last Resort Objective of ensuring stability of banking sector

Liquidity problems as the primary cause of bank failures

Lack of liquidity when needed the most during crises

Essentially a government set-up agency

Provision of short-term loans to banks facing temporary liquidityproblems

Principles of LOLR function

Lend only against good collateral

Accept all good collateral

Penal rate of interest on loans

Policies as public knowledge


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Deposit Insurance Objective of Deposit Insurance

Protection of savings of depositors

Banking failures and bank runs primarily a result of liquidityproblems

Early private solutions like mutual agreements, own deposit

insurance schemes, etc. The credibility problem breakdown of the pooling arrangements

Provision of liquidity post failure

The solution - governments to provide deposit insurance


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Deregulation of banking Removal of administered interest rate regimes

Removal of portfolio restrictions on banks

Increasing scope and nature of activities allowed to banks

Setting up of financial markets and introducing a wider range offinancial instruments

Allowing a greater variety and number of non-bank financialintermediaries to be setup

Allowing easier entry to foreign banks


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Continental Bank & Thrifts A common problem with all deposit insurance schemes

Moral Hazard

Continental Illinois Bank the first post-war failure of a large bank

Multiple failures in the S&L industry

Some common features

Excessive risk taking on the asset side

Short-term non-deposit funds and maturity mismatches

The regulatory response Risk-based capital requirements (Basel-I)

Innovations in payments systems and short-term liquiditymarkets

M l H d d th T Bi T F il


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Moral hazard as the taking on of more risk than warranted in theabsence of a safety net

Deposit insurance and moral hazard in banking

More acute moral hazard problem for large banks

Creditors of large bank with an implicit government guarantee as torepayment in event of failure Contagion effect of large bank failures

Better safe than sorry approach of regulators

Moral Hazard and the Too-Big-To-Fail

Problem


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Basel Norms Basel-1 introduced in developed economies in early 1990s

Objective of ensuring sufficient capital maintenance

Leveling global playing field

Capital Requirements

Risk-Weighted Assets

Tier 1 and Tier 2 Capital Instruments

Basel-1 and Credit Risk

Standardized Risk Weights

Basel 1.5 and Market Risk

Growing importance of market traded securities

Tier 3 Capital Instruments


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Repeal of Glass Steagall Act Growing size of investment banks and other non-bank financial

intermediaries

Scope for profitability and risk diversification for banks

Glass-Steagall Act as final set of restrictions on banks

Repealed in 1999

US Commercial banks free to provide all kinds of financial services The universal bank model

Some reservations Conflicts of interest

Higher risks with securities activities


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Traditional Services

Safekeeping of assets

Currency exchange

Providing business loans

Discounting commercial bills

Demand deposit & Savings deposit accounts

Financing governments

Providing guarantees

Services offered by Modern Banks


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Relatively recent trends

Consumer lending

Financial advisory

Equipment leasing

Cash management

Venture capital finance

Mutual funds & Portfolio management services

Selling insurance & Retirement policies

Securitization Investment banking

Risk management

And so on

Services offered by Modern Banks


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Banking Structures


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Increasing activities of banks driven by competition Search for higher profits

Exploiting economies of scale and scope

Asset-side competition Investment (Merchant) banks, Venture capital funds, Financial markets,

Mutual funds, Pension funds, Hedge funds, etc

Liability-side competition Money market mutual funds

Investment banks

Insurance companies

Other Financial Services Securities Brokers

Investment banks

Competition as a driver of change


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Competition and ConsolidationAssets SizeNumber of

Banks < $100 M $100M - $1B $1B - $10B > $10B

10,242 7,123 2,741 331 631995(69.55%) (26.76%) (3.23%) (0.62%)

9,451 6,147 2,900 331 731997

(65.04%) (30.68%) (3.50%) (0.77%)8,580 5,157 3,029 318 76

1999(60.10%) (35.30%) (3.71%) (0.89%)

8,080 4,486 3,194 320 802001

(55.52%) (39.53%) (3.96%) (0.99%)7,769 3,911 3,434 341 83

200350.34% 44.20% 4.39% 1.07%

7,630 3,655 3,530 360 852004 (47.90%) (46.26%) (4.72%) (1.11%)

Asset SizeTotalAssets < $100 M $100M - $1B $1B - $10B > $10B

$4,116 $310 $668 $1,077 $2,0611995

(7.54%) (16.22%) (26.17%) (50.07%)

$4,642 $277 $711 $995 $2,6581997

(5.97%) (15.32%) (21.45%) (57.27%)

$5,735 $243 $755 $915 $3,8231999

(4.23%) (13.16%) (15.96%) (66.65%)$6,569 $222 $819 $915 $4,613

2001(3.37%) (12.47%) (13.93%) (70.22%)

$7,603 $201 $910 $947 $5,5452003

(2.64%) (11.97%) (12.46%) (72.93%)

$8,413 $189 $953 $973 $6,2972004

(2.25%) (11.33%) (11.57%) (74.85%)


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M&A activity in banking on rise since the 1990s

Driven by competition and the exploitation of scale economies Tendency of banks to grow larger (e.g. Number of German banks reduced

by 35% between 1997 and 2008 )

Dismantling of Glass-Steagall and the rise in Mega-Mergers

Providing greater product diversity to customers

Greater efficiency in risk management, liquidity and capitalmanagement

Stability and bank size changing regulatory trends

Removal of geographical expansion restrictions

Competition and Consolidation


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Cost indivisibility Higher share of fixed costs

Indivisibility of reputation

Financial economies of scale Netting and liquidity requirements

Portfolio diversification and equity requirements

Claimed benefits of consolidation on banking sector efficiency Lowered costs for customers

Competitive pricing of deposits and loans

Broader access to banking services

Sources of Scale Economies


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The growth of Universal Banks since the 1990s Provide a broad range of financial services and products

Dominant structure of banks in Continental Europe

Claimed Benefits Cross-Selling of Products

Better resource utilization for common activities

Information re-use

From Bank Holding Companies (BHCs) to Financial HoldingCompanies (FHCs) BHCs restricted from carrying on most non-banking activities

Repeal of Glass Steagall Act & removal of restrictions on M&A

Difference in type of M&A transactions since 1999-00.

Sources of Scope Economies


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The financial innovation cycle Development of a new product

Selling product to existing clientele

Duplication of product by other banks & FIs

Widespread use and active trading on financial markets

Key drivers of financial innovation Search for profits by banks

Competition

Regulatory restrictions

Low and stable interest rate environment

Financial Innovation


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Two post-war eras of financial innovation 1950-mid 1980s

Mid 1980s onwards

High Return vs. Risk Sharing Products

Demand driven financial innovation vs. Supply push financialinnovation

Rapid growth of non-bank financial intermediaries

A clientele for new financial products Sophisticated clientele searching for better yields

Shift towards developing risk sharing financial products

Financial Innovation


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Creating stable return distributions for clients

Demand Side Factors

Managerial Self-Interest

Bankruptcy Costs

Capital Market Imperfections Participation Costs

Increased Cross-border Transactions

Supply Side Factors

Technology

Transaction Costs

Competition & First Mover Advantage

Risk Sharing Innovations

Off-Balance Sheet Activities of Banks


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Rapid growth in off-balance sheet transactions of banks Fee-based incomes

Trading profits

Increasing importance of derivative contracts Nominal Amt of outstanding derivative contracts nearly USD 700 trillion

Banks and other FIs as dominant counterparties Risk reducing transactions?

Clientele effect and Market segmentation

Risk appetites differ across different investor categories Better risk sharing

Increased liquidity risks

Off-Balance Sheet Activities of Banks


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Frequent occurrence of banking crises and greater instability ofbanking sectors

Liquidity problems as primary driving forces of bank failures

Increased concerns with bank solvency since the mid1980s

Belief of solvency problems as an outcome of undue risk taking

Adequate maintenance of capital by banks as a solution to limit undue risktaking

Regulatory separation of liquidity problems and solvency risks

Shift of regulatory approaches from micro-management tosupervisory

Re-Recognition of Contagion post East Asian Crisis

Bank Regulation : Shifts in Thought


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Systemic risk as the risk of failures in a set of financial markets/financial intermediaries Macroeconomic Factors & Systemic Risk

Asset Markets & Systemic Risk

Contagion as thespreadof problems from one intermediary/market

to other intermediaries/markets

Bank Runs?

Banking sector most prone to systemic crises & contagion

Loss of depositor confidence Inter-linkages between banks Inter-bank markets

Inter-linkages between banks Counterparties in financial markets

Systemic Crises & Contagion


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Moral hazard effect of deposit insurance Risk taking by banks needs to be monitored and restrained

Preventing disruptions in payments and settlement systems Bank deposits as money

Banks as largest players in payments & settlement systems Systemic Risk

& Contagion

Opacity of risks taken up by banks Depositor Safety

Monitoring the monitor Banks as agencies monitoring behavior of borrowers

Enhanced efficiency of banks Maintenance of competitive conditions

Consumer Protection

Bank Regulation : Some Rationales


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Shift to prudential regulation principles Safety and soundness of financial system as a whole

Depositor protection

Regulators as not micro-managers

Regulatory costs and financial system efficiency

Creation of an enabling operating environment Reducing regulatory disparities

Some prudential regulation measures Capital adequacy norms

Risk measurement practices Sectoral credit limits

Disclosure & accounting practices

Shift towards self-regulatory organizations

Bank Regulation- Prudential Regulation


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Traditional view of regulation as a solution to negative externalities

Regulation as the outcome of a bargaining process betweenregulators and interested entities

Pervasive regulation as an outcome of rational self-interest of

powerful interest groups

Regulation formulation as an optimal solution to the claims of allinterested parties Doubts on the efficacy of regulation

Regulation as more of a satisfactory give and take solution

Regulation and Social Benefits???


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Term structure as the schedule of interest rates across differentmaturities

Interest rate for a risky asset = Interest rate on risk-free asset + riskpremium

Government securities as risk-free assets default risk free

Some general observations about interest rate behavior Yield curves almost always slope upwards

When short term rates are very high, yield curves likely to have a negativeslope

Interest rates on bonds of different maturities move together over time

An important point Each yield curve has an underlying set of assumptions about default risks at

different maturities

Theories of Interest Rate Term Structure


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Expectations hypothesis Long-term interest rates as expected values of future short-term rates

No specific preference for a particular maturity by bond investors (i.e. allmaturities as perfect substitutes)

Explains only downward sloping yield curves and co-movement of bondinterest rates

Cannot explain typical observation of upward sloping yield curves

Market segmentation hypothesis Investors concerned with both interest rates & maturities

Different categories of investors with different maturity preferences &

interest rate risk tolerance Smaller maturities with very low interest rate risk

Explains only upward sloping behavior of yield curves



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Liquidity Premium Theory Explains all 3 observations

Key assumption that different maturities as imperfect substitutes

Investors as risk averse need increasing reward for bearing higher levelsof interest rate risk

Interest rate as comprising two components expectation of future short-term interest rates and liquidity premium for the corresponding maturity

Rise in current short-term interest rates as a signal of higher future short-term rates. So interest rates on different maturities move together.

Inverted yield curve an abnormal occurrence only when expectations of avery sharp fall in future interest rates



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The Monetary Policy Framework

Goals

Targets Operating Targets

Intermediate Targets

Operating Instruments

Monetary policy targets Money Supply

Interest Rates

Exchange Rates

Inflation

Banks & Monetary Policy


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Monetary Policy Interest Rate Targets On the very short-end of the yield curve

Domestic inter-bank interest rates

Overnight repo rate

Overnight call money interest rates

Central banks typically as short-term lenders of reserve balances intra-day

overnight

short-term

Provision of reserve balances against collateral Government securities as accepted collateral


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Other Monetary Policy Targets Money supply targeting

Very commonly used until mid-late1980s

Monetary policy instruments to change the amount of money supply

Breakdown due to financial innovation & money multiplier instability

Definitional issues for money supply High powered money (M0), Narrowmoney (M1), Broad money (M3), and so on.

Not much used in practice

Exchange rate targeting Adopted by economies heavily dependent on international trade

Economies must be small relative to global economy

Fewer options for central banks

Inflation targeting Extremely popular since late 1990s

Monetary policy instruments design to control inflation


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Monetary Policy Tools

Changes in Money Supply Reserve Requirements

Open Market Operations

Discount Window Loans

Temporary Liquidity Provision Repos & Reverse Repos Standing Facilities

Other instruments

Inflation forecasts Credible Signaling

Moral Suasion

Market-based operations through g-sec markets

Alternative classification of monetary policy


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te at ve c ass cat o o o eta y po cy

instruments Portfolio Restrictions

Reserve balance requirements

Sectoral lending floors and ceilings

Interest Rates and Liquidity Provision Discount window & the Bank rate

Standing facilities loan and deposit of reserves

Interest rates on reserve balances

Repos & Reverse Repos

Outright purchase transactions

Interest rate changes by central banks Feed through inter-bank interest rates and other short-term money market

instruments

Monetary Policy Impact on the Economy-


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y y p y

Some Facts Unanticipated changes in monetary policy have only transitory

effects on interest rates

Unanticipated tightening of monetary policy is followed bysustained declines in real GDP and the price level

Aggregate demand changes relatively quickly compared to changes

in production. Inventories change quickly in the short-run

The earliest and sharpest changes in aggregate demand occur inresidential investment

Spending on consumer goods lags changes in residential investment

Capital investment by business lags changes in consumer goodsspending

Unconventional Monetary Policy Measures in


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y y

Emerging Economies during the Credit Crisis


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Two sets of markets Goods Markets

Financial Markets

The Goods Market Equilibrium Condition Investment = Savings

The Financial Markets Equilibrium Condition Demand for Money = Supply of Money

Central role of interest rates

Liquidity Preference

Monetary policy as operating upon the financial marketsequilibrium

The IS-LM Model :A Quick Refresher


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Why do people demand money? To meet their day-to-day transactions (transactions motive)

To meet unforeseen future liquidity requirements (precautionary motive)

To take advantage of expected profitable avenues (speculative motive)

Demand from first two motives relatively stable

Two sets of assets in financial markets Money & Financial Securities

Increasing interest rates on securities lower demand for money

Supply of Money & Financial Securities unchanged

Increase in money supply lower rates of interest on securities Supply of financial securities unchanged

IS-LM: Financial Markets Equilibrium


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LM curve construction assumes unchanged supply of money and

financial securities One LM curve per money supply-financial securities supply configuration

Suppose the supply of financial securities increases Interest rates would increase

Suppose the supply of money decreases Interest rates would increase

Inflation in IS-LM model Some part of money supply increase as higher transaction balances

More money chasing same amount of goods

Inflation as the result



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IS-LM model as the basic logic for explaining effects of monetary

policy actions

But why only banks as conduits for monetary policy?

The role of reserve balances

Reserve balances akin to minimum deposit balances Central banks as monopoly creator of reserve balances

Increase the cost to banks of expanding their balance sheets?

Resort to other mechanisms by banks e.g. inter-bank lines of credit

Central banks as having power overmoney supply Definitions of Money Supply

Reduced over time money multiplier instability

Switch to targeting interest rates Money Supply the adjusting variable


Other Monetary Policy Channels


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Credit channel Credit rationing is a pervasive phenomenon

Always some fringe borrowers

Monetary policy actions & interest rate on all credit

Monetary policy as influencing the size of this fringe Reduction of interest rates & decline in size of fringe

Increase in interest rates & increase in size of fringe

Two different sub-channels Balance Sheet Channel

Bank Lending Channel

y y



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Balance Sheet Channel Net-Worth, Adverse Selection, & Moral Hazard

Asymmetric Information & External Finance Premium

Borrowers having short-term/floating rate debt

Value of Collateral

Bank Lending Channel A set of borrowers solely dependent upon banks for credit

Monetary policy as primarily influencing cost of credit for such borrowers

Same logic as for Balance Sheet Channel

y y



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Bank Balance Sheet Channel & Bank Capital Channel Recent developments

Credit channel implications

Monetary policy actions as not restricting bank asset growth

Portfolio reallocations and change in risk aversion of banks the outcome

Capital levels of banks an important consideration in the nature of portfolioreallocations

y y

Interest Rate Channel


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GDP

Money SupplyExpected

Inflation

Real Interest

Rates

Investment

Balance Sheet Channel / Bank Lending


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g

Channel

Money Supply ExpectedInflation

GDPInvestment

Bank Loans

BorrowerNet Worth

Moral HazardAdverse

Selection

Exchange Rate Channel


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Money Supply Short-TermInterest Rate

Expected Long-

Term InterestRate

Expected

Exchange Rate

Net Trade

Balance

GDP

Investment

Tobins q Channel


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GDP

Money SupplyExpected

Inflation

Tobins q

Investment

Unanticipated Price Level Changes Channel


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Money Supply

Unanticipated

Price LevelChange

Moral Hazard

Adverse

Selection

Investment GDP

WindfallBusiness

Profits

Bank Loans

Cash Flow Effects Channel


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Money Supply NominalInterest Rates

Moral Hazard

Adverse

Selection

Investment GDP

Business CashFlows

Bank Loans

Wealth & Debt Effects Channel


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Money SupplyExpected Price

Levels

Financial

Asset Prices

Wealth

Likelihood of

Financial

Distress

Consumer Durables

& Hsg ExpGDP

Consumer Debt

Capacity

Liquidity Effects Channel


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Money Supply Expected PriceLevels

Financial

Asset Prices

Likelihood of

Financial

Distress

Borrowing

Capacity

Investment;

Consumer Durables

& Hsg Exp GDP

Bank Balance Sheet Channel


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Money Supply

AdverseSelection

ExpectedInflation

Moral Hazard(Bank)

GDPInvestment

Bank Loans

Bank Capital Channel


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Money Supply

Govt. Securities

InterestRates

Capital Gains

on Securities

Portfolio

GDPInvestment

CapitalAdequacy

LevelsLoans

Bank Liquidity Preference (Risk Aversion)


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Channel

Money Supply InterestRates

Cost of BankFunds

GDPInvestment

Bank Risk

AversionLoans

Bank Liquidity Preference (Risk Aversion)


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Channel

Money Supply InterestRates

GDPInvestment

Bank Risk

AversionLoans

ExpectedInterest Rates

Monetary Policy Transmission Channels A


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Summary

Monetary Policy Transmission Some Key


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Monetary policy actions will not always lead to a changein long-term interest rates

Prices & conditions in other short-term debt markets arecritical to the efficient transmission of monetary policy

Financial health and risk aversion of banks critical to theefficient transmission of monetary policy

Unanticipated fluctuations in inflation are to be avoided as

they have significant impact on economic activity

Central bank policies will be most effective only whenthey are not anticipated by economic agents

Lessons


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to regulate the issue of Bank Notes and keeping ofreserves with a view to securing monetary stability inIndia and generally to operate the currency and creditsystem of the country to its advantage

Multiple objectives for RBI Regulate the issue of currency

Monetary Stability

Operating credit system

Monetary Policy in India Mandates of RBI


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Monetary Stability Price stability

External value of rupee exchange rate

Banking sector stability

Operating credit system Adequate credit to productive sectors

Accelerate economic growth

Policies of the RBI

Monetary Policy Credit Policy

Problems in balancing conflicting requirements

Monetary Policy in India Mandates of RBI


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Portfolio Restrictions Cash Reserve Ratio

Statutory Liquidity Ratio

Priority Sector Lending

Selective Credit Control

Interest Rates and Liquidity Management Discount window - Term Loans, Bank rate, Marginal Standing Facility

Standing facilities Liquidity Adjustment Facility

Repos & Reverse Repos

Outright purchase transactions

Market Stabilization Scheme

Monetary Policy Instruments in India


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Pre 1984 Inflation as a result of supply shocks

Selective credit control

1984-1998

Monetary Targeting Reserve requirements as operating instruments

M3 as intermediate target

Shift to Interest Rate Targeting Call money rate as the operating target Introduction of Liquidity Adjustment Facility

Development of money markets

Monetary Policy Targets in India

i i i i


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Monetary Policy Decision Making Process

CRR & SLR


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Portfolio Restrictions - low yield assets

Not much used post liberalization

Changes affect interest rates and bank asset expansion

No fine-tuning - for large changes only Used sparingly by RBI

Decreasing trend since liberalization

Primarily used for sterilizing expansionary effect of governmentborrowings

Currently CRR = 6% ; SLR = 24%

CRR & SLR

CRR


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CRR as a percentage of net demand and time liabilities Excludes inter-bank deposits & foreign currency deposits

Basis of average fortnightly deposits (Saturday-Friday)

To be maintained in full by next reporting Friday (i.e. after onemore fortnight)

Interim 70% daily maintenance

Penal interest First day(bank rate + 3% p.a.); Subsequent days(bank rate + 5% p.a.)

No Interest on CRR balances

Only Reserve Balances with RBI as qualified assets

CRR

SLR


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SLR as a percentage of net demand and time liabilities Excludes inter-bank deposits & foreign currency deposits

Basis of average fortnightly deposits (Saturday-Friday)

To be maintained in full each day until next reporting Friday(i.e. after one more fortnight)

Penal interest First day(bank rate + 3% p.a.); Subsequent days(bank rate + 5% p.a.)

No interest by RBI on SLR balances

Cash balances (after meeting CRR), Gold, Government

Securities as qualified assets

SLR

Liquidity Adjustment Facility (LAF)


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Provision of overnight & intra-day liquidity to banks Repurchase transactions in government securities

Daily LAF Auctions

Repo rate as signal of short-term liquidity cost

The operating target of RBIs monetary policy Repos to provide intra-day liquidity

Repos only for g-sec holdings over SLR

Reverse Repos to absorb excess liquidity

Repo rate 100 bps Marginal Standing Facility to provide distress liquidity

Max limit -1% of NDTL

Repo rate + 100 bps

Liquidity Adjustment Facility (LAF)


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Other Monetary Policy Instruments


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Priority Sector Lending Norms 40% of total advances

Market Stabilization Scheme (MSS) For long-term liquidity position

Special Dated Securities & T-Bills issued by GOI Money raised from banks kept in a separate account

MSS securities qualified for SLR maintenance

Multiple Indicator Approach


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Monetary Policy of RBI & Other Central

B k


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Banks

P t & S ttl t S t


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Payments & Settlement Systems

Central role of payments and settlement systems (PSS) for

banks and central banks The means to settle obligations to counterparties

Financial stability as a mandate of central banks

Central bank objectives for PSS Risk reduction Systemic Risk , Credit Risk, Liquidity Risk

Increasing efficiency

Settlement with finality A key feature of PSS

Point at which payment transaction deemed complete, legallyenforceable and irrevocable

Ri k i PSS


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Risks in a PSS

Credit Risks

Liquidity Risks

Legal Risks

Operational Risks

Security Risks Market Risks

Systemic Risk & Contagion Value of payments settled

Number of participants

Interaction between banks

Importance of PSS


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Importance of PSS Smooth functioning of economy

A carrier of systemic risk Liquidity problems a main cause of bank failures

Enormous amounts of transaction flows (nearly USD 4 trillion daily

in Forex markets alone) Transaction processing as a source of fee-based revenue for banks

Most PSS operated by central banks Provision of intra-day reserve loans

Some relatively recent trends Reduction of time for transaction settlement Adoption of RTGS

Debates on netting or gross settlements

Evolution of PSS Instruments


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Evolution of PSS Instruments Fixed costs of processing payments and their settlements

Scale economies for processing large transactions Most innovation in payment systems

Clearing houses and transaction aggregators e.g. CHIPS, ACH, LCHClearnet, MEPS+, CHAPS, Fedwire, ECS, etc

Technological Advances

Delivery versus payment systems Collateralized transactions

Popular due to growth of repo transactions

Levels of PSS


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Levels of PSS

Two Levels of PSS Entities other than banks

Inter-bank PSS

Corresponding PSS

Small Value Transfer Systems Large Value Transfer Systems

Large Value Transfer Systems operated by Central Banks

Customer PSS & Inter-bank PSS-An Example


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Bank 1

Customer deposits 200 Loans to customers 100

Equity 50 Reserve balances 100

Loans from other banks 50 Loans to other banks 100

Total 300 Total 300

Bank 2




Total 300 Total 300



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Bank 1




Total 300 Total 300

Bank 2




Total 350 Total 350



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Bank 1




Total 250 Total 250

Bank 2




Total 350 Total 350

Types of PSS


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Types of PSS

Cash based settlement systems

Non-Cash settlement systems

Netting Systems Bilateral Netting

Novation Netting

Close-Out Netting

Multilateral Netting

Gross Settlement Systems Real-Time Gross Settlement

Bilateral Netting


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Bilateral Netting

Multiple transactions during the day

Obligations netted out at end of day

Lowered liquidity requirements & liquidity costs

Risk of large unwanted exposures to a single counter-party

Is the netting arrangement legally enforceable? Novation Netting



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Further reduction of transactions Number of transactions under bilateral netting [0,(n2 -n)/2]

Number of transactions under multilateral netting [0,n]

Smaller amount of final settlement transfers Lowered liquidity requirements

From whom to collect and how much?? Credit risks at least as high as under bilateral netting

Central clearing-house as counterparty

Credit risk reduction

Managing/Reducing Credit Risks


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Managing/Reducing Credit Risks

Insolvency laws & procedures

Bilateral exposure limits

Shortening Netting Intervals

Restricting access to PSS

Clearing Houses

Collateral Pools

How to compute each members contribution

Close-Out Procedures Dealing with counterparty default

RTGS


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RTGS

Each transaction settled on a gross basis in real time

Number of transfers very large

Zero credit risk

Higher liquidity requirements/liquidity risk

Continuous requirements of liquidity Requires support from central bank for intra-day liquidity

provision

Incentive Issues in RTGS


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Incentive Issues in RTGS

Delaying Payments Trade-off between expected revenue losses from customers &

cost of liquidity

Incentive weaker when liquidity costs are very low

Delaying payments is optimal only if all other banks dothe same

Synchronization of payments by all banks

Price for intra-day credit

Collateralized system for intra-day credit

Standards for PSS (Lamfalussy Report)


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Well founded legal basis under all relevant jurisdictions

Participants have clear understand of system on each ofthe risks affected by the netting process

System should have clearly defined procedures ofmanagement of credit and liquidity risks that specify theresponsibilities of the system and the participants



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System capable of timely completing of daily settlements

even if the participant with the largest position fails

System should have objective and disclosed criteria foradmission that permit fair and open access

System must ensure operational reliability of systems andavailability of back-up facilities

Netting vs RTGS


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Netting vs. RTGS

Risks & Costs Netting Systems RTGS

Credit Risks Higher Negligible

Liquidity Requirements & LiquidityRisk

Lower Higher

Legal Risks Higher Minimal

Costs of Customer Payment Delays High Negligible/Nil

Interest cost on liquidity funding Lower Higher

Nature of liquidity requirements Lumpy Continuing

Transfer/Payment Processing Costs Lower Higher

Netting vs RTGS


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Netting vs. RTGS Netting based settlement systems

Netting as a more efficient means of settlement End of day final transfer of reserve balances

Exposure to credit risk on intra-day transactions

Bilateral Netting vs. Multilateral Netting

RTGS Greater requirement of intra-day reserve balances

Improved ability of central banks to influence interest rates

Reduced credit risk

Drivers of PSS choice


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Drivers of PSS choice

Credit risk vs. transfer cost trade-off

Credit risk vs. liquidity risk

Customer benefits vs. liquidity cost Implicit & Explicit liquidity costs

PSS in India


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PSS in India Board for Regulation and Supervision of Payment and Settlement

Systems as the primary regulator

Governed by the Payment & Systems Act, 2007 & Payment &Systems Rules 2008

Multiple Systems All operated by RBI

Electronic Clearing System

National Electronic Funds Transfer

RTGS based systems for inter-bank transactions

RBI as providing standby intra-day credit facilities through repos.

Dimensions of the modern operatingenvironment


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Increased focus on transparency

Management of risk exposures

Competition for customers

Capital adequacy

Technological developments

Financial innovation

environment

Comm Bkg, Sessions 1-8

Documents

Transcript of Comm Bkg, Sessions 1-8