Banking and money facts

direct finance

borrowers borrow funds directly from markets by selling securities. Promotes economic efficiency by producing an efficient allocation of capital which increases production.

indirect finance

financial intermediaries like banks borrow funds from lender-savers and use these funds to make loans to borrower-spenders.

functions of financial intermediaries

• reduce transaction costs (economies of scale and liquidity services)

• reduce the exposure of investors to risk (risk sharing and diversification)

• deal with asymmetric information problems (adverse selection and moral hazard)

transformation risks of banks

• size transformation

• maturity transformation

  • risk transformation

size transformation

Banks perform a savings mobilisation function:

• Savers prefer to lend (deposit) smaller amounts than borrowers require

• Exposes banks to risk (that they cannot satisfy borrowers' demand for larger loans

  • To manage this risk, banks agglomerate the small deposits of multiple savers and repackage them into larger-size loans

maturity transformation

• Banks "borrow short and lend long"

  • Banks transform funds lent for short periods into medium- and LT loans

  • Exposes banks to maturity mismatch (between assets & liabilities) aka duration risk

  • Maturity mismatches can cause liquidity risk (bank has insufficient funds to meet customer demand to withdraw their deposits)

risk transformation

All borrowers carry a risk of default, i.e., the risk of not repaying the bank aka credit risk

• Banks must manage a mismatch of risks:

  • Small, liquid, low-risk deposits vs larger, illiquid, higher risk loans

How do banks resolve mismatch of risk and manage loan default risk?

• Diversify the loan portfolisizeo (don't put all eggs in one basket)

• Require borrowers to hold collateral as a guarantee (against default)

• Screen and monitor borrowers (to ensure compliance with the terms of the loan contract)

• Hold sufficient regulatory capital and liquid assets to buffer against unexpected losses

• By properly pricing risk, i.e., charge higher interest rates to riskier borrowers

adverse selection

Hard to tell good ("peaches") from bad ("lemons") credit risks. Therefore, pricing reflects the average risk of loans -->

• Under-pricing: bad borrowers will borrow (as much as they can) at the average

• Over-pricing: good borrowers won't borrow at the average

• Outcomes: bank loan books become overweight in bad risks, loan portfolio quality falls, the amount of credit supplied falls

Banks use credit management function to manage adverse selection problems.

moral hazard

• MH can emerge before a loan is granted

  • Borrowers may window dress information on their projects

• MH can emerge after a loan is granted

  • Borrowers engage in riskier behaviour --> less likely a loan will be repaid

Banks minimise moral hazard by monitoring borrowers

benefits of indirect finance

• Banks produce more information about borrowers than markets: Hard and soft information

  • Hard information is quantifiable (credit scoring models)

  • Loans officers source soft information from borrowers about their expected returns/risks

• Flexible contract terms (easy to renegotiate/reduce transactions costs)

• Timely intervention disciplines bank borrowers (threat of bank calling loans)

• Once firms develop and/or achieve size and credibility, they may be able to access markets directly, i.e., banks play a certification role for their borrowers

banks total lending costs

• Search costs (banks must find borrowers)

• Evaluation/verification costs (is the borrower suitable?)

• Monitoring costs (once the loan has been made)

• Enforcement costs (ensuring compliance with terms of loan)

theories of financial intermediation

1. delegated monitoring

2. information production

3. liquidity transformation

4. consumption smoothing (insurance against shocks)

5. committment mechanisms (market discipline)

three players in the money supply process

1. the central bank

2. banks (depository institutions, financial intermediaries)

3. depositors (individuals and institutions)

the central bank’s balance sheet

Liabilities:

• Currency in circulation = in the hands of the public

• Reserves = bank deposits at the CB and vault cash

 

Assets:

• Government securities = holdings by the CB that affect money supply and earn interest

• Discount loans = CB provides reserves to banks and earns the discount rate

effect of open market purchases

• The effect on an open market purchase on reserves depends whether the seller of bonds keeps the proceeds from the sale in currency or in deposits

  • If the proceeds are kept as deposits, an open market purchase will result in an increase in reserves equal to an increase in the monetary base

  • If the proceeds are kept as currency, an open market purchase will result in an increase in the monetary base, but the effect on reserves is uncertain.

• The effect of an open market purchase on the monetary base always increases the monetary base by the amount of the purchase

money supply increases

effect of open market sale

Result: reduces monetary base by the amount of the sale. Reserves remain unchanged.

The effect of OMO on the monetary base is much more certain than the effect on reserves.

money supply decreases

other factors affecting the monetary base

1. Float: when the CB clears cheques, it tends to credit the bank depositing the cheque (increases the banks reserves) before it debits (decreases reserves) of the bank on which the cheque is drawn

2. Treasury deposits at the CB: if treasury moves deposits from commercial banks to its account at the CB, this will cause a deposit outflow at banks (decreases reserves)

3. (CB interventions in the forex market)

critique of the simple model of multiple deposit creation

• Holding cash stops the process:

  • Currency has no multiple depsit expansion

• Banks may not use all their excess reserves to buy securities or make loans

• Depositor decisions (how much currency to hold) and bank decisions (how much excess reserves to hold) also cause the money supply to change

goals of monetary policy

1. High employment and output stability

2. Economic growth

3. Stability of financial markets

4. Interest-rate stability

5. Stability in foreign exchange markets

6. price stability

hierarchical mandates vs dual mandates

hierarchical mandates = put the goal of price stability first. So long as it is achieved, other goals can be pursued.

Dual mandates: aim to achieve two coequal objectives, price stability and maximum employment (output stability)

Either mandate is acceptable providing it operates to make price stability the primary goal in the long run but not the short run

effect of discount window

• the higher the discount rate, the lower the amount of funds that banks will decide to borrow

• the lower the discount rate, the higher the amount of funds that banks will decide to borrow

effect of reserve requirements

• the higher the required reserve ratio, the lower, the amount of funds available to the banks

• the lower the required reserve ratio, the higher, the amount of funds available to the banks

dynamic OMO

intented to change the level of reserves and the monetary base

defensive OMO

offset movements in factors which affect reserves and the monetary base

relative advantages of the tools of monetary policies

• Open market operations is the dominant tool of monetary policy:

  • The CB has complete control over the volume of transactions, operations are flexible and precise, easily reversed and can be quickly implemented

• Discount rate is less well used. It is no longer binding for most banks, can cause liquidity problems, and increases uncertainty for banks:

  • The discount window remains of tremendous value because it allows the CB to act as a lender of last resort.

• Reserve requirements like "trying to crack a nut with a hammer"

zero-lower-bound problem

When interest rates are at or close to 0%, the central bank cannot significantly reduce rates further to stimulate spending and investment. This limits the effectiveness of conventional monetary policy during economic downturns.

nonconventional monetary policy tools

• Liquidity provision

  • e.g. discount window expansion, term auction facility, new lending programmes

• Large-scale asset purchases

  • to lower interest rates for particular types of credit

• Quantative easing and credit easing

choosing a policy instrument

1. tools of the central bank (OMO’s, rr, discount policy, etc.)

2. policy instruments (reserve aggregates, short-term interest rates)

3. intermediate targets (monetary aggregates, interest rates)

4. goals (e.g. price stability, economic growth)

criteria of choosing a policy instrument

• observable and measurable

• controllable

• predictable effect on goals

nominal anchor

a nominal variable, such as the inflation rate or the money supply, which ties down the price level to achieve price stability.

time-inconsistency problem

• Arises from the pursuit of short-term goals which lead to bad long-term outcomes

• Policy makers should use rules to condition the expectations of agents and to stick to the rules and not change them, i.e. to be time consistent

devising a strategy for price stability

• institutional commitment

• public announcement

• information-inclusive approach

• increased transparency

• increased accountability

advantages and disadvantages of inflation targeting

Advantages:

• Not reliant on one variable to achieve target

• Easily understood

• Reduces potential of falling in time-inconsistency trap

• Stresses transparency and accountability

 

Disadvantages:

• Delayed signaling

  • Inflation outcomes have a long lag

• Too much rigidy

  • Deny discretion for policymakers

• Potential for increased output fluctuations:

  • Can lead to monetary policy being too tight when inflation is above target leading to fluctuations/rising unemployment

• Low economic growth during disinflation

what is central bank independance?

• Goal independence: insulate central bank from political influence

• Instrument independence: free to implement policy instruments in pursuit of goals

for vs against independence

The case for independence:

• Political business cycle (boost output in the short term) is inflationary. Boom-and-bust cycles.

• Politicians wish to be insulated from unpopular macroeconomic policies

• Politicians want to be re-elected

 

The case against independence:

• Macroeconomic stability is best achieved if monetary policy is coordinated with fiscal policy

• Theory of bureaucratic behavior: self-interest, power and prestige over the public interest

why regulate banks?

1. political dimension

2. consumer protection

different types of bank regulation

1. systematic (macropru) regulation = focus on safety and soundness of banking system. top-down supervision (aggregate effect of individual bank actions)

2. prudential (micropru) regulation = focus on consumer protection. bottom-up supervision (focus on individual banks)

3. conduct of business regulation = focus on how banks conduct business

the financial safety net

• lender of last resource facility (LOLR)

• deposit insurance schemes (DIS)

• bank insolvency and resolution laws

• co-operation and resolution processes

lender of last resource facility

Emergency lending by central banks to banks with temporary liquidity problems. Called "discount lending" and is provided through the "discount window":

• Short-term loans charged at a higher rate. To be repaid on the resolution of the liquidityproblem

• Typically used to support banks during episodes of financial crises. short-term tool

deposit insurance schemes

A system that guarantees deposits up to a specified limit if a bank fails. By protecting depositors' funds, DIS reduces the incentive for bank runs and helps maintain confidence and stability in the banking system. Banks fund the scheme through contributions, and coverage is typically limited to encourage depositors to monitor banks and promote market discipline.

Basel 1

Introduced risk-weighted assets (RWA), meaning capital requirements depend on the riskiness of assets rather than total assets alone. Banks must maintain a capital ratio of at least 8% of RWA, with at least 4% (Basel 3 = 6%) in Tier 1 capital.

basel 2

Increased risk sensitivity (accounted for other types of risks; operational and market risk) and introduced the Three Pillars:

1. Minimum capital requirements (credit, market, and operational risk)

2. Supervisory review

3. Market discipline through greater disclosure and transparency

basel 3

Introduced after the Global Financial Crisis (2007-09) to strengthen bank resilience. Key features include higher-quality capital requirements, capital conservation buffers, and both microprudential (bank-level) and macroprudential (system-wide) regulation to reduce systemic risk and improve financial stability.

risk classes

• no risk = 0%

• low risk = 20%

• moderate risk = 50%

• standard risk = 100%

high-quality liquid assets

HQLA level 1: highest quality, most liquid assets

• Cash, central bank reserves, certain marketable securities backed by sovereigns & CBs

HQLA level 2 assets:

• Certain government securities, covered bonds, corporate debt securities. Possibly lower rated corporate bonds, RMBS and equities meeting certain conditions (aka level 2b)

• Level 2 assets can account for no more than 40% of HQLA, level 2b for no more than 15%

BCBS crypto-assest classification

• Group 1: Tokenised assets and qualifying stablecoins (crypto-assets linked to an asset such as gold or a currency). Treated under existing Basel capital rules.

• Group 2: Unbacked cryptocurrencies and non-qualifying stablecoins. Considered high risk and subject to a 1250% risk weight and exposure limits.

Key idea: The riskier the crypto-asset, the more capital a bank must hold against it

limits of bank regulation

• regulatory forbearance

  • When regulators allow a troubled bank to continue operating instead of closing it, trading off short-term stability against the risk of future moral hazard.

• agency capture

  • banks capture the regulatory process and use it in their favour

• compliance costs

  • increasing and relates to systems, training, management time, and capital required by regulations to support operational risk

asset transformation

selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics

general principles of bank management

• liquidity management

• asset management

• liability management

• capital management

asset and liability management

Three goals:

1. Seek highest returns on loans and securities

2. Reduce risk

3. Hold adequate liquidity

 

Four tools:

1. Find borrowers who will pay high interest rates and have low possibility of defaulting

2. Buy securities with high returns and low risk

3. Lower risk through diversification

4. Balance the need for liquidity against increased returns from less liquid assets

four options for banks to acquire the needed reserves

1. borrowing from other banks

2. selling securities

3. borrowing from central bank (negative signal)

4. reducing or calling in loans

skin-in-the-game effect

When bank capital is low, shareholders may favour excessive risk-taking because they gain from the upside while much of the downside is borne by creditors; higher capital requirements put more of shareholders' own funds at risk, reducing this incentive.

interest rate risk

Arises when the maturities of a bank’s assets and liabilities do not match. Short-funded banks face refinancing risk, while long-funded banks face reinvestment risk

duration gap

measures the average lifetime of a security’s stream of payments, duration, in years, and uses this information to estimate the effects of interest rate changes

managing credit risk

• long-term customer relationships

• loan commitments

• collateral/compensating balances

• credit rationing

off-balance-sheet (OBS) activities

Banks earn profits through activities such as loan sales, fee income, and trading that do not appear on the balance sheet. These activities can be highly profitable but also increase risk, especially due to the principal-agent problem where traders benefit from gains while the bank bears the losses.

how can banks control principal-agent problem (OBS risk)

• separate trading activities and bookkeeping and put limits on exposure on tranders’ transactions

• value-at-risk (calc maximum loss the portfolio is likely to sustain for given interval)

• stress testing

market (trading) risk

The risk of losses from changes in market prices (e.g., interest rates, exchange rates, or asset prices) affecting a bank’s trading and investment positions; commonly measured using Value-at-Risk (VaR).

operational risk (& cyber risk)

The risk of losses caused by failed internal processes, people, systems, or external events (e.g., cyberattacks, fraud, IT disruptions, or human error); a key risk category introduced under Basel II. includes a large portion of RWA

sustainability (or ERG) risk

he risk that environmental, social, or governance (ESG) factors negatively affect a bank's performance, reputation, or investments.

Types of risk:

• Physical risk: Losses from climate change impacts such as extreme weather and natural disasters.

• Transition risk: Losses arising from the shift to a low-carbon economy, including new regulations, taxes, technologies, and changing consumer preferences

different types of banks

• Global banks

  • Major players (offer a wide array of products and services globally)

• National banks

  • Like global banks in terms of providing services (but smaller in the size and market penetration)

• Local banks

  • Restricted by their own countries

• By ownership

  • State-owned, private-owned or mutual

transactions banking

Features: high frequency transactions services with standardised features that require little human input to manage:

• Used by large banks that compete across geographic and product markets

• Typically, lenders with sufficient volumes of such transactions offer them globally with limited investment in human capital

• Banks use technology to price products low enough to discourage competitors

• Banks can securitise assets (if loan originators and CRAs can assess the underlying credit risk)

relationship banking

Personal bank-customer relationships:

• Lender adds value to borrower during credit granting process (e.g. accounting, business/tax planning expertise) and aggressively markets other services (cross-selling)

• Lending institutions generally charge higher rates and often hold the loans in their own portfolio (sharing the risk)

• Borrowers willingly pay for the assurance that funds will be advanced as needed with minimal repetitive negotitations

• Customers often follow their favourite banker to another bank

retail banking

• multiple transactions

  • ledning to individuals, households and SMEs

  • standard corporate lending

• earnings:

  • interest income is most important

  • seek opportunities to cross-sell

wholesale banking

• fewer transactions, larger amounts

  • larger corporate customers

• provide a broad range of products and services, often participate in syndicated lending

• earnings:

  • greater emphasis on non-interest income

  • Some banks income is roughly split 50:50 between interest income and non-interest income

least funding from customer deposits, most dependent on net interest income. high leverage, least risk costs, limited stable funding

investment banking

not protected by the financial safety net

• Clients: Large corporations and financial institutions

• Services: Large customised transactions, lending, securities issuance, hedging, M&A advice

• Activities: Trading and structured finance

• Specialised finance: Repayment comes mainly from the cash flows of specific assets/projects rather than the borrower itself. e.g. securitisation

primarily trading assets, least dependent on net interest income, most leveraged, less stable funding.

funding: issue debt securities, negative derivative positions

universal banking

Combines everything under one roof. Banking, insurance, underwriting and trading.

• Clients: banking, insurance, securities underwriting, and trading

• Rationale:

  • To maximise/achieve economies of scale (benefits of size) and scope (benefits of providing more services)

  • Cross-sell products to different groups

• Earnings: universal bank revenues are highly diversified

identification of bank business models

• Loans-to-assets: measures wholesale and interbank activities (and risks). Proxy indicator of liquidity

• Trading assets-to-assets: a greater trading ratio exposes banks to market and liquidity risk

• Liabilities-to-assets: using short-term funds to support long-term assets = maturity mismatch

• Customer deposits-to-assets: indicates reliance on more stable (core) funds

• Debt liabilities-to-assets: measures wholesale market funding (volatile funding)

• Derivative exposure-to-assets: key and risky investments and trading activities

diversified retail

• Combines retail banking with other activities (e.g. wealth management, investment banking, insurance, asset management)

• Multiple sources of income (interest and fees)

• Better income diversification

• More complex operations and potentially broader risk exposures

most customer loans outstanding and debt liabilities for funding. receive largest share from trade income. stable funding, moderate leverage/loan loss

focused retail

• Concentrates mainly on traditional retail and commercial banking

• Income comes primarily from interest on loans

• Simpler business model and risk profile

• More dependent on local customers and lending activity

primarily provide customer loans funded by customer deposits. trading income relatively unimportant. low leverage, stable funding. highest loan losses and market risk

securitisation

The process of pooling loans (e.g., mortgages) and converting them into tradable securities that can be sold to investors, allowing banks to transfer risk and free up capital.

stages of securitisation

1. design stage (originator select assets to sell to SPV)

2. creation (create the SPV as a separate legal entity)

3. structuring the transaction (modify risk and return to investors, achieved by tranching and credit enhancement)

4. issue (SPV issues the security to end-investors

(other participants and functions: underwriter = investmentbank that markets, distributes and sell products issued by the SPV, credit rating agencies)

Special purpose vehicle (SPV) vs structured investment vehicle (SIV)

SPV (Special Purpose Vehicle):
A bank sells a pool of loans to an SPV, which packages them into Asset-Backed Securities (ABS) and sells them to investors. The loans are effectively transferred to investors, so the SPV's role is mainly to facilitate securitisation and risk transfer.

SIV (Structured Investment Vehicle):
A SIV does not issue ABS. Instead, it issues commercial paper (ABCP) to investors, uses the proceeds to buy loans or securities, and keeps these assets on its balance sheet until maturity. The SIV earns a profit from the spread between asset returns and funding costs and acts like a "shadow bank"

Collacteralised debt obligations (CDOs)

backed by fewer, but larger and more heterogeneous assets, compared to ABS/MBS.

Such as high-yield bonds, leveraged loans, or tranches of other ABS/MBS; often combined with credit risk management tools such as CDS

collateralised loan obligations (CLO)

loans owned by a bank. backed primarily by a pool of loans, especially leveraged loans made to companies.

collateralised bond obligations (CBO)

bonds traded on the market. backed primarily by a pool of bonds, often corporate or high-yield bonds.

methods of credit enhancement

1. subordination

2. overcollateralisation

3. excess spread

subordination (CE)

the process of prioritising the order in which (mortgage loan) losses are allocated to the various layers of bonds:

• --> lower-rated junior bonds serve as credit support for higher-rated senior bonds

• --> all princpial losses on the underlying pool of assets go to the most junior bonds first, resulting in a write-down of their principal balance

• Similarly, any interest shortfalls will affect the junior bonds first

overcollateralisation (CE)

the face value of the underlying loan pool is larger than the par value of the issued bonds

• Can still pay bondholders what they are expected to be paid

• --> if some payments from underlying loans are late or default, the transaction may still pay principal and interest payments on the securitised bonds

excess spread

additional revenue generated by difference between coupon on the underlying collateral  (e.g. a mortgage interest rate) and the coupon payable on the securities:

• e.g., borrowers whose mortgages are in a given collateral pool may be paying 7% interest, while the coupon of the MBS (mortgage-backed security) may be 4%

• The transaction uses the excess spread to absorb collateral losses or build overcollateralisation to its target level

tranching

Tranching means issuing securities with different risk, duration, and other characteristics (e.g. credit protection):

 

1. Senior tranche (investment grade assets) supported by…

2. Mezzanine tranche supported by…

3. Equity tranche:

   • The equity class or junior tranche is subordinate to the other tranches and contains unrated assets

   • Equity is the riskiest tranche of the securitisation deal

   • Equity is commonly retained by originating banks on their balance sheets

tranching benefits

• Enables creation of one or more classes of securities whose rating is higher than the average rating of the underlying collateral asset

• senior claims expected to be insulated from the default risk of the underlying asset

• investors can further diversify their portfolios

tranching disadvantages

• adds complexity to deals

• Modeling the performance of tranched transactions based on historical performancce may have caused over-rating (by CRAs) and underestimation of risks (by end investors) of ABS

• more difficult for investors to assess who ultimately bears the risk

• Revealed in the subprime mortgage crisis