Money, Banking, and Financial Crises Notes

Money, Banking, and Financial Crises

Summary

• This lecture covers local versus global banking, the global dollar cycle, and the economics of the global banking glut and crisis.

Local Banking

• Endogenous Money: Banks create money through lending.
• Loans create deposits, and these deposits circulate through the banking system.
• This circulation generates demand for reserves/base money.
• Deposits fund credit creation.
• Money Creation Process:
  • When a bank makes a new loan, it creates a new deposit.
  • This deposit can then be used by the borrower to make payments.
  • The recipient of the payment then has a new deposit in their account.
  • The funds circulate through the banking system as deposits are transferred from one bank to another.
• Bank Balance Sheets and Money Creation (Figures 1 & 2): These figures illustrate the changes in balance sheets of central banks, commercial banks, and consumers during money creation.
  • Figure 1: Shows money creation by the aggregate banking sector.
    • Before loans, assets include reserves; liabilities include base money and currency.
    • After loans, new loans appear as assets, and new deposits appear as liabilities.
  • Figure 2: Demonstrates money creation for an individual bank. Includes balance sheet changes for house buyer and seller.
    • When a mortgage is issued, the buyer's bank creates new deposits.
    • These deposits are transferred to the seller's bank when the buyer pays the seller.
    • Reserves are also transferred to settle the transaction.
• Sustainability of Money Creation:
  • Settling transactions solely through reserve transfers is unsustainable.
  • The buyer's bank would deplete its reserves, making it difficult to meet potential outflows (e.g., deposit withdrawals).
  • Continuous new loans without sufficient reserves can lead to reserve shortages.

Monetary Control

• Central Bank's Role:
  • The central bank targets the price of reserves/liquidity to control monetary policy.
  • This influences short and long-term interest rates, aggregate demand, and inflation.
• Macroprudential Policy:
  • Aims to contain systemic risk within the banking system.
• Banking Crises:
  • Central bank acts as the lender of last resort during crises.

Global Banking

• Global Systemically Important Banks (G-SIBs):

  • Banks are categorized into different buckets based on their systemic importance.
  • Higher buckets indicate greater systemic importance.
  • Examples: JP Morgan Chase, Citigroup, HSBC, Bank of America, Bank of China, Barclays, BNP Paribas, China Construction Bank, Deutsche Bank, Goldman Sachs, etc.
  • Buckets:
    • Bucket 5: (Empty as of the provided data)
    • Bucket 4: JP Morgan Chase, Citigroup
    • Bucket 3: HSBC, Agricultural Bank of China, Bank of America, Bank of China, Barclays, BNP Paribas, China Construction Bank, Deutsche Bank, Goldman Sachs, Groupe Crédit Agricole, Industrial and Commercial Bank of China, Mitsubishi UFJ FG, UBS
    • Bucket 2: Bank of Communications (BoCom), Bank of New York Mellon, Groupe BPCE, ING, Mizuho FG, Morgan Stanley, Royal Bank of Canada, Santander, Société Générale, Standard Chartered, State Street, Sumitomo Mitsui FG, Toronto Dominion, Wells Fargo
    • Bucket 1: (Not applicable in this context)
    • Bucket 0: (Not applicable in this context)

• Global Banking Models:

  • Cross-border banking: Lending across borders through banking markets.
  • Foreign ownership: Subsidiaries and branches of global banks operating in different countries (internal capital markets).

• Cross-Border Bank Lending in US Dollars (Figure 3):

  • Illustrates the flow of funds in US dollars between local corporations, regional banks, and global banks.
  • Involves stages of wholesale funding and local currency transactions.

• Foreign Claims and Other Potential Exposures (as of end-Q1 2024):

  • A. Foreign claims, by type (CBSI): Shows foreign claims, international claims and local claims in local currency over time.
  • B. Foreign claims and other exposures (CBSG): Graphs include foreign claims in addition to derivatives exposures, guarantees, and credit commitments.
  • C. Other exposures by counterparty (CBSG): Presents derivatives exposures, guarantees, and credit commitments as a percentage of foreign claims, broken down by geographic region (e.g., GB, EA, US, JP, OAES, EMES, AFME, LatAm, EMEUR, EMAsia).

• Concentration in Foreign Claims (end-Q1 2024):

  • A. By banking system: Shows the share of foreign claims by different banking systems, with a cumulative share.
  • B. By borrower country: Shows the distribution of foreign claims by borrower country, along with a cumulative share.

• Rise and Fall of Banks' Foreign Claims:

  • A. All banking systems, by counterparty region: Presents the ratio of foreign claims to world GDP over time, distinguishing between claims scaled by World GDP and Tier 1 capital.
  • B. Selected banking systems, scaled by capital: Compares European and non-European banks’ foreign claims scaled by Tier 1 capital.

Global Banking Crisis of 2008

• Regulatory Issues:
  • Regulators permitted banks to hold assets off-balance sheet without requiring capital.
  • J.P. Morgan Chase & Co. and Citigroup each had nearly $1 trillion in assets off their books in special securitization vehicles by the end of 2007. For Citigroup, this was about half the bank’s overall assets.
  • Giant banks were allowed to measure their own risk and set their own capital requirements.
• Value at Risk (VAR):
  • VAR estimates the highest possible loss in the value of a portfolio of securities over a fixed time interval with a specific statistical confidence level.
• Transmission of Crises:
  • The IMF noted that global crises are transmitted through a handful of large, complex financial intermediaries, mostly transnational banks.

Global Banking Crises

• Destabilizing Cross-Border Loans:
  • Cross-border banking loans can be destabilizing, causing “floods and droughts” in financial markets.
• Global Banks as Superspreaders:
  • Global banks can amplify and spread systemic risk throughout the financial system.
• Internal Capital Markets:
  • Increase the transmission of risks between a bank’s home and host countries.
• Search for Yield and Global Banking Glut:
  • Banks seek higher returns, contributing to a global banking glut.

Shift to Market-Based Banking and Wholesale Financing

• Evolution of Liabilities and Assets of MFIs (1998-2012):
  • Charts illustrating the changes in liabilities and assets of Monetary Financial Institutions (MFIs) in the euro area.
  • Liabilities include customer deposits and other liabilities.
  • Assets include customer loans and other assets.

Global Banking Glut

• Intermediation:
  • European global banks intermediate between US savers and borrowers.
  • Involves the US banking sector, shadow banking system, and wholesale funding markets.
• European Banking Glut:
  • Amount owed by banks to US prime money market funds.
  • Breakdown by currency and sponsor location.
• US GSIB Dollar Intermediation:
  • Conducted by US Global Systemically Important Banks (GSIBs).
• Funding Dynamics:
  • Shift from foreign parent banks funding US subsidiaries to the parent bank funding US subsidiaries.

Basel III Rules

• Leverage Ratio:
  • A backstop measure, requiring a minimum ratio of Tier 1 capital to total exposure:
    \frac{\text{Tier 1}}{\text{Total Exposure}} \geq 3\%
  • Total exposure is calculated without reference to Risk-Weighted Assets (RWAs).
• Liquidity Coverage Ratio (LCR):
  • Requires banks to hold sufficient high-quality liquid assets to cover net cash outflows over a 30-day stress period:
    \frac{\text{High Quality Liquid Assets}}{\text{30 Days Net Cash Outflows}} \geq 100\%
• Net Stable Funding Ratio (NSFR):
  • Ensures banks have enough stable funding to cover their funding needs over a one-year horizon:
    \frac{\text{Available Stable Funding}}{\text{Required Stable Funding}} \geq 100\%

Summary

• Global banks play a critical role in the dollar financial cycle, influencing leverage and risk-taking.
• Cross-border bank lending operates differently from internal capital markets.
• Basel III rules are designed to contain risks associated with market-based banking.