Economics for Business I - Lecture 6: Money and Financial Institutions

Reading for Today

• Textbook: Sloman, Garratt, Guest (11th ed.), Ch. 18.1, pp. 561-563; Ch. 18.2, pp. 563-574.
• Supplementary reading: Sloman economics news site, The Financial Times (6/5/2025) - Money market.

The Role of Money and Financial Institutions

• Money and financial institutions are important for the economy.
• Changes in the money supply can impact:
  • Inflation
  • Unemployment
  • Economic growth
  • Interest rates
  • Exchange rates
  • The balance of payments
• Systemic importance of financial institutions revealed in financial crises.
• Key questions:
  • How can we avoid financial crises?
  • Are some financial institutions still too big to fail?
  • Can we prevent financial institutions from fueling credit bubbles?
  • Can we better align incentives of banks and the wider community?

Aim of this Lecture

• Introduce the meaning and functions of money.
• Examine the operation of the financial sector.
• Discuss bank liquidity, profitability, and capital adequacy.

Meaning and Functions of Money

Meaning of Money

• Money is more than just cash (notes and coins).
• The main component of money supply is bank deposits.
• Banks generally have enough cash to meet customer demands.
• Most transactions are done without cash, involving transfers between bank accounts.

Functions and Attributes of Money

Functions of Money:

• Medium of exchange: Acceptable in exchange for goods and services.
• Store of wealth: Holds its value over time.
• Unit of account: Allows comparison of the value of goods, services, or assets.

Attributes of Money:

• Durability: Withstands repeated usage.
• Divisibility: Comes in a number of denominations.
• Transportability: Light enough to be carried around.
• Non-counterfeitability: Hard to forge.

Money Supply

What Counts as Money?

• The narrowest definition of money includes just cash (notes and coins).
• Broader definitions include various types of bank accounts.
• Even broader definitions include various financial assets.

Money Supply vs. National Income and Wealth

• If money supply increases, national income will not increase by the same amount.
  • Rise in national income > rise in money supply, as extra money is spent more than once per year.
• Money supply is not the same as national wealth.
  • A nation’s wealth consists of real assets: land, buildings, machines, etc.

Cryptocurrency

• Is cryptocurrency money? (Discussion point)

The Financial System

The Role of the Financial Sector

• Financial intermediaries channel funds from depositors to borrowers.
• They provide:
  • Expert advice: investment and borrowing.
  • Expertise in channeling funds: assess risk and seek the highest return.
  • Maturity transformation: exchanging deposits into loans of a longer maturity.
  • Risk transformation: spreading risk by having many borrowers.
  • Transmission of funds: transferring money without the use of cash.

The Banking System

• Monetary Financial Institutions (MFIs): Deposit-taking institutions including banks, building societies, and the Bank of England.
  • Retail banks: Retail deposits and loans to individuals and businesses.
  • Wholesale banks: Wholesale deposits and loans to companies and other banks.
  • Universal banks: Conducting retail and wholesale banking.
  • Building societies: Loans (mortgages) for house purchase.
• Financial deregulation (removal/reduction in legal rules and regulations) has blurred the distinction between these MFIs.

Deposit Taking and Lending

• MFIs provide financial instruments – financial claims by one party over the other.
• Customers’ claims on the bank (e.g., deposits).
• Bank’s claims on its customers (e.g., loans).
• Balance sheets itemize liabilities and assets.
• Liabilities are all legal claims for payment that outsiders have on an institution.
• Assets are possessions or claims on others.
• Significance of banks: Total assets of UK MFIs in 2023 were around 4 times the UK’s annual GDP.

Financial Liabilities

• Major types of financial liabilities:
  • Sight deposits: Can be withdrawn on demand without penalty.
  • Time deposits: Require notice of withdrawal; a fee is charged for withdrawals on demand.
  • Certificates of deposit: Issued by banks for large, fixed-term interest-bearing deposits (e.g., £100,000 for 18 months); can be resold by the owner.
  • ‘Repos’: Agreements to sell and then repurchase assets at a fixed price and date.
  • Capital and other funds: Largely share capital in banks.

Financial Assets

• Major types of financial assets:
  • Cash and balances in the central bank.
  • Market loans are short-term loans (typically days or weeks) to other financial institutions.
  • Bills of exchange are certificates promising to pay the holder a specified sum on a particular date, typically 3 months after issue; sold at a discount, redeemed at face value; commercial bills (loans to companies) or treasury bills (loans to government).
  • Longer-term loans: e.g., fixed-term loans (6 months to 5 years), mortgages (20-30 years).
  • Investments: government bonds (gilts); subsidiary financial institutions.

Sterling Liabilities and Assets (January 2024)

• Balance sheet of UK banks: January 2024
  • Source: Based on data in Bankstats (Bank of England), Table B1.4, data published 2 April 2024
• Breakdown of Sterling Liabilities (£bn and %):
  • Sight deposits: 90.6
  • Time deposits: 185.7
  • Repos: 282.1
  • Certificates of deposit & bonds: 187.8
  • Sterling capital & other funds: 437.2
  • Other: 74.7
  • Total sterling liabilities: 4154.5 (100.0)
  • Liabilities in other currencies: 4505.1
  • Total liabilities: 8659.6
• Breakdown of Sterling Assets (£bn and %):
  • Notes and coin: 9.7
  • Balances with the Bank of England: 11.2
  • Market loans: 213.3
  • Bills of exchange: 4.1
  • Investments: 426.1
  • Advances: 2274.8
  • Items in suspense/collection: 36.3
  • Other assets: 46.8
  • Total sterling assets: 4242.2 (100.0)
  • Assets in other currencies: 4417.4
  • Total assets: 8659.6

Liquidity, Profitability, and Capital Adequacy

• Banks make profits by lending money out at a higher rate of interest than that paid to depositors.
• Liquidity: The ease with which an asset can be converted into cash without loss.
  • Cash, by definition, is perfectly liquid.
  • Banks must maintain sufficient liquidity to meet the demand for money withdrawals.
  • Balance between liquidity and profitability.
  • Maturity gap: The difference in the average maturity of loans and deposits.
  • Liquidity ratio: The proportion of a bank’s total assets held in liquid form.
• Capital adequacy ratio: The ratio of a bank’s capital (reserves and shares) to its risk-weighted assets.
  • Risk weights: Inter-bank loans < mortgages < personal loans, credit cards.

Lecture Summary

1. Money’s main function is as a medium of exchange; what counts as money depends on how narrowly it is defined.
2. Bank’s balance sheets (liabilities and assets) consist of financial instruments.
3. Banks aim to make profits, but they must also have a sufficient capital base and maintain sufficient liquidity.