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

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Monetary policy tools

The interest rate Open market transactions Reserve requirements Exchange requirements

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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

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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

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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

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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

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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

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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

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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

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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

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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,

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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?

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„Special” central banks

The European Central BankThe Bank for International Settlements

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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

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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