The Role and Functioning of Banks: Essence, Money Creation, and Risks, Slides of Accounting

Download The Role and Functioning of Banks: Essence, Money Creation, and Risks and more Slides Accounting in PDF only on Docsity!

Prof. Dr AP Faure

Banking: An Introduction

Download free books at

2

AP Faure

Banking: An Introduction

Banking: An Introduction

4

Contents

Contents

1 Essence of banking 7 1.1 Learning outcomes 7 1.2 Introduction 7 1.3 The financial system 8 1.4 Principles of banking 19 1.5 The balance sheet of a bank 29 1.6 Bibliography 39

2 Money creation 41 2.1 Learning objectives 41 2.2 Introduction 41 2.3 What is money? 42 2.4 Measures of money 44 2.5 Monetary banking institutions 45 2.6 Money and its role 46 2.7 Uniqueness of banks 47 2.8 The cash reserve requirement 51

Click on the ad to read more

Stand out from the crowd Designed for graduates with less than one year of full-time postgraduate workexperience, London Business School’s Masters in Management will expand your thinking and provide you with the foundations for a successful career in business. The programme is developed in consultation with recruiters to provide you with the key skills that top employers demand. Through 11 months of full-time study,you will gain the business knowledge and capabilities to increase your career choices and stand out from the crowd. Applications are now open for entry in September 2011. For more information visit www.london.edu/mim/ email mim@london.edu or call +44 (0)20 7000 7573

Masters in Management

London Regent’s Park Business School London NW1 4SAUnited Kingdom Tel +44 (0)20 7000 7573Email mim@london.edu www.london.edu/mim/

Fast-track

your career

Banking: An Introduction

5

Contents

2.9 Money creation does not start with a bank receiving a deposit 52 2.10 Money creation is not dependent on a cash reserve requirement 63 2.11 Is “money supply” a misnomer? 65 2.12 The money identity and the creation of money 66 2.13 Role of the central bank in money creation 68 2.14 How does a central bank maintain a bank liquidity shortage? 69 2.15 Bibliography 71

3 Risk in banking 72 3.1 Learning outcomes 72 3.2 Introduction 72 3.3 The concept of risk 73 3.4 Interest rate risk 75 3.5 Market risk 84 3.6 Liquidity risk 86 3.7. Credit risk 93 3.8 Currency risk 99 3.9 Counterparty risk 102 3.10 Operational risk 103 3.11 Bibliography 107

Click on the ad to read moreClick on the ad to read more

Linköping University –

innovative, highly ranked, European

Interested in Strategy and Management in International Organisations? Kick-start your career with an English-taught master’s degree.

Click here!

Banking: An Introduction

7

Essence of banking

1 Essence of banking

1.1 Learning outcomes

After studying this text the learner should / should be able to:

1. Describe the context of banking: the financial system.
2. Explain the principles of banking.
3. Elucidate the broad functions of banks.
4. Analyse and explain the basic raison d’être for banks.
5. Describe the components of the balance sheets of banks.
6. Elucidate the liability and asset portfolio management “problem” of banks.

1.2 Introduction

Private sector banks play a significant role in the financial system and the real economy. They intermediate between all sectors of the economy and other financial intermediaries and institutions, and some of them provide the payments system, which most of us use every day.

Banks are unique in that their liabilities, bank notes and coins (N&C – central bank) and deposits (BD – private sector banks) are regarded as the means of payments / medium of exchange, which is the definition of money. So, put simply M3^1 = N&C + BD (held by the domestic non-bank private sector (NBPS). Because of this, banks are able to create additional money when required by individuals, businesses and government (with the assistance of the central bank). This unique feature, plus their balance sheet structure, places banks in a unique position in another way: they are inherently unstable, and therefore require robust regulation and supervision.

Banks are innovative, largely a function of intense competition, and they are therefore at the forefront of new developments, not only in banking but also in the wider financial markets. This makes regulation and supervision complex.

Banking: An Introduction

8

Essence of banking

In essence, banks are straightforward institutions: they take existing deposits (and loans to a small degree) and loan these funds, and, at the same time, make new loans and create new deposits (new money). However, while their basic function may be simple, the risks they assume are not, and this makes them complex. This text aims to cover banking in a comprehensible manner, and the following are the sections:

• Essence of banking.
• Money creation.
• Risks in banking.
• Bank models & prudential requirements.

This section serves as introduction to banking and offers the following sections:

• The financial system.
• Principles of banking.
• The balance sheet of a bank.

1.3 The financial system

1.3.1 Introduction

Securities INTERMEDIARIESFINANCIAL Securities

Indirect investment / financing

Securities

Direct investment / financing

Figure 1: simplified financial system

BORROWERS^ ULTIMATE (def icit economicunits)

HOUSEHOLDSECTOR CORPORATESECTOR GOVERNMENTSECTOR FOREIGNSECTOR

ULTIMATELENDERS (surplus economicunits)

HOUSEHOLDSECTOR CORPORATESECTOR GOVERNMENTSECTOR FOREIGNSECTOR

Surplus funds

Surplus funds Surplus funds

Figure 1: simplified financial system

Banking: An Introduction

10

Essence of banking

The members of these sectors may be either lenders or borrowers or both at the same time. For example, a member of the household sector may have a mortgage bond (= borrower by the issue of a non- marketable debt instrument) and at the same time hold a balance on your accounts at the bank (= a lender; a holder of money).

1.3.3 Financial intermediaries

The second element is financial intermediaries. As seen in Figure 1, lending and borrowing takes place either directly between ultimate lenders and borrowers [e.g. when an individual buys a share (also called equity or stock) issued by a company], or indirectly via financial intermediaries. Financial intermediaries essentially solve the differences (or conflicts) that exist between ultimate lenders and borrowers in terms of their requirements: size, risk, return, term of loan, etc.

An example: your friend Johnny (a member of household sector) has LCC 2 10 000 he would like to lend out (= invest) for 30 days at low risk. You (a member of household sector) would like to borrow LCC 20 000 for 365 days to buy a car. You don’t mind who you borrow from, because you represent the risk, not the lender. Your and Johnny’s requirements don’t match at all; direct financing won’t work. He places his LCC 10 000 on deposit with a prime bank for 30 days and you borrow LCC 20 000 from the bank for 365 days. You and Johnny are both in high spirits; the bank satisfied your different requirements.

Financial intermediaries exist not only because of the divergence of requirements of lenders and borrowers, but for the specialised services they provide, such as insurance policies (insurance companies), retirement fund products (retirement funds), investment products (securities unit trusts, exchange traded funds), overdraft and deposit facilities (banks), and so on. The banks also provide a payments system, the system we don’t see but rely much on. The central bank provides an interbank settlement system (as we will see later).

ULTIMATELENDERS

HOUSEHOLDSECTOR CORPORATESECTOR GOVERNMENTSECTOR FOREIGNSECTOR

BORROWERS^ ULTIMATE HOUSEHOLDSECTOR CORPORATESECTOR GOVERNMENTSECTOR FOREIGNSECTOR

INVESTMENTVEHICLES CIs CISs AIs

CENTRALBANK

BANKS BANKS

Debt

Debt Debt & shares

Debt & shares

Debt & shares

Debt & shares Debt & shares

Deposits Deposits

Investmentvehicle securities (Pis)

DFIs, SPVs,QFIs: Finance co’sInvestment co’s

Debt

Interbankdebt

Interbankdebt

Figure 2: financial intermediaries

Figure 2: financial intermediaries

Banking: An Introduction

11

Essence of banking

The main financial intermediaries that exist in most countries and their relationships with one another are presented in Figure 2. A useful of classification of them is presented in Box 1. Note that the non- deposit intermediaries may also be seen as investment vehicles. Their products (= their liabilities), which can be called participation interests (PIs), are designed as investments for the household sector (and in some cases other financial intermediaries).

1.3.4 Financial instruments

The third element is financial instruments. They are also called securities; borrowers issue securities. They are therefore evidences of debt or shares. They also represent claims on the issuers / borrowers.

Ultimate lenders exchange money (deposits) for securities and ultimate borrowers exchange (issue new) securities for money. Financial intermediaries issue their own securities (e.g. deposits) and hold the securities of the ultimate borrowers (e.g. treasury bills). As you know, the banks have a special and unique role in this market for money in that they are able to create money (bank deposits) by making new loans (buying new securities).

Securities offer a return that is fixed (fixed-interest debt) or variable (variable-rate debt and share dividends). The capital amount of shares and debt is paid back after a period (bonds and preference shares) or not ever (perpetual bonds and shares). Securities are also either marketable of non-marketable. This is discussed in more detail in the next section.

Box 1: financial intermediaries MAINSTREAM FINANCIAL INTERMEDIARIES DEPOSIT INTERMEDIARIES Central bank (CB) Private sector banks NON-DEPOSIT INTERMEDIARIES (INVESTMENT VEHICLES) Contractual intermediaries (CIs) Insurers Retirement funds (pension funds, provident funds, retirement annuities) Collective investment schemes (CISs) Securities unit trusts (SUTs) Property unit trusts (PUTs) Exchange traded funds (ETFs) Alternative investments (AIs) Hedge funds (HFs) Private equity funds (PEF’s) QUASI-FINANCIAL INTERMEDIARIES (QFIs) Development finance institutions (DFIs) Special purpose vehicles (SPVs) Finance companies Investment trusts / companies Micro lenders

Banking: An Introduction

13

Essence of banking

The instruments of debt and shares and their issuers are as follows:

The household sector issues:

• Non-marketable debt (NMD) securities
  • Examples: overdraft loan from a bank; mortgage loan from a bank.

The corporate sector issues:

• Share securities (marketable = listed & non-marketable = non-listed)
  • Ordinary shares (aka common shares).
  • Preference shares (aka preferred shares).
• Debt securities
  • Non-marketable debt (NMD).
  • Marketable debt (MD) ■ Examples: corporate bonds, commercial paper (CP), bankers’ acceptances (BAs), promissory notes (PNs).

The government sector issues:

• Marketable debt (MD) securities
  • Treasury bills (aka TBs and T-bills).
  • Bonds (aka T-bonds).

The foreign sector issues (into the local markets):

• Foreign share securities (inward listings).
• Foreign debt securities (inward listings).

The deposit financial intermediaries (central and private sector banks) issue:

• Deposit securities
  • Central bank ■ Non-negotiable certificates of deposit (NNCDs). ■ Notes and coins. ■ Central bank securities 3.
  • Private sector banks ■ Non-negotiable certificates of deposit (NNCDs). ■ Negotiable certificates of deposit (NCDs). ■ Loans (mainly from the central bank).

Banking: An Introduction

14

Essence of banking

The quasi-financial intermediaries issue:

• Debt securities
  • Non-marketable debt (NMD) ■ Example: utilised overdraft facility.
  • Marketable debt (MD) ■ Examples: bonds, commercial paper (CP)

The above may be summarized as in Table 2.

As we have indicated, it is rare that the individual invests in these financial instruments (the exceptions are bank deposits in the form of NNCDs and shares). Rather, they invest in these ultimate financial instruments via the investment vehicles, by buying their PIs.

Click on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read more

^                 

Banking: An Introduction

16

Essence of banking

Figure 4: primary & secondary markets

LENDERS BORROWERS

the difference BUYERS SELLERS

the difference

Figure 4: primary & secondary markets

Primary market

Secondary market

Funds Securities

Funds Securities

Figure 5: financial markets

LOCAL FINANCIAL MARKETS

capital market

Debt market / interest- bearing market / fixed-interest market Money market

Forex market = conduit

Listed share market

Bond market

Forex market = conduit

FOREIGN FINANCIAL MARKETS

FOREIGN FINANCIAL MARKETS

ST debt market

LT debt market

Share market

= Marketablepart = Marketablepart =

Figure 5: financial markets

There are a number of markets for financial instruments: the market for life policies (a primary market only), the market for PIs (also called units) of securities unit trusts (a primary market and a partial secondary market: the units are saleable to the issuer), the market for PIs in retirement funds (strictly a primary market), the deposit market (primary market for NNCDs and a secondary market for NCDs), the bond market (secondary market), and so on.

The financial markets are depicted in Figure 5. As we will show later, the money market should be defined as the short-term debt market (STDM = marketable and non-marketable debt), while the bond market is the marketable arm of the long-term debt market (LTDM).

Banking: An Introduction

17

Essence of banking

The money market (STDM) and the LTDM together make up the debt market (also known as the interest- bearing market and the fixed-interest market). The terms interest-bearing and fixed-interest oppose the debt market from the share market because the returns on shares are dividends and dividends are not fixed – they depend on the performance of companies. The LTDM and the share market is called the capital market.

The foreign exchange market is not a financial market, because lending and borrowing do not take place in this market. Rather, it is a conduit for foreign investors into local financial markets and for local investors into foreign financial markets.

In addition to these cash or spot markets [where the settlement of deals takes place a few days after transaction date (T+0)] we have the so-called derivative markets. They are comprised of instruments (forwards, futures, swaps, options and “others” such as weather derivatives) that are derived from and get their value from the spot financial markets. Whereas cash markets settle as soon as possible, derivative markets settle at some stage in the future.

Click on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read more

your chance

to change

the world

Here at Ericsson we have a deep rooted belief that the innovations we make on a daily basis can have a profound effect on making the world a better place for people, business and society. Join us. In Germany we are especially looking for graduates as Integration Engineers for

• Radio Access and IP Networks
• IMS and IPTV We are looking forward to getting your application! To apply and for all current job openings please visit our web page: www.ericsson.com/careers

Banking: An Introduction

19

Essence of banking

1.3.8 Allied participants on the financial system

From the above discussion it will be evident that there are a number of allied participants on the financial system. By this we mean participants other than the principals (those who have financial liabilities or assets or both). As we now know, the principals are:

• Lenders.
• Borrowers.
• Financial intermediaries.

The allied participants, who play a major role in terms of facilitating the lending and borrowing process (the primary market) and the secondary markets are the financial exchanges and their members. Also we need to mention the fund managers, who are actively involved in sophisticated financial market research and therefore play a major role price discovery, and the regulators of the financial markets. Thus the allied non-principal participants in the financial markets are:

• Financial exchanges.
• Broker-dealers.
• Fund managers.
• Regulators.

1.4 Principles of banking

1.4.1 Introduction

The previous section presented the banking sector in the context of the financial system. This section goes a little further and covers:

• Fundamental issues in banking.
• Basic raison d’être for banks: information costs and liquidity.
• Broad functions of banks.

1.4.2 Fundamental issues in banking

Banks are unique financial intermediaries.^4 They are the only intermediaries that intermediate between all ultimate lenders and borrowers and all other non-bank financial intermediaries. In this way they perform crucial functions, including providing the means of payments. In fact, they are such significant intermediaries that their very survival (particularly the large banks) is in the interests of the country; there exist social costs to their failure.

Banking: An Introduction

20

Essence of banking

For this reason, banks are the most regulated intermediaries. In most countries the central bank regulates and supervises the banks, and they are obliged to have large departments and skilled persons to carry out this function. The banks are innovative and create new products continually, because of the competitive nature of banking, making the task of the supervisor challenging.

The hardware and software systems requirements of banks are sophisticated, not only because of the complex deals they undertake, but to cater for the strict and diverse reporting requirements of banks. This and the high capital resource requirements create substantial barriers to entry.

Banks exist because of the information costs they carry and because of the demand for liquidity by deposit clients. Banks earn their keep by the management of financial risks, and this is what differentiates them from other companies. Essentially, they are risk managers. According to Heffernan^5 , the “organisation of risk management within a bank is as important as the development of risk management techniques and instruments to facilitate risk management…. There is no such thing as a generic banking strategy. But banks need to be planning how, in the future, existing competitive advantage is going to be sustained and extended. The outlook for banks is optimistic, provided they can create, maintain, and sustain a competitive advantage in the products and services (old and new) they offer.”

Click on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read moreClick on the ad to read more

www.fuqua.duke.edu/ globalmba

BUSINESS HAPPENSBUSINESS HAPPENS HERE.