Transcript Intro to Banking 5

Guy Hargreaves
ACE-102
Recap of yesterday
 Reasons for the term structure of interest rates
 Risk based pricing theory
 Generic bond and discount instrument valuation
models
 FX and forward rate pricing
 The concepts of market efficiency and arbitrage
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Today’s goals
 Understand Central Bank roles and goals in monetary
policy setting
 Describe lender of last resort
 Understand Central Bank roles in supervision
 Describe the relationship between Central Banks and
the banks they regulate
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Central Banks
 Central Banks play a critical role at the heart of every
currency’s financial system
 Responsible for oversight of monetary system
underpinning the currency
 Some Central Banks are also charged with oversight of
the deposit-taking and non deposit-taking financial
institutions in their financial system
 Most common goal of a Central Bank is to manage
monetary policy to foster growth without inflation
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Central Bank majors
Country
Currency
Central Bank
USA
USD
Federal Reserve
UK
GBP
Bank of England
China
RMB
PBOC
Europe
EUR
ECB
Canada
CAD
Bank of Canada
Australia
AUD
Reserve Bank of Australia
Japan
JPY
Bank of Japan
Hong Kong
HKD
HK Monetary Authority
India
INR
Reserve Bank of India
Singapore
SGD
Mon Auth of Singapore
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Central Banks
 Most common roles of a Central Bank are:





Control the issue of banknotes and coins
Control or influence the amount of credit creation within a
financial system
Act as “lender of last resort”
The Government’s banker
Oversee FX, gold and other reserves
 Effectively Central Banks control credit expansion,
liquidity and money supply of an economy
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Macroeconomic policy
 Government policy focused on economic management
can generally be viewed in five categories:
1.
2.
3.
4.
5.
Monetary policy (influence supply and cost of money)
Fiscal policy (government taxation and spending)
Exchange rate policy (influence FX rates)
Prices / incomes policy (inflation and earnings)
National debt policy (government debt management)
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Central Bank monetary policy
 Monetary policy is the most important role of Central
Banks
 Governments tend to set objectives for monetary
policy – Central Banks take independent actions to try
and meet these objectives
 Price Stability (low or no inflation, and not deflation)
 Full employment (low unemployment)
 Stable economic growth (not too hot and not too cold)
 Financial market stability (FX, interest rates and the
financial system itself)
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Monetary policy tools
 The major tools of a Central Banker are:



Open Market Operations (OMOs)
The Discount window
Reserve requirements
 Via these tools Central Banks can influence:



Short term interest rates
FX rates
Bank reserves
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Open market operations
 The Central Bank will buy or sell government securities in
the open market to influence both interest rates and the
overall money supply

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eg the US Federal Reserve (Fed) announces to the market its target
for the overnight Fed Funds rate
Fed Funds are interbank borrowings used to manage the reserves
they are required to hold at the Fed
If Fed Funds is higher than the Fed’s target rate it will inject money
into the banking system through “repo” lending transactions
As money is pushed into the system the Fed Funds rate falls to the
level targeted by the Fed The opposite happens if Fed Funds is
trading lower than the Fed’s target
Banks and financial markets use the Fed Funds rate as a base rate to
set other interest rates from
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Quantitative easing
 Since the 2007-9 GFC the Fed and other Central Banks
have been conducting a type of OMO called
Quantitative Easing (QE)
 Typical OMOs are very short term – often overnight –
and therefore alter the money supply short term
 With QE the Fed purchased longer term securities
such as RMBS, in theory expanding the money supply
more permanently
 QE was designed to reduce long term interest rates
and boost inflation at a time when deflation was a risk
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The discount window
 Eligible banks are able to access their Central Bank’s
Discount Window
 The discount window is a facility that allows banks to
borrow from the Central Bank by discounting
securities
 Discount window rates are typically higher than rates
targeted by Central Banks through their OMOs
 Discount windows are generally considered to be used
only in times of financial system stress
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Reserve requirements
 Banks are required to hold a certain % (reserve ratio)
of their deposits in Reserve Assets, making these funds
unavailable for on-lending
 By increasing the reserve ratio Central Banks can force
banks to reduce their existing lending or reduce future
lending
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Recall: theory of credit creation
Bank
$ Deposit
taken
$ Loan
made
$ Reserve
held
A
50.0000
45.0000
5.0000
B
45.0000
40.5000
4.5000
C
40.5000
36.4500
4.0500
D
36.4500
32.8050
3.6450
E
32.8050
29.5245
3.2805
…
…
…
…
500.000
450.000
50.000
Total
 Under a 10% Reserve Ratio for each $1 deposit taken the banking system can
create $10 in new deposits
 Credit Multiplier = Change in Deposits / Change in Reserves = 500 / 50 = 10
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Changing reserve requirements
Reserve
Ratio
$ Deposit
taken
$ Credit
Created
5%
50
1,000
10%
50
500
15%
50
333.3
 Reducing the reserve ratio from 10% to 5% allows the
banking system to create more new deposits, whereas
increasing it to 15% reduces the amount of new credit
creation possible
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Monetary policy
 Of the five policy categories managed by
Governments, monetary policy is the only area Central
Banks can effectively manage:
1.
2.
3.
4.
5.
Monetary policy – OMOs, discount and reserves
Fiscal policy – government decisions
Exchange rate policy – very open market
Prices / incomes policy – government decisions
National debt policy – government decisions
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Monetary policy theory
 Milton Friedman: “inflation is always and everywhere a
monetary phenomenon” - prominent in the school of
Monetarism

One of many theories on the underlying cause of inflation
 The equation of exchange: MV = PY

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
M is the quantity of money
V is the velocity of money
P is the price level (or GDP deflator)
Y is real GDP
 Quantity theory of money:


Assuming the velocity of money was constant then for a given real
GDP, the price level P is directly related to the money supply M
Seems intuitive but empirical evidence is mixed
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Exchange rate policy
 Direct action in the FX markets to impact prices is
extremely difficult for any party, including Central
Banks – for fully floating currencies with little
exchange restrictions
 Many countries have fixed exchange rates (eg HKD,
RMB) which are allowed to trade within a controlled
band
 FX rates can be set to be higher or lower than they
would be if prices were allowed to float
 Market truism: “you can control price, or you can
control volume – but you can’t control both”
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Central Bank independence
 Independent Central Banks tend to meet their
monetary policy objectives more often
 Thinking about our policy mix what might
governments see as quick fixes for their political
fortunes?
1.
2.
3.
4.
5.
Fiscal policy – highly political
Exchange rate policy – impractical
Prices / incomes policy – highly political
National debt policy – highly political
Monetary policy – tempting???
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The lender of last resort
 Central Banks through their discount window and
supervisory responsibilities are considered by some as
“lenders of last resort”



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In a time of crises banks can access the discount window to
stay afloat when there might be a “run” on
This function is really about providing liquidity and not
solvency to a bank or group of banks
Solvency is the ability of a bank to ultimately meet all its
liabilities from its asset base with an acceptable level of equity
remaining
“Bank Liquidity” is the ability of a bank to reissue maturing
liabilities as and when they become due
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The lender of last resort
 Many consider lender of last resort to introduce “moral
hazard” into the banking system

Banks have a perverse incentive to take excessive risk if they
feel their Central Bank will “bail them out”
 Banks arguably occupy the most privileged position in
the economy


Able to leverage their balance sheets (total assets / equity 1030x)
Able to tap their Central Banks for liquidity if business
becomes difficult
 Many economists and others argue for less regulated
“Free Banking” – this has its +ves and -ves
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Supervision
 Central banks around the globe have many and varied
roles in supervision or many functions and features of
their respective financial systems

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Monetary analysis (data and statistics)
Oversee financial market stability
Promote market stability
Supervise banks (some CBs, not others)
Reserve portfolio management
Payment systems
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Banks and Central Banks
 The Federal Reserve is responsible for supervising
banks licensed to operate in the US
 In Germany, while the ECB is responsible for monetary
policy for EUR, it’s currency, the Bundesbank and
BAFin are responsible for bank supervision
 In Australia RBA is responsible for AUD monetary
policy, but APRA is responsible for bank supervision
=> the only rule is there are no rules!
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What is bank supervision?
 Banks occupy a highly privileged position in the
economy, being highly leveraged but with
“government guaranteed” liquidity!
 To ensure banks do not fall to moral hazard and they
are soundly run the regulators have established rules
around bank capital, liquidity and other risks
 Global standards for regulation have been set by the
Bank for International Settlements (BIS), based in
Basel, Switzerland
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What is bank supervision?
 The Basel capital accords, negotiated amongst its 60
members, are supposed to set a standardised global
framework for sound bank management practices
 Being non-binding, the BIS I, II and incoming III
accords have not been adopted uniformly worldwide
leading to effects from the “law of unintended
consequences”
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Regulatory “arbitrage”
 Banking regulations are a significant driver for banks:

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Business mix (eg mortgage versus High Yield corporate
lending)
Capital management strategy
Transaction structures
Risk / reward and compensation policies
 Banks have had great ability to react quickly to
regulatory opportunities in the past
 “Regulatory arbitrage” under BIS I was commonplace
because of uneven treatment of risk weightings in that
system
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Regulatory “arbitrage”
 Under BIS I corporate bonds were “risk weighted” at
100% for determining capital required to support them


Didn’t matter if the issuer was AAA or BB
Capital for $10m of corporate bonds = $10m * 100% * 8%
= $800k
 But for the same corporate bonds sold to SPC which
issues 364 day CP supported by the bank liquidity
facility would be 0% risk weighted for the bank
=> Banks set up SPVs to fund their corporate bonds!
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Goals of bank supervision
 Bank supervision aims to:

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Minimise regulatory arbitrage (reduce to zero!
Watch bank leverage and liquidity carefully
Maintain system stability to avoid the discount window being
used
Create a stable financial system
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