IF1204 Banking and Financial Institutions Notes, for City University London students, contain an overview of every topic covered within the module.
Summarised two-terms’ notes into a 60-page single document, the notes were prepared using both lecture notes, in-class discussions and core textbook...
Lecture 1 – AN INTRODUCTION TO MONEY AND FINANCIAL MARKETS
THE 6 PARTS OF THE FINANCIAL SYSTEM (F.S.):
1) MONEY – to pay for purchases and store wealth
2) FINANCIAL INSTRUMENTS (stocks, mortgages, insurance policies) – to transfer resources from
savers to investors & to transfer risk to those best equipped to bear it
3) FINANCIAL MARKETS (The New York Stock Exchange) – to buy and sell financial instruments
4) FINANCIAL INSTITUTIONS (banks, insurance companies, pension funds, brokerage firms,
investment companies) – pool funds from people who save and lend them to people who need
to borrow, providing an access to financial markets; and collect information
5) REGULATORY AGENCIES (government) – to make sure the 6 parts of the F.S. operate in a safe
and reliable manner, by examining the systems a bank uses to manage its risk
6) CENTRAL BANKS (The Federal Reserve) – control the availability of money and credit to ensure
low inflation, high growth and the stability of the financial system
THE 5 CORE PRINCIPLES OF MONEY & BANKING:
1) TIME has value – the borrower pays the interest rate to compensate the lender for the time
during which the borrower has used the funds because the money that the borrower borrowed
has an opportunity cost to the lender, so the borrower has to pay for it
2) RISK requires compensation – no one takes other people’s risks for free therefore risk requires
compensation and this compensation is made in a form of payment
3) INFORMATION is the basis for decisions – before a bank makes a loan, it will investigate the
financial condition of the borrower and provide loans only to the highest-quality borrowers
because if lenders fail to assess the creditworthiness of borrowers, they will end up with more
low-quality borrowers. Financial intermediaries eliminate the information costs
4) MARKETS determine price & allocation of resource – financial markets gather information from
a large number of individuals and combine it into a set of prices that signals what is valuable and
what is not, thus by attaching prices to different stock/bonds they provide a basis for allocation
of capital. Financial markets are essential to the economy, allocating the resources, minimizing
the cost of gathering information and making transactions
5) STABILITY (is a desirable quality) improves welfare – the central bank controlling and
eliminating the risks that individuals cannot eliminate on their own such as an inflation and
business cycle insures economic stability and this improves welfare
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,Lecture 2 – MONEY AND THE PAYMENT SYSTEM
MONEY – is an asset that is generally accepted as payment for goods and services or repayment of debt
INCOME – is a flow of earnings over time
WEALTH = the value of assets minus liabilities
THE 3 FUNCTIONS OF MONEY:
1) IT IS A MEANS OF PAYMENT – people require payments made with money at the time the
good/service is supplied because the alternative payment methods don’t work really well. The
role of money reduces the likelihood that a seller needs to have an information about buyer.
Money is easier & finalizes payments
2) IT IS A UNIT OF ACCOUNT – we use money to quote prices and debts. Consumers and producers
use prices’ information to ensure that resources are allocated to their best uses. Using money
(quoting prices in dollars) to compare different products is easier.
3) IT IS A STORE OF VALUE – money stores its value in paper currency and in many other forms
such as stocks, bonds, houses and cars. But we all hold money because it is liquid
LIQUIDITY – is a measure of the ease with which an asset can be turned into a means of payment,
quickly at a low cost. The more costly it is to convert an asset into money, the less liquid it is.
MARKET LIQUIDITY – selling assets for money (liquidating assets)
FUNDING LIQUIDITY – borrowing money (make loans) to buy securities
PAYMENT SYSTEM (төлбөрийн систем) – is a web of arrangements that allow for the exchange of
goods/services/assets. Money is at the heart of the payment system because almost every transaction
we engage in involves the use of money at some point
THE 3 METHODS OF PAYMENT:
1) COMMODITY & FIAT MONIES – paper money. People use them as a means of payment because
we will be able to use them in the future over a long time; and law says people must accept
them (government action). In 20th century gold has been the most common commodity money.
2) CHECKS – instruction to the bank to take funds from your account and transfer them to another
account; and it is not a final payment
3) ELECTRONIC PAYMENT: credit & debit cards, electronic funds transfers, stored-value card, e-
money
CHANGES IN THE AMOUNT OF MONEY IS RELATED WITH:
1) INTEREST RATES
2) ECONOMIC GROWTH
3) INFLATION – is when prices are increasing over time. Inflation makes money less valuable and
the primary cause of inflation is the issuance of too much money but we must be able to
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, measure how much money is circulating. So, we sort different financial assets by their degree of
liquidity (from most to least). For this, the Central banks have developed several measures of
money, called monetary aggregate (M1 & M2)
M1 = the most liquid assets in the financial system (ex: currency, checks and deposits)
M2 = M1 + the least liquid assets (ex: small-denomination time deposits, retail money
market mutual shares)
M2 is the most commonly used monetary aggregate since its movements are most
closely related to interest rates and economic growth. Comparing the size of the
monetary aggregates to the size of the economy and the nominal GDP gives much larger
number than M1 & M2.
Then which M should we use to understand the inflation?
Until 1980 economists looked at M1, however the introduction of some accounts/assets made
M1 less useful. If you total some accounts in M1 it represents only small fraction of GDP, but if
you total accounts in M2 the total number represents almost one-half of the GDP. So, M1 is no
longer a useful measure of money.
Between 1960-1980 the growth rates of M1 & M2 moved together. But after 1980, they are
started to move into completely opposite directions. The reasoning behind this is that, in the
1970-1980, inflation rose more than 10%. People who had 0-ineterest accounts suffered from
this because their money lost its value, however, soon financial firms offered the “money
market” account that compensated people during inflation times. This account is part of M2 and
made M2 more liquid. This movement of funds into M2 meant that the 2 measurements are no
longer move together and analysts started to look at M2, and not M1.
Controlling inflation means controlling the money supply. However does money growth help
to forecast the inflation?
M2 stopped being a useful tool in forecasting the inflation and same for other aggregates. M2
works only when there is a high inflation or over a longer period of time.
CPI – is the change in the price of a given basket of goods/services relative to benchmark. It
tells us how much more would it cost for people to purchase today the same basket of goods and
services that they actually bought at some fixed time in the past.
COST OF THE BASKET – people’s expenditure on goods/services + the prices of these goods/services
GDP – is the market value of final goods and services produced in a country during a year
MARKET VALUE - all the goods and services produced times their market price
FINAL GOODS AND SERVICES - only look at the final market of destination
DURING A YEAR - during a calendar year, although GDP measures are released quarterly
INDIRECT FINANCE – is when an institution stands between the lender & borrower (The car becomes
borrower’s asset, and the loan becomes borrower’s liability)
DIRECT FINANCE – is when borrowers sell securities directly to lenders in the financial markets (The
security becomes lender’s asset, and the loan becomes borrower’s liability)
THE 3 COMPONENTS OF A FINANCIAL SYSTEM:
A. FINANCIAL INSTRUMENTS/SECURITIES – stocks, bonds, loans & insurance
B. FINANCIAL MARKETS – New York Stock Exchange, Nasdaq
C. FINANCIAL INSTITUTIONS
A. FINANCIAL INSTRUMENTS – a legal obligation of one party to transfer something of value,
usually money, to another party at some future date under certain conditions
THE 3 MAIN FUNCTIONS OF FINANCIAL INSTRUMENTS:
1) MEANS OF PAYMENT – purchase of goods/services (ex: employee stock option)
2) STORES OF VALUE – transfer purchasing power into the future. Over time, they generate
increases in wealth that are bigger than those we can obtain from holding money
3) TRANSFER OF RISK – transfer of risk from one person to another (ex: futures, insurance)
LEVERAGE – use of borrowing to finance a part of an investment
DELEVERAGE – selling assets and issuing financial instruments to raise their net worth
THE 2 FUNDAMENTAL CLASSES OF FINANCIAL INSTRUMENTS:
1) UNDERLYING – used by lenders to transfer resources directly to borrowers (ex: stocks & bonds
that offer payments based on the issuer’s status). These instruments are used to efficiently
allocate the resources
2) DERIVATIVE – their payoffs are derived from the behavior of the underlying instrument (ex:
futures, options & insurance). Its value is based on the price of some other asset. Derivatives
specify a payment to be made at some future date between the borrower and lender. The
amount to be made depends on various factors associated with the price of the underlying
asset. These instruments are used to shift risk among investors
THE 4 CHARACTERISTICS INFLUENCING THE VALUE OF FINANCIAL INSTRUMENTS:
1) SIZE OF THE PAYMENT – the bigger the promised payment, the more valuable the financial
instrument
2) WHEN THE PAYMENT IS TO BE MADE – the sooner the payment is made, the more valuable the
financial instrument
3) LIKELIHOOD THE PAYMENT IS TO BE MADE – this involves risk therefore it needs to be
compensated, so the more likely the payment will be made, the more valuable the financial
instrument
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