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Summary Money and Banking; 2nd year (H2 t / m 16)
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Summary of 34 pages for the course Geld en Bankwezen at UvA (H2 t/m 16)
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H2. An overview of the financial system.Financial markets perform direct financing between
lender-savers (those who have saved and are lending
funds) and borrower-spenders (those who must
borrow funds to finance their spendings). Financial
markets promote efficient allocation of capital (from
people lacking productive investment opportunities to
people with such opportunities). This leads to higher
production and economic growth. It also improves
directly the well-being of consumers by allowing
them to time their purchases better (e.g. houses).
Structure of financial markets.
• Debt and equity markets. The most common method is to issue a debt instrument,
such as bonds or mortgages. A debt instrument is short-term if its maturity is less
than a year, medium (>1,<10) and long-term if its maturity is longer than 10 years.
The second method is by issuing equities, such as common stock. Equities often make
periodic payments (dividends) to their holders and are long-term because they have no
maturity date.
• Primary and secondary markets. A primary market is a financial market in which
new issues of a security, such as a bond or a stock, are sold to initial buyers by the
corporation or government agency borrowing the funds. An important financial
institution here is the investment bank, which underwrites securities; guaranteeing a
price for a corporation’s securities and then sell them to the public. A secondary
market is a financial market in which securities that have been previously issued can
be resold. This can happen in two ways; first trough exchange markets (e.g. NYSE,
Euronext etc.) or second with over-the-counter markets (e.g. government bond
market). Secondary markets make financial instruments more liquid and they
determine the price of the security that the issuing firms sells in the primary market.
• Money and capital markets. The money market is a financial market in which only
short-term debt instruments (<1 year) are traded, and therefore is more liquid. In the
capital market only long-term debt and equity instruments (>1 year) are traded.
Money market instruments (least risky investments).
- Treasury bills. These are highly liquid because they are the easiest to trade and they
are the safest because there is almost no possibility of default.
- Bank bills. Are like Treasury bills and are issued and bought mostly by the bank at a
greater discount (higher implied yield).
- Certificates of deposit. A debt instrument sold by a bank to depositors that pays
annual interest of a given amount and at maturity pays back the original purchase
price.
- Commercial paper. Short-term debt instrument issued by large banks and well-
known corporations.
- Interbank deposits. Here, surplus banks can lend to cash-short banks.
- Gilt repurchase agreements (repos). Short-term loans for which UK government
gilt-edged securities (bonds, Treasury bills) but also high-grade commercial paper and
certificate of deposits act as collateral.
Capital market instruments (risky investments).
− Stocks. Equity claims on the net income and assets of a corporation.
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, − Mortgages. Loans to households or firms to purchase housing, land, or other real
structures, where the structure or land itself serves as collateral for the loans.
− Corporate bonds. Long-term bonds issued by corporations with very strong credit
ratings. The principal buyers are insurance companies, pension funds and households.
− Government bonds. Long-term debt instruments issued by the government. They
have the highest rating (AAA) and are therefore highly liquid securities.
− Local authority bonds. Long-term bonds issued by various local autorithies.
− Bank and building society bonds and loans.
Financial intermediaries (banks) perform indirect finance between the lender-savers and
borrower-spenders. It does this by borrowing funds from the lender-savers and then using
these funds to make loans to borrower-spenders. They are important for three reasons:
1. Lower transaction costs, by developing expertise and economies of scale.
2. Reduce exposure to risk, by creating and selling assets with low risk and use funds to
buy assets with more risk (e.g. risk sharing or asset transformation).
3. Reduce asymmetric information, banks have better information about parties
involved. They are better equipped than private individuals to screen bad from good
credit risk (reduce adverse selection). And they develop expertise in monitoring the
parties they lend to (reduce moral hazard).
- Adverse selection: problem created by asymmetric information before the transaction
occurs. It occurs when the potential borrowers who are the most likely to produce an
undesirable (adverse) outcome – the bad credit risks – are the ones who most actively seek
loans and are thus more likely to be selected. Thus, lenders may decide to provide fewer
loans.
- Moral hazard: problem created by asymmetric information after the transaction occurs. It is
the risk (hazard) that the borrower might engage in activities that are undesirable (immoral)
from the lender’s point of view, making it less likely that the loan will be paid back. Because
it lowers the probability that the loan will be repaid, lenders will provide less loans.
Types of financial intermediaries, falling into 3 categories:
1. Depository institutions (banks): commercial banks, building societies and credit
unions. They primarily obtain funds trough savings deposits (e.g. mortgages, loans).
2. Contractual savings institutions: insurance companies and pension funds. Acquire
funds at periodic intervals on a contractual basis (e.g. premiums, contributions).
3. Investment intermediaries: finance companies, mutual funds and money market
mutual funds. They raise funds by selling commercial paper, stocks, bonds and shares.
H3. What is money?
Economist’s meaning of money (or “Money Supply”): anything that is generally accepted in
payment for goods and services or in repayment of debts.
Currency: paper money and coins.
Wealth: the total collection of pieces of property that serve to store value, including: money,
bonds, common stock, art furniture, cars and houses.
Income: a flow of earning per unit of time. Money, by contrast, is a stock: it is a certain
amount at a given point in time.
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, There are three functions of money:
1. Medium of exchange: Eliminates the trouble of finding a double coincidence of needs
(reduces transaction costs). As medium of exchange money must:
- be easily standardized - be widely accepted
- be divisible - be easy to carry
- not deteriorate quickly
2. Unit of account: it is used to measure value in the economy.
3. Store of value: it is used to save purchasing power over time. Money is the most
liquid of all assets but loses value during inflation.
Payment system: method of conducting transactions in the economy, it evolves over time:
1. Commodity Money: precious metals (e.g. gold or silver);
2. Fiat Money: paper money decreed by governments as legal tender (currency), but not
convertible into coins or precious metal;
3. Cheques: instruction to your bank to transfer money from your account;
4. Electronic payments (e.g. online bill pay);
5. E-Money (electronic money): Debit cards, Stored-value cards, Smart cards, E-cash;
Various definitions of monetary aggregates (supply):
− Differences in what members of each society accept as a medium of exchange.
− Due to financial innovations, some assets are accepted as money in some societies but
not in others.
− Differences amongst institutions responsible for issuing monetary aggregates,
normally the central bank and depository institutions.
Measures of money:
- M1: The narrowest measure of money and is more or less the same for most countries. M1
consists of currency in circulation as well as demand deposits + other chequeable deposits.
- M2: Considerably differs from one country to another. It includes M1 + the savings deposits
and most time deposits.
- M3: The broadest definition of money and its definitions vastly differ significantly from one
country to another. It is calculated by many central banks such as the ECB and BoE.
However, a number of central banks no longer do, e.g. Fed discontinued M3 in March 2006.
Which measurement should central banks consider when trying to affect variables (e.g.
inflation) in the economy?
– If the monetary aggregates move together, it does not matter much that we are
not sure of the appropriate definition of money
– If they do not move together, then what one monetary aggregate tells us is
happening to the money supply might be quite different from what another
monetary aggregate would tell us.
H4. Understanding interest rates. PV = today's (present discounted) value
Yield to maturity: interest rate that equates today’s value with CF = future cash flow (payment)
present value of all future cash flows. i = interest rate or yield to maturity
n = years to maturity
There are four basic types of credit market instruments:
CF
1. Simple loan. In this loan, the lender provides the borrower with an amount PV =
of funds (the principal) that must be repaid to the lender at the maturity date, (1 + i ) n
along with an additional payment for the interest.
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