Financial markets and Institutions
Part 1: Geert Gielens
Table of contents:
1. Introduction
2. Money and money creation (chapter 1)
3. Financial intermediaries (chapter 2)
- Financial institutions
- Why do banks exist
- Banks
4. Regulatory context part 1 (chapter 3)
- Regulatory authorities
5. Financial instruments & markets (chapter 4)
- Money markets (incl.repo’s)
- Bond markets
- Interest rate swaps aka derivates
6. Exercice session
7. (Regulatory context part 2) (chapter 5)
- Monetary authorities
Exam:
- True of false questions (explain why true or false)
- Open question
- Exercise question similar to the ones we see in the class
The exam is not necessary in english, you can chose to answer in English or in
dutch.
Chapter 0: introduction
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The first equation that we see is the most important Macroeconomic identity you have.
It’s income, GDP (gross domestic product), and you relate it to consumption of households(C) ,
investments(I), government expenditures (G), export (X), imports (M).
There is no economic reason why this is an identity (gelijkheid), we define it to be like that.
Previsions of growth and some stuff like that are all based on this equation.
In the second step, we substract the T from the two sides of the identity, the T
represent the Taxes
In the 3rd step, we put the consumption of the households on the left side
Y-T-C -> what’s left over is named savings (you have your income, you paid your
taxes and your consumption)
If we concentrate only on the S and the I -> S=I -> savings is the surplus, it’s
what I didn’t spent -> the I is the investment -> Typically you are going to borrow
money
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,Typically, in the economy -> what’s leftover(S) equals what’s needed(I)
There is no reason why this equation should hold like this, but we define it to be
like this, the financial system is the one that can assure that
savings=investments
The surplus that we have in the economy can go to where it’s needed, that’s
what we do, we displace money from part A to part B, part A has too much
money, and we use to that to give it to the persons or institutions that don’t have
enough money. And that’s basically what the basic function of the hole financial
system is.
We are going to talk about the financial plumbing of the economy, you can
consider banks and the financial system like a kind of infrastructural element
(like when you create electricity, you have the things that transfer the
electricity), the financial system is like the infrastructure of the economy.
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Important to know about the financial system is that It’s endogenous, it’s not god
given, the financial system looks like it looks today because it has been created
by all the different circumstances today, which means it’s time dependent, the
financial system today isn’t the same of the financial system of 20 years ago.
If you want to work in finance you will have to reschool all the time because it
changes constantly, because it does change, and it changes because the
financial system answers to the needs of the economy and the economy changes
as well.
The system is also geographically dependent, the financial system of Europe
is not the same as the one of the UK, nether than the one of the US and definitely
not the same as the one of china.
The principles could be the same (the way you calculate some things, let’s say
the mathematic stuff), but the system in itself is completely deferent (the role of
the bank, the regulations, what banks can do,…).
So, what we see in this course holds for Europe on average, on average because
there is no really unified system within the European union, all the financial
markets within each country come from the boundaries(grenzen) of each country
and they largely state within those national boundaries.
Despite the banking union, despite the fact that the European union should be a
one open space, for the financial markets that’s not really true, for many reasons:
o Language (in France they
speak French, in Italy they
speak Italian,…)
o The insolvency law (the law
that regulates bankruptcy of
corporates(bedrijven) is
extremely different within
each country.
o Consumer habits are different
in each country (a mortgage
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, loan (hypotheek lening) is
different in each country)
Probably one day it will become
unified.
So, here we have two countries, country A and B
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Economic agents (consumers, corporations, governments, institutional players) -
> we use money to buy things. If we use money to buy things that means that
there is a payment system behind it.
If you transfer money or pay with the QR-code, how are you sure that the money
is transferred, how are you sure that the right person receives the money you
have to pay. That’s not evident to know.
It simply means that there is an IT system and people that checks everything
behind it.
There is a lot of payment system developed.
You can also invest, with your savings, you can invest it on capital markets or
exchanges, if you want to buy stock or equity. Or you work with the financial
intermediaries, banks (B), shadow banks (SB).
NB. A shadow bank is a bank that basically enters into credit like business but it’s
not registered as a bank
This is what happens within one country simply
On top of those things, you see the regulators: central bank, FSMA (consumer
protection in the financial context), a lot of laws come from the European
commission, the European banking authority (EBA)-> they basically do all the
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,calculations and qualibrations of the laws (kind of research department for the
regulator).
If I want I can buy for instance a honeywell stock (amercian stock) that I can buy
on the american stock exchange.
So that means that when I am doing this I am entering the international capital
markets which is a bridge between one country and another.
Flows will go normally, usually if there is regeulations and laws that permit that,
you have to organize this via laws.
What we have nowadays are Central Clearing Party (CCP), something that didn’t
exist 15 years ago, it’s one of the things that have been invented after the crisis
of 2008 in order to make the system safer and more secure. It basically means
that for some type of transactions every bank is forced to work true CCP in order
to reduce the risk.
Some definitions before looking at the figures: 11
Equity -> the value of the shares issued by corporates (firms)
Bond -> obligaties
Swap -> een swap is een financieel product waarbij een partij een bepaalde
kasstroom of risico ruilt met dat van een andere partij.
Interst rate swap (IRS) (renteswap) -> wordt in het algemeen gebruikt om
renterisico’s te beheersen of af te dekken, of om te speculeren op ontwikkelingen
in de rentestand. Bij een renteswap ruilen partijen rentebetalingen uit gedurende
een vooraf bepaalde looptijd.
Equity issuance was less than a billion in 2017, it seems a lot but that’s a very
small number in financial markets.
Bond issuance & derivaties was 3 to 6 billion so already 3 to 4 times bigger, it’s
not that big but it’s bigger than the equity.
If you think about the banking system (deposits and loans), there you see under
the form of new production 13 and 18 billion respectively.
So, the banking system is much much more important than capital markets
within Europe, and this is true definitely for Belgium (because those are Belgium
data) but it’ s also true for France or Germany or holland,..
We are a banking system, we are not a capital market system (we are not the US,
we are not the UK).
If you think about derivatives (interest rates swaps), its 1300 billion (one trillion
and 300 billion).
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,It doesn’t mean that capital markets are very redundant or marginal, every
professional party (banks) use capital markets extensively, if a bank wants to
hedge(behoeden) against his risks, wants to make transactions so that it secures
it’s risks exposure it will use interest rate swaps. If a bank goes into the capital
market in order to reduce its risks via swaps, you can think about transactions of
about 5 to 10 billion.
Systems are becoming more and more digital; you simply push on a screen and
its done. You do banking now on your mobile phone. Belgium is pretty good at
such things, we are in the top 5.
Chapter 1: Money & creation of money
Contents: 2
1. Money & creation of money
1.1. Origin and characteristics
a. Definition
b. Function
c. Characteristics
d. Evolution
e. Forms
1.2. Supply of money
a. Definitions
b. Money supply: base money
c. Money supply: multiplier
d. Some numbers
1.1. Origin and characteristics
A. Definition 3
So, everyone knows a note of 5€, and that’s money, but nowadays you can also pay with
your phone.
The difference is that the note of money is “central bank money”.
A more important question is “why do we think this is money?” it’s just paper, so why do we
think it’s worth 5€.
Basically is money a good like anything else (a car, a bread,…), it’s a good that you use as
intermediary to make exchanges, so it’s a good that is very suitable to make exchanges.
Basically, the most defining aspect as money is that we consider it as money because
anybody else consider it as money, it’s a convention.
In the US there is another convention, there they pay with US dollars.
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, We decide to use this because we have trust, confidence that other people will expect the 5€
note as a payment. So, it’s purely a convention based on trust.
And if you have this good, this mean of exchange, that has the trust that everybody will
accept and use it than you have a good that is money.
Euro’s are the legal tender (wettig betaalmiddel) in Europe, at least in the member states of
the euro zone. A legal tender is a law, and in the law, they say euro’s are legal tender so you
can use it to make payments and if you use it to make payments your debt will be fulfilled.
It’s by law defined to be the means of exchange.
Is this sufficient to really talk about money? Not necessarily, most of the time yes but not
necessarily.
For example, if we look at the example of Argentina, there they use pesos, but argentina is a
country in deep economic trouble, and if you ask the people to have a payment in US dollars
or in the Pesos they will mostly all say they want the US dollars. Even if pesos is the legal
tender. And the reason is that there is no faith(geloof) in the stability of the peso, the people
don’t like it, even though peso is the legal tender.
It never is a given, wathever the central bank does in the production of
euro’s can influence the faith (geloof) in this euro’s.
Ex. One of the reasons Bitcoin has been invented is because those people
didn’t believe in the stability of the euro and they thought to many euros
were created by the central bank, so they wanted to develop their one
system (the Bitcoin).
B. Functions 4
If you have this generally accepted means of payment, that we call money
it has most of the time 3 functions (on the slide 4 but most of the time 3 ->
“standard for future payments” derived from the other 3)
Means of exchange
It’s the function, you use money in order to pay for goods and
to create an exchange (ex. Buying bread: you exchange
money for the bread).
We use it as means of exchange because we believe it has a
stable purchasing power.
Investment
If it has a stable purchasing power it’s also a good
investment, I can keep my valuables in money.
If there would be hyperinflation, like after the first world war,
people didn’t want to have their valuables stocked in money
anymore but they started stocking it in cigarettes, because
cigarettes where more valuable than money in that period of
time.
Untit of account
We express value in terms of money (one car costs 10 000€
while the other costs 50 000€) we compare the value of this
cars in terms of money.
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, This is wat we do with money
But still not answer to the question “why is the 5€ note considered as
money” and not for example a bar of gold or a payment of Rubens.
So, a good means of exchange (good money) had to have different
characteristics, and we will choose that good as means of exchange that
has most of the characteristics embedded in itself.
C. Characteristics 5
Valuable in comparison to its weight
Why do we prefer a 5€ note of money instead of a bar of gold? A bar
of gold would be very heavy, and you can’t make transactions with
that. So you want something that is practical.
Valuable in comparison to its weight -> practical
Durable
Means that it can’t perish (vergaan) when you use it, for example if
you would use a banana as use of exchange, after two weeks the
banana would be perished and the ‘money’ would be gone.
The 5€ note, despite the fact that it’s paper is extremely durable,
extremely difficult to destroy (you can burn it but illegal, you can cut
it into pieces but it’s still valuable).
Divisible
You must be able to split it up into smaller parts, you have 10€
notes, 5€ notes, 500€ notes. For example if something is worth half
a painting of Rubens you want cut into 2 pieces.
Standardized quality
All 5€ notes have exactly the same worth, the quality is
standardized.
Suppose you use diamonds they are not standardized quality
because they all have different quality what determines their value.
Easily recognizable
Stable purchasing power
I must be shore that the 5€ note today permits me to buy something
that’s worth 5€ the day after and a year later (of course there is
inflation but mild inflation doesn’t matter)
Those 6 characteristics determine why people decide to use a certain good
as means of exchange. And if your means of exchange as this
characteristics you can use it to exchange stuff in order to preserve value
and in order to use it as a unit of account (rekeneenheid).
D. Evolution 6
7
, What we see as money is changing nowadays enormously. 20 years ago
only notes and coins where money, mobile phones didn’t exist.
Nowadays we have Bitcoin (“is bitcoin money?”), the central bank will
issue its CBDC (Central Bank Digital Currency).
The world of what we use as payments is changing.
o Barter trade
We exchanged one good for another and there was not really money
at that moment of time
o Commodities used as “money”
Grain for instance (bijvoorbeeld)
o Precious metals
A step further when precious metals where born we used that, first
bronze then sliver and then gold
o Means of payment: coins (minted). -> coins where we put a stamp
on
Paper money
o Legal tender (came like 100 years ago)
We started to say “this is the money that we use”
o Fiduciary money (chartaal geld)
Basically, the 5€ note is fiduciary money.
This is money that you have trust hat a 5€ note really is worth 5€
You accept that it has this value even if in itself its absolutely not
worth the 5€
o E-money – cryptocurrencies (started 10 years ago)
e-money -> you put money on a chip of something you can borrow
with you (a credit card) and that you can use to pay someone who
wants to sell you something
E. Forms of money 8
Paper money and coins (central bank money)
It’s called central bank money because they issue it
Those are the only official money that exists
Sight deposits (commercial bank money)
Other forms of money are called sight deposits
Ex.when you pay with your phone
Commercial bank money is the money that you have on your
sight account (zichtrekening) or on your savings deposit
(spaarrekening).
E-money
Alternative forms of money (cryptocurrencies and specifically
stable coins)
Basically, anything that’s really accepted by everybody as a
form of exchange
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What about this statement? (could be exam question!!)
Bitcoin is a means of payment but not an alternative form of money.
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,Answer: it’s a means of payment! There is a map that shows all the stores that
accept bitcoin payments in Belgium (quite map).
A rock, a banana can be a means of payment, if your neighbor needs help and
you help him and he helps you a week later that’s also a means of payment.
Actually, anything can be a means of payment bu it’s not making it money.
Money is something that is generally accepted by society that you can use it
exchange goods. Money has the idee of trust and all the 6 characteristics that we
need, and Bitcoin does not have dose characteristics.
So cryptocurrencies are not Money !!
1.2. Money supply 10
There are two components of money nowadays in our societies:
- Currency
Refers to the notes and the coins, the central bank money.
This is about 10% of everything that we call money in our society.
All the other things are fiduciary money, we trust it to be money.
- Cashless money
Things that we call money but it’s not cash.
Definition:
(Narrow sense) (smale/kleine): the amount of money on sight deposits (so
the amount of money at the bank), what you use when you pay with your
mobile phone.
(Large sense) (bredere definitie): savings deposits (spaarrekeningen), term
accounts (termijnrekeningen), financial assets with a longer maturity
N.B:
Term account: you put money on the bank, but you agree that it has to
stay there for a period.
Is this then money? yes, it is because if I want in can break the contract
and transfer my money again to my sight account.
The definition of money is arbitrary (is money on a term account really
money? Is a bond money?) it’s what we define it to be, and “we” means
the economic society.
So nobody really knows what the real supply of money in a society is, it’s
dependent upon your definition, who is arbitrary.
Macro-economic definitions: 11
M1: money in circulation (the cash) + overnight deposits (sight accounts)
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, Cash + sight accounts
M2 (near money): it’s M1 + the deposits at the bank with maturities up
to 2 years and deposits refundable with a notice period of 3 months.
Closer to money because money that I have on my savings account I can
bring it to my sight account and immediately use it to pay.
M3 (near, near money): M2 + repurchase agreements (a way you can
turn bonds into cash easily -> see more in detail later in the cursus) +
money market fund (see later) + money market paper (see later) +
securities with a maturity up to 2 years.
De table shows the way the monetary system changed over time. 12
Fully centralized -> where money is only what the central bank issues
Fully decentralized (ex. Bitcoin)
M = m.B 13
M = monetary base
m = multiplier
the money supply is fully endogenous, how much money there is in the
economy is fully determined by the economy by itself, it’s not the central
bank that says money supply is … .
the monetary base is what you find on the balance sheet of the central 14
bank, it’s currency (the amount of coins and notes issued by the central
bank) + bank reserves (money that bank deposit at the central bank),
mandatory (under an obligation of the central bank or when they decide to
do it themselves).
The central bank can really decide about CP
The amount of cash is completely a decision of them. The reserves are
partly decided by them, there are minimum reserves that are a decision of
them (1% of all deposits) but banks can decide to put more money at the
central bank (so that they can’t control).
The graphs shows the amounts we are talking about: 15
In blue we have the banknotes in circulation (that’s the cash), it
grows over time, logically because the economy grows and there is
inflation, but it grows verry stable.
In orange and grey, we have the current accounts and deposit
facility, we can consider this to be the reserves and you see that this
exploded when covid took place (money creation by central bank).
Little dump when Greece went into default, and Italy and Portugal almost
as well.
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On chart B, the blue line is the base money, we see the financial crisis in
2008, in 2011-2013 the Euro crisis with Greece went in default, and then
an inflation period.
The orange line is the money multiplier, and the money multiplier has kind
of a mirror image of the base. You can increase your money base
enormously, but the multiplier will react, and it goes in the other way as
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