12 Financial Markets and Monetary Policy Flashcards
(420 cards)
1
Q
What two concepts are necessary to understanding financial markets?
A
- Assets
- Liabilities
2
Q
What is an asset?
A
A resource which has monetary value and can be sold to retrieve this monetary value.
3
Q
What are liabilities?
A
Amounts owed to creditors.
4
Q
What are current liabilities?
A
Short-term liabilities.
5
Q
What are non-current liabilities?
A
Long-term liabilities.
6
Q
Is everything either an asset or a liability?
A
No.
- Some things have no monetary value
- Some things are both assets and liabilities
- Some things have no monetary value.
- Some things are both assets and liabilities.
7
Q
Example of something which is both an asset and a liability?
A
Cash.
8
Q
How is cash an asset and a liability simultaneously from the Bank of England’s perspective?
A
- It is an asset to the person owning it because it gives them X amount of spending power.
- It is a liability for the Bank of England. In the past they had to issue gold to the value of your note, but now they simply replace notes
9
Q
How has the status of cash as a liability for the BoE decreased?
A
Since 1931 - You cannot convert bank notes into gold.
10
Q
How is cash an asset and a liability for commercial banks? What key fact is true?
A
- The creation of CREDIT gives the bank an interest-earning asset.
- But it also gives the bank a liability because it must pay the fee of the CREDIT when the consumer requires
- The cash is naturally an asset of the person who took out the loan
- But the consumer now also has a liability because they must meet interest and repayment deadlines
ASSETS=LIABILITIES WHEN COMMERCIAL BANKS CREATE CREDIT
11
Q
What is the key difference between commercial bank credit creation and BoE credit creation and eval?
A
Commercial banks create credit such that ASSETS=LIABILITIES
Bank of England doesn’t make liabilities since 1931 after WE CAME OFF THE GOLD STANDARD
SO THE BANK OF ENGLAND CANNOT RUN OUT OF MONEY
12
Q
What fundamentally does the gold standard do?
A
Force the central bank to generate liabilities when it creates credit, which limits the money supply.
13
Q
What currencies prefer to use the gold standard and example?
A
Those seeking to cement confidence, reduce inflation psychology and attract investment
2024 - Zimbabwe returns to gold standard
2024 - Zimbabwe returns to gold standard.
14
Q
What is money?
A
it’s a gas
Something which serves as a medium of exchange and a store of value
Something which serves as a medium of exchange and a store of value.
15
Q
What are the two functions of money?
A
- Medium of exchange.
- Store of value.
16
Q
How can money store wealth?
A
- Be used to buy assets which themselves can store wealth
- Be saved in its own rights
Creeping inflation
17
Q
What is creeping inflation?
A
A gradual increase in prices.
18
Q
What is commodity money?
A
Objects that have value in themselves and that are also used as money.
19
Q
What are the 4 steps in the development of money?
A
- Barter.
- Commodity money, which replaces barter.
- Representative money, which replaces commodity money.
- Token money, which is either state money or bank money.
20
Q
What was the problem of barter?
A
Requires double coincidence of wants.
21
Q
Example of commodity money?
A
Hudson’s Bay Company - when they arrived in Canada, they could not trade with First Nations leaders, who insisted on commodity money such as pelts.
22
Q
What is representative money?
A
Money that is backed by an item of value, such as gold or silver.
23
Q
Why did representative money replace commodity money?
A
More effective at the 5 requirements of money.
24
Q
What are the 5 prerequisites of money?
A
RUDPD
- Relative scarcity - cannot be forged, and cannot be made infinite
- Uniformity - each unit must be identical
- Durability - must last a reasonable time to be a good store of value
- Portability - must be transportable
- Divisibility - must be divisible
25
What was wrong with sea shells as commodity money in West Africa?
Relative scarcity - was far more abundant at the coasts, making coastal communities richer.
26
When do commodity currencies often come into use?
When representative/token money becomes useless due to breakdown of external markets e.g. 2022 Kherson - Ukrainian state media reports
27
The 5 properties of good money create..., which creates....
Confidence in money
Acceptability
28
How did representative money develop?
Wealthy individuals used gold as commodity money, and therefore they needed somewhere safe to store this wealth. These storage units gave them receipts which were effectively money
29
Why was confidence in gold-linked representative money high?
Linked to something with intrinsic value.
30
What is token money and eval?
Money with no intrinsic value of its own
Has become more popular since we left the gold standard
31
What are the 2 types of token money?
1. Cash
2. Bank deposits
Bank deposits BY FAR predominate
32
What proportion of the UK money supply is cash?
4%.
33
Key requirement of token money and example?
Must be a monopoly issuer to ensure 5 functions remain in place
Bank of England in the UK, though some delegation to devolved banks has taken place
## Footnote
Bank of England in the UK, though some delegation to devolved banks has taken place.
34
2 secondary functions of money? Together make?
1. Measure of value
2. Standard of deferred payment
UNIT OF ACCOUNT function
35
How is money a measure of value?
Relative information communicated by prices - what Hayeck won the 1974 NEP for. Money is a way of making comparisons
36
How is money a standard of deferred payment?
Ability to withhold payment into the future, even though goods and services are being provided immediately.
37
What is a building society?
A bank which is:
1. Run by its members.
2. Focus on providing savers a better return.
3. Usually used to finance houses.
38
Was a bank deposit always regarded as money?
No.
39
When is barter impractical? What consequences does this have?
When communities are large and hence information about bartering opportunities are imperfect
Bartering returns during wars, but only in small communities
40
What concept is associated with the double coincidence of wants problem?
Search costs.
41
Why is the double coincidence of wants bad?
1. Prevents specialisation and hence productive efficiency.
2. Search costs and inefficiency.
42
What is the money supply?
The total stock of financial assets which functions as money.
43
How much attention was paid to the money supply before monetarism and why?
Not much
Keynesians saw the money supply as something in derived demand, and rejected the REVERSE CAUSATION ARGUMENT of monetarists
44
What are the 2 types of money?
1. Narrow money.
2. Broad money.
45
What is narrow money?
The part of the stock of money composed of LIQUID assets including cash and bank/building society deposits.
46
What is broad money?
NARROW MONEY + THE REST
Includes some illiquid assets not considered near money
## Footnote
Includes some illiquid assets not considered near money.
47
What is key about narrow money?
All of the money contained within this definition can be used in the immediate term as a medium of exchange.
48
What are the code names for money supply classifications?
M0 - M4 where M0 and M1 were narrowest and M3 and M4 were broadest.
49
What is liquidity?
How easily an asset can be converted into cash without loss of value.
50
What is the most liquid asset?
Cash.
51
What are two things that make things illiquid?
1. Search costs or time waiting for a buyer.
2. Substantial loss of value.
52
What is a pre-known value and how can it affect liquidity?
If somethings value fluctuates far from a pre-known value, it can reduce liquidity e.g. volatile stocks versus stabler ones
53
What "law" (read - theory) explains why monetarism fell out of favour? Explain?
Goodhart's Law
As soon as a government tries to control one aspect of the money supply, economic agents seeking to expand the money supply to finance an increased number of transactions merely start using near money as a medium of exchange, in effect making that near money into money.
Attempting to control the money supply is like trying to catch one's shadow
## Footnote
As soon as a government tries to control one aspect of the money supply, economic agents seeking to expand the money supply to finance an increased number of transactions merely start using near money as a medium of exchange.
54
Why did monetarism keep changing the definition of money?
Goodhart's Law.
55
How can we link Goodhart's Law to the Financial Crisis?
The increased proliferation of debt bearing assets as mediums of exchange potentially increased systemic risk in the financial sector.
56
What is equity?
All the assets that people own - net wealth.
57
What is debt?
All the assets that people owe.
58
Equity is the opposite of?
Debt.
59
Equity is considered an ____ whereas debt is considered a ____.
asset
liability
60
What are shares?
1. UNDATED FINANCIAL ASSETS - they are owned indefinitely.
2. Issued by a company.
3. UNLIKE A LOAN, incurs partial ownership of the firm.
61
What are the 2 types of company?
1. PLCs (public limited companies) - shares exchangeable in a secondary market.
2. Private limited companies (Ltd) - shares not exchangeable in a secondary market.
62
What is positive equity? Example?
When the value of your asset rises faster than the value of the liability you leveraged to buy it
Buying a house using a mortgage, only for the rise in house prices to outstrip the mortgage rate
## Footnote
Buying a house using a mortgage, only for the rise in house prices to outstrip the mortgage rate.
63
Example of negative equity?
2007 rapid fall in house prices.
64
What are 3 effects of negative equity?
1. Cannot easily resolve the debt by selling the property, which potentially freezes up the housing market
2. Negative wealth effect, consumer confidence and declining consumption
3. Increased reliance on private debt rather than EQUITY WITHDRAWALS
65
What goes on when negative equity occurs?
The value of the asset relative to the liability used to buy it falls, due to a decreasing value of the asset, ceteris paribus
This can lead to a RISING DEBT:ASSET RATIO.
66
What is the negative equity trap?
When you get stuck with the asset because you can no longer afford to sell it to move on.
67
Who was worst affected by the negative equity trap in 2007 and why?
Young first-time buyers
Couldn't move up the housing ladder as their parents had done
## Footnote
Couldn't move up the housing ladder as their parents had done.
68
What macroeconomic state could cause a negative equity trap and why?
Recession - prices fall due to deflation.
69
What is a portfolio?
A collection of financial assets.
70
Portfolio balance decision explanation?
Decisions which must be made when making a portfolio on the SPECTRUM of PROFITABILITY to LIQUIDITY and the opportunity cost here
Should you hold too many physical/illiquid assets, you may be at risk from negative equity during a downturn.
71
Eval on gilts as a liquidity/profitability portfolio balance decision?
Great because they are at once exchangeable in a secondary market and fairly profitable too.
72
How are the financial markets arranged on a spectrum of competition?
At the one end, some capital and foreign exchange markets are very international and digitalised whereas markets for commercial bonds, Treasury bills etc. are centralised in the City
But for the most part, all financial markets are more competitive than the vast majority of other markets
73
What are financial markets?
Markets in which financial assets or securities are traded.
74
What is a treasury bill?
Short-dated government debt (usually 3 months to maturity) which pays the holder a fixed rate of interest until redemption.
75
Is the rate of interest on Treasury Bills and Government Bonds nominal or real?
Treasury Bills - nominal
Government bonds - mix. CONVENTIONAL are nominal, INDEX-LINKED are, well, index-linked. BUT TO RPI, to make bonds more attractive to investors
76
What is maturity?
The date at which the original capital cost of the loan is repaid.
77
What index are index-linked bonds linked to, since when? Eval?
RPI
2005
Higher than CPI
## Footnote
Higher than CPI.
78
What proportion of UK gilts are conventional and eval?
75%
1. Hence inflation first and foremost - must satisfy the bond markets
79
What is security?
Any financial asset which secures a claim against an economic agent - for instance, a share secures a claim in a company
80
What are the 3 types of financial market?
1. Money markets.
2. Capital markets.
3. Foreign exchange markets.
81
What are money markets?
1. For trading short-dated financial assets such as Treasury and commercial bills.
2. Maturities range from a day to a year.
3. Liquid.
82
What is a commercial bill?
(a.k.a. a bill of exchange) a kind of short-term liability which is usually used in trade transactions.
83
What are capital markets?
1. For the trade of long-dated liabilities such as bonds and shares.
84
What are FOREX markets?
1. Buying and selling currency.
85
What is a fact about the size of the FOREX markets?
Collectively, the largest markets in the economy.
86
FOREX MARKETS IN A NORMAL ECONOMY ARE THERE IN...
Eval?
DERIVED DEMAND FOR GOODS AND SERVICES BOUGHT IN FOREIGN CURRENCIES
Largest movers are institutional groups such as investment banks
87
Of capital markets, financial markets are further subdivided into what two categories?
1. Primary markets (NEW ISSUE MARKETS).
2. Secondary markets.
88
What do secondary markets give?
Liquidity.
89
FOREX markets are further divided into?
1. Spot markets.
2. Forward markets.
90
Example of other financial markets?
1. Commodities futures markets.
2. Insurance product markets.
91
Example of an important money market?
London interbank market and the LIBOR.
92
What is LIBOR?
London Interbank Offered Rate
Rate for short-term money market exchange in the London interbank market
93
What practical purpose do money markets serve?
Provide a liquid side of the liquidity/profitability portfolio balance decision, usually so that banks can trade highly liquid short-term assets to finance their operation
94
What is the purpose of capital markets?
Provide the mechanism through which PLCs can finance their long-term growth
Also, the government market provides a similar function for government
95
Eval on PLCs?
Largest type of UK businesses usually, not usually SMEs.
96
What are corporate bonds?
Debt security issued by a company. Sold as new issues to people who lend long term to the company. Can usually be resold in secondary markets, for instance the London Stock Exchange.
97
What critical role do bond markets perform?
Allow a government to finance a budget deficit.
98
Two of the most important money markets?
1. Commercial bills market.
2. Treasury bills market.
99
What is a gilt-edged security/gilt?
SAME AS A GOVERNMENT BOND
100
What is the function of money markets?
Provide both private-sector commercial firms and the government with a source of short-term finance.
101
What is the substitute for a commercial bill?
Commercial bank loan in the conventional sense.
102
Who sells commercial bills?
Investment banks, on behalf of their clients.
103
What is a bill?
Short-dated loan raised by sale on the money market.
104
What is a bond?
Long-dated loan raised on a capital market.
105
What are the 3 main things traded on capital markets?
1. Shares.
2. Gilts.
3. Commercial bonds.
106
What is the relationship between bond prices and interest rates?
Inverse relationship between bond prices and interest rates.
107
When we say bond price in the context of interest rates, we mean?
The price of a bond on the secondary market.
108
What is a short-dated loan raised by sale on the money market?
Bill
109
What is a long-dated loan raised on a capital market?
Bond
110
What are the 3 main things traded on capital markets?
1. Shares
2. Gilts
3. Commercial bonds
111
What is the relationship between bond prices and interest rates?
Inverse relationship between bond prices and interest rates
112
What do we mean by bond price in the context of interest rates?
The price of a bond on the secondary market
113
What do we mean by interest rates in the context of bond prices?
The rate of interest paid on the bond annually
114
How are bond prices inversely proportional to interest rates?
1. Buy a bond
2. The bond valuates
3. The fixed nominal value of the bond remains constant
4. So it is a smaller proportion of the new, higher value of the bond
5. Therefore the annual yield of the bond as a percentage of the price has fallen
115
How often are gilt payments made?
2 instalments per year, each 6 months apart
116
If bond prices rise, what happens to yields?
Fall
117
Do index-linked bonds experience the same interrelationship between bond prices and interest rates?
Yes
The index-linked bit is only the repayment
## Footnote
The index-linked bit is only the repayment
118
What is capital gain?
The profit made on the buying and selling of assets
Capital losses are the reverse
119
Why does the cost of government borrowing rise when interest rates rise?
Bonds are charged at market rates to remain competitive
120
When do bond prices tend to fluctuate less?
As maturity date approaches
121
How can bonds create capital gains?
If we buy a bond on a primary issue or simply when it is cheap on the secondary market with an expectation it will valuate, then we can do so, and make a capital gain later, with associated profits.
But the size of the bond markets as well as the power of market makers, it is not a perfectly competitive market. The speculative demand this can create can actually create the rise in prices originally foreshadowed
122
What is an important determinant of short-run bond prices?
Speculative buying and selling due to the behaviour of other people in the same position
123
What is a consol?
Consolidated Stock - government bonds with no maturity date
124
Evaluation of a consol?
1. Relatively high interest rates
2. Since no maturity was inbound, the yield on Consol was a good indicator of long-run interest rates across other markets
125
What was the Consol yield a good indicator of and why?
General economic confidence
If Consol rates were low, this was because prices were high, suggesting that economic growth expectations or the prospect of capital gains in other financial markets was lower. Usually therefore a lead indicator of low growth or low inflation. The opposite was also true.
## Footnote
If Consol rates were low, this was because prices were high, suggesting that economic growth expectations or the prospect of capital gains in other financial markets was lower.
126
What happened to Consuls?
2014 - still in circulation from financing the First World War
2014 - Government announces enforced redemption of all Consols. 2015 - last of the Consols was redeemed
127
What is a coupon?
The guaranteed fixed annual interest payment, often divided into six-month payments, paid to bondholders. IS A NOMINAL VALUE
128
What is yield?
The annual interest rate on a bond expressed as % of a bond's current market price
129
What is a maturity date?
The date on which the issuer of a dated security such as a gilt-edged security or a Treasury Bill pays the face value of the security back to the owner
130
The annual coupon payment on a 40-year bond issued last year is 8. When the bond was first sold, the long-run interest rate was 8%. The bond's maturity value is 100. Within the last year, long run interest rates have fallen to 4%. What is the current market price of this bond?
200
131
A 100 bond paying a nominal rate of interest of 10% with 30 years to maturity has just paid this year's annual coupon. Long-term interest rates are currently 6%. Assuming that other factors such as expectations of capital gains are not involved, which one of the following is the best approximation of the current market price?
A = 105.62
B = 106
C = 110
D = 100
E = 166
166, I think.
132
Does the maturity value always equal the initial issue price?
Not necessarily - can be issued at a discount to give higher yields or at a premium when demand for bonds is high
133
When are investors more likely to accept a bond premium?
When market interest rates are lower than the current coupon rate
134
What are the two parts of the capital markets?
1. New-issues market
2. Secondary market
135
What is the LSE?
Main secondary capital market
136
What is the difference between capital markets and stock exchanges?
Capital market is the market which provides long-run finance to firms and governments
Stock exchange is a secondary market WITHIN the capital market
137
Why is the primary issue the main determinant of the company's finances?
This is where the money is actually raised
138
What are the two ways for firms to raise finance on the capital markets?
1. Sell corporate bonds and pay them back later
2. Sell shares or equity in the company indefinitely
139
What is the AIM?
An example of another secondary market which is not the LSE (though it is run by the LSE)
140
Firms increase their debt when they do what on the capital markets?
Sell corporate bonds
141
When do firms issue shares in the primary market?
1. IPO - 'going public'
2. New equity issue
142
The new equity issue for an existing PLC is most often a..., meaning...
Why? Eval?
Rights issue
Existing shareholders buy first
Allows them to maintain their share in the company and hence, if the company remains profitable, their rate of return
Too many rights issues and investors can be put off for constant desire for cash
## Footnote
Existing shareholders buy first
143
What role do investment banks play in the capital markets for equity and shares?
Provide the primary market, and give the firms somewhere to do their IPO - connect firms with consumers
144
What do the secondary capital markets do?
Help incentivise buyers who buy the initial issues of shares because they give liquidity
145
What companies were often undervalued at the primary issue, only to make huge profits on secondary markets and eval?
Firms which were being privatised e.g. BT, which was hugely oversubscribed
Many of the small shareholders ended up selling to investment banks and consolidated funds, making the argument that privatisation is popular capitalism much less compelling, in order to make a RISK FREE CAPITAL GAIN
146
Why are shares a type of equity?
because they are net wealth
147
Why are FOREX markets important?
International trade has been key to post-war global development
148
What are the two types of FOREX market and their legitimate uses?
1. Spot market - immediate exchange for purchases of goods and services
2. Forward markets - used by exporters and importers to hedge so that they have a supply of a safe currency in case of an exchange rate crisis
149
Virtually all modern money is...
Token money with no intrinsic value
150
What is the main aim of a bank?
MAXIMISE PROFITS, as it is a normal firm in this regard
151
What are the three types of bank?
1. Central bank
2. Commercial bank
3. Investment bank
152
Why is the Bank of England an exception?
Though highly profitable, its aim is not to maximise profits but to oversee the financial system and implement monetary policy
153
What are three words for commercial bank?
1. Commercial bank
2. Retail bank
3. High-street bank
154
What is a commercial bank?
A bank which makes profit by selling banking services to consumers
155
How have commercial banks changed character in recent years?
Reduced high street presence
156
What are the two main roles of a commercial bank?
1. Accept deposits
2. Create deposits
157
Distinguish between a retail bank and a central bank.
1. Central bank also has a regulatory role
2. Central bank is also the 'lender of last resort' for other banks
3. Central bank implements government monetary policy
158
Where were investment banks before the development of the internet?
Clustered within the square mile of the City of London
159
What is an example of an external economy of scale in the banking sector?
City of London - square mile but full of banks
160
What is the purpose of investment banks?
Help companies, financial institutions and other agencies such as governments raise finance by selling shares or bonds to investors and to secure against risk
161
What is the chief way investment banks make money?
Underwriting share issues - for a substantial fee, will agree to buy up all shares of a company following an unsuccessful launch
162
How have investment banks made money at the expense of the taxpayer? Eval?
Underwriting share issues for the privatisation of government industries, e.g. Royal Mail in 2013
They really shouldn't do this because privatised firms are often under-priced to ensure a risk free capital gain
163
The other side of investment bank activity? Eval?
Trade on their own behalf in shares, bonds and other financial assets
CONFLICT OF INTEREST CAN EXIST HERE - the departments of investment banks responsible for IPOs are strictly separated from trading departments to prevent conflict of interest
NEVERTHELESS, LEAKAGES DO OCCUR, and even if they didn't, there is a risk of divorce of ownership from control. One side doesn't know what the other is up to and vice versa, so MORAL HAZARD occurs.
164
What fact about the size of investment banks?
Many trade in financial assets which are larger than the GDP of most of the world's countries
165
How do most investment banks come into existence? Example?
The merger of a retail bank and a previously smaller independent investment bank
S.G. Warburg & Co - on the FTSE 100 once. Merged with Swiss Bank Corporation and became part of UBS, a Swiss investment bank
166
How are investment banks global?
Usually have HQ somewhere but branches in many financial centres e.g. London, New York, Shanghai etc.
167
What are two investment banks that have remained independent of the retail sector for their whole existence?
JPMorgan
Goldman Sachs
168
What are the 5 largest investment banks by fees in 2019?
1. JPMorgan
2. Goldman Sachs
3. Morgan Stanley
4. Bofa Securities
5. Citigroup
169
What is an example of how consolidation characterises the banking sector?
2000 - JPMorgan and Chase Manhattan merge
170
What is systemic risk?
The risk of a breakdown of the entire financial system due to the interdependence between banks in the financial system
171
What is one-off risk?
Something that only affects one bank
172
What exacerbates systemic risk and who said this?
The Vickers Report - 2011 - key cause of the Financial Crisis was interlinkages between commercial and retail banks
173
What is the process of separating commercial and investment banks known as?
Ringfencing
174
When was ringfencing made law?
1st January 2019 in the UK
175
Why is a ringfence needed?
The mergers and acquisitions (M&A) department of the investment bank may obtain inside knowledge about a company it is advising
With this inside knowledge, the trading department can make informed decisions about trading said companies' shares
176
Counter eval to ringfencing?
MORAL HAZARD if the two departments are completely separated.
177
What is an example of a bank that was torn apart by M&A/trading competition?
1980s Lehman Brothers CEO Pete Peterson forced to resign over conflict
178
How does credit creation fundamentally work?
1. If we took a promissory note to a vendor and asked for something, they'd almost certainly say no
2. If we had it backed up by the bank i.e. Barclays promises to pay the sum of..., they'd probably say yes
3. We have created money
179
What is credit?
When a bank creates a loan, it creates credit. This is an advance, an asset on the bank's balance sheet but equally a liability.
180
TEXTBOOK: How does a bank create credit?
1. Assume a monopoly bank
2. The bank receives deposits. This becomes an asset of the bank, BUT ALSO AN EQUAL AND OPPOSITE LIABILITY, because at any rate the bank could be asked at any notice to repay the asset to the consumer
3. The bank now sets a ca1sh ratio. This is the proportion of liabilities it will have covered by near money/liquid assets
4. The rest of their asset can be given away to other consumers as credit, WHICH WORKS IF CREDITORS ARE RELIABLE AND WILL PAY THEIR MONEY BACK
181
What is a safe-deposit institution?
A bank with a cash ratio of 100%
182
What is the fractional-reserve theory of the 2008 Recession?
1. Customers didn't pay back their liabilities
2. Banks ran out of money to cover their liabilities
3. LIQUIDITY CRISIS
183
What is an advance?
The amount of the bank's assets which are then used to create other liabilities
184
If a bank receives a deposit of 10,000, and it wishes to maintain a cash ratio of 10%, how much may it issue in advances?
90,000
185
What is the real world cash ratio?
Lower than 10%, closer to 5%
186
2 constraints on bank deposit creation in the fractional reserve theory?
1. The need for the bank to hold sufficient cash to meet likely withdrawals
2. The need for effective demand for credit
187
What is the proper word for cash ratio?
Liquidity ratio
188
How does a multi-bank banking system differ from a monopoly one (fractional reserve theory)?
In a multi-bank system, coordinated credit expansion across all banks ensures that interbank payments offset each other.
189
The effect of the fractional reserve school is that commercial banks tend to ___ the money supply.
Increase
190
What is the classical view of how banks create money?
1. Banks attract deposits first
2. They then basically reallocate these deposits, with no added credit
Not true
191
What is the contemporary view of how banks create credit?
1. THEY SIMPLY TYPE THEM INTO EXISTENCE first of all
2. Consumers subsequently repay them, destroying money
192
How can we understand how banks create credit by reference to a bank's balance sheet?
On their balance sheet, the bank has assets. THESE CAN USUALLY BE SPLIT UP INTO LOANS TO UK HOUSEHOLDS AND OTHER LIQUID ASSETS SUCH AS CASH
The bank also has liabilities, INCLUDING RETAIL FUNDING (DEPOSITS), WHOLESALE FUNDING (E.G. FROM OTHER BANKS) AND CAPITAL (FROM ISSUING SHARES)
So long as the assets are covered by the liabilities, the bank is okay (SOLVENT)
193
What are the two requirements for lending for commercial banks?
1. Sufficient supply of reserve assets i.e. cash
2. Sufficient supply of capital
194
What is a sight deposit? What is a time deposit? Eval?
Sight deposit - bank accounts which the owner can withdraw cash from at any time
Time deposit - bank accounts which are the property of the bank for a fixed amount of time
195
What is a time deposit?
Bank accounts which are the property of the bank for a fixed amount of time
196
What are reserve assets?
Liquid
197
What happens if a bank loses reserves to other banks?
It will constrain its ability to lend further.
198
What is a sight deposit?
Bank accounts which the owner can withdraw cash from at any time.
199
What is a time deposit?
Bank accounts which are the property of the bank for a fixed amount of time.
200
What are reserve assets?
Liquid assets owned by banks to allow banks to meet any likely consumer demands for cash.
201
Example of a bank that ran down its supply of liquid reserve assets?
Northern Rock
202
What trade-off do banks face in trying to be profitable?
Liquidity-profitability trade off.
203
At the most liquid end of the liquidity-profitability trade off...
Banks would just be safe-deposit institutions. The bank's profits, if it earned any, would be solely from the fees it charged consumers for guarding their valuables
204
How does a bank create profit using advances?
1. Cash acts as 'HIGH-POWERED MONEY'
2. Creating deposits and the total money supply
3. The rates of interest charged by the retail banks on these advances are a major source of bank profits.
205
What can happen if banks create too many profitable advances?
They could face a liquidity crisis.
206
Run on the banks and eval?
When consumers lose confidence in a bank and start demanding their deposits back
Last occurred for Northern Rock 2007
## Footnote
Last occurred for Northern Rock 2007.
207
What is profitability?
The state or condition of yielding a financial profit or gain.
208
Security (loans)
Loans which are secured against the value of a property etc. which are less risky for banks.
209
What does prudent banking require?
An acceptable trade-off between liquidity and hence consumer confidence in the bank and also profitability from advances.
210
Why can we see the banking system as something of a race to the bottom in terms of profitability/liquidity trade-offs?
Oligopoly interdependence.
211
What is crucial about the 5% liquidity ratio in UK banking?
When liquidity ratios dip below this, we see Financial Crises etc.
When liquidity ratios are above this, banks are safer, but less profitable
## Footnote
When liquidity ratios are above this, banks are safer, but less profitable.
212
What other trade-off do banks face besides liquidity and profitability?
Security of assets
Hence why banks are keen to issue mortgages
Lack of security a key cause of the Financial Crisis
## Footnote
Hence why banks are keen to issue mortgages. Lack of security is a key cause of the Financial Crisis.
213
If banks are dealing with unsecured loans, they tend to...
Why can this create adverse selection?
Charge higher interest rates
Make higher profits
214
Why are advances to customers highly profitable but illiquid?
It generates a high return, but is hard for the bank to access.
215
How liquid is the reserve account each bank has at the Bank of England?
Very - the Bank can merely run down its supply of cash there - as liquid as cash.
216
What is money borrowed at call and short notice?
Money borrowed in the interbank market to meet short-term liquidity demands.
217
What is money at call?
Money which must be paid back in very short time periods e.g. the next day.
218
What is money at short notice?
Money which must be paid back at short notice, but usually over a slightly longer period e.g. a month.
219
What is the inter-bank market?
The market in which banks quickly loan money to one another.
220
Where does money on short and call notice appear on a bank's balance sheet?
Both assets and liabilities, for the same reason that deposits are both.
221
Money at call and short notice is considered a highly ___ asset.
Liquid.
222
What are the 7 common types of asset often held in a commercial bank portfolio, in order of liquidity?
1. Cash
2. Balances at the Bank of England
3. Money at call and short notice (interbank market)
4. Bills (commercial or treasury)
5. Investments (capital market assets e.g. bonds and mortgages)
6. Advances (loans extended)
7. Non-current assets (e.g. bank premises)
223
Why do Treasury Bills tend to make profit for banks purchasing them as assets?
Frequently sold at a discount in the first instance, and banks have disproportionate access to the primary market.
224
Why are Treasury Bills good assets for banks?
1. Highly liquid - can be sold in the DISCOUNT MARKET
2. Reliably profitable.
225
Do commercial banks often buy shares? Why?
No. They never mature and they may have to be sold in a falling capital market.
226
Given commercial banks rarely use shares as assets, what do banks often use as long-term illiquid assets instead?
Things like corporate bonds and gilts.
227
Why are gilts considered illiquid by banks even though there is a secondary market?
If there is some situation in which systemic risk means the banks face a liquidity crisis, the bank is liable to have to sell its bonds in a falling capital market, which creates a decline in price.
228
What is a central bank?
A national bank that provides financial and banking services for a national government and banking system, as well as implementing government monetary policy targets and issuing currency.
229
What is the history of the Bank of England?
Founded 1694, privatised 1946, with surplus profits going to the state, and given operational independence on 6/5/97.
230
What are the two roles of the central bank, broadly outlined?
1. Implement monetary policy targets and assist with macroeconomic stability
2. Help achieve financial stability.
231
What remit does the Bank of England have vis-a-viz maintaining macroeconomic stability?
Price stability through the manipulation of base interest rates
Subsequently assist with full employment and growth
232
The Bank of England is tasked with achieving ___ first and foremost as regards macroeconomic stability
Price stability, with 2% CPI +/- 1%
Low and stable creeping inflation necessary for economic growth
233
What are macroeconomic stability versus macroeconomic performance?
1. Stability - the satisfaction, consistently, of the macroeconomic objective
2. Performance - measurements to the specific degree to which these desirable objectives are being achieved.
234
What are 5 ways central banks can achieve their objectives?
1. Regulation of the financial system
2. Lender of last resort
3. Controlling the note issue
4. Acting as the government's bank
5. Buying and selling currencies to manipulate the exchange rate.
235
What is the lender of last resort? Eval?
The ability of banks to extend loans to banks that are solvent but which have short-term liquidity problems.
236
What is the 'banker's bank' function?
Banks keep 'operational balances' at the Bank of England just as customers keep balances at retail banks.
237
Eval on the banker to government function of the Bank of England?
Substantial changes. E.g. since 1998 the Debt Management Office has issued gilts on behalf of the Treasury, and in 2000 the DMO took over short-term cash powers
But still the government keeps accounts at the BoE
238
What is monetary policy?
Part of government macroeconomic policy which uses control of the money supply and associated monetary policy instruments in order to achieve macroeconomic objectives.
239
How was monetary policy done before 1997? Eval?
Bank of England was in control, but frequently consulted with HM Treasury
Led to conflict of policy objectives e.g. 1972 Barber Boom
240
What is the difference between a policy instrument and a policy objective?
1. Objective - some target that the Bank of England tries to hit
2. Instrument - some method that the Bank of England uses to attempt to meet its target.
241
How can we separate up monetary policy instruments?
1. Those which affect the supply of new deposits
2. Those which affect the demand for new deposits.
242
What is the main objective of UK monetary policy?
Inflation control.
243
What are the two types of policy objectives?
1. Ultimate
2. Intermediate.
244
Who sets the inflation target and when was it updated?
The Chancellor set it at 2% in 2003.
245
What relationship is there between the Chancellor and the MPC?
The Chancellor sets the target and then the MPC has to meet it.
246
How often does the MPC meet?
8 times a year.
247
What is the composition of the MPC?
Governor and independent experts.
248
Did the MPC exist before '97?
No.
249
What else, apart from interest rates, can the MPC do?
Implement unconventional monetary policy, for instance quantitative easing.
250
What is the Bank Rate?
The rate of interest that the Bank of England pays the banks on their reserve accounts held at the Bank of England. Main monetary policy instrument
251
How has the government shifted away from fiscal policy since the end of Keynesianism?
Monetary policy is now the main method by which AD is controlled, through influencing demand for credit.
252
What is the difference in effect on AD of monetary policy versus fiscal spending?
Fiscal - affects G
Government spending - affects, C, I and (X-M)
253
What does the MPC consider in setting Bank Rate?
1. Inflation and expectations
2. Consumer and business confidence
3. Trend rate
4. Employment and unemployment
5. Other indicators.
254
What happens if the BoE misses the 2% CPI inflation by more than 1% either side?
The Governor must write an open letter to the Chancellor explaining why.
255
When was control of inflation not the Bank's main macro objective and what did they do?
2008-09
Needed to grow the economy at all costs by expanding AD
256
What is contractionary monetary policy?
Use higher interest rates to decrease AD.
257
WHAT DETERMINES THE OPPORTUNITY COST OF CONTRACTIONARY MONETARY POLICY?
THE SHAPE OF THE SRAS CURVE
258
When is government failure in contractionary monetary policy especially likely?
If the government induces a large negative multiplier.
259
3 ways, broadly, that contractionary monetary policy leads to a decrease in AD?
1. Reduce I
2. Reduce C
3. Affect X-M.
260
How does contractionary monetary policy decrease consumption? 4 ways
1. Increases incentive to save because interest rates on savings accounts are higher. People substitute spending for saving
2. Increase the effective cost of borrowing and hence reduce amount of income left after interest payments
3. Asset prices may fall, reducing personal wealth and hence passive income and equity withdrawals
4. Falling wealth can induce a negative wealth effect and hence declining consumer confidence
261
How does contractionary monetary policy decrease investment? 3 ways
1. Business postpone or cancel investments because they fret that the cost of borrowing makes the investment unprofitable
2. Business confidence may fall, reducing future investment
3. A decrease in consumption due to higher interest rate reduces the need to invest
262
What is the exchange rate?
The external price of a currency, usually one currency measured against another.
263
How can contractionary monetary policy affect (X-M)?
1. Incentivises people to save in pounds due to high rate of return on liquid assets
2. So people buy pounds to save them
3. The exchange rate hence rises, making imports more competitive and UK exports less competitive
BOP WORSENS
AD SHIFTS LEFTWARDS
264
What is sterling?
GBP.
265
How does expansionary monetary policy work?
1. C rises
2. I rises
3. X-M betters.
266
How does the change to (X-M) following contractionary monetary policy reduce inflation?
Reduce cost of imports for UK firms.
267
4 things which a change in the Bank Rate directly affects, via the what?
MONETARY POLICY TRANSMISSION MECHANISM
1. Market rates of interest
2. Asset prices
3. Expectations/confidence
4. Exchange rate
268
Why does a change in the BoE base rate affect asset prices, and what effect does it have?
When interest rates rise, asset prices fall
1. Fewer people buying assets
2. Increased opportunity cost of saving
Other things
269
What is the time lag in monetary policy?
The time between an initial change in Bank Rate and the resulting change in the rate of inflation
Estimated at 2 years - effect of inflation within 2 years, effect on output usually within 1
270
How significant does the BoE believe a change in Bank Rate is?
1% change in Bank Rate -> 0.2%-0.4% change in inflation after 2 years.
271
What is the transmission mechanism?
The medium of communication from an initial change in a policy instrument and the effect on macroeconomic performance.
272
Which parts of the monetary policy transmission mechanism do not affect AD directly?
The relative price of import inflation for price inelastic goods
AD not hit, but costs lower e.g. imports of raw materials
273
What is conventional monetary policy?
Measures such as the Bank Rate which are used most commonly.
274
When did conventional monetary policy break down?
In the UK, in 2008-9
The combination of a credit crunch, where banks were institutionally reluctant to lend, and depressed animal spirits and AD after a devastating and unexpected recession, led to severe challenges to AD
275
When did the Bank of England achieve its lowest interest rates?
2008 - cut to 0.5%,
2020 - cut to 0.1%, lowest ever.
276
Did conventional monetary policy work?
No. Growth was anaemic for much of the 2010s.
277
2 reasons why conventional monetary policy can fail in a deep recession, besides low consumer confidence?
1. Zero Lower Bound (ZLB)
2. Liquidity trap.
278
What is the Zero Lower Bound?
When the Bank Rate reaches 0%, it can evidently not go any further. AD cannot be stimulated further.
279
What is a liquidity trap?
When conventional monetary policy doesn't work because:
1. ZLB is reached
2. Confidence/animal spirits are too low
3. Consumers begin to hoard cash because the interest rates are so low it isn't worth buying assets with it and they prefer to feel safe
4. There are deflationary expectations
280
What kind of unconventional monetary policy may be employed which still uses interest rates and eval?
Negative interest rates
Used in Japan and ECB during post-recession
1. Banks unlikely to find such a situation profitable
2. May increase systemic risk in the banking sector. Loaners take more risks, banks become more stretched by liabilities and simultaneously, savers are likely to leave the banking sector entirely and store cash elsewhere
## Footnote
Used in Japan and ECB during post-recession.
281
What is quantitative easing?
When the Bank of England buys assets, usually government bonds, with assets the Bank has created electronically.
282
How does QE allegedly work?
1. Buy assets from banks and give them liquidity.
2. More liquidity bolsters their side of the liquidity ratio.
3. They are hence able to expand their lending.
283
Is QE new?
No, largely a spin on a 1930s policy known as 'expansionary open market operations'.
284
Does the Bank Rate affect the demand or the supply of money?
Demand.
285
How is QE fundamentally different than Bank Rate manipulation?
Attempts to influence the supply of money and not the demand.
286
When was QE started in the UK? Who had tried it before?
2009
Japan
287
What are 4 ways QE is supposed to work?
1. Those whose assets are bought go out and spend
2. Those whose assets are spent go out and buy other assets, driving up their prices, generating positive wealth and equity for the owners of those assets
3. Higher asset prices give lower yields, so lower cost of borrowing for households. Can help drive down interest rates further
4. Banks, imbued with more reserves, lend more to consumers and businesses
288
What is the weakest part of QE and how does the Bank allegedly address it? Eval?
Banks might not expand their reserves when they have their assets bought
Bank buys assets out of the private sector capital markets instead and government bonds which are privately owned
This HUGELY increases inequality
## Footnote
This HUGELY increases inequality.
289
What else does QE indirectly affect?
Business and consumer confidence.
290
What is the effect of lower borrowing costs on households?
It yields lower costs of borrowing for households and can help drive down interest rates further.
291
How do banks respond to increased reserves?
Banks, imbued with more reserves, lend more to consumers and businesses.
292
What is the weakest part of QE?
Banks might not expand their reserves when they have their assets bought.
293
What assets does the Bank buy in QE?
The Bank buys assets out of the private sector capital markets and government bonds which are privately owned.
294
What is a significant consequence of QE?
It hugely increases inequality.
295
What does QE indirectly affect?
Business and consumer confidence.
296
What is the total value of all rounds of QE deployed in the UK?
The total is 895 billion.
297
What are the values of the QE rounds in the UK?
1. QE1 - 200 billion - 2009
2. QE2 - 125 billion - 2011
3. QE3 - 50 billion - 2012
4. QE4 - 60 billion - 2016
5. QE5 - 450 billion - 2020 - largest round yet, with IR at 0.1%.
298
SYNOPTIC LINK: Why might the UK be left reliant on unconventional monetary policy so often?
INEQUALITY - QE didn't work because wealth MPC is low
299
Quantitative tightening and eval?
Selling back the assets bought, particularly bonds
No prospect given uncertainty of COVID-19 etc.
300
What are three ways QE was a success?
1. 2008-09 wasn't a depression.
2. QE in foreign countries helped stimulate the UK economy, most notably American QE.
3. Reduced strain on government.
301
How did QE reduce the strain on government?
QE made it cheaper for central government to borrow to finance its large budget deficit. Because demand for the remaining bonds was higher, driving up bond prices and reducing yields. Lower yields -> lower borrowing costs (can charge a lower percentage on future bonds to stay competitive)
302
Key, key weakness of QE?
Worsens inequality
Those who benefit the most are asset-owning people, the least likely to be left unemployed or homeless by a recession. They also used the money occasionally to buy overseas assets, which was why US QE was so good for us
303
Eval of low Bank Rate?
Savers suffer whilst borrowers gain.
304
How successful did the BoE believe QE had been?
In Q4 2012, it was estimated that the 375 billion up to that point had increased nominal GDP by nearly 6%.
305
Evidence disagreement exists about QE?
In 2013, Henderson Global Investors claimed that QE delivered a boost to the money supply only 35% of the size claimed by the BoE.
306
How was QE4 different?
It involved 10 billion set aside for corporate bonds to make it easier for firms to raise finance for investment in the capital markets.
307
What is the Term Funding Scheme?
A form of unconventional monetary policy where the BoE lends to banks at a rate close to 0.25%. If banks reduce their lending from the funds given to them by this policy, the BoE increases the rate of interest
308
2 reasons the Brexit campaign were critical of the BoE response to Brexit?
1. If the majority of those who voted voted to leave the EU, why would they start immediately hoarding cash?
2. After a volatile couple of days, the markets did calm down, when it became clear that single market membership was ensured for at least the next 2 years
309
What were three immediate economic consequences of Brexit?
1. New business investment slowed.
2. 15% depreciation in Sterling against the Dollar, leading to imported inflation.
3. Consumer spending remained strong, financed by increasing debt and reduced savings ratios.
310
What is the long-term economic consequence of Brexit?
Economists predict the UK economy is 2% smaller than it would have been without Brexit.
311
Which political body found problems with QE? What did they find?
Economics Affairs Committee, 2021
1. Not transparent enough
2. Continued use of QE to essentially finance government borrowing would reduce the credibility of the UK financial sector, making it harder to control inflation expectations and maintain financial stability
3. No plan for QT had been put in place
312
What are three types of unconventional monetary policy?
1. Forward guidance.
2. QE/QT.
3. Term Funding Scheme.
313
What is forward guidance?
Attempts to send signals to financial institutions about future Bank of England interest rate policy, so that no changes come as a major shock
314
Why is forward guidance needed?
If financial institutions believe higher interest rates are coming, they will raise interest rates and loans will tighten up. If the BoE has no intention of doing this, it must say so
315
What is the main aim of forward guidance?
To increase the credibility of monetary policy.
316
What does forward guidance act on? Depends upon?
Altering expectations
Rational, not adaptive, expectations
317
How was forward guidance overall received? Example?
Not well
Schroder's UK - called it a "bamboozling cluster bomb" of mixed messages
318
What are three problems with forward guidance?
1. Bank often ignores its own forward guidance. E.g. the first issue of FG said BoE would not raise interest rates until unemployment fell below 7%. When it did, they didn't
2. Repetitive changes in guidance before the end of the period challenged credibility. E.g. 2014 Bank unlinks forward guidance from unemployment rate, replacing it with an 18 indicator measure
3. Abandoned by Andrew Bailey, who succeeded Mark Carney in 2020
319
How might forward guidance have created government failure?
Uncertainty now bigger than when forward guidance started.
320
A contractionary monetary policy leads the exchange rate to...
How? Effects?
Appreciate against other currencies, ceteris paribus
1. Hot money inflows due to increased rate of return
2. Hence imports more competitive to exports
3. And export prices rise, decreasing export AD
321
In May 2022, the Bank Rate was 1% and the CPI 7%. What was the real rate of Bank Rate? Eval?
-6%
Net transfer from savers to borrowers which tends to improve wealth inequality
322
How can you ALWAYS evaluate a low interest rate?
Wherever CPI > IR, a net transfer from savers to borrowers occurs
323
How do we illustrate monetary policy?
Using AD/AS.
324
When was forward guidance introduced?
In 2013.
325
Regulation
Limitations on free will for firms and consumers
326
What is financial regulation?
Limiting the freedom of banks and other financial institutions and attempting to direct them towards a social equilibrium output
327
What was financial regulation like before 2001?
It was largely controlled by the Bank of England.
328
First institution for financial regulation in the UK? What happened?
1985 - self-regulatory board, the Securities and Investments Board, was created, with a limited number of regulatory powers
Hit by scandals in the 1990s, and the collapse of Barings Bank
329
Why was the Barings Bank collapse a turning point in UK financial history?
Barings was an investment bank brought down by a single rogue trader. It was a spectacular failure of self-regulation
330
Which body replaced the Securities and Investment Board and when?
Financial Services Authority (FSA), 1997
331
How was the FSA emboldened? What ultimately happened to it?
1998 Bank of England Act - given sole responsibility for the regulation of deposit-taking institutions
2007-08 failure led to Treasury abolishing the FSA and replacing it, in 2013, with 3 new regulatory agencies
332
What happened to the FSA in 2007-08?
It was abolished and replaced in 2013 with three new regulatory agencies.
333
What are the regulatory agencies that replaced the FSA?
1. Financial Policy Committee of the BoE.
2. Prudential Regulation Authority of the BoE.
3. Financial Conduct Authority, independent of the BoE.
334
Financial Policy Committee?
The part of the Bank of England charged with protecting the security of the entire banking sector against systemic risk
MACROPRUDENTIAL regulation
335
What does the FPC represent within the Bank of England?
The main way by which the Bank accomplishes its second key role - maintaining macroeconomic stability
336
Which body is responsible for macroprudential regulation in the UK?
The FPC.
337
Which body is responsible for microprudential regulation in the UK?
The PRA and the FCA.
338
What is macroprudential regulation?
Identifying and removing risks to the financial system AS A WHOLE
339
What is microprudential regulation?
Ensuring the stability of individual banks or individual groups within the financial system.
340
What weakness was there in the UK's financial regulation system pre-2008, in the broadest possible terms?
Too much emphasis on microprudential regulation and no emphasis on macroprudential regulation.
341
Which act created the PRA, the FCA, and the FPC?
The 2012 Financial Services Act.
342
What are two roles of the FPC?
1. Carry out the BoE's statutory role as a maintainer of order in the financial system
2. Tertiary to this, supporting government economic policy where it possibly can
343
3 things the PRA can do?
1. Sets standards and supervises individual firms
2. Ensures individual firms are not at risk
3. Can issue specific regulation to individual firms e.g. mandate liquidity/capital ratios for a specific firm
344
What is the fundamental role of the PRA?
Microprudential supervision of individual institutions.
345
What are four institutions regulated by the PRA?
1. Banks.
2. Building societies.
3. Credit unions.
4. Investment firms.
346
What kind of stress testing does the PRA do?
Stress testing individual firms for crisis readiness, and not the whole financial sector
347
Example of how the PRA can regulate individual firms?
Often sets mandatory capital and liquidity ratios to ensure that individual risk does not become systemic
348
What does the FCA resemble?
A sort of CMA for the banking sector, with primarily responsibility to ensure competitive markets, protect consumers and protect financial markets from outside vulnerabilities
349
What is bank capital?
The net stock of assets left behind when liabilities are subtracted from assets.
350
Why is bank capital a small part of the bank's balance sheet?
The other components e.g. commercial bonds, savings accounts are liabilities AS WELL AS assets
351
What is a key fact about the FSA?
It was an external regulator, such as Ofwat
The 1998 Bank of England Act was hence a transfer of regulatory control away from the Bank and to an external regulator
352
How has the Bank of England centralized control over financial regulation?
The creation of the FPC in 2013 was a reorganisation of regulatory power back to the BoE, and the PRA is part of the BoE
353
What relationship does the FPC have to the PRA and the FCA?
Can instruct them
354
Why did Osborne reform the financial regulation system?
Because he wanted to centralise control at the BoE and make it clear that there would never be a repeat of 2008
355
Will the PRA allow an insolvent bank to fail?
Yes, except when doing so would jeopardize the entire financial system.
356
The FPC is fundamentally assessing...
Systemic risk.
357
Are micro and macroprudential regulation separable?
No
Sometimes the failure of an individual firm is a systemic risk, where interdependence is significant enough
358
Most recent nationalisations in UK history and eval?
HBOS, Lloyds and RBS amongst others after 2008
Some banks "too big to fail"
359
Who does stress testing?
The PRA, after the FPC recommended it.
360
Second key function of the central bank after inflation control?
To maintain stability of the financial sector.
361
What is the cash ratio?
The ratio of a bank's cash and other liquid assets to its deposits.
362
Eval on FCA?
Accused of incompetence in 2015 after creating a false market for insurance shares.
363
When was fractional reserve banking debunked?
In the 2014 Bank of England paper 'Money Creation in the Modern Economy.'
364
Fractional reserve banking theorises that banks lend a multiple of...
The central bank injection, with a certain fraction left in reserve
365
The fractional reserve theory of commercial banking has been widely disputed and discredited, for instance in the Bank of England's 2014 paper Money Creation in the Modern Economy. What theory is considered more accurate than fractional reserve theory? Can you explain in simple terms how it works? What are the constraints on credit creation in this scenario?
CREDIT CREATION THEORY
1. Banks create credit.
2. Spending by consumers of this credit spreads the money around the different banks. With it, the attendant liabilities
Banks must maintain capital and liquidity ratios as mandated by the PRA, but also because not doing so risks a solvency or liquidity crisis
366
What are the constraints on credit creation?
Banks must maintain capital and liquidity ratios as mandated by the PRA.
367
What are included in a bank's liabilities?
1. Private debt.
2. Wholesale funding.
368
What are two crises that can beset a bank?
1. Liquidity crisis.
2. Solvency crisis.
369
Explanation of a solvency crisis?
Occurs when assets are worth less than liabilities
1. Assets depreciate in value. This could occur if asset prices fall or if some risky assets e.g. subprime mortgages go bad
2. Liabilities are money owed to those outside the bank, such as money from bank deposits. This cannot be used for financing a decline in asset prices
3. Only capital - net wealth, usually raised from sales of shares - can cover a depreciation in capital
4. If this cannot occur, the bank faces a solvency crisis. It owes more than it owns.
370
Which banks are most exposed to solvency crises?
Risky asset banks and size of assets.
371
How can a bank be bailed out when it is balance sheet insolvent?
Recapitalisation i.e. refill the capital part of the balance sheet with taxpayer cash
372
Why is the liquidity ratio important?
Cash and liquid assets such as gilts must be able to cover losses on the liabilities side
373
Explain a liquidity crisis
When banks run out of money to finance liabilities (what they owe to external creditors)
1. A shock occurs. Agents withdraw cash from the bank
2. The bank erodes a base of cash and gilts which is regarded as an asset. Cash and gilts are liquid because gilts can be sold with no loss on secondary markets, ceteris paribus
3. The bank runs out of money and faces a liquidity crisis (bankruptcy)
374
What type of liability is most likely to go bad during a liquidity crisis?
"Flighty" funding e.g. money on short and call notice
375
SONIA relation to IR?
Usually higher than bank rate, and follows base rate, since banks have less demand for interbank cash when reserve accounts are full
376
WHY DO WE NEED BONDS? Eval?
1. When the government spends, it fills reserve accounts
2. Filling the reserve accounts reduced SONIA
3. The government hence issues bonds to drain the reserve accounts. Banks buy bonds and gain a liquid asset rather than pure liquidity. Demand for money rises again
4. SONIA returns to target rate
QE. QE refilled reserve accounts by buying the assets of banks and giving them back the money. Again SONIA fell, and the Bank Rate is now more important. This is why the BoE thought QE this would drive IR down, despite poor credit ratings
377
What is bankruptcy?
When the bank is insolvent.
378
What is wholesale funding?
Raising money from non-retail sources, including interbank lending
379
What is the main cause of systemic risk?
Interbank transfers TRANSFERRING LIABILITIES AS WELL
380
What does QE do?
QE refilled reserve accounts by buying the assets of banks and giving them back the money.
381
What is the main cause of systemic risk?
Interbank transfers TRANSFERRING LIABILITIES AS WELL
382
What is a liquidity crisis?
A liquidity crisis occurs when a bank does not have sufficient liquidity at hand to meet external demands for credit.
383
What protects creditors against a fall in the value of assets?
Capital.
384
What key thing can increase confidence in the stability of the banks against liquidity and solvency crises?
Bank of England LENDER OF LAST RESORT status.
385
Why is the LENDER OF LAST RESORT function necessary?
Banks borrow short-term, but lend long-term
E.g. they may borrow overnight money on the INTER BANK MARKET and then issue long term loans such as mortgage loans
386
Example of moral hazard in the banking sector
pre-2007 - firms take too many risks and accept more risky assets which have high profitability but low liquidity, enticed by the promise of high profits but insulated from the risk of bankruptcy
387
What are two reasons for bank failure?
1. Insufficient liquidity
2. Insufficient capital
388
What happens if capital is exceeded by asset depreciation?
A solvency crisis occurs, and the bank must cease trading.
389
What is the capital ratio?
The amount of capital on a bank's balance sheet as a proportion of its loans.
390
What is the credit crunch?
A severe shortage of money or credit.
391
What market was largely responsible for the credit crunch and how?
Inter-bank market
1. BNP Paribas' failure to honour creditor demands in 2007 kickstarted the crisis
2. Interbank lending lead to "originate and sell" rather than "originate and hold". Banks sold assets to one another to supplement their balance sheets, but there was INFORMATION FAILURE. Sub-prime mortgages often marked as prime
3. Interbank lending broke down in the crisis, interest rates soared, lenders could not borrow to finance aforementioned debts and subsequently the market seized up
392
3 effects of the financial crisis on the real economy?
1. Collapse in confidence and AD shifts left, causing recession
2. Asset prices fall, creating negative wealth effect
3. Huge deficits had to be run to support AD and to nationalise banks due to systemic risk
393
What is M0?
Physical cash.
394
5 FUNCTIONS OF FINANCIAL MARKETS
1. Saving function
2. Market for equities
3. Forward markets for insurance against risk
4. Exchange of goods and services
5. Finance for businesses and individuals
395
What is the main cause for demand for credit?
Buying a house.
396
What is the conventional model of how banks make profit?
Differential interest rates on savings accounts versus loans.
397
Why is there a liquidity profitability trade-off?
1. Higher interest rates can be charged on assets lent out for a long time
2. Some assets such as bonds - the asset can be bought low, and earn interest + maturity. Closer to maturity date, the price approximates the bond face value
398
When was the Big Bang?
1986.
399
What is the CCyB?
Countercyclical capital buffer rate.
400
What is the liquidity coverage ratio?
Liquidity coverage ratio measures how ready a bank is to cover liabilities in the event of an economic shock.
401
What is the role of the Financial Policy Committee (FPC)?
Directs other regulators.
402
What is the main determinant of LIBOR?
BoE Bank Rate.
403
What influence does the interest rate have on house prices?
Lower interest rates make mortgages cheaper, driving up effective demand for housing stock.
404
What is the effect of interest rates on exchange rates?
Lower interest rates lead to depreciation of the currency.
405
What is the purpose of quantitative easing (QE)?
To create money for the Bank of England to purchase bonds.
406
What happens when interest rates rise?
Consumers may enter a debt spiral that becomes unaffordable.
407
What is the liquidity coverage ratio?
Measures how ready a bank is to cover liabilities in the event of an economic shock.
408
What is the difference between capital ratios and liquidity ratios?
Liquidity ratios measure cash available for current liabilities, while capital ratios measure net equity.
409
How have private healthcare providers aimed to reduce the moral hazard?
Deductibles - require an initial fee from the consumer
410
What is the liquidity coverage ratio?
How ready is a bank to cover liabilities in the event of an economic shock
411
Why are capital ratios and liquidity ratios a balancing act?
Inactive assets, which reduces profitability
412
Distinguish between capital ratios and liquidity ratios.
Liquidity ratios - what percentage of a bank's assets are cash available for current liabilities
## Footnote
Capital ratios - what percentage of a bank's net equity are capital
413
What is a stress test?
How able is a bank to provide credit to the real economy in the face of an economic downturn or economic shock
414
How can capital be thought of?
The difference between assets and liabilities
415
How much was spent on bailouts in the UK in 2009?
850 billion GBP
416
What was the LIBOR fixing scandal?
Tom Hayes of UBS fixed LIBOR for years, went to prison
417
What is the main source of financial market failure?
Asymmetric information
418
Give an example of how financial market failure can occur under normal circumstances.
Hedge fund and asset managers receive commission from making asset bubbles, so may collude to do so, disrupting the real economy e.g. by overvaluing houses
419
True or false; the price of government bonds falls during QE.
FALSE!
420
How can QE's effect on asset prices worsen inequality?
Drive up house prices etc. and make them unaffordable for average people as bondholders divest
