Download - Comm Bkg, Sessions 1-8
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Financial Intermediation and Banking-Theoretical Foundations
Prof. Santosh SangemXLRI, Finance Area
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Most regulated of all financial entities Bank deposits a widely used form for settling economic
obligations.
Also widely misunderstood
Banks are Dinosaurs .(Bill Gates, quoted in O Sullivan,1996)
The banking industry is dead, and we ought to just bury it(Dick Kovacevich (CEO, Norwest), quoted in Davis,1999)
The Banking Sector is becoming irrelevant economically andits almost irrelevant politically (William Isaac, FormerChairman, FDIC; quoted in Boyd and Gertler (1994))
Why Study Commercial Banks?
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Why Study Commercial Banks?
Prominent role of banks in almost all major financialcrises during twentieth century The U.S. Banking Panic of 1907
The Great Depression
Savings & Loan Crisis of the 1980s Continental Illinois Bank Failure of 1984
Asian Financial Crisis of 1997-98
The Sub-Prime crisis/Credit crisis of 2007-
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Why Study Commercial Banks?
Costs of Banking Crises Direct costs of restructuring banking sector
Lowered GDP growth
Estimates of impact from 5% of GDP to 300% of GDP
Banking crises accompanied by crises in other parts of financialsystem and currency crises
A Paradox
Economic booms and claims of growing irrelevance of banks inmodern economies
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Some Typical Issues
Are banks special or not??? Banks and external macro-environment
Regulation as the provider of incentives/disincentives
Deposit Insurance and Capital Maintenance requirements
Liquidity Maintenance & Management
Risk Management & Financial Innovation
Off- Balance Sheet Activities of Banks & Securitization
Excessive Risk Taking and Bank Failures
Banks are Financial Intermediaries
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Banks and Non-Financial Firms
Both finance themselves through equity and borrowed funds Both invest funds raised in income generating assets
Surplus over expenses paid to providers of capital
Too many similarities on the surface. But are they really similar?
A closer look at balance sheet composition
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Banks and Non-Financial Firms
Assets ManufacturingFirms Banks
(% of Total Assets)
Net Fixed Assets 50%-60% 3%-5%
Investments 10%-20% 25%-30%Current Assets 20%-40% -
Loans & Advances (incl. in CurrentAssets)
40%-60%
Reserve Balances with CentralBank - 3%-5%
Inter-Bank Balances - 5%-10%
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Banks and Non-Financial Firms
Liabilities ManufacturingFirms
Banks
(% of Total Assets)
Net Worth 40%-50% 5%-10%
Long-Term Borrowed Funds 30%-40% 0%-5%
Short-Term Borrowed Funds &Current Liabilities
10%-25% 0%-10%
Deposits from Customers - 75%-90%
Contingent Liabilities 15%-20% 200%-400%
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Banks and Non-Financial Firms
Financial Assets as Major Component of Bank Assets Loans as Primary Assets
High Financial Leverage
Low Net Worth
Deposits as Primary Source of Bank Funds Typically interest cost of deposits is much lower than cost of
borrowed funds for manufacturing firms
Inter-Bank Balances and Reserve Balances
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Banks and Non-Financial Firms
Much higher financial risks of banks relative to other firms Business of Banking
Taking up a variety of financial risks to make profits
Reducing Financial Risks through reduction of leverage
Reduction of Profitability
Importance of Off-Balance Sheet Transactions for Banks
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What is Financial Intermediation
Intermediaries as third parties Financial intermediaries (FIs) intermediate between providers and
users of capital
Some FIs use their resources to borrow from the providers of
capital and lend to users of capital
FIs as providing valuable services to both providers and users ofcapital
Which services do they provide?
Why are they able to provide these services?
Are these really useful for both providers and users of capital?
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Direct Finance
Direct finance a transaction between provider and end-user ofcapital
Both meet and exchange funds for financial assets
Borrowers
(deficit budget unit)Lenders
(surplus budget unit)
Flow of Funds
Primary Security
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Issues with Direct Finance
Direct finance an expensive means of transacting for savers andborrowers
Total information collection and processing = 2N2
Lesser extent of diversification for savers and borrowers
Liquidity risk for savers
An intermediary to collect, process, and match requirements (Abroker)
Total number of transactions = 2N
Savings equivalent to 2(N2 N) * cost per transaction
The screening function of financial intermediaries
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Issues with Direct Finance
When would such brokers come ahead? Private nature of information
Re-usability of information
Specialization and scale economies over time
Role of profitability and entry barriers
Asymmetric information and ex-post screening??
Liquidity risk for savers?? Portfolio diversification for savers??
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Indirect Finance
Savers
(surplus budget unit)
FlowofFunds
PrimarySe
curity
Financial Intermediary
Flow
ofF
unds
Borrowers
(deficit budget unit)
PrimarySecurity
Indirect finance as risk-taking by Financial Intermediaries
Portfolio diversification benefits, liquidity creation, and ex-postmonitoring
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Qualitative Asset Transformation
Demand from savers for liquidity risk management services Risk aversion of providers of capital
Risk of default of borrower replaced with risk of default ofFinancial Intermediary
Liquidity creation and provision
Maturity transformation and mismatched balance sheets
Business of managing financial risks
Interest spread as primary source of income
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Issues in QAT
Characteristics of the Financial Intermediary
Capitalization
Ability to manage financial risks, especially liquidity risk
Resources for ex-ante screening and ex-post monitoring
Transaction costs for savers in monitoring the financial intermediary??
Reducing this element of transaction costs??
Total costs of screening and information collection = N Make the liabilities of FIs risk-free for savers
Insured deposits
Characteristic of only banks
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What else do Financial Intermediaries do?
Functions performed by FIs The brokerage function
Adverse Selection, Screening, and Information Collection
Scale economies & reusability of information
Moral hazard and post-funding monitoring Providing funds just one activity of financial intermediaries
Other services provided by FIs
Transaction services
Financial advisory Issuances
Guarantees
and so on
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Lack of clear and well-accepted definitions of bank Definition by functions
Definition by services
Definition by legal basis
Definition by functions/services as inadequate Changing nature of functions & services provided by banks
Definition by legal basis Issue demand deposits and making business loans
Qualified for deposit insurance
Definitional Issues
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Banks are financial institutions that are privileged by the laws of anation to have thepower to issue deposits that are payable ondemand and which deposits are also generally accepted by economicagents in final settlement of transactionsbetween them
Emphasis on payments/transaction services
Regulations as laying down boundaries on activities of banks
Definitional Issues
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But why do banks exist
Debate on rationale for existence of banks Transaction cost & Asymmetric information based theories
Scale economies in information collection, monitoring, andliquidity provision
Debt as a contract brings forth optimal behavior from users offunds Agency Costs
Banks exist to deal with ex-ante & ex-post informationasymmetries
Industrial Organization based theories Banks as portfolio managers for depositors
Arguments equally applicable to other financial intermediaries
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But why do banks exist Incomplete Markets Theories
Typical providers of capital are risk averse
Need to manage liquidity risks across time
Bank deposits as a risk-free liquid asset
Banks (and other FIs) provide a variety of risk management servicesto providers and users of capital
Understand banks in terms of their role in the functions of afinancial system
Providing a payments system for the exchange of goods and services
Pooling of funds for undertaking large-scale indivisible enterprise
Transfer economic resources across time, industries and geographicallocations
Managing uncertainty and controlling risk
Provide price information
Provide a way to deal with asymmetric information
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But why do banks exist
Other rationales Banks as providing a means of payment
Banks as the central players in transmission of monetary policyactions
Banks as having ability to create liquidity to business throughprovision of funds
Why the unique role of banks in payments and provision of risk freeliquid asset?
History of banks and bank regulation
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A brief history of banking
The Medici Bank (1397) as the first formal bank Early banks serving the needs of merchants Money changer banks
and merchant banks
Large number of failures in Continental Europe driven by bad
debts
Charters to deposit banks - primarily transaction services
Another objective of charters to finance the governments needs
Banks also as safe-keepers of money
Banks as universal banks
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A brief history of banking
The growth of fractional reserve banking Logic of un-coordinated withdrawal requirements of depositors Wider reach and accessibility
Large number of bank failures in 19th century and early 20th century
Bank failures attributed to liquidity problems and undue risk taking
US banking panic of 1907 and the creation of the federal reserve Lender of last resort
The Great Depression Deposit Insurance
Glass-Steagall Act
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A brief history of banking
Deposit insurance and risk-free deposits Commercial banking under Glass-Steagall Act
Banks to provide only loans to business and governments
Banks as sole entities to issue deposits
Competition among banks as a destabilizing factor Interest rate controls
Restrictions on geographical expansion
The introduction of reserve requirements
Payment of deposit insurance premium
Capital Maintenance The early forms
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A brief history of banking The US Scenario
Competition from foreign banks for customer deposits
Rise in interest rates since the late 1950s
The response financial innovation Eurodollar deposits, inter-bank repos, commercial paper, etc
Financial innovation driven by demand of depositors and borrowers
Increasing competition from non-bank financial intermediaries Declining profitability and viability of banks
Dangers of losing monopoly position in payments function
The regulatory response leveling the playing field Deregulation
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Lender of Last Resort Objective of ensuring stability of banking sector
Liquidity problems as the primary cause of bank failures
Lack of liquidity when needed the most during crises
Essentially a government set-up agency
Provision of short-term loans to banks facing temporary liquidityproblems
Principles of LOLR function
Lend only against good collateral
Accept all good collateral
Penal rate of interest on loans
Policies as public knowledge
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Deposit Insurance Objective of Deposit Insurance
Protection of savings of depositors
Banking failures and bank runs primarily a result of liquidityproblems
Early private solutions like mutual agreements, own deposit
insurance schemes, etc. The credibility problem breakdown of the pooling arrangements
Provision of liquidity post failure
The solution - governments to provide deposit insurance
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Deregulation of banking Removal of administered interest rate regimes
Removal of portfolio restrictions on banks
Increasing scope and nature of activities allowed to banks
Setting up of financial markets and introducing a wider range offinancial instruments
Allowing a greater variety and number of non-bank financialintermediaries to be setup
Allowing easier entry to foreign banks
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Continental Bank & Thrifts A common problem with all deposit insurance schemes
Moral Hazard
Continental Illinois Bank the first post-war failure of a large bank
Multiple failures in the S&L industry
Some common features
Excessive risk taking on the asset side
Short-term non-deposit funds and maturity mismatches
The regulatory response Risk-based capital requirements (Basel-I)
Innovations in payments systems and short-term liquiditymarkets
M l H d d th T Bi T F il
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Moral hazard as the taking on of more risk than warranted in theabsence of a safety net
Deposit insurance and moral hazard in banking
More acute moral hazard problem for large banks
Creditors of large bank with an implicit government guarantee as torepayment in event of failure Contagion effect of large bank failures
Better safe than sorry approach of regulators
Moral Hazard and the Too-Big-To-Fail
Problem
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Basel Norms Basel-1 introduced in developed economies in early 1990s
Objective of ensuring sufficient capital maintenance
Leveling global playing field
Capital Requirements
Risk-Weighted Assets
Tier 1 and Tier 2 Capital Instruments
Basel-1 and Credit Risk
Standardized Risk Weights
Basel 1.5 and Market Risk
Growing importance of market traded securities
Tier 3 Capital Instruments
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Repeal of Glass Steagall Act Growing size of investment banks and other non-bank financial
intermediaries
Scope for profitability and risk diversification for banks
Glass-Steagall Act as final set of restrictions on banks
Repealed in 1999
US Commercial banks free to provide all kinds of financial services The universal bank model
Some reservations Conflicts of interest
Higher risks with securities activities
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Traditional Services
Safekeeping of assets
Currency exchange
Providing business loans
Discounting commercial bills
Demand deposit & Savings deposit accounts
Financing governments
Providing guarantees
Services offered by Modern Banks
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Relatively recent trends
Consumer lending
Financial advisory
Equipment leasing
Cash management
Venture capital finance
Mutual funds & Portfolio management services
Selling insurance & Retirement policies
Securitization Investment banking
Risk management
And so on
Services offered by Modern Banks
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Banking Structures
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Increasing activities of banks driven by competition Search for higher profits
Exploiting economies of scale and scope
Asset-side competition Investment (Merchant) banks, Venture capital funds, Financial markets,
Mutual funds, Pension funds, Hedge funds, etc
Liability-side competition Money market mutual funds
Investment banks
Insurance companies
Other Financial Services Securities Brokers
Investment banks
Competition as a driver of change
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Competition and ConsolidationAssets SizeNumber of
Banks < $100 M $100M - $1B $1B - $10B > $10B
10,242 7,123 2,741 331 631995(69.55%) (26.76%) (3.23%) (0.62%)
9,451 6,147 2,900 331 731997
(65.04%) (30.68%) (3.50%) (0.77%)8,580 5,157 3,029 318 76
1999(60.10%) (35.30%) (3.71%) (0.89%)
8,080 4,486 3,194 320 802001
(55.52%) (39.53%) (3.96%) (0.99%)7,769 3,911 3,434 341 83
200350.34% 44.20% 4.39% 1.07%
7,630 3,655 3,530 360 852004 (47.90%) (46.26%) (4.72%) (1.11%)
Asset SizeTotalAssets < $100 M $100M - $1B $1B - $10B > $10B
$4,116 $310 $668 $1,077 $2,0611995
(7.54%) (16.22%) (26.17%) (50.07%)
$4,642 $277 $711 $995 $2,6581997
(5.97%) (15.32%) (21.45%) (57.27%)
$5,735 $243 $755 $915 $3,8231999
(4.23%) (13.16%) (15.96%) (66.65%)$6,569 $222 $819 $915 $4,613
2001(3.37%) (12.47%) (13.93%) (70.22%)
$7,603 $201 $910 $947 $5,5452003
(2.64%) (11.97%) (12.46%) (72.93%)
$8,413 $189 $953 $973 $6,2972004
(2.25%) (11.33%) (11.57%) (74.85%)
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M&A activity in banking on rise since the 1990s
Driven by competition and the exploitation of scale economies Tendency of banks to grow larger (e.g. Number of German banks reduced
by 35% between 1997 and 2008 )
Dismantling of Glass-Steagall and the rise in Mega-Mergers
Providing greater product diversity to customers
Greater efficiency in risk management, liquidity and capitalmanagement
Stability and bank size changing regulatory trends
Removal of geographical expansion restrictions
Competition and Consolidation
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Cost indivisibility Higher share of fixed costs
Indivisibility of reputation
Financial economies of scale Netting and liquidity requirements
Portfolio diversification and equity requirements
Claimed benefits of consolidation on banking sector efficiency Lowered costs for customers
Competitive pricing of deposits and loans
Broader access to banking services
Sources of Scale Economies
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The growth of Universal Banks since the 1990s Provide a broad range of financial services and products
Dominant structure of banks in Continental Europe
Claimed Benefits Cross-Selling of Products
Better resource utilization for common activities
Information re-use
From Bank Holding Companies (BHCs) to Financial HoldingCompanies (FHCs) BHCs restricted from carrying on most non-banking activities
Repeal of Glass Steagall Act & removal of restrictions on M&A
Difference in type of M&A transactions since 1999-00.
Sources of Scope Economies
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The financial innovation cycle Development of a new product
Selling product to existing clientele
Duplication of product by other banks & FIs
Widespread use and active trading on financial markets
Key drivers of financial innovation Search for profits by banks
Competition
Regulatory restrictions
Low and stable interest rate environment
Financial Innovation
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Two post-war eras of financial innovation 1950-mid 1980s
Mid 1980s onwards
High Return vs. Risk Sharing Products
Demand driven financial innovation vs. Supply push financialinnovation
Rapid growth of non-bank financial intermediaries
A clientele for new financial products Sophisticated clientele searching for better yields
Shift towards developing risk sharing financial products
Financial Innovation
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Creating stable return distributions for clients
Demand Side Factors
Managerial Self-Interest
Bankruptcy Costs
Capital Market Imperfections Participation Costs
Increased Cross-border Transactions
Supply Side Factors
Technology
Transaction Costs
Competition & First Mover Advantage
Risk Sharing Innovations
Off-Balance Sheet Activities of Banks
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Rapid growth in off-balance sheet transactions of banks Fee-based incomes
Trading profits
Increasing importance of derivative contracts Nominal Amt of outstanding derivative contracts nearly USD 700 trillion
Banks and other FIs as dominant counterparties Risk reducing transactions?
Clientele effect and Market segmentation
Risk appetites differ across different investor categories Better risk sharing
Increased liquidity risks
Off-Balance Sheet Activities of Banks
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Frequent occurrence of banking crises and greater instability ofbanking sectors
Liquidity problems as primary driving forces of bank failures
Increased concerns with bank solvency since the mid1980s
Belief of solvency problems as an outcome of undue risk taking
Adequate maintenance of capital by banks as a solution to limit undue risktaking
Regulatory separation of liquidity problems and solvency risks
Shift of regulatory approaches from micro-management tosupervisory
Re-Recognition of Contagion post East Asian Crisis
Bank Regulation : Shifts in Thought
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Systemic risk as the risk of failures in a set of financial markets/financial intermediaries Macroeconomic Factors & Systemic Risk
Asset Markets & Systemic Risk
Contagion as thespreadof problems from one intermediary/market
to other intermediaries/markets
Bank Runs?
Banking sector most prone to systemic crises & contagion
Loss of depositor confidence Inter-linkages between banks Inter-bank markets
Inter-linkages between banks Counterparties in financial markets
Systemic Crises & Contagion
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Moral hazard effect of deposit insurance Risk taking by banks needs to be monitored and restrained
Preventing disruptions in payments and settlement systems Bank deposits as money
Banks as largest players in payments & settlement systems Systemic Risk
& Contagion
Opacity of risks taken up by banks Depositor Safety
Monitoring the monitor Banks as agencies monitoring behavior of borrowers
Enhanced efficiency of banks Maintenance of competitive conditions
Consumer Protection
Bank Regulation : Some Rationales
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Shift to prudential regulation principles Safety and soundness of financial system as a whole
Depositor protection
Regulators as not micro-managers
Regulatory costs and financial system efficiency
Creation of an enabling operating environment Reducing regulatory disparities
Some prudential regulation measures Capital adequacy norms
Risk measurement practices Sectoral credit limits
Disclosure & accounting practices
Shift towards self-regulatory organizations
Bank Regulation- Prudential Regulation
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Traditional view of regulation as a solution to negative externalities
Regulation as the outcome of a bargaining process betweenregulators and interested entities
Pervasive regulation as an outcome of rational self-interest of
powerful interest groups
Regulation formulation as an optimal solution to the claims of allinterested parties Doubts on the efficacy of regulation
Regulation as more of a satisfactory give and take solution
Regulation and Social Benefits???
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Term structure as the schedule of interest rates across differentmaturities
Interest rate for a risky asset = Interest rate on risk-free asset + riskpremium
Government securities as risk-free assets default risk free
Some general observations about interest rate behavior Yield curves almost always slope upwards
When short term rates are very high, yield curves likely to have a negativeslope
Interest rates on bonds of different maturities move together over time
An important point Each yield curve has an underlying set of assumptions about default risks at
different maturities
Theories of Interest Rate Term Structure
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Expectations hypothesis Long-term interest rates as expected values of future short-term rates
No specific preference for a particular maturity by bond investors (i.e. allmaturities as perfect substitutes)
Explains only downward sloping yield curves and co-movement of bondinterest rates
Cannot explain typical observation of upward sloping yield curves
Market segmentation hypothesis Investors concerned with both interest rates & maturities
Different categories of investors with different maturity preferences &
interest rate risk tolerance Smaller maturities with very low interest rate risk
Explains only upward sloping behavior of yield curves
Theories of Interest Rate Term Structure
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Liquidity Premium Theory Explains all 3 observations
Key assumption that different maturities as imperfect substitutes
Investors as risk averse need increasing reward for bearing higher levelsof interest rate risk
Interest rate as comprising two components expectation of future short-term interest rates and liquidity premium for the corresponding maturity
Rise in current short-term interest rates as a signal of higher future short-term rates. So interest rates on different maturities move together.
Inverted yield curve an abnormal occurrence only when expectations of avery sharp fall in future interest rates
Theories of Interest Rate Term Structure
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The Monetary Policy Framework
Goals
Targets Operating Targets
Intermediate Targets
Operating Instruments
Monetary policy targets Money Supply
Interest Rates
Exchange Rates
Inflation
Banks & Monetary Policy
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Monetary Policy Interest Rate Targets On the very short-end of the yield curve
Domestic inter-bank interest rates
Overnight repo rate
Overnight call money interest rates
Central banks typically as short-term lenders of reserve balances intra-day
overnight
short-term
Provision of reserve balances against collateral Government securities as accepted collateral
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Other Monetary Policy Targets Money supply targeting
Very commonly used until mid-late1980s
Monetary policy instruments to change the amount of money supply
Breakdown due to financial innovation & money multiplier instability
Definitional issues for money supply High powered money (M0), Narrowmoney (M1), Broad money (M3), and so on.
Not much used in practice
Exchange rate targeting Adopted by economies heavily dependent on international trade
Economies must be small relative to global economy
Fewer options for central banks
Inflation targeting Extremely popular since late 1990s
Monetary policy instruments design to control inflation
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Monetary Policy Tools
Changes in Money Supply Reserve Requirements
Open Market Operations
Discount Window Loans
Temporary Liquidity Provision Repos & Reverse Repos Standing Facilities
Other instruments
Inflation forecasts Credible Signaling
Moral Suasion
Market-based operations through g-sec markets
Alternative classification of monetary policy
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te at ve c ass cat o o o eta y po cy
instruments Portfolio Restrictions
Reserve balance requirements
Sectoral lending floors and ceilings
Interest Rates and Liquidity Provision Discount window & the Bank rate
Standing facilities loan and deposit of reserves
Interest rates on reserve balances
Repos & Reverse Repos
Outright purchase transactions
Interest rate changes by central banks Feed through inter-bank interest rates and other short-term money market
instruments
Monetary Policy Impact on the Economy-
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y y p y
Some Facts Unanticipated changes in monetary policy have only transitory
effects on interest rates
Unanticipated tightening of monetary policy is followed bysustained declines in real GDP and the price level
Aggregate demand changes relatively quickly compared to changes
in production. Inventories change quickly in the short-run
The earliest and sharpest changes in aggregate demand occur inresidential investment
Spending on consumer goods lags changes in residential investment
Capital investment by business lags changes in consumer goodsspending
Unconventional Monetary Policy Measures in
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y y
Emerging Economies during the Credit Crisis
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Two sets of markets Goods Markets
Financial Markets
The Goods Market Equilibrium Condition Investment = Savings
The Financial Markets Equilibrium Condition Demand for Money = Supply of Money
Central role of interest rates
Liquidity Preference
Monetary policy as operating upon the financial marketsequilibrium
The IS-LM Model :A Quick Refresher
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Why do people demand money? To meet their day-to-day transactions (transactions motive)
To meet unforeseen future liquidity requirements (precautionary motive)
To take advantage of expected profitable avenues (speculative motive)
Demand from first two motives relatively stable
Two sets of assets in financial markets Money & Financial Securities
Increasing interest rates on securities lower demand for money
Supply of Money & Financial Securities unchanged
Increase in money supply lower rates of interest on securities Supply of financial securities unchanged
IS-LM: Financial Markets Equilibrium
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LM curve construction assumes unchanged supply of money and
financial securities One LM curve per money supply-financial securities supply configuration
Suppose the supply of financial securities increases Interest rates would increase
Suppose the supply of money decreases Interest rates would increase
Inflation in IS-LM model Some part of money supply increase as higher transaction balances
More money chasing same amount of goods
Inflation as the result
IS-LM: Financial Markets Equilibrium
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IS-LM model as the basic logic for explaining effects of monetary
policy actions
But why only banks as conduits for monetary policy?
The role of reserve balances
Reserve balances akin to minimum deposit balances Central banks as monopoly creator of reserve balances
Increase the cost to banks of expanding their balance sheets?
Resort to other mechanisms by banks e.g. inter-bank lines of credit
Central banks as having power overmoney supply Definitions of Money Supply
Reduced over time money multiplier instability
Switch to targeting interest rates Money Supply the adjusting variable
IS-LM: Financial Markets Equilibrium
Other Monetary Policy Channels
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Credit channel Credit rationing is a pervasive phenomenon
Always some fringe borrowers
Monetary policy actions & interest rate on all credit
Monetary policy as influencing the size of this fringe Reduction of interest rates & decline in size of fringe
Increase in interest rates & increase in size of fringe
Two different sub-channels Balance Sheet Channel
Bank Lending Channel
y y
Other Monetary Policy Channels
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Balance Sheet Channel Net-Worth, Adverse Selection, & Moral Hazard
Asymmetric Information & External Finance Premium
Borrowers having short-term/floating rate debt
Value of Collateral
Bank Lending Channel A set of borrowers solely dependent upon banks for credit
Monetary policy as primarily influencing cost of credit for such borrowers
Same logic as for Balance Sheet Channel
y y
Other Monetary Policy Channels
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Bank Balance Sheet Channel & Bank Capital Channel Recent developments
Credit channel implications
Monetary policy actions as not restricting bank asset growth
Portfolio reallocations and change in risk aversion of banks the outcome
Capital levels of banks an important consideration in the nature of portfolioreallocations
y y
Interest Rate Channel
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GDP
Money SupplyExpected
Inflation
Real Interest
Rates
Investment
Balance Sheet Channel / Bank Lending
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g
Channel
Money Supply ExpectedInflation
GDPInvestment
Bank Loans
BorrowerNet Worth
Moral HazardAdverse
Selection
Exchange Rate Channel
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Money Supply Short-TermInterest Rate
Expected Long-
Term InterestRate
Expected
Exchange Rate
Net Trade
Balance
GDP
Investment
Tobins q Channel
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GDP
Money SupplyExpected
Inflation
Tobins q
Investment
Unanticipated Price Level Changes Channel
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Money Supply
Unanticipated
Price LevelChange
Moral Hazard
Adverse
Selection
Investment GDP
WindfallBusiness
Profits
Bank Loans
Cash Flow Effects Channel
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Money Supply NominalInterest Rates
Moral Hazard
Adverse
Selection
Investment GDP
Business CashFlows
Bank Loans
Wealth & Debt Effects Channel
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Money SupplyExpected Price
Levels
Financial
Asset Prices
Wealth
Likelihood of
Financial
Distress
Consumer Durables
& Hsg ExpGDP
Consumer Debt
Capacity
Liquidity Effects Channel
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Money Supply Expected PriceLevels
Financial
Asset Prices
Likelihood of
Financial
Distress
Borrowing
Capacity
Investment;
Consumer Durables
& Hsg Exp GDP
Bank Balance Sheet Channel
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Money Supply
AdverseSelection
ExpectedInflation
Moral Hazard(Bank)
GDPInvestment
Bank Loans
Bank Capital Channel
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Money Supply
Govt. Securities
InterestRates
Capital Gains
on Securities
Portfolio
GDPInvestment
CapitalAdequacy
LevelsLoans
Bank Liquidity Preference (Risk Aversion)
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Channel
Money Supply InterestRates
Cost of BankFunds
GDPInvestment
Bank Risk
AversionLoans
Bank Liquidity Preference (Risk Aversion)
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Channel
Money Supply InterestRates
GDPInvestment
Bank Risk
AversionLoans
ExpectedInterest Rates
Monetary Policy Transmission Channels A
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Summary
Monetary Policy Transmission Some Key
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Monetary policy actions will not always lead to a changein long-term interest rates
Prices & conditions in other short-term debt markets arecritical to the efficient transmission of monetary policy
Financial health and risk aversion of banks critical to theefficient transmission of monetary policy
Unanticipated fluctuations in inflation are to be avoided as
they have significant impact on economic activity
Central bank policies will be most effective only whenthey are not anticipated by economic agents
Lessons
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to regulate the issue of Bank Notes and keeping ofreserves with a view to securing monetary stability inIndia and generally to operate the currency and creditsystem of the country to its advantage
Multiple objectives for RBI Regulate the issue of currency
Monetary Stability
Operating credit system
Monetary Policy in India Mandates of RBI
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Monetary Stability Price stability
External value of rupee exchange rate
Banking sector stability
Operating credit system Adequate credit to productive sectors
Accelerate economic growth
Policies of the RBI
Monetary Policy Credit Policy
Problems in balancing conflicting requirements
Monetary Policy in India Mandates of RBI
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Portfolio Restrictions Cash Reserve Ratio
Statutory Liquidity Ratio
Priority Sector Lending
Selective Credit Control
Interest Rates and Liquidity Management Discount window - Term Loans, Bank rate, Marginal Standing Facility
Standing facilities Liquidity Adjustment Facility
Repos & Reverse Repos
Outright purchase transactions
Market Stabilization Scheme
Monetary Policy Instruments in India
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Pre 1984 Inflation as a result of supply shocks
Selective credit control
1984-1998
Monetary Targeting Reserve requirements as operating instruments
M3 as intermediate target
Shift to Interest Rate Targeting Call money rate as the operating target Introduction of Liquidity Adjustment Facility
Development of money markets
Monetary Policy Targets in India
i i i i
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Monetary Policy Decision Making Process
CRR & SLR
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Portfolio Restrictions - low yield assets
Not much used post liberalization
Changes affect interest rates and bank asset expansion
No fine-tuning - for large changes only Used sparingly by RBI
Decreasing trend since liberalization
Primarily used for sterilizing expansionary effect of governmentborrowings
Currently CRR = 6% ; SLR = 24%
CRR & SLR
CRR
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CRR as a percentage of net demand and time liabilities Excludes inter-bank deposits & foreign currency deposits
Basis of average fortnightly deposits (Saturday-Friday)
To be maintained in full by next reporting Friday (i.e. after onemore fortnight)
Interim 70% daily maintenance
Penal interest First day(bank rate + 3% p.a.); Subsequent days(bank rate + 5% p.a.)
No Interest on CRR balances
Only Reserve Balances with RBI as qualified assets
CRR
SLR
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SLR as a percentage of net demand and time liabilities Excludes inter-bank deposits & foreign currency deposits
Basis of average fortnightly deposits (Saturday-Friday)
To be maintained in full each day until next reporting Friday(i.e. after one more fortnight)
Penal interest First day(bank rate + 3% p.a.); Subsequent days(bank rate + 5% p.a.)
No interest by RBI on SLR balances
Cash balances (after meeting CRR), Gold, Government
Securities as qualified assets
SLR
Liquidity Adjustment Facility (LAF)
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Provision of overnight & intra-day liquidity to banks Repurchase transactions in government securities
Daily LAF Auctions
Repo rate as signal of short-term liquidity cost
The operating target of RBIs monetary policy Repos to provide intra-day liquidity
Repos only for g-sec holdings over SLR
Reverse Repos to absorb excess liquidity
Repo rate 100 bps Marginal Standing Facility to provide distress liquidity
Max limit -1% of NDTL
Repo rate + 100 bps
Liquidity Adjustment Facility (LAF)
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Other Monetary Policy Instruments
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Priority Sector Lending Norms 40% of total advances
Market Stabilization Scheme (MSS) For long-term liquidity position
Special Dated Securities & T-Bills issued by GOI Money raised from banks kept in a separate account
MSS securities qualified for SLR maintenance
Multiple Indicator Approach
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Monetary Policy of RBI & Other Central
B k
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Banks
P t & S ttl t S t
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Payments & Settlement Systems
Central role of payments and settlement systems (PSS) for
banks and central banks The means to settle obligations to counterparties
Financial stability as a mandate of central banks
Central bank objectives for PSS Risk reduction Systemic Risk , Credit Risk, Liquidity Risk
Increasing efficiency
Settlement with finality A key feature of PSS
Point at which payment transaction deemed complete, legallyenforceable and irrevocable
Ri k i PSS
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Risks in a PSS
Credit Risks
Liquidity Risks
Legal Risks
Operational Risks
Security Risks Market Risks
Systemic Risk & Contagion Value of payments settled
Number of participants
Interaction between banks
Importance of PSS
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Importance of PSS Smooth functioning of economy
A carrier of systemic risk Liquidity problems a main cause of bank failures
Enormous amounts of transaction flows (nearly USD 4 trillion daily
in Forex markets alone) Transaction processing as a source of fee-based revenue for banks
Most PSS operated by central banks Provision of intra-day reserve loans
Some relatively recent trends Reduction of time for transaction settlement Adoption of RTGS
Debates on netting or gross settlements
Evolution of PSS Instruments
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Evolution of PSS Instruments Fixed costs of processing payments and their settlements
Scale economies for processing large transactions Most innovation in payment systems
Clearing houses and transaction aggregators e.g. CHIPS, ACH, LCHClearnet, MEPS+, CHAPS, Fedwire, ECS, etc
Technological Advances
Delivery versus payment systems Collateralized transactions
Popular due to growth of repo transactions
Levels of PSS
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Levels of PSS
Two Levels of PSS Entities other than banks
Inter-bank PSS
Corresponding PSS
Small Value Transfer Systems Large Value Transfer Systems
Large Value Transfer Systems operated by Central Banks
Customer PSS & Inter-bank PSS-An Example
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Bank 1
Customer deposits 200 Loans to customers 100
Equity 50 Reserve balances 100
Loans from other banks 50 Loans to other banks 100
Total 300 Total 300
Bank 2
Customer deposits 200 Loans to customers 100
Equity 50 Reserve balances 100
Loans from other banks 50 Loans to other banks 100
Total 300 Total 300
Customer PSS & Inter-bank PSS-An Example
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Bank 1
Customer deposits 150 Loans to customers 100
Equity 50 Reserve balances 100
Loans from other banks 100 Loans to other banks 100
Total 300 Total 300
Bank 2
Customer deposits 250 Loans to customers 100
Equity 50 Reserve balances 100
Loans from other banks 50 Loans to other banks 150
Total 350 Total 350
Customer PSS & Inter-bank PSS-An Example
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Bank 1
Customer deposits 150 Loans to customers 100
Equity 50 Reserve balances 50
Loans from other banks 50 Loans to other banks 100
Total 250 Total 250
Bank 2
Customer deposits 250 Loans to customers 100
Equity 50 Reserve balances 150
Loans from other banks 50 Loans to other banks 100
Total 350 Total 350
Types of PSS
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Types of PSS
Cash based settlement systems
Non-Cash settlement systems
Netting Systems Bilateral Netting
Novation Netting
Close-Out Netting
Multilateral Netting
Gross Settlement Systems Real-Time Gross Settlement
Bilateral Netting
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Bilateral Netting
Multiple transactions during the day
Obligations netted out at end of day
Lowered liquidity requirements & liquidity costs
Risk of large unwanted exposures to a single counter-party
Is the netting arrangement legally enforceable? Novation Netting
Multilateral Netting
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Multilateral Netting
Further reduction of transactions Number of transactions under bilateral netting [0,(n2 -n)/2]
Number of transactions under multilateral netting [0,n]
Smaller amount of final settlement transfers Lowered liquidity requirements
From whom to collect and how much?? Credit risks at least as high as under bilateral netting
Central clearing-house as counterparty
Credit risk reduction
Managing/Reducing Credit Risks
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Managing/Reducing Credit Risks
Insolvency laws & procedures
Bilateral exposure limits
Shortening Netting Intervals
Restricting access to PSS
Clearing Houses
Collateral Pools
How to compute each members contribution
Close-Out Procedures Dealing with counterparty default
RTGS
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RTGS
Each transaction settled on a gross basis in real time
Number of transfers very large
Zero credit risk
Higher liquidity requirements/liquidity risk
Continuous requirements of liquidity Requires support from central bank for intra-day liquidity
provision
Incentive Issues in RTGS
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Incentive Issues in RTGS
Delaying Payments Trade-off between expected revenue losses from customers &
cost of liquidity
Incentive weaker when liquidity costs are very low
Delaying payments is optimal only if all other banks dothe same
Synchronization of payments by all banks
Price for intra-day credit
Collateralized system for intra-day credit
Standards for PSS (Lamfalussy Report)
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Standards for PSS (Lamfalussy Report)
Well founded legal basis under all relevant jurisdictions
Participants have clear understand of system on each ofthe risks affected by the netting process
System should have clearly defined procedures ofmanagement of credit and liquidity risks that specify theresponsibilities of the system and the participants
Standards for PSS (Lamfalussy Report)
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Standards for PSS (Lamfalussy Report)
System capable of timely completing of daily settlements
even if the participant with the largest position fails
System should have objective and disclosed criteria foradmission that permit fair and open access
System must ensure operational reliability of systems andavailability of back-up facilities
Netting vs RTGS
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Netting vs. RTGS
Risks & Costs Netting Systems RTGS
Credit Risks Higher Negligible
Liquidity Requirements & LiquidityRisk
Lower Higher
Legal Risks Higher Minimal
Costs of Customer Payment Delays High Negligible/Nil
Interest cost on liquidity funding Lower Higher
Nature of liquidity requirements Lumpy Continuing
Transfer/Payment Processing Costs Lower Higher
Netting vs RTGS
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Netting vs. RTGS Netting based settlement systems
Netting as a more efficient means of settlement End of day final transfer of reserve balances
Exposure to credit risk on intra-day transactions
Bilateral Netting vs. Multilateral Netting
RTGS Greater requirement of intra-day reserve balances
Improved ability of central banks to influence interest rates
Reduced credit risk
Drivers of PSS choice
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Drivers of PSS choice
Credit risk vs. transfer cost trade-off
Credit risk vs. liquidity risk
Customer benefits vs. liquidity cost Implicit & Explicit liquidity costs
PSS in India
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PSS in India Board for Regulation and Supervision of Payment and Settlement
Systems as the primary regulator
Governed by the Payment & Systems Act, 2007 & Payment &Systems Rules 2008
Multiple Systems All operated by RBI
Electronic Clearing System
National Electronic Funds Transfer
RTGS based systems for inter-bank transactions
RBI as providing standby intra-day credit facilities through repos.
Dimensions of the modern operatingenvironment
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Increased focus on transparency
Management of risk exposures
Competition for customers
Capital adequacy
Technological developments
Financial innovation
environment