Financial System Junhui Qian

Outline Banking Financial Markets Monetary Policy Stock Market Bond Market Monetary Policy

Banks Commercial banks Investment banks Policy banks Central banks

Commercial Bank The basic activity of a commercial bank is to accept deposits and make loans. Three transformations Credit transformation Term (maturity) transformation Liquidity transformation Commercial banks also provide other services such as checking, payments, remittance, etc.

Fractional Reserve and Money Creation A bank accepts deposits and holds a fraction in reserves, which are held at the bank as currency, or as deposits in the bank's accounts at the central bank. The cash reserve at commercial banks and the deposit reserve at the central bank constitute the base money in the economy. When a bank makes a loan, it creates new “money” and multiplies money supply in the economy.

Case Studies History of Chinese Commercial Banking Piaohao (票号) Qianzhuang (钱庄) The birth of fractional reserve banking in Amsterdam From goldsmith to banker In the past, savers looking to keep their coins and valuables in safekeeping depositories deposited gold and silver at goldsmiths, receiving in exchange a note for their deposit (see Bank of Amsterdam). These notes gained acceptance as a medium of exchange for commercial transactions and thus became an early form of circulating paper money. As the notes were used directly in trade, the goldsmiths observed that people would not usually redeem all their notes at the same time, and they saw the opportunity to invest their coin reserves in interest-bearing loans and bills. This generated income for the goldsmiths but left them with more notes on issue than reserves with which to pay them. A process was started that altered the role of the goldsmiths from passive guardians of bullion, charging fees for safe storage, to interest-paying and interest-earning banks. Thus fractional-reserve banking was born.

Investment Bank The basic activity of an investment bank is to help individuals, corporations, and governments raise capital in the market. An investment bank may also help mergers and acquisitions (M&A), provide market making, directly trade derivatives and equities, and provide FICC services (fixed income instruments, currencies, and commodities). Investment banks do not take deposits.

Policy Banks There are three policy banks in China: Agricultural Development Bank of China (ADBC), China Development Bank (CDB), and the Export-Import Bank of China (Chexim). These banks were set up in 1994 to take over the government-directed spending functions of the big four state-owned commercial banks, so that the big four might specialize in commercial banking. Policy banks do not take deposits and rely on bond financing and borrowing from the central bank.

The Central Bank The basic activity of a central bank is to deliberate on and implement monetary policy. A typical modern central bank controls an intermediary variable, short-term interest rate, for the objective of achieving full employment with moderate inflation. The central bank also provides lender-of-last-resort function for commercial banks. Many central banks are also responsible for monitoring and regulating the banking sector.

Bank Regulation A healthy banking industry is vital to economy, but the banking industry is inherently vulnerable to failures, which are often contagious. Asymmetric information: savers cannot monitor banks’ lending. Some safety net (e.g., deposit insurance) is thus necessary, but the safety net increases moral hazards and adverse selection. To mitigate the effect of moral hazards and adverse selection, government must enforce regulation and supervision of the industry. Moral hazard: depositors would not impose the discipline of the market on banks by withdrawing deposits when they suspect that the bank is taking too much risk. Adverse selection: risk-loving entrepreneurs or even crooks may find it attractive to enter the industry. They are willing to offer high interest rate to savers and engage in risky investment and lending, driving those conservative banks out of the market.

Cost of Bank Bailouts Date Country Cost (% GDP) 1980-1982 Argentina 55 1997-1998 South Korea 27% 1995 Mexico 20 1990s Japan >12 1991-1994 Finland 11 1991-1995 Hungary 10 1987-1993 Norway 8 Sweden 4 1984-1991 United States 3

Shadow Banking Shadow bank refers to any market entity that provides banking services outside the scope of government regulation and supervision. Credit transformation Term transformation Liquidity transformation Shadow banking is closely intertwined with the regular banking sector. Without government regulation, shadow banks may use excessive leverage, making the financial system vulnerable. The competition of shadow banks also forces banks to seek higher return by pursuing risky projects.

Shadow Bank with Chinese Characteristics Shadow banking flourished in China thanks to the government restrictions on loans, interest rates, and capital flows. Trust (信托) Entrusted loans (委托贷款) Copper finance (“融资铜”) The Chinese shadow banking is even more intertwined with the banking sector than its counterpart in US. It is often called the shadow of the bank.

Outline Banking Financial Markets Monetary Policy Stock Market Bond Market Monetary Policy

Equity and Bond Financing In addition to bank loans, a company may also obtain financing by issuing securities, equities (stocks, shares) or bonds. The owner of equities and bonds provide financing for the company and obtain either residual claim or fixed-income claim on the company. The equities or the bonds may be listed in an exchange, so that the market participants may buy and sell these securities. These securities, in turn, obtain liquidity.

Stock Market Stock market is often referred to as the stock exchange, where shares of different companies are listed and traded. In general terms, stock market also includes over-the-counter markets. Stock market participants include retail investors, mutual funds, hedge funds, insurance companies, social security funds, endowment funds, and other institutional investors. Stock market provides an efficient way of allocating financial resources and sharing risk (profit).

Stock Exchanges Around The World (May, 2015) Ranking Stock Exchange Capitalization (million USD) 1 NYSE 19 686 944.9 2 NASDAQ OMX 7 378 758.4 3 Shanghai SE 5 903 863.2 4 Japan Exchange Group - Tokyo 5 004 759.7 5 Shenzhen SE 4 368 478.6 6 Hong Kong Exchanges 3 966 069.2 7 Euronext 3 496 579.7 8 TMX Group 2 114 803.6 9 Deutsche Börse 1 823 127.0 10 SIX Swiss Exchange 1 614 938.0

Private Equity Private equity consists of equity and debt that are not publicly traded on a stock exchange. Private equity investors fall into the following categories: Angel investor Venture capital investor (VC) Private equity investor (PE) IPO (Initial Public Offering) in a stock market provides the ultimate exit and incentive for all private equity investors.

Bond Market Bonds can be traded much like stocks in securities exchanges. In China, the major bond market is the inter-bank market. The bond market determines interest rates of different terms and credit levels Government bonds: risk-free interest rate + term premium Corporate and municipal bonds: risk-free interest rate + credit risk premium + term premium

Outline Banking Financial Markets Monetary Policy Stock Market Bond Market Monetary Policy

Monetary Policy Long-term objectives: Target market variables: Moderate inflation Low unemployment rate (economic growth) Fixed exchange rate Target market variables: Short-term interest rate Money growth Exchange rate Instruments: Open market operations Reserve requirement Others

Taylor’s Rule In the United States, it is widely believed that the FED follows the Taylor’s rule, at least during the normal times, federal fund rate=inflation+2 +0.5 inflation−2 +0.5 GDP gap Rule-based policy making mitigates the problem of time inconsistency. Even if the monetary authority strictly follows a rule, policy making cannot be automatic, since key macroeconomic variables have to be measured and forecasted.

The Science of Monetary Policy: Generations of Macroeconomic Models Early Keynesian econometric models (Tinbergen 1939, Klein 1968): no important role for monetary policy. The MIT-Penn-SSRC (MPS) model (Modegliani et al., 1960s): important role for monetary policy. In the 1970s, the accelerationist Phillips curve was incorporated in MPS. The FRB/US model (Brayton and Tinsley 1995; Reifschneider, Stockton and Wilcox 1997; Reifschneider, Tetlow, and Williams 1999): important role for expectation. DSGE with New-Keynesian features (Woodford 2003) Intermediate Macroeconomics

The Art of Monetary Policy Monetary policy will always need some “judgment”. Formal models may be able to use only a small subset of data that are informative on our complex economy. High-frequency data Anecdotal observations (Beige Book of the US Fed) Model selection problem: economists are never sure which model or which modeling approach is the correct one. Model instability problem: a model may be correct for a time and fails next period after some structural change in the economy. Intermediate Macroeconomics

The Trend Toward Central Bank Independence Before 1990s, only a few central banks were highly independent: the Bundesbank, the Swiss National Bank, the Federal Reserve. In the 1990s, many countries in the developed world achieved greater central bank independence: Japan, South Korea, New Zealand, Sweden, the UK, etc. Intermediate Macroeconomics

The Trend Toward Inflation Targeting Five components of IT (Mishkin 2004): The public announcement of medium-term numerical targets for inflation, An institutional commitment to price stability as the primary goal of monetary policy, An information-inclusive strategy to set policy instruments, Increased transparency of the monetary policy strategy, and Increased accountability of central bank for attaining its inflation objectives. Inflation targeting was first adopted by New Zealand in 1990. By 2006, a total of 24 countries had adopted IT. Intermediate Macroeconomics

Increasing Attention on Financial Stability Early central banks (e.g., Riksbank, Bank of England), with substantial commercial banking business, focus on the nature and quality of bank assets, primarily the commercial bills. They do not focus on direct examination of the books or the management practices of other commercial banks. Banking crises during the interwar period led to establishment of institutions with responsibility for bank supervision, some within the central bank, some separate, and others only formally separate. From late 1960s, resurgent financial instabilities, often international, reinforced the role of central banks in designing the regulations, monitoring that rules were followed, imposing sanctions if rules were violated, and being the lender of last resort if crises occurred. Since 1980s, under the influence of the free-market ideology, financial regulation failed to catch up with “financial innovations”. The recent global financial crisis once again reinforced central banks’ attention on financial stability. Intermediate Macroeconomics

End-of-Semester Remarks Models simplify. A good model is one that omits unnecessary details and focuses on the main question. Time horizon matters. In the long run, prices adjust flexibly and the classical theory roughly holds; while in the short-run, price rigidity produces real effects of monetary and fiscal policies. Monetary and fiscal policies matter, not only for textbook reasons (nominal rigidity), but also for other reasons such as balance sheet effect, wealth effect, change of expectation, and so on. Macroeconomic conditions change, and there are no time-invariant answers, even for the same question. What we learn is some basic skills for conducting rigorous studies of the economy. Investment alone does not bring prolonged economic growth. For an under-developed country, market-friendly reform, political stability, education, social trust and mobilization all contribute to growth.

End-of-Semester Remarks Familiarity with data is the key to the understanding of economy. “I think…” is an ominous phrase to start economic analysis. “Data suggest…” is a promising one. Respect the status quo and avoid radicalism. A scientist rejects a consensus theory only when there are overwhelming evidence against it. A conservative opts for revolution only when the establishment breaks down and rejects reform. Data include not only macro variables, but also various market indicators, and even self-constructed ones.