Finance THE BANKING SYSTEM

Finance Lecture outline  The types and functions of banking  Central banking  Commercial and investment banks

Finance Types of banking  The central bank  Commercial banks  Investment banks

Finance The central bank’s functions (1)  A bank for the state  A bank for banks  Money issuance  Monetary policy  The lender of last resort  Foreign reserves managament  Financial supervisory functions

Finance The central bank’s functions (2)  The bank for the state- it manages the state accounts with other countries  The bank for banks- all the commercial banks have accounts in the central banks

Finance The central bank’s functions (3)  The central bank has the exclusive right to issue cash  It is responsible for controlling the monetary base and money supply  To fulfill these functions the central bank is provided with several monetary policy tools

The goal of monetary policy  The general goal of monetary policy is inflation stabilization  To achieve this goal central banks can pursue different monetary policy strategies Finance

Monetary policy strategies  Exchange rate target e.g. during the Bretton Woods system,  Monetary base target- a popular strategy in the 80-ties  Direct inflation targeting- currently the most popular strategy

Finance Monetary policy tools  The interest rate  Open market transactions  Reserve requirements  Exchange requirements

Finance What are interest rates for?  Through setting the interest rates the central bank wants to influence market interest rates  It setting of interest rates leads to series of lending or borrowing money until the targeted market rate is reached  These transactions take place between the central bank and a limited number of qualified banks  The same target can be reached by purchasing and selling bonds

Finance What are open market operations?  Open market operations are aimed at direct influencing of the money supply  The central bank carries out open market operations by buying and selling securities on the open market  Each purchase of securities increases the money supply, each sell of securities decreases the money supply

Finance What’s the purpose of reserve requirements?  Commercial banks have to hold cash reserves for the case of bank-runs  The reserves constitute usually only a fraction of the deposits  The central bank sets the level of the required reserves in order to influence the amount of loans granted by commercial banks  This way it influences monetary creation, economic activity and the level of inflation

Finance What role do exchange requirements play?  The role of exchange requirements depends on the convertibility of the currency  If the currency is only partially convertible the central bank has to purchase the foreign currency from the domestic enterprises who own the foreign currency  The purchase of foreign currency leads an increase of money supply  If the currency is convertible there can be constraints on bank foreign exchange operations e.g. central bank permits are necessary to transfer money abroad

The central bank as the lender of last resort (1)  The lender of last resort is an institution willing to extend credit when no one else will  The function of the lender of last resort is triggered in the case of financial difficulties of important institutions  In order to avoid their bankruptcy the central bank may grant credit to the failing institution Finance

The central bank as the lender of last resort (2)  The purpose of this function is to protect depositors in times of crises  It constitutes an insurance against the default risk  It is aimed at preventing panic withdrawals in the time of crisis

Finance Foreign reserves managament  The foreign reserves constitute a part of central banks assets held in foreign currency  The foreign reserves are an important element of backing the central banks liabilities

Central banks assets and liabilities Assets  Gold  Foreign assets (foreign exchange reserves)  Domestic assets Liabilities  Domestic money supply  Other domestic liabilities  Foreign liabilities Finance

Financial supervisory functions of the central bank  Financial supervisory systems differ from country to country  The financial supervision function van be divided between institutions or consolidated  Central bank play a crucial role as supervisory institutions

Finance Financial supervisory functions of the central bank  Entry into banking regulation  Banking activity regulation  Capital requirements  Deposit insurance schemes

The functions of commercial banks (1)  The commercial banks can issue money in the form of loans but not in the form of cash  Commercial banks like every enterprise pursue the goal of profit maximizing  The profit derives from the interest earned from loans and deposits Finance

The functions of commercial banks (2)  Commercial banks process payment transfers  They are involved in financing trade  They are involved in brokerage (securities trade) as market makers  Large banks fulfill the function of underwriters in bond issuance

Finance The notion of credit (1)  One of the basic functions of banks is issuing credit  Credit is a relation between the debtor and the creditor  It is based on an agreement according to which the creditor provides resources to the debtor and the debtor is obliged to return the resources

Finance The notion of credit (2)  Credit itself can relate to monetary or non- monetary resources  The banking credits refer to monetary resources  Banking credits are usually: current credits, investment credits or consumption credits

Finance Current credits  Credits granted for financing the current activity needs of enterprises e.g. production, supply, warehousing, sales  Short term credits  The largest fraction of banking credits

Finance Investment credits  Credits aimed at financing investments  The investments may be aimed modernizing, restitution or creation of new estate of the debtor  Medium and long term credits

Consumption credits  Usually granted for households  Aimed at financing consumption e.g the purchase of a car  Paid off in installments Finance

Credit vs. loans  A loan refers to monetary resources only  The loan is a type of debt  The borrower initially receives monetary resources from the lender, and is obligated to pay back an equal amount of money to the lender at a later time

Bank loans  The banks grant loans in the form of credit at the cost of specified interest  Simple interest=interest rate* initial balance* duration of the loan  Real interest- accounting for inflation  Cummulative interest= interest 1 *interest 2 *…*interest n Finance

Investment banks functions  Primarily the function of investment banks was to act as brokers and market makers for securities trading, especially derivatives and foreign exchange  The introduction of electronic brokerage systems led to the decrease of their role as intermediary  Currently they act mainly as a consultant, provide assistance in raising capital by underwriting and assist companies involved in mergers and acquisitions, Finance

International banking  Banks can act internationally as branches or subsidiaries of the bank based in the home country  A branch is bank which is a part of the parent corporation  A subsidiary is a separate legal entity  Implications for the lender of last resort- which central bank should support a branch and which one a subsidiary? Finance

„Special” central banks  The European Central Bank  The Bank for International Settlements Finance

The European Central Bank  Responsible for the monetary policy in the whole euro area  The reserves created from the contributions of national central banks  According to the Treaty the ECB can not act as the lender of last resort- the no bail out principle Finance

The Bank for International Settlements  The bank for the central banks  It provides banking services to central banks and international institutions  Broadly involved in banking regulation  The BIS is not accountable to any national government Finance

Literature R.W.Melicher, E.A.Norton, Introduction to Finance. Markets, Investments and Financial Management, John Wiley&Sons,2007