1. How is Saving Allocated?

2. Fred ThompsonFinancial Architecture2 Direct versus Indirect Financing Direct: Savers and borrowers link directly Indirect: An intermediary channels funds from saves to borrowers. Bank Borrowing: –UK 70% –Japan 65% –US 30% (Over 50% through foreign banks!)

3. Fred ThompsonFinancial Architecture3 Efficient Financial Intermediation An efficient system reduces x-inefficiency costs. Intermediaries make pooling of funds possible and, therefore, economies of scale and risk pooling. Intermediaries can reduce information asymmetries and other market failures.

4. Fred ThompsonFinancial Architecture4 Potential for Misallocation of Capital There is a potential for unfettered capital markets to misallocate capital –Intermediaries undermine domestic policy –Financial market shocks increase –Greater potential for contagion. –Loss of Economic Growth Evidence on the latter

5. Fred ThompsonFinancial Architecture5 Market Failures Asymmetric Information: Possession of information by one party that is not available to a another party of the transaction. Can lead to: –Adverse Selection: Those least worthy most likely to borrow. –Herding Behavior: Savers follow someone they feel is better informed.

6. Fred ThompsonFinancial Architecture6 Market Failures Moral Hazard: Borrower engages in riskier activity once the financing is in place. –Moral hazard can result from information asymmetries or from national government or international organization guarantees. Policy Created Distortions: –Differential taxes, regulations, tariffs –Regulatory Arbitrage

7. Fred ThompsonFinancial Architecture7 Conclusion Potentially large allocative and efficiency gains to be enjoyed from capital market liberalization. Policy-created distortions and market failures must be addressed.

8. Fred ThompsonFinancial Architecture8 Payments Systems Risks Liquidity Risk: The risk of loss that may occur when a payment is not received when due. Credit Risk: The risk of loss that may occur when one party fails to abide by the terms of an agreement. Systemic Risk: The possibility that liquidity risk or credit risk may affect a third party.

9. Fred ThompsonFinancial Architecture9 System Risk Systemic Risk involves a negative externality. Herstatt Risk: Liquidity, credit, and systemic risk across international borders. Term comes from the events surrounding the failure of the Herstatt bank in 1974. G10 nations developed a netting arrangement to minimize Herstatt risk (early 1990s).

10. Fred ThompsonFinancial Architecture10 Central Bank Functions Fiscal Agents Bankers’ Bank Lenders of Last Resort Macroeconomic and Monetary Policy Makers –Exchange market intervention –Monetary policy

11. The Monetary Base and the Money Stock

12. Fred ThompsonFinancial Architecture12 The Monetary Base A nation’s monetary base can be measured by viewing either the assets or liabilities of the central bank. The assets are domestic credit (DC) and foreign exchange reserves (FER). The liabilities are currency in circulation (C) and total reserves of member banks (TR).

13. Fred ThompsonFinancial Architecture13 Simplified Balance Sheet of the Central Bank AssetsLiabilities Domestic Credit (DC) Currency (C) Foreign Exchange Reserves (FER) Total Reserves (TR) Monetary Base (MB) Monetary Base (MB)

14. Fred ThompsonFinancial Architecture14 Money Stock There are a number of measures of a nation’s money stock (M). The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.

15. Fred ThompsonFinancial Architecture15 Money Multiplier Most nations require that a fraction of transactions deposits be held as reserves. The required fraction is determined by the reserve requirement (rr). This fraction determines the maximum change in the money stock that can result from a change in total reserves.

16. Fred ThompsonFinancial Architecture16 Money Multiplier Under the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only. In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement, m = 1/rr.

17. Fred ThompsonFinancial Architecture17 Relating the Monetary Base and the Money Stock Under the assumptions above, we can write the money stock as the monetary base times the money multiplier. M = m  MB = m(DC + FER) = m(C + TR). Focusing only on the asset measure of the monetary base, the change in the money stock is expressed as  M = m(  DC +  FER).

18. Fred ThompsonFinancial Architecture18 Example - BOJ Intervention Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the private banking system. This action reduces the foreign exchange reserves and total reserves component of the BOJ’s balance sheet.

19. Fred ThompsonFinancial Architecture19 BOJ Balance Sheet AssetsLiabilities DC C FER TR MB -¥1 million

20. Fred ThompsonFinancial Architecture20 BOJ Intervention Because the monetary base declined, so will the money stock. Suppose the reserve requirement is 10 percent. The change in the money stock is  M = m(  DC +  FER),  M = (1/.10)(-¥1 million) = -¥10 million.