Vous êtes sur la page 1sur 51


Summary Money and Banking: book " The Economics of

Money, Banking and Financial Markets, European Edition,"
Mishkin, Matthews, Giuliodori
Geld en Bankwezen (Universiteit van Amsterdam)

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Summary Money and Banking

Part I
Chapter 1 Why study money, banking and financial markets
Financial markets markets in which funds are transferred from people with an excess to people
with a shortage. Well-functioning ones are a key factor in producing high economic growth while
poorly performing ones are one reason many countries remain desperately poor.
Security (financial instrument) the claim on the issuers future income or assets
Interest rate the cost of borrowing or the price paid for the rental of funds. While rates can differ
substantially (3 month Treasury bills fluctuate more than 10 year ones), they have a tendency to
move in unison which is why they are frequently lumped and referred to as the interest rate. Rates
differ between countries because of differing inflation, political and default risks.
Common stock (stock) represents a share of ownership in a corporation
Indirect quote expresses the foreign currency per unit of domestic. Advantageous because a rise is
an appreciation and a fall a depreciation
Financial intermediaries institutions that borrow funds from people who save and in turn make
loans to others
Financial crises major disruptions in financial markets that are characterized by sharp declines in
asset prices and the failures of many financial and non-financial firms
Banks financial institutions that accept deposits and make loans
Money (money supply) anything that is generally accepted in payment for goods or services or in
the repayment of debts
Aggregate output total production of goods and services
Unemployment rate the percentage of the available labour force unemployed
Monetary theory the theory that relates changes in the quantity of money to changes in aggregate
economic activity
(Aggregate) price level the price of goods and services in an economy
Inflation a continual increase in the price level that affects individuals, business and the
Monetary policy the management of money and interest rates
Fiscal policy decisions about government spending and taxation
Budget surplus G<T G = Government spending T = Taxation
Budget deficit G>T
Central bank the organization responsible for conducting a nations monetary policy
Gross domestic product (GDP) a measure of aggregate output relative to the size of the economy.
It includes the market value of all final goods and services produced in a country during the course of
the year. It excludes two sets of items; purchases of goods that were produced in the past (houses,
stocks or bonds) and intermediate goods used to produce a final good (otherwise theyd be counted
Aggregate income the total income of factors of production (labour, land and capital) from
producing goods and services during the course of the year
GDP-deflator Pt = Nominal GDP / Real GDP = Paasche, underestimated outcome
CPI (PCE) deflator Pt = Price of basket of goods and services / Price same basket in base period =
Laspeyres, overestimated outcome
Growth/inflation rate ((xt xt-1) / xt-1)*100

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Chapter 4 Understanding interest rates

There are four basic types of credit market instruments
1. Simple loan the lender provides the borrower with an amount of funds, called the
principal, that must be repaid at the maturity date along with an additional payment for the
PV = CF/(1 + i)n
For a simple loan, the simple interest rate equals the yield to maturity.

2. Fixed payment loan (fully amortized loan/annuity) the lender provides the borrower with
an amount of funds which must be repaid by making the same payment every period
consisting of part of the principal and interest for a set number of years.
PV = (C/i) (1-1/(1+i)n)
This rate can be solved using a computer or with trial and error on a calculator. i YTM.

3. Coupon bond the owner gets a fixed interest payment every year until the maturity date,
when a specified final amount (face or par value) is repaid. Remember that the final
payment also includes a coupon payment. This type of bond is identified by three pieces of
information; the issuing corporation or government agency, the maturity date and the
coupon rate.
PV = CPN/(1 + YTM) + CPN/(1 + YTM)2 + + (CPN + FV)/(1 + YTM)n
There are three interesting facts about this type of bond:
If P = FV, YTM = coupon rate
P and FV are negative related, i.e. if YTM rises P falls.
YTM is greater than the coupon rate when the bond price is below FV.
Consol (perpetuity) a special case of a coupon bond without maturity date.
P = C/i
For a long term bond the yearly coupon payment divided by the price of the security is called
current yield, often used as an approximation of the interest rate on long-term bonds.

4. Discount (zero) coupon bond bought at a price below its value and repaid at face value
which includes the interest rate.
PV = FV/(1 + i)n

Yield to maturity the interest rate that equates the present value of cash flows received from a
debt instrument, with its value today. Economists consider it the accurate measure of interest rates.
It can happen that YTM is (slightly) negative (recently in Japan -.004%), implying that you are willing
to pay more for something today than you will receive in the future. This is driven by the weakness of
the economy and a flight to quality; investors found it more convenient to hold treasury bills as a
store of value than holding cash.

How well someone does by holding a security is measured by the rate of return. The return on a
bond is not necessarily equal to the YTM of that bond; an increase in interest rate leads to a lower
price and perhaps to a loss.

R= = + = i + g = Current yield + Rate of capital gain

Several findings are generally true for all bonds

The only bond whose return equals the initial YTM, is one whose time to maturity is the
same as the holding period.
A rise in interest rates comes with a fall in bond prices, resulting in capital losses when the
terms to maturity are longer than the holding period

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


The more distant a bonds maturity

- The greater the size of the percentage price change associated with the interest rate
- The lower the rate of return that occurs as a result of the increase in the interest rate

Prices and returns for long-term bonds are more volatile than those for shorter term bonds.
Therefore long-term bonds are regarded more risky, the results are referred to as interest-rate risk.

Real interest is the difference between the nominal rate and the expected inflation, as according to
Fischers equation.
i = ir + e
When the real interest rate is low, there are greater incentives to borrow and fewer incentives to
lend. Especially during recessions the real rate may be negative.

Chapter 5 The behaviour of interest rates

Four factors influence the demand in the bond market. A change in the price or interest rate causes a
movement along the curve. A change in the demand for every price (or interest) level means the
whole curve shifts.
1. Wealth. Holding everything else constant, an increase in wealth raises the quantity
demanded of an asset. A business cycle expansion shifts the curve to the right. An increased
propensity to save also increases the demand, shifting the curve to the right.
2. Expected returns. Ceteris paribus, an assets expected return relative to that of an
alternative asset, raises the quantity demanded. Higher expected interest rates in the future
lower the expected returns for long-term bonds which shifts the demand curve to the left. A
higher expected inflation lowers the real interest rate (Fischer) and makes lending less
profitable. The demand declines and the curve shifts to the left.
3. Risk. Ceteris paribus, if an assets risk rises relative to that of alternative assets, the quantity
demanded will fall. An increased riskiness shifts the curve to the left.
4. Liquidity. Ceteris paribus, the more liquid an asset is relative to alternative assets, the more
desirable it is and the greater the quantity demanded. Increased liquidity of alternative
assets lowers the demand for bonds (relatively) and shifts the demand to the left.

Three factors influence the supply in the bond market.

1. Expected profitability of investment opportunities. A rapidly growing economy comes with
profitable opportunities and the supply of bonds increases.
2. Expected inflation. In real terms, increased inflation lowers the cost of borrowing. So while
increased inflation lowers the demand because of the lowered profitability, it increases the
supply and shifts the curve to the right.
3. Government budget. The higher the government deficits, the greater the needs for extra
funding thus the greater the supply.
Two pointers: remember that price and interest is negatively related and that you are assuming
ceteris paribus.

The Fischer effect when expected inflation rises, interest rates will rise. This is because expected
inflation lowers demand (if nominal rates are held constant, real returns on bonds decrease), raises
supply (borrowing money gets cheaper in real terms) and leads to an equilibrium where prices are
lower interest rates higher.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Evidence of the Fischer effect in the US:

In the UK it looks similar. Aside from during the crisis in 2008-2009 when monetary policy has
actively been used to lower rates, the interest rate on three month treasury bills has moved along
with the expected inflation rate.

What happens when the business cycle expands? In a supply perspective, the outlook is positive for
businesses and they want to invest so the supply curve shifts to the right. From a demand point of
view wealth increases making more money available to invest in bonds; the demand curve therefore
also shifts to the right. Depending on which curve shifts the most (usually it is the supply curve since
there are alternative ways of spending ones wealth), the prices can rise or get lower with the interest
rate moving the opposite direction. The empirical evidence from both the UK and the US supports
this theory; interest rates decrease during crises.

Keynes Liquidity preference framework is an alternative approach to determining interest rates. He

assumed that there were two main categories of assets to store wealth: money and bonds. The total
ealth in the economy is therefore equal to
Ms + Bs = Md + Bd which can be rewritten as Md Ms = Bs Bd meaning that when one market is in
equilibrium, so is the other. And when Ms Md > there is excess supply over demand (and vice versa).

Shocks can cause the curves and thus equilibrium to shift. Two factors can cause the demand curve
for money to shift: income and the price level.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Income effect: A higher level of income causes the demand for money at each interest rate to
increase and the demand curve to shift to the right.
Price-level effect: A rise in the price level causes the demand for money at each interest rate to
increase and the demand curve to shift to the right.

Money supply can only be regulated by the Central bank by means of monetary policy. An increase in
the money supply (engineered by the CB) will shift the supply curve for money to the right.

According to this theory, a shift in money supply moves the supply curve to the right and in the new
equilibrium, the interest is lower. According to Friedman however, there are additional second round
Income effect: Increasing money supply is an expansionary influence on the economy which raises
both national income and wealth. Both the liquidity preference and bond supply and demand
frameworks indicate that interest rates will then rise. The income effect of an increase in the money
supply is a rise in interest rates in response to the higher level of income.
Price-level effect: an increased money supply can also cause the overall price level to rise. The price-
level effect from an increase in the money supply is a rise in interest rates in response to the rise in
price level.
Expected-inflation effect: The higher inflation rate that results from an increase in the money supply
also affects interest rates by affecting expected inflation rates. More money higher price levels
expected expected higher inflation higher inflation.
The effect that higher money growth has on interest is ambiguous.

While at first it may appear that the price-level effect and the expected-inflation effect are the same
thing (they both indicate that increases in the price level induced by additional money supply
increases interest rates), there is a difference: the price-level effect remains even after prices have
stopped rising, whereas the expected-inflation effect disappears. The expected-inflation effect will
only persist as long as the price level continues to rise.

An important issue for policymakers is which of these three scenarios (see picture) is closest to
reality. If a decline in interest rates is desired, an increase in money supply is better when the
liquidity effect is larger than the other effects. If the liquidity effect is smaller a decreased money
supply would have the desired outcome as is shown above/below.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


What does the evidence show? That depends on how fast peoples expectations about inflation
adjust. Graphically it is not clear, but there are indications that increased money growth temporarily
lowers short-term interest rates (consistent with Keynes theory: at first they decrease but then as
according to Friedman they increase again).

Chapter 6 The risk and term structure of interest rates

This chapter is about why bonds have different interest rates. There are two reasons behind it:
1. The risk structure bonds with same maturity but different risk. Three determinants:
default risk, 2) liquidity and 3) income tax considerations.
2. The term structure bonds with same risk but different maturity. Three theories:
expecations theory, 2) segmented markets theory and 3) liqidity premium theory
(preferred habitat).

Risk structure

Looking at the graph above, youll see the risk structure: Baa bonds have the highest yield and
state/government bonds the lowest. The interest rates on corporate vs. Treasury bills move very
closely although there are differences; especially in times of crises (1980, 2008) the spread may be as
high as 2 percentage points. The higher the risk, the more compensation investors want to hold that
bond and the higher the yield must be.

During a recession there is a flight to quality so the demand for corporate bonds decreases (demand
curve to the right, price is lower, yield is higher) while the demand for treasury bonds increases
(demand curve to the left, price increases and yield is lower). The spread between the yields, ic it is
referred to as the risk premium. A bond with default risk will always have a positive risk premium,
and an increase in its default risk will raise the risk premium.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Default risk: Credit rating agencies are investment advisory firms that rate the quality of corporate
and municipal bonds in terms of the probability of default: from Aaa to C or D. Bonds with ratings
below Baa (BBB) are speculative and called junk bonds.

Nowadays we know that government bonds are also not default free, look at the GIIPS countries

After 2008 they started increasing compared to Germany as Greece (admitting to higher budget
deficit than was previously known), followed by Spain and Ireland (real estate bubbles) lost the
markets confidence. Latest order: Greece, Ireland, Portugal, Spain, Italy (GIPIS).

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Liquidity: the more liquid an asset is, the more desirable it is. If corporate bonds become relatively
less liquid, the (always liquid) treasury bonds become more attractive which is another factor
increasing the liquidity premium. More accurately the premium should be referred to as risk and
liquidity premium but convention dictates that it is called a risk premium.

Income tax: In the US, municipal bonds are tax exempt. It may therefore be that a treasury bond
pays less after tax compared to a municipal bond even though the yield is higher. This would make
municipal bonds relatively more attractive. If taxes are lowered (tax cut by the Bush administration)
treasury bills become relatively more attractive which decreases demand on municipal and increases
it on treasury bonds.

Term structure
Yield curve is the plot on bonds with different maturity but same risk, liquidity and tax
considerations. They can be classified as:
Upward sloping Short term rates < Long term rates
Flat Short term rates = Long term rates
Inverted Short term rates > Long term rates
There are three important empirical facts:
1. Interest rates on bonds with different maturities move together over time
2. When short-term interest rates are low, yield curves are more likely to have an upward
slope; when short-term interest rates are high, yield curves are more likely to slope
3. Yield curves almost always slope upward.

Three theories have been put forward to explain these facts:

1. The expectations theory (fact 1 and 2)
2. The segmented markets theory (fact 3)
3. The liquidity premium theory (fact 1, 2 and 3)

Expectations theory:
Key assumption: bonds of different maturities are perfect substitutes. Implication: the expected rate
of return on bonds of different maturities are equal. There are two strategies for a two-year horizon:
Buy-and-hold: buy a two-year bond and hold it until maturity
Expected return = ((1 + i2t)(1 + i2t) 1)/1 = (1 + 2i2t + i2t2 1)/1 2i2t
Rolling strategy: buy a one-year bond and when it matures, buy another one-year bond.
Expected return = ((1 + it)(1 + iet+1) 1)/1 = (1 + it + iet+1 + it(iet+1) 1)/1 it + iet+1
If both strategies are perfect substitutes, expected returns are equal and thus
i2t = (it + iet+1)/2 (Note that squared percentages are so small that they can be ignored)
In words: The n-period interest rate equals the average of the one-period interest rate expected to
occur over the n-period life of the bond.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


The theory explains the first fact, that short and long rates move together: If the short-rate rises, the
average of the future rates also rises; the two are positively correlated. It also explains the second
fact, that yield curves have a steep slope when short rates are low and downward when short rates
are high: when short rates are very low, they are expected to rise to normal levels and the long rate
will be well above todays short rate (and v.v.). Since it cannot explain fact three:

Segmented markets theory:

Key assumption: Bonds of different maturities are not substitutes at all. Implication: Markets are
completely segmented and the interest rate at each maturity is determined separately.
As people typically prefer short holding periods with less interest rate risk, the for those bonds are
higher; price is higher and yield is lower. This theory does not explain fact 1 or 2.

Liquidity premium (preferred habitat) theory:

Key assumption: bonds of different maturities are substitutes but not perfect ones. Implication: it
modifies the Expectations theory with features from the Segmented markets theory. Since investors
prefer short term bonds they require a positive liquidity (term) premium lnt to hold long-term bonds.

Comparing the yields with those of the expectations theory, the liquidity premium theory produces
more steeply upward sloped yield curves. It explains all three facts.

Empirical evidence found in the 1980s showed that the spread between long- and short-term
interest rates does not always help to predict future short-term interest rates, which may be because
of substantial fluctuations in the liquidity (term) premium for long-term bonds. More recent research
favours a different view; it can be used for the very short and the long term but is unreliable on the
intermediate term.

The yield curve can be used as a forecasting tool for inflation and real output fluctuations. When the
curve is flat or downward sloping, it suggests that future short-term interest rates are expected to
fall and that the economy is more likely to enter a recession. Inverted yield curves often precede
recessions. Nominal interest rates, as according to Fischer, contains information about both the
future path of nominal interest rates and future inflation. A steep curve predicts a future increased

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Interpretations: 1981 sharp fall expected, 1997 slight fall, 1996 flat and 1993/2011 a rise.

Chapter 7 The stock market, the theory of rational expectations and the efficient market
Common stock is the principal way that corporations raise equity capital. Stockholders become the
residual claimant of the funds (cash flows) flowing into the firm and dividends are periodical
payments. Stock can be valued in three ways:
The one-period valuation model

Where ke is the required return on investment in equity.

The generalized dividend valuation model where the value of the stock today = PV of all CFs
(because Pn is so far into the future it can be ignored).

The Gordon growth model assumes that growth is constant forever and that g < ke.

How are prices determined in the market?

1. The price is set by the buyer willing to pay the highest price. This is not necessarily the
highest price the asset could fetch, but incrementally greater than what anyone else would
2. The market price will be set by the buyer who can take best advantage of the asset, the one
who can put the asset to the most productive use.
3. Superior information about an asset can increase its value by reducing its perceived risk.
Information is important for individuals in order to be able to value an asset. When new information
is released, expectations about future dividends or risk can lead to price changes. Since new
information is constantly received, expectations and therefore stock prices change frequently.
An example is the Subprime financial crisis and the stock market. Future growth prospects where
lowered and uncertainty (ke) increased leading to dropping stock prices as according to the Gordon
growth model.

The theory of rational expectations:

This theory is the most widely used theory to describe the formation of business and consumer
expectations. According to adaptive expectations, the expected inflation for example is an average
of past inflation rates. In this light expectations would slowly change as data changes. Because
people use other information than just past data to form their expectations (monetary policy for
example), expectations may change quickly. Muth (1961) therefore developed the theory of rational
expectations which states that expectations will be identical to optimal forecasts (the best guess of
the future) using all available information. Formally stated:
Xe = Xof The expected value = The optimal forecast
Even though a rational expectation equals the optimal forecast using all available information, a
prediction based on it may not always be perfectly accurate because:
1. It takes too much effort to make the expectation the best guess possible
2. The best guess is not accurate because the predictor is unaware of some relevant
3. Unpredictable shocks, chance and coincidence.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Why do people make rational decisions? Because it is costly not to. Optimal forecasts are especially
strong in financial markets since people with better forecasts are more likely to get rich. The
application of the theory here is referred to as the efficient market hypothesis.

Implications: 1) If there is a change in the way a variable moves, the way in which expectations of this
variable are formed will change as well. The normal behaviour of a variable could for example be
something different compared to before and a rational individual will take that into consideration.
The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time.
If they could, the rational decision maker would adjust his expectations.

Application: The return from holding a security equals the sum of the gain plus any cash payments
divided by the initial purchase price.

At the beginning of a period, we know Pt and C but we need to form an expectation of Pt+1. Since the
market has rational expectations Pet+1 = Poft+1 and thus Re = Rof. According to the supply and demand
analysis, Re is equal to the equilibrium return R*, so Rof = R*. An important conclusion:

Current prices in a financial market will be set so that the optimal forecast of a securitys return using
all available information equals the securitys equilibrium return. In an efficient market all unexploited
profit opportunities will be eliminated. Therefore not everyone in a financial market must be well
informed or have rational expectations for its price to be driven to the point at which the efficient
market condition holds.

In an efficient market, prices thus reflect the true fundamental (intrinsic) value of the securities. All
prices are correct and reflect market fundamentals (items that have a direct impact on future
income streams). This view has several important implications in the academic view of finance:
One investment is as good as any other because prices are correct. 2) A securitys price reflects all
available information. 3) Security prices can be used by managers of both financial and non-financial
firms to assess their cost of capital and hence these prices can be used to help make the correct
decisions about whether a specific investment is worth making.

Application: When investing in the stock market, recommendations from investment advisors cannot
help us outperform the market. A hot tip is most likely information already contained in the price of a
stock (or insider trading). Stock prices respond to announcements only when the information is new
and unexpected. A buy and hold strategy is the most sensible for the small investor.

Chapter 2 An overview of the financial system

In direct finance borrowers borrow funds directly from lenders by selling them securities (financial
instruments): claims on future income or assets. These are assets for the one who buys them and
liabilities for the firm selling them. In the absence of financial markets the allocation of capital funds
between those who have excess and those lacking would not be equally efficient. Customers would
also not be able to time their purchases as well.

A firm or an individual can obtain funds in a financial market in two ways: by issuing a debt
instrument (bond or mortgage) or by issuing equity (common stock claims to future income). A
disadvantage of owning equity is being the residual claimant, meaning that others have higher
priority in being repaid first.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


In the primary market, new issues of a security is sold to initial buyers. In the secondary market,
previously issued securities are traded (exchanges like NYSE or Euronext, or over-the-counter (OTC)).

Financial market instruments

The money market refers to short term debt instruments (<1 year) and the capital market to long
term debt (>1 year) as well as equity. Bonds or mortgages are debt instruments.

Money market instruments (MMIs):

Treasury bills highly liquid, short-term debt instruments. Safest of all MMIs because default risk 0.
Bank bills like treasury bills but are sold at a greater discount (higher yield).
Certificate of deposit (CD) sold by a bank to depositors that pay annual interest and at maturity pays
back the original purchase price. Extremely important source of funds for commercial banks.
Commercial paper short-term debt instrument issued by large banks and well-known corporations.
Growth of the market has been substantial.
Interbank deposits maturities from overnight to a year. Growing dependency in the past years.
Gilt repurchase agreements (repos) are short-term loans for which UK government gilt-edged
securities (bonds, TBs) but also commercial paper and CDs act as collateral. Started in 96.

Capital market instruments:

Stocks are equity claims on the net income and assets of a corporation. Their value fell with the
Mortgages are loans to households or firms to purchase housing, land or other real structures, where
the asset is used as collateral.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Corporate bonds are issued by corporations with very strong credit ratings. Typically pay interest
twice per year and pay off when the bond matures. Some are called convertible because of that
additional feature.
Government bonds are long-term debt instruments issued by the government to finance deficit.
Local authority (municipal) bonds are issued to finance local projects
Bank and building society bonds and loans typically fixed rates 1-5 years. Some banks issue bonds
based on investments in selected stock and provide a minimum rate of return< these have some
properties of equity rather than debt.

Why are financial intermediaries important?

1. They lower transaction costs because of their expertise and economies of scale. They also
provide their customers with liquidity services, which make it easier for customers to conduct
2. They reduce exposure to risk because of the process known as risk sharing also known as
asset transformation because risky assets are turned into safer ones for investor (low
transaction costs so risks are shared at a low cost, enabling a profit). They also help by means
of diversification.
3. They reduce asymmetric information which can cause issues like adverse selection and
moral hazard.

Adverse selection takes place before the transaction occurs. Borrowers who are most likely to
produce counter-productive outcomes (=adverse) are most likely to seek loans lenders provide
less loans. Example: health care, you know exactly how likely you are to get ill but insurance
company has no idea.

Moral hazard takes place after the transaction. Occurs when one party has an incentive to engage in
undesirable activities that are not in the interest of the common goal of the agreement lenders
provide less loans. Example: fire insurance, after the contract is signed the insured party takes
excessive risk (fireworks in the basement). Immoral behaviour.

Financial intermediaries reduce both problems because they are better equipped to screen (ex ante)
bad from good credit risk, and they develop expertise in monitoring (ex post) the parties that borrow.

Types of financial intermediaries

The intermediaries can be grouped in three categories; depository institutions (banks, most
important in this course), contractual savings institutions and investment intermediaries.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


In the Euro area as well as the UK the value of assets for all three types of institutions has grown
from 1999 until now. Commercial banks have been the most important but in the euro area,
investment intermediaries have grown strongly the past years. In the UK as well, where it has
surpassed the contractual savings institutions in order of importance.

Regulation of the financial system is set in place to 1) increase the information available to investors
and 2) to ensure the soundness of the financial system to limit financial panic.

Chapter 8 An economic analysis of financial structure

There are eight basic facts about financial systems throughout the world:
1. Stocks are not the most important source of external financing for businesses.
2. Issuing equities is not the only type of marketable security by which businesses finance their
3. Indirect finance, which involves the activities of financial intermediaries, is many times more
important than direct finance, in which businesses raise funds directly from lenders in
financial markets.
4. Financial intermediaries, particularly banks, are the most important source of external funds
used to finance businesses.
5. The financial system is among the most heavily regulated sectors of the economy.
6. Only large, well-established corporations have easy access to securities markets to finance
their activities.
7. Collateral is a prevalent feature of debt contracts for both households and businesses.
8. Debt contracts typically are extremely complicated legal documents that place substantial
restrictions on the behaviour of the borrower

Sources of external funds for investments

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Financial structure of nonfinancial businesses

An important feature of financial markets is that they have substantial transaction and information
costs. An economic analysis of how these costs affect financial markets provides us with explanations
of the eight facts, which gives a much deeper understanding of how the financial system works.

Transaction costs such as wanting to purchase only a small portion of stock that are sold in large
bundles, or the inability to diversify can be solved by financial markets. They use economies of scale
and expertise.

Asymmetric information, adverse selection and moral hazard are also better off with financial
markets. The analysis of how asymmetric information problems affect economic behaviour is called
agency theory.
How adverse selection influences financial structure:
The lemons problem is the reason that marketable securities are not the primary source of financing
in most places. It also explains why stocks are not the most important source of financing for
American businesses.

Private production and sale of information are ways to solve the adverse selection problem, by
providing full details about the individuals or firms seeking to finance private investments. Credit
rating agencies do so. However, because of the free-rider problem it is not completely efficient
(those informed who have paid for it change their behaviour, seen on the market and others can
benefit too).
Government regulation to increase information is another way to soothe the asymmetric
information issue, as is financial intermediation. Here you involve financial experts like car dealers,
allowing sellers and buyers to have more confidence in the market. Collateral and net worth is a way
to provide a warranty.

How moral hazard affects the choice between debt and equity contracts:
Equity contracts are subject to the principal-agent problem. Tools that can help solve it are
production of information: monitoring which has the disadvantage that it is costly. Government
regulation to increase information is another way; here too financial intermediation and venture
capital firms (that pool the resources of their partners to start new businesses in exchange for equity
shares. By being part of the board they can track the progress closely) are a benefit. Debt contracts
are another option as the borrower will suffer the consequences of irresponsible behaviour.

How moral hazard influences financial structure in debt markets:

With equity borrowers have an incentive to take on investment projects that are riskier than the
lenders would like. Net worth and collateral as well as monitoring and enforcement of restrictive
covenants (to inform, keep collateral valuable, encourage desirable and discourage undesirable

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


behaviour) are other issues tackled by financial intermediaries. Below is an overview, study it
carefully and make sure you understand it:

Chapter 10 Banking and the management of financial institutions

What is the structure of a banks balance sheet and how do banks manage their liquidity, assets,
liabilities and capital? This will help us understand the importance of regulation of the banking sector
and the recent financial crisis, as well as the role of banks in the money supply process.
Total assets = Total liabilities + Capital
Liabilities are sources of bank funds and assets are uses to which the funds are put. Funds are
obtained by borrowing and by issuing other liabilities like deposits.

Sight deposits are bank accounts that allow immediate cash withdrawals and that are not interest
bearing. Time deposits cannot be withdrawn like sight deposits (without a penalty). Banks deposits
and other funding relates to interbank and central banks borrowings. Debt and other securities are
funds obtained by borrowing from the financial market. Foreign currency deposits shows how the
bank borrows and lends in foreign currency. Bank capital (equity or net worth) = Total assets

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Reserves are deposits plus currency which is physically held by banks (vault cash). Reserves =
required + excess reserves = ER + RR. Securities are an important income-earning asset, and they can
be classified into three categories:
1. Government and agency securities (treasury bills and short government bonds secondary
2. Commercial paper
3. Private-sector bonds and other securities.
Loans are the banks primary source of income; firms, mortgages, consumers and interbank loans (in
the order of importance). Net trading and other assets are commercial securities such as derivatives
that the bank holds for the purpose of selling them for a profit, and the physical capital (buildings,
computers and other equipment).

Basic banking using T-accounts

When a bank receives or loses deposits, reserves increase or decrease by the same amount. The
reserve ratio, set by politics, is defined as r = RR/D.
Asset transformation: banks borrow short and lend long, applying the law of large numbers. This is
known as maturity transformation.

General principles of bank management

These principles can be divided into four categories of management:
Liquidity management refers to keeping enough cash on hand, the acquisition of sufficiently liquid
assets to meet the banks obligations to depositors. Asset management refers to that the bank
manager has to pursue an acceptably low level of risk by acquiring assets with a low rate of default
and by diversifying asset holdings; managing credit risk and interest-rate risk. Liability management
is acquiring funds at a low cost. Capital adequacy management entails deciding on the amount of
capital the bank should maintain and then acquiring it.

1) Liquidity management The fundamental role of a healthy level of liquidity is that it reduces costs
associated with deposit outflows as well as the probability of bank runs or bank panics. This bank
starts off with a reserve ratio of 10% but after a deposit outflow of 10 mln, it has to eliminate the
shortfall as soon as possible to prevent insolvency:

It has four basic options to increase the reserves again:

1. Borrow from other banks (interbank market). This leads to increased reserves together with
an additional item under liabilities, Borrowing.
2. Sell securities. This causes no change under liabilities but redistributes amounts under
assets, from Securities to Reserves.
3. Borrowing from the central bank has the same effect on the balance sheet as option 1

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


4. Call in or sell loans. Here thered also be no changes to the liabilities, just a redistribution
from Loans to Reserves on the balance sheet. This option has an even lower priority than
lending from the CB, the lender of last resort, since it can have serious consequences to the
markets trust in the bank.

Excess reserves are insurance against the costs associated with deposit outflows. The higher the
costs associated with deposit outflows, the more excess reserves banks will want to hold.

2) Asset management to maximize profits, there are three main goals in managing assets:
Simultaneously seeking the highest possible returns on loans and securities; minimizing the risk
associated with them; and making adequate provisions for liquidity by holding liquid assets.

There are four main ways to achieve this:

1. Find borrowers who will pay high interest rates and are unlikely to default.
2. Purchase securities with high returns and low risk, and further lower those risks by
diversifying the portfolio.
3. Lower credit- and interest-rate risk.
4. Fulfilling the need for liquidity (=satisfying the required reserves) without bearing huge
(opportunity) costs; balancing the need for liquidity against increased returns from less liquid
Strategies to manage credit risk
1. Screening and information collection (credit score based on extensive surveys etc.)
2. Specialize in lending (trade-off with diversification, becoming an expert but putting more
eggs in one basket)
3. Monitoring and enforcement of restrictive covenants
4. Establish long-term customer relationships
5. Loan commitments (to increase information collection)
6. Collateral and compensating balances
7. Credit rationing
Interest-rate risk
There are two ways of measuring interest-rate risk; Gap analysis and Duration analysis.
Gap analysis: Say for example that the rate-sensitive assets are 20 and the rate-sensitive liabilities
50. The interest rate increases with 5%:
Gap = (rate sensitive assets) (rate sensitive liabilities) = -30
Profits = i * Gap = 5% * 30 = 1,5 mln
In other words: if rate sensitive assets < rate sensitive liabilities, an increased interest rate causes loss
of profits (and v.v.).

Duration analysis: Measures the sensitivity of market value of a banks total assets and liabilities,
how they react to changes in interest rates. Remember that the longer the maturity of an asset or
liability, the stronger its market value changes with interest rate changes.
% Change in market value of a security (percentage point change in interest rate) * (duration in
years). The total change in bank capital is equal to the difference between Asset Liability
Example: The average duration of assets is 3 years and of liabilities 2 years. What happens if the
interest rate increases with 5%? MV(Assets) = (3*5%) = 15%. MV(Liabilities) = (2*5%) = 10%.
That entails that with the below balance sheet, the change in assets will be 15 mln and the change
in liabilities 9 mln (0,1*90). Bank capital = (15 (9)) = 6 mln

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Strategies to manage interest-rate risk

1. Rearrange balance-sheets to have a balance between rate-sensitive assets and liabilities, and
the same duration
2. Use financial derivatives (interest-rate swaps, options, forwards and futures)

3) Liability management with the development of the interbank market in the 1960s, banks
became able to redistribute funds; those with a surplus could lend to those in need. Since that time
banks are no longer primarily dependent on sight- and demand deposits. Now when a bank finds an
attractive loan opportunity, it can acquire funds by selling a negotiable CD. Or in case of a reserve
shortfall, it can borrow on the interbank market without high transaction costs. Most banks now
manage both sides of the balance sheet together in an Asset-liability management (ALM) committee
with the goal of minimizing the costs of deposits and borrowing.

4) Capital adequacy management the bank capital is a cushion to prevent bank failure. The amount
also affects returns for the owners (equity holders) and a minimum amount (bank capital
requirements) is set by the authorities (see Basel Accords). Strategies for managing bank capital
1. Buying back/issuing new stock: you can reduce the amount of bank capital by buying back
some of the stock.
2. Paying higher/lower dividends to stockholders: you can reduce the bank capital by paying out
higher dividends.
3. In-/Decreasing bank assets (=changing the bank capital relative to the assets): you can keep
bank capital constant but increase the assets by acquiring new funds, f.e. by issuing new CDs,
and then seek out loan businesses or purchasing more securities with these new funds.

ROE = Returns on equity = (Profits after tax) / (Equity capital) = P/E

ROA = Returns on assets = (Profits after tax) / (Assets) = P/A
EM = Equity multiplier = A/E ROE = P/E = P/A * A/E = ROA * EM
Thus for any given ROA, if E then ROE. Shareholders want a high ROE, i.e. a low E. This explains
the fact that there is a trade-off between safety and returns to equity holders (ROE).

Off-Balance-Sheet (OBS) activities

As the environment for banks has become more competitive in recent years, banks have been
aggressively seeking profits by engaging in these activities. They involve trading financial instruments
and generating income from fees and loans sales; activities that do affect profits and risk but do not
appear on the balance sheets. Examples: fees from specialized services linked to securitization
(pooling various types of contractual debts like mortgages and credit card obligations), derivative and
foreign exchange transactions, guarantees of securities and backup credit lines etc.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Chapter 11 Economic analysis of financial regulation

Regulation is about setting specific rules of behaviour that financial firms have to avoid. Financial
markets are regulated for two reasons: to increase information (reducing AS and MH) and to ensure
soundness of financial intermediaries (preventing financial panics and potential crises).

There are eight basic categories of financial regulation:

1. The government safety net the government is responsible for deposit insurance and for
serving as the lender of last resort. The deposit insurance, set in place in response to the
current crisis, is 100.000 for practically all euro-countries and the equivalent in the local
currency for the remaining countries (UK, SE, DK). IE and SK are exceptions with unlimited
2. Restrictions on asset holdings as moral hazard may be encouraged by the government
safety net, banks are restricted to the holding of risky assets such as common stock.
Regulations also promote diversification to reduce risk.
3. Capital requirements as regulators became increasingly concerned about OBS, the Basel
Accord was put in place. See more information on this part below.
4. Prompt corrective action when there is a low level of capital, banks are closer to failure
because of the lack of cushion, and they are also more likely to take excessive risk because
they have little skin in the game. Regulators therefore also examine this point.
5. Licensing and examination entails overseeing how banks are operated, prudential
supervision. It is put in practice using CAMELS rating among others.
6. Assessment of risk management assessment and rating of the quality of oversight
provided by the directors, the adequacy of policies and limits for activities presenting
significant risk, the quality of risk measurement and monitoring, the adequacy of internal
controls and guidelines on bankers remuneration and bonuses that feed into risk-taking
7. Disclosure requirements more public information of an institutions portfolio and the
amount of its exposure to risk enables stockholders, creditors and depositors to evaluate and
monitor institutions and also act as a deterrent against excessive risk taking.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


8. Consumer protection f.e. implementation of an EU directive which requires all lenders, to

provide information to consumers about the actual cost of borrowing, including a
standardized interest rate and the total finance charges on the loan.

Disadvantages of regulation
1) Moral hazard: safety-net arrangements lead to cases of too big to fail or too important to fail.
TBTF refers to the interdependence between banks and that a disruption on one bank can have
severe consequences if not caught early. TITF refers to that if the CB organized a bailout of a
financial institution in trouble because it thought that failure would influence the rest of the financial
system, the intervention alone could create moral hazard.
2) Costs of compliance: heavy and complex regulation may lead to higher costs of financial services
for clients and entry barriers; i.e. that the costs become relatively very expensive for smaller players.
3) Regulatory capture: the regulation process gets captured by big banks WHAT IS THIS

Basel Accord I (1988)

Set out a common minimum risk weighted capital to asset ratio for international banks, amounting to
8% of risk-weighted assets (RWA). Four risk weights are applied; 0.0 for no risk (reserves,
government bonds); 0.2 for low risk (money market loans); 0.5 for moderate risk (mortgages) and 1.0
for standard risk (commercial and consumer loans). The RWA of all elements, including OBS, is added
up to a total.

The motivation behind this accord was the Latin-American debt crisis of the early 1980s, and
introduced capital requirements aiming to reduce the likelihood of bank collapses. It was meant to
strengthen the national and international financial system against the spread of systematic risk,
through international financial linkages. The global approach was taken because of national
differences in bank capital requirements previously, could lead to banks relocating to countries with
the most advantageous (lowest) capital requirements. National differences could also cause banks in
some countries to become more competitive than in others.

Disadvantages: some categories were insufficiently differentiated. Several OBS-commitments were

not subjected to capital requirements (giving banks an incentive to take advantage and go around
the rules). It also contained biases, since there was preferential treatment for government debtors
f.e. while several corporations have better credit ratings.

Basel Accord II (2004)

This accord was implemented to address the shortcomings of Basel I. It was based on three pillars:

Pillar 1 set minimum capital requirements, making the calculation of RWA more sophisticated to
better reflect the risk. Capital requirements for large, internationally active banks were more closely
linked to actual risk for three types: market risk, credit risk and operational risk. More categories of
assets were specified with different risk weights in a standardized approach. Alternatively,
sophisticated banks could pursue an internal ratings-based approach permitting the bank to use its
own model of credit risk. The definition of the regulatory capital (the numerator) remains basically
unchanged while the general minimum capital requirement (8% of RWA) is unchanged.

Pillar 2 focuses on strengthening the supervisory process, particularly in assessing the quality of
risk management in banking institutions and evaluating whether these have adequate procedures to
determine how much capital they need. First banks asses their capital adequacy on basis of its own
internal risk management, and then national supervisors review if the capital is consistent with the
overall risk profile.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Pillar 3 focuses on improving market discipline by increasing disclosure of details about a banks
credit exposures, the reserves and capital, the officials who control the bank and the effectiveness of
the its internal rating system.

Disadvantages: this accord was very complex and costly to implement which lead to entry barriers.
The standardized approach based on credit ratings are not always reliable and there is a pro-
cyclicality in lending; during bad times the probability of default is higher and Basel II will require
more capital which leads to a reduction in lending that can make the crisis worse (also works in the
opposite way in good times).

Basel Accord III (2009)

To tackle the fact that Basel II did not prevent the recent problems in the banking sector, supervision
and regulation had to be strengthened. In July 2009 emergency measures were taken: higher risk
weights for securitization exposures were implemented, to better reflect the riskiness of these
products, as well as stricter rules for OBS. Banks are also required to conduct more rigorous credit
analyses of externally-rated securitization exposures.

Relationship between price and YTM:

Difference between YTM and rate of return:

Key facts on the maturity and volatilty of bond returns:

1. Return = Yield only when the Maturity = Holding period
2. When the bond has a maturity that is greater than the holding period, interest rate increases
imply a capital loss
3. The loner the maturity, the greater is the percentage of a price change associated with an
interest rate change
4. The longer the maturity, the more return changes with change in interest rate
5. Bonds with a high initial interest rate can still have a negative return if the interest increases

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Part II
Financial crises occur when an increase in asymmetric information (AS and MH) problems make
financial markets incapable to function. In general, we can identify six factors: 1) asset market effects
on balance sheets, 2) deterioration in financial institutions balance sheets, 3) banking crisis, 4)
increases in uncertainty, 5) increases in interest rates and 6) government fiscal imbalances.

The relative importance of each of these factors is not unique. Each financial crisis has its own special
underlying factors and dynamics.

1. Asset market effects on balance sheets this factor can be caused by several underlying
reasons. A stock market decline can cause deterioration in borrowing firms balance sheets.
In turn this deterioration may increase AS and MH. The decline means that the net worth of
the corporation has fallen and this makes lenders less willing to lend because the value of the
collateral has declined. This leads to a decline in aggregate output which increases moral
hazard since it provides incentives to make risky investments. Overall decreased economic

Another reason is unanticipated decline in the price level which also decreases the net
worth of firms. The value of borrowing firms liabilities in real terms decreases but the assets
do not. Unanticipated decline in the value of the domestic currency is reason number three.
Non-financial firms in developing countries may find it easier to issue debt in a foreign
currency and this may lead to a financial crisis in the same way that a price decline can. Lastly
asset write downs may also lead to a contraction of lending, see next category.

2. Deterioration in financial institutions balance sheets the state of banks and of their
financial intermediaries balance sheets has an important effect on lending. A contraction in
their capital means they have fewer resources to lend so lending and therefore economic
activity decreases.

3. Banking crisis if the above deterioration is severe enough, banks will start to fail. Fear may
spread to other institutions causing even healthy ones to go under. A bank panic occurs
when multiple banks fail simultaneously and the source of the contagion is asymmetric
information. When a large number of banks fail in a short period there is loss of information
production in financial markets and a direct loss of the financial intermediation. The
decreased lending leads to higher interest rates, increases AS and MH and the contraction in
economic activity may be even more severe.

4. Increases in uncertainty perhaps because of the failure of a prominent financial or non-

financial institution, a recession or stock market crash, lenders have a hard time to screen
god from bad credit risk. Lenders are unable to separate good from bad risk lenders due to
AS, lend less and economic activity decreases.

5. Increases in interest rates if increased demand for credit or a decline in the money supply
market drives up interest rates sufficiently, good credit risks are less likely to want to borrow.
Lenders are aware of the increased AS and become reluctant to make loans. Increased
interest rates can promote financial crisis through their effect on cash flow, the difference
between cash receipts and expenditures. A firm with sufficient cash flow can finance its
projects internally. An increase in interest rates in household and firm interest payments
decreases their cash flow. With less cash flow there are fewer internal funds meaning
external sources are needed. Asymmetric means the bank may choose not to lend which
again has a negative effect on economic activity.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


6. Government fiscal imbalances may create fears if default on government debt. The most
recent example is the Eurozone sovereign debt crisis. Demand from individual investors from
government bonds may fall, causing the government to force financial institutions to
purchase them. If the debt declines in price, financial institutions balance sheet weakens and
from there it continues

Dynamics of past crises in developed countries

Stage one: Initiation of financial crisis. There are several ways that can initiate a financial crisis:
mismanagement of financial liberalization or innovation, asset price booms and busts, spikes in
interest rates or a general increase in uncertainty when there are failures of major financial
institutions. From tutorial: Balance sheet deteriorates (caused by financial innovation), prices of
assets decrease, interest rates increase, uncertainty increases; all four factors are interconnected.
This leads to asymmetric information and MH/AS increases. Financial innovations lead to fast
developments, bubbles. Subprime mortgages are an excellent example; derivatives that lead to
excesses in combination with insufficient control. Why does MH/AS get worse? Banks try to fix the
maturity mismatch by increasing the (relative) capital. How? Shrink the bank, lend less. What if the
prices of the active decrease? That means your collateral value decreases, which also leads to moral
hazard. Interest rate increases adverse selection because only risky lenders accept the high rate.
This leads to moral hazard

Stage two: Banking crisis. Depositors begin to withdraw funds from banks and due to fire sales, some
banks may fail, and others need to be rescued or taken over. From tutorial: GDP decreases because
AS/MH which leads to a banking crisis. That crisis leads to even worse AS/MH, which further lowers

Stage three: Debt deflation. If the economic dornwturn leads to a sharp decline in prices, the
recovery process (help from public and private authorities in the previous stage) may be short-
circuited. This stage was prevented in the most recent crises, unlike in the 1930s and the Great
Sequence of events, developed countries

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Dynamics of crises in emerging market economies

Following and sparked by the subprime crisis, was the European sovereign debt crisis. Investors
became nervous that some Eurozone countries would be unable to pay the debts back. Emerging
market economies are those in an earlier stage of market development that have recently opened
up to the flow of goods, services and capital from the rest of the world.

Stage one: Initiation of financial crisis. Typically there are two paths. Path one: mismanagement of
financial liberalization refers to that emerging markets have weak supervision and lack expertise.
The lending boom often leads to riskier lending than in advanced countries. Eventually all of the
highly risky lending starts producing high losses, and because the securities market and other
financial institutions are not well developed, there are no other players to solve the asymmetric
information problems. The impact is even worse than in developed countries. Path two: severe fiscal
imbalances when there are substantial budget deficits, emerging countries governments cajole or
force banks to purchase government debt. The banks holding the debt get a big hole on their assets
side and there is a huge decline in net worth.

Stage two: Currency crisis. As the above factors build on each other, foreign exchange market
participants may sense an opportunity to make huge profits by betting on depreciation. Currency
sales flood the market and the currency collapses. This is called speculative attacks which plunges the
economy into a full-scale vicious downward spiral. Fiscal imbalances may also directly lead to a
deterioration of bank balance sheets; government deficits spin out of control, investors become
suspicious and start pulling money out.

Stage three: Full-fledged financial crisis. Since it takes more domestic currency to pay back the debt
denominated in foreign currency, the net worth decreases which increases AS and MH.

Sequence of events, emerging markets

The subprime financial crisis of 2007-2008 (from book)

Before 2000, only the most creditworthy (prime) borrowers could obtain residential mortgages. Due
to financial innovation, subprime mortgages could now be issued. Bundling of smaller loans into
standard debt securities, securitization, was also implemented; mortgage-backed securities and
collateralized debt obligations provided a new source of funding. All of this developed into a trillion
dollar market by 2007, and a housing price bubble formed.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


What then followed were agency problems. The subprime mortgage market was an originate-to-
distribute business model that typically involved a mortgage broker before the loan was
redistributed. The investor had little incentive to make sure that the mortgage had good credit risk
which caused principal-agent problems. Adverse selection became especially severe since risk-loving
investors could obtain loans to acquire houses and just walk away if prices went down. Mortgage
brokers could encourage borrowers or commit fraud by falsifying mortgage applications.

In the OTD-model model, banks transfer the credit risk (of loans and mortgages) to others. How?
One option is to originate the loan and resell it straigh away. The issue is that loans are illiquid and
risky, so not very attractive. This can be solved by securitization the process of transforming illiquid
financial assets (residential mortgages, credit card loans etc.) into a marketable debt security. A
portfolio of mortgages are sliced into different tranches. Legally, the portfolio is transferred to a
special purpose vehicle (SPV) a financial entity with only purpose to collect principal and interests
from the underlying portfolio and pass them to the tranches owners. Tranches are chosen to ensure
a specific credit rating, from senior (first to be paid out, lowest risk and lower return) to junior
(highest risk and highest expected return).

The third step in the securitization process is to sell tranches to investors such as pension funds,
hedge funds, structured investment vehicles (SIVs), investment banks etc., with different risk
preferences. The most notorious structured credit products and asset-backed securities (ABS) are
securities in the underlying portfolio: Collaterized Debt Obligations (CDOs, corporate bonds)
Collaterized Loan Obligations (CLOs) or Collaterized Mortgage Obligations (CMOs).
CDO2: is identical to a CDO except for the assets securing the obligation. Unlike the CDO, which is
backed by a pool of bonds, loans and other credit instruments; CDO-squared arrangements are
backed by CDO tranches. CDO-squared allows the banks to resell the credit risk that they have taken
in CDOs. CDO-cubeds allow the banks to resell the credit risk that they have taken once again by
repackaging their CDO-squareds.

Securitization insights:
The larger is the number of securities in the underlying pool, the larger is the fraction of the
tranches ending up with higher credit ratings than the average (credit enhancement).
Reapplying securitization to the junior tranches (e.g. second round of securitization) can
create lower risk senior tranches.
A key factor in creating tranches that are safer than the underlying portfolio is the correlation
of default: the higher the correlation, the less safe the senior tranche.
If defaults are perfectly correlated, securitization achieves no credit enhancement for the
senior tranche.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Maturity mismatch: Most investors prefer assets with short maturity. Commercial banks created OBS
entities (SIVs) to shorten the maturity of long-term structured products. SIVs invest in illiquid long-
term assets and issue short-term asset-backed commercial papers (ABCPs). Typical maturity is 90
days. Being exposed to funding liquidity risk since the ABCPs need to be rolled over every 90 days, a
sponsoring bank grants a credit line (liquidity backstop) to SIVs. In the end the sponsoring bank still
bears the liquidity risk and exposure to maturity mismatch. Also, investment banks increasingly
financed themselves with short-term repurchase agreements (repos)

Pros and cons of securitization

Increased funding (liquidity) for banks. Doing this they get unlimited access to new loans.
Reduced capital requirements for banks (Basel II but also related to the first point)
Reduced (transferred) credit risk, better risk diversification for the issuing banks as well as for
the buyer
Investors can diversify their investment portfolios, reduces credit risk for the bank (also
related to the third point)

Agency problems: reduces incentive for bank to screen and monitor these loans (only
pipeline risk)
Lack of transparency and high complexity: nobody knows anymore who exactly bears what
Rating agencies are not completely independent (conflict of interest).
Banks effectively get OBS activities that are very risky because they are affiliated with the
hedge funds they resell to.

Why did banks hold structured products? Some toxic waste tranches were held in the balance sheets
because banks could not sell them. But the main reason is the behaviour of bank and fund managers,
whose performance was based on earnings they generate relative to their peers. Managers ended up
taking excessive risks to boost their short term performance and as a result bonuses.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Empirical evidence

Unfolding of the crisis

Firstly: agency problems arise. The OTD-model is subject to principal-agent problems between the
investor and mortgage broker. Borrowers had little incentive to disclose information about their
ability to pay, and commercial as well as investment banks (+CRAs) had weak incentives to assess the
quality of securities. The housing price bubble burst and there was recognitioin of the actual risks
associated with structured products (=increase in uncertainty).

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


With the burst of the bubble came an increasing number of people who could not repay their
(subprime) mortgage loans. Banks repossessed the houses underlying the mortgages to sell them off;
this lead to falling houseprices (from 2006). This in turn leads to more and more subprime borrowers
with underwater mortgages, giving them high incentives to walk away.

What followed was that increasing default on mortgages meant that ABSs pay out less. The CRAs
woke up and started down-grading them based on the sub-prime mortgages. When the concerns
about strutcutred products increase and confidence in the reliability of ratings drops, the demand for
ABCPs collapses.

This brought many SIVs and hedge funds into liquidity problems as their main source of funding
disappeared. Instead of a classic bank run, there was a run on the shadow banking system.
Haircuts, the amount of collateral above the value of the loan in order to get it, rose to high levels
(up to 509%). There were two options for banks, to use credit lines from sponsoring banks or to sell
of ABSs quickly to raise the necessary funds to pay off maturing ABCPs (fire sales). In other words,
banks were in trouble. Sponsoring banks extended credit lines to SIVs/hedge funds. Banks incurred
loses themselves on ABSs they hold in their portfolio; the interbank money market started drying up
because banks needed liquidity themselves and the trust between banks decreased. The TED spread

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


(difference between Eurodollar and Treasury bills, 3m) increased from 0.4 to 24 percent points in
August 2007.

Fire sales drove prices of structured products down and deteriorated balance sheets (and capital) of
banks. To ease the liquidity crunch, major central banks 1) lowered interest rates, 2) provided
liquidity and 3) broadened the type of collateral banks could post (anonymously) or lenghtened the
maturity of lending. Banks in solvency troubles either went bankrupt, were taken over or received
government support. Recession and deflation risks led CBs to introduce additional non-conventional
policies (f.e. quantitative easing) .

Failure of High-profile firms: Bear Stearns got big liquidity problems. JP Morgan acquired it with Fed
backing in the beginning of 2008. Fannie Mae and Freddie Mac were put into federal conservatorship
mid 2008. Lehman Brothers did not receive government guarantee and went bankrupt soon
thereafter (september). Merrill Lynch, AIG, Wachovia and Citibank were also in major trouble, and
either subject of a take-over or received government support (Troubled Asset Relief Program, TARP).

Government support for banks

Some finishing lessons: Central banks should avoid fuelling asset prices with persistently low interest
rates. Micro- and macro prudential supervision of financial institutions should be improved. Capital
requirements should be higher and counter-cyclical (Basel Accords). Better statistical models should
be used to evaluate risk of new products and regulate rating agencies. Corporate governance: there
should be no perverse incentives of fund managers.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Chapter 13 The goals and structure of Central banks

Price stability, which central bankers define as low and stable inflation, is increasingly viewed as the
most important goal of monetary policy. This is due to that inflation creates uncertainty which may
hamper economic growth.

The benefits of price stability are:

Improving transparency of relative prices which facilitates the efficient allocation of resources as it is
easier for people to disentangle changes in relative prices.
Reducing distortions of tax and social security systems; taxes are usually not indexed meaning that
even though someones real income has not increased he will still have to pay tax.
Preventing arbitrary redistribution of wealth and income high inflation is associated with high
uncertainty which leads to unintended wealth transfers between creditors and debtors.
Reducing inflation risk premia in interest rates. If investors are uncertain about the general price
development, they will ask for an inflation-risk premium to compensate.
Avoiding unnecessary hedging activities a high-inflation environment may lead to the stockpiling
of real goods, preventing efficient allocation.
Increasing benefits of holding cash since higher inflation leads to higher nominal interest rates
meaning an increasing opportunity cost of holding it.

A central element in a successful monetary policy is the use of a nominal anchor, a variable to tie
doewn the price level to achieve price stability. Examples include exchange rates, monetary
aggregate and inflation rates.

A more subtle reason is that it can limit the time-inconsistency problem: the inability to follow a
good long-term plan consistently over time. This occurs when you have a plan that leads you to best
possible results in the long run, but in the short run you are tempted to deviate from it. A good long-
run plan which may be reneged by short-run temptations is time-inconsistent.

Childrens behavior with Sinterklaas is an example, but a more relevant one is monetary policy by
central banks: the long-run plan is to have a stable policy aimed at keeping inflation low in the long
term, but in the short term it might be tempting to have a policy that is more expansionary than
people expect to boost the economy in the short run.
This problem can be solved by delegating monetary policy to an independent central bank with a pre-
set behavior rule to achieve price stability.

Other goals of monetary policy include 1) high employment (full employment, at the natural rate and
excluding frictional unemployment which cannot be prevented), 2) economic growth, 3) stability of
financial markets, 4) interest rate stability and 5) stability in foreign exchange markets.

Structure of the Bank of England

Founded in 1694, the Bank of England (BoE) is one of the oldest in the world. The main decision
making body is the Monetary Polcity Committee (MPC) which meets monthly and consists of 9
members: Governor + 2 Deputy Directors + 6 other members. Their decisions on monetary policy are
made by voting.

Structure of the Federal Reserve System (Fed)

This system is made out of 12 Federal Reserve Banks (FRBs), a Board of Governors (BG) and a Federal
Open Market Committee (FOMC). The largest of the 12 belong to New York, Chicago and San
Francisco with the NY-one being the most important. The FRBs are quasi-public institutions that are
owned by private commercial banks in the district that are members of the Fed system. The bank
members in each system elect 6 directors and 3 more are appointed by the BG. 9 directors appoint
the president of the bank subject to approval by the BG.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


5 of the 12 FRBs presidents (rotating) have a vote in the FOMC. The president of the NY Fed is a
permanent member of the FOMC.
The functions of the Fed are:
Hold deposits for banks in the district
Administer and make loans to banks in their districts
Ensure working of payment system
Supervise and regulate financial institutions
Issue new currency and withdraw damaged currency from circulation
Collect data on local conditions and research topics related to the conduct of monetary

The BG is structures as follows. 7 members are head quartered in Washington, D.C. Each member is
appointed by the US president and confirmed by the Senate, and they have to come from different
districts. Their terms are 14 years and non-renewable. The chairman serves four (renewable) years
and is chosen by the governors. The BG has the majority of the votes in the FOMC.
The functions of the BG are:
Vote on the conduct of open market operations within the FOMC
Set reserve requirements
Control the discount rate
Bank regulation functions: 1) approving bank mergers and applications for new activities, 2)
specifying permissible activities of bank holding companies, 3) supervising activities of foreign
banks operating in the U.S. Federal Open Market Committee

The FOMC has 12 members; 7 from BG + president of NY Fed + 4 presidents of other FRBs (rotating).
It meets eight times per year and issues directives to the trading desk at the NY Fed (implementation
of monetary policy is centralized). The chairman is Ben Bernanke (since 1 Feb 2006, and Janet Yellen
as of 31 Jan 2014).

Structure of the ECB

Is similar to that of the Fed. The European system of central banks includes the ECB plus the 27 EU
countries National central banks (NCBs). The Eurosystem refers to the ECB plus the 17 NCBs of the
euro countries.
The main decision making bodies of the ECB are the Executive board (EB) with 6 members, and the
Governing Council (GC) with 6 EB members + 17 NCB governors.

The governing council has 23 members: 6 EB members (President, vice-president and four other
members) + 17 NCB governors. They meet every month at the ECB in Frankfurt.
The functions of the GC are: deciding on key interest rates, reserve requirements and provision of
liquidity to banking system of euro area. It usually operates by consensus but as new countries join
EMU (as per 18 on the 1st of January 2014) it will be based on a system of rotation with voting. The
president is Mario Draghi (since 1 Nov 2011).

Structure of NCBs
They have similar functions as FRBs and implement monetary policy set by the GC (providing liquidity
to banking system in their countries). They ensure settlement of domestic and cross-border
payments, issue and handle euro notes in their countries, collect national statistical data and are
typically involved in banking supervision (e.g. DNB) which, with the single supervisory mechanism will
be more under the control of the ECB (Autumn 2014).
What are the main differences between the ESCB and the FRS? Only 5 of the 12 presidents of the
FRBs can vote in the FOMC (voting rotation system), whereas in the GC all 17 governors can vote.
Therefore the BG has the clear majority in the FOMC and as a result a dominating position. Also, the

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


FOMC meets every six weeks whereas the GC every month. Other significant differences are:
monetary policy is implemented by the NCBs in the euro area (decentralized implementation),
whereas is implemented by the New York Fed in the US (centralized implementation); 2) the ECB is
not involved in the direct supervision and regulation of the financial system, but single NCBs may be,
like for instance the DNB. This situation will change in 2014 as the ECB will take on a supervisory role
for the largest Eurozone-based banks within the Single Supervisory Mechanism (supervision of the
smaller banks remains at the national level).

Central banks can be considered to be independent in two ways: Instrument independence refers to
the ability of the central bank to set monetary policy instruments, while Goal independence refers to
the ability concerning the goals.

Bank of England
Instrument independence: Government can overrule the Bank and set rates only in in
extreme economic circumstances
Goal independence: Inflation target set by the Chancellor of the Exchequer
Financial independence: determines its own budget
Political independence: Governor appointed by Chancellor (5-year term, renewable)
It is less independent than Fed and ECB

The Fed
Instrument- and Goal independent
Financial independence: independent revenue due to holdings of securities (and loans to
Political independence: Fed is structured by legislation from Congress and accountable for its
actions. It also has presidential influence:
- Through his influence on Congress
- By appointing members of the Board of Governors
- By appointing chairman although terms are not concurrent

Most instrument and goal independent in the world (based on the Maastricht Treaty)
Financial independence: determines its own budget and Eurosystem is prohibited from
financing governments
Political independence:
- Executive-board members are appointed for an 8 year non-renewable term
- Removal only in case of incapacity and serious misconduct
- Appointed by heads of states of all EMU members
- NCB governors appointed by national governments for a minimum of 5 years

Cases for independence:

Independent central bank likely to have longer-run objectives (e.g. price stability)
Avoids political business cycle where the economy is stimulated to maximize re-election
Budget deficits are less likely to be financed by printing money or directly purchasing
government bonds
Monetary policy are too important and complicated to be left to politicians
Cases against independence:
Undemocratic and there is a lack of accountability
Lack of coordination between monetary and fiscal policy

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Independent central banks do not always operate successfully (e.g. Fed during the Great

The current trend goes towards greater independence, and empirical evidence shows that higher
independence leads to lower inflation in the long run. One research however showed that this
relationship was only significant for 20% of the examined countries and one should remember that
correlation is not causation (as with Germany (and Switzerland) for example, a history of
hyperinflation may also be a cause for the current low inflation).

Chapter 3 What is money?

Money is anything that is generally accepted in payment of goods and services or in repayments of
debt. It has three functions:
Medium of exchange eliminates the trouble of finding a double coincidence of needs (reduces
transaction costs). It must be easily standardized, widely accepted, divisible, easy to carry and not
deteriorate quickly.
Unit of account used to measure value in the economy.
Store of value used to save purchasing power over time; most liquid of all assets but loses value
during inflation.

Payment system is the method of conducting transactions in the economy. It evolves over time, from
beginning until now:
1. Commodity money precious metals with real value (e.g. gold or silver)
2. Fiat Money paper money decreed by governments as legal tender
3. Cheques instruction to your bank to transfer money from your account
4. Electronic payments (e.g. paying your bills online)
5. E-Money (electronic money): Debit cards, Stored-value cards, Smart cards, E-cash

There are various definitions of monetary aggregates. They depend on what members of each
society accept as a medium of exchange. Due to financial innovations and the creation of new assets
which are accepted as money, the definition of money (and thus M1-M3) changes over time. There
are also differences between the institutions responsible for issuing monetary aggregates (normally
the central bank and depository institutions).

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


M1 is thus the narrowest measure of money and is more or less the same for most countries. It
consists of currency and demand deposits plus other chequeable deposits.
M2 is considerably different between copuntries. The savings deposits and most time deposits are
usually included.
M3 is the broadest definition of money, and the definitions significantly differ between countries.
Many central banks (e.g. ECB and BoE) still calculate it while others (the Fed) do not. Which
measurement should CBs consider when they try to affect variables in the economy such as GDP
growth and inflation? Usually they move together but when they do not, it would matter which one.
Below is an overview of M1 and M3 in the euro area from 1999 to 2010. The reason why M1
increases rapidly after 2008 is a monetary expansion.

The money supply process

There are three layers involved in the money creation process:
1. The Central bank; the government agency that oversees the banking system and is
responsible for the conduct of monetary policy.
2. Banks (depository institutions) the financial intermediaries that acce3pt deposits from
individuals and institutions and make loans: commercial banks, building societies, savings
banks etc.
3. Depositors individuals and institutions that hold deposits in banks.

The CBs balance sheet has four items: Assets = Government securities (S) + Loans to banks (LB).
Liabilities = Monetary base (MB, high powered money) = Currency (C) + Reserves (R).
Reserves = Required reserves (RR) + Excess reserves (ER). Government securities are holdings by the
CB that affect money supply and earn interest. Loans to banks are provisions that earn interest at the
lending rate.

The high powered money can be controlled by the CB in two ways:

1. Open market operations the purchase or sale of government securities in the open market
2. Loans to banks loans by the CB at the lending rate.
The composition of the MB can change as a result of
3. Currency withdrawal the shift from deposits to currency

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Scenario 1 a central bank purchases 100 of bonds from a bank and pays them with a cheque. As a
result R increases by 100 and C is unchanged so MB = +100.

Scenario 2.1 there is an OMO, a purchase of 100 securities from the non-bank public. The person
deposits a cheque with the money it has received from the CB, at the local bank. The result at the CB
is that R increases by 100, C is unchanged so MB = +100.

Scenario 2.2 there is an OMO as above but the person cashes the cheque from the CB at the local
bank. Instead of the CBs reserves increasing by 100, the same happens to the C. The effect on MB is
the same as above.

We can summarize the effects as follows: the effect that an open market purchase has on reserves
depends on whether the seller of the bond keeps the proceeds from the sale in currency or in reserves.
The effect of an open market purchase on the monetary base is always the same; it increases by the
amount of the purchase no matter what.

Scenario 3 the CB makes a loan to a bank that requests it. The effect is inverted on the two banks,
but for the CB R increases by 100, as well as the MB. The opposite will of course happen when the
bank pays the CB back.

Scenario 4 there is a currency withdrawal which changes the composition of the MB but not the

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


The central bank can thus not unilaterally determine and therefore also not perfectly predict the
amount of borrowing by banks. It is therefore useful to split the monetary base into two
components: one that the CB can control completely and one that is less tightly controlled.
MBn = MB BR where MBn = non-borrowed monetary base and BR = borrowed reserves from the
central bank. The less tightly controlled component is the one created by banks loans from the CB
and the remainder is the MBn.

A simple model of multiple deposit creation

If the bank had chosen to invest the excess reserves in securities, the result would have been the
same for bank B, the effect on the deposit expansion.

Bank Change in deposits Change in loans Change in reserves

A 1000 1000 + 800 200
B 800 640 160
C 640 512 128
D 512 409.6 102.4

Total of banks 5000 5000 1000

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


The above example shows what happens when the required reserve ratio is 20% and the ECB
purchases 1000 worth of government securities from Bank A. Bank A in turn lends 1000 to a
customer for the purchase of a car, and the car dealer deposits the amount from the sale in Bank A.
Bank A uses the proceeds for deposits at Bank B.

The simple deposits multiplier the multiple increase in deposits generated from an increase in the
banking systems reserves can be derived as follows: D = 1/r * R where
D = the change in the total chequable deposits in the banking system
r = required reserved ratio
R = change in reserves for the banking system.
If we assume that banks do not hold on to any excess reserves, so R = RR. The total amount of
required reserves RR = r*D = R D = 1/r *R. The model does not work if 1) banks do hold excess
reserves, or 2) proceeds from loans are kept in currency.

The money multiplier tells us how much the money supply changes for a given change in the
monetary base. It extends the simple deposits multiplier with the excess reserves as well as the
currency held.
c = C/D = currency ratio r = RR/D = required reserves ratio e = ER/D = excess reserves ratio
We can start by deriving the model with R = RR + ER. Because MB = R + C, MB = RR + ER + C.
C = c*D, ER = e*D and RR = r*D so MB = (r + e + c)*D D = MB/(r + e + c).
If we use the M1 definition of the money supply as currency plus chequable deposits (M = C + D =
c*D + D) we can conclude that M = (c + 1)*D M = m*MB m = M / MB = ((c + 1)*D)/(D*(r + e + c))
m = (c + 1)/(r + e + c)
m < 1/r because there is no multiple expansion for currency as excess reserves.
m > 1 as long as (r + e) < 1.
Lets consider an example where r = 0.1 c = 400 bln D = 800 bln ER = 0.8 bln
M = M1 = C + D = 1200 bln. What is the resulting money multiplier?
m = (400/800 + 1)/(0.1 + 0.8/800 + 400/800) = 1.5/0.601 2.5.
Although there is multiple expansion of deposits, there is no such expansion for currency. Thus if some
portion of the increase in high-powered money finds its way into currency, this portion does not
undergo multiple deposit expansion; a higher c leads to a smaller m (effect).

If we recognize that MB = MBn + BR, we can also rewrite the function as

M = (c + 1)/(r + e + c)*(MBn + BR). Thus:

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


If c and e are stable and predictable, we can expect a close link between MB and M ( m is stable).
m however tends to show large swings which are mostly caused by changes in c and e; in practice
money supply control is very difficult. This is one of the main reasons why most Central banks do not
use the monetary base as an interest anymore, but interest rates.

Data from the UK:

The Euro area:

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


The US:

Data on currency ratio and excess reserves from the Fed (Great Depression):

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Chapter 15 The tools of monetary policy

Overnight interbank interest rate the interest rate on loans of reserves from one bank to another.
This official interest rate is called the Main Refinancing Rate in the euro area, the Bank Rate in the
UK and the Federal Funds Rate target in the US. The overnight bank rate is called SONIA in the UK,
the Federal Funds Rate (FFR) in the US and EONIA in Europe euro overnight index average. During
the financial crisis the central banks around the world introduced unconventional monetary policy
tools to supplement the conventional ones.

The three tools that the CBs have to conduct monetary policy are:
1. Open market operations (OMOs), CB buys and sells securities to affect the quantity of
reserves and the monetary base
2. Standing facilities, CB sets interest rates at which banks on their own initiative can borrow
and deposit reserves at CB
3. Reserve requirements, CB sets the required reserve ratio

We start with deriving the demand and supply curve.

Demand curve, Rd: Recall that R = RR + ER. Excess reserves are an insurance against deposit outflows.
The cost of holding them is the opportunity cost that could have been earned when lending, minus
the rate that the CB pays in its deposit facility; the deposit rate id. So if i* increases relative to id, the
opportunity cost of holding ER increases and the demand decreases. That is why the demand curve is
downward sloping and becomes infinitely elastic at id if i < id banks would rather hold ER than lend
to each other.

Supply curve, Rs: The supply can also be divided into two components, the amount of reserves
supplied by the CBs OMOs NBR, and the amount of reserves borrowed from the CB BR. I.e.
Rs = NBR + BR. The cost of borrowing from the CB is equal to the lending rate il. Borrowing from the
CB is a substitute for borrowing from other banks so if i* < il banks will not borrow from the CB
BR = 0, Rs = NBR and the curve is vertical. If i* > il banks will borrow more and more and re-lend at i
(arbitrage opportunity) and Rs is perfectly elastic at il.

Now let us see how the tools of monetary policy affect the overnight rate. 1) When there is an OMO,
the effect on i* depends on whether Rs initially intersects Rd in the flat section (no effect). When the
CB conducts an open market purchase, NBR increases and Rs shifts to the right. You can remember
this by thinking about what happens in the bonds market: if CB starts buying, price goes up and yield
goes down and this is consistent with the reaction in the R- and i-relationship. See below for the

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Open market purchase by CB

Standing facilities mean that there are two options provided by CBs that are always available. They
refer to the lending and the deposit rate il and id. 2) What happens when the CB decides to change the
lending rate also depends on where the intersect is; if it is below Rs the change has no effect on i*
and if it is in Rs, it does have an effect. If the CB changes the deposit rate, i* will only change if the
intersect was in the horizontal section. Most changes in the lending- and deposit rate have no effect
on the overnight rate. See below for the graphs, first lending and then deposit.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


When there is a shift in the required reserve ratio, that affects Rd as a result of the shift in RR.
When the CB decreases r, Rd shifts to the left and the overnight rate i* increases.

Open market operations

OMOs are the most important monetary policy tool because they are the primary determinants of
changes in interest rates and the monetary base, the main source of fluctuations in the money
supply. Open market sales shrink reserves and the monetary base, decreasing the money supply and
raising short-term interest rates. There are two types of OMOs:
1. Outright outright purchase of sale of securities, permanently adding or draining reserve
2. Temporary with repurchase agreements/repos the effect is shorter
Advantages of OMOs are: 1) CB has complete control over their volume, 2) they are flexible and
precise, 3) can easily be reversed and 4) they are quickly implemented without administrative delays.

The ECB uses OMOs as its primary tool for monetary policy. It buys and sells eligible assets (=not just
anything, but bonds) to affect reserves and as a result, the EONIA. These operations are
implemented by NCBs, and the main form is Main refinancing operations (MROs), weekly repos with
a week maturity. The Main refinancing rate (MRR) is applied, the official policy rate which is the
minimum bid rate allowed, fixed by the Governing Council. Other forms of OMOs include Long-Term
Refinancing Operations (LTROs), Fine-Tuning Operations and Structural Operations.

Standing facilities
Are available to banks on their own initiative. Two alternatives:
1. Marginal lending facility to obtain overnight liquidity from NCBs. The marginal lending rate
is equal to MRR + 100 bps (currently 50). There is no limit in size, as long as collateral is
provided. Ceiling for EONIA
2. Deposit facility to make overnight deposits at NCBs. Deposit rate = MRR 100 bps
(currently 25). Floor for EONIA
As we can conclude from above, il and id limit the possibilities/ranges of i*

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


From 1999 until today this corridor has had the following size:
Apr-99 to Oct-08: 200 bp Oct-08 to Jan-09: 100 bp Jan-09 to May-09: 200 bp
May-09 to May-13: 150 bp May-13 to Nov-13: 100 bp Nov-13 to Today: 75 bp
The narrow window can benefit stability and confidence in the interest rates. If there is too much
volatility the interbank market may dry up. Probably the most recent decrease to 75 in combination
with the low lending rate is stimulate the economy.
Advantages of standing facilities are: 1) that they are operational facilities to implement the corridor
system, 2) they serve as a lender of last resource, preventing banking and financial panics triggered
by bank and liquidity failure (Black Monday, Dow Jones down by 20% or sub-prime crisis).
The disadvantage is moral hazard, banks may take more risks and therefore be more vulnerable to
negative shocks.

Reserve requirements
In euro area, all deposit-taking institutions were typically required to hold 2% (of short-term
deposits, debt securities and money market papers) in reserves at their respective NCB (now the
reserve requirement ratio is 1%). The ECB pays interest rate on the required reserves (average MRR
over maintenance period). The institutions that are subject to reserve requirements have access to
the ECBs standing facilities and participate in OMOs.
The advantages of reserve requirements are: 1) Macro-prudential and i.e. ensure a minimum amount
of liquidity for all financial institutions, and 2) they create a stable demand for reserves, which helps
controlling the interest rate.

An overview of the tools and their functions:

In the recent financial crisis, in addition to lowering the interest rates to virtually zero, CBs applied
unconventional tools to tackle depression and deflation: 1) new lending facilities (bonds with
longer maturities as the short ones had already been traded), 2) management of expectations (Fed,
as long as its needed, interest rates will be held low) and 3) outright purchases of public and
private securities from bank and non-bank sectors (QE see more below). While the measures were
different between different countries, the balance sheets of the ECB, BoE and Fed increased
dramatically. Starting with an index of 1, the ECB is currently at 2.5, the BoE at 4 and the Fed right
below 3.5.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Quantitative easing
The first experience of QE was in Japan from 2001-2006. From 2007, the BoE and Fed engaged in
large-scale asset purchases a process known as quantitative easing. Hereby banks can expand the
supply of reserves beyond the level that is needed to maintain its policy rate target. As you can see in
the graph this does not influence i* but does raise the supply of NBR.

The Enhanced Credit Support (ECS) programme of the ECB

The first set of non-standard was adopted in October 2008 and additional ones in May 2009. The
programme included:
1. Extension of the maturity of liquidity provision, maturity of LTROs extended from 3 or 6 to 12
2. Fixed-rate full allotment, giving euro area financial institutions unlimited access to central
bank liquidity subject to collateral.
3. Currency swap agreements allowing the ECB to lend in dollars (or other currencies) with
euros as collateral.
4. Collateral requirements not just bonds were accepted as collateral but also toxic assets
such as CDOs (asset backed securities). Very close to bailout.
5. Covered bonds purchase programme (CBPP) by which euro-denominated bonds were
covered, OMOs conducted.

With the outbreak of the sovereign debt crisis in 2010, the Eurosystem responded by introducing the
Securities market programme (SMP). This entailed the outright purchase of public and private debt
instruments. In line with the Maastricht Treaty, the purchases of government bonds were strictly
limited to secondary markets and sterilized every liquidity-enhancing operation was offset by an
equal-=size liquidity-absorbing operation to maintain reserves unchanged. Fundamentally the SMP
was therefore different from a QE policy.

Lastly, by conducting outright monetary transactions (SMP with restrictions), the ECB, EC and IMF
provided (the promise of) unlimited support as long as certain requirements were fulfilled
(unemployment rates, fiscal policy changes etc.).

Chapter 16 The conduct of monetary policy: strategy and tactics

Overly expansionary monetary growth leads to high inflation which decreases the efficiency of the
economy and hampers economic growth. Too tight monetary policy can produce serious recessions
with output falls and rising unemployment. It can also lead to deflation which can be especially
damaging to an economy because it promotes financial instability and can worsen financial crises.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Alternative monetary policy strategies to achieve price stability in the long run and tactics the
choice and setting of the monetary policy instrument. Last week we saw that to solve the time-
inconsistency problem, independent central banks have to commit (credibly) to a behaviour rule.
This implies choosing a nominal anchor (or target), typical ones being monetary aggregate, inflation
rate and exchange rate. The nominal anchor functions as basis to which agents can form their
inflation expectations which drives current inflation. There are four main policy strategies:
1. Monetary targeting use of a specific monetary aggregate (M1, M2 or M3) as intermediate
2. Inflation targeting use of a specific medium-term numerical target for inflation
3. Implicit nominal anchor (mainly applied by the Fed)
4. Exchange rate targeting (not covered until next course, IMB).

Monetary targeting was adopted by several countries in the 70s and 80s (DE, CH, CA, UK, US).
Advantages are that 1) it almost instantly helps to fix inflation expectations and thus produce less
inflation. 2) The accountability is also almost immediate.
Disadvantages include that 1) you have to rely on a stable relationship between inflation and targeted
monetary aggregate, that there is correlation. 2) You have to have full control over the monetary
aggregate, which the CB does not (M = m*MB).

Inflation targeting was first introduced in the early 90s (NZ, CA, UK, SE, FI). The main elements of this
strategy are
Publicly announcing the target for inflation over the medium-term.
Institutional commitment to price stability as the primary, long-term goal of monetary policy,
and a commitment to achieve the inflation goal
Information-inclusive approach in which many variables are used in making decisions
Increased transparency through communication
Increased accountability for obtaining the inflation goal
Recall the difference between the approach of Greenspan and the most recent ECB-announcement.

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Advantages are that 1) it does not rely on one variable, 2) it is easily understood by the public and 3)
increases transparency and accountability force a better communication.
Disadvantages include 1) delayed signalling about achievement of target, that it 2) could impose too
much rigidity and that 3) there is a potential for increased output fluctuations and low economic
growth if the sole focus is on inflation.
The fan-chart in the book shows the goals of the BoE and the probability of achieving them; the
likelier it is, the darker the colour.

The ECBs monetary goal: price stability is defined as a year-on-year increase in the Harmonized
Index of Consumer Prices (HICP) for the euro are, of below, but close to, 2% to be maintained over the
medium term (2 years red.). Since there is no mention of another goal, this is a hierarchical

The ECB has a two-pillar strategy with the first one being economic analysis: monitoring indicators
such as wages, energy prices, exchange rates etc, to assess the short- to medium-term risk to price
stability. The second pillar is monetary analysis: money stock is a reference value to assess the
medium- to long-term risks to price stability.


Expected and realized inflation in the Euro area 99-12

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Implicit nominal anchor a relevant example is the just do it-strategy applied by the Fed, based on
achieving price stability in the long run together with maximum sustainable employment is a dual
Advantages include that 1) there are many sources of information and that 2) it has a demonstrated
success over the years.
Disadvantages include that 1) there is lack of transparency leading to higher uncertainty on future
inflation and output, 2) there is low accountability and 3) there is strong dependence on the
preferences, skills and trustworthiness of the individuals in charge.

How does the CB decide on the policy instrument (operating instrument), the variable that responds
to the three tools discussed above? This is a variable that response to the central banks tools and
indicates the stance (easy or tight) of monetary policy. There are two types of policy instruments at
the CBs disposal: reserve aggregates (total reserves, non-borrowed reserves, the monetary base and
the non-borrowed base) and interest rates (short-term ones). Because interest and reserve targets
are incompatible, the CB cannot target reserves and interest rates simultaneously.

Why is that? Although the CB expects the demand curve for reserves to be at Rd*, it fluctuates
between Rd and Rd because of movements in deposits (hence required reserves) and changes in
banks desire to hold excess reserves. If the CB has a non-borrowed reserves target of NBR*, it
expects that the short-term interest rate will be i*. However, as the first figure indicates the short-
term interest rate will fluctuate between iand i. To maintain the interest rate at i*, the CB would
have to move the NBR along and let it fluctuate between NBR and NBR. This is the reason the
targets are incompatible.

Three criteria have to be fulfilled for choosing the policy instrument:

1. Observability and measurability quickly observable and measurable
2. Controllability instrument should be fully controlled with tool
3. Predictable effect on goals there must be a stable and predictable relationship with the
goal, a correlation

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Nowadays most CBs target short-term interest rates as policy instrument. But how should this
rate be set?

Taylor rule
i = equilibrium real i + inflation rate + (inflation gap) + (output gap)
i = r* + + ( *) + (Y Y*)
(where * and Y* are the objective levels respectively, output gap = % deviation of real GDP from
its potential level)
The Taylor principle is thus that if the inflation rate increases by 1%, the CB should raise i by
1.5%. Stabilizing the real output is an important concern and the output gap is an indicator of
future inflation.

When looking at the empirical comparison between Taylor and the actual EONIA in the past
years, two things deserve attention: 1) Taylor is structurally higher than EONIA and 2) they both
consistently move in the same direction.

Almost the same applies for the UK and US:

Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)


Distributing prohibited | Downloaded by Elia Aile (yypieesp@abyssmail.com)