Académique Documents
Professionnel Documents
Culture Documents
Learning outcomes
Describe and discuss the different roles of financial
intermediaries.
Describe why maturity transformation is so important in
financial markets.
Define on which side of a bank's balance sheet deposits
and loans appear and
Explain why the balance sheet must indeed balance.
Explain how the monetary authorities can influence the
total money supply by changing the monetary base or by
introducing mandatory reserve ratios or other Regulation.
Essential reading
Artis, M.J. and M.K. Lewis Money in Britain:
Monetary policy, innovation and Europe.
(New York; London: Philip Allan, 1991).
Goodhart, C.A.E. Money, Information and
Uncertainty. (London: Macmillan, 1989)
Chapters 5, 6 and 10.
McCallum, B. Monetary Economics. (New
York;
Macmillan;
London:
Collier
Macmillan, 1989).
Financial intermediaries
Financial intermediaries, such as banks,
are hugely important in activities such
as the financing of investment projects
and in the safekeeping of savings.
The main service is the collection of
funds from those who wish to save and
the lending out of funds to those who
wish to borrow.
Question
If there are agents who want to save
and others who want to borrow,
why do those with funds to spare not
just lend directly to those who want to
borrow?
scale
in
transactions
and
Insurance:
Agents are, in general, risk-averse.
Banks provide insurance services by
guaranteeing a rate of return to depositors
even if loans made to borrowers turn bad.
Without the bank, the default risk would be
faced entirely by the individual/depositor.
Maturity transformation:
Individual lenders generally want to lend (to the bank)
while still having quick access to their money, in order
to make transactions or for precautionary motives.
The liabilities of the bank (the deposits of savers) are
then liquid and the bank will promise to convert the
depositors assets on demand.
The banks assets, on the other hand, will tend to be
illiquid since private borrowers tend to want to hold
long maturity liabilities (the loans/assets of the bank).
CONCEPTS AND
DEFINITIONS
Reserve
Money
=
Currency
in
circulation + Bankers deposits with
the RBI + Other deposits with the
RBI.
M1 = Currency with the public +
Demand deposits with the banking
system + Other deposits with the
RBI.
Liquidity Aggregates
L1 = NM3 + All deposits with the post
office savings banks (excluding National
Savings Certificates).
L2 = L1 +Term deposits with term lending
institutions and refinancing institutions
(FIs) + Term borrowing by FIs +
Certificates of deposit issued by FIs.
L3 = L2 + Public deposits of nonbanking
financial companies.
BALANCE SHEET OF
COMMERCIAL BANKS
LIABILITIES
ASSETS
1) Cash Balances
a) With Central Bank
b) With other Banks
b) Demand Deposits
c) Saving Deposits
4) Borrowings
4) Investments
5) Other Liabilities
Liabilities
Capital: The bank has
commencing its business.
to
raise
is
capital
the
before
accumulated
Assets
Cash:
Here we can distinguish cash on hand from
cash with central bank and other banks cash
on hand refers to cash in the vaults of the
bank.
It constitutes the most liquid asset which
can be immediately used to meet the
obligations of the depositors. Cash on hand
is called the first line of defence to the bank.
Bills Discounted:
The commercial banks invest in short term bills
consisting of bills of exchange and treasury bills
which are self-liquidating in character.
These short term bills are highly negotiable and
they satisfy the twin objectives of liquidity and
profitability.
If a commercial bank requires additional funds, it
can easily rediscount the bills in the bill market and
it can also rediscount the bills with the central bank.
INVESTMENT POLICY OF
BANKS
The financial position of a commercial
bank is reflected in its balance sheet.
The balance sheet is a statement of the
assets and liabilities of the bank.
The assets of the bank are distributed in
accordance
with
certain
guiding
principles.
Liquidity
In the context of the balance sheet of a
bank the term liquidity has two
interpretations.
First, it refers to the ability of the bank to
honour the claims of the depositors.
Second, it connotes the ability of the
bank to convert its non-cash assets into
cash easily and without loss.
Profitability
The bank has to earn profit to earn income to
pay salaries to the staff, interest to the
depositors, dividend to the shareholders and to
meet the day-to-day expenditure.
Since cash is the least profitable asset to the
bank, there is no point in keeping all the assets
in the form of cash on hand.
The bank has got to earn income. Hence, some
of the items on the assets side are profit
yielding assets.
Liquidity Vs Profitability
Cash has perfect liquidity but yields
no return at all, while other incomeyielding assets such as loans are
profitable but have no liquidity.
The bank should strike a balance
between liquidity and profitability
RECONCILING TWIN
OBJECTIVES
A good banker is one who follows a
wise
investment
policy
and
distributes the assets in such a way
that both the requirements of liquidity
and profitability are satisfied.
The more liquid the assets, the less
profitable it is.
Liquidity vs Profitability
Cash :Cash balance have perfect liquidity, but no profitability. Cash is held
to meet the withdrawal needs of depositors.
Money At Call :Surplus cash of commercial banks is lend to each other. This earns
some interest and is also very liquid.
Investment In Securities :Statutorily banks have to invest a part of their assets in government
securities.
These securities have low rate of interest but banks can borrow from
RBI against these securities. Thus investment in securities provide
returns as well as liquidity to bank.
Process of Credit
Creation
The credit creating function of the commercial
banks is the process of multiple-expansion of credit.
The banking system as a whole can create credit
which is several times more than the original
increase in the deposits of a bank.
This process is called the multiple-expansion or
multiple-creation of credit.
Similarly, if there is withdrawal from any one bank,
it leads to the process of multiple-contraction of
credit.
Assumption
(a)The existence of a number of banks, A,
B, C etc., each with different sets of
depositors.
(b) Every bank has to keep 10% of cash
reserves, according to law, and,
(c) A new deposit of Rs. 1,000 has been
made with bank A to start with.
Example
Suppose, a person deposits Rs. 1,000
cash in Bank A.
As a result, the deposits of bank A
increase by Rs. 1,000 and cash also
increases by Rs. 1,000. The balance
sheet of the bank is as fallows:
Subject Guide
Let the total money supply in the
economy, M, be made up of deposits,
D, and the liabilities of the
government, notes and coins, C.
Therefore:
M=D+C
(4.1)
Competitive equilibrium
The profits made by the bank will equal
the quantity of loans, L, multiplied by
the interest earned on those loans, iL
(which is the bank's revenues) minus
the costs faced by the bank.
Costs will equal the interest paid to
depositors in order to encourage them
to hand over their funds to the bank.
Costs then equal the quantity of deposits, D, times the interest rate
paid on deposits, iD.
Denoting bank profits by
equilibrium, profits equal zero:
Solving for the interest rate on deposits, which equals the interest rate charged
on loans from (4.8), gives
This implies total deposits, D, which equals total loans, L, equals d 0 from either
(4.4) or (4.5).
Equilibrium
Government regulation
of the deposit rate
One way that the government could
reduce or control the money supply is by
setting a limit on the interest rate paid on
deposits.
If the maximum interest rate banks can
pay on deposits is less than i in the above
example, then the amount of funds
savers are willing to deposit with the bank
will fall, resulting in a lower money supply.
Diagram
If government sets the interest rate on deposits equal to zero. From (4.4), the quantity of
deposits is fixed at D = d0 - d1i.
Diagram
The level of deposits, and hence of the money supply, has fallen from d0 to d0 - d1i
because of the government regulation.
Diagram
Since deposits must equal loans in order for the bank's balance sheet to balance
The lower level of deposits means a lower level of loans, which is associated with a
higher interest rate charged, iL > i.
Diagram
Since there is a difference between the interest rate charged on loans and that paid on
deposits (which has been set at zero),
The government regulation has allowed the banks to make positive profits.
Reserves
banks will try to keep a fraction of their
assets in liquid form in order to meet the
day-to-day needs of depositors who
withdraw their funds.
Assume that the government introduces a
mandatory reserve ratio, r*.
The bank's assets now comprise loans, as
before, but now include these reserves.
As D cancels out.
Then substituting out iL from (4.12), show that the rate of interest paid on
deposits is equal to:
the money
the rate of
it can also
mandatory
where