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STUDY UNIT 1: THE FINANCIAL SYSTEM: AN OVERVIEW

LEARNING OUTCOMES

After completing this study unit you will have mastered the following:

• The general role of the financial system in a modern economy. • The key players within the South African economy. • Describe the properties and functions of money. • What savings is and its uses. The South African financial sector South Africa, middle income country and the only African member of the Group of 20, is the‐ largest economy in the continent.

Its financial sector is backed by a sound regulatory and legal framework and boasts of dozens of domestic and foreign institutions providing a full range of services, commercial, retail and merchant banking, mortgage lending, insurance and investment.

The South African Financial system compares favourably with those of industrialised countries.

Foreign banks are well represented and electronic banking facilities are extensive with a nationwide network of automated teller machines (ATMs) and internet banking facilities available.

THE BANKING SYSTEM The banking system is well developed and effectively regulated, comprising a central bank, a few large, financially strong banks and investment institutions and a number of smaller banks. The banking sector is dominated by commercial banks which, with assets amounting to 120 percent of GDP represent the largest segment of the market.

The institutional investor base is well developed, with pension assets at 112% of GDP and long term life insurers at 80 percent of GDP. The sector is highly concentrated with four banks

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accounting for most of the sector deposits. It can be argued safely that the South African banking system is reasonably well managed and that the there is reasonable level of financial capability which refers to the knowledge, understanding, attitudes and most importantly – behaviours – which consumers need to display in order to manage their money well, adapt to new financial circumstances and take advantage of financial opportunities as they arise.

The Banking Act is primarily based on similar legislation in the United Kingdom, Australia and Canada.

SOUTH AFRICAN MARKET PLAYERS The Financial Services Board The Financial Services Board is a unique independent Institution established by the statute to oversee South Africa’s none banking financial services industry in the public interest.

The FSB's mission is to promote sound and efficient financial institutions and services together with mechanisms for investor protection in the markets it supervises.

The Banking Association South Africa Formerly the Banking Council is the representative voice of banking in South Africa. Its members include foreign, retail, merchant, investment and commercial banks. Its role is to “establish and maintain the best possible platform on which the banking groups can do competitive, profitable and responsible banking”. Comments and submissions on regulatory changes, legislation, consumer concerns and policy documents, as well as research and study into best international practice, are core strategic activities of The Banking Association.

National Credit Regulator The National Credit Regulator (NCR) was established as the regulator under the National Credit Act 34 of 2005 (the Act) and is responsible for the regulation of the South African credit industry. It is tasked with carrying out education, research, policy development, registration of industry participants, investigation of complaints, and ensuring enforcement of the Act. The NCR is also tasked with the registration of credit providers, credit bureaux and debt counsellors; and enforcement of compliance with the Act.

SOUTH AFRICA’S EXCHANGES The JSE Limited

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The JSE Limited (JSE), formerly the Johannesburg Stock Exchange, is the only equities exchange in South Africa.

It was founded to enable the new mines and their financiers to raise funds for the development of the fledgling mining industry. Today, the majority of the companies listed are non mining organisations. The exchange fulfils its main function – the raising of primary capital‐ – by rechanneling cash resources into productive economic activity.

The JSE is the 18th largest exchange in the world by market capitalisation with approximately 400 listed companies and a market liquidity of 31.2% (September 2005). The exchange becomes an essential cog in the functioning of South Africa’s economy providing an orderly market for dealing in securities and thereby creating new investment opportunities in the economy.

The Bond Exchange of South Africa

The Bond Exchange of South Africa (BESA) is an independent financial exchange, operating under an annual license granted by the country’s securities market regulator, the Financial

Services Board. BESA is responsible for regulating the debt securities market in South Africa.

Debt securities are issued by central and local government, public enterprises and major corporations. The debt securities listed by BESA are: fixed interest bearing bonds with a single redemption date; fixed interest bearing bonds with multiple redemption dates; zero coupon bonds, and variable interest rate bonds.

Almost 250 bonds issued by over 30 different borrowers with a nominal value of R420 billion are listed, about 80% of all listed securities are bonds issued by the South African government.

Co operative Banks‐ The government is getting ready to open a new front for small banks in South Africa as it puts the finishing touches to the rules and regulations that will apply to so called “co operative‐ ‐ banks”.

Co operative banks are meant to formalise the world of credit unions (group savings and‐ lending schemes) and larger stokvels, which currently operate in a regulatory vacuum provided by an exemption from the Banks Act (under which all manner of sins from pyramid schemes to outright theft have taken place).

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READ Chapter one and two of the prescribed book deals with the history of money, the properties of money, and the functions of money which you must read and understand. (Refer to pages 6‐38 of the prescribed book.)

Thoroughly study and understand the money creation process by banks and endeavour to master the circular flow diagram covered under chapter three as this is very fundamental to your understanding of the rest of the module.

ACTIVITY

Self assessment question 1‐ Who are the main players in the South African financial system and what is their role?

Self assessment question 2‐ What are the main reasons why the South African financial system is regarded as one of the best in the world?

ASSESSMENT

Possible questions:

• Define the main functions of money. • List and explain the main qualities of money.

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• Define the players within the South African financial system and explain their different roles. To what extent have these contributed to the stability of the market?

STUDY UNIT 2: THE INTERMEDIATION PROCESS

LEARNING OUTCOMES

After completing this study unit you will have mastered the following:

• What is meant by the term “intermediation” • The reasons behind intermediation. • The roles of financial institutions under intermediation. • The types of intermediation. What is intermediation?

Financial intermediation consists of “channeling funds between surplus and deficit agents”. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.

Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers).

In any market, a financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly.

That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages. Alternatively, they may lend the money directly via the financial markets, which is known as financial disintermediation.

Why are financial intermediaries important?

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One reason is that the overwhelming proportion of every dollar financed externally comes from banks. Bank loans are the predominant source of external funding in almost all the countries. As the main source of external funding, banks play important roles in corporate governance, especially during periods of firm distress and bankruptcy.

The idea that banks “monitor” firms is one of the central explanations for the role of bank loans in corporate finance. This facilitates intervention and renegotiation of capital structures. Bankers are often on company boards of directors. Banks are also important in producing liquidity by, for example, backing commercial paper with loan commitments or standby letters of credit. Consumers use bank demand deposits as a medium of exchange – that is, writing cheques, using credit cards, holding savings accounts, visiting automated teller machines, and so on. Demand deposits are securities with special features. They can be denominated in any amount; they can be put to the bank at par (i.e., redeemed at face value) in exchange for currency. These features allow demand deposits to act as a medium of exchange. But, the banking system must then “clear” these obligations. Clearing links the activities of banks in clearinghouses. In addition, the fact that consumers can withdraw their funds at any time has led to banking panics in some countries, historically, and in many countries more recently.

Basically, financial intermediation is the root institution in the savings investment process. Ignoring it would seem to be done at the risk of irrelevance.

What role do financial institutions play under intermediation?

Functions performed by financial intermediaries

Financial intermediaries provide 6 major functions:

1. Maturity transformation

Converting short term liabilities to long term assets (banks deal with large number of lenders‐ and borrowers, and reconcile their conflicting needs)

2. Risk transformation

Converting risky investments into relatively risk free ones. (Lending to multiple borrowers to‐

spread the risk)

3. Convenience denomination

Matching small deposits with large loans and large deposits with small loans.

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4. They borrow from one group of agents and lend to another group of agents.

5. The borrowing and lending groups are large, suggesting diversification on each side of the balance sheet.

6. The claims issued to borrowers and to lenders have different state contingent payoffs

The terms “borrow” and “lend” mean that the contracts involved are debt contracts. So, to be

more specific, financial intermediaries lend to large numbers of consumers and firms using debt contracts and they borrow from large numbers of agents using debt contracts as well.

Advantages of financial intermediaries

There are 2 essential advantages from using financial intermediaries:

1. Cost advantage over direct lending/borrowing.

2. Market failure protection: the conflicting needs of lenders and borrowers are reconciled, preventing market failure.

The cost advantages of using financial intermediaries include:

1. Reconciling conflicting preferences of lenders and borrowers

2. Risk aversion: intermediaries help spread out and decrease the risks

3. Economies of scale: using financial intermediaries reduces the costs of lending and borrowing

4. Scope: intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs)

Types of financial intermediaries Financial intermediaries include:

• Discount houses • Commercial banks • Merchant and investment banks • Pensions, insurance and provident funds • Brokers and financial advisory services providers DISCOUNT HOUSES

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The discount houses are the oldest of the money market players.

Traditionally the discount houses have always played an intermediation role between issuers of financial instruments and consumers of those instruments.

Prior to and during the early ages of financial independence the discount houses were used by central banks as the vehicle of communication between the central bank on one hand and the commercial banks and the investing public at large.

In some way central banks would indirectly communicate critical monetary policy issues on interest rates through the discount houses.

The central bank would issue instruments like treasury bills and government stocks through the discount houses.

This was done for a variety of reasons among which were the following.

a. Mopping up of excess liquidity from the market.

b. Genuinely raising funds from the investing public on behalf of the government c. Giving an indication to the market on the direction of interest rates.

d. In situations where central banks wanted to ease liquidity problems in the market they would buy certain type of paper through discount houses.

In adding to the critical role discussed above the discount houses would take short term money from the commercial banks and recycle it into short term investments.

Their roles have evolved however as a result of deregulation .Although they still perform some of the traditional roles it is not uncommon today for discount houses to have positions of their own and though they are still not allowed to take deposits directly from the public there is now a very thin dividing line between discount houses and commercial banks on that front.

COMMERCIAL BANKS

Banks are deposit takers; they take deposits from the public and on lend the same funds to borrowers obviously at a profit to the bank.

The banks take funds from surplus units (usually households through pension funds and insurance policies) and pass it on to deficit units among which are the government.

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The investing public has a number of reasons for entrusting their money with commercial banks. Some of the reasons include:

1. The need to save for the rainy day.

2. The need for safety of their funds.

3. To cultivate banking relationships for future borrowing requirements. 4. Savers also want liquidity.

Banks have generally played a very pivotal role in the development of any economy and because of this important role it is not surprising that they receive a lot of attention from a lot of stakeholders.

Governments for example through the central bank would like to ensure a very stable financial market as any crisis will erode people’s confidence with ripple effects on the economy.

Foreign investors among other factors will look at the stability of the financial sector before deciding whether or not to invest in that particular country.

The investing public itself would always keep a very watchful eye on the operations of commercial banks as they are worried about the safety of their funds.

MERCHANT BANKS

Traditionally merchant banks have been the vehicle through which international trade is financed. They deal in wholesale depositions and their transactions are very massive in size. These facilitate trade between foreign players through the issuance of letters of credits and other offshore funding arrangements.

Most parastals tend to issue bonds and other financial instruments through merchant banks. These instruments are normally used to fund the development of infrastructure and major construction projects.

Merchant banks are key players in the secondary/primary markets because of their ability to access international credit.

PENSION FUNDS INSURANCE COMPANIES AND OTHER INVESTMENT INSTITUTIONS

Pension funds and insurance companies are big mobilisers of funds; they pick up deposits from ordinary households in the form of insurance premiums and other annuities and repackage it for consumption by large corporations including governments.

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They play a pivotal role in the development of infrastructure and are also big buyers of primary market paper. In some countries e.g. Zimbabwe the pension funds and insurance companies have a statutory provision which compels them to invest in certain prescribed type of investments and this includes government stocks and treasury bills with a certain specified maturity period. They thus constitute major consumers of most government and municipal paper.

We have seen the primary role of these institutions changing over the past decade because of their crucial ammunition, these institutions are cash rich and we have seen a lot of banks luring them to bed because of their liquidity positions.

The so called strategic alliances have seen most of these institutions buying into banks, building societies and supermarket chains. Their roles have thus evolved over time and in some instances they are offering indirect competition to registered commercial banks.

BROKERS AND OTHER FINANCIAL ADVISORS

In the strictest sense these are not participants per se but are very important intermediaries as they contact research on the market and feed this information into the market. This helps to level out first mover or benefits accruing as a result of access to classified information.

This is not to suggest, however that these institutions are full print because there is no legislation at the moment that compels them to disclose information to the market without discriminating. The market is so small for most African markets to render a lot of brokers useful. In developed countries with highly developed financial markets like markets in Europe, the United States and South Africa, brokers are a key component of the market.

In summary, financial institutions (intermediaries) perform the vital role of bringing together those economic agents with surplus funds who want to lend, with those with a shortage of funds who want to borrow.

In doing this they offer the major benefits of maturity and risk transformation. It is possible for this to be done by direct contact between the ultimate borrowers, but there are major cost disadvantages of direct finance.

Indeed, one explanation of the existence of specialist financial intermediaries is that they have a related (cost) advantage in offering financial services, which not only enables them to make profit, but also raises the overall efficiency of the economy. The other main explanation draws on the analysis of information problems associated with financial markets.

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ACTIVITY Self assessment question 1‐ What is meant by intermediation and why has it become so important in today’s financial systems?

Self assessment question 2‐ Who are the main players in the intermediation process and what role do each of the institutions mentioned play in the process?

ASSESSMENT

Possible questions:

• What are the main principles behind intermediation? • List and explain the reasons for the different roles played by institutions which are

part of the intermediation process. STUDY UNIT 3: MONEY AND CREDIT

LEARNING OUTCOMES

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After completing this study unit you will have mastered the following:

• What the circular flow of income and expenditure is. • What the interest rate is. • How the supply of and demand for money and/or credit influence the interest rate. • How in general changes in money and credit influence nominal GDP, real GDP, and prices.

• What the inflation rate is and how to calculate it.

This study unit is based on chapter three of the prescribed book.

A detailed understanding of the circular flow diagram is required. The student is expected to master issues pertaining to the demand and supply of money, factors affecting demand for money, the role of interest rates in the demand supply equation, shift in the demand and supply curves, understanding the credit creation process by banks and the role of the federal bank in the money supply growth management. (Read specifically pages 42–58.)

ACTIVITY Self assessment question 1‐ Using Exibit 3 1, explain why saving is equal to investment in a simplified economy with no‐ government or foreign sector.

Self assessment question 2‐

How does real GDP differ from nominal GDP?

ASSESSMENT Possible questions:

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• With the aid of a diagram, explain why saving is equal to investment in a simplified economy with no government or foreign sector.

• What are the effects of an increase in the supply of money on interest rates, prices and output? Do these effects occur simultaneously?

• Show on a graph how interest rate and the quantity of money demanded is related. Do the same for the quantity of money supplied. When is the market in equilibrium?

STUDY UNIT 4: THE CENTRAL BANK

LEARNING OUTCOMES

After completing this study unit you will have mastered the following:

• What are the main functions of the central bank? • What are the instruments at the central bank’s disposal as it executes its main functions? • What are the main monetary policy objectives? • What are the supervisory duties of the central bank? • What are the supervisory methods that are employed by the central bank.

The South African Reserve Bank The Bank regards its primary goal in the South African economic system as “the achievement and maintenance of financial stability”. The Bank deems it essential that South Africa has a growing economy based on the principles of a market system, private and social initiative, effective competition and social fairness. It recognises, in the performance of its duties, the need to pursue balanced economic policies that enhance both development and growth.

The central bank is also the issuer of securities and supplier of credit to commercial banks under its mandate as the lender of last resort. The South African Reserve Bank collects financial data, in respect of the major institutional sectors from financial institutions such as banks, insurers and pension funds, as well as from other organisations such as public corporations and local authorities. This information is used inter alia for analysing the flow of funds between sectors, establishing which sectors require which types of financing and which sectors provide in these particular needs. Due to the numerous individual organisations and persons that are economically active, it is necessary to make meaningful groupings or sector classifications of the parties involved.

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In 1985, a department for bank supervision was created in the Reserve Bank to monitor the foreign activities of South African banking institutions. With this step, South Africa confirmed its support of the Basle Concordat of June 1983, in supervisory activities to include the international activities of banking institutions to facilitate closer co operation between the‐ supervising authorities.

Among the many functions of the central bank are the establishment of certain capital and liquidity requirements and the continuous monitoring of institutions’ adherence to legal requirements and other guidelines.

The other major reason for the operations of the Reserve Bank in the money market is to implement the bank’s interest rate policy as determined by the Monetary Policy Committee (MPC), with the aim of achieving the bank’s inflation target.

In its monetary operations, the Bank endeavours to promote financial stability by managing the liquidity needs of the banking system as a whole. It also contributes to the development and efficiency of the domestic financial markets in particular the interbank market.

Summary of the functions of the central bank Adviser and banker to government The central bank is the banker and advisor to government as it manages public debt. This is achieved in part through the issuance of government paper mainly treasury bills and retail savings bonds when the government is in need of funds for the financing of recurrent expenditure and through government bonds when government is looking at financing long term projects like infrastructure.

Banker of last resort

One of the functions of the central bank is to ensure that there is stability within the financial sector. The central bank is expected to help alleviate liquidity challenges should there be some within the market. The mother bank has a number of options to adopt in this role and these include but not limited to:

1. Opening the rediscount window.

From earlier discussions we noted that the central bank sells paper into the market as a way of mopping up excess liquidity from the market.

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On the strength of this the bank can also buy back some of its own paper from the market without distorting the market activities. At its own discretion the bank can buy back treasury bills of certain tenure, certain classes of bankers’ acceptances which are commonly referred to as class one bills. These are bills that would have been used to finance the purchase of stocks for export and they have to be accompanied by the central bank’s CDI forms which are a proof that the customer has exported some goods and is awaiting payment within a certain specified period of time.

The mother bank has not offered this facility of late however but positive arguments for this practice the world over have been rife.

2. The overnight accommodation route

Commercial banks participate in the clearing process and the central bank accommodates banks that will be short in clearing on an overnight basis. The loan advance can either be on a secured or non secured basis depending on the bank‘s risk perception of the‐ borrowing bank.

The rates applicable vary from time to time but there is a higher premium for borrowing on an unsecured basis.

The central bank may use the frequency of borrowing from it as an indicator of the borrowing bank’s financial stability. The central bank does not want continuous reliance on this facility as that can mean that there is a fundamental problem with the borrowing bank. Banks facing temporary liquidity problems can also approach the central bank and make arrangements for temporary liquidity support without the rest of the market knowing about it.

Occasionally the central bank will enter the market either borrowing or offloading paper. Through this process, the central bank sets the tone for interest rates direction through acceptance and non acceptance of bid rates at their major tenders for the financial‐ instruments issued through it.

Other central bank roles include the following:

a. Supervision of the financial sector.

b. Smooth implementation of the national payment system.

c. Preparation and communication of monetary policy.

d. Ensure the stability of the financial sector.

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MONETARY POLICY OBJECTIVES

Under its monetary policy objectives central banks aim to achieve the following:

a. Maintain a stable exchange rate

b. Achieve acceptable levels of economic growth

c. Equitable distribution of income

d. Maintain price stability

e. Achieve and maintain a positive balance of payment position

MONETARY POLICY INSTRUMENTS

The central bank has a number of instruments that it employs in its bid to attain the above mentioned objectives and some of them are discussed below. There is usually an overlap in the use of instruments that the central bank may or can use to supervise the commercial banks or to advance its monetary policy objectives.

As an example, the bank may use certain prudential guidelines as a means of supervising commercial banks and at the same time advancing its monetary policy objectives.

When the central bank sets minimum statutory reserve requirements for example, the bank would be trying to create a deposit fund from which depositors can recover something in the event of a bank going under and the same statutory deposits may be used to alleviate temporary liquidity problems by the depositing bank. When the bank is doing this, it is fulfilling its supervisory role.

The central bank may use the same method to monitor money supply growth within the economy. Should the bank feel that inflation is on the increase, it may increase the statutory reserve requirement in order to reduce the banks’ ability to create money. Other instruments that can be used by the central bank to advance its monetary policy objectives include the following:

1. Use of open market operations (OMOs).

2. Use of interest rate (usually via the overnight accommodation rate or the repo rate). 3. Use of exchange rates.

OPEN MARKET OPERATIONS (OMOS)

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The central bank implements monetary policy by directly influencing short term interest rates. It does this through its control of the interbank lending rate, also known as the repo rate. This involves supplying just enough reserves to meet the demand at its target rate.

The objective

The central bank supplies reserves to banks through its open market operations (OMO) and its discount window lending. The principal tool is OMO in which the central bank buys or sells government securities in the secondary market to add or drain banking system reserves.

Normally the objective of OMO is not to effect a net change in reserves; rather it is to counter variations in the total.

These variations are caused mainly by changes in the treasury’s cash balances at the central bank, checking system float, foreign central bank transactions, and net cash flows in or out of banks. However as net bank lending varies the aggregate demand for reserves will vary and require the central bank to adjust the total in order to maintain control of the repo rate.

Basic Operations

OMO is usually executed by the trading desk of the reserve banks of the various countries, on behalf of the entire reserve system. The desk buys securities from government securities dealers who have an established trading relationship with the central bank. It pays for the securities by sending funds to the dealer's account at its clearing bank, as it takes delivery of the securities at the central bank. This action adds reserves to the banking system. Conversely, when the central bank sells securities to a dealer, it delivers the securities and the account of the dealer is debited. This action drains reserves from the banking system.Types of transactions

The trading desk most often engages in short term repurchase agreements (repos) which are‐ used in situations that call for temporary additions to bank reserves. With repos, the desk buys securities from the dealers, who agree to repurchase them at a specified date and at a specified price. When the repo matures, the added reserves are automatically drained. If there is a temporary need to drain reserves, the trading desk executes reverse repos with dealers in treasuries. These transactions involve a contract for immediate sale of treasury bills to the dealer, with a matching contract for later purchase from the dealer.

The use of the repo rate

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The repo rate is the rate at which banks that participate in the clearing borrow money from the central bank. It is also used as an indicator to the direction of short term interest rates. Banks can either be long or short during clearing.

If the market is overall short and is thus strained of liquidity, the central bank may opt to reduce the repo rate and should it feel that inflation is on the increase as a result of money supply growth, the central bank may increase the repo rate.

Use of exchange rates

The central bank may use the exchange rate to monitor the level of foreign currency reserves of a country. Should the foreign currency reserves increase (as a result of good export performance of the economy), the central bank may revalue its currency – a move that may result in imports becoming much cheaper.

THE SPECIAL ROLE OF BANK SUPERVISION

The central bank supervises the operations of the market players through a number of ways.

1. Through moral persuasion and other instruments the central bank sets out the trading parameters for the rest of the market.

2. It approves or disapproves the trading in other instruments depending on its own perception of their impact on its broad monetary policy objectives.

3. It conducts both onsite and offsite inspections of its affiliates on a regular bases.

4. It requires its affiliates to submit certain reports periodically to the bank.

THE REGULATORY ROLE

The central bank regulates the operations of those financial institutions that are registered with it.

As part of its regulatory role, the central bank coordinates the clearing process within the country.

It requires some commercial banks registered with it to maintain a current account with the bank and all major transactions in and out of that account are monitored. All other registered commercial banks that do not hold an account with the central bank do their clearance through certain designated commercial banks.

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This is meant to assist the central bank to fish out any unorthodox transactions within the financial sector.

The account with the reserve bank is never supposed to over draw and any unauthorised overdrafts will result in heavy penalties which in extreme cases can lead to the cancellation of the trading license.

The use of ratios and minimum capital requirements

The central bank uses the statutory reserve ratio as a tool to manage money supply growth within the market. The participating banks are expected to deposit a certain percentage of every dollar they take from the public with the central bank.

There are various arguments put forward for this practice but the dominant ones are that this money is supposed to act as a buffer to protect depositors and in the event of a run on the bank central bank can use some of that money to pay off depositors.

The other argument emphasises the economic purpose of this practice which is to reduce credit creation by banks as this is deemed to be inflationary.

This has the effect of increasing or reducing liquidity within the market which in turn has a direct impact on interest rates.

Use of liquidity ratio requirements

The central bank also requires commercial banks and all its other affiliates to keep a percentage of the assets on the balance sheet in liquid or near money form.

The ratio varies from time to time and from country to country depending on the objectives of the central bank at a particular time.

The instruments that qualify for liquidity purposes are at the discretion of the central bank and in most situations the following instruments qualify:

1. Notes and coins (both local and foreign)

2. Nostro balances.

3. Treasury bills with a tenure of not more than a year.

4. Government stock with tenure of not more than one year.

5. Other stocks as specified by the central bank.

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6. Balances in accounts with central bank.

7. Balances or call money with other banks. The use of minimum capital ratios

Banks are required to keep at least 8% of their total assets as the minimum capital in accordance with the Basel Accord. This is in line with the minimum capital requirements the world over. There have been debates over this move and its application has not been as strictly adhered to as was originally thought.

ACTIVITY Self assessment question 1‐ For what reasons would a country need a central bank?

Self assessment question 2‐

Assess the effectiveness of the central bank in the execution of its main responsibilities in your own country over the past two years.

ASSESSMENT

Possible questions:

• What are the main functions of the central bank? • Discuss the successes/failures of the central bank in your country in its supervisory role

over the past two years. • What are the instruments at the central bank’s disposal as it executes its main functions? • What are the main monetary policy objectives? • What are the supervisory duties of the central bank? • What are the supervisory methods that are employed by the central bank?

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STUDY UNIT 5: MONEY AND CAPITAL MARKETS

LEARNING OUTCOMES

After completing this study unit you will have mastered the following:

• What is a market? • Differentiate money from capital markets. • Understand the characteristics of money and capital market instruments. • Define money market instruments. • Define the foreign exchange market. • Define capital market instruments. • Differentiate primary from secondary markets. The money market

There is no physical place called the money market, one cannot touch nor can one feel the money market so it is important for readers to appreciate that there is no address on which one can find the money market.

Instead the money market is anywhere where trading of money market instruments or financial instruments exchange hands or are traded.

The money market is an integration of individuals, institutions, governments, corporate, dealers and brokers using the latest technology to facilitate communication.

The key point here is the interaction which comes as a result of the trade that takes place among the participants. Investors from the U.S.A., the United Kingdom, Japan, Switzerland, Egypt, India, South Africa and Zimbabwe can exchange instruments without physical contact of each other.

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There are only three conditions that need to be satisfied for trading to conform or qualify as money market trading.

a. There must be players or participants. These stimulate trade and development of

products depending on their needs and or requirements.

b. There must be instruments (of a financial nature) that are to be traded. These instruments (subject to discussion later) are born out of a need by the participants. People as players have individual needs that are satisfied through the provision of appropriate financial instruments, in some instances tailor made to suit individual requirements.

c. There must be interaction (buying and selling of instruments).

The interaction takes different forms; it can be through the phone, internet, computers,

Reuters or physical contact. This exchange results in some sections of the participants becoming buyers and others become sellers.

The money market in most financial markets is a major part of the nation's financial system in which banks and other participants trade hundreds of billions of dollars every working day.

It is a wholesale market for low risk, highly liquid, short term debt instruments. They include‐ ‐ short term treasury and federal agency debt, negotiable bank certificates of deposits, bank deposit notes, bankers' acceptances, and short term participations in bank loans, municipal‐ notes, commercial paper and Eurodollars. The heart of the money market is in the trading rooms of dealers and brokers. In truth it is not one market but several markets for distinct and different instruments which nevertheless have close interrelationships. A notable feature is the speed of transactions involving hundred million dollar blocks and the trust that exists among the traders. Trades are negotiated by phone or computer terminal within seconds and no one reneges. The motto is: my word is my bond.

Borrowers in the market include domestic and foreign banks, the treasury, corporations of all types, the federal home loan banks and other federal agencies, dealers in money market instruments, and many states and municipalities. The lenders include most of the above plus insurance companies, pension funds, and various other financial institutions.

The money market accomplishes several vital functions

One is shifting vast sums of money between banks. This is required because most large banks need more funds than they obtain in deposits, whereas many smaller banks have more deposits than they can profitably use internally. The money market also provides a means by which funds of cash rich corporations and other institutions can be funneled to banks that‐ need short term money.‐

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The money market is where the central bank can sell huge quantities of debt with ease. It is also where the central bank carries out its open market operations to control interest rates and provide for growth of the money supply. The market is where participants determine the term structure of short term interest rates affecting the yields on treasury bills and commercial paper of different maturities. It has also become an international short term capital market‐ where much of the dollar denominated trade by foreign entities is financed.

CAPITAL MARKETS Primary markets The primary market is the market where trading instruments are originated.

a. More direct relationship between issuer of financial instrument and seller/distributor.

b. Fewer players are involved c. The amounts on the instruments tend to be very high. In most cases the

handler/distributor assumes or is assumed to have taken care of the issuer’s credit risk. Participants are large corporations, parastatals, governments, central banks, commercial banks merchants and development banks.

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An illustrative diagram of the relationship between the primary and the secondary markets.

THE SECONDARY MARKET

This is the market where securities or instruments issued in the primary market are traded. The characteristics of the secondary market:

a. There are more players.

b. The instruments are unbundled into smaller units for affordability by small players.

c. The general investing public and the discount houses are key players.

d. In most cases the investing public does not consider the instrument’ credit risk as they purchase against the reputation of the seller. This assumption has led to a lot of problems for market/investor in the event of the paper/instrument not being honoured on maturity.

e. Most trades are margin based i.e. the seller sells the instrument adding a small margin to the original cost of the instrument.

f. It implies therefore that the instrument becomes slightly more expensive. It is not uncommon to find players who are participants in both markets as situations and requirements will always differ.

THE INTERBANK MARKET

The interbank market refers to the interaction of financial institutions including the central bank where trade is conducted between and on behalf of the various institutions’ clients.

The volume of trade within the interbank market is very high and the individual institutions will then resale these instruments to clients within their books.

Participating institutions also trade paper among themselves settling their positions.

This market is governed by the broad parameters as set out within the Banking Act and or as promulgated by the central bank from time to time.

The interbank market is used in most cases by the central bank to distribute paper emanating from it.

The volume and intensity of trade within the interbank market is to some extend a function of the economic vibrancy of the particular country.

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In summary the interbank market performs the following roles:

1. Trades instruments between or among structured money market participants.

2. Takes a cue from central bank on the direction of interest rates on the money market instruments.

3. Break investment instruments into smaller chunks consumable by the ordinary investor on the street.

4. Provide some form of feedback to central banks on the market’s perception of certain instruments or policy issues through market canvassing, participation in the tender process and so forth.

The foreign exchange market

Because so much of world trade is conducted directly in US dollars, foreign exchange between non U.S. currencies usually involves conversion into and out of U.S. dollars. The foreign‐ exchange market is an international market, active around the clock. London has by far the largest market, followed by New York, Tokyo, and Singapore. Large banks and security dealers maintain trading rooms where they post on computer screens around the world their bid and ask prices for currencies relative to the U.S. dollar. Quotes are offered for both the spot market and the forward market. Foreign exchange trading has grown rapidly since 1971. That is the year Nixon ended gold backing for the U.S. dollar in international payments, thus leaving the exchange rates of the world’s currencies to float at market prices.

The volatility of those rates has increased dramatically since the mid 1970s, creating‐ investment risk as well as opportunities for speculative gain. Foreign exchange trading in support of commerce is now just the tip of the iceberg, probably less than 5% of the total.

Payment involving the transfer of bank deposits from the buyer’s account to the seller’s account is very simple if both buyer and seller share the same bank. The process is only a little more complex when they have different banks if both banks are part of the same clearing system. If the two banks are in different clearing systems, payment is substantially more complex.

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A case of different clearing systems

Consider a U.S. importer who buys a shipment of Swiss watches. Assume the exporter requires payment in francs to his account at a Swiss bank, which of course is in a different clearing system. Normally the importer will go to the foreign exchange desk of his own bank and pay the dollars required to buy the francs as a deposit in a Swiss bank. The details of this transaction are handled by his own bank. A cheque can then be drawn on the Swiss bank in payment to the exporter. When the exporter deposits the check in his Swiss bank, it will clear in the normal fashion through the Swiss banking system.

Where does the U.S. bank get the Swiss francs to sell to the importer? If the bank is large enough and does business in foreign exchange, it may maintain a deposit of its own at a Swiss bank.

If not, it can buy the francs in the interbank market in foreign currencies where the ownership

of deposits in different currencies is traded. Small banks may need the services of a correspondent bank that has trading facilities.

Money market instruments

The repo market The over the counter repo market is now one of the largest and ‐ ‐most active sectors in most money markets. Repos are widely used for investing surplus funds short term, or for borrowing short term against collateral. Dealers in securities use repos to manage their liquidity, finance their inventories, and speculate in various ways.

The Fed uses repos to manage the aggregate reserves of the banking system. What are repos?

Repos, short for repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often treasury securities. On the termination date, the seller repurchases the asset at the same price at which he sold it, and pays interest for the use of the funds. Although legally a sequential pair of sales, in effect a repo is a short term‐

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interest bearing loan against collateral. The annualised rate of interest paid on the loan is‐ known as the repo rate. Repos can be of any duration but are most commonly overnight loans. Repos for longer than overnight are known as term repos. There are also open repos that can be terminated by either side on a day’s notice. In common parlance, the seller of securities does a repo and the lender of funds does a reverse. Because money is the more liquid asset, the lender normally receives a margin on the collateral, meaning it is priced below market value, usually by 2 to 5 percent depending on maturity. The overnight repo rate normally runs slightly below the fed funds rate for two reasons:

First a repo transaction is a secured loan, whereas the sale of fed funds is an unsecured loan. Second, many who can invest in repos cannot sell fed funds. Even though the return is modest, overnight lending in the repo market offers several advantages to investors. By rolling overnight repos, they can keep surplus funds invested without losing liquidity or incurring price risk. They also incur very little credit risk because the collateral is always high grade paper.

Repos are not for small investors

The largest users of repos and reverses are the dealers in government securities.

Primary dealers must be well capitalised, and often deal in hundred million dollar‐ chunks. In addition there are several hundred dealers who buy and sell treasury securities in the secondary market and do repos and reverses in at least one million dollar chunks. Big suppliers of repo money are money funds, large corporations, state and local governments, and foreign central banks.

Generally the alternative of investing in securities that mature in a few months is not

attractive by comparison.

THE EURO MARKET

Eurodollars

Many foreign banks as well as foreign branches of U.S. banks accept deposits of U.S. dollars and grant the depositor an account denominated in dollars. Those dollars are called Eurodollars. They exist under quite different constraints from domestic dollars. While Eurodollar banking got its start in Europe, such banking is now active in major financial centers around the world.

Importance of Eurodollars

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Today the Eurodollar market is the international capital market of the world. It includes U.S. corporations funding foreign operations, foreign corporations funding foreign or domestic operations, and foreign governments funding investment projects or general balance‐ofpayment deficits.

Overseas branches of a U.S. bank are treated as an integral part of the parent bank. In its published statements the parent bank consolidates the assets and liabilities of all branches, domestic and overseas, and it has just one account at the Fed, held by the head office.

However each overseas branch keeps its own books for day to day operations.‐ ‐

An example

Suppose the AAA Corporation draws a cheque for five million dollars on Citibank, it’s New York bank, and deposits it at a London Eurodollar bank. The result is that the ownership of five million U.S. dollars has passed from AAA to the London bank in exchange for a Eurodollar time deposit. The London bank now holds a deposit at Citibank balanced by a liability, the time deposit credited to AAA.

Since that money earns no interest at Citibank, the London bank will use the funds to make a loan, say to the BBB Corporation which banks at Wells Fargo. Citibank will then show a decrease of five million dollars on deposit at the Fed and a decrease in liability of that amount to the London bank. Wells Fargo will gain that deposit at the Fed and an equal liability as a deposit for BBB. The London bank will record a loan of five million dollars to BBB balanced by a time deposit owed to AAA.

Source of Eurodollar funds

The funds that form the basis for the Eurodollar market are provided by a wide range of depositors: large corporations (domestic, foreign, multinational), central banks and other government bodies, supranational institutions such as the Bank for International Settlements, and wealthy individuals. Most of the funds come in the form of time deposits with fixed maturities. The Euro banks also receive a certain amount of call money. A call account can be a same day value account, a 2 day notice, or a 7 day notice account. The going rate for call‐ ‐ ‐ money closely tracks the overnight Eurodollar rate, which in turn is tied by active arbitrage to the U.S. Fed funds rate.

The main attraction of a call deposit is liquidity. Time deposits pay more, but a penalty is incurred if such a deposit is withdrawn before maturity.

Other money market instruments

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READ

There are other money market instruments that have not been discussed in the study guide but are well covered in the prescribed book. These include treasury bills, banker’s acceptances, commercial paper, and negotiable certificates of deposits and call money. These are covered in detail in chapter 5 of the prescribed book.

It is in your interest to read and understand the different characteristics of these instruments.

Capital market instruments

READ All major capital market instruments are covered under chapter 5 of the prescribed book.

Please make sure you read and understand the different characteristics of these instruments.

ACTIVITY

Self assessment question 1‐ Discuss the various types of markets that you came across in this study unit.

Self assessment question 2‐

What are the main instruments that you came across in your reading and what are the main properties of each?

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ASSESSMENT

Possible questions:

• Define the main principles of a market. • List and explain the main features of money market instruments. • What is meant by the term Euro dollar and who are the main participants in this market‐

and why? • Explain what is meant by the term “repo” and give an example of a situation where a repo

may be traded. • Discuss the main features of a bond and demonstrate your understanding of the

relationship between bond prices and interest rates. • Define and contrast stocks and bonds. What are the advantages of owning common and

preferred stocks?

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STUDY UNIT 6: INTEREST RATES AND BOND PRICES

LEARNING OUTCOMES

After completing this study unit you will have mastered the following:

• Why interest rate represent the time value of money? • What compounding and discounting are? • Why interest rates and bond prices are inversely related? • The major determinants of interest rates. • The relationship between nominal and real interest rates. • How interest rates fluctuate over a business cycle?

READ • This study unit is based on Chapter 6 of the recommended book.

You are encouraged to read with deep understanding the following areas:

1. The concept of the present value against the future value, with a view of understanding questions that involve comparing the present with the future.

2. The concept of the time value of money again with the view of appreciating the importance of the timing of cash flows.

3. The concept of compounding and discounting. The main objective behind understanding this is to enable students to be able to compare investments with different time horizons and be able to make informed decisions based on comparing apples with apples concept.

4. Understand the relationship between interest rates and bond prices. In the process, the student must be able to identify all the properties of a bond and be able to understand all the variables that have a bearing on the prices of bonds.

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5. Read and understand the main determinants of interest rates and relate these to your own economy.

6. Establish the link between inflation and interest rates and again be able to relate these issues to one’s own economy.

ACTIVITY Self assessment question 1‐ Define the concept of compounding and discounting.

Self assessment question 2‐ Assume that after graduating, you get a job as the Chief Financial Officer of a small company. Explain why being able to forecast the direction of interest rate changes may be critical for your success in that position.

ASSESSMENT Possible questions:

• What is the present value concept and when do we get to use it? • Under what conditions will a bond sell at a premium and under what conditions will it sell

at a discount? • Use the concept of present value to explain why a trip to the UK next year would mean

more to most people than the trip in the year 2017.

• What factors affect the demand for loanable funds and what factors affect the supply of loanable funds?

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• Assume that after graduating, you get a job as the chief financial officer of a small company. Explain why being able to forecast the direction of interest rate changes may be critical for your success in that position.

Recommended books/material for further reading

1. Reserve Bank Quarterly bulletin. (Try and familiarise yourself with the content of this bulleting in your country.)

2. Monetary policy statements from your own central banks.

3. The information in the study guide and from the prescribed book will be sufficient for examination purposes but it is important for the student to constantly visit the internet for the most up to date developments within the banking field.

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