money, banks and the payments system

Money, Banks and the Payments System

Michael McMahon

Money and Banking (2): Money & Banks 1 / 59

To Cover

1. Money - its uses and how it developed;2. Retail payment systems;3. Wholesale payment systems and interbank settlement;4. Major policy issues for payment systems;5. Measuring money.6. Banks’ Balance Sheets;7. Money creation and Central Bank control;8. Current crisis and the first signs in the Northern Rock crisis.


“To Pay”

• Related to the verb “to pacify”, and comes from the idea of bloodmoney (“weregild”);

• Key idea is the transfer of value from one party to another.

Bank for International Settlements (BIS) defines a payment system as:“a set of instruments, banking procedures and, typically,

interbank funds transfer systems that ensure the circulation ofmoney”


Is Money Obvious?

Barter discussed in problem set 1.

Kiyotaki-Wright model of money in a search economy and they find 2equilibria:

1. No one accepts money, or2. all accept money in exchange for goods and services.


Money

4 Classic Functions of Money

1. Medium of Exchange;2. Means of deferred payment;3. Unit of Account;4. Store of Value.

But first is most important...others follow.“The original function of money ...is that of a generally used

intermediary of exchange. ... Precisely the objects of trade thathave become generally used media of exchange tend also to takeon a series of other functions in the economy” (Menger, 1892)


Money

Some important features of money

1. Anonymity - also a problem for crime?;2. Ease of transportation;3. Divisibility into smaller denominations;4. Durability.

Fiat money (Kubilai Khan!) vs. Commodity money.


Basic Payment System

One form of payment system is whereby everyone pays using money.⇒ this is pretty inefficient especially with large payments!

There are many levels of payment system whichc exist alongside oneanother:

• e.g. Retail payments vs. wholesale payments (LVPS)


Developments in Retail Payment Systems

• Money (fiat or commodity)• Cheques (checks)• Electronic Payment• eMoney - debit cards, smart cards with stored value.


Money leading to Banks

Money-changers and goldsmiths:

• able to value coins so leave coins with them and just keep a record;• safe-keeping.

Receipts were then used as a means to transfer value.• Records show this activity in Venetian banks by the 14th Century.

But no inter-bank arrangements until later.


Interbank Settlement Systems and Central Banks

Consider 3 main types of system:

1. Bilateral settlement systems;2. Mutually-owned multilateral clearing house - settle in money;3. A central bank - settle in the Bank’s liabilities.

Consider the 3 Bank example on the next slide.


3 Bank Example

Bank A

1. Owes $5m to Bank B2. Is owed $5.5m from Bank C

Bank B

1. Owes $4.5m to Bank C2. Is owed $5m from Bank A

Bank C

1. Owes $5.5m to Bank A2. Is owed $4.5m from Bank B


3 Bank Example (contd)

• A Bilateral Settlement System involves total transfers of $15mbetween the banks.

• A multilateral clearing system involves transfer of $1m:

• Bank C to Bank A = $0.5m• Bank C to Bank B = $0.5m




• A multilateral clearing system involves transfer of $1m:• Bank C to Bank A = $0.5m

• Bank C to Bank B = $0.5m




• A multilateral clearing system involves transfer of $1m:• Bank C to Bank A = $0.5m• Bank C to Bank B = $0.5m


Another Complication

Real Time Gross Settlement (RTGS)

• Payment is transferred immediately so no credit risk;• used in business to business transactions, and large purchases by

consumers.• But high amounts of liquidity and flows between the banking parties.• e.g. In the UK: “CHAPS”.

Deferred Net Settlement (DNS)

• System of netting at a specified point in time (end of day);• lower volume of flows, but greater credit risk.• e.g. In the UK: Bacs.


Central Banks and the public good

• Retail systems as a public good - Government control or oversight;• In LVPS, there are 2 main risks:

1. Failure of one agent spills over to other agents in the network;2. Infrastructure and ‘single points of failure’.

Both of these risks are systemic - a large aggregate risk which is largerthan summed individual risks and so individuals under-invest in trying toavoid or mitigate these risks.

• Lender of last resort function - lend to solvent but illiquid banks.But some payment systems remain privately organised

• Canada and Switzerland


How the Bank of England got its place

1. Founded in 1694 (to help finance a war!) as a private bank, except:• Only joint-stock bank allowed in London;• Banker to the government.

2. Govt role, and being one of the largest London banks, BOE developeda central position in the heart of the growing financial system.

3. By 1770s, settlement of bankers positions (through the Bankers’Clearing House) had switched into BOE notes (from gold).

• Settlements took place twice a day• Bilateral until 1841.

4. 1844 - gained monopoly power in the issuance of UK currency.5. BOE stopped competing with other banks by 1910 because:

5.1 overburdening a private bank, and5.2 access to important information.

6. BOE was nationalised in 1946.


Recent (non-crisis) Policy Issues - See extra reading

1. How and on what terms should a central bank supply “money” tofinancial institutions both intra-day and overnight?

2. What future for money? Will it be replaced by eMoney?


Measuring Money I

• Difficult to ”count” the amount of money in an economy• Central banks have narrow to broad measures• In the US, measures are called M1 (currency) and M2 (broad money)

- M3 is no more!

The measurement is not very reliable:

1. infrequent reporting;2. seasonal adjustment.


Measuring Money II

• Money supply: the total quantity of money available• The components of money are:

M1 Currency in circulation + Checking accountsM2 M1 + Savings accounts + Small time depositsM3 M2 + Money-market funds + Large time deposits

How does money enter the system?The central bank prints money, buys securities or lends it to commercialbanks.


Measuring Money III

U.S. Monetary AggregatesApril, 2012 (billions $)

M1

Currency

Total Checkable Deposits

1,034

1,218

2,252

M2

Components of M1

Savings Deposits

Small-Denomination Time Deposits

Money Market Mutual Funds

2,252

6,242

717

634

9,846


Measuring Money IV

Euro area money supply

-100

100

300

500

700

900

1100

1300

1500

1700

-2000

1000

4000

7000

10000

1997.09 1999.04 2000.11 2002.06 2004.01 2005.08 2007.03 2008.10 2010.05 2011.12

Currency in circulation(right scale)

M1

M3

M2

(bill

ion

so

feu

ros)


Measuring Money V

The two main measures historically in the UK are:

• M0 - “comprised sterling notes and coin in circulation outside theBank of England (including those held in banks’ and buildingsocieties’ tills), and banks’ operational deposits with the Bank ofEngland”.

• This is the monetary base (MB=Reserves of bank+Cash).• Since Spring 2006, this series has been discontinued and the relevant

narrow money series is ”Notes and Coins”, Cash in our equation,which has historically made up the bulk of the monetary base (97.5%in August 2005).


Measuring Money VI

The two main measures historically in the UK are:

• M4 - “The M4 private sector’s (i.e. the UK private sector other thanmonetary financial institutions’ (MFIs)) holdings of:

• sterling notes and coin;• sterling deposits, including certificates of deposit;• commercial paper, bonds, FRNs and other instruments of up to and

including five years’ original maturity issued by UK MFIs;• claims on UK MFIs arising from repos (from December 1995);• estimated holdings of sterling bank bills;• and from end-1986, 95% of the domestic sterling interbank (now

inter-MFI) difference (allocated to wholesale deposits/other financialcorporations, the remaining 5% being allocated to transits).”

Thus M4 is broad money and the main difference with M3 (as used in theUK previously, and used in Europe) is the treatment of building societies.


Currency in circulationHow much money is need?

Currency holdings per capita in USD (April 2012)

USA $3,530 per personEuro area $3,318 per person

• Are these numbers reasonable?• Who holds the money?• Euro area: total currency in circulation 848 Billions Euro. Out of

which 290 Billions are in 500 Euro notes (almost two 500 euro notesper person)


Measuring Money (Divisia)

• Don’t treat each of the different assets as perfect substitutes;


Bank Balance Sheets

Assets LiabilitiesReserves 4% Checkable Deposits 7%Securities 23% Time Deposits 59%Loans 66% Borrowings 26%Other assets (e.g. physical capital) 7% Bank Capital 8%

decreasing liquidity

Recall:• Basic idea is to make more on the assets than you pay on the

liabilities ⇒ profits• T-account is the change in the balance sheet for various transactions


Central Bank Balance Sheets

Like the banks, the Central Bank (Fed, BOE, ECB) also maintains abalance sheet of interest:

Assets LiabilitiesGovernment Securities Currency in circulation

Discount loans to banks Reserves (from Banks)Other assets

The liabilities side is known as the monetary base (MB = Cash + reserves)The CB also engages in OMO to change the monetary base


Central Bank Balance SheetsFrom http://katchum.blogspot.co.uk


Central Bank Open Market Operations

Consider a $100 purchase of a government bond (from Bank A):

Central BankAssets Liabilities

Government Securities +100 Currency in circulation -Discount loans to banks - Reserves (from Banks) +100

Other assets -

Bank AAssets Liabilities

Required Reserves - Deposits -Excess Reserves +100Loans -Securities -100


Multiple Deposit CreationConsider how Bank A will now use these excess reserves following theOMO to create a loan:


Required Reserves DepositsExcess Reserves +100LoansSecurities -100

Bank BAssets Liabilities

Required Reserves DepositsExcess ReservesLoansSecurities


Multiple Deposit CreationConsider how Bank A will now use these excess reserves following theOMO - creates deposits to needs to put 10 in required reserves:


Required Reserves +10 Deposits +100Excess Reserves -10Loans +100Securities




Multiple Deposit CreationThe money goes from Bank A to Bank B via a cheque payment: - excessreserves of A depleted


Required Reserves -10 Deposits -100Excess Reserves -90LoansSecurities


Required Reserves +10 Deposits +100Excess Reserves +90LoansSecurities


Multiple Deposit CreationB now has excess reserves of 90, which are used to create new loans worth90 - with 9 now becoming required reserves:




Required Reserves +9 Deposits +90Excess Reserves -9Loans +90Securities


Multiple Deposit Creation

• Consilidated Balance Sheet (not T-account)• Assume start with 10,000 in deposits• Loans are 8,900 (securities are 100)• 1,000 in reserves• 1,000 is currency in circulation outside the banks

Consolidated Bank Balance Sheet (A + B)Assets Liabilities

Required Reserves 1000 Deposits 10000Excess ReservesLoans 8900Securities 100

M1 = currency in circulation + deposits = 1,000 + 10,000 = 11,000



• Consilidated Balance Sheet (not T-account)• Assume start with 10,000 in deposits• Loans are 8,900 (securities are 100)• 1,000 in reserves• 1,000 is currency in circulation outside the banks

Consolidated Bank Balance Sheet (A + B)Assets Liabilities

Required Reserves 1019 Deposits 10190Excess Reserves 81Loans 9090Securities

M1 = currency in circulation + deposits = 1,000 + 10,190 = 11,190



This simple process can keep going, with each Bank leveraging up on thebasis of only 10% of new deposits being required for the reserves, untilthere is no longer any increase in deposits:

∆Deposits (D)= ∆Reserves(initial)reserve requirement

Therefore, with a 10% reserve requirement, an OMO which increasesbanking system reserves by $100 can lead to an increase in deposits of$1000!


Money Multiplier ApproachWe can be more formal with this approach:

Ms = m ×MB (1)Ms = Cash + D (2)

MB = Cash + reserves (3)reserves = RR + ER

Let:

e =ERD

r =RRD

c =cashD


Money Multiplier Approach (contd)Using these substitutions:

MB = Cash + reserves= Cash + RR + ER

MBD = c + r + e

MB = (c + r + e) .D

Therefore:

Ms = Cash + D= c.D + D= (1 + c).D

=(1 + c)

c + r + e .MB


Money Multiplier Approach (contd)

m =(1 + c)

c + r + eSo this approach tells us:

• So long as r + e < 1, an increase in MB that goes into currency, isnot multiplied and therefore higher c means lower multiplierδmδc = (c+r+e)−(1+c)

(c+r+e)2 = r+e−1(c+r+e)2 < 0 if r + e < 1;

• excess reserve ratios and reserve requirements similarly lower themultiplier.

e ≈ 0.001− 0.003; r ≈ 0.1; c ≈ 0.5 .... though all changeable such as inthe Great Depression.


Rejection of Monetary Base Control

”Virtually every monetary economist believes that the CentralBank can control the monetary base...Almost all those who haveworked in a Central Bank believe that this view is totallymistaken” (Goodhart, 1994)

Why reject this idea? Among the reasons are:

• Quantity controls would lead to excessive volatility in prices (theinterest rate);

• Predicting CB liabilities is not always accurate;• Bank assets are non-marketable and so there could be excessive real

volatility - Open Market sale⇒ house repossessions?


Rejection of the Money Multiplier Approach

• Banks are more likely to be constrained by equity and their own creditextension decisions than by reserve requirements

• But banks do create deposits when they make loans• Central banks can influence the total amount of money by controlling

interest rates• Bank of England recently discussed this

• 2014, Quarterly Bulletin: 2 articles by McLeay, Radia and Thomas.

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q101.pdfhttp://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf


http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q101.pdf




The Subprime and Financial Crisis


The Subprime and Financial Crisis IUS House Prices Since 1890 (adjusted for inflation)


The Subprime and Financial Crisis IIUS House Prices and Equity Markets Fell Sharply


The Subprime and Financial Crisis IIIUS House Prices and Equity Markets Have Fallen Sharply


The Subprime and Financial Crisis IVThe Fall has led to a rise in foreclosures


The Subprime and Financial Crisis V

• But bank losses due to mortgages in this crisis are relatively small• approximately US$1,000 mn• this is equivalent to a 3% fall in the stock market (at end 2006 prices)• In October 1987, the S&P 500 fell 20 % in a single month with almost

no macroeconomic repercussions

• Therefore, we need to understand how the shock got transmitted tobecome the large scale, global crisis that we have seen in the last 2years.

I will focus here on the idea of leverage.


Leverage and the US Banking Crisis I

Leverage =assetscapital

Assets LiabilitiesReserves Checkable DepositsSecurities Time DepositsLoans BorrowingsOther assets (e.g. physical capital) Bank Capital


Leverage and the US Banking Crisis II

Leverage =assetscapital = 10

Assets LiabilitiesAssets 100 Debt 90

Bank Capital 10


Leverage and the US Banking Crisis II

Leverage =assetscapital = 9.18


Bank Capital 11

• If debt constant, leverage is inversely proportional to asset values:• assets ↓ ⇒ leverage ↑

• Holding debt constant ⇒ counter-cyclical leverage


Leverage and the US Banking Crisis IIIHouseholds


Leverage and the US Banking Crisis IVPNFCs


Leverage and the US Banking Crisis VBanks


Leverage and the US Banking Crisis VIImplications of Asset Price Fall with Procyclical Leverage


TARGET = 10


Bank Capital 10

• Pro-cyclical leverage means that as asset prices go up, we increaseleverage by buying even more assets using debt.

• But buying more assets pushes the value of assets ↑ ⇒ circular• When prices start to fall, we get a firesale of assets.




NEW TARGET = 9 (falls)


Bank Capital 9






Bank Capital 9

• To achieve new target the bank must sell off assets and use theproceeds to pay down debt

• 1% fall in asset prices ⇒ 18% sale of assets which puts further pressureon prices.


Leverage and the US Banking Crisis VIIImplications of Asset Price Fall with Procyclical Leverage



Assets LiabilitiesAssets 101.25 Debt 90

Bank Capital 11.25

• Could have raised capital and used the proceeds to buy assets.• raised 2.25 in new capital and buys assets with this.


Leverage and the US Banking Crisis VIIIA Game of Two Halves

In the beginning of the crisis (up until August 2008), banks tried to coverthe declines in the values of their assets (marked-to-market) and reducethe firesale activity by raising new capital:


Leverage and the US Banking Crisis IXA Game of Two Halves

From September 2008, were unable to raise new capital (confidence wasgone after Lehman) and so the governments stepped in to recapitalise thebanks and stop the firesale.


Leverage and the US Banking Crisis XA Game of Two Halves

Seemed to work:


Northern Rock - A slightly different problem

ProblemFrom the provided articles, can you develop an understanding of why theNorthern Rock crisis occurred? What were the primary failings of thebank? What was the policymakers response?

Two articles on Northern Rock:

1. Official press release from the company on 14th September.[http://www2.warwick.ac.uk/fac/soc/economics/current/modules/ec230/details/interesting_links/5.1_-_northern_rock_1.pdf]

2. Speech by Mervyn King (Governor of the Bank of England) onOctober 9. [http://www2.warwick.ac.uk/fac/soc/economics/current/modules/ec230/details/interesting_links/5.2_-_northern_rock_2_-_mak_speech.pdf]


http://www2.warwick.ac.uk/fac/soc/economics/current/modules/ec230/details/interesting_links/5.1_-_northern_rock_1.pdf



http://www2.warwick.ac.uk/fac/soc/economics/current/modules/ec230/details/interesting_links/5.2_-_northern_rock_2_-_mak_speech.pdf



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Questions?
