UNIT 8.

Banking
Central banks dont have divine wisdom. They try to do the best analysis they can and must be prepared to stand or fall by the quality of that analysis. Eddie George, Governor of The Bank of England 1. Before reading the information in the texts below, try answering the following questions by using your knowledge: 2. Do banks create base money when they issue loans? Do a banks reserves consist in more then its cash within the bank and its deposits with the Central Bank of the country it is based in? Does the Central Bank control the amount of money supply on the national market? Does a bank have to hold reserves at least equal to a fraction of its total deposit liabilities? Do the reserve requirements of a bank uarantee a banks solvency?

!!ording to the knowledge you already ha"e, establish whether the following statements are true or false# $ro"ide the ne!essary arguments for your !hoi!e. !ome countries do not impose minimum reserve requirements to their banks. Banks lend the money they receive from their depositors. Banks money is at risk when issuin a loan. "on#bankin financial institutions $investment banks% finance companies& cannot accept demand deposits. 'hen a bank issues a loan% its liabilities and reserves increase by the amount of the loan. (urodollars are )! dollars issued by a (uropean bank

%. &at!h the following terms with their !orres$ondent ex$lanations' o"erdraft ("erb' to o"erdraw), standing order, T& (!ash dis$enser), reser"e ratio, yield, banker*s draft, base rate, dis!ount rate, net yield, $romissory note, lender of last resort. * machine at a bank branch or other location which enables a customer to perform basic bankin activities +t is the rate at which commercial banks may borrow short term funds directly from a Central Bank +t is the amount of money and liquid assets that commercial banks must hold in cash or on deposit with the Central Bank ,he interest rate that British banks char e to their blue chip customers. +t is the same as prime rate in the ).!

,he e-tension of credit by a lendin institution usually to natural persons and within the limits of the double amount specified in the account * function of a central bank% accordin to which it lends money to a bank facin unusually heavy liquidity problems * document si ned by a borrower promisin to repay a loan under stipulated periods ,he annual profit on an investment% e-pressed as a percenta e *n instrument si ned by a drawer to a drawee requestin payment at a future time to a third party *n authori.ation by a customer to make re ular periodic payments on specified dates to a payee /ate of profit on an investment after deductin all commissions% costs of purchase% and ta-es

+. Brainstorm to find out the ,omanian equi"alents for the following !ollo!ations' to draw a check to endorse a check to stop a check to write out a check town check I. Banks - a bird*s eye "iew "owadays when people refer to the term 0bank1 they may have in mind different financial institution such as:

Commercial bank

+nvestment bank

.inan!ial institutions asso!iated by $eo$le with banks 2utual !avin s fund4 bank unit trust

Banks *ccept deposits 2ake loans actin as financial intermediates 3lay as instruments of a overnments monetary policy * banks reserves are primary o cash

o deposits o reserves required by the Central Bank secondary o securities bou ht by the bank to meet its short term cash needs% usually it is about ,#bills. ,he e-cess reserves 5 the money a bank has on hand after it meets its reserve requirements. ,he e-cess reserves create money. /. Think out at the next hy$otheti!al situation' 6 deposits 7 899 in bank *. Bank * keeps 7 199 to meet its reserve requirements. +t lends then 7 :99 to ;% who uses the money to buy a frid e. ,he company from which ; bou ht the frid e deposits the 7 :99 in its account at bank B. Bank B keeps 7 <9 of it on reserves% but it can lend out the other 7 1:9 as its own e-cess reserves. *nd the cycle continues. ,his phenomenon is called the multiplier effect. ,he si.e of the multiplier depends on the amount of money banks must keep on reserve. Use the sim$le balan!e sheets below to fill in with the data $ro"ided abo"e'
Balance sheet Bank "A" Assets Reserves Loans Liabilities and net worth Demand deposits Assets Reserves Loans Balance sheet Bank "B" Liabilities and net worth Demand deposits

0u$$ose a 1 bank has the following balan!e sheet'

Assets Reserves Securities Loans USD 220 USD 380 USD 400 (1) ------(2) ------Liabilities and Net Worth Demand deposits USD 1000 (1) --(2) ---

a. 2hat is the maximum amount of new loans, whi!h this bank !an make3 0how in !olumn 4 how the bank*s balan!e sheet will a$$ear after the bank has lent the additional amount. b. 5ow will the bank*s balan!e sheet a$$ear after !he!ks drawn for the entire amount of the new loans ha"e been !leared against this bank3 0how this !hange in !olumn 2. 5ow Banks &ake &oney Banks are enerally owned by stockholders= at the end of the year% a bank pays some or all of its profits to its shareholders in the form of dividends. ,he bank may retain some of

its profits to add to its capital. !tockholders may also choose to reinvest their dividends in the bank.

Banks create money by: ,he spread% mar in or difference between the interest rate they pay for deposits and the interest rate they receive on the loans they make. ,hey earn interest on the securities they hold ,hey et a commission for various customer services% loan servicin % financial counselin etc. N. B.' Banks only earn 1> every year= the fi ure is referred to as /?*% or a banks return on assets employed. II. Ty$es of Banks * bank raises funds by attractin deposits% borrowin money in the inter#bank market% or issuin financial instruments in the money market or a capital market. ,he bank then lends out most of these funds to borrowers. @owever% it would not be prudent for a bank to lend out all of its balance sheet. +t must keep a certain proportion of its funds in reserve so that it can repay depositors who withdraw their deposits. Bank reserves are typically kept in the form of a deposit with a central bank. 6. &at!h the ty$es of banks with their !orres$ondent definitions' !ommer!ial bank, mer!hant bank, offshore bank, in"estment bank, sa"ings bank, !entral bank, building so!iety, uni"ersal bank +t is a non#commercial body char ed with controllin interest rates and money supply across the entire economy. +t acts as lender of last resort in case of a crisis. +t mostly deals with deposits and loans from businesses or natural persons. +t is a bank located in Aurisdictions with low ta-ation and re ulation= it is a private bank. +t focuses on retail bankin : payments% savin s products% credits and insurances for individuals or small and medium#si.ed enterprises= it usually provides local services. +t is usually located in )B= it provides mort a es for people to buy houses and flats and it pays a hi her interest than an ordinary bank. +t underwrites stock and bond issues% provide financial advice to corporations en a ed in capital markets activities such as mer ers and acquisitions. +t provides capital to firms in the form of shares rather than loans= it tends not to invest in new companies. +t is involved in commercial and retail lendin % in share and bond dealin % investment advice= its subsidiaries in ta-#havens offer offshore bankin services to customers in other countries.

Task 7i"ide yoursel"es in two grou$s, brainstorm for the ne!essary answers, then !om$are them to the ones gi"en by your !olleagues. a. @ow is the Central Bank controllin the reserve requirements of a commercial bank? b. 'hy are commercial banks required to deposit reserve requirements? c. (-plain why reserves are assets to commercial banks% but liabilities to the Central Bank? d. 'hat are e-cess reserves?

UNIT 8. The &onetary 9oli!y and its 1orrelation with 1entral Banking
I dont believe a committee can write a book. It can, oh, govern a country, perhaps, but I dont believe it can write a book. Arnold J. Toynbee

1.

:.

8. E.

Before getting into the information $ro"ided by the text remember that' ,he Coals of 2onetary 3olicy are: 3rice stability Dull # employment "on#inflationary level of domestic output ,he monetary policy represents the main aim of the Central Bank% which% in its turn% tar ets to: +nflation (-chan e rate Controllin the monetary a re ates ,he monetary tar ets are also set by overnments% besides central banks. ,he tools of the monetary policy are: ?pen market operations 2onetary base /eserve requirements Discount window lendin +nterest rates

,he monetary policy can be e-pansionary or contractionary% dependin on the oal to be reached and the situation to be controlled. +t is the Central Bank in each country% which supervises the operations tri ered by the need to control different issues.

;x$ansionary monetary $oli!y

Gower interest rate

1ontra!tionary monetary $oli!y

@i her interest rate

Decreased forei n demand for national currency "ational currency depreciates "et e-port increase

+ncreased forei n demand for national currency "ational currency appreciates "et e-port decrease

3roblem: ,;1;00I<N

3roblem: IN.> TI<N

T5; &<N;T ,= 9<>I1=

,he primary tool of monetary policy is o$en market o$erations. By this% the Central Bank controls the quantity of money in circulation throu h the buyin and sellin of various credit instruments% forei n currencies or commodities. )sually the short term oal of open market operations is to achieve a specific short term interest rate tar et. +n time% the monetary policy has increased its activity by coverin various obAectives% such as: Felocity of money in circulation throu h the economy= (-chan e rates= Credit outstandin = Bonds and equities issues= +nternational capital flows of money= Derivatives ,he Central Bank influences interest rates by e-pandin or contractin the monetary base consistin in: Currency in circulation Banks reserves on deposits at the Central Bank ,he monetary base can be affected by means of ?pen market operations ,rade of overnment bonds Chan in the reserve requirements 4. 7e!ide whi!h o$tion is the right one' 1. +f the Central Bank wants to in!rease:de!rease interest rates% it sells:buys overnment bonds= then the money supply increases. :. By in!reasing:de!reasing reserve requirements% the Central Bank ives different banks the opportunity to de!rease:in!rease loans or sell:buy different assets.

8. * Central Bank can only operate an independent monetary policy when the e-chan e rate is fixed:floating. E. +f the e-chan e rate is $egged: floating% the Central Bank will have to buy or:and sell forei n e-chan e. H. +n order to maintain its monetary policy tar et% the central bank will ha"e: not ha"e to sterili.e forei n e-chan e operations. I. +f a central bank buys:sells forei n e-chan e% base money will increase. J. ,o sterili.e the amount% the central bank must also sell:buy overnment debt. <. "owadays% many Central Banks are:are not independent of the rest of e-ecutive overnment. Ty$es of monetary $oli!ies Inflation targeting 2. .ill in using' target (2), o$en market o$erations, !ash flow, interbank rate, ad?ustments a& ,he inflation tar et is achieved throu h periodicK..to the Central Bank interest rateK.. ,he interest rate used is enerally theK..at which banks lend to each other for K..purposes. b& ,he interest rateK.is maintained for a specific period usin K... ,ypically the period that the interest rate tar et is kept constant will vary from moths up to years. c& ,his monetary policy is currently used in *ustralia% Canada% !weden% "orway% )nited Bin dom etc. 9ri!e le"el targeting 'hen we talk about price level tar etin we have to take into account that the rowin of the consumer price inde- in one year may be offset in the followin years such that% in time% the price level on a re ate does not chan e. %. a. 9ro"ide some exam$les of !ountries that ha"e used the $ri!e le"el targeting. b. re nowadays !ountries o$erating a monetary $oli!y based on $ri!e le"el targeting3 !. 7o you think that ,omania !ould o$erate su!h a monetary $oli!y3 rgument your o$inions. .ixed ex!hange rate +. a. 1hoose the right o$tion' ,his policy is based on maintainin a fi-ed e-chan e rate with foreign !urren!ies:foreign bills of ex!hange. Currency is bou ht or:and sold by the central bank daily to achieve the tar et e-chan e rate. ,his policy dele ates responsibility for monetary policy to the national :the foreign go"ernment.

b. 2hi!h are the !ountries that ha"e used this monetary $oli!y3 @old standard /. 1hoose the best o$tion out of the two written in bold' ,he old standard is a system in which the price of the national currency as measured in units of old is !onstant:"ariable by the daily buyin and sellin of base:fiat currency. ,his process is called open market operations. ,oday this type of monetary policy is no lon er used% althou h a form of old standard was used widely across the world between 1LEE% the moment the Bretton 'oods a reement was si ned% and till it was concluded in 1LJ1.

Tools of the &onetary 9oli!y &onetary base 6. .ill in using hard !urren!y, soft !urren!y, monetary base (%), money in !ir!ulation, buy, sell Chan in the si.e of theK..means chan in the total amount ofKK. * central bank can use open market operations to chan e theK... ,he central bank wouldK..bonds in e-chan e forK... 'hen the central bank collects this KKpayment% it chan es the amount of currency in the economy% thus alterin theKK. A. ,eser"e requirements 2onetary policy can be implemented by chan in the proportion of K..that banks must hold in reserve with the central bank. a. assets= b. liquid assets c. illiquid assets = d. liabilities Banks only maintain a small portion of theirK.as cash available for immediate withdrawal= the rest is invested inKKlike mort a es and loans. a. assets= b. liquid assets= c. illiquid assets= d. liabilities By chan in the proportion ofK.. to be held asK..cash% the central bank chan es the availability of lentK.... ,his acts as a chan e in the money supply. a. assets = b. liquid assets c. illiquid assets = d. liabilities 8. 7is!ount window lending 2any central banks have the authority to lend funds to financial institutions within their country. ,he lent funds represent an e-pansion in the monetary base. By e-tendin new loans% the monetary authority can directly chan e the si.e of the money supply. 9ro"ide se"eral exam$les of institutions that !entral banks !an lend funds to. 9ro"ide an adequate ex$lanation a!!ording to whi!h the monetary base !an influen!e the money su$$ly.

Interest rates 8. .ill in using market interest rates, money su$$ly, offi!ial interest rate ,he central bank en a es in open market operations to alter theK.. ,his rate has some effect onKK% but there is no direct relationship. By alterin the interest rate$s& under its control% a monetary authority can affect theK... 1urren!y board * !urren!y board is a monetary authority which is required to maintain an e-chan e rate with a forei n currency. ,his policy obAective requires the conventional obAectives of a central bank to be subordinated to the e-chan e rate tar et.
4B. &ark the following statements as true or false# ex$lain your !hoi!e'

,he currency board will only issue a set number of units of local currency for each unit of forei n currency it has in its deposit. ,he surplus on the balance of payments of such a country is reflected by lower deposits local banks hold at the central bank ,he rowth of the domestic money supply can be coupled to the additional deposits of the commercial banks at the central bank Currency stability no lon er represents an issue under the currency board. ,he drawbacks are that the country no lon er has the ability to set monetary policy accordin to different domestic considerations.

N.B. Bul aria adopted a currency board in 1LLJ= /omania% even if advised in its most critical year% 1LLL% to adopt the currency board re ime% it stepped out of this strict monetary policy. Task 4 0u$$ose you are a member of the Board of the National Bank of ,omania. The e!onomy is ex$erien!ing a $rolonged inflation. 2hat !hanges would you re!ommend in' a. reser"e ratio b. dis!ount rate !. o$en market o$erations3 ;x$lain how ea!h !hange would affe!t' a. !ommer!ial bank reser"es b. money su$$ly !. interest rates Task 2 2hy ha"e the o$enCmarket o$erations de"elo$ed as the $rimary means of !ontrolling !ommer!ial bank reser"es3 2hat are the s$e!ifi! limitations of monetary $oli!y in this !ase3 Task % ;x$lain why a 1entral Bank !annot simultaneously !ontrol interest rates and money su$$ly.