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Banking System

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BANKING SYSTEM Instructor: Prof. Insukindro, Ph.D
Transcript
Page 1: Banking System

BANKING SYSTEM

Instructor:

Prof. Insukindro, Ph.D

Page 2: Banking System

COMMERCIAL BANKSThe reason of studying commercial banks

(or banks) 1. Banks are one particular subset of financial

intermediaries /institutions. In most countries, they make up a large subset of financial intermediaries

2. The liabilities of banks are the principle components of any country’s money supply and so the behavior of banks is intimately connected with changes in supply of money. As we pointed out before that one general effect of any increase in financial intermediation is the creation of liquidity, but if the increased activity involves primarily Banks, then the increase in liquidity takes the specific form of ‘money’.

Page 3: Banking System

Flow of funds from savers to borrowers

Source:Ritter at al. (2009:196)

Page 4: Banking System

Size of Bank and Stock Markets (percentage of GDP), 2007

Source:Ritter at al. (2009: 318)

Page 5: Banking System

Assets of financial inst. in indonesia

79.5

8.8

4.43.12.71.1

0.4

B A NK UMUM

A S UR A NS I

S E K UR ITA S

P E NS IUN

P E MB IA Y A A N

B P R

P E G A DA IA NSource: BI, 2009a

(Commercial banks)

(Insurance Company)

(Securities)

(Investment Inst)

(Rural credit banks)

(Pawn shop)

(Pension Funds)

Page 6: Banking System

3. Many economists take the view that changes in the money supply have important effects upon the economy, especially if the changes are large or sudden. What these effects are temporary or permanent, are matters of controversy. However, the banks behavior may have effects upon the economy which is rather different from that of other intermediaries.

4. Even if one doubts the importance of money in the economy, anyone interested in finance has to recognize that government and central banks certainly behave as if it matters.

Howells & Bain (2008, Ch. 12)

Page 7: Banking System

Financial SystemFinancial System

Households Firms Government

Borrowers / Demanders

Households Firms Government

Savers / Suppliers

Returns

Funds

Returns

Funds

Funds

Returns

Returns

Funds

Key Services Provided by the Financial System

Source: Hubbard (2008:39, 41), modified

Financial Intermediaries

Financial Market

7

Information

Risk Sharing Liquidity

Page 8: Banking System

THE ROLE OF BANKSThe economic and financial life of a country

depends on banks in three important respects.

1. They occupy a central place in the payments mechanism for households, government and business.

2. They accept deposits, which are widely regarded as “money”; which are expected to be repaid in full, either on demand or at their due term; and which constitute part of society’s financial assets.

3. Banks in market economies play a major role in the allocation of financial resources, intermediating between depositors of surplus funds and would-be borrowers, on the basis of active judgments as to the latter’s ability to repay.

Ware (1996)

Page 9: Banking System

BALANCE SHEET OF A COMMERCIAL BANK

Assets LiabilitiesCurrency held by the bank Cb

Deposits at the central Db

bank

Loans to the public sector Lg

Loans to the private sector Lp

Loans to the money Lm

Markets

Investments Ib

Other assets Oa

Demand deposits Dd

Saving deposits Sd

Time deposits Td

Capital & shareholders’ Sf

funds

Other liabilities Ol

Page 10: Banking System

Monetary base = Reserve Money = B = Cp + Cb + Db

where: Cp is currency held by the publicor B = Cp + R, where: R is bank’s reserve

Looking at the structure of assets of the bank, we may drawtwo conclusions. Firstly, yields are likely to increase as we read down the list (Cb pays no interest, nor in most system do Db); secondly, banks will wish to maximize their loans and their holding of reserves and investments.

Like any other firm, a bank makes profits which are the difference between revenues and costs. Revenues will consistof interest, fees and commissions charged for its services, etc. Costs will consist of interest paid to depositors, wages, salaries and premises, etc.Howells & Bain (2008, Ch. 12)

Page 11: Banking System

RESERVE RATIOThe public’s confidence requires that deposits convertible

into cash on demand and thus banks have to maintain sufficient cash or central bank balances which they can exchange for cash. In order to ensure convertibility, the level of bank reserves is usually expressed as a ratio to its deposits. This is known as the reserve ratio or the reserve requirement. In some countries, this ratio is set down by central bank (a mandatory ratio), and in others it is left to bank’s own judgement (a prudential ratio). In the latter case, banks are obligated to inform the central bank if the banks want to change the ratio.

Now, letting M1 and M2 stand for narrow money and broad money, therefore we have:

M1 = Cp + Dp and M2 = M1 + Sd + Td

Page 12: Banking System

LOANS BY A MULTI-BANK SYSTEM

Assets Liabilities

Cb

Db

Lg

Lp

Lm

I

Oa

Dp

Sp

Tp

Sf

Ol

Assets Liabilities

Cb

Db

Lg

Lp

Lm

I

Oa

Dp

Sp

Tp

Sf

Ol

Bank A Bank B

Page 13: Banking System

MONEY SUPPLY DETERMINATION

As mentioned before, money in circulation can be measured using many different concepts or definitions, such as the narrow or broad money. It depends on how closely substitutable various assets are for definitive money.

In general, it can be analyzed using two approaches (Howell & Bain, 2008: Ch.12)

1. Base-Multiplier Model

2. Flow of Fund Model

Page 14: Banking System

BASE-MULTIPLIER MODELThe model has several characteristics.

a. The model concentrates on stocks

b. The stock are the stock of monetary base

and the stock of deposits at commercial

banks.

c. The monetary base is under control of

the monetary authorities.

d. The authorities’ decisions are central to

any change in the quantity of money.

Page 15: Banking System

BASE-MULTIPLIER MODELLet begin with definitions as follows:

B is the monetary base

Cp is the currency held by the public

Dp is the banks’ costumer deposits

R is the bank reserves at the central bank

M1 is the money in circulation

Therefore:

B = R + Cp and M1 = Cp +Dp

M1/B = (Cp + Dp)/(R+Cp)

Page 16: Banking System

BASE-MULTIPLIER MODELM1/B = {(Cp/Dp)+(Dp/Dp)}/{(R/Dp)+(Cp/Dp)}

= {α+1}/{β+α}

M1 = {α+1}/{β+α}B or M1 = m1.B

The quantity of money is equal to the monetary base (B) multiplied by money multiplier m1 .

α = α (rm, T) and β = β (rr, ro, rd, RR, σ)

- ? + - + + +

M1 = M1 (α, β, B}

= M1 (B, rm, T, rr, ro, rd, RR, σ)

+ + ? - + - - -

Page 17: Banking System

Where: rm is the rate of interest on bank deposits, T denotes technical considerations relating to the ease and convenience of replenishing cash from holdings from cash dispensers andthe efficiency of the money (that is, deposits) transmissionmechanism operated by the banks, rr is the rate of interest earned on reserve assets, ro is the interest rate paid on other assets, rd is rediscount rate charged for lender of last resortfacilities, RR is reserve requirement and γ is variability of inward and outward flows of funds.

From equation above, we may identify a number of variablesOver which the central banks have some influence and thanCan use to control the supply of money:M1 = M1 (B, rb, rd, RR, r)

+ + - - -

Page 18: Banking System

FLOW OF FUNDS MODELThe model has some characteristics

1. This model concentrates on flows.2. The flows are flows of new lending.3. The demand for new loans is generally

positive.4. Control of the money supply means

controlling its growth rate.

Note: Discuss some cases in developed and developing countries.

Page 19: Banking System

The demand for new lending is assumed as a rule to be positive because the demand for loans, at any given rate of interest rate, is determined by the level of economic activity and the level of prices. The demand for loans is endogenous which is determined by key variables within the economic system. In order to control supply of money in this model, we require either that the central banks control demand for loans or that they control banks’ ability to respond to the demand. For example, the central banks can control or set reserve ratio, short-run interest rate and discount rate.

Discuss: the effect of economic activity and interest rate on demand for loans using inter-temporal choice.

Page 20: Banking System

FLOWS THAT CHANGE THE STOCK OF MONEY

1. Central bank loans to government (∆CBLg)2. Central bank sales or purchases of government debt

(∆Bg) from: the government, banks and non-bank private sector.

3. Central bank holding of foreign currency (∆F) as a results of transactions with government or foreign exchange market intervention.

4. Bank loans to the non-bank private sector (∆Lp)

5. Bank loans to the public sector (∆Lg)

6. Bank purchases/sales of government debt (∆Bg) from the non-bank private sector

7. Bank purchases of government debt (∆Bg) directly from government to finance a government deficit.

Page 21: Banking System

THE NATURE OF BANKING-INHERENT INSTABILITY

The business of banking has a number of attributes which have the potential to generate instability.

1. High gearing (or “leverage”) results from banks’ financialintermediation between depositors and borrowers; by comparison with the generality of industrial and commercial companies, a bank’s capital is small in relation to the size of its balance sheet. Therefore, any loss can have a profound effect on the bank’s viability.

2. Typically, the term structures of assets and liabilities arefundamentally mismatched, with assets tending to have a longer maturity than liabilities - again a virtually inevitable consequence of the role of the banks as intermediaries.

Page 22: Banking System

3. Flowing from these observations, a bank’s solvency depends on its ability to retain the confidence of both its depositors and the financial markets or institutions on which it may rely for funding.

4. Sometimes, the lack of transparency in published financial statements hinders, or even defeats, counterparties’ efforts at rational analysis of a bank’s strengths and weaknesses; banks’ balance sheets and off-balance sheet positions can change more rapidly than industrial and commercial companies’, and customers’ knowledge of their banks is inevitably imperfect.

Ware (1996)

Page 23: Banking System

GENERAL PRINCIPLES OF SUPERVISION

Underlying the diversity of supervisory regimes and practices which exist in different countries are some common objectives and judgments.

As objectives, supervisors seek to ensure that banks are:1. financially sound,2. well managed, and3. not posing a threat to the interests of their depositors

Page 24: Banking System

GENERAL PRINCIPLES OF SUPERVISION

In pursuing these objectives supervisors are trying to form three judgments:

1. how much risk is each bank undertaking?

2. what resources are available to manage that risk?

The resources may be tangible (eg capital, liquidity) or intangible (eg quality of management and control systems).

3. whether the identified level of resources is sufficient to balance the risk.

Page 25: Banking System

BANKING RISKSThe risks can be categorized as follows1. Credit risk - the risk that the bank’s counterparty

might not pay on the due date. Though most often associated with lending, credit risk arises whenever another party enters into an obligation to make payment or deliver value to the bank, eg in foreign exchange or securities transactions.

2. Liquidity risk - the risk that the bank might itself fail to meet its obligations when they fall due.

3. Yield risk - the risk that the bank’s assets may generate less income than the expense generated by its liabilities.

Page 26: Banking System

BANKING RISKS4. Market risk - the risk of loss resulting from

movements in the market price of financial instruments in which the bank has a position. Such instruments include bonds, equities, foreign exchange and associated derivative products.

5. Operational risk - the risk of a failure in the bank’s procedures or controls, whether from external causes or as a result of error or fraud within the institution.

6. Ownership/management risk - the risk that shareholders, directors or senior management might be unfit for their respective roles, or actually dishonest.

Page 27: Banking System

ECONOMIC ANALYSIS OF BANKING REGULATIONS

SEVEN BASIC CATAGORIES OF BANKING REGULATIONS:1. Government safety net2. Restrictions on bank asset holdings3. Capital requirements4. Chartering and bank examination5. Disclosure requirements6. Consumer protection7. Restrictions on competition

(Mishkin, 2003:279-288)

Page 28: Banking System

REFERENCESHowells, P.G.A. and K. Bain (2008), The Economics of

Money, Banking and Finance: A European Text, Prentice Hall

Hubbard, R.G. (2008), Money, the Financial System, and the Economy, Pearson Education, Inc

Mishkin, F.S. (2003), The Economics of Money, Banking and Financial Markets, Addison Wesley

Ritter, L.S., W.L. Silber and G.F. Udell (2009), Principles of Money, Banking & Financial Markets, Pearson Education, Inc.

Ware, D. (1996), Basic Principles of Banking Supervision, in S. Gray, Handbook in Central Banking, No. 7, Bank of England.


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