Principles of Economics - 10. Banks, Money, and the Credit ...

Income, borrowing and savingBalance sheet and wealth

Banks and moneyAsymmetric information in credit markets and credit rationing

Principles of Economics1

10. Banks, Money, and the Credit Market

Giuseppe Vittucci Marzetti2

SCORDepartment of Sociology and Social Research

University of Milano-Bicocca

A.Y. 2018-19

1These slides are based on the material made available under Creative Commons BY-NC-ND4.0 by the CORE Project©, https://www.core-econ.org/.

2Department of Sociology and Social Research, University of Milano-Bicocca, Via Bicoccadegli Arcimboldi 8, 20126, Milan, E-mail: [email protected]

Giuseppe Vittucci Marzetti Principles of Economics 1/43

https://www.core-econ.org/



Layout

1 Income, borrowing and savingMoneyWealth, income, and savingsConsumption over time: feasible set, intertemporal preferences, optimal choiceSaving and investment

2 Balance sheet and wealth

3 Banks and moneyBanks, base money and bank moneyDefault risk, liquidity risk and banking crisisCentral bank, money market, and interest ratesBanking business and bank balance sheets

4 Asymmetric information in credit markets and credit rationingPrincipal-agent problemCredit rationingLending and inequalitySummary




MoneyWealth, income, and savingsConsumption over time: feasible set, intertemporal preferences, optimal choiceSaving and investment

Money

Money is a medium of exchange consisting of bank notes, bankdeposits, cheques or anything else that can be used to purchasegoods and services, and is accepted as payment because others canuse it for the same purpose.

Money allows purchasing power to be transferred among people andover time.

Money requires trust to function: for money to do its work, everyoneelse must trust that others will accept your money as payment.





Wealth and incomeWealth is the value of the stock of assetsowned – real assets (car, land, buildings,machinery, etc.) and financial assets(shares, bonds and other credits, i.e. debtsowed to the person) – minus the debts(e.g. the mortgage owed to the bank).

Your wealth is the largest amount youcould consume without borrowing, afterhaving paid off your debts and collectedany money owed to you.

Income is the amount of profit, interest,rent, labor earnings, and other paymentsreceived measured over a period of time(flow), such as a year.

Your income is the maximum amount thatyou could consume and leave your wealthunchanged.





Depreciation, consumption, saving and investment

Depreciation is the reduction in the value of a stock of wealth overtime, either due to use (wear and tear) or simply the passage oftime (obsolescence).

Net income is gross income minus depreciation.

Consumption (C ) is the expenditure on consumer goods, both:

short-lived goods and services;long-lived goods (consumer durables).

Saving (S) is income less consumption:

An individual, or household, saves when consumption is less than netincome, so wealth increases.Wealth is the accumulation of past and current saving.Saving can take the form of purchases of financial assets, such ashares (or stocks) in a company or (government or corporate) bonds.

Investment (I ) is the expenditure on newly produced capital goods(machinery and equipment) and buildings.





Consumption over time

There is a trade-off between consuming goods now and later.

Borrowing and lending allow us to rearrange our capacity to buygoods and services across time.

Borrowing allows us to buy more now, at the cost of buying less later.Lending allows us to buy more later, at the cost of buying less now.

The opportunity cost of having more goods now is having fewergoods later.

Interest rate (r) is the price of bringing some buying power forwardin time.





Borrowing, the interest rate, and the feasible set

Initially Julia is at the point labeled “Julia’s endowment”.To consume now, Julia might consider taking out a payday loan.If Julia borrows $91 now bypromising to pay later the lender$100:

repayment = principal + interest

= 91 + r · 91 = (1 + r)91 = 100

If “later” means in one year fromnow, the annual interest rate (r) is:

r =repayment

principal− 1 =

100

91− 1

= 0.1 = 10%At the same interest rate, all of her possible combinations ofconsumption now/later, ($91,$0), ($70,$23), ($30,$67),. . . ,generate the feasible frontier.





Interest rates and feasible sets

If the interest rate becomes 78%,Julia can only borrow a maximumof $56 using up all $100 of herfuture income.

The interest rate increase makesthe feasible frontier pivot inwardand the feasible set becomessmaller.

(1 + r) is the MRT of goods fromthe future to the present: to haveone unit of the good now you haveto give up (1 + r) goods in thefuture.





Intertemporal preferences and impatience

Borrowing allows us to bring consumption forward.

How much consumption individuals bring forward depends on theirimpatience, i.e. their preference to move consumption from thefuture to the present.

This preference is derived from:

diminishing marginal returns to consumption;pure impatience





Diminishing marginal returns to consumption andconsumption smoothing

Diminishing marginal returns toconsumption: the value of anadditional unit of consumptiondeclines, the more consumption theindividual has.

Individuals smooth theirconsumption to avoid consuming alot in one period and little in theother.





Pure impatienceA different reason for preferring the good now is pure impatience.

Two reasons for pure impatience:

Myopia (shortsightedness): people imagine the present satisfactionmore strongly than the same satisfaction at a future date.Prudence: people know that they may not be around in the future(carpe diem, quam minimum credula postero).

To measure pure impatient, we askwhether a person values a goodnow more highly than later, whenher initial endowment is having thesame in both periods.

The slope of the indifference curveof 1.5 (in absolute value) at pointA means that she values an extraunit of consumption now 1.5 timesas much as an extra unit ofconsumption later.





Optimal decision-making

A person’s discount rate (ρ) is:a measure of a person’s impatience: how much she values an extraunit of consumption now over an extra unit of consumption later.the slope of her indifference curve between consumption now andconsumption later, minus 1.

Discount rate depends on:

Desire to smoothconsumption;Pure impatience (subjectivediscount rate).

Individual borrows at the pointwhere discount rate equalsinterest rate

MRS︷︸︸︷1 + ρ =

MRT︷︸︸︷1 + r

ρ = rGiuseppe Vittucci Marzetti Principles of Economics 12/43




The effect of a higher interest rate

If the interest rate at whichJulia can borrow increases

the feasible set gets smaller.the best Julia can do is toborrow less ($35 instead of$58), as shown by point G .

The difference in currentconsumption at the lower andhigher interest rate (at E andG ) is composed of an incomeeffect and a substitution effect.





Borrowers and savers

Reservation indifferencecurve is the locus of all ofthe points at which theindividual would be just aswell off as at the reservationposition (endowment).

The borrower and the saverhave different indifferencecurves because they havedifferent endowments anddifferent preferences.





Saving and lending

A saver smoothes hisconsumption by postponingit into the future.

Lending expands the saver’sfeasible set.

In order to smoothconsumption, Marco could:

store the grain. If he didit, mice would eat 20% ofit (depreciation);lend the grain. If he canbe assured of repaymentof $(1 + r) for every $1lent, then he couldconsume 100(1 + r) later,or any combination alonghis new feasibleconsumption line.





Investment

Investment is another way tomove consumption to thefuture.

If Marco owns some land, hecould invest the grain:planting it as seed andfeeding it to his draftanimals to help him work thefields until harvest.

The (absolute value of the)slope of the red line (1.5) isthe MRT of investment intoreturns: (1+rate of returnon investment).





Investment and borrowing

A combination of investingand borrowing can increaseconsumption in both periods.

Marco might invest all thegrain (at the 50% return oninvestment) and borrow tofinance current consumption(at the 10% rate).





Factors affecting lending, borrowing, saving and investing

Three differences between Marco and Julia explain the disparity intheir outcomes:

Marco starts with an asset while Julia starts with nothing.Marco has a productive investment opportunity while Julia does not.Marco and Julia may face different interest rates:

By starting with an asset, Marco borrows against his future income atthe 10% rate.Julia, lacking assets, may have no alternative but to borrow at thehigher rate of 78%.

People engage in lending, borrowing, saving and investing because:

They can increase their utility by smoothing consumption.They can increase their consumption in both periods (by lending, orinvesting).

People differ in which of these activities they engage (someborrowing, some lending) because:

They have differences in their situation.They differ in their level of pure impatience.




Balance sheet

A balance sheet summarizes what the household or firm owns, and whatit owes to others.

Net worth =

Anything of value that is owned︷︸︸︷Assets − Liabilities︸︷︷︸

Anything of value that is owed




Balance sheet and wealth

Net worth does not change when you lend or borrow.

A loan adds both assets and liabilities to the balance sheet:

the borrowed money (cash) is an asset;the debt is an equal liability.




Banks, base money and bank moneyDefault risk, liquidity risk and banking crisisCentral bank, money market, and interest ratesBanking business and bank balance sheets

Banks

A bank is a firm that makes profits by lending and borrowing.

Banks borrow from:

households (deposits);other banks;the central bank.

The interest they pay on deposits is lower than the interest theycharge on loans, which is how banks make profits.





Types of money

Base money (or legal tender or high-powered money):

It has to be accepted as payment by law.It is the sum of:

Cash, i.e. notes and coins, andReserves, i.e. the balances held by commercial banks in theiraccounts at the central bank.

Bank money :

Money in the form of bank deposits created by commercial bankswhen they extend credit to firms and households.Most of what we count as money is bank money.

Broad money :

The stock of money in the hands of the non-bank public;The sum of

base money (excluding legal tender held by banks, i.e. reserves andcurrency not in circulation), andbank money.





How banks work

Marco deposits $100 in Abacus Bank:

Marco wants to pay $20 to Gino, so he instructs Abacus Bank totransfer the money to Gino’s account in Bonus Bank:

Money supply does not change ($100).





How banks work

Bonus Bank grants Gino a loan of $100:

Gino pays Marco $10:





How banks create moneyBank money has been created by Bonus Bank when it granted aloan to Gino.

Bank money is a liability to the bank and they earn profits bycharging interest on it.Base money remains essential, however, because customers mighttake out cash (note that if Marco and Gino were customers of BonusBank, when Gino paid Marco $10 there would be no loss of basemoney for it).Banks make many transactions to one another, most canceling eachother out, and they settle up at the end, therefore they do not needthe legal tender to cover all transactions or demand for cash.





Base money and broad money

The ratio of base money to broad money varies across countries and overtime.

Source: ECB, 2018.

Figure: Base money and money supply (different measures: M1, M2, M3) inthe euro area (billion euro)





Default risk, liquidity risk and banking crisis

By taking deposits and making loans, banks provide the economywith the service of maturity transformation:

short-term borrowing: deposits can be withdrawn at any time;long-term lending: loans only need to be repaid after a specifiedtime. E.g. in the case of a mortgage, i.e. a loan for a house purchasesecured by the property itself (collateral), could be 30 years in thefuture.

This is also liquidity transformation:deposits are liquid (free to flow out of the bank on demand);loans to borrowers are “frozen” (illiquid).

This exposes the bank to risks:Default risk: the risk that credit given as loans will not be repaid.Liquidity risk: the risk that an asset cannot be exchanged for cashrapidly enough to prevent a financial loss.

If all customers demanded their money at once (because they fearthat banks may go bankrupt and not honor their liabilities), thebanks would not be able to repay: this is called a bank run.





Central bankThe central bank (or reserve bank, or monetary authority) is theorganization dealing with the financial and monetary stability,through the supervision over the banking system, the control ofmoney supply, interest rates and exchange rates.The central bank acts as the banker for the commercial banks, whohave accounts at the central bank that hold legal tender (reserves).By crediting these accounts, the central bank can create money.The central bank is the only bank that can create legal tender.The most important central banks in the world are:

Federal Reserve (Fed) in the United States;European Central Bank (ECB), the central bank of the euro area,made up of 19 out of the 28 EU member states:

1998 - Austria, Belgium, Finland, France, Germany, Ireland, Italy,Luxembourg, the Netherlands, Portugal, Spain.2001 - Greece; 2007 - Slovenia; 2008 - Cyprus, Malta; 2009 - SlovakRepublic; 2011 - Estonia; 2014 - Latvia; 2015 - Lithuania.

Bank of England (BoE);Bank of Japan (BoJ);People’s Bank of China.





Money market and base rate

Banks need enough base money to cover their net transactions.

They borrow base money on the money market at the short-terminterest rate:

The supply of base money is a decision by the central bank.The demand for base money depends on how many transactionscommercial banks have to make.

Since the central bank controls the supply of base money, it can alsodecide the interest rate.

The central bank intervenes in the money market by setting the baserate (official rate, or policy rate), i.e. the interest rate at which itlends base money (i).

The technicalities of how the central bank implements its chosenpolicy interest rate vary among central banks around the world.





Base rate and bank lending rate

The base rate:

applies to banks that borrow base money from each other, and fromthe central bank,matters in the rest of the economy because of its knock-on effect onother interest rates.

The bank lending rate is:

the average interest rate charged by commercial banks to firms andhouseholds;typically above the policy interest rate, the difference being themarkup or spread on commercial lending.





The financial systemSavers might:

deposit money in a bank current account, which we assume pays nointerest, orbuy government bonds in the money market (the interest rate iscalled the yield)





Bond

A bond is a particular financial asset, where the bond issuerpromises to pay a given amount over time to the bondholder.

Issuing or selling a bond is equivalent to borrowing, because thebond issuer receives cash today and promises to repay in the future.A bond buyer is a lender or saver, because the buyer gives up cashtoday, expecting to be repaid in the future.

Both governments and firms borrow by issuing bonds.

Households buy bonds as a form of saving both directly andindirectly through pension funds.

Bonds typically last a predetermined amount of time (maturity), andprovide two forms of payment:

face value (F ): an amount paid when the bond matures;coupons (C): a fixed payment every period (for example, every yearor every 3 months) until maturity.





Bond prices and yieldsFor a bond of maturity T , the yield (y) (or yield-to-maturity) of thebond solves the following:

P︸︷︷︸price

=C

(1 + y)+

C

(1 + y)2+ . . .+

C

(1 + y)T︸︷︷︸discounted coupons

+F

(1 + y)T︸︷︷︸discounted face value

Buying a bond with yield y is equivalent to saving your money atthe guaranteed constant interest rate of i = y .Since a saver (a lender) can choose between buying a governmentbond, lending the money in the money market, or putting it into abank account, the yield on the government bond will be very closeto the rate of interest in the money market.The amount that a lender will be willing to pay for a bond will be itspresent value (PV ), which depends on:

the bond’s face value;the series of coupon payments;the interest rate: negative relation between bond prices and interestrate: ↑ i ⇒ ↓ P





Examples of “treasuries” before the substitution ofpaper-form securities by book-entry securities(dematerialization)

(a) War bond (40-year) (issued November1942)

(b) 26-week T-Bill (issued October 1969)

Source: Museum of American Finance, Herbstman Memorial Collection of American Finance.





The business of banking

Bank’s costs:

operational costs: the salaries of bank officers, branch rents, etc.interest costs: paying interest on their liabilities (deposits and otherborrowing).

Bank’s revenue:

interest on and repayment of the loans;bank commission, i.e. the fee charged for banking services.

The expected return is the return on the loans, taking into accountthe default risk.

If the risk of making loans (the default rate) is higher, then there isa larger gap (or spread or markup) between the interest rate bankscharge on the loans they make and the cost of their borrowing.





Bank’s balance sheet

Assets: bank lending

Liabilities: deposits, and borrowing (secured and unsecured).





Bank’s net worth

The net worth of a bank (or equity) is what is owed to theshareholders/ owners.

Net worth = Total assets – Total liabilities

Negative net worth means the bank is insolvent.

Leverage describes the reliance of a company on debt:for banks and other financial institutions, leverage ratio (or gearing)is defined as:

Leverage ratio =Total assets

Net worthfor other companies (non-financial institutions), leverage is definedas:

Leverage ratio =Total liabilities

Total assetsIf for a bank the leverage ratio is 25, this means that:

Total assets are 25 times the net worth;The bank finances its assets 4% equity (1/25) and 96% debt.A decrease in the value of its assets greater than 4% wipes out itsnet worth and makes the bank insolvent.





Policy rate and the economy

The central bank’s policy rate affects the level of spending in theeconomy, because households and firms borrow to spend.

↑ interest rate → ↓ spending today

The amount of spending in the economy affects firms’ decisionsabout how many people to employ and what prices to set.In this way, the central bank can affect the level of unemploymentand inflation (rising prices).




Principal-agent problemCredit rationingLending and inequalitySummary

Principal-agent problem in credit markets

When loans are granted for investment projects, often the borrowerhas more information than the lender about the quality of theproject and its likelihood of success.

Principal-agent relationship: relationship where one party (theprincipal) would like another party (the agent) to act in some way,or have some attribute that is in the interest of the principal, andthat cannot be enforced or guaranteed in a binding contract.

The principal-agent problem arises from the conflict of interestbetween principal and agent, about some hidden action or attributeof the agent not enforceable or guaranteed in a binding contract.

In the lender-borrower relationship, the lender is the principal andthe borrower is the agent.





Equity and collateral

To reduce the conflict of interest between the principal (lender) andthe agent (borrower):

Equity : the lender may require the borrower to put some of herwealth into the project.Collateral : the borrower has to set aside property that will betransferred to the lender if the loan is not repaid.

When borrowers have their money (via equity or collateral) at stake:

They have greater incentives in making the right decisions to ensurethe project’s success.It signals they think projects are of sufficient quality to succeed.





Credit rationing

Money, says the proverb, makes money. When you have got a little it isoften easy to get more. The great difficulty is to get that little.

(Adam Smith, 1776)

But typically the reason why borrowers need loans is that they arenot wealthy.

As a result, they may be unable to provide enough equity orcollateral to sufficiently reduce the conflict of interest, and lendersrefuse to offer loans.

Credit rationing is when those who are wealth-constrained are:

credit-constrained, i.e. they borrow on unfavorable terms comparedwith those with more wealth;credit-excluded, i.e. they are refused loans entirely.

According to Gross and Souleles (2002) approximately 2/3 of USfamilies may be credit-constrained or excluded.





Lending and inequalityInequality may increase when some people are in a position to profitby lending money to others.Credit-rationing increases inequality: people with limited wealth arenot able to profit from the investment opportunities that are open tothose with more assets.

Example:

For every euro borrowed andinvested the farmer gainsincome of 1 + Π.The farmers repay the loansat interest rate i .Income is divided betweenthe lender (i/Π) and theborrower who receives theremainder (1− i/Π).If 40 of the prospectiveborrowers are excluded theGini coefficient increases.





Summary

Ways to move consumption forward/into the future.

Borrowing, saving, investing.Options available depend on individual’s endowment.Optimal choice depends on individuals discount rate.

Outline of the banking system.

Banks create money (lend) to make profits.Central bank sets the policy rate, which influences spending.Issues: principal-agent problem, credit constraints.


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