Introduction to Financial Institutions and Money

1. Lesson 1 Money, Financial Institutions and Financial Intermediation: An Introduction

2. A. An Introduction to Financial Institutions • Financial system: a set of procedures, institutions, instruments and technologies existing to facilitate trade and transactions. • Financial institutionsprovide financial services to their clients, including: • Services related to transactions, • Deposits and • Investments • Institutions issue financial claims and contracts in primary markets and trade instruments in secondary markets • For example, firms issue stock in primary markets through IPOs (initial public offerings), and these shares are trade in secondary markets such as the New York Stock Exchange or the BorsaItaliana.

3. Partial Listing of Financial Institution Categories • Depository Institutions • Commercial banks • Savings associations • Credit unions • Investment Institutions • Investment banks • Securities firms • Mutual funds • Unregistered Investment Institutions • Pension funds • Hedge funds • Private equity firms • Venture capital firms • Insurance Companies • Life Insurers • Property-casualty insurers • Other Institutions • Governments • Finance Companies

4. B. An Introduction to Money • Money might be defined as anything that is generally accepted for the payment of goods and services or in the repayment of debts. • Money functions as a • medium of exchange • unit of account and • a store of value

5. Money Supply • M1: Currency + Demand deposits + Coinage + Money orders + Overnight deposits (for ECB only) + Time deposits less than 3 months (for ECB only) – Currency held in the banking system • M2: M1 + Insured Money Market accounts and funds + Time deposits – Time deposits more than 2 years (ECB only) • MZM: M2 - Time deposits + uninsured non-bank money market accounts

6. Backing Money Supply • Money has value because people accept it. Why? • Gold or other precious metal or stone backing • Bimetallism • Token money • Fiat money

7. Money Multipliers • M1 = K + (1 - r)K with one round of deposits • M1 = K + (1 - r)K + (1 - r)2K + . . . + (1 - r)∞K Infinitely re-deposited • (1 - r)M1 = (1 - r)1K + (1 - r)2K + (1 - r)3K + . . . + (1 - r)∞+1K First step of Geometric Expansion • (1 - r)M1 - M1 = (1 - r)∞+1K - K- rM1 = -K Second step of Geometric Expansion • M1 = K/r

8. Cryptocurrency and Distributed Ledgers • Cryptocurrency: digital currency, in which encryption (cryptography) regulates its creation and supply and to verify its transfer among users. • Distributed ledgers: accounting records maintained on multiple distinct computing systems.

9. Blockchains • Blockchains: distributed ledgers comprised of permanent digitally recorded data in packages called blocks. • Historical precedent: Real estate title companies • Applicable to diamonds, intellectual property, stocks, fine art, etc.

10. Bitcoin • Bitcoin: P2P payment network and digital currency. • Does not rely on a central monetary authority • Open source protocol that uses a public but anonymous transaction log. • As of February 2018, a total of approximately 16.8 million in Bitcoin has been issued worth roughly $140 billion. • Bitcoin existed since 2009, created by “Satoshi Nakamoto” • Units of Bitcoin (BTC) are created by evidence of forced work. • Math problems related to public and private keys • Solving problems pertain to verifying transactions

11. Bitcoin and Transactions • Transactions by Bitcoin are executed by hashing; i.e., updating the public transaction log called a blockchain. • Payments are made to bitcoin "addresses," which are 33-character alpha-numeric strings, e.g., 13dGsFstudwDsYUIerBppokCh8DoostDfi. • The log to which this address is added is the blockchain, the complete listing of previous Bitcoin transactions. • All transactions are cleared by a database housed on user computers. • A potential major advantage as a currency is that its supply is not a function of political whims

12. The Payments System • The payments system is the economy-wide mechanism for making payments or settling accounts. • Written orders of payment, or polizza, rather analogous to paper checks (or cheques), originated in Florence in the 14th century, significantly simplifying the payment process. • Checks are now cleared and collected through local clearing houses or by the central bank. • Wire transfers are used extensively by business and financial institutions to settle accounts. The Fed has operated Fedwire since 1918, which routes and facilitates payments by wire. Competing private systems are operated by CHIPS (Clearing House Interbank Payment System) and SWIFT (Society for Worldwide Interbank Financial Transactions).

13. C. An Introduction to Central Banks • The central bank of a country (in the United States, the Federal Reserve System, often referred to as the Fed; in Europe, the European Central Bank or ECB) typically conducts the monetary policy on behalf of that country or currency area. • In many countries, the central bank also serves as a financial or banking regulator.

14. Typical Central Bank Objectives • Managing monetary policy so as to maintain a low long-term inflation rate, • Maintaining a stable and growing real economy (low unemployment and sustainable growth rate) and to smooth business cycles and offset shocks to the economy. Countries do differ in the responsibility that their central bank assumes for the real sector. • Maintaining an effective and efficient payments system.

15. Central Bank Policy Mechanisms • Issue currency • Set reserve requirements • Conduct open market operations: Purchasing (selling) securities increases (reduces) money supply • Discount window lending: Central banks often play the role of lender of last resort. • Intervention in foreign exchange markets, or fix exchange rates • Set the overnight rate: The Fed sets the Fed Funds rate • Capital requirements: Central banks play a central role in setting capital requirements • Margin requirements in securities markets

16. Central Bank Origins • The SverigesRiksbank was the first European central bank, established in 1668 . • In 1694, the Bank of England, was also chartered as a joint stock company. • Proposed by William Patterson, a Scot-born entrepreneur as an institution to serve the public good in perpetuity • Approved by the U.K. Parliament to provide funding to the government. • These institutions evolved to serve as lenders of last resort, providing for liquidity in times of poor harvests or war. • Initially a private response (privately funded with government approval) to difficulties that arose in banking systems with many small banks (Gorton and Huang [2001]).

17. Other Early Central Banks • Much later, in 1800, the Banque de France was established by Napoleon to stabilize currency, and, again, to make loans to the government finance. • The Bank of Spain, National Bank of Austria and numerous other European central banks were founded for similar purposes. • Central banks also issued their own currencies.

18. 19th Century U.K. Central Banking • The U.K. experienced many banking crises during the first half of the 19th century. • After an 1866 U.K. crisis and following the advice of Walter Bagehot, the Bank of England began lending to troubled correspondent banks based on collateral and penalty interest rates. • The U.K. remained free of banking panics from 1866 until 2007.

19. 19th U.S. Century Central Banking • The U.S. experienced many banking crises during the 19th century. • There were two early attempts at chartering and maintaining central banks in the U.S.: • The Bank of the United States (1791-1811) • The Second Bank of the United States (1816-1836)

20. Co-insurance Coalitions • Before establishment of the U.S. Fed, banks formed co-insurance coalitions issuing "clearinghouse loan certificates" during banking panics. • These certificates were a sort of private currency for which all coalition members were jointly responsible. • This system of co-insurance was the precursor to the modern discount window. • Led to banks monitoring fellow coalition members, setting the stage for central bank monitoring. • During the panics of 1893 and 1907, these certificates were issued directly to bank depositors, again, as a sort of private currency. • These 19th century U.S. coalitions or clearinghouses originated as interbank payments systems.

21. Motivating a Permanent U.S. Central Bank • After the early attempts at chartering and maintaining central banks, the U.S. Federal Reserve System was established in 1913, largely in response to the severe U.S. Banking Panic of 1907. • The interims between the central banks were characterized by significant numbers of banking crises.

22. The Federal Reserve System • The Federal Reserve System (the Fed) was established in 1913 as the Central Bank of the United States. • Its principal responsibility is setting monetary policy for the United States. • The Fed's conduct of monetary policy is intended to promote price stability, full employment, balanced economic growth and stability in exchange rates. • The Fed maintains regulatory authority over most commercial banks, particularly with respect to issues that might affect the stability of the banking system.

23. The European Central Bank • The European Central Bank (ECB), headquartered in Frankfurt was established by the Treaty of Amsterdam in 1998 as the central bank of the Eurozone (the 19 EU members that adopted the euro as their official currency). • Its stock, totaling roughly €5 billion, is held by the 28 member EU states. • Its principal mandate is to maintain price stability. • Its primary responsibility is setting monetary policy for the Eurozone. • More generally, the Eurosystem, comprised of the ECB and Member States central banks seek to safeguard financial stability and promote European financial integration

24. European Bank Supervision • Through its Single Supervisory Mechanism (SSM), the ECB maintains regulatory authority over the largest 123 Euro area banks, accounting for approximately 85 of the area's aggregate banking assets. • The majority of European banks are still monitored by national supervisory bodies such as the Deutsche Bundesbank and non-Eurozone EU country banks are exempt from participation.

25. D. Key Financial Institutions in the International Banking Environment • The International Monetary Fund (IMF): Initially sought to maintain a stable payments system • The World Bank: Seeks to reduce poverty • Regional Development Banks: Provides development assistance in defined regions • The Bank for International Settlements: A sort of central bank for central banks

26. The World Bank Group • The World Bank: makes loans with somewhat conventional terms for projects with high economic priority and for projects have a high expectation of profitability. Government guarantees are required. • International Development Association (IDA) which finances low profitability projects at easy terms with government guarantees. • International Finance Corporation (IFC) which finances projects in private sector without government guarantees. The IFC sometimes participates in equity of these projects. • The Multilateral Investment Guarantee Agency (MIGA), which promotes foreign direct investment into developing countries and • The International Center for Settlement of Investment Disputes (ICSID).

27. The Bank for International Settlements • The Bank for International Settlements (BIS) was founded as a result of the Hague agreement of 1930 to facilitate Germany’s payments of reparations for World War I. • Since WWI, the BIS has evolved into a sort of “central bank for central banks,” providing for regulation and supervision of central banks and commercial banks, fostering transparency and coordination among central banks and promoting monetary and financial stability. • The BIS is headquartered in Switzerland, where it has hosted important banking treaties, including the Basel I and II Capital Accords that, among other things, set standards for bank risk management.

28. E. An Introduction to Financial Intermediation • A major purpose of the financial system is to channel funds from agents with surpluses to agents with deficits. • A financial facilitator acts as a broker without transforming those assets. • Money marketsvs. capital markets: investors their surpluses directly to deficit firms, creating marketable securities and instruments • A financial intermediary can facilitate this channeling process from surplus to deficit agents by transforming assets.

29. Financial Transformation • Preferred terms can be affected by transformations to contractual terms: • Maturity transformation • Risk transformation • Size transformation

30. Functions of Financial Intermediaries (Bhattacharya and Thakor [1993])

31. Why do Financial Intermediaries Exist? • Transactions Costs (Benston and Smith [1976]): Intermediaries reduce contracting costs between users and providers of capital • Delegated Monitoring (Diamond [1994]): e.g., banks monitor borrowers on behalf of lenders • Providers of Liquidity: Banks finance illiquid assets with liquid liabilities. • Resolving Problems Related to Incomplete Markets and Asymmetry of Information

32. Transactions Costs (Benston and Smith [1976])   • Intermediaries reduce contracting and transactions costs between users and providers of capital • Intermediaries reduce such costs by engaging in a variety of services ranging from brokering to asset transformation. • Scale economies and diversification are key factors leading to costs reduction.

33. Delegated Monitoring (Diamond [1994]) • Banks monitor firms to which they extend financing. • Securities sold to widely dispersed public investors do not normally lead to comparable monitoring, governance and renegotiating activities. • Banks acquire private information in the screening process. • Banks often hold demand deposits of client borrowers, providing further special information concerning clients. • Banks often maintain long-term relationships with client borrowers.

34. Providers of Liquidity:Diamond and Dybvig [1983] • A central role of a bank is to create and enhance liquidity by financing illiquid assets with more liquid liabilities. • Bank liabilities, particularly demand deposits, function as mediums of exchange, as do other products as credit cards. • Agents deposit their endowments in interest-bearing bank claims that enable them to finance future, perhaps unanticipated consumption needs. Such deposits enhance consumption flexibility and increase utility of consumption. • Had agents could have invested their endowments in illiquid production technologies, higher than anticipated consumption needs could force them to liquidate investments too early, reducing overall consumption. • In effect, the deposit serves as an insurance contract against the costs of unanticipated consumption in earlier periods. 

35. F. Financial Sector Growth and Financialization • Financial services industries play a crucial role in national and world economies by creating, trading and settling financial instruments. • facilitate capital needed for production of goods and services, • shift funds from "surplus agents" to "deficit agents“ • Shift funds for risk shifting and mitigation. • Growth in financial service sectors often accompanies growth in real production sectors • True during the 1920s era characterized by technological improvements and the post 1980s IT growth era. • Less true during the post-War period 1945-70 with only a modest share of growth in the financial services sectors.

36. Financial Sector Growth Table 2: Value Added by Industry as a Percentage of Gross Domestic Product Adapted from: Bureau of Economic Analysis; Release Date: November 3, 2016 

37. Financialization • Financialization: a pattern of accumulation in which profits accrue primarily through financial channels rather than through trade and commodity production. (Arrighi [1994]) • Philippon (2015) characterizes the cost of financial intermediation as "the sum of all spreads and fees paid by non-financial agents to financial intermediaries.“ • Philippon estimated these costs over each of 142 years in the U.S., finding them to range around 1.5% to 2% of intermediated assets, showing a constant rather than increasing returns to scale and remarkable consistency over time despite drastic improvements in technologies. • Firms were able to obtain needed capital at pretty much the same per-unit cost in 2012 as in 1870, despite huge growth and prodigious applications of new technologies in finance industries. • How is it that the per-unit costs to firms seeking financial services do not decrease, even as the technological innovation would seem to reduce the financial institutional costs for providing these services?

38. Costs of Financialization • Philippon argues that these efficiencies were consumed as compensation and profits by finance professionals and financial institutions. • He suggests that financialization did not so much improve the process of intermediating capital between surplus and deficit agents, but instead was associated with increased creation and trading of financial instruments, which served to increase compensation to financial executives and profits to financial institutions. • Turner (2010) argued that “There is no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability.” If financialization did not significantly improve growth, stability or firms’ access to capital, how did it impact the economy? • Perhaps, even worse, Godechot (2016), based on his study of 18 OECD countries, argues that the GDP share of the finance sector is a substantial driver of world inequality, explaining between 20 and 40 percent of the increase in wealth inequality from 1980 to 2007.

39. Financialization and Transactions Taxes • Highly liquid financial markets do reduce costs of capital. They generally reduce risk and improve information flows. • Have our economies attained appropriate levels of financial market activity given the various benefits and costs? • Is it time to consider transactions and similar taxes discourage excessive devotion of resources to areas of economy that are not entirely or always productive (See, for example, Summers & Summers 1989)? • The area of financialization is now an important research area with increasing levels of activity.