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ECONOMICS 3150M. Winter 2014 Professor Lazar Office: N205J, Schulich 736-5068. Lecture 11: February 12 Ch. 20, 21. Creation of Eurocurrencies.

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economics 3150m


Winter 2014

Professor Lazar

Office: N205J, Schulich


creation of eurocurrencies
Creation of Eurocurrencies
  • Bombardier sells US$46 M CRJ-900 to Jet Airways – Jet pays initial deposit of US$10 M by check drawn on U.S. bank branch in Mumbai (Citibank)
  • Options for Bombardier
    • Convert to C$ at current spot rate (E)
    • Keep US $ (required for purchases of engines, avionics, consulting services, etc.)
      • Buy US TBs
      • Buy CD from US bank
      • Buy Euro-US dollar deposit from Royal Bank branch in Montreal
        • Only this option leads to creation of Eurodollar deposit – no change in US money supply
creation of euro us dollars

Asset: US$ Deposit with RB (Montreal)

Liability: US$ customer advances

Jet Airways

Asset: US$ customer advance

Liability: US$ loan from Citi

Citi (Mumbai)

Asset: US$ Loan to Jet Airways

Liability: US$ Loan from Citi (NY)

Citi (NY)

Asset: +US$ Loan to Citi (Mumbai)

Asset: -US$ Deposits with Fed

Royal Bank (Montreal)

Asset: US$ Deposit with DB (Frankfurt)

Liability: US$ Deposit of Bombardier

Deutsche Bank (Frankfurt)

Asset: US$ Deposit with JPMorgan Chase (NY)

Liability: US$ Deposit of RB

JPMorgan Chase (NY)

Asset: US$ deposits with Fed

Liability: US$ Deposit of DB

Creation of Euro-US Dollars
  • Absence of regulatory oversight
  • Inter-bank lending (as in preceding example) – hierarchy of banks
    • “Offshore”bank in turn lends to another bank – interest rate on Eurodollar deposits increases as the money moves up the hierarchy of banks
    • At top of the hierarchy, much greater default risk than at bottom
    • If bank or ultimate borrower at top defaults, default could create domino effect – Royal’s exposure may be much different because of interbank lending
      • Consider structure of CDOs, credit default swaps
counter party risks
Counter-Party Risks
  • Derivatives
    • Exchange traded – rules, collateral
    • Private transactions – no rules (other than contracts), no collateral (other than specified in contracts)
    • CDS
    • Other risks related to assumptions entered into black boxes
domestic safeguards
Domestic Safeguards
  • Deposit insurance
  • Reserve requirements
  • Capital requirements and asset restrictions
  • Bank examination
  • Lender of last resort facilities – central bank
  • Government-organized bailout
  • Difficulties in regulating international banking
interdependence of financial markets
Interdependence of Financial Markets
  • Bubbles and collapses
  • Herd effects – equilibrium and overshooting/undershooting
  • Diversification – geographic, industry, asset class: purpose of diversification
  • Contagion effects – spreading of economic shocks: open vs. closed financial markets
    • Is geographic diversification possible?
interdependence of financial markets1
Interdependence of Financial Markets
  • “We have more complexity today because of the sheer size of the capital markets and the presence of new and unpredictable players” (Robert Bruner, Dean of the business school at the U. of Virginia in Charlottesville)
    • Complex financial instruments: new generations of derivatives
    • Increasing use of leverage
    • New institutions: hedge funds
    • Globalization
    • Ineffective regulations
    • Rapid movement of capital
financial crisis 1
Financial Crisis 1
  • Rocket scientists, derivatives and a free lunch
  • Banks: more money in fees than direct lending
  • Investors: searching for higher returns without more risk
    • Money for nothing and the ….. for free
  • Leverage
  • Shadow banking system
  • Greed, trust, uncertainty
  • Absence of regulatory oversight
  • Central banks did not appreciate degree of interdependence between Lehman and all major financial institutions
financial crisis 11
Financial Crisis 1
  • Fed:
    • Widespread declines in underwriting standards
    • Breakdowns in lending oversight by investors and rating agencies
    • Increased reliance on complex and opaque credit instruments that proved fragile under stress
    • Unusually low compensation for risk-taking
st bernanke time magazine person of the year
St. Bernanke: Time Magazine Person of the Year
  • Innovations – quantitative easing
    • Provision of short-term liquidity to banks and other depository institutions and other financial institutions
    • Provision of liquidity directly to borrowers and investors in key credit markets
    • Expanded traditional tool of open market operations to support the functioning of credit markets through the purchase of longer-term securities
    • Interest on reserve balances with Fed
traditional balance sheet
Assets (Fed @ Aug/07)

U.S Treasury securities: $791 B

Gold, SDRs, other: $83 B

Total: $874 B

Liabilities (Fed @ Aug/07)

Currency in circulation: $814 B

Bank deposits: $17 B

Treasury balance: $5B

Traditional Balance Sheet
changes in fed balance sheet august 1 2007 to december 17 2008

Treasury securities: +$340B

Mortgage-backed securities: +$18B

Lending to banks: +$538B

Credit extended to AIG: +$82 B

Lending to primary dealers: +$47B

Lending for purchase of Commercial Paper: +$346B

Assets purchased from Bear Stearns: +$27B

Swaps with central banks: +$572B

Total: +$1.4 T


Currency in circulation: +$64B

Bank deposits: +$785B

Treasury cash deposits: +$475B

Changes in Fed Balance Sheet:August 1, 2007 to December 17, 2008
current balance sheet
Assets 12/18/13

US Treasury securities: $2,192 B

Mortgage-backed securities: $1,483 B

Federal agency debt securities: $57 B

Gold: $11 B

Foreign currency denominated assets: $24 B

Total: $4.0 T

Liabilities @ 12/18/13

Currency in circulation: $1,230 B

Reverse repurchase agreements: $116B

Bank deposits: $2,521 B

Current Balance Sheet
financial crisis 12
Financial Crisis 1
  • US Treasury allocated US$700 B to buy troubled assets from banks
  • US$250 B used instead to invest in capital of banks
    • Earned profit on investments
    • “Bailout of Wall Street” needed to prevent collapse of Main Street
  • US$85 B used to bailout AIG and counter-parties to about US$400B in CDS sold by AIG
  • Investments in GM and Chrysler