Financial System
Junhui Qian
Outline
• Banking
• Financial Markets
– Stock Market
– Bond Market
• Monetary Policy
Banks
•
•
•
•
Commercial banks
Investment banks
Policy banks
Central banks
Commercial Bank
• The basic activity of a commercial bank is to
accept deposits and make loans.
• Three transformations
– Credit transformation
– Term (maturity) transformation
– Liquidity transformation
• Commercial banks also provide other services
such as checking, payments, remittance, etc.
Fractional Reserve and Money
Creation
• A bank accepts deposits and holds a fraction in
reserves, which are held at the bank as currency,
or as deposits in the bank's accounts at the
central bank.
• The cash reserve at commercial banks and the
deposit reserve at the central bank constitute the
base money in the economy.
• When a bank makes a loan, it creates new
“money” and multiplies money supply in the
economy.
Case Studies
• History of Chinese Commercial Banking
– Piaohao (票号)
– Qianzhuang (钱庄)
• The birth of fractional reserve banking in
Amsterdam
– From goldsmith to banker
Investment Bank
• The basic activity of an investment bank is to
help individuals, corporations, and
governments raise capital in the market.
• An investment bank may also help mergers
and acquisitions (M&A), provide market
making, directly trade derivatives and equities,
and provide FICC services (fixed income
instruments, currencies, and commodities).
• Investment banks do not take deposits.
Policy Banks
• There are three policy banks in China: Agricultural
Development Bank of China (ADBC), China
Development Bank (CDB), and the Export-Import Bank
of China (Chexim).
• These banks were set up in 1994 to take over the
government-directed spending functions of the big
four state-owned commercial banks, so that the big
four might specialize in commercial banking.
• Policy banks do not take deposits and rely on bond
financing and borrowing from the central bank.
The Central Bank
• The basic activity of a central bank is to deliberate
on and implement monetary policy.
• A typical modern central bank controls an
intermediary variable, short-term interest rate,
for the objective of achieving full employment
with moderate inflation.
• The central bank also provides lender-of-lastresort function for commercial banks. Many
central banks are also responsible for monitoring
and regulating the banking sector.
Bank Regulation
• A healthy banking industry is vital to economy,
but the banking industry is inherently vulnerable
to failures, which are often contagious.
– Asymmetric information: savers cannot monitor banks’
lending.
• Some safety net (e.g., deposit insurance) is thus
necessary, but the safety net increases moral
hazards and adverse selection.
• To mitigate the effect of moral hazards and
adverse selection, government must enforce
regulation and supervision of the industry.
Cost of Bank Bailouts
Date
Country
Cost (% GDP)
1980-1982
Argentina
55
1997-1998
South Korea
27%
1995
Mexico
20
1990s
Japan
>12
1991-1994
Finland
11
1991-1995
Hungary
10
1987-1993
Norway
8
1991-1994
Sweden
4
1984-1991
United States
3
Shadow Banking
• Shadow bank refers to any market entity that provides
banking services outside the scope of government
regulation and supervision.
– Credit transformation
– Term transformation
– Liquidity transformation
• Shadow banking is closely intertwined with the regular
banking sector. Without government regulation,
shadow banks may use excessive leverage, making the
financial system vulnerable.
• The competition of shadow banks also forces banks to
seek higher return by pursuing risky projects.
Shadow Bank with Chinese
Characteristics
• Shadow banking flourished in China thanks to the
government restrictions on loans, interest rates,
and capital flows.
– Trust (信托)
– Entrusted loans (委托贷款)
– Copper finance (“融资铜”)
• The Chinese shadow banking is even more
intertwined with the banking sector than its
counterpart in US. It is often called the shadow of
the bank.
Outline
• Banking
• Financial Markets
– Stock Market
– Bond Market
• Monetary Policy
Equity and Bond Financing
• In addition to bank loans, a company may also
obtain financing by issuing securities, equities
(stocks, shares) or bonds.
• The owner of equities and bonds provide
financing for the company and obtain either
residual claim or fixed-income claim on the
company.
• The equities or the bonds may be listed in an
exchange, so that the market participants may
buy and sell these securities. These securities, in
turn, obtain liquidity.
Stock Market
• Stock market is often referred to as the stock
exchange, where shares of different companies
are listed and traded. In general terms, stock
market also includes over-the-counter markets.
• Stock market participants include retail investors,
mutual funds, hedge funds, insurance companies,
social security funds, endowment funds, and
other institutional investors.
• Stock market provides an efficient way of
allocating financial resources and sharing risk
(profit).
Stock Exchanges Around The World
(May, 2015)
Ranking
1
2
3
4
5
6
7
8
9
10
Stock Exchange
NYSE
NASDAQ OMX
Shanghai SE
Japan Exchange Group - Tokyo
Shenzhen SE
Hong Kong Exchanges
Euronext
TMX Group
Deutsche Börse
SIX Swiss Exchange
Capitalization (million USD)
19 686 944.9
7 378 758.4
5 903 863.2
5 004 759.7
4 368 478.6
3 966 069.2
3 496 579.7
2 114 803.6
1 823 127.0
1 614 938.0
Private Equity
• Private equity consists of equity and debt that are
not publicly traded on a stock exchange.
• Private equity investors fall into the following
categories:
– Angel investor
– Venture capital investor (VC)
– Private equity investor (PE)
• IPO (Initial Public Offering) in a stock market
provides the ultimate exit and incentive for all
private equity investors.
Bond Market
• Bonds can be traded much like stocks in securities
exchanges.
• In China, the major bond market is the inter-bank
market.
• The bond market determines interest rates of
different terms and credit levels
– Government bonds: risk-free interest rate + term
premium
– Corporate and municipal bonds: risk-free interest rate
+ credit risk premium + term premium
Outline
• Banking
• Financial Markets
– Stock Market
– Bond Market
• Monetary Policy
Monetary Policy
• Long-term objectives:
– Moderate inflation
– Low unemployment rate (economic growth)
– Fixed exchange rate
• Target market variables:
– Short-term interest rate
– Money growth
– Exchange rate
• Instruments:
– Open market operations
– Reserve requirement
– Others
Taylor’s Rule
• In the United States, it is widely believed that the
FED follows the Taylor’s rule, at least during the
normal times,
federal fund rate = inflation + 2
+0.5 inflation − 2 + 0.5 GDP gap
• Rule-based policy making mitigates the problem
of time inconsistency.
• Even if the monetary authority strictly follows a
rule, policy making cannot be automatic, since
key macroeconomic variables have to be
measured and forecasted.
The Science of Monetary Policy:
Generations of Macroeconomic Models
• Early Keynesian econometric models (Tinbergen 1939,
Klein 1968): no important role for monetary policy.
• The MIT-Penn-SSRC (MPS) model (Modegliani et al.,
1960s): important role for monetary policy.
• In the 1970s, the accelerationist Phillips curve was
incorporated in MPS.
• The FRB/US model (Brayton and Tinsley 1995;
Reifschneider, Stockton and Wilcox 1997; Reifschneider,
Tetlow, and Williams 1999): important role for
expectation.
• DSGE with New-Keynesian features (Woodford 2003)
Intermediate Macroeconomics
The Art of Monetary Policy
• Monetary policy will always need some “judgment”.
• Formal models may be able to use only a small subset
of data that are informative on our complex economy.
– High-frequency data
– Anecdotal observations (Beige Book of the US Fed)
• Model selection problem: economists are never sure
which model or which modeling approach is the
correct one.
• Model instability problem: a model may be correct for
a time and fails next period after some structural
change in the economy.
Intermediate Macroeconomics
The Trend Toward Central Bank
Independence
• Before 1990s, only a few central banks were
highly independent: the Bundesbank, the
Swiss National Bank, the Federal Reserve.
• In the 1990s, many countries in the developed
world achieved greater central bank
independence: Japan, South Korea, New
Zealand, Sweden, the UK, etc.
Intermediate Macroeconomics
The Trend Toward Inflation Targeting
• Five components of IT (Mishkin 2004):
1. The public announcement of medium-term numerical
targets for inflation,
2. An institutional commitment to price stability as the
primary goal of monetary policy,
3. An information-inclusive strategy to set policy
instruments,
4. Increased transparency of the monetary policy strategy,
and
5. Increased accountability of central bank for attaining its
inflation objectives.
• Inflation targeting was first adopted by New Zealand in
1990. By 2006, a total of 24 countries had adopted IT.
Intermediate Macroeconomics
Increasing Attention on Financial
Stability
• Early central banks (e.g., Riksbank, Bank of England), with substantial
commercial banking business, focus on the nature and quality of bank
assets, primarily the commercial bills. They do not focus on direct
examination of the books or the management practices of other
commercial banks.
• Banking crises during the interwar period led to establishment of
institutions with responsibility for bank supervision, some within the
central bank, some separate, and others only formally separate.
• From late 1960s, resurgent financial instabilities, often international,
reinforced the role of central banks in designing the regulations,
monitoring that rules were followed, imposing sanctions if rules were
violated, and being the lender of last resort if crises occurred.
• Since 1980s, under the influence of the free-market ideology, financial
regulation failed to catch up with “financial innovations”.
• The recent global financial crisis once again reinforced central banks’
attention on financial stability.
Intermediate Macroeconomics
End-of-Semester Remarks
• Models simplify. A good model is one that omits unnecessary
details and focuses on the main question.
• Time horizon matters. In the long run, prices adjust flexibly and the
classical theory roughly holds; while in the short-run, price rigidity
produces real effects of monetary and fiscal policies.
• Monetary and fiscal policies matter, not only for textbook reasons
(nominal rigidity), but also for other reasons such as balance sheet
effect, wealth effect, change of expectation, and so on.
• Macroeconomic conditions change, and there are no timeinvariant answers, even for the same question. What we learn is
some basic skills for conducting rigorous studies of the economy.
• Investment alone does not bring prolonged economic growth. For
an under-developed country, market-friendly reform, political
stability, education, social trust and mobilization all contribute to
growth.
End-of-Semester Remarks
• Familiarity with data is the key to the
understanding of economy. “I think…” is an
ominous phrase to start economic analysis. “Data
suggest…” is a promising one.
• Respect the status quo and avoid radicalism. A
scientist rejects a consensus theory only when
there are overwhelming evidence against it. A
conservative opts for revolution only when the
establishment breaks down and rejects reform.