INTERNATIONAL FINANCIAL INSTITUTIONS AND MARKETS, Schemi e mappe concettuali di Economia Finanziaria

Scarica INTERNATIONAL FINANCIAL INSTITUTIONS AND MARKETS e più Schemi e mappe concettuali in PDF di Economia Finanziaria solo su Docsity! LESSON 1-OVERVIEW OF FINANCIAL SYSTEM A financial services holding company offers a full set of financial services. Financial system (OECD) — a financial system consists of institutional units and markets that interact in a complex manner, for the purpose of mobilizing funds for investment and providing facilities, including payment systems, for the financing of commercial activity. Financial institutions channel funds from those with surplus funds (supplier of funds) to those with shortages of funds (users of funds). Direct transfer— funds go directly from suppliers of funds to users of funds and viceversa financial claims like equity and debt instruments flow from users of funds to suppliers. BUT there is asymmetric information —> * adverse selection (one party has more and more accurate information) so before the transaction it must do a screening ex ante and potential borrowers most likely to produce adverse outcome are ones most likely to seek aloan * moral hazard (risk that a party has not entered a contract in good faith or has provided misleading information about assets, liabilities); it arises after the transaction (monitoring ex post). The borrower has incentives to engage in indesirable activities making it more likely that he won't pay back its loan Because of asymmettic information it is necessary to gather information and monitor, do contracts, collateral, net worth and restrictive covenants. Liquidity costs fund suppliers may choose to hold cash for consumption expenditures Price risk risk that an asset’s sale price will be lower than its purchasing price Transaction costs Low level of funds transferred directly Indirect finance/ intermediated financing The intermediary obtains funds from savers and then makes loans/investments with borrowers. Benefits to suppliers of funds> * Lowers monitoring costs large FI can collect information at a lower average cost (it is the a delegated monitor for fund suppliers) * lowersliquidity and price risk— FI are asset transformers (financial claims issued by an FI are more attractive than those issued by corporations), they diversify (reduce risk by holding a number of different securities in a portfolio) some of their investment risk, they exploit the law of large mumbers in making their investment decision and diversification permits to predict more accurately expected return and risk. * Lowers transaction costs economies of scale (cost reduction in trading and other transaction services results in increased efficiency when Fis perform these services) * Maturity intermediation— FIs can bear the risk of mismatching the maturities of their assets and liabilities, higher liquidity and better management of risks * denomination intermediation— many assets are sold in large denominations and are either out of reach of individual savers or would result in savers holding very undiversified asset portofolios. Functions to the financial system * transmission of monetary policy as deposits are a significant component of the money supply, which directly impacts the rate of economic growth, depository institutions (commercial banks) play a key role in the transmission of monetary policy from the central bank to the rest of the economy. * Credit allocation— major source of financing for particular sectors of the economy (efficient allocation) * time intermediation (intergenerational wealth transfer) ability of savers to transfer wealth from their youth to old age and across generations * paymentservices— check-clearing and wire transfer services. The intermediation involves risks (credit risk, foreign exchange risk, country or sovereign risk, interest rate risk, asset price risk, off-balance-sheet risk, liquidity risk, operational risk) — need fora specific regulation in an attempt to prevent market failure and the cost it would impose on the economy and the society (regulation imposes private costs on FI owners and managers). FI are institutions through which suppliers channel money to users of funds. They can be distinguished by : * Whether they accept deposits —> depository institutions: commercial bank, saving associations, savings banks, credit unions, ‘Whether they receive contractual payments from customers —> non-depository institutions: contractual savings institutions (acquire funds from clients at periodic intervals on a contractual basis and have failly predictable future payout requirements for ex insurance companies and pension funds), non contractual savings institutions (securities firms and investment banks, mutual funds, finance companies, hedge funds) The shadow banking system— is a credit intermediation involving entities and activities outside the regular banking system, but it performs bank-like activities — ex: insurance corporations and pension funds, other financial intermediaries (OFI) in particular investment funds, money market funds. It can also be called “non-bank financial intermediation” The tradition banking system (credit intermediation) creates maturity/liquidity transformation, interest rate and credit risk. The composition of the financial system varies across jurisdications; banks are the largest single sector of the financial system in 22 jurisdictions but non-bank sectors represent 50% ofthe financial system inl1 of them. Financial markets are structures through which funds flow. * Primary markets markets in which users of funds (corporations and government) raise funds by issuing financial instruments (stocks and bonds). The users of funds issue securities in the external primary markets to raise additional funds, new issues of financial instruments are sold to the initial suppliers of funds (households) in exchange for funds that the user of fund needs. It is arranged through investment banks that serve as intermediaries between the issuing corporation (fund user) and the investor (fund supplier). Instruments of primary markets are issues of equity by firms initially going public (initial public offerings). Secondary markets markets where financial instruments once issued in the primary market are traded (re-bought and sold) among investors. Buyers of secondary market securities are economic agents with excess funds, sellers are economic agents in need of funds. The original issuer of the instrument (user of fund) is not involved in the transaction. A derivative security is a financial security whose payoffs are linked to other, previously issued primary securities. Secondary markets offer benefits for both investors and issuing corporations and offer liquidity (the ability to tum an asset into cash quickly at its fair market value ) and information about prices or the value of their investment. They can be fiuther classified in: © Exchanges © Over-the-counter markets Money markets> markets that trade debt securities or instnuments with maturities of one year or less. They have little or no risk of capital loss, but low retum and are said to be mostly over-the counter markets. Their instruments are treasury bills, federal funds, repurchase agreements, commercial papers, negotiable certificates of deposit, banker”s acceptance. Capital markets markets that trade equity (stocks) and debt (bonds) instruments with maturities of more than one year. There is substantial risk of capital loss but higher promised retum. The instruments are: corporate stock, mortgages, corporate bonds, treasury bonds, state and local government bonds, U.S govemment agencies, bank and consumer loans. The relative size of the market value of capital market instruments outstanding and it is number of securities issued x their market prices. Foreign exchange markets cash flows from the sale of products or assets denominated in a foreign cumrency are transacted. Foreign exchange markets: trading one currency for another. Spot foreign exchange: the immediate exchange of currencies at current exchange rates. Forward foreign exchange: the exchange of currencies in the future on a specific date and at a pre-specified exchange rate. Cash flows from securities denominated in a foreign currency expose corporations and investors to the foreign exchange risk. Central governments sometimes intervene in foreign exchange markets directly or affect foreign exchange rates indirectly by altering interest rates. Derivative security markets markets in which derivative securities are traded (financial securities whose payoff is linked to another, previously issued security or commodity; they involve an agreement between two parties to exchange a standard quantity of an asset or cash flow at a predetermined price and at a specified date in the future). The main purpose of the derivatives market is to transfer risk between market paiticipants. Some examples of exchange listed derivatives are many options and future contracts and examples of over the counter derivatives are forward contracts, forward rate agreements, swaps and securitized loans. © Debt markets markets in which debt instruments (mortgage or bond) are used that are contractual agreements by the borrower to pay the holder of the instrument fixed amounts at regular intervals Factors that cause the demand curve for loanable funds to shift include the utility derived from assets purchased with borrowed funds, the restrictiveness of non-price conditions on borrowing, and economic conditions. Utility Derived from Assets Purchased with Borrowed Funds. As the utility derived from an asset purchased with borrowed funds increases, the willingness of market participants to borrow increases and the absolute dollar value borrowed increases. Accordingly, at every interest rate, the demand for loanable funds increases, or the demand curve shifts up and to the right. Conversely, as the utility derived from an asset purchased with borrowed funds decreases, the willingness of market participants to borrow decreases and the absolute dollar amount borrowed decreases. Accordingly, at every interest rate, the demand for loanable funds decreases, or the demand curve shifts down and to the left. Restrictiveness of Non-price Conditions on Borrowed Funds. As the non-price restrictions put on borrowers as a condition of borrowing decrease, the willingness of market paiticipants to borrow increases and the absolute dollar value borrowed increases. Such non-price conditions may include fees, collateral, or requirements or restrictions on the use of funds. The lack of such restrictions makes the loan more desirable to the user of funds. Accordingly, at every interest rate, the demand for loanable funds increases, or the demand curve shifts up and to the right. Conversely, as the non-price restrictions put on borrowers as a condition of borowing increase, market participants’ willingness to borrow decreases, and the absolute dollar value borrowed decreases. Accordingly, the demand curve shifts down and to the left. Economic conditions. When the domestic economy experiences a period of growth, such as that in the United States in the 1990s and mid-2000s, market participants are willing to bomow more heavily. Accordingly, the demand curve for funds shifts up and to the right. Conversely, when domestic economic growth is stagnant, market participants reduce their demand for funds. Accordingly, the demand curve shifts down and to the left. DETERMINANTS OF INTEREST RATES FOR INDIVIDUAL SECURITIES We examine the specific factors that affect differences in interest rates across the range of real-world financial markets. These factors include inflation, the “real” interest rate, default risk, liquidity risk, special provisions regarding the use of funds raised by a security’s issuance, and the term to maturity of the security. Inflation The first factor to affect interest rates is the actual or expected inflation rate in the economy. Specifically, the higher the level of actual or expected inflation, the higher will be the level of interest rates. the higher the rate of inflation, the more expensive the same basket of goods and services will be in the future. Inflation of the general price index of goods and services (IP) is defined as the (percentage) increase in the price of a standardised basket of goods and services over a given period oftime. Real Interest Rates A real interest rate is the interest rate that would exist on a security if no inflation were expected over the holding period (e.g., a year) of a security. The real interest rate on an investment is the percentage change in the buying power of a dollar. Fisher Effect. The relationship among the real interest rate (RIR), the expected rate of inflation [Expected (IP)], described above, and the nominal interest rate (i) is often referred to as the Fisher effect. The Fisher effect theorises that nominal interest rates observed in financial markets (e.g., the one-year Treasury bill rate) must compensate investors for any reduced purchasing power on funds lent (or principal lent) due to inflationary price changes and an additional premium above the expected rate of inflation for forgo- ing present consumption (which reflects the real interest rate discussed above). When an investor purchases a security that pays interest, the nominal interest rate exceeds the real interest rate because of inflation. i= RIR +Expected (IP) + [RIR_ Expected (IP)] Where RIR Expected (IP) is the inflation premium for the loss of purchasing power on the promised nominal interest rate payments due to inflation. For small values of RIR and Expected (IP) this term is negligible. Thus, the Fisher effect formula is often written as: i= RIR + Expected (IP) Default or Credit Risk Default risk is the risk that a security issuer will default on making its promised interest and principal payments to the buyer of a security. The higher the default risk, the higher the interest rate that will be demanded by the buyer ofthe security to compensate him or her for this default (or credit) risk exposure. Not all securities exhibit default risk. The difference between a quoted interest rate on a security (security j) and a Treasury security with similar maturity, liquidity, tax, and other features (such as call-ability or convertibility) is called a default or credit risk premium (DRPj). That is: DRP= ijt-iTt where ijt = interest rate on a security issued by a non-Treasury issuer (issuer j) of maturity m at time t iTt = interest rate on a security issued by the U.S. Treasury of maturity m at time t Liquidity Risk A highly liquid asset is one that can be sold at a predictable price with low transaction costs and thus can be converted into its full market value at shoit notice. The interest rate on a security reflects its relative liquidity, with highly liquid assets camying the lowest interest rates (all other characteristics remaining the same). Likewise, if a security is illiquid, investors add a liquidity risk premium (LRP) to the interest rate on the secumity. Special Provisions or Covenants Numerous special provisions or covenants that may be written into the contracts underlying the issuance of a security also affect the interest rates on different securities. Some of these special provisions include the security’s taxability, convertibility, and call-ability. A convertible (special) feature of a security offers the holder the oppoitunity to exchange one security for another type of the issuer’s securities at a preset price. In general, special provisions that provide benefits to the security holder are associated with lower interest rates, and special provisions that provide benefits to the security issuer (e.g., call-ability, by which an issuer has the option to retire—call—a security prior to maturity at a preset price) are associated with higher interest rates. Term to Maturity Interest rates are also related to the term to maturity of a security. This relationship is often called the term structure ofinterest rates or the yield curve. The term structure of interest rates compares the interest rates on securities, assuming that all characteristics (i.e., default risk, liquidity risk) except maturity are the same. The change in required interest rates as the maturity of a security changes is called the maturity premium (MP). The MP, or the difference between the required yield on long- and short-term securities of the same characteristics except maturity can be positive, negative, or zero. Putting the factors that impact interest rates in different markets together, we can use the following general equation to determine the factors that functionally impact the fair interest rate (ij *) on an individual (jth) financial security: ij*= f (IPRIR,DRPj,LRPj,SCPj.MPj) ‘Where IP= Inflation premium RIR = Real interest rate Default risk premium on the jth security Liquidity risk premium on the jth security SCPj =Special feature premium on the jth security MPj =Maturity premium on the jth security The first two factors, IP and RIR, are common to all financial securities, while the other factors can be ‘unique to each security. THE YIELD CURVE A plot of the yields on bonds with differing terms to maturity but the same risk, liquidity, and tax considerations is called a yield curve, and it describes the term structure of interest rates for particular types of bonds, such as govemment bonds. Yield curve can be three shapes that includes: normal and steep, inveited and flat. NORMAL YIELD CURVE: it shows curving up curve to show the greater financial reward for increased risk. The line represents your investment over a period. The longer time you hold your money in an investment, the greater the risk of changes in thing such as interest rate. The normal yield curve is associated with positive economic growth. STEEP YIELD CURVE: one which the short term yields are at a normal level, but the long term yields are higher. This curve signals that the interest rates are expected to be increased in the future. INVERTED YIELD CURVE: It is a curved line that slope down indicating that bonds with longer terms may continue to fall indicating economic regression. When investors determine an inverted curve is occurring, there is an opportunity to lack in yield before they drop lower. There are some factors that affect an inverted curve. When there is an initial demand for lower-maturity bonds and a lack of demand shorter-term securities, it leads to higher prices of a security but lower yields on longer-maturity bonds. The opposite happens to shorter-term securities with lower prices but higher yields fiuther pushing down the inverted cuive. FLAT INVERTED CURVE: It can occur either when there is a normal cuive or inverted curve. When the economy is transitioning between economic growth and economic decline is when you will find the flat yield curve. When the economy is going from economic growth to economic decline yields on the longer maturity bonds drop and shorter maturity bonds go up. If the opposite happens and the economy is going from recession to a potential economic growth yields on longer maturity bonds go up and the short term go down. Explanations for the shape of the yield curve fall predominantly into three theories: the unbiased expectations theory, the liquidity premium theory, and the market segmentation theory. Unbiased Expectations Theory According to the unbiased expectations theory of the term stmucture of interest rates, at a given point in time the yield curve reflects the market’s current expectations of future short-term rates. It is assumed that bonds with different maturity are perfect substitutes. According to this theory, yields tend to change overtime, but the theory fails to define details of yield curve shape. Liquidity Premium Theory The second theory, the liquidity premium theory of the term structure of interest rates, is an extension of the unbiased expectations theory. It is based on the idea that investors will hold long-term maturities only ifthey are offered at a premium to compensate for future uncestainty in a security’s value, which increases with an asset’s maturity. The liquidity premium theory states that long-term rates are equal to geometric averages of current and expected shoit-term rates, plus liquidity risk premiums that increase with the maturity of the security. According to the liquidity premium theory, an upward-sloping yield curve may reflect investors’ expectations that future shoit-term rates will be flat, but because liquidity premiums increase with maturity, the yield curve will nevertheless be upward sloping. Indeed, an upward-sloping yield curve may reflect expectations that future interest rates will rise, be flat , or even fall , as long as the liquidity premium increases with maturity fast enough to produce an upward-sloping yield curve. Market Segmentation Theory The market segmentation theory argues that individual investors and FIs have specific maturity preferences, and to get them to hold securities with maturities other than their most preferred requires a higher interest rate (maturity premium). Accordingly, the market segmentation theory does not consider securities with different maturities as perfect substitutes. The market segmentation theory assumes that investors and borrowers are generally unwilling to shift from one maturity sector to another without adequate compensation in the form of an interest rate premium. As the supply of securities decreases in the short-term market and increases in the long-term market, the slope of the yield curve becomes steeper If the supply of short-term securities had increased while the supply of long-term securities had decreased, the yield curve would have a flatter slope and might even have sloped downward. CHAPTER 3 - MONEY MARKET Money markets exist to transfer funds from individuals, corporations, and government units with short-term excess funds (suppliers of funds) to economic agents who have short-term needs for funds (users of funds). Money market securities have three basic characteristics in common: * They are usually sold in large denominations. * They have low default risk. * They mature in one year or less from their original issue date. Most money market instruments mature in less than 120 days. Money market securities usually have an active secondary market. This means that after the security has been sold initially, it is relatively easy to find buyers who will purchase it in the future. Another characteristic of the money markets is that they are wholesale markets. This means that most transactions are very large, usually in excess of $1 million. The size of these transactions prevents most individual investors from participating directly in the money markets. Instead, dealers and brokers, operating in the trading rooms of large banks and brokerage houses, bring customers together. The Purpose of the Money Markets Eurodollar market than in their domestic market. At the same time the borrower is often able to receive a more favourable rate in the Eurodollar market than in their domestic market. London Interbank Market Eurodollars are an alternative to fed funds. Banks from around the world buy and sell overnight funds in this market. The rate paid by banks buying funds is the London interbank bid rate (LIBID). Funds are offered for sale in this market at the London interbank offer rate (LIBOR). CHAPTER 4- BANKING AND THE MANAGEMENT OF FINANCIAL INSTITUTIONS The Bank Balance Sheet To understand how banking works, we start by looking at the bank balance sheet, a list of the bank” assets and liabilities. As the name implies, this list balances; that is, it has the characteristic that —> total assets = total liabilities + capital. A banks balance sheet is also a list of its sources of bank funds (liabilities) and uses to which the funds are put (assets). Banks obtain funds by borrowing and by issuing other liabilities such as deposits. They then use these funds to acquire assets such as securities and loans. O Liabilities A bank acquires funds by issuing (selling) liabilities, such as deposits, which are the sources of funds the bank uses. The funds obtained from issuing liabilities are used to purchase income-earning assets. * Deposits the primary source of bank funds. There are two basic types of non-transaction deposits: savings accounts and time deposits (also called certificates of deposit, or CDs). Savings accounts (demand deposits) withdrawable on demand with or without interest. Transactions and interest payments are recorded in a monthly statement or in a passbook held by the owner of the account. Time deposits have a fixed maturity length, ranging from several months to over five years, and assess substantial penalties for early withdrawal. Borrowings funds obtained by borrowing from other banks, and corporations. Borrowings from the Fed are called discount loans (also known as advances). More expensive. Other sources of borrowed funds are loans made to banks by their parent companies (bank holding companies), loan arrangements with corporations (such as repurchase agreements), and borrowings of Eurodollars (deposits denominated in U.S. dollars residing in foreign banks or foreign branches of U.S. banks). Other liabilities The final category on the liabilities side of the balance sheet is bank capital, the bank”'s net worth, which equals the difference between total assets and liabilities. A bank”s capital is raised by selling new equity (stock) or from retained earnings. This category includes tax payments that do not require interest to be paid. O Assets A bank uses the funds that it has acquired by issuing liabilities to purchase income-eaming assets. Bank assets are thus naturally referred to as uses of funds, and the interest income earned on them are what enable banks to make profits. * Cash and due from depository institutions or Reserves: deposits plus currency that is physically held by banks (called vault cash because it is stored in bank vaults). Although reserves earn a low interest rate, banks hold them for two reasons. First, some reserves, called required reserves, are held because of reserve requirements, the regulation that for every dollar of checkable deposits at a bank, a certain fraction must be kept as reserves. This fraction is called the required reserve ratio. Banks hold additional reserves, called excess reserves. * Cash Items in Process of Collection is an asset for your bank because it is a claim on another bank for funds that will be paid within a few days. * Deposits at Other Banks in exchange for a variety of services, including check collection, foreign exchange transactions, and help with securities purchases. This is an aspect of a system called correspondent banking. Collectively, reserves, cash items in process of collection, and deposits at other banks are referred to as cash items. * Securi zare an important income-eaming asset. These securities can be classified into three categories: U.S. govemment and agency securities, state and local govemment securities, and other securities. The U.S. government and agency securities are the most liquid because they can be easily traded and conveited into cash with low transaction costs. Because of their high liquidity, shoit-term U.S. government securities are called secondary reserves. Banks hold state and local government securities because state and local governmments are more likely to do business with banks that hold their securities. State and local government and other securities, although tax deductible, are both less marketable (less liquid) and riskier. Loans and loans Banks make their profits primarily by issuing loans. A loan is a liability for the individual or corporation receiving it, but an asset for a bank, because it provides income to the bank. Loans are typically less liquid than other assets because they cannot be tumed into cash until the loan matures. Ifthe bank makes a one-year loan, for example, it cannot get its funds back until the loan comes due in one year. Loans also have a higher probability of default than other assets. Because of the lack of liquidity and higher default risk, the bank earns its highest retum on loans. Leases— the bank as owner of a physical asset, allows a customer to use an asset in return for a periodic lease payment; Basic Banking In general terms, banks make profits by selling liabilities with one set of characteristics and using the proceeds to buy assets with a different set of characteristics. This process is often referred to as asset transformation. Another way this process of asset transformation is described is to say that the bank “borrows short and lends long” because it makes long-term loans and funds them by issuing shoit-dated deposits. —> T account analysis Let's say that Jane Brown has a $100 checkable deposit at the bank, which shows up as a $100 liability on the bank”’s balance sheet. The bank now puts her $100 bill into its vault so that the banks assets rise by the $100 increase in vault cash. Because vault cash is also part ofthe bank's reserves, we can rewrite the T-account as follows: First National Bank Assets Liabilities Vault cash +$100 Checkable deposits +$100 Note that Jane Brown’s opening of a checking account leads to an increase in the bank! reserves equal to the increase in checkable deposits. When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses an equal amount of reserves. Let's retum to the situation when the First National Bank has just received the extra $100 of checkable deposits. As you know, the bank is obliged to keep a certain fraction of its checkable deposits as required reserves. If the fraction (the required reserve ratio) is 10%, the First National Bank's required reserves have increased by $10, and we can rewrite its T-account as follows: First National Bank Assets Liabilities Required reserves +$10 Checkable deposits +$100 Excess reserves +$90 Servicing the extra $100 of checkable deposits is costly, so the bank is taking a loss! One way to do this is to invest in securities. The other is to make loans. Let us assume that the bank chooses not to hold any excess reserves but to make loans instead. The T-account then looks like this: First National Bank Assets Liabilities Required reserves +$10 Checkable deposits +$100 Loans +$90 The bank is now making a profit because it holds short-term liabilities such as checkable deposits and uses the proceeds to buy longer-term assets such as loans with higher interest rates. Bank Management The bank manager has four primary concems. The first is to make sure that the bank has enough ready cash to pay its depositors when there are deposit outflows—that is, when deposits are lost because depositors make withdrawals and demand payment. To keep enough cash on hand, the bank must engage in liquidity management, the acquisition of sufficiently liquid assets to meet the banks obligations to depositors. Second, the bank manager must pursue an acceptably low level of risk by acquiring assets that have a low rate of default and by diversifying asset holdings (asset management). The third concern is to acquire funds at low cost (liability management). Finally, the manager must decide the amount of capital the bank should maintain and then acquire the needed capital (capital adequacy management). * Liquidity Management and the Role of Reserves_ —> the acquisition of sufficiently liquid assets to meet the bank’s obligations to depositors. Suppose that the First National Bank” initial balance sheet is as follows: (just read) Assets Liabilities Reserves $20 million Deposits $100 million Loans $80 million Bank capital $ 10 million Securities $10 million The banks required reserves are 10% of $100 million, or $10 million. Assets Liabilities Reserves $10 million Deposits $90 million Loans $80 million Bank capital $10 million Securities $10 million But because its required reserves are now 10% of only $90 million ($9 million), its reserves still exceed this amount by $1 million. In short, if a bank has ample excess reserves, a deposit outflow does not necessitate changes in other parts ofits balance sheet. The situation is quite different when a bank holds insufficient excess reserves. Let's assume that instead of initially holding $10 million in excess reserves, the First National Bank makes additional loans of $10 million, so that it holds no excess reserves. Its initial balance sheet would then be: Assets Liabilities Reserves $0 Deposits $90 million Loans $90 million Bank capital $10 million Securities $10 million STRATEGY —> Monetary policy operates by steering shoit-term interest rates, thereby influencing economic developments, in order to maintain price stability for the euro area over the medium term. The operational framework ofthe Eurosystem consists of the following set of instruments: . open market operations, ° standing facilities, e Minimumteserve requirements for credit institutions. In addition, since 2009 the ECB has implemented several non-standard monetary policy measures, i.e. asset purchase programmes, to complement the regular operations of the Eurosystem. Transmission Mechanism This is the process through which monetary policy decisions affect the Shocks outside È 1 the control of the economy in general and the price Official interest rates central bank level in particular. The transmission mechanism is characterised by long, Expectations _|— Money market variable and uncertain time lags. interest rates Changes in Thus it is difficult to predict the 2 precise effect of monetary policy [ I I Changes in actions on the economy and price Money, |_J Asset LJ Bank 1..| Exchange bank capital level. credit prices rates rate Changes in the The chart below provides a global economy schematic illustration of the main transmission channels of monetary Wage and Supply and demand in Changes in policy decisions price-setting goods and labour markets fiscal policy The central bank provides funds to = invi Changes in the banking system and charges La commodity prices prices pica interest. Given its monopoly power over the issuing of money, the central bank can fully determine this interest rate. The change in the official interest rates affects directly money-market interest rates and, indirectly, lending and deposit rates, which are set by banks to their customers. Expectations of future official interest-rate changes affect medium and long-term interest rates. In particular, longer-term interest rates depend in pat on market expectations about the future course of short-term rates. Monetary policy can also guide economic agents’ expectations of future inflation and thus influence price developments. A central bank with a high degree of credibility firmly anchors expectations of price stability. In this case, economic agents do not have to increase their prices for fear of higher inflation or reduce them for fear of deflation. The impact on financing conditions in the economy and on market expectations triggered by monetary policy actions may lead to adjustments in asset prices (e.g. stock market prices) and the exchange rate. Changes in the exchange rate can affect inflation directly, insofar as impoited goods are directly used in consumption, but they may also work through other channels. Changes in interest rates affect saving and investment decisions of households and firms. For example, everything else being equal, higher interest rates make it less attractive to take out loans for financing consumption or investment. In addition, consumption and investment are also affected by movements in asset prices via wealth effects and effects on the value of collateral. For example, as equity prices rise, share-owning households become wealthier and may choose to increase their consumption. Conversely, when equity prices fall, households may reduce consumption. Asset prices can also have impact on aggregate demand via the value of collateral that allows bomrowers to get more loans and/or to reduce the risk premia demanded by lenders/banks. For example, higher interest rates increase the risk of borrowers being unable to pay back their loans. Banks may cut back on the amount of funds they lend to households and firms. This may also reduce the consumption and investment by households and firms respectively. Changes in consumption and investment will change the level of domestic demand for goods and services relative to domestic supply. When demand exceeds supply, upward price pressure is likely to occur. In addition, changes in aggregate demand may translate into tighter or looser conditions in labour and intermediate product markets. This in turn can affect price and wage-setting in the respective market. Changes in policy rates can affect banks’ marginal cost for obtaining external finance differently, depending on the level of a bank's own resources, or bank capital. This channel is particularly relevant in bad times such as a financial crisis, when capital is scarcer and banks find it more difficult to raise capital. In addition to the traditional bank lending channel, which focuses on the quantity of loans supplied, a risk- taking channel may exist when banks’ incentive to bear risk related to the provision of loans is affected. The risk-taking channel is thought to operate mainly via two mechanisms. First, low interest rates boost asset and collateral values. This, in conjunction with the belief that the increase in asset values is sustainable, leads both borrowers and banks to accept higher risks. Second, low interest rates make riskier assets more attractive, as agents search for higher yields. In the case of banks, these two effects usually translate into a softening of credit standards, which can lead to an excessive increase in loan supply. Open market operations Open market operations play an impoitant role in steering interest rates, managing the liquidity situation in the market and signalling the monetary policy stance. Five types of financial instrument are available to the Eurosystem for its open market operations. The most important instrument is the reverse transaction which may be conducted in the form of a repurchase agreement or as a collateralised loan. The Eurosystem may also make use of outright transactions, issuance of debt certificates, foreign exchange swaps and collection of fixed-term deposits. Open market operations are initiated by the ECB, which decides on the instrument and the terms and conditions. It is possible to execute open market operations on the basis of standard tenders, quick tenders or bilateral procedures. Four types of open market operation Open market operations can differ in terms of aim, regularity and procedure. @ Main refinancing operations are regular liquidity-providing reverse transactions conducted by the Eurosystem with a frequency and maturity of normally one week. They are executed in a decentralised manner by the national central banks on the basis of standard tenders. The main refinancing operations play a pivotal role in fulfilling the aims of the Eurosystem's open market operations and normally provide the bulk of refinancing to the financial sector. e Longer-term refinancing operations are liquidity-providing reverse transactions with a longer maturity than the main refinancing operations. Regular longer-term refinancing operations have a maturity of three months and are conducted each month by the Eurosystem on the basis of standard tenders in accordance with the indicative calendar on the ECB’s website. The Eurosystem may also conduct non-regular longer-term operations, with a maturity of more than three months. Such operations, with maturities of up to 48 months (the longest being the targeted longer-term refinancing operations, or TLTROs), are not included in the indicative calendar. Longer-term refinancing operations are aimed at providing counterparties with additional longer-term refinancing and can also serve other monetary policy objectives. @ Fine-tuning operations can be executed on an ad hoc basis to manage the liquidity situation in the market and to steer interest rates. In particular, they are aimed at smoothing the effects on interest rates caused by unexpected liquidity fluctuations. Fine-tuning operations are primarily executed as reverse transactions, but may also take the form of foreign exchange swaps or the collection of fixed- term deposits. The instruments and procedures applied in the conduct of fine-tuning operations are adapted to the types of transaction and the specific objectives pursued in performing the operations. Fine-tuning operations are normally executed by the Eurosystem through quick tenders or bilateral procedures. The Eurosystem may select a limited number of counterparties to participate in fine- tuning operations. @ Structural operations can be carried out by the Eurosystem through reverse transactions, outright transactions, and the issuance of debt certificates. These operations are executed whenever the ECB wishes to adjust the structural position of the Eurosystem vis-à-vis the financial sector (on a regular or non-regular basis). Structural operations in the form of reverse transactions and the issuance of debt instruments are carried out by the Eurosystem through standard tenders. Structural operations in the form of outright transactions are normally executed through bilateral procedures. The Eurosystem’s regular open market operations consist of one-week liquidity-providing operations in euro (main refinancing operations, or MROs) as well as three-month liquidity-providing operations in euro (longer-term refinancing operations, or LTROs). MROs serve to steer short-term interest rates, to manage the liquidity situation and to signal the monetary policy stance in the euro area, while LTROs provide additional, longer-term refinancing to the financial sector. Standing Facilities Standing facilities aim to provide and absorb overnight liquidity, signal the general monetary policy stance and bound overnight market interest rates. Two standing facilities, which are administered in a decentralised manner by the NCBs, are available to eligible counterpasties on their own initiative. The Euro-system offers credit institutions two standing facilities: @ Marginal lending facility in order to obtain overnight liquidity from the central bank, against the presentation of sufficient eligible assets; © Depositfacilityinorderto make overnight deposits with the central bank. Marginal lending facility —> Counterparties can use the marginal lending facility to obtain overnight liquidity from the NCBs against eligible assets. The interest rate on the marginal lending facility normally provides a ceiling for the overnight market interest rate. Deposit facility —> Counterparties can use the deposit facility to make overnight deposits with the NCBs. The interest rate on the deposit facility normally provides a floor for the overnight market interest rate Minimum reserves The ECB requires credit institutions established in the euro area to hold deposits on accounts with their national central bank. These are called "minimum" or "required" reserves (MRR). The intent of the minimum reserve system is to pursue the aims of stabilising money market interest rates and creating (or enlarging) a structural liquidity shortage. The reserve requirement of each institution is determined in relation to elements ofits balance sheet. In order to pursue the aim of stabilising interest rates, the Eurosystem's minimum reserve system enables institutions to make use of averaging provisions. This implies that compliance with the reserve requirement is determined on the basis of the institutions’ average daily reserve holdings over a maintenance period of about one month. The reserve maintenance periods stait on the settlement day of the main refinancing operation (MRO) following the Goveming Council meeting at which the monthly assessment of the monetary policy stance is pre-scheduled. The required reserve holdings are remunerated at a level corresponding to the average interest rate over the maintenance period of the main refinancing operations of the Eurosystem. Pandemic emergency purchase programme The ECB’s pandemic emergency purchase programme (PEPP) is a non-standard monetary policy measure initiated in March 2020 to counter the serious risks to the monetary policy transmission mechanism and the outlook for the euro area posed by the coronavirus (COVID-19) outbreak. The PEPP is a temporary asset purchase programme of private and public sector securities. On 4 June 2020 the Governing Council decided to increase the €750 billion envelope for the PEPP by €600 billion to a total of €1,350 billion. All asset categories eligible under the existing asset purchase programme (APP) are also eligible under the new programme. Under the PEPP, a waiver of the eligibility requirements will be granted for securities issued by the Greek Government. In addition, non-financial commercial paper is now eligible for purchases both under the PEPP and the corporate sector purchase programme (CSPP). The residual maturity of public sector securities eligible for purchase under the PEPP ranges from 70 days up to a maximum of 30 years and 364 days. For the purchases of public sector securities under the PEPP, the benchmark allocation across jurisdictions will be the capital key of the national central banks. At the same time, purchases will be conducted in a flexible manner. This allows for fluctuations in the distribution of purchase flows over time, across asset classes and among jurisdictions. The Goveming Council will terminate net asset purchases under the PEPP once it judges that the COVID-19 crisis phase is over, but in any case not before the end of June 2021. The maturing principal payments from securities purchased under the PEPP will be reinvested until at least the end of 2022. In any case, the future 1oll-off ofthe PEPP portfolio will be managed to avoid interference with the appropriate monetary stance. forward hedging. Needless to say, Boeing will not always gain in this mammer. If the spot rate is, say, $1.50/£ on the maturity date, then Boeing could have received $15.0 million by remaining unhedged. Thus, one can say ex post that forward hedging cost Boeing $0.40 million. The gain/loss is computed as follows: Gain = (F2 - S7) x £10 million The gain will be positive as long as the forward exchange rate (F) is greater than the spot rate on the maturity date (57), that is, F. S7, and the gain will be negative (that is, a loss will result) if the opposite holds. the firm theoretically can gain as much as $14.6 million when the pound becomes worthless, which, of course, is ‘unlikely, whereas there is no limit to possible losses. Other minor techniques include: * Cross-Hedging Minor Curency Exposure FT Ifa firm has receivables or payables in major cumencies such as the British pound, euro, and Japanese yen, it can easily use forward, money market, or options contracts to manage its exchange risk exposure. In contrast, if the firm has positions in less liquid currencies such as the Korean won, Thai bhat, and Czech koruna, it may be either very costly or impossible to use financial contracts in these currencies. This is because financial markets of developing countries are relatively underdeveloped and often highly regulated. Facing this situation, the firm may consider using cross-hedging techniques to manage its minor currency exposure. Cross-hedging involves hedging a position in one asset by taking a position in another asset. * Hedging Contingent Exposure FT In addition to providing a flexible hedge against exchange exposure, options con- tracts can also provide an effective hedge against what might be called contingent exposure. Contingent exposure refers to a situation in which the firm may or may not be subject to exchange exposure. * Hedging Recurrent Exposure with Swap Contracts FT Firms often have to deal with a “sequence” of accounts payable or receivable in terms of a foreign currency. Such recurrent cash flows in a foreign cumrency can best be hedged using a currency swap contract, which is an agreement to exchange one currency for another at a predetermined exchange rate, that is, the swap rate, on a sequence of future dates. As such, a swap contract is like a portfolio of forward contracts with different maturities. Swaps are very flexible in terms of amount and maturity;, the maturity can range from a few months to 20 years. Hedging through Invoice Currency OT ‘While such financial hedging instruments as forward, money market, swap, and options contracts are well known, hedging through the choice of invoice currency, an operational technique, has not received much attention. The firm can shifi, share, or diversify exchange risk by appropriately choosing the currency of invoice. Hedging via Lead and Lag OT Another operational technique the firm can use to reduce transaction exposure is leading and lagging foreign currency receipts and payments. To “lead” means to pay or collect early, whereas to “lag” means to pay or collect late. The finn would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and benefit from the appreciation of the hard currency. For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables. To the extent that the firm can effectively implement the lead/lag strategy, the transaction exposure the fimm faces can be reduced. Exposure Netting OT If the firm would like to apply exposure netting aggressively, it helps to centralise the firm’s exchange exposure management function in one location. Many multinational corporations are using a reinvoice- center, a financial subsidiary, as a mechanism for centralising exposure management functions. CHAPTER 8 - MICROFINANCE Microfinance is a banking service provided to unemployed or low-income individuals or groups who otherwise would have no other access to financial services. In addition, allows people to take on reasonable small business loans safely, and in a manner that is consistent with ethical lending practices. GOAL —> to give impoverished people an opportunity to become self-sufficient, especially for women. Despite being excluded from banking services, those who live on as little as $2 a day they do attempt to save, borrow, acquire credit and they do make payment on their debit. Sometimes, poor people look to family, friends and even loan shark for help. This is why Microfinance is the best option for low-income individuals. There are three needs that drive much of the financial activity: 1. Managing basics —> to transform irregular income flows into a resource to meet daily needs; 2. Coping with risk —> dealing with emergencies” 3. Raising lump sums —> seizing opportunities and paying for big-ticket expenses by accumulating usefully large sums of money utilised for life-cycle needs, opportunities and emergencies. Conversely, some people are excluded from financial services. There are 3 different dimension that all help together to understand the boundaries the financial exclusion: * Access to financial services, * Sustainability of this financial services to needs, * The access to usage that are appropriate to a normal life. Some causes: * Geographical access, * Access exclusion * Condition exclusion * Price exclusion * Marketing exclusion * Self-exclusion ‘Why is risky for bank ? Giving credit for poor people is highly risky for many reasons: * Incomplete information about poor people —> risky, lack of information * High transaction costs for small amount of money * Small transactions * Bank cannot monitor the borrower after making the loans = market failure * High interest rate —> it drives safer customers out of the credit market A solution for market failure are the state-owned sectoral banks, fundamental to give credit for poor people. Beginning of Microfinance —> GRAMEEN BANKS in Bangladesh created by Muhammad Yunus. It started lending his money, then he convinced the Bangladesh Banks to set up a special branch to lend to poor borrowers. This type of credit institutions was based on group lending —> 5 poor borrowers as guarantors for each others. Other characteristics regard thee dynamic incentives to faster payment and it is focused on women and low-income households. Microfinance is an effective tool in reducing poveity also it can cope to financial needs and help poor people, but it is not enough to “delete” poverty without adequate policies. Chapter 9 - FINANCIAL SERVICE PROVIDERS COMMUNITY BASED PROVIDERS - INFORMAL FINANCIAL INTERMEDIARIES ( Community-based providers YI Institutional providers ) Community-based groups Individuals Indigenous groups: Registered institutions Regulated institutions Moneylenders ROSCAs, ASCAS Financial cooperatives Deposit-taking MFIs Deposit collectors Burial societies SACCOs Savings and postal banks Pawnbrokers Facilitated groups: Suppliers, buyers State banks Traders CVECAS NGO MFls Commercial microfinance banks Shop owners Friends, Family Savings groups Self-help groups Financial service associations Mutual insurers Money transfer companies Mobile network operators* Non-bank financial institutions Commercial insurers Level of formalization ) Community-based providers offer flexible services that can accommodate uncertain cash flows and provide discipline to encourage regular savings and loan payments. One of the greatest benefits of community-based providers is accessibility, determined by both proximity and product features that suit the needs of poor women and men. Informal or community-based financial service providers can be divided into two broad categories: indigenous and facilitated. 1. Indigenous providers, both individuals and groups, emerge within communities with no extemal input or training. Individual providers such as moneylenders generally offer basic credit services using their own capital. A rotating savings and credit association (ROSCA) pools money to circulate among the members in tum, while a mutual aid society pools member contributions to have funds available to respond to unexpected or emergency expenses. Group members determine the rules that govern the group. Rotating Savings and Credit Associations ROSCAs are the simplest form of financial intermediation: several people form a group and contribute an agreed amount on a regular basis. At each meeting (or round), the money is collected, and the total is given to one member on a rotating basis. When the last member has received the lump sum, the group can choose to stait a new cycle or disband. Transactions take place only during regularly scheduled meetings (often monthly) and are typically witnessed by every member. In addition, since no money is retained by the group, often no records are required (other than possibly the list of who is to receive the funds when), and there is no need to safeguard funds. The system further reduces risk to members because it is time limited—typically lasting no more than 12 months. This mitigates potential losses should a member take the funds early and stop contributing. These characteristics make the system transparent, flexible, and simple, providing a financial service well suited to poor communities with low literacy rates. However, a ROSCA's simplicity is counterbalanced by risk and lack of flexibility: . AIl ROSCA members receive the same amount of money in a predetermined order. Each must wait her tum regardless of need, and there is no flexibility to contribute more or less than the agreed amount. . The fund does not grown value, as no loans are made and no interest is paid. . Those who are last in line of risk not receiving their payout if the group disbands. When a ROSCA collapses, members who have not yet received their proceeds have no recourse. As a result of these limitations, informal secondary markets may be created, whereby one member pays a premium to another member to switch tums. These premiums sometimes exceed 50 percent or more of the value ofthe proceeds. Accumulating Savings and Credit Associations ‘While still indigenous, an ASCA is a more flexible and more complex group savings mechanism than a ROSCA. Like a ROSCA, group members save regularly, but the combined contributions are not distributed at each meeting; instead, savings are pooled for the purpose of lending to members. While all members save, not everyone borrows. Members borrow only when needed, in amounts that they and the rest of the members are confident will be repaid. Members may borrow different amounts on different dates for different periods. Interest payments provide a retum on savings that is shared fairly among the group. ASCAs may be “time-bound,” with members saving, borrowing, and repaying for a predetermined amount of time, usually 6-12 months. However, given the diversity ofindigenous ASCAs, the cycle can vary in length. Depending on the time frame and the simplicity of their structure, ASCAs can operate without keeping any records by periodically dividing the accumulated funds equally. However, more complicated ASCAs require bookkeeping, particularly those that deal in large amounts or operate for long periods of time. 2. Facilitated providers are groups (not individuals) that receive extemal training or assistance, typically provided by nongovemmental organisations (NGOs) or govemment, to develop and implement a process for saving and lending. Many forms of facilitated groups have been introduced over the years, but perhaps the largest, most well- known are India’s Self-Help Groups (SHGs). Examples of facilitated groups in the informal sector include Savings Groups (SGs), SHGs, and community associations. SGs are essentially “time-bound distributing” ASCAs. SHGs are generally not time-bound and are most often linked to banks for access to wholesale loans. They generally rely on ongoing external management, unlike other community-based groups, where the facilitation process normally ends (although SHGs may also require ongoing assistance). By offering financial services to members, many of whom have had limited access to savings and loans, these facilitated groups support financial inclusion. FINANCIAL INSTITUTIONAL PROVIDERS - FORMAL FINANCIAL INSTITUTIONS