Summary - International Financial Markets, Appunti di Finanza

Scarica Summary - International Financial Markets e più Appunti in PDF di Finanza solo su Docsity! 1.Overview of Financial Systems • The Dow Jones Industrial Average (DJIA) (=a price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq) returned to its pre-crisis levels only in 2013. • Changes in the financial institutions (FI) industry: before 1930s the banking industry operated as a full-service industry; after 1930s there was a separation of some of these activities and the rise in mutual funds, brokerage funds…; today: a reversal of these trends thanks to new technologies; after the crisis: regulations are an attempt to again separate FI activities. • Financial System: OECD DEFINITION: consists of institutional units and markets that interact, typically in a complex matter for the purpose of mobilizing funds for investment and providing facilities, including payment systems, for the financing of commercial activity. • Financial institutions (FI): perform the essential function of channeling funds from -those with surplus funds (suppliers of funds; also called users of funds; borrower-spenders; deficit units) -to those with shortages of funds (users of funds; also called suppliers of funds; lender-savers; surplus units). • In a world without FI: only direct transfers would take place. Financial claims would flow directly from users of funds to suppliers of funds, without intermediaries. BUT: financial market activity would likely remain quite low in a world based on direct transfers, Because: a) monitoring costs: collect information to monitor borrowers’ behavior (e.g. making sure they neither steal the funds, nor waste them) would be extremely costly for the single supplier. The problem of asymmetric information, in fact, occurs when one party to an economic transaction possesses greater material knowledge than the other party. Two faces of the problem: -adverse selection: lack of symmetric information occurs prior to a deal between a buyer and a seller; the potential borrowers most likely to produce adverse outcome are the ones most likely to seek a loan (e.g. smoker gaining more from a life insurance company than the one who does not smoke) -moral hazard: a change in the user’s behavior occurs after a deal is struck with a supplier. (e.g. homeowner with a flood insurance will behave less carefully when there is the risk of a flood compared to the one without insurance). b) liquidity costs: the relatively long-term nature of many financial claims creates a disincentive for suppliers of funds, who instead prefer to hold cash to face expenses; c) price risk: the risk that the price at which investors can sell a security on secondary market may be lower than its purchase price. • The indirect transfer (or intermediated financing) happens when funds are transferred between suppliers and users through a financial intermediary. the presence of FI increase the transactions because they perform several services: Services that benefit suppliers of funds 1)lower Monitoring costs Aggregation of funds in an FI provides not only greater incentive to collect a firm’s information and monitor actions (e.g. large FI hire employees specialized in monitoring), but also lower average cost of information through economies of scale. The FI becomes a delegated monitor: an economic agent appointed to act on behalf of smaller investors in collecting information and/or investing funds on their behalf. 2)lower Liquidity and price risk FI perform an asset transformation : transform financial claims issued by users of funds (mortgages, bonds, stocks…) in financial claims that are more attractive to investors (deposits, insurance policies…). Basically they invest in less liquid, high price-risk securities, while offering highly liquid, low price-risk securities. Liquidity and price risk are lowered through diversification : FI exploit the law of large numbers in making their investment decisions, buying a portfolio of investments not perfectly positively correlated with each other; on the contrary, smaller investors are constrained to hold undiversified, thus risky, portfolios. 3) lower Transaction cost services The average transaction cost is lower than for the individual investor because of economies of scale (but today thanks to new technologies and the possibility to direct access to financial markets and online information, these benefits are less predominant) 4) Maturity intermediation Have better ability to bear the risk of mismatching the maturities of their assets and liabilities. 5) Denominated intermediation Many assets sold in very large denominations are out of reach for the individual saver, but not for large FI. Services Benefiting the Overall Economy 1] Transmission of monetary policy Depository institutions are the conduit through which monetary policy actions impact the rest of the financial system and the economy in general. 2]Credit allocation FIs are often viewed as the major, and sometimes only, source of financing for a sector of the economy, such as farming and residential real estate. 3] Intergenerational wealth transfers FIs, especially life insurance companies and pension funds, provide savers with the ability to transfer wealth from one generation to the next. 4] Payment services The efficiency with which depository institutions provide payments services directly benefits the economy. • Intermediation involves several risks: -credit risk: risk of default on a debt that may arise from a borrower failing to make required payments. -foreign exchange risk : when a financial transaction is denominated in a currency, the risk that changes in the currency exchange rates will cause losses; -country or sovereign risk: the risk that a central bank will impose foreign exchange regulations that will reduce or negate the value of forex contracts. -interest rate risk: change in the asset's value resulting from the variability of interest rates. -market risk: the possibility of an investor experiencing losses due to factors that affect the overall performance of the financial markets in which he or she is involved. -off-balance-sheet risk: associated with assets and liabilities held off the balance sheets. -liability withdrawal or liquidity risk: the inability to convert a security or hard asset to cash without a loss of capital and/ or income in the process. -technology risk and operational risk: failures of real resources and back-office support systems. -insolvency risk: when FI has not enough capital reserves to offset a sudden loss incurred. • To prevent these types of market failures and the costs they would impose on the economy and society at large, FI and Financial Markets need to be regulated (even though this imposes private costs and regulatory burdens)!! • Classification of financial institutions: -Depository intuitions: accept deposits: Commercial banks: major assets are loans, mortgages, government securities; major liability are deposits. Savings and Loans associations: major assets are mortgages; major liability are deposits. Mutual savings banks: major assets are mortgages; major liability are deposits . Credit Unions: major assets are consumer loans; major liability are deposits. -Non-depository institutions: do not accept deposits; among these: - contractual savings institutions: acquire funds from clients at periodic intervals on a contractual basis, and have fairly predictable future payout requirements insurance companies: protect individuals and corporations from adverse events. Major assets are bonds and mortgages; major liabilities are premium from policies. pension funds: offer savings plans through which fund participants accumulate savings during their working years before withdrawing them during their retirement years. Major assets are bonds and stocks; major liabilities are employer and employee contributions. - non-contractual savings institutions: securities firms and investment banks mutual funds finance companies hedge funds NB: in the euro area financial intermediaries (banks mostly) are the main agents for channeling funds from savers to borrowers. • • Financial markets: structures through which funds flow. There are several types. • Primary markets: markets in which users of funds (e.g. corporations) raise funds through new issues of financial instruments (e.g. stocks and bonds). 2 -if we do not assume the production function is concave, again, the marginal return of the poor entrepreneur may be lower than the rich one. • In reality poor borrowers have a hard time getting financing from banks and other FIs. Several reasons: 1) Banks have incomplete information about poor borrowers, and cannot say who is a risky and who is a safe customer: -besides, the bank faces higher transaction costs to gather and evaluate information on a big number of small borrowers; -this lead to an increase in the average interest rates charged by the bank; -these high rates scares away the safest customers this is the problem of adverse selection; -banks faces also moral hazard: are unable to ensure that customers are making the full efforts required for their investment projects to be successful + difficulties of enforcing contracts in poor countries because of a poor judicial system. 2) Poor borrowers do not have marketable assets to offer as collaterals (to compensate for the risk rising from the lack of information)poverty feeds itself =BANKS PREFER NOT TO LEND TO POOR • Other factors of financial exclusion: -geographical access : the potential customer lives too far from the FIs and has problem reaching them; -access exclusion: restricted access because of the process of risk assessment; -condition exclusion: the conditions attached to financial products are unsuitable for some people; -price exclusion: some people can only access financial products at prices that cannot afford; -marketing exclusion: some people are excluded by targeted marketing and sales; -self-exclusion: people decide that there is no point in applying for a financial product because they believe that they would be refused. • Solutions to Market Failures • Normally poor borrowers borrow money from informal sources: moneylenders, neighbors, relatives, local traders… problems: have the information, but their resources are limited • After WWII Large state agricultural banks were created to allocate funds for the development of the agricultural sectors, but the majority of the projects FAILED or even HARMED THE POORS: main characteristics: -banks received subsidies by the government to compensate for high risk/high transaction costs; -this led to charging low interest rates (or even negative real interest rates!) to borrowers, and to a surge in demand; -credits was more often than not allocated on the basis of political ties, or social concerns (e.g. India’s Integrated Rural Development Program IRDP during the 1970s-80s: 30% of funds allocated toward socially excluded groups; 30% toward women). problems: -credit was not allocated to the most efficient entrepreneurs: good projects unfunded; -low repayment rates (default rates between 40 and 95% in Africa, Middle East, Latin America, South and South East Asia!) because banks were not pressed to achieve efficiency but relied on the subsidies, and they tended to forgive loans before elections; -No incentives for banks to collect savings deposits (as they could rely on government funds) did not provide poor households with the instruments they needed. • The beginnings of microfinance • Microfinance institutions: NGOs, non-banking financial institutions, credit unions, specialized banks… • Grameen Bank is the first example of microfinance: -after Bangladesh gained independence in 1971, it was stricken by a flooding that triggered a famine; -this inspired prof. Muhammad Yunus (Nobel Peace Prize in 2006) to start a pilot program in his region, Jobra: he started lending money from his own pocket to poor villagers that wanted to run business activities (e.g. rice husking, bamboo weaving…). -then he convinced the Bangladesh Bank to set up a special branch to lend to poor borrowers, the Grameen Bank. • The classic Grameen contract: is based on group lending. -Each group accounts for 5 members: first a loan is granted to the first 2 members, then to another 2, finally to the 5th. -The cycle of lending, however, occurs as long as loans are being repaid. If one member defaults and fellow group members do not pay off her debt (as they are “jointly liable” for the members’ loans), all in the group are denied subsequent loans. This gives members incentives to select responsible partners in the first place, and to support and monitor their fellows. -Payments occurs weekly and are made in public: each 5-member groups is part of a “center” composed of 8 groups, that meet weekly to witness that repayments are being made. -there are also dynamic incentives, because the loan size granted to the group increase if the customers demonstrate reliability. -the focus is on women (95% of the customer base), who are more reliable customers than their husbands, and improve social impacts. this mechanism works because it takes advantage of local information, peer support and peer pressure. • Recently there are 2 trends: -a shift from only “social collateral” mechanism to more focus on small loans to the individuals; -a shift form just microcredit to microfinance. • Microcredit vs. Microfinance • These two words are often used interchangeably, but they have different meanings: a) microcredit: small loans to poor people, excluded form the mainstream financial system, mainly for income generating activities, such as purchasing productive assets for running a “microenterprise” (like those provided by Grameen Bank); b) microfinance: financial facilities for financially excluded people (not only loans, but also deposits and microinsurance). • there is a whole debate about what the poor need: -to some scholars, the poor live so close to subsistence that saving is impossible, thus, they need loans (not savings facilities); -to others, the poor could save if only the had the means; since they rarely use loans in a productive way, savings facilities it’s what they need the most. maybe a combination of the two would be appropriate, as behavioral economies shows there are close linkages between borrowing and saving. • Recently there has been a trend of commercialization in microfinance: micro lenders are transforming from nonprofit to regulated institutions, or banks are adding microfinance industry to their operations. On one hand, this is positive: access to commercial funding fivers microfinance institutions freedom from reliance on donor support and subsidies. On the other hand: only lenders with proved profitability can have access to commercial funding, and in order to achieve that micro lenders are raising their interest rates…to many this is a “mission drift”. • DATA from the Microcredit Summit Campaign Report 2013: -total borrowers: 211 billion, 75% of which women; -Grameen Bank is the first in terms of customers; -Almost 89% of the institutions are concentrated in Asia and Pacific (with India and Bangladesh on top). 2.1The Portfolios of the Poor (Collins et al., 2009) • According to the World Bank data in 2005: -2.5 billion people lived with less than 2 $ a day per person; -1.1 billion people lived with less than 1 $ a day per person. (poverty benchmarks se by the Millennium Development Goals of the UNare based on purchasing power parity (PPP) exchange rates: are adjusted dollars to account for the greater purchasing power present in the poor countries, compared to what market rates imply. Of course these PPP factor have limitations: 1) are based on baskets of goods reflecting the consumption patterns of the entire population (and not only the poor!); 2)were based in 1993 dollars; 3)the international poverty line was achieved looking at the median poverty line of the 10 poorest countries in the world, but this was 1.08 dollar-per-day-per-person (not 1$) and 2.15 dollar-per- day-per-person (not 2$).) • Normally if you are in this category you are a casually or part-time or self-employed in the informal sector. The bulk of poor people resources are spent on food, but how do poor people manage their money to afford other needs and to face emergencies? Traditional surveys do not help much in understanding the poor financial behavior and the day-to-day nature of poverty. 6 • This research shed light on the fact that most of the poor households rarely consume all the money earned: at some point they cross path with a financial institution, a moneylender, a saving-and-loan club, they borrow from a neighbor…so they divert their money either into savings or they use it to pay down loans. • Two things emerge: -money management for the poor is a fundamental part of everyday lifewhen you have small, irregular and unpredictable income money management is everything; -poor households are frustrated by the poor quality of the instruments they use to manage their incomeswe could argue that poor people need financial services more than any other groups! =So, if poor households enjoyed assured access to better financial tools, their chances of improving their lives would surely be much higher. • Financial diaries: research technique. It involves the construction of “diaries” based on interviews to poor households surveyed (in South Africa, Bangladesh and India) about what they were doing with their money. Data collection happened every 2 weeks. Tools like balance sheets and cash-flow statements were created to understand the financial behavior of 250 families. • Authors considered the financial activities of poor households as portfolios composed of a mix of instruments, and then tracked those mixed over time to discover how they were deployed. • In fact, the surveyed families used no less than 4 different types of financial instruments, which ranged from more formal (microfinance) to informal (moneylenders, storing money in their house, …). • Another finding: price of a financial service is less important to poor households than having a repayment schedule that matches installments to the household’s cash flow. Also, they do not consider interest paid on very short-duration loans in terms of annualized interest rate, but as one-time feesHere is why they often prefer moneylenders compared to microfinance. • The need of the poor to save and borrow was dictated by a “triple whammy”: -their income is low; -their income is irregular and unpredictable; -they have a lack of financial tools they can access. • 3 needs drive much of the financial activity of the poor households: 1. Managing basics: cash-flow management is needed to transform irregular income flows into a dependable resource to meet daily needsshort-term money management: need financial instruments that can access freely and frequently (e.g. hide savings at home or entrust cash to their next-door neighbor); 2.Coping with risk: dealing with the emergencies that can derail families with little in reservelong-term money management: need financial instruments that have structure and help their self-discipline (e.g. bigger loans with money- lenders); 3. Raising lump sums: seizing opportunities and paying for big expenses by accumulating usefully large sums of moneylong-term money management: same. • The idea that poor households are bankable has been widely embraced recently. It seems these families need not only loans but all types of savings and borrowing mechanisms + more reliable financial partners. 3.Financial Service Providers • Providers of Financial Intermediation Services are different, and we can classify them based on the degree of formality: (put here table p. 150 reading “community-based providers”) • Informal financial service providers are also called community-based providers. They are: -not supervised / not regulated; -services: loans and deposits for small firms / poor households; -based on social sanctions instead of legal enforcement; -flexible and fit to the client’s situation, but sometimes unreliable. PROs CONs -limited product offering associations, credit unions, building societies…). All participants are shareholders in the cooperatives: they buy shares whose value is set by the cooperative and is the same for all members. They also have equal voting rights (one share=one vote). The founding comes primarily from equity, but limited amounts can come from external sources as well. Services offered are mainly providing loans at lower interest rates than MFIs. Excess earnings can be reinvested in the cooperative, that returns them to members under the form of dividends. They can be very small to very large. They are subject to the country’s laws and pay taxes; normally the bigger ones are subject to more government supervision. Governance is delegated to a board elected by the members – this often triggers bad governance and principal-agent problems! They could be affiliated with an Apex institution, that represent the cooperative at national level, provides training and technical assistance, act as central deposit and inter-lending facility, allow economies of scale… -NGOs MFIs and Multipurpose NGOs: nonprofit organizations that provide social and economic services. Are not member owned and managed: there is a board appointed by the founder(s), who act as shareholders. They differ in the level of formality (are registered under national laws; are overseen by government bodies or international networks, but typically are not supervised by the central banks) and size. They are limited in the services that can offer: normally only credit, especially microenterprise loans. The funding structure is a mix of grants, debts and accumulated equity; they may depend heavily on donors seen that they are limited to borrow commercially (although a few are able to issue bonds). They have a low level of formalization, which allow them to be more fit to respond to the poor needs. Management is often weak, especially when they grow in size. NGOs are nowadays less and less involved in microfinance, concentrating more on other services. -Deposit-taking MFIs: can be set up as greenfield institutions (by a bank or operate under a special category for deposit- taking MFIs) or be transformed from an NGO (even though this is time-consuming and costly, because a change in the governance structure and the development of front-office and back-office operations is required). It is subject to regulatory approval to be able to mobilize and intermediate deposits (but also providing loans, insurance and other payment services). Is subject to control by the central bank. It is funded both through earnings and deposits, and other forms of debt. -Banks: licensed and regulated by the central bank or other agency/ministry; “microfinance banks” outreach customers not normally reached by traditional formal financial institutions. Several types: Rural and community banks: operate in rural areas and serve farmers. Are usually part of rural development strategies set up by national governments. Can be either government owner, member owned or privately owned. Are often part of an apex institution or association. Are often smaller institutions and offer more limited products compared to commercial products (short- and long-term savings products, investment and consumption loans with a focus on agriculture and trading, maybe money transfers and payments); Savings banks: operate in broad geographic areas, with large branch networks, so they enjoy better geographic proximity. They are usually not profit maximisers, but serve clients not served by other banks. Their savings services usually have low minimum balance requirements and low or no fees. Can often provide additional services such as financial education programs. Among these of particular importance are postal savings banks: in addition to their core postal activity, they can provide financial services (payment and money transfers, saving services in small amounts, credit or insurance products…) often on behalf of a commercial bank. Often they are wholly or majority owned by governments, and are supervised by specialized units of the central bank or by separate government agencies. In 2010 post offices had twice the number of commercial bank branches! State banks: public or semipublic entities, owned and controlled primarily by the government. They are funded largely by investment of public funds, as well as deposits. They include agriculture banks, development banks, postal banks and even commercial state banks. They have often been established to correct market failures or to provide resources to underserved or high-priority sectors. More often than not they do not operate profitably: they rely on government guarantee, have poor collection practices and frequent forgiveness schemes, are reluctant to operate under prudent financial management and accounting practices. Then, political ties may compromise full transparency, and board members may be appointed more on political criteria, rather than their professional skills. Private commercial banks: are only starting to be involved in microfinance. They operate mainly in urban areas and have wealthier clientele. Offer a full range of financial services (payments, credit, savings). They are more highly leveraged, given that they can access to different sources of funding: equity or debt. They engage in microfinance in 3 ways: 1)by expanding their product offering to microclients either through the creation of a separate internal unit or through a new subsidiary (DOWNSCALING). The new subsidiary might be held by the parent bank + other specialized consulting firms that will manage the new subsidiary. In order to effectively downscale, a commercial bank need to make profound changes in its organization and the products offered. E.g. loan products must take into accounts that most micro clients do not have collaterals; savings services need to have lower or no minimum balances; pricing may need to be adapted; there is a need to focus on household cash flows. 10 2) by creating a new institution for the specific purpose of offering regulated formal financial services to the poor (GREENFIELDING). Often, they take the structure of holding companies, in which the sponsor or primary shareholder provide the technical expertise, while other like-minded investors (foreign entities or local partners) provide other forms of funding/expertise. After the foundation stage, operation breakeven is expected by the 3rd/4th year, while another injection of capital is usually needed by the 6th year. 3) by establishing an AGENCY RELATIONSHIP with an experienced microfinance organization or other provider. Microfinance clients engage directly with the partner organization acting as the bank’s agent; loans and savings are bookend on the balance sheet of the bank. Usually partners operate on a fee-for-service basis, being rewarded by the bank for each new loan. Partners knows low-income clients better. They can be MFIs, SACCOs, or even other banks (“corresponding banking”: a bank performs services for another bank located in a different city or country, enabling banks to extend their geographic coverage without having to invest in physical infrastructure). Benefits are reciprocal (e.g. money transfer companies such as MoneyGram or Western Union often arrange to have a kiosk located within the branch of a bank). -Other non-bank financial institutions (NBFIs): include leasing companies, insurance companies, specialist credit companies such as finance companies, consumer credit companies, suppliers and buyers. Normally they are restricted by law in the range of services they can offer (normally not intermediation of deposits), therefore it is easier to have get a license for a NBFIs and they have lowed initial capital requirements. Leasing companies: private, are only started engaging with low-income clients. Under a leasing model, the company retains ownership of the leased asset, which is generally used as collateral for the transaction; the lessee pays a certain amount periodically until she owns the asset. Finance and Consumer Credit Companies: used to purchase consumer durable goods; they are associated with consumer credit and installment contracts. Can be specialized consumer finance companies, or supplier credit and retail stores. Suppliers and Buyers: normally credit is granted in existing business relations among the members of the same value chain. For example, supplier credit is provided by input suppliers and wholesalers (e.g. seed supplier provide seeds to farmers and will get his payment at the time of harvest – of course the price of the seeds will include the financing costs), but also exporters, processors and buyers. Insurance companies: several actors can be included in ‘microfinance’, some profits-driven (Commercial Insurance Providers) or nonprofit (NGO Insurance Providers or Mutual Insurers). Normally the insurance activity involves at least two organizations: the insurer, that carrier the risk, design and develop the products; the delivery channel, that sells the product and provides after-sales services (can be MFIs, cooperatives, churches, post offices…). Regulated insurances have the possibility to access reinsurance, a risk management tool whereby one insurance company purchases insurance from another insurance company. Payment service providers: a wide range of actors that offer services called electronic transfer of funds, or money transfers, transfer services, transactions, mobile money. Can be either money transfer companies (often the only means of unbanked customers), post offices (so-called “giro” transfers), banks (through their current accounts) or other internet networks or mobile network operators (MNOs) (seen the recent trend of offering payment services using mobile phones). 4.Fundacion Integral Campesina (FINCA) Costa Rica, case study • Already a scheme 5. Credit and Savings Products Copy slides for Credit • Savings • Savings: more general term used when discussing a broad set of activities related to holding assets stored by others • Deposits: the portion of savings held in financial institutions. • Overall: mobilizing deposits is way more difficult than providing credit: -providing credit: need to select borrowers that lenders might trust; -mobilizing deposit: the customers must trust the service provider. • Savings and the poor • Since the 1970s the importance of saving has been overlooked: -poor households lack the resources to save -access to credit is supposed to have more positive social and economic impacts. -most NGOs were (and still are) allowed to lend, but not to collect deposits. • Some changes have occurred: -it has been noticed that also the very poor household save (often save and borrow simultaneously); -new saving devices have been developed; -also insurance services have been created. • Why save: saving is important at least for 3 reasons: 1)to smooth consumption: saving and withdrawing money when needed (a mechanism of “accumulation before expenditure”; Also borrowing is actually a way to smoot consumption: borrowing when money is needed and then repaya mechanism known as “expenditure before accumulation”); 2)to enhance productivitytaking advantage of investment opportunities; 3) to being protected against shocks. • Saving constraints: • 1) lack of formal savings institutions: -existing formal institutions: not preferred (complicated procedures and document requirements; often amounts are so small that is not worth paying transaction costs; difficulties in reaching the provider…) besides what the poor value the most in a saving system: convenience, access (proximity), instilling discipline and securityover interest, earnings. • 2) Informal savings mechanisms are not convenient nor reliable, and pay no interest on the deposit e.g. savings in kind, livestock (but is not safe + there are costs associated with food, water, shelter, grazing land…) or jewelry (good to avoid risks posed by inflation, but high risk of theft, fraud…), reciprocal arrangements with neighbors… • 3) uncertainty about the future • 4) social arrangements • 5) lack of discipline. • To overcome saving constraints: 1) restricted access to deposits 2) deposit reminders: offered by institutions to make a scheduled deposit. 3) mental accounting: the tendency to treat funds differently based on their source or intended use. Different saving accounts for different sues. • Institutional capacity: for FIs in order to offer deposit services to the public must be licensed to do so. 5 main conditions need to be met to be licensed: -1.the political economya minimum political and macroeconomic stability is needed; -2.the policy and regulatory environmentshould be adequate, with liberalized interest rates and regulations. -3.public supervision banking supervision by government authorities and the application of high standards protect the customers; -4.strong institutional performance recordhigh-quality governance, management capacity, high-level performance and transparency, high rate of loan recovery, regular good returns, financial self-sufficiency. -5.preparation for far-reaching changeswillingness to changes in terms of governance and institution’s organization, leadership, infrastructure… • Furthermore to be able to meet the poor’s need banks should be able to: -attract a large number of poor’s depositssince the poor have small accounts, a large number of small savers can help spreading out high transaction costs; and also reduce the risk of liquidity; -attract differentiated depositsoffering services for both rich and poor, organizations and institutions helps avoiding risk of liquidity; -having management skillsnot only strong financial capabilities, but adequate understanding of local markets; -having sufficient reserves, capital and operating fundsto cover any operating losses or losses due to catastrophic events without using client deposits; -ensure physical security and accessibility of fundsadequate protection to inspire clients’ trust, make withdrawals simple 12 • THE MONEY MARKET CHANNEL: the money issued by the central bank (base money) serves to banks to meet the public demand for currency, to clear interbank balances, to meet the requirements for minimum reserves. So, there is a direct influence on money market interest rates, whose conditions will indirectly affect: -money credit: the costs of short-term loans and deposits offered by the banks, because if the official interest rates are higher, banks will pass on these costs when lending to their customers. Also the quantity available for lending will be affected; -asset prices: there is an inverse relations between security prices and interest rates. This factor affect the wealth of those who have purchased assets (households, firms…), but also the market value of banks that have these assets in their balance sheets; -bank rates; all these 3 last factors have an influence on wage and price-setting, that in turn influence domestic prices, and thus price developments. -exchange rates: in general, and holding everything else constant, if a country’s interest rates are higher, this country’s currency will appreciate. This will influence the supply and demand in goods and labor markets, as it will have a direct influence on domestic prices and an indirect influence on import prices, with an overall influence on price developments. • THE EXPECTATION CHANNEL: • Influence the private sector’s short and medium-term expectations about interest ratesaccording to the yield curve, for medium term maturities (up to 2,3,5 years) interest rates depends on expectations. [The monetary policy can do little about longer-term expectations instead, as in this case the development of interest rates depends more on real factors!] • Also, influence the expectations about inflation: If the commitment to maintain price stability is strong, inflation expectations will remain anchored to price stability. This will influence wage and price-setting, that will not have to adjust for fear of higher inflation in the future. • Overall, Depends on the credibility of the central bank. • EXTERNAL SHOCKS OUTSIDE THE CONTROL OF CENTRAL BANK: they influence price developments, but are outside the control of monetary policies applied by the central bank, such as: -changes in risk premia (e.g. when there is a sovereign dept crisis, risk premia goes up, and since risk premia are a component of interest rates, interest rates also go up); -changes in bank capital (tend to influence they way in which banks fund their activities, choosing to rely more or less on money markets); -changes in the global economy; -changes in fiscal policy; -changes in commodity prices; =usually for all these external shocks the central bank is required to apply non-standard measures. • The way transmission mechanism works is still under study. Through numerous studies carried on by the ECB and through experience, it has been noticed that: 1)long and uncertain lags exist also in the euro area; 2)in normal times, monetary policy affects the economy mainly through the interest rate channel (a tightening of monetary policya decrease in output, that reaches it maximum after one or two yearsa more gradual decline of prices); 3)also the credit channel is relevant (interest rate changes affect the firms’ cash flows and the supply of bank loans). • General principles of ECB monetary policy strategy 1-monetary policy works better when the money markets are functioning (and this depends on the behavior of banks and on their willingness to entertain smooth exchanges of liquidity in the interbank market); 2-changes in the monetary policy affect prices only after a number of quarters or years thus monetary policy must be forward-looking and pre-emptive; 3-monetary policy should have a medium-term orientation (because lags make it impossible to offset unanticipated shocks in the short run, and in the longer run there are large elements of uncertainty); 4-monetary policy should firmly anchor inflation expectations of the economic actors to be effective (ECB should specify its goal, and communicate clearly and openly); 5-monetary policy should be broadly based since it faces many uncertainties. • ECB monetary policy strategy has a euro-area wide focus (=it aims at achieving price stability for the aggregate economy). It is composed of 2 main elements: 1)-a quantitative definition of price stability: they have provided a definition to both: making it easy to understand monetary policy (thus, anchoring inflation expectations of the economic actors) and to make ECB more accountable, and its policy transparent. -Definition of 1998: “Price stability:=a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area below 2%. Price stability is to be maintained over the medium term”. -Added in 2003: “inflation rates have to be maintained below, but close to, 2% over the medium term”. [some considerations: the HICP data are elaborated by Eurostat in collaboration with the national statistical institutes. It is the index that most closely approximates the changes over time in the price of a representative basket of consumer expenditures (58% are goods, 42% are services; individual components such as energy, processed and unprocessed food, housing services, transports…can be identified). Together with this index also the “core inflation index” (that exclude certain volatile components from the basket, such as energy and unprocessed food) is considered. the definition implies also that: -deflation (=a self-sustaining fall in the broad price index ) is excluded, it is inconsistent with price stability. In this situation, the weakness of monetary policy is shown: it is more difficult for monetary policy to fight deflation than to fight inflation. When interest rates fall to levels very close to zero, any attempt to bring the nominal interest rate below zero would fail, as the public would prefer to hold cash rather than to lend or hold deposits at a negative rate. Solutions are possible, but these stimulating monetary policy actions are very costly!; -potential measurement bias are taken into account (e.g. small but positive bias in the measurement of HICP due to not taking into account the changes in the quality of the goods); -implications of inflation differentials in the euro area are also considered. Due to differences in demographic trends, or long-term catching-up processes, or ongoing adjustments…there are inflation differentials across regions in the union, which cannot be addressed by the monetary policy of the ECB, but rather should be addressed by domestic policies. To many, though, the ECB’s monetary policy should aim to achieve “an inflation rate for the area as a whole that is high enough to prevent regions with structurally lower inflation rates from having to meet the costs of possible downward nominal rigidities or entering periods of protracted deflation”. The rule of below 2% does also provide that. -the “medium term” is not specified in terms of a predetermined time horizon. This takes into account that the transmission lags are long, variable and uncertain, so it gives the ECB more flexibility. 2)--a two-pillar approach to the analysis of the risk to price stability. The two-pillar framework is a tool used by the Governing Council to organize, evaluating, and cross-checking all information relevant for assessing the risk to price stability; in this way, no relevant information is lost! It is based on 2 analytical perspectives: the economic analysis: aimed at assessing the short to medium-term determinants of price developments. -Basically, it assess the dynamics of real activity and the likely development of prices from the perspective of the interplay of supply and demand in the goods, services and factor markets. The economic and financial variable analyzed are many: 1. aggregated demand and its components, 2. fiscal policy, 3. capital and labor market conditions, 4.a range of price and cost indicators, 5. developments in the exchange rate and balance of payments, 6. developments in the financial market indicators* and asset prices and financial yields,...). -The goal is revealing the nature of the shocks. -Several statistics are used in the process (from general economic statistics, to monetary statistics and those related to FIs, balance of payment statistics, euro area accounts, government finance statistics, and even ECB’s own surveys such as the Survey of Professional Forecasters (SPF) which provides information on expectations regarding euro area inflation, GDP growth and unemployment rates by sector). -The ECB publishes macroeconomic projections aimed at summarizing the overall situation, four times a year in its Monthly Bulletin. Of course they are not free from limitations, as they are a simplification of reality, based on models that cannot incorporate all the information and are always based on specific assumptions. -Overall, the ECB economic analysis has been enhanced over time. [*for example, to extract information from financial market prices about the changes in investors’ inflation expectations we look at the break-even inflation rate (BEIR)= the difference between a conventional nominal and an inflation-linked bond yield with the same residual maturity, which represents investors’ inflation expectations and related inflation risk premia. OR we can look at the inflation swap rates= derivative instruments under which the two contract parties agree to exchange a fixed payment with a payment that is linked to actual inflation developments during the contract period] -the monetary analysis: focuses on a medium to longer-term horizon. Is a way of cross-checking the indications derived from the economic analysis. 16 • [other possible monetary policy strategies: but that haven’t been adopted cause they would not work for EU… monetary targeting: a central bank changes interest rates in an attempt to speed up or slow down monetary growth to a specific and pre-announced rate; direct inflation targeting: a central bank communicate monetary policy decisions in terms of a more or less mechanical reaction to deviations in a forecast for a measure of inflation from the inflation target at a particular horizon. exchange rate targeting: it works for small open economies, but not for EU (large and relatively closed).] • Monetary policy implementation -The operational framework comprises a set of instruments and procedures which the Eurosystem uses to steer interest rates, manage liquidity in the money market and signal monetary policy intentions. It determines how to achieve the interest rate level, previously determined through the strategy, using the available monetary policy instruments and procedures. [instead, the strategy determined which level of money market interest rates is required to maintain price stability over the medium term.] -Main tasks of the operational framework: 1) steering short-term interest rates and managing liquidity: ECB has the monopoly on the monetary base (=banknotes and coins in circulation, reserves held by counterparties with the Eurosystem, recourse by credit institutions tot eh Eurosystem’s deposit facility), so it allocates an amount of liquidity to allow euro area credit institutions to fulfil their liquidity needs; 2) signaling the monetary policy stance: by changing the conditions under which is willing to enter into transactions with credit institutions; 3) ensuring an orderly functioning of the money market. -Key principles of the operational framework: 1.operational efficiency: the capacity of the operational framework to enable monetary policy decisions to feed through as precisely and as quickly as possible to short-term money market rates. 2.separation between monetary policy decisions that are geared towards the maintenance of price stability and liquidity operations intended to keep market interest rates close to the level determined; 3.market orientation : act in accordance to the principles of market-oriented economy and free competition; 4.equal treatment of financial institutions :credit institutions must be treated equally across the euro area, irrespective of their size or location 5.harmonisation of rules and procedures throughout the euro area: aims to ensure equal treatment by providing identical conditions for all credit institutions in the euro area; 6.simplicity and transparency: ensure that financial market participants understand the intentions behind monetary policy operations; 7.continuity: requires the avoidance of frequent and major adjustments in instruments and procedures, so that central banks and their counterparties can rely on past experience when participating in monetary policy operations; 8.safety: quriesystem0s financial and operations risks must be kept to a minimum; 9.cost efficiency: should ensure low operational costs for both the Eurosystem and tis counterparties arising from the operational framework; 10. Decentralization of the implementation of monetary policy: ECB coordinates the operations, by the transactions are implemented by the NCBs. • Operations used • To achieve its objectives, the Eurosystem standard tools are: 1) conducing open market operations; 2) offering standing facilities (lending and deposit facilities); 3) requiring credit institutions to hold minimum reserves on accounts with the Eurosystem. The official interest rates and reserve requirementsinfluence banks’ assets and liabilities influence monetary base and price developments. • 1) OPEN MARKET OPERATIONS: central bank’s purchase or sale of bonds in the open market. it lead to an increase/decrease in the quantity of money in circulation: 1.purcahse of bonds=increase the money supply, because they pay money to purchase bonds from banks; 2.sales of bonds=decrease the money supply, because the central bank pay offers bonds and banks pay them for obtaining these bonds.