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Money and Banking

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Money & Banking ­ MGT411
VU
Lesson 29
THE GOVERNMENT SAFETY NET
There are three reasons for the government to get involved in the financial system
To protect investors
To protect bank customers from monopolistic exploitation
To ensure the stability of the financial system
Investor Protection
Small investors are unable to judge the soundness of financial institutions
In practice only force of law ensure the bank's integrity, thus investors rely on government to
protect them from mismanagement and malfeasance
Protection from monopolistic exploitation
Monopolists exploit their customers by raising prices to earn unwarranted profits
Government intervenes to prevent firms in an industry from becoming too large. The same may
apply to banks as well
Stability of financial system
Liquidity risk and information asymmetry indicate the instability of financial system
Financial institution can create and destroy the value of its assets in a very short period, and a
single firm's failure can bring down the whole system
Government officials employ a combination of strategies to protect investors and ensure the
stability of the financial system
They provide the safety net to insure small depositors
They operate as the lender of last resort
The Unique Role of Depository Institutions
Depository institutions receive a disproportionate amount of attention from government
regulators because
They play a central role in the economy
They face a unique set of problems
We all rely heavily on banks for access to the payments system
Banks are also prone to runs, as they hold illiquid assets to back their liquid liabilities,
promising full and constant value to the depositors based on assets of uncertain value
They are linked to each other both on their balance sheets and in their customers' minds;
This interconnectedness of banks is almost unique to the financial industry
The Government as Lender of Last Resort
The best way to stop a bank failure from turning into a panic is to make sure solvent institutions
can meet their depositors' withdrawal demands
The existence of a lender of last resort significantly reduces, but does not eliminate, contagion
For the system to work, central bank officials who approve the loan applications must be able to
distinguish an illiquid from an insolvent institution
It is important for a lender of last resort to operate in a manner that minimizes the tendency for
bankers to take too much risk in their operations
Problems Created by the Government Safety Net
Protected depositors have no incentive to monitor their banks' behavior, and knowing this,
banks take on more risk than they would normally
In protecting depositors the government creates moral hazard
Some banks are too big to fail, meaning that their failure would cause havoc in the financial
system.
The managers of such institutions know that if they begin to founder the government will have
to bail them out
The too-big-to-fail policy limits the extent of the market discipline that depositors can impose
on banks and compounds the moral hazard problem
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Money & Banking ­ MGT411
VU
Regulation and Supervision of the Financial System
Government officials employ three strategies to ensure that the risks created by the safety net
are contained:
Regulation establishes rules for bank managers to follow,
Supervision provides general oversight of financial institutions,
Examination provides detailed information on the firms' operations
Regulatory requirements are designed to minimize the cost of failures to the tax-paying public
One example of regulation is the requirement that banks obtain a charter in order to operate;
This provides screening to make sure that the people who own and run banks will not be
criminals.
Once a bank is operating other regulations control the assets, the amount of capital, and makes
information about the bank's balance sheet public
Government supervisors enforce the regulations;
They monitor, inspect, and examine banks to make sure that their business practices conform to
regulatory requirements
State Bank of Pakistan (SBP) is supreme regulatory authority for banking sector in Pakistan
www.sbp.org.pk
Asset Holding Restrictions and Minimum Capital
Requirements
The simplest way to prevent bankers from exploiting their safety net is to restrict banks' balance
sheets;
This can be through restrictions on the kinds of assets banks can hold and requirements that they
maintain minimum levels of capital
The size of the loans a bank can make to particular borrowers is also limited
Minimum capital requirements complement these limitations on bank assets
Capital serves as a cushion against declines in the value of the bank's assets, lowering the
likelihood of the bank's failure, and is a way to reduce the problem of moral hazard
Capital requirements take two basic forms:
The first requires banks to keep their ratio of capital to assets above some minimum level
regardless of the structure of their balance sheets;
The second requires banks to hold capital in proportion to the riskiness of their operations
Banks must provide information to the financial markets about their balance sheets;
Supervision and Examination
The government enforces banking rules and regulations through an elaborate oversight process
called supervision, which relies on a combination of monitoring and inspection
Supervision is done remotely, through an examination of the detailed reports banks must
submit, as well as through on-site examination
At the largest institutions, examiners are on site all the time; this is called continuous
examination
The most important part of a bank examination is the evaluation of past-due loans, to see if they
should be declared in default
Supervisors use the acronym CAMELS to describe the criteria used to evaluate the health of the
bank:
Capital adequacy,
Asset quality,
Management,
Earnings,
Liquidity,
Sensitivity to risk
Current practice is for examiners to act as consultants to banks, advising them on how to get the
highest return possible while keeping risk at an acceptable level that ensures the bank will stay
in business
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Table of Contents:
  1. TEXT AND REFERENCE MATERIAL & FIVE PARTS OF THE FINANCIAL SYSTEM
  2. FIVE CORE PRINCIPLES OF MONEY AND BANKING:Time has Value
  3. MONEY & THE PAYMENT SYSTEM:Distinctions among Money, Wealth, and Income
  4. OTHER FORMS OF PAYMENTS:Electronic Funds Transfer, E-money
  5. FINANCIAL INTERMEDIARIES:Indirect Finance, Financial and Economic Development
  6. FINANCIAL INSTRUMENTS & FINANCIAL MARKETS:Primarily Stores of Value
  7. FINANCIAL INSTITUTIONS:The structure of the financial industry
  8. TIME VALUE OF MONEY:Future Value, Present Value
  9. APPLICATION OF PRESENT VALUE CONCEPTS:Compound Annual Rates
  10. BOND PRICING & RISK:Valuing the Principal Payment, Risk
  11. MEASURING RISK:Variance, Standard Deviation, Value at Risk, Risk Aversion
  12. EVALUATING RISK:Deciding if a risk is worth taking, Sources of Risk
  13. BONDS & BONDS PRICING:Zero-Coupon Bonds, Fixed Payment Loans
  14. YIELD TO MATURIRY:Current Yield, Holding Period Returns
  15. SHIFTS IN EQUILIBRIUM IN THE BOND MARKET & RISK
  16. BONDS & SOURCES OF BOND RISK:Inflation Risk, Bond Ratings
  17. TAX EFFECT & TERM STRUCTURE OF INTEREST RATE:Expectations Hypothesis
  18. THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock
  19. VALUING STOCKS:Fundamental Value and the Dividend-Discount Model
  20. RISK AND VALUE OF STOCKS:The Theory of Efficient Markets
  21. ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings
  22. ROLE OF FINANCIAL INTERMEDIARIES (CONTINUED):Providing Liquidity
  23. BANKING:The Balance Sheet of Commercial Banks, Assets: Uses of Funds
  24. BALANCE SHEET OF COMMERCIAL BANKS:Bank Capital and Profitability
  25. BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk
  26. INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking
  27. NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms
  28. SECURITIES FIRMS (Continued):Finance Companies, Banking Crisis
  29. THE GOVERNMENT SAFETY NET:Supervision and Examination
  30. THE GOVERNMENT'S BANK:The Bankers' Bank, Low, Stable Inflation
  31. LOW, STABLE INFLATION:High, Stable Real Growth
  32. MEETING THE CHALLENGE: CREATING A SUCCESSFUL CENTRAL BANK
  33. THE MONETARY BASE:Changing the Size and Composition of the Balance Sheet
  34. DEPOSIT CREATION IN A SINGLE BANK:Types of Reserves
  35. MONEY MULTIPLIER:The Quantity of Money (M) Depends on
  36. TARGET FEDERAL FUNDS RATE AND OPEN MARKET OPERATION
  37. WHY DO WE CARE ABOUT MONETARY AGGREGATES?The Facts about Velocity
  38. THE FACTS ABOUT VELOCITY:Money Growth + Velocity Growth = Inflation + Real Growth
  39. THE PORTFOLIO DEMAND FOR MONEY:Output and Inflation in the Long Run
  40. MONEY GROWTH, INFLATION, AND AGGREGATE DEMAND
  41. DERIVING THE MONETARY POLICY REACTION CURVE
  42. THE AGGREGATE DEMAND CURVE:Shifting the Aggregate Demand Curve
  43. THE AGGREGATE SUPPLY CURVE:Inflation Shocks
  44. EQUILIBRIUM AND THE DETERMINATION OF OUTPUT AND INFLATION
  45. SHIFTS IN POTENTIAL OUTPUT AND REAL BUSINESS CYCLE THEORY