Chapter 10

Financial systems 2
domestic institutions
and markets

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CHAPTER CONTENTS
LEARNING OUTCOMES ------------------------------------------------- 115
COMMERCIAL BANKS AND CREDIT CREATION ---------------------- 116
FINANCIAL INSTRUMENTS -------------------------------------------- 119
ROLE OF CENTRAL BANKS --------------------------------------------- 122
FINANCIAL MARKETS -------------------------------------------------- 123
THE GLOBAL BANKING CRISIS ---------------------------------------- 124

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LEARNING OUTCOMES
(a) Explain the role of commercial banks in the process of credit creation and in
determining the structure of interest rates.
(b) Explain the role
regulation.

and in prudential

(c) Explain the origins of the 2008 banking crisis and credit crunch.

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COMMERCIAL BANKS AND CREDIT CREATION

Commercial banks perform a number of functions including: a store of wealth,
provision of loan finance, acting as financial intermediaries as well as the
provision of foreign currency.
However, above all else, commercial banks have three different and potentially
conflicting aims.

Profitability

Aims
Liquidity

Security

Credit creation
The bank multiplier is the name given to banks ability to create credit and hence
money, by maintaining their cash reserves at less than 100% of the value of their
deposits.

A
commercial bank on the other hand will look to make a profit by lending cash and
charging interest.

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The cash ratio describes the percentage of cash that a bank holds in reserve in
order to honor on demand withdrawals.

Exercise 1
In the following illustration we shall assume that there is only one bank in the
banking system and that all money lent by the bank is re-deposited by secondary
customers. The bank wishes to maintain a 25% cash ratio.
Complete the following table:
Deposit

Cumulative
Deposits

Cash Reserve
Ratio (25%)

Cumulative
Loans

Incremental
Loan

$1,000

$1,000

$250

$750

$750

$750

Formula to calculate the quantitative side of credit creation:

Deposits

Note: exam questions may well ask for either the total money supply following an
initial injection, or alternatively for just the increase. If asked to calculate the
increase then remember to deduct the initial deposit.

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Exercise 2
If all the commercial banks in a national economy operated on a cash reserve ratio
of 20%, how much cash would have to be deposited with the banks for the money
supply to increase by $300 million?
A

$60 million

$75 million

$225 million

$240 million

Exercise 3
A banking system in a small country consists of just four banks. Each bank has
decided to maintain a minimum cash ratio of 10%. Each bank now receives
additional cash deposits of $1 million. There will now be a further increase in total
bank deposits up to a maximum of:
A

$400,000

$4 million

$36 million

$40 million

Capital adequacy rules

In order to reduce their risk exposure banking institutions are required to maintain
a minimum amount of financial capital, ensuring the financial soundness and
consumer confidence in such institutions.

The Basel III Agreement was developed following the recent world financial
crisis, adding more stringent requirements regarding capital adequacy ratios and
minimum capital requirements.

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FINANCIAL INSTRUMENTS
Financial instruments are tradable assets. The yield on a financial instrument refers
to the return on an investment, calculated by dividing the nominal return by the
market price.

Nominal and real rates of interest

The real value of income from investments is eroded by inflation. The rate of
return after inflation has been deducted is called the real rate of interest.
The real rate of interest may be calculated as follows:

= 1 + real rate

Treasury bills
Treasury bills (T-Bills) are short term debt obligations. Their key characteristics
include:
Maturity < 1 year
Issued at a discount from their par value
The par value is re-paid at maturity.
Yield calculations
Discount yield

!



Investment yield

Key
F=

face value

P=

purchase price

M=

maturity of bill in days

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Treasury bonds
Treasury bonds (T-Bonds) are marketable, fixed interest debt with a maturity
greater than 1 year. Their key characteristics include:
Maturity > 1 year
Set yield, known as the coupon rate
Face value redeemed at maturity

Despite a fixed rate of interest, the market value of a bond is subject to change
over time, for two reasons:
1.

Perceived risk

2.

Interest rate fluctuation

Yield calculation
x 100

Differentiate between the various types of yield, which includes: redemption,

nominal, flat and running yield!

Note:

yields for bonds are inversely related to bond prices. As the price of a
bond falls, the yield percentage will rise.

Ordinary shares
The yield derived on ordinary shares may be determined as at a particular point in
time based on the following formulae:

Dividend Yield =

However, assessing the long term rate of return is problematic. Firstly, ordinary
shares do not have a set maturity date. Secondly, the dividend paid out varies
over time. Assuming a constant growth rate for dividends, it is possible to
approximate the overall return on equities in the long run.
Ke
Where

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Ke

= rate of return on equity

P = share price

= dividend paid

G = dividend growth rate

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Risk and return on financial instruments

Low risk

High risk

The relative ordering of the above instruments relates to the degree of certainty
surrounding the investors return.

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ROLE OF CENTRAL BANKS

A central bank is a bank which acts on behalf of the government. The central bank
for the UK is the Bank of England. The Bank of England is a nationalised
corporation.

Monetary
stability
Financial
stability

Lender of
last resort

Issuing
new notes

Holds
forex

Banker to
govt' &
commercial
banks

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FINANCIAL MARKETS
Financial markets comprise:
1.

Money markets

2.

Capital markets
shares.

which trade short term instruments.

which trade in long term instruments such as bonds and

Money markets
Money markets are essentially short term debt markets, with loans being made for
a specified period at a specified rate of interest. The money market may be subdivided as follows:

Capital markets
Stock markets enable the trade in company equities. Significant markets include
the New York Stock Exchange and the London Stock Exchange.
A stock exchange is an organised capital market.
stock exchanges:

Within a functioning economy,

Enable firms to raise long term capital.

Publicises the prices of quoted shares.
Enforces rules of conduct, providing investor confidence.

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THE GLOBAL BANKING CRISIS

In many respects the global economy is still reeling from the effects of the 20072010 financial crisis.

Causes of the 2007-2010 financial crisis

1.

The US Property boom of 1997

2.

The sub-prime mortgage crisis

3.

Low market interest rates

4.

Poor regulation of the financial sector

5.

Excessively complex financial assets

6.

Greed and poor governance.

Consequences of the 2007

2006

2010 financial crisis

1.

Collapse of the property sector

2.

Credit squeeze

3.

Government intervention

4.

More regulation of banks and financial institutions

5.

Austerity budgets

6.

Concern over structural deficits.

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