FIN3010 Banking and Credit Review Notes

FIN3010 Banking and Credit
Subject Review Notes
FIN3010 BANKING AND CREDIT

LECTURE 01: OVERVIEW OF FINANCIAL SYSTEM
WHAT ARE MAJOR COMPONENTS IN A FINANCIAL SYSTEM?
1.
2.
3.
4.
Financial Markets: Direct allocation of capital and distribution of funds from surplus sources to targets where funds
Financial Industry: include such lender-savers as individuals, institutions, governments, and foreigners.
Financial Governance: include such borrower-spenders as households, firms, public sectors, and foreigners.
Financial Intelligence: Securities as financial instruments to channel funds serve as assets to lenders but as liabilities.
WHAT ARE THE FUNCTIONS OF FINANCIAL MARKETS?

1)
Direct allocation of capital and distribution of funds from surplus sources to targets where funds are deficient.
2) The surplus sources of funds include such lender-savers as individuals, institutions, governments, and foreigners.
3) The deficit targets of funds include such borrower-spenders as households, firms, public sectors, and foreigners.
4) Securities as financial instruments to channel funds serve as assets to lenders but as liabilities to borrowers.
5) Financial markets thus:
Perform the essential function of channeling funds from economic players that have saved surplus funds to those
that have a shortage of funds;
Promote economic efficiency by producing an efficient allocation of capital, which increases production;
Improve the well-being of consumers by allowing them to time purchases better.
HOW ARE FINANCIAL MARKETS STRUCTURED?

1)
2)
3)
4)
Debt (bond) and Equity (stock) Markets

Debt markets are for trading bonds (fixed-income securities) with different maturities from short term through
intermediate term to long term.
Equity markets are for trading stocks (claims to share in the net income and the assets of a business) with periodic
dividends paid to their holders with no maturity date.
Primary and Secondary Markets
Investment Banks underwrite securities in primary markets
Brokers and dealers work in secondary markets
Money (short-maturity) and Capital (long-maturity) Markets
Money markets deal in short-term debt instruments
Capital markets deal in longer-term debt and equity instruments
Organized Exchanges and Over-the-counter (OTC) Markets
Organized exchanges are where buyers and sellers of securities (or their agents or brokers) meet in one central
location to conduct trades.
OTC markets are where dealers at different locations who have an inventory of securities stand ready to buy and sell
securities over the counter to anyone who comes to them and is willing to accept their prices.
WHAT KINDS OF FINANCIAL INSTRUMENTS ARE THERE?

1)
2)
Money-market Instruments
Treasury Bills (T-Bills)
Negotiable Certificates of Deposits (CDs)
Commercial Papers (CPs)
Repurchase Agreements (Repos)
Federal Funds (Fed funds)
Capital-market Instruments
Common Stocks
Securitized Loans: Asset/Mortgage-backed Securities (ABS/MBS), Collateralized Debt Obligations (CDOs)
Corporate Bonds
Government Securities
Government Agency Securities
Local Government Bonds
Tax-exempt Municipality Bonds (Munis)
Commercial and Consumer Loans
HOW COULD FINANCIAL MARKETS BE INTERNATIONALIZED?

1)
2)
Eurocurrencies, Eurobonds, and Foreign Bond Markets

Eurocurrencies foreign currencies deposited in banks outside the home country, e.g., Eurodollars which are US
dollars deposited in foreign banks outside the U.S. or in foreign branches of US banks
Eurobond bond denominated in a currency other than that of the country in which it is sold
Foreign Bonds sold in a foreign country and denominated in that countrys currency
World Stock Markets
The increased interest in foreign stocks has prompted the development of mutual funds that specialize in trading in
foreign stock markets, e.g., the Nikkei 300 Average and the Financial Time Stock Exchange (FTSE) 100 Index.
Dr. Warren Wus Section 4
Page 1 of 31
May 8, 2014
WHAT ARE THE FUNCTIONS OF FINANCIAL INDUSTRY?

1)
2)
3)
4)
Transaction-cost Reduction
Economies of scale
Liquidity services
Risk Sharing and Reduction
Asset transformation
Diversification
Asymmetric-information Alleviation
Adverse Selection (before the transaction) more likely to select risky borrower
Moral Hazard (after the transaction) less likely borrower will repay loan
Economy-of-scope Provision
Multiple financial services to lower the cost of information production for each service by applying one information
resource to many different services.
Benefits of multiple financial services must be weighed against their potential cost of conflict of interest in which
those services may lead an institution to conceal information or disseminate misleading information.
WHAT KINDS OF FINANCIAL INTERMEDIARIES ARE THERE?

1)
2)
3)
Depository Institutions
Commercial Banks
Thrift Institutions
Credit Unions
Contractual Savings Institutions
Life Insurance Companies
Property and Casualty Insurance Companies
Pension and Government Retirement Funds
Investment Institutions
Investment Banks
Mutual Funds
Money-market Mutual Funds
Finance Companies
WHAT ARE THE FUNCTIONS OF FINANCIAL GOVERNANCE?

1)
2)
Increasing Information Available to Investors

Reduce adverse selection and moral hazard problems
Reduce insider trading
Ensuring the Soundness of Financial Intermediaries
Disclosure
Restrictions on entry
Restrictions on assets and activities
Deposit insurance
Limits on competition
Restrictions on interest rates
WHAT ARE THE FUNCTIONS OF FINANCIAL INTELLIGENCE?

1)
2)
3)
4)
Accounting and Auditing of Financial Reports

Provide preparation and verification services to firms or institutions that compliantly and voluntarily report their
financial positions and performance to the market participants and regulatory agencies.
Credit Assessment and Rating of Financial Instruments
Provide evaluation and monitoring services to firms that issue fixed-income securities and to investors who require
objective and unbiased reports on those firms credit positions and performance.
Quantitative Research and Analysis on Financial Risks
Provide research and analytical services to firms that issue equity or contingent-claim securities and to investors
who require insightful intelligence on those firms risk positions and performance.
Advisory and Consultancy Services for Investors and Fundraisers
Provide expert opinions and proprietary due-diligence services to firms and investors who require strategic outlooks
and alternatives on global investment and fundraising opportunities.
Page 2 of 31
May 8, 2014
LECTURE 02: BANKING INDUSTRY AND MANAGEMENT

HISTORICAL DEVELOPMENT OF THE U.S. BANKING SYSTEM
Bank of North America was chartered in 1782.

Controversy over the chartering of banks erupted during 1832.
National Bank Act of 1863 created a new banking system of federally chartered banks:
Office of the Comptroller of the Currency (OCC)
Dual banking system (i.e., national and state levels)
Federal Reserve System (Fed) was created in 1913.
Regulate and supervises all state banks that are members of the Fed.
The Fed also regulates bank holding companies (BHCs).
Federal Deposit Insurance Corporation (FDIC) was created in 1933 to insure state banks that are not the Fed members.
Other fifty state banking authorities are responsible for state-level banks that are not covered by FDIC insurance schemes.
GROWTH OF A SHADOW BANKING SYSTEM IN THE U.S.

1)
2)
3)
4)
5)
Financial Innovation and Engineering

Financial innovation is driven by the desire of financial institutions to earn profits.
Changes in financial conditions will stimulate a search by financial institutions for innovations that are likely to be
profitable, e.g., financial engineering processes.
Responses to Changes in Demand Conditions: Interest-rate Volatility
Adjustable-rate Mortgages
1. Flexible interest rates keep profits high when rates rise.
2. Lower initial interest rates make them attractive to home buyers.
Financial Derivatives
1. Allow financial institutions and their clients to hedge interest-rate risk.
2. Payoffs (i.e., contingent cash flows) are either linked to or derived from previously issued securities.
Responses to Changes in Supply Conditions: Information Technology
Improved computer technology to lower transaction costs
Bank credit cards, debit cards, and financially smart cards
Electronic banking, Internet banking, and Online banking
ATM, home banking, ABM, and virtual banking
High-yield (junk) bonds & Commercial papers (CPs) markets
Securitization of relatively homogeneous assets
1. Transforms illiquid financial assets (e.g., mortgage loans) into marketable capital-market securities (e.g.,
mortgage-backed securities).
2. Played a prominent role in the development of the subprime mortgage market in the mid-2000s, which
eventually led to the 2008 Global Financial Crisis.
Avoidance of Existing Regulations
Reserve requirements act as a tax on deposits (banks pass on their costs to depositors)
Deposit-interest restrictions led to disintermediation (banks cant compete with markets)
Money-market mutual funds (banks pool funds and link them to market performance)
Sweep Accounts
Decline of Traditional Banking
As a source of funds for borrowers, market share has fallen.
Commercial banks share of total financial intermediary assets has fallen.
No decline in overall profitability.
Increase in income from off-balance-sheet activities.
Decline in cost advantages in acquiring funds (liabilities)
1. Rising inflation led to rise in interest rates and disintermediation.
2. Low-cost source of funds, checkable deposits, declined in importance.
Decline in income advantages on uses of funds (assets)
1. Information technology has decreased need for banks to finance short-term credit needs or to issue loans.
2. Information technology has lowered transaction costs for other financial institutions, increasing competition.
COMPETITIVE STRUCTURE OF THE U.S. COMMERCIAL BANKING INDUSTRY

1)
2)
3)
Responses to Shadow Banking Growth

Expand into new and riskier areas of lending
1. Commercial real estate loans
2. Corporate takeovers and leveraged buyouts
Pursue off-balance-sheet activities
1. Non-interest income
2. Concerns about risk
Responses to Branching Restrictions
Bank Holding Companies (BHCs)
Automated Teller Machines (ATMs)
Nationwide Consolidation of Banking Institutions
Benefits: i) Increased competition drives inefficient banks out of business.
ii) Increased efficiency is derived from economies of scale and scope.
iii) Lower probability in bank failure can result from more diversified portfolios.
Page 3 of 31
May 8, 2014
Costs:
4)
i) Elimination of community banks may lead to less lending to small business.

ii) Banks expanding into new areas may take increased risks and fail.
Separation of Banking and Other Financial-service Functions
The Glass-Steagall Act of 1933
Prohibited commercial banks from underwriting corporate securities or engaging in brokerage activities.
Section 20s loophole in the Act was allowed by the Fed enabling affiliates of approved commercial banks to
underwrite securities as long as the revenue did not exceed a specified amount.
The United States Supreme Court validated the Feds action in 1988.
The Gramm-Leach-Bliley Act of 1999
Abolishes (repealed) the Glass-Steagall Act.
States regulate insurance activities.
SEC keeps oversight of securities activities.
OCC regulates bank subsidiaries engaged in securities underwriting.
Fed oversees bank holding companies.
Universal Banking
No separation between banking and securities industries.
British-style Universal Banking
May engage in security underwriting.
Separate legal subsidiaries are common.
Bank equity holdings of commercial firms are less common.
Few combinations of banking and insurance firms.
Some legal separations allow banks to hold substantial equity stakes in non-bank firms but BHCs are not legal.
COMPETITIVE STRUCTURE OF INTERNATIONAL BANKING INDUSTRY

1)
2)
3)
4)
Rapid Growth in Trades and Investments

Growth in international trade and multinational corporations
Global investment banking is very profitable
Ability to tap into the Eurodollar market
The Eurodollar Markets
Dollar-denominated deposits held in banks outside of the U.S.
Most widely used currency in international trade
Offshore deposits not subject to regulations
Important source of funds for U.S. banks
Overseas American Banks
Shell operations in offshore financial centers
Edge-Act corporations through bank BHCs
Offshore operations via International banking facilities (IBFs)
are not subject to regulation and taxes
may not make loans to domestic residents
Foreign Banks in the U.S.
Agency office of a foreign bank
can lend and transfer fund within the U.S.
cannot accept deposits from domestic residents
is not subject to the U.S. regulations
Subsidiary U.S. bank
is subject to the U.S. regulations
is owned by a foreign bank
Branch of a foreign bank
may open branches only in state designated as home state or in state that allow entry of out-of-state banks
with limited services may be allowed in any other state
Subject to the U.S. International Banking Act of 1978
The Basel Accords (1988 - Present)
are an example of international coordination of bank regulation
set minimum capital requirements for banks
WHAT DOES A BANKS BALANCE SHEET LOOK LIKE?

1)
2)
Bank Assets
Reserves (per requirements from a central bank)
Cash Items in Process of Collection
Deposits at Other Banks (e.g., interbank lending as borrowed reserves)
Securities (of national, state, provincial, and local government agencies)
Loans (e.g., commercial, industrial, consumer, and mortgage loans)
Other Assets (e.g., long-lived tangible and intangible assets)
Bank Liabilities
Checkable Deposits (i.e., non-interest-bearing demand deposits)
Non-transaction Deposits (e.g., saving and time deposits)
Borrowings (from other banks, non-bank firms, and a central bank)
Bank Capital (i.e., shareholders equity, minority interests, preferred stocks, etc.)
Page 4 of 31
May 8, 2014
WHAT ARE THE BASIC OPERATIONS OF A BANK?

1)
Taking Cash Deposit

Checking-account opening leads to an increase in the banks reserves equal to the increase in checkable deposits.
Assets
Vault Cash
2)
Assets
Reserves
First National Bank

Liabilities
+$100 Checkable deposits
+$100
Taking Check Deposit

When a bank receives (loses) deposits, it gains (loses) an equal amount of reserves.
Assets
Reserves
3)
First National Bank

Liabilities
+$100
Checkable deposits +$100
First National Bank

Liabilities
+$100
Checkable deposits +$100
Second National Bank

Assets
Liabilities
Reserves
+$100 Checkable deposits
+$100
Making Profit
A bank transforms its assets by selling liabilities with one set of characteristics and using the proceeds to buy assets
with a different set of characteristics. In this process, the bank borrows short and lends long.
First National Bank
Assets
Liabilities
Required reserves +$100 Checkable deposits +$100
Excess reserves
+$90
Second National Bank

Assets
Liabilities
Required reserves +$100 Checkable deposits
Loans
+$90
+$100
WHAT ARE THE GENERAL PRINCIPLES OF BANK MANAGEMENT?

1)
Liquidity Management
Excess Reserve: If a bank has excess reserves, a deposit outflow need not change other parts of its balance sheet.
Assets
Reserves
Loans
Securities
$20M
$80M
$10M
Liabilities
Deposits
$100M
Bank Capital
$10M
Assets
Reserves
Loans
Securities
$10M
$80M
$10M
Liabilities
Deposits
$90M
Bank Capital
$10M
Shortfall Reserve: Reserves are a legal requirement and the shortfall must be eliminated. Excess reserves are
insurance against the costs associated with deposit outflows.
Assets
Reserves
Loans
Securities
$20M
$80M
$10M
Liabilities
Deposits
$100M
Bank Capital
$10M
Assets
Reserves
Loans
Securities
$10M
$80M
$10M
Liabilities
Deposits
$90M
Bank Capital
$10M
Borrowed Reserve: incurs cost in terms of the interest rate paid on the borrowed funds.
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$10M
Deposits
Borrowing
Bank Capital
$90M
$9M
$10M
Securities Sale: The cost of selling securities is the brokerage and other transaction costs.
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$1M
Deposits
$90M
Bank Capital
$10M
Central Bank Borrowing: incurs interest payments based on the discount rate.
Assets
Reserves
Loans
Securities
Liabilities
$9M
$90M
$10M
Deposits
Borrowing
Bank Capital
$90M
$9M
$10M
Loans Reduction: is the most costly way of acquiring reserves. But, calling back in loans antagonizes customers
while other banks may only agree to purchase loans at a substantial discount.
Assets
Reserves
Loans
Securities
2)
3)
Liabilities
$9M
$81M
$10M
Deposits
$90M
Bank Capital
$10M
Asset Management
Three Goals: 1) to seek the highest possible returns on loans and securities; 2) to reduce risk; and 3) to have
adequate liquidity.
Four Tools: 1) Find borrowers who will pay high interest rates and have low possibility of defaulting; 2) Purchase
securities with high returns and low risk; 3) Lower risk by diversifying; and 4) Balance need for liquidity against
increased returns from less liquid assets.
Liability Management
Recent phenomenon due to rise of money center banks.
Expansion of overnight loan markets and new financial instruments (such as negotiable CDs).
Checkable deposits have decreased in importance as source of bank funds.
Page 5 of 31
May 8, 2014
4)
Capital Adequacy Management

Bank capital helps prevent bank failure
Assets
Reserves
Loans
Assets
Reserves
Loans
High-capital Bank
Liabilities
$10M
Deposits
$90M
$90M
Bank Capital
$10M
High-capital Bank
Liabilities
$10M
Deposits
$90M
$85M
Bank Capital
$5M
Assets
Reserves
Loans
Assets
Reserves
Loans
Low-capital Bank
Liabilities
$10M
Deposits
$96M
$90M
Bank Capital
$4M
Low-capital Bank
Liabilities
$10M
Deposits
$96M
$85M
Bank Capital
-$1M
The amount of capital affects return for the owners (equity holders) of the bank
1. Return on Asset (RoA) = Net Profit / Assets
2. Return on Equity (RoE) = Net Profit / Assets * Assets / Equity
Regulatory requirement for bank capital as self-insured buffer for safety
1. Benefits the owners of a bank by making their investment safe
2. Costly to owners of a bank because the higher the bank capital, the lower the return on equity
3. Choice depends on the state of the economy and levels of confidence
HOW DOES A BANK MANAGE ITS CREDIT RISK?
1)
2)
3)
4)
5)
Screening and Monitoring

Screening of borrowers based on lending specialization
Monitoring and enforcement of restrictive covenants
Long-term Customer Relationships
Customer Relationship Management (CRM) System
Enable lenders to deal with unanticipated moral hazard issues
Allow borrowers to obtain more favorable terms on future loans
Loan Commitments
Serve as forward arrangements to lock-in amounts, rates, and times
Enable lenders to collect more internal information about their borrowers
Allow borrowers to save on their future funding costs with less uncertainty
Collateral and Compensating Balances
Collateral serves as a pledge to compensate lenders if borrowers default while reducing adverse selection
Compensating balance helps lenders to monitor borrowers activities while reducing moral hazard
Credit Rationing
To prevent adverse selection, lenders could refuse loans even if borrowers are willing to pay higher interest rates
To prevent moral hazard, lenders could restrict the loan sizes even if borrowers are willing to borrow more amount
HOW DOES A BANK MANAGE ITS INTEREST-RATE RISK?

1)
2)
Gap Analysis
Deals with an impact on net interest margin (NIM) from changes in interest-rate sensitive assets and liabilities
Positive gaps indicate a potential increase in NIM due to a change in market interest rates
Negative gaps indicate a potential decrease in NIM due to a change in market interest rates
Maturity bucket approach measures the gap for several maturities to calculate rate impacts over a multiyear period
Standardized gap approach measures different degrees of sensitivity for different rate-sensitive assets and liabilities
Duration Analysis
Deals with an impact on market value (MV) of rate-sensitive assets and liabilities to movements in interest rates
The Macaulay Duration (D) measures the average lifetime of a cash-flow stream of an asset or a liability
A modified Duration (MD) measures the sensitivity of MV of an asset or a liability to changes in an interest rate
WHAT ARE OFF-BALANCE-SHEET ACTIVITIES OF A BANK?

1)
2)
3)
4)
Loan Sales
Also called secondary loan participation to sell all or part of the cash stream from a specific loan
Lenders could earn immediate profits from sale of quality loans while readjusting their balance-sheet diversification
Lenders could realize immediate losses from sale of troubled loans while removing their risks from balance sheets
Fee-income Generation
Specialized financial services, e.g., currency exchanges, payment transfers, stand-by credit lines, debt guarantees
Standby credit lines include note issuance facilities (NIF) and revolving underwriting facilities (RUF) for Euronotes
Debt guarantees serve as a put-option contract for the buyers to let the lenders bear default risk of their behalf
Structured investment vehicles (SIV) are securitized instruments that lenders enhance liquidity for their borrowers
Trading Activities
Lenders trades derivatives (futures, options, forwards, swaps) on exchanges or OTC to facilitate their businesses
Lenders often try to outguess the markets and engage in speculation that is risky and could lead to insolvencies
Risk Management Techniques
Lenders also trades derivatives to hedge their market risk rather than speculating or arbitraging market movements
Lenders need to employ reliable risk-quantification methods to accurately measure and properly manage their risks
Page 6 of 31
May 8, 2014
LECTURE 03: ANALYSIS OF FINANCIAL REGULATION

WHAT ARE THE APPROACHES TO FINANCIAL REGULATION?
1.
Government Safety Net

Bank Panics and Deposit Insurance
Other Forms of Government Safety Net
Moral Hazard and Government Safety Net
Adverse Selection and Government Safety Net
Financial Consolidation and Government Safety Net
The Too Big To Fail Doctrine
5. Restrictions on Asset Holdings
Since safety net encourages banks moral-hazard behavior, asset-holding restrictions aim to curb such a motive.
Banks are less willing to disclose their risky activities to the public lest they shift their deposits to less risky banks.
It is for the public interest that banks asset portfolios be more diversified than concentrated through restrictions.
Yet, excessively inflexible asset-holding restrictions would make banks less competitive and more prone to losses.
Thus, those restrictions should be applied across-the-board to all financial services firms to level their playing field.
6. Capital Requirements
Adequately capitalized banks are less likely to take excessive risks as their equity-holders also stand to lose.
Bank capital also serves as a cushion when bad shocks occur, making it less likely that the banks will fail.
Leverage-ratio Requirement: >5% for well-capitalized banks; <3% for banks that are subject to tighter regulation.
Basel Capital Standard: >8% capital over risk-weighted assets, i.e., 0.0 for government securities, 0.2 for claims on
banks, 0.5 for residential mortgages, 1.0 for corporate and consumer loans, and 1.5 for off-balance-sheet (OBS) items.
Regulatory arbitrage occurs when banks could adhere to capital requirements but their actual risks are much higher.
7. Prompt Corrective Actions
When banks capital fell below the required level, regulators such as Federal Deposit Insurance Corporation (FDIC)
would intervene earlier and more vigorously to correct the deficiency by categorizing banks into five groups:
1) Well-capitalized banks: are allowed some privilege to do some securities underwriting
2) Adequately capitalized banks: are not subject to corrective actions but not allowed any privilege
3) Undercapitalized banks: fail to meet capital requirements and are subject to prompt corrective actions
4) Significantly undercapitalized banks: are not allowed to pay deposit-interest rates higher than average
5) Critically undercapitalized banks: are required to submit a capital-restoration plan and restricted on asset growth
Banks that are so undercapitalized with equity capital less than 2% of their assets would be required to close down.
8. Financial Supervision and Oversight
Institutional chartering to prevent undesirable people to own, control, and run banks or financial-services firms (FSFs).
Prudential examination to monitor whether banks and FSFs comply with asset-holding restrictions and capital
requirements based on the CAMELS rating (i.e., capital, assets, management, earnings, liquidity, and sensitivity).
9. Disclosure Requirements
To lessen a free-rider problem, banks are required to disclose their portfolio quality and the amounts exposed to risks.
All OBS portfolio transactions and positions of banks as well as their valuation methodologies must also be disclosed.
The Sarbanes-Oxley Act of 2002 increased incentives for firms to produce accurate audits of their financial reports.
Disclosures have moved away from book-value to fair-value accounting in which asset values are marked to market.
10. Assessment of Risk Management
Periodic on-site examination focuses on banks balance-sheet quality and control of their excessive risk-taking.
However, due to financial-innovation usage, healthy banks could fall victim to illiquidity or insolvency in short notice.
Hence, regulators shifted their focus to banks management processes and control systems for their risk exposures.
The CAMELS rating was expanded to include risk-management rating (i.e., bank oversight quality, risk-exposure-andlimit policy, risk-measuring-and-monitoring quality, and internal risk-control system adequacy).
Stress tests on the banks value-at-risk (VaR) and expected shortfall (ES) measures under extreme market shocks are
required for banks to perform every two weeks to measure the size of unexpected losses on their trading portfolios.
11. Restrictions on Competition
Competition within a financial-services industry in some countries might lead to more moral hazard than it should.
Such seemed to pose more harm than good as consumers were charged more while banks efficiency deteriorated.
Bank Branching Restriction: The US used to have the McFadden Act of 1927 but had eliminated it since 1994.
Bank Activities Restriction: The US used to have the Glass-Steagall Act of 1933 but had repealed it in 1999.
12. Consumer Protections
The Consumer Protection Act of 1969 (aka the Truth in Lending Act) requires all lenders to provide to their borrowers
the cost-of-borrowing information, e.g., annual percentage rate (APR) and total finance charge on the loan.
The Fair Credit Billing Act of 1974 requires creditors to provide information on the method of assessing finance charges
and that billing complaints be handled speedily. Federal Reserve enforces both laws under Regulation Z.
The Equal Credit Opportunity Act of 1974 & its 1976 Extension forbid discrimination by lenders based on race, gender,
age, marital status, or national origin. Enforcement of these laws is under the Federal Reserves Regulation B.
The Community Reinvestment Act of 1977 prevents redlining, i.e., a practice in which lenders refuse to lend in a
particular area, by requiring lenders to show and prove that they lend in all areas which they take deposits.
Public demands to strengthen the regulation on subprime mortgage-backed securities have been underway.
Page 7 of 31
May 8, 2014
13. Micro- vs. Macro-prudential Supervision

Micro-prudential Supervision: focuses on the safety and soundness of individual banks in terms of their compliance
with capital and disclosure requirements as well as on prompt corrective actions against non-compliant institutions.
When asset value of banks deteriorated relative to their liabilities, their capital levels automatically declined leading to a
rapid deleveraging process (i.e., banks cutting back on their lending activities), which exacerbates systemic risk.
Macro-prudential Supervision: focuses on the safety and soundness of the whole financial system by seeking to mitigate
system-wide fire sales and deleveraging and assessing its overall capacity to avoid liquidity shortages.
When liquidity in a financial system was high during a booming period, banks expanded their credit that would raise
asset levels thereby increasing their capital levels and enabling them to make more loans at their regulatory capital.
When liquidity in the financial started to dry during a busting period, banks contracted their credit that would reduce
asset levels thereby decreasing their capital levels and disabling them to make more loans at their regulatory capital.
Since such a leverage cycle destabilizes the whole financial system, macro-prudential supervision aims at making
regulatory-capital level countercyclical by raising it during the booming period and lowering it during the busting one.
Also, banks credit extension during the booming period must be tightened in order to limit speculative loans whereas
their credit contraction during the busting period must be loosened to provide the system with adequate liquidity.
To ascertain banks adequate liquidity, macro-prudential supervision requires that banks maintain adequate net stable
funding ratio (NSFR), which is the percentage of the banks short-term funding on their total funding.
WHAT IS THE FUTURE OF FINANCIAL REGULATION?
1)
The Wall Street Reform and Consumer Protection Act of 2010 (aka the Dodd-Frank Act)
Objectives: The Dodd-Frank Act aims at
1. Promoting the financial stability of the US by improving accountability and transparency in the financial system
2. Ending the Too Big To Fail doctrine
3. Protecting the American taxpayer by ending bailouts
4. Protecting consumers from abusive financial services practices, and for other purposes
Suppositions: The Dodd-Frank Act purports to
1. Provide rigorous supervisory standards to protect the American economy, consumers, investors, and businesses
2. End taxpayer-funded bailouts of financial institutions and financial services firms
3. Provide for an advanced warning system on the stability of the economy
4. Create rules on executive compensation and corporate governance
5. Eliminate some loopholes that led to the 2008 economic recession
Regulators: The Dodd-Frank Act affects the following regulatory agencies
1. Financial Stability Oversight Council (FSOC) newly established
2. The Federal Reserve System (Fed)
3. Federal Deposit Insurance Corporation (FDIC)
4. Federal Insurance Office (FIO)
5. Federal Housing Finance Agency (FHFA)
6. National Credit Union Administration Board (NCUAB)
7. Office of the Comptroller of the Currency (OCC)
8. Office of Credit Ratings (OCR)
9. Office of Thrift Supervision (OTS) eliminated
10. Office of Financial Research (OFS) newly established
11. Securities and Exchange Commission (SEC)
12. Commodity Futures Trading Commission (CFTC)
13. Securities Investor Protection Corporation (SIPC)
14. Bureau of Consumer Financial Protection (BCFP) newly established
Systemic Risk Regulation: The Dodd-Frank Act enables FSOC to
1. Monitor markets for asset price bubbles and the buildup of systemic risk.
2. Designate which firms are systemically important financial institutions (SIFIs) who pose a risk to the overall
financial system because their failure would cause widespread damage, e.g., bank holding companies.
3. Subject SIFIs to additional regulation, including higher capital standards, stricter liquidity requirements, and a
requirement to draw up a plan for orderly liquidation of the firm gets into financial difficulties.
Resolution Authority: The Dodd-Frank Act enables FDIC to
1. Seize assets of failing SIFIs and wind them down in an orderly manner.
2. Levy fees on financial institutions with more than $50 billion in assets to recoup any losses.
Consumer Protection: The Dodd-Frank Act authorizes BCFP to
1. Examine and enforce regulations for issuers of residential mortgage products having over $10 billion in assets.
2. Examine and enforce regulations for issuers of other financial products marketed to low income people.
3. Require lenders to verify borrowers ability to repay loans based on their income, credit history, and job status.
4. Ban payments to brokers for pushing borrowers into higher-priced loans (i.e., predatory loans).
5. Allow states to impose stricter consumer protection laws on national banks.
6. Give state attorney-general power to enforce certain rules issued by BCFP.
7. Increase the level of federal deposit insurance to $250,000 permanently.
The Volcker Rule: The Dodd-Frank Act improves upon the Bank Holding Company Act of 1956 as follows
1. Banking entity, including insured depository institution and bank holding company, would be limited in the
extent of its proprietary trading and allowed to own a small percentage of hedge fund and private equity fund.
2. The rule limits banking entities to own no more in a hedge/private-equity fund than 3% of total ownership. The
total of all of the entitys interests in hedge/private-equity funds cannot exceed 3% of the entitys tier-1 capital.
3. No bank that has a direct or indirect relationship with a hedge fund or private equity fund may enter into a
transaction with the fund or its subsidiaries without disclosing the full extent of the relationship to the regulators
and assuring that there are no conflicts of interest.
4. Banking entity must comply with the Act within two years of its passing, although it may apply for time
extensions.
Page 8 of 31
May 8, 2014
2)
Financial Derivatives Regulation: The Dodd-Frank Act requires that

1. Standardized derivative instruments (i.e., plain-vanilla derivatives) be traded on exchanges and cleared through
clearinghouse to reduce the risk of losses if any counterparty in the derivative transaction goes bankrupt.
2. Customized derivative instruments (i.e., exotic derivatives) would be subject to higher capital requirements,
more disclosure requirements, and asset-holding/trading restrictions.
Future Financial Regulation
Capital Requirements
Executive Compensation
Government-sponsored Enterprises (GSEs)
Credit-rating Agencies
The danger of over-regulation
Page 9 of 31
May 8, 2014
LECTURE 04: ANALYSIS OF FINANCIAL STRUCTURE

WHAT ARE BASIC FACTS ABOUT FINANCIAL STRUCTURE?
1.
2.
3.
4.
5.
6.
7.
8.
Stocks are not the most important source of external financing for businesses
Stock markets accounted for only a small fraction of the external financing of businesses in advanced economies during
1970-2000: 12% in Canada, 11% in the US, 8% in Germany, and 5% in Japan.
Issuing debt and equity securities is not the primary way to finance businesses
Debts represented a higher portion of businesses external financing in advanced economies than stocks during 19702000: 15% in Canada, 32% in the US, 7% in Germany, and 9% in Japan.
Indirect finance through intermediaries is more important than direct finance through financial markets
Within those relatively smaller-sized direct-financing markets, less than 5% of newly issued debt securities and 33% of
equity securities have been sold directly to individual investors with the balances being bought by institutional investors.
Financial intermediaries are the more important sources of external funds for businesses
Loans from depository institutions (banks) and financial-services firms (non-banks) took up the larger slices in
businesses financing in advanced economies: 73% in Canada, 57% in the US, 85% in Germany, and 86% in Japan.
The financial system is among the most heavily regulated sectors of the economy
Governments regulate financial markets and intermediaries primarily to promote the provision of information and to
ensure the soundness and stability of the financial system.
Only large corporations have easy access to securities markets to finance their businesses
Unlike well-known corporations, small-to-medium enterprises (SMEs) that are not well established are less likely to
raise funds through financial markets but more so from financial intermediaries.
Collateral is a prevalent feature of debt contracts for both households and businesses
As a property pledged to a lender, collateral is used by borrowers to guarantee their payment in the events of default.
Commercial and farm mortgage loans with collateral make up 25% of borrowing by businesses.
Debt contracts are complex legal documents that place substantial restrictions on the borrowers behavior
Debt contracts have a provision called covenants to restrict certain activities in which borrowers can engage. Other
covenants include a requirement for borrowers to maintain sufficient insurance on properties purchased with the loan.
WHAT ARE THE ROLES OF TRANSACTION COSTS?

1)
2)
How transaction costs influence financial structure

High transaction costs prevent small-volume investors to trade securities directly and discourage them to
participate actively in financial markets.
Transaction costs also lead investors to concentrate their investments in a few securities in order to build adequate
volumes resulting in higher market risk due to lack of diversification.
How financial intermediaries reduce transaction costs
Economies of Scale: A financial intermediary is able to spread out its fixed portion of fund-pooling or investmentbundling expenditures more efficiently in order to reduce the unit cost as the size (scale) of transactions increases.
Expertise: A financial intermediary serves to transform non-tradable assets into high-liquidity marketable
securities while reducing their unit prices so that those securities become more affordable to small-volume
investors.
WHAT ARE THE ASPECTS OF ASYMMETRIC INFORMATION?

1)
2)
3)
Adverse Selection
Adverse selection occurs before a transaction takes place or a financial contract is entered.
6) Lemons Problem: arises when product-sellers or fund-borrowers are not willing to reveal information that makes
the quality of their products or credit-ratings look worse than they want them to be to that they could sell for the
highest possible price or borrow at the best possible deal.
2) Free-rider Problem: occurs when a majority of market participants take advantage over a minority in bargaining the
transactions by observing the deals best outcomes so that the former need not share the costs with the latter.
Moral Hazard
Moral hazard arises after a transaction took places or a financial contract has been entered.
1) Risk-shifting Problem: occurs when product-buyers pursue their entitlements or privileges under the contracts at
their product-sellers expense or when fund-borrowers unilaterally switch their intents or behavior to utilize fund to
maximize their own self-interest at their fund-lenders risk during the period of their contracts.
2) Cherry-picking Problem: arises when product-sellers or fund-lenders (agents to the contracts) pursue their own
self-interests by conducting hidden or opaque activities that undermine or sub-optimize the interests of their
product-buyers or fund-borrowers (principals to the contracts) during the period of their contracts.
Conflicts of Interest
Conflicts of interest arise when an institution has multiple objectives and conflicts among those objectives.
1) Incentive-related Conflict: As institutions face conflicting objectives, there is a strong incentive for them to distort
one set of information over another thereby reducing in the information quality while increasing its asymmetries.
7) Agency-related Conflict: Within an institution, there are underinvestment and overinvestment problems caused by
conflicts between principals and agents making it unable to channel funds into productive investment
opportunities.
Page 10 of 31
May 8, 2014
HOW DOES ADVERSED SELECTION AFFECT FINANCIAL STRUCTURE?

1)
2)
Lemons problem in debt and equity markets

In debt markets, lends will buy a bond only if its interest rate is high enough to compensate him for the average
default risk of the good and bad firms that try to sell their bonds. As a result, good firms would not prefer to raise
their funds in debt markets lest they have to pay too high an interest rate.
In equity markets, investors will buy a stock only if its price reflects the average quality between its good and bad
issuers. Knowing that the price of their stocks is undervalued, good firms would not want to their raise funds in
equity markets. Consequently, those investors are discouraged to invest lest they buy bad stocks.
Tools to help solve lemons problems
Production and sale of information
Government regulation to increase information
Financial intermediation
Collateral and net worth
HOW DOES MORAL HAZARD AFFECT FINANCIAL STRUCTURE?

1)
2)
3)
4)
Agency problem in equity contracts

Underinvestment Problem: occurs when the risks (e.g., accountability for poor performance) from investments are
borne by managers (agents) while the benefits (e.g., increased firm value) accrue to equity-holders (principals).
Incentive Implication: follows when managers who deploy resources yet get paid with a fixed compensation do not
maximize the interest of the equity-holders who own resources by minimizing (slacking off) their productive efforts.
Tools to help solve agency problems in equity market
Monitoring and verification of information
Debt contracts
Risk-shifting problem in debt contracts
Overinvestment Problem: arises when the risks (e.g., potential losses) from investments are borne by debt-holders
(passive principals) while the benefits (e.g., windfall profits) accrue to equity-holders (active principals).
Incentive Implication: follows when equity-holders who are obliged to pay a fixed cash flow to debt-holders see and
seize the opportunity to bet the borrowed fund in risky projects expecting the maximize their investment payoffs.
Tools to help solve moral hazard problems in debt market
Collateral and net worth
Monitoring and enforcement of restrictive covenants
HOW DO CONFLICTS OF INTEREST AFFECT FINANCIAL STRUCTURE?

1)
2)
Underwriting vs. Research in Investment Banking

Underinvestment Problem: occurs when the risks (e.g., accountability for poor performance) from investments are
borne by managers (agents) while the benefits (e.g., increased firm value) accrue to equity-holders (principals).
Incentive Implication: follows when managers who deploy resources yet get a fixed compensation do not maximize
the interest of the equity-holders who own resources by minimizing (e.g., slacking off) their productive efforts.
Auditing vs. Consulting in Accounting Firms
Monitoring and verification of information
Debt contracts
HOW ARE CONFLICTS OF INTEREST REMEDIED?

1)
2)
Public Accounting Return and Investor Protection Act of 2002 (aka the Sarbanes-Oxley Act)
Increases supervisory oversight to monitor and prevent conflicts of interest.
Establishes a Public Company Accounting Oversight Board.
Increases the Securities and Exchange Commissions (SEC) budget.
Illegalizes public accounting firms to provide non-audit service to clients while performing an impermissible audit.
Raises criminal charges for white-collar crime and obstruction of official investigations.
Requires the CEO and CFO to certify that financial statements and disclosures are accurate.
Requires members of the audit committee to be independent.
Global Legal Settlement of 2002
Requires investment banks to sever the link between research and securities underwriting.
Bans spinning.
Imposes $1.4 billion in fines on accused investment banks.
Requires investment banks to make their analysts recommendations public.
Over a 5-year period, investment banks are required to contract with at least 3 independent research firms that
would provide research to their brokerage customers.
Page 11 of 31
May 8, 2014
LECTURE 05: CENTRAL BANKING

HOW INDEPENDENT IS A CENTRAL BANK LIKE THE FED?
1.
2.
3.
4.
5.
The Fed has goal-independence in conducting its monetary policy.

The Fed is also independent over its monetary-policy instruments.
The Fed has independence in generating and keeping its revenues.
However, the Feds institutional structure (i.e., charter) is governed by the US Congress and subject to change at any time.
Furthermore, the Feds decision-making mechanisms are influenced by the US President:
Influence on the Congresss decisions
Appoints members of the Feds Board of Governors
Appoints Fed chairman although terms are not concurrent
WHAT MAKE THE FEDS CHAIRPERSON ABLE TO INFLUENCE?

1)
He/she is a spokesperson on behalf of the Feds Board of Governors.
2) He/she helps set the agenda for the Feds meetings and votes first about monetary policy.
3) He/she has the authority to supervise professional economists and economic-policy advisers.
4) He/she has a pivotal role in negotiating with the US Congress and the US President.
SHOULD A CENTRAL BANK BE MORE OR LESS INDEPENDENT?

1)
2)
The Case for Independence of a Central Bank

Subjecting the Fed to more political pressures would pass an inflationary bias onto monetary policy due to politicalbusiness cycle.
The Feds independence could be used to facilitate the Treasury Department financing of large budget deficits, i.e.,
fiscal-policy accommodation.
Monetary policy is too important to be left for politicians to decide based on the presumption that principal-agent
problems are worsened by politicians.
The Case Against Independence of a Central Bank
Subjecting the Fed to be under the influence of elected officials, would allow the process and conduct of monetarypolicy, which affects almost everyone in the economy, to be more democratic than being controlled by an elite group
that is responsible to, or accountable for, no one.
It is more difficult in practice than in theory to coordinate monetary policy with fiscal policy since the Feds
discretions are not always successful.
WHAT UNDERPIN A CENTRAL BANKS BEHAVIOR?

1)
By default, a bureaucratic system should serve the public best interest.
2) However, some economists developed the Theory of Bureaucratic Behavior arguing that there are other factors that
influence how the bureaucratic system operates and bureaucrats within it behave.
3) Such a theory claims that the objective of a bureaucracy is to maximize its own welfare relating to power and prestige.
Fight vigorously to preserve autonomy (i.e., unchallenged power)

Avoid conflict with more powerful groups (i.e., untouchable prestige)
4) The theory may be a useful guide to predicting what motivates the Fed and other central banks.
5) Nonetheless, it does not rule out altruistic intent of a central bank.
HOW INDEPENDENT ARE CENTRAL BANKS IN OTHER NATIONS?
1)
2)
3)
4)
The European Union

The European Central Bank (ECB) is the most independent in the world.
Members of the ECBs Executive Board have long-term appointments
The ECB can determine its own budget.
The ECB is less goal independent in favor of price stability.
The ECBs charter cannot by changed by legislation; only by revision of the Maastricht Treaty
Other OECD Countries
Bank of Canada: Essentially controls monetary policy
Bank of England: Has some instrument independence.
Bank of Japan: Recently (1998) gained more independence
The trend toward greater independence
Transitional Economies (of Central Europe and the former USSR)
Market economy institutions were to be created.
State-owned, dual-role banks were changed to central banks and commercial banks.
Gradual central bank independency has been granted so that successful solutions to inflation and bank supervision
can be undertaken.
Nascent Economies (with 80% world population but 20% world GDP)
Many of these are newcomers to the concept of central banking.
Low levels of independence and capital with inability to generate adequate revenues and conduct monetary policy.
Examples of the most independent central banks in nascent economies are the Reserve Bank of Africa and Central
Bank of Egypt.
Multinational central banks (The Eastern Caribbean Central Bank) and currency unions (Panama, El Salvador,
Ecuador) are different charters to substitute conventional central-banking roles to ensure the stability of the
currency, supervise the banking system, and conduct monetary policy.
Page 12 of 31
May 8, 2014
LECTURE 06: THE MONEY SUPPLY PROCESS

HOW CAN A CENTRAL BANK CREATE MONEY SUPPLY?
1)
2)
Total Deposits (TD) Creation from Reserves in a Financial Industry

Importance of TD in creating credit availability for a financial system
Increasing TD by Total Reserves = Required Reserve (RR) + Excess Reserve (ER)
Money Supply (MS) Creation from Monetary Base (MB)
Monetary Base = TD x (Total Reserves + Circulating Currency)
Total Deposits = MB / (RR + ER + Circulating Currency)
3)
Money Supply = TD + Circulating Currency

Control of MB with Desirable Effects on MS by a Central Bank
Adjustments in TD through Required Reserve Ratio (rrr)
Adjustments in MB through investing in Open Market Operations (OMO)
Adjustments in MB through lending from Discount Window Loans (DWL)
HOW IMPORTANT DEPOSIT CREATION IS TO CREDIT AVAILABILITY?

1)
2)
3)
4)
5)
Deposits from the public are a major source of funds of a financial industry that are transformed into credit to be
allocated to households and firms.
Creating more deposits would expand credit in a financial system with its resultant MS being utilized for consumption
and investment purposes.
Stakeholders whose roles in deposit-creation include:
Central bank (CB) who formulates monetary policy and supervises financial industry;
Depository institutions (DI) who take deposits from and grant loans to the public;
Depositors who provide insurable funds to depository financial institutions;
Borrowers who receive credit and loans from depository financial institutions.
Both CB and DI directly influence deposit- and credit-creation whereby the former specifies the RR and the latter
allocates credit in markets from ER.
Both depositors and borrowers are the beneficiaries of the central banks RR monetary policy and the depository
institutions ER credit policy as total reserves (TR) have direct impacts on both funding cost and credit quantity.
HOW MORE DEPOSITS ARE CREATED FROM REQUIRED RESERVE?

Since deposit funds in excess of required reserve (ER) are loanable, they can be further deposited continuously in a
financial system. However, such ER-based deposits would grow at a decreasing rate until they reach zero.
2) We could determine the magnitude of how much ER leads to multiple deposits from the reciprocal of the required
reserved ratio (rrr) or 1/rrr.
For example, given an initial deposit of $100 and an rrr of 10%, an ER equal to $90 would be generated for a bank
to lend, which in turn is deposited at another bank.
The second bank that is required to hold RR of 10% could lend only $81; the third bank, $72.90; the forth bank,
$65.61; and so on until the last deposit is fully depleted.
Total RR in the system is $100, which is derived from initial RR of $10 times 1/10%.
Total ER in the system is $1,000, which is derived from total RR of $100 times 1/10%.
1)
3) The ratio (1/rrr) is known as a Deposit Multiplier.
HOW IS MONEY SUPPLY CREATED BY A MONETARY BASE?

1)
2)
3)
4)
5)
The Money Supply (MS) consists of CC + DD

Circulating currency (CC) is what people are holding for their transactional purposes.
Demand deposits (DD) in a financial industry can be lent out in a financial system.
The Monetary Base (MB) or high-powered money comprises CC + TR
Circulating currency (CC) is what people are holding for their transactional purposes.
Total reserves (TR) can be allocated as required reserve (RR) and excess reserve (ER):
TR = RR + ER
DD can be used as MB because
Deposits are available funds that the financial industry could lend to any borrower to enhance credit and liquidity in
the financial system.
If the ratio CC/DD is high, then an ability to create multiple deposits would fall.
If the rrr is set too high, the ability to create multiple deposits would also fall.
MB can be transformed into MS based on:
Money Supply = Circulating Currency + Demand Deposits or MS = CC + DD
Monetary Base = Circulating Currency + Total Reserves
or MB = CC + RR + ER
DD is determined from a combination between RR and ER. A bank with high ER is able to transform it into more
credit that in turn leads to additional deposits for other banks. If the allocated credit is not deposited further, MS
would not be augmented.
CC and total reserves (RR + ER) can be transformed into DD based on:
demand deposit rate
ddr
DD / DD = 1
circulating currency rate
ccr
CC / DD
required reserve rate
rrr
RR / DD
Page 13 of 31
May 8, 2014
excess reserve rate
err
ER / DD
Money Supply = Demand Deposits x (ddr + ccr)

or
MS = DD x (1 + ccr)
Monetary Base = Demand Deposits x (rrr + err + ccr)
or
MB = DD x (rrr + err + ccr)
Demand Deposits = Monetary Base / (rrr + err + ccr)
or
DD = MB / (rrr + err + ccr)
6) Substituting DD into the MS equation gives:
Money Supply = Monetary Base / (rrr+err+ccr) x (1+ccr) or MS = [MB / (rrr+err+ccr)] (1+ccr)
Money Supply = Monetary Base x (1+ccr) / (rrr+err+ccr) or MS = MB x (1+ccr) / (rrr+err+ccr)
7) The ratio between MS and MB becomes the multiplier (m):
Money Supply / Monetary Base = (1+ccr) / (rrr+err+crr) or MS/MB = (1+ccr) / (rrr+err+ccr)
Multiplier = (1 + ccr) / (rrr + err + ccr)
or
m = (1 + ccr) / (rrr + err + ccr)
N.B. The ratios for ccr, rrr, and err are all based on DD from the whole financial industry.
A reduction in any one of such ratios would cause m to be higher and hence a larger MS.
8) The ratio (1 + ccr) / (rrr + err + ccr) is therefore the Money Supply Multiplier.
HOW CAN A CENTRAL BANK CONTROL THE MONETARY BASE?
1)
2)
Since a central banks assets must equal its liabilities, we could rearrange the equation as follows:
MB =
(NBR + BR) = (CC + TR)
NBR =
CC + TR BR
=
CC + (RR + ER) BR
=
CC + RR + (ER BR)
NBR =
CC + RR + NFR
We could then link MB to MS as follows:
MS =
CC + DD
DD =
MS CC
=
MS MS*(CC/MS)
DD =
MS * (1 h)
RR =
rrr * MS(1 h)
NBR =
(h*MS) + [rrr*MS(1 h)] + NFR
MS =
(NBR NFR) / [h + rrr(1 h)]
where: TR = Total Reserves = RR + ER

where: NFR = Net Free Reserve = ER BR
write CC in terms of MS
where: h = CC/MS or CC = h*MS
where: RR = rrr*DD
substituting in equation 5 above
rearrange in terms of MS
HOW CAN A CENTRAL BANK ADJUST THE MONEY SUPPLY?

1)
2)
From the MS equation being obtained above:

MS = (NBR NFR) / [h + rrr(1 h)]
Notice that MS depends on 4 variables, including NBR, NFR, rrr, and h.
The first three variables are controlled by the central bank while the last one is determined from peoples liquidity
preference whether to hold CC or DD.
Observation on the numerator: If NBR rises, MS would increase, and vice versa.
Observation on the denominator: If either h or rrr rises, MS would decrease.
We could interpret the above MS equation as follows:
MS = NBR / [h + rrr(1 h)] NFR / [h + rrr(1 h)]
Notice that MS is divided into two parts between NBR and NFR.
NBR is an exogenous variable that could be influenced by the central bank through trading government securities in
the open market, i.e., open market operations (OMO).
NFR is an endogenous variable that depends on financial institutions responses to loanable funds (ER) and interest
rate from discount window, i.e., borrowed reserve (BR).
Page 14 of 31
May 8, 2014
LECTURE 07: THE MONETARY POLICY TOOLS

WHAT ARE THE GOALS AND ROLES OF CENTRAL BANKS?
1.
2.
3.
Goals and Roles of Central Bankers

Price stability through inflation-level management and control
Growth stimulation through productivity and GDP enhancements
Financial stability through money-supply or interest-rate adjustments
Price Stabilization and Growth Stimulation
Monetary Targeting (MT)
Inflation Targeting (IT)
Implicit Anchoring (IA)
Financial (Systemic) Stabilization
Open Market Operations (OMO)
Discount Windows Loans (DWL)
Reserve Requirements (RR)
WHAT ARE THE GOALS AND ROLES OF MONETARY POLICY?

1) Domestic Monetary Policy Goals of a Central Bank
Price stability to reduce value uncertainties in domestic economic system
Employment stability by inducing productive growth in open economic systems
Financial stability to moderate systematic volatility in domestic financial system
2) Domestic Monetary Policy Roles of a Central Bank
Nominal anchoring of money-aggregate or inflation levels to stabilize price levels of goods/services and assets and
reduce short-term discretionary monetary policy.
Implicit anchoring of money-aggregate or inflation levels to control (accelerate or decelerate) their effects on price
stabilization and employment productivity.
Monetary policy encompasses the management of non-borrowed reserves (NBR), borrowed reserves (BR), and
required reserves (RR) by financial institutions in order to adjust money-aggregate or inflation levels so as to lend
impacts on credit availability and interest rates within domestic economic and financial systems.
WHAT ARE THE GOALS AND ROLES OF PRICE STABILITY?
1) Price Stability
Price stability means a condition in which an inflation level is relatively low with predictable trends and volatilities
in market values of goods, services, and assets.
Irrational or erratic rises of inflation rates would place more uncertainties on consumption activities and pose more
risks in investment activities.
As consumers and/or investors become less confident in price levels, their decisions would be sub-optimized
causing an economic growth to slow down.
2) Value Stabilization
Nominal anchoring on such price-level determinants as MS or inflation rates allows a central bank to stabilize value
dynamics within a desirable band in a long run yet sacrifice its flexibility to manage values in a short horizon.
However, monetary-policy discipline through nominal anchoring helps prevent the central bank from discretionary
pressures to ease or tighten credit conditions.
WHAT ARE THE GOALS AND ROLES OF EMPLOYMENT STABILITY?
1) Employment Stability
Employment stability means a condition wherein unemployment rates are relatively low with commensurate
productivity and economic growth rates.
Imbalanced employment and economic growth rates would negatively affect disposable income in the real sector
and asset values in the financial sector.
As income and/or values are reduced, either consumption and/or investment would decline or household and/or
business debts would rise unnecessarily.
2) Productive Growth
The effects of value stabilization lead initially to a stability in consumption and investment, uncertainty reduction,
heightened public confidence, higher money stock, lower interest rates, and eventually to more employment and
productivity, rising income and values, and more visible and predictable economic development.
Some central banks stress price-stability goal over employment-stability one (i.e., hierarchical mandates), others
place an equal emphasis (i.e., dual mandate).
WHAT ARE THE GOALS AND ROLES OF FINANCIAL STABILITY?
1) Financial Stability
Financial stability means a condition in which volatility in asset-price and/or interest-rate levels is relatively low
within a domestic financial system.
High volatility in either asset prices or interest rates would automatically increase risks of losses and systemic
fragility in the financial system.
As fund-providers and/or fundraisers lose their confidence in the financial system, its financial markets would
become less active while its financial industry riskier.
2) Systemic Stabilization
A central bank stabilizes domestic financial system through quantitative measures (e.g., credit volumes and interest
rates) and qualitatively (e.g., financial supervision of risk management and regulation on leverage management).
Quantitative measures include but are unlimited to NBR, BR, and RR management.
Page 15 of 31
May 8, 2014
Qualitative measures include risky-asset restrictions and risk-based capital-adequacy regulations.

HOW DOES A CENTRAL BANK STABILIZE PRICE LEVELS?
1)
2)
3)
Monetary Targeting (MT)

Setting explicit goals for an expansion/contraction of money supply (MS), which measures money-aggregate level.
The MS lends a direct impact on the level of interest rates and indirect effect on the level of expected inflation rates.
Inflation Targeting (IT)
Setting explicit goals for an increase/decrease in domestic expected inflation rates (), which is a measure of
monetary value for consumption or investment purposes.
The lends a direct impact on the level of good/asset prices as well as employment income and investment returns.
Implicit Anchoring (IA)
Monetary targeting could be ineffectual due to low MS and correlation.
Inflation targeting could be ineffectual due to targeted and expected inconsistency.
Implicit anchoring allows central bankers to pursue necessary preemptive actions instead of responding to
problems that could destabilize domestic price levels.
WHAT ARE THE PROS AND CONS OF MONETARY TARGETING?

1)
2)
Advantages of Monetary Targeting

Adjusting monetary base (MB), i.e., high-powered money, transmits impact to MS.
MT allows all stakeholders to immediately know a central banks stance.
MT is effective in controlling inflation as it directly deals with MS origin and in curbing discretionary decisions.
Disadvantages of Monetary Targeting
MT is less effective when the correlation between MS and is low since it could not lead to desirable levels of
inflation rates and prices.
With such a low correlation, a central bank would tend to be less transparent in its monetary-policy decisions and
actions, thereby raising doubts and increasing inconfidence among stakeholders and market participants as well as
systematic uncertainties and systemic risks as to the directions and levels of expected inflation rates, market
interest rates, and good/service/asset prices.
WHAT ARE THE PROS AND CONS OF INFLATION TARGETING?

1)
2)
Advantages of Inflation Targeting

Adjusting inflation rate () directly resolves the low-correlation problem with MS, leading to a more transparent
monetary-policy decisions and actions.
IT allows stakeholders to continuously monitor a central banks implementation.
IT helps reduces impacts of inflation on stakeholders as they have been prepared.
Disadvantages of Inflation Targeting
Outcomes of IT tend to reveal very slowly, making the central banks signaling efforts to domestic economy
inconsistent with the ongoing economic realities.
The delayed impacts of IT cause the central bank to be reluctant in responding to short-term shocks while awaiting
the effects of IT to materialize in a longer term.
Emphasis on IT alone could impede domestic growth despite long-term price-level stability since gross domestic
production (GDP) quantity is contingent upon expected inflation rates that would fluctuate in a short-term.
WHAT ARE THE PROS AND CONS OF IMPLICIT ANCHORING?

1)
2)
Advantages of Implicit Anchoring

Eliminating the low correlation problem between MS and in MT.
Reducing the delayed impact of IT because a central bank already took action.
Allowing the central bankers to respond/counteract short-term shocks or exploit unexpected opportunities to
improve the outcomes more promptly and decisively.
Disadvantages of Implicit Anchoring
The central banks decisional and operational transparency would be low, disallowing stakeholders and market
participants to monitor and scrutinize its efficiency/effectiveness thereby reducing public confidence.
IA would lead to more discretionary monetary-policy practices that might be in conflict with the central banks
other long-terms goals.
IA would be least effective in shoring up public and market confidence if the behavior of principal central bankers is
inconsistent and doubtful.
HOW DOES A CENTRAL BANK STABILIZE MONEY SUPPLY?

1)
2)
Four types of financial-institution reserves with a central bank

Non-borrowed Reserve (NBR) represents a supply of reserves that a central bank injects into (reclaims from)
domestic financial institutions through buying (selling) government securities (i.e., open-market operations).
Borrowed Reserve (BR) represents a supply of reserves that a central bank prepares to lend to domestic financial
institutions through discount windows whey they could not borrow from other financial institutions in the market.
Required Reserve (RR) represents a demand for reserves that all financial institutions must keep on their
balance sheets to maintain their liquidity in order to withstand any massive withdrawal from their depositors.
Excess Reserve (ER) represents a demand for reserves that any financial institution could choose to lend to its
customers (as credits and loans) or to borrow from other institutions to replenish their RR without resorting to
raising deposits in short notice.
Equilibrium between Demand for and Supply of Monetary Base
(NBR + BR) = (RR + ER + CC) = MB
A rise in NBR or BR by a central bank would cause MS to rise, forcing interest rates to fall.
Page 16 of 31
May 8, 2014
A rise in RR, ER, or CC in financial institutions would cause MS to fall, forcing interest rates to rise.
Page 17 of 31
May 8, 2014
LECTURE 08: THE MONETARY POLICY CONDUCT

WHAT ARE THE CONVENTIIONAL MONETARY POLICY STRATEGIES?
1.
2.
3.
Open Market Operations (OMO)

When a central bank purchases government securities, it injects NBR into domestic financial system through a financial
industry, raising MS and lowering the level of short-term interest rates in both markets and inter-bank transactions.
The opposite is true whenever a central bank sells government securities.
Discount Window Loans (DWL)
A central could inject BR directly to a financial industry to raise MS but would not affect the level of short-term interest
rates since a discount rate is set below them.
A central bank could raise its discount rate to discourage financial institutions from borrowing directly from it when it
wants to slow-down domestic credit expansion.
Reserve Requirements (RR)
If a central bank raised the required reserve ratio (rrr) of all financial institutions, their RR would rise causing the MS
multiplier to fall thereby reducing MS and raising short-term market interest rates.
A rising short-term market interest rate would cause financial institutions to reduce their ER due to opportunity losses in
lending to their customers.
WHAT ARE THE ADVANTAGES OF OPEN MARKET OPERATIONS?
OMO allow a central bank to

Completely control the changes in reserves, monetary base, and money supply without any concern about the behavior
of any financial institution whether or not it would obstruct its monetary policy conduct.
2) Flexibly adjust the levels of market interest rates with high precision since it could calibrate interest-rate changes with
the changes in government-securities trading.
3) Promptly negate its decisional errors by reversing its OMO transactions with minimum impacts and maximum fairness
to all parties concerned, if necessary.
4) Automatically execute trading without any tedious decision-making process within the boundary of its monetary policy.
1)
WHAT ARE THE PROS AND CONS OF DISCOUNT WINDOW LOAN?

1)
2)
Advantages of DWL
It serves as the lending of last resort for financial institutions to secure their reserves and liquidity in an emergency.
It is a source of reserves outside the banking industry for a central bank to control short-term market interest rates.
Disadvantages of DWL
The decision whether to borrow from a central bank belongs to a bank as it would compare across different sources.
If the discount rate is less competitive than interbank rates or those prevailing in the markets, then the central
banks intent to affect the financial institutions reserves might not be fulfilled.
WHAT ARE THE DISADVANTAGES OF RESERVE REQUIREMENT?
The downsides of RR include

1) Unenforceability toward unregulated institutions that do not take deposits, i.e., shadow banking firms.
2) Illiquidity problem in some financial institutions if the rrr applicable to them was set too high.
3) Liquidity-management issues in financial institutions if the rrr has been changed back and forth too frequently.
4) With the above rationales, many economists have recommended that RR be abandoned or abolished entirely.
WHAT ARE THE NON-CONVENTIIONAL MONETARY POLICY STRATEGIES?

1.
2.
3.
Purchase of Risky Assets (an extension of OMO)

A central bank could purchase such riskier assets as long-term government and non-government securities in addition to
the usual liquid short-term securities to raise money-supply level with a corresponding effect on interest-rate reduction.
Such a practice is known as quantitative easing (QE) wherein the central bank deliberately expands the asset classes in
its balance sheet beyond the riskless securities that it holds, leading to an increase in monetary base.
However, if the rise in monetary base does not translate into new loans (since banks are unwilling to lend to risky
borrowers), then the credit markets would still freeze up and the asset markets would still spiral down.
The central bank must ensure that its QE leads to credit easing (CE) which improves credit conditions.
Provision of Extra Liquidity (an extension of DWL)
A central bank could provide additional or extraordinary liquidity through financial industry by
1) Lowering its discount rate relative to the prevailing interbank lending rates,
2) Auctioning its temporary loan facility at competitive lending rates than its discount rate, and
3) Extending new loans to non-depository institutions (investment or insurance firms) to promote asset investments.
Such extra liquidity injections should help the central bank mobilize funds from excess reserves due to QE to more loans
in the credit markets due to CE and more purchases of existing securities in the asset markets to stabilize their prices.
Commitment to Policy Actions (for policy credibility)
A central bank could commit itself to some quantitative targeting strategies such as reducing the short-term interbank
lending rates (from banks excess reserves deposited at the central bank) in a long run to a near zero percent so that the
long-term interest rates in financial markets would fall either with or without conditions attached.
A conditional commitment of the central bank is less credible than an unconditional one since the market participants
could expect it to abandon its commitment.
An unconditional commitment is less preferred by the central bank because it could not unwind its commitment when
Page 18 of 31
May 8, 2014
economic situations or market conditions have improved.
WHAT ARE THE TACTICS THAT A CENTRAL BANK CAN CHOOSE?

1)
2)
3)
Monetary Tools
Open market operations to affect NBR by controlling stock and flow of reserves.
Discount rates to affect BR by adjusting short-term rate to compete in the market.
Reserve requirements to affect RR and ER by adjusting a money-supply multiplier.
Policy Instruments
Reserve-aggregate targets (NBR, BR, RR, ER, and CC resulting in monetary base)
Interest-rate targets (short-term rate changes resulting in different reserve levels)
Intermediate Targets
Intermediate targets (e.g., medium-term money-supply and interest-rate levels)
Reserve-aggregate and interest-rate targets are incompatible, i.e., a central bank must choose one way or the other.
WHAT ARE THE CRITERIA FOR CHOOSING POLICY INSTRUMENTS?
Observability allows adequate transparency in monetary-policy conducts

Measurability allows appropriate disclosure for quantitative comparability
Controllability allows a central bank to manage monetary-policy tools
Predictability allows a central bank to forecast monetary-policy impacts
1) Inflation Gap & Output (Employment) Gap
Real output stabilization is an important concern.
Output gap is an indicator of future inflation as shown by the short-run Phillips curve (i.e., a trade-off between
unemployment and inflation).
Unemployment rate can be reduced in a short run by increasing inflation rate. Demand and output will rise.
Therefore, if the government attempts at reducing unemployment through fiscal deficits, then the market could
expect the inflation to rise, and vice versa.
The question is how much unemployment rate should be targeted so that the inflation rate would not rise.
2) Non-accelerating Inflation Rate of Unemployment (NAIRU) is the long-run Phillips curve.
NAIRU is a natural unemployment rate at which there is no tendency for an inflation rate to change.
If the actual unemployment rate is below NAIRU, inflation will accelerate.
If the actual unemployment rate is above NAIRU, inflation will decelerate.
If the actual unemployment rate is equal to NAIRU, inflation will stabilize.
HOW HAS THE FED CONDUCTED ITS MONETARY POLICY?
The United States has achieved excellent macroeconomic performance, including low and stable inflation, without
using an explicit nominal anchor such as an inflation target until the onset of the 2008 global financial crisis.
2) Historical Development
The Fed began to announce publicly targets for money supply growth in 1975 (monetary targeting).
Fed chairman, Paul Volker, focused more in non-borrowed reserves in 1979 (open market operations).
Fed chairman, Alan Greenspan, announced in 1993 that the Fed would not use any monetary aggregates as a guide
for conducting monetary policy (e.g., inflation targeting).
There is no explicit nominal anchor in the form of an overriding concern for the Fed.
Forward looking behavior and periodic preemptive strikes (implicit anchoring) to prevent rational-expectations
inflation to rise ahead of output (or employment) growth.
The goal is to prevent inflation from getting started (due to excess liquidity or below-NAIRU unemployment).
1)
WHAT ARE PROS & CONS OF THE FED MONETARY STRATEGY?

1)
2)
3)
4)
Advantages of Implicit Anchoring Approach

Uses many sources of information
Demonstrated success
Disadvantages of Implicit Anchoring Approach
Lack of accountability
Inconsistent with democratic principles
Advantage of Just Do It Approach
Forward-looking behavior and stress on price stability help to discourage overly expansionary monetary policy,
thereby lessening the time-inconsistency problem.
Disadvantages of Just Do It Approach
Lack of transparency
Highly dependent on the preferences, skills, and trustworthiness of the persons in charge of the central bank
WHAT ARE THE LESSONS FROM THE 2008 GLOBAL CRISIS?

1)
2)
Developments in financial system yield crucial impacts on economic activities than they did earlier.
The zero-lower-bound interest rates can be a problem as negative rates are possible (as an incentive for not to lend).
The cost of cleaning up after a financial crisis is higher than what the public funds (tax-payer money) could cover.
Price and output stability do not always ensure financial stability while misbehavior (e.g., greed and lies) of
financial participants is still rampant.
How should central banks respond to asset price bubbles?
Page 19 of 31
May 8, 2014
3)
4)
5)
Asset-price bubbles: pronounced increase in asset prices that depart from intrinsic values, which eventually burst.
What are the factors that induced asset-price bubbles?
Aggressive/predatory credit extension (e.g., resulting in the subprime crisis)
Irrational exuberance of investors/speculators (e.g., in real-estate markets)
Should central banks respond to bubbles?
Strong argument for not responding to bubbles driven by irrational exuberance.
Bubbles are easier to identify when asset prices and credit volumes are increasing rapidly at the same time.
Monetary policy should not be used to pierce bubbles.
Macropudential Policy
Regulatory policy that reflects what happened and affects what will happen in credit markets at the aggregate level.
Managed Monetary Policy
Central banks and other regulators should not have a laissez-faire attitude and let credit-driven bubbles proceed
without any reaction.
Page 20 of 31
May 8, 2014
LECTURE 09: THE FOREIGN EXCHANGE MARKET

HOW IS AN EXCHANGE RATE VALUED AND DETERMINED?
1.
Valuation of a Foreign Exchange (FX)

FX appreciation vs. depreciation
The Purchasing Power Parity (PPP)
The Interest Rate Parity (IRP)
Observations in FX changes from the PPP and IRP standpoints
Relationships between FX rates and interest rates (nominal vs. real)
Determination of FX in Short- and Long Terms
Determinants in free trade of goods & services that affect FX rates in a long run
Determinants in free flow of money & capital that impact FX rates in a short run
FX equilibrium in asset markets
2.
HOW IS AN FX QUOTED AND WHY ITS VALUE IS IMPORTANT?

An FX rate is a price of foreign currency (f) per a unit of domestic currency (d), e.g., USD0.16/CNY, or a price of
domestic currency per a unit of foreign currency, e.g., CNY6.22/USD.
2) The first FX convention which is the ratio between f/d is called a direct quote whereas the second FX convention
which is the ratio between d/f is known as an indirect quote.
3) FX bears significance in both domestic and international financial systems because:
It measures a countrys competitive performance in trade and finance vis-
-vis others amid global marketplaces.
On trade, a country whose FXd value is weaker relative to its trading partners could export more than it could
import, allowing it to have a surplus in trade balance or current-account balance since its revenues are in FXf, but
its import costs of raw material, machinery, energy, or technology would be too high.
On finance, a country with weaker FXd could attract more foreign capital to invest in its assets and employ its
resources, allowing it to have more economic growth, but its borrowing costs would be too high leading to a deficit
in capital-account balance or balance of payments as it has to service debts in FXf.
1)
WHAT CAUSE AN FX TO CHANGE OR ADJUST IN VALUE?

1)
FX variations are caused by 1) global market mechanisms or 2) domestic interventions by government or central bank.
2) Based on the first source, the FX rate would change according to dynamics in the demand and supply of different
currencies. Based on the second source, authorities in a certain country could intervene to adjust its FX d by actively
trading it in the global markets in order to minimize any undesirable impact on its economic or financial system.
3) A change in FX due to global market mechanisms can lead to two outcomes: 1) FX appreciation or 2) FX depreciation.
If a direct quote is used, an FX appreciation or depreciation would also be direct, e.g., from USD0.16/CNY to
USD0.17/CNY when appreciating and from USD0.16/CNY to USD0.15/CNY when depreciating.
If an indirect quote is used, an FX appreciation or depreciation would also be inverse, e.g., from CNY6.22/USD to
CNY6.21/USD when appreciating and from CNY6.22/USD to CNY6.23/USD when depreciating.
4) An adjustment in FX due to domestic interventions can lead to two outcomes: 1) FX revaluation or 2) FX devaluation.
HOW CAN AN FX CHANGE BE ESTIMATED BY THE PPP?
Purchasing Power Parity (PPP)

The Law of One Price posits that identical goods (or perfect substitutes) though produced in different countries ought to
have the same price, for their different prices would lead to a country with a weaker FXd to sell such goods more cheaply
than others with stronger FXf, resulting in such countries adjusting their FXf to make their goods more competitive.
At the macro level, if a price level in one country rises (falls) according to its domestic inflation rate in the present, its
FXd would depreciate (appreciate) in the future so that its relative price level of goods in the global market is would be
competitive, following the Law of One Price.
The PPP Theory specifies that a change in relative price levels of goods due to different inflation-rates, foreign (f ) and
domestic (d ), has a long-run effect on a change in FXd as follows:
%FXd = f d
If f > d, then FXd would appreciate (+%FXd) in a long term.
If f < d, then FXd would depreciate (%FXd) in a long term.
HOW CAN AN FX CHANGE BE ESTIMATED BY THE IRP?
Interest Rate Parity (IRP)

The Law of One Price can be applied to assets that pay the same rates of return but are traded in different countries.
When an interest rate underlying assets is low, asset prices would rise making their returns higher thereby attracting
foreigners to invest in them. As that happens, FXd would appreciate so that the domestic interest rate would adjust to
equate with other foreign interest rates.
At the macro level, if an interest rate in one country rises (falls) according to its domestic credit condition in the present,
its FXd would depreciate (appreciate) in the future so that its relative price level of assets in the global market would be
competitive, following the Law of One Price.
The IRP Theory specifies that a change in relative price levels of assets due to different interest rates, iforeign (if) and
idomestic (id), has a short-run impact on a change in FXd as follows:
%FXd = [ (1+ if ) / (1+ id) ] 1
If if > id, then FXd would appreciate (+%FXd) in a short term.
If if < id, then FXd would depreciate (%FXd) in a short term.
Page 21 of 31
May 8, 2014
AN EXAMPLE OF HOW A CHANGE IN FX CAN BE ESTIMATED BY THE IRP.

1)
A Chinese investor has a choice between buying a local bond that pays domestic interest rate of (id) 3% p.a. and a US
bond that pays foreign interest rate of (if) 4% p.a. Assume that a current FXd today between CNY and USD is
CNY6.22/USD.
2) With an existing interest-rate relationship in which if > id, it could be expected based on the IRP that a future FXd
would be appreciating in a short term (i.e., within one year).
3) The investor would compare which bond pays a higher return taking into account a future change in FXd rate. Assume
that she contemplated investing CNY10,000 in either bond.

Return on the local bond after 1 year = CNY10,000 * 1.03
= CNY10,300.00
Return on the US bond after 1 year = CNY10,000/6.22 * 1.04
= USD1,672.03
1. If FXd stays the same, the US bonds return in terms of CNY = $1,672.03 * 6.22 = CNY10,400
2. If FXd depreciates, the US bonds return in terms of CNY = $1,672.03 * 6.23 = CNY10,416.75
3. If FXd appreciates, the US bonds return in terms of CNY = $1,672.03 * 6.21 = CNY10,383.31
4) The FXd that would equate the return from either bond is 10,300/1,672.03 = CNY6.16/USD.
5) Therefore, the FXd one year from today must appreciate from CNY6.22/USD to CNY6.16/USD if if > id today.
WHAT ARE IMPORTANT OBSERVATIONS ABOUT FX CHANGES?

1)
2)
By comparing FX results based on the PPP and IRP, it is found that:

A change in FX rate can be either positive (appreciation) or negative (depreciation) due to adjustments in relative
inflation rates (good price level) or in relative interest rates (asset price level) between any given pair of countries.
Adjustments in relative inflation rates stem from changes in demand & supply conditions in a domestic economy for
goods & services and in import & export conditions between trading partners in a global economy.
Adjustments in relative interest rates stem from changes in demand & supply conditions in domestic markets for
assets & capital and investment & funding conditions between financial parties in an international financial system.
Adjustments in good price level and inflation rate occur slower than adjustments in asset prices and interest rates.
Uncertainties that drive changes in FX rates are typically influenced by:
Factors affecting the price levels of cross-border goods such as transportation costs might give the results that
deviate from what the Law of One Price predicts.
Factors affecting the price levels of assets from two sources: 1) inflation-induced interest rate (nominal rate); and 2)
inflation-adjusted interest rate (real rate). If an interest rate changes nominally, then FX rate change will be invert;
if it changes in a real term, then FX rate change will be direct.
WHAT ARE IMPORTANT OBSERVATIONS ABOUT FX CHANGES?

1) An inverse relationship between FXd and nominal interest rate (Nominal Effect)
A rise in nominal interest rate due to growing inflation would push the costs of domestic funding above the returns
on investment. As a result of higher costs, domestic capital would flee domestic assets causing FXd to depreciate.
A fall in nominal interest rate due to shrinking inflation would press the costs of domestic funding below the returns
on investment. As a result of lower costs, foreign capital would flow into domestic assets causing FXd to appreciate.
2) A direct relationship between FXd and real interest rate (Real Effect)
A rise in real interest rate would drive down domestic asset prices (cheaper) thereby increasing their returns on
investment. As a result of lower prices, foreign capital would flow into domestic assets causing FXd to appreciate.
A fall in real interest rate would drive up domestic asset prices (more expensive) thereby lowering their returns on
investment. As a result of higher prices, foreign capital would flee domestic assets causing FXd to depreciate.
WHAT DETERMINE FX RATES IN A LONG RUN?
In addition to relative price levels and inflation rates among countries (i.e., nominal effect), other real factors that
affect FX rates in a long run include:
Trade barriers that could raise the costs of import or export due to tariffs or non-tariffs, which affect either
relative prices or quantities of goods and services.
Consumer preferences that cause demands for either domestic goods and services in foreign countries or
foreign goods and services in domestic country to change without anything to do with relative price levels.
Relative productivity that causes production costs in one country to be different (i.e., higher or lower) from
those in others leading to changes in relative prices without anything to do with relative inflation rates.
Long-run changes in FXd could be caused by the real factors in economic systems beyond the nominal factors
that have occurred among countries.
2) Thus, the PPP relationship being used to forecast future FX should be adjusted as:
1)
%FXnominal = (f d) + %FXreal
WHAT DETERMINE FX RATES IN A SHORT RUN?
There are factors that could impact FX rates in a short run including relative interest rates and relative returns from
investing in assets whose prices are identical across different countries in terms of uncertainty levels.
2) The factor that is most impactful on short-term returns is volatility of asset prices in financial markets. If domestic
asset volatility is lower (higher), demands for domestic assets would rise (fall), causing FXd to appreciate (depreciate).
3) Asset volatility affects the following variables that determine short-term FX rates:
Domestic interest rate, as a cost of fund, would inversely cause asset prices to change. If interest rate has risen, then
domestic asset prices would fall, causing demand for domestic assets to rise and FXd to appreciate relative to FXf.
Foreign interest rate that also inversely causes foreign asset prices to change. If foreign interest rate has risen, then
foreign asset prices would fall causing demand for foreign assets to rise and FXd to depreciate relative to FXf.
Expected FXd that would cause returns on domestic assets to change. If the expected FXd has risen, demand for
1)
Page 22 of 31
May 8, 2014
domestic assets would rise and FXd would appreciate relative to FXf.
Money supply that would cause liquidity level to change thereby changing asset prices. If domestic liquidity level
has risen, then domestic asset prices would also rise, causing demand for domestic assets to fall and FX d to
depreciate relative to FXf.
Short-run changes in FXd are the results of demand and supply of domestic assets.
4) Beyond the IRP relationship, other variables impacting FXd must be considered.
WHAT IS FX EQUILIBRIUM IN ASSET MARKET?
FX Equilibrium in Asset Market

Due to the changes in a real interest rate that directly affect asset prices and FX, the changes in demand for and supply of
assets would also affect an equilibrium FX as follows:
FXd rate that has been strong would support domestic asset prices to remain at a high level, resulting in an excess supply
of assets. Investors would then sell domestic assets more than buying them, causing FXd to depreciate.
FXd rate that has been weak would keep domestic asset prices to remain at a low level, resulting in an excess demand for
assets. Investors would then buy domestic assets more than selling them, causing FXd to appreciate.
As demand for and supply of assets are equal, holding other factors constant, the FXd would reach its equilibrium rate.
At that equilibrium FXd, an equilibrium interest rate would also be determined.
Page 23 of 31
May 8, 2014
LECTURE 10: ANALYSIS OF FINANCIAL CRISES

WHAT IS A FINANCIAL CRISIS?
1.
2.
Financial Frictions: stem from asymmetric-information problems that act as a barrier to efficient allocation of capital
after which financial markets are less capable of channeling funds efficiently from savers to households and firms.
Financial Crisis: occurs when information flows in the financial markets experience a particularly large disruption, with
the result that financial frictions increase sharply and financial markets stop functioning.
WHAT CAUSE FINANCIAL CRISES IN ADVANCED ECONOMIES?

1)
2)
3)
Stage One: Initiation of Financial Crisis

Mismanagement of financial innovation (new funding products) or financial liberalization (less funding
restrictions) is deemed to be the origin of a financial crisis, not the prudent and well-managed utilization of them.
Credit boom (lending spree due to excess liquidity) before a crisis and deleveraging (lending curb due to loan
losses) after a crisis. Deterioration in banks balance sheets and net worth leads to credit crunch (lending
contraction)
Asset-price boom (irrational exuberance) and bubble (uncovered speculation) pre-crisis and bust (price correction
to fundamental value) post-crisis. Deterioration in borrowers balance sheets leads to more risk-shifting behavior
that triggers banks to start limiting their loans (deleveraging and credit crunch).
Increased uncertainties around or after a crisis are caused by inadequate or lack of information, which would lead
to a widespread deterioration in trust that further aggravates the impacts of the crisis on financial markets.
Stage Two: Banking Crisis
Bank panic caused by simultaneous failures of a few banks facing insolvency (negative net worth) after a financial
crisis trigger massive withdrawals by depositors (bank runs) because of their fear of losing money amid increased
uncertainties fueled by asymmetric information and deterioration in depositors trust in banks.
Fire sale (forced liquidation) of insolvent banks assets to raise funds to pay their depositors and creditors during a
banking crisis worsens financial frictions in the markets as asset prices across the board plummet, dragging down
the values of healthy banks along the way until the crisis contagion becomes a full-fledged bank panic.
Stage Three: Debt Deflation
Debt deflation, i.e., a rise in the value of liabilities relative to that of assets in real term due to their fixed contractual
payments are in nominal term, occurs when a unanticipated sharp decline in the market-price level of financial
assets during their fire sale and a prolonged economic downturn. As a result, the value of net worth in real term
declines.
Real-term net worth decline in the balance sheets of both borrowers and banks causes an increase in risk-taking by
the borrowers and deleveraging by the banks, which exacerbate credit contraction in the whole economy.
HOW WAS THE GREAT DEPRESSION OF 1930 DEVELOPED?

1)
2)
3)
4)
5)
Stock Market Crash

After stock prices doubled in US equity market during 1928-29, the US central bank (Federal Reserve) believed it
was due to speculation and decided to raise market interest rates to curb speculative investments.
Stock prices rapidly adjusted downward by 40 percent leading to equity market crash in October 1929.
Bank Panics
After stock prices rebounded during mid-1930, banks that lent to farmers in the Midwest suffered loan losses from
mortgage defaults following severe droughts, triggering bank runs and full-fledged bank panic by the end of 1930.
With many banks failed leaving only a few with deteriorating net worth in operations, financial markets struggled to
channel funds to borrowers with productive investment opportunities as deleveraging process phased in.
Stock Prices Decline
As financial frictions arose, healthy businesses were charged with higher interest rates by banks, resulting in a rise
of credit spread (i.e., a difference between the interest rate on risky loans and that on safe assets).
As financial crisis hit the markets by mid-1932, stock prices fell sharply again by 90 percent from their 1929s peak
level due to increased uncertainty in business conditions, asymmetric information, and economic contraction.
Debt Deflation
A 25-percent decline in asset price level following the stock-market crash caused a debt deflation in which a realterm net worth of all borrowers fell because a decrease in their asset values led to an increase in their debt burdens.
Credit conditions worsened as banks curbed their loans to productive borrowers with deteriorating net worth
thereby raising unemployment rate to as high as 25 percent and prolonging a nationwide economic contraction.
International Dimensions
As the US economy contracted, its demand for foreign goods had declined. The worldwide depression caused great
hardship as millions of people were out of jobs.
The resulting discontent led to the rise of fascism and World War II. The consequences of the Great Depression
financial crisis were disastrous.
HOW WAS THE GLOBAL FINANCIAL CRISIS OF 2008 DEVELOPED?

1)
Causes of the 2008 Global Financial Crisis

Financial innovation in the mortgage markets
1. Advanced and enhanced quantitative assessment of credit risk engendered a new class of residential mortgages
allowing less creditworthy individuals to borrow funds below prime rates (i.e., subprime).
2. Banks found it more liquid to bundle different mortgages that have similar credit risk exposure, through their
loan securitization process, into marketable assets called mortgage-backed securities (MBSs).
3. Banks also securitized their other risky assets into asset-backed securities (ABSs) and bundled them with MBSs
to form a securitized portfolio of structured products called collateralized debt obligations (CDOs).
Page 24 of 31
May 8, 2014
2)
3)
4)
Agency problems in the mortgage markets

1. Since CDOs were underwritten by investment banks and distributed by securities brokers who had no incentive
to monitor the performance of loans or collateral assets that back them, banks found it profitable to grant more
securitizable mortgages to borrowers who relied on the rising value of their houses.
2. Risk-taking borrowers could either reap capital gain from future prices of their houses that might exceed their
mortgage values or walk away if future prices drop since banks or MBS investors would absorb the risk.
3. Knowing privately that those CDOs were risky, banks started protecting themselves against any potential loss by
entering into credit default swap (CDS) contracts with insurance firms, who in turn sold a separate set of CDSs
to other investors who wished to bet against the value of CDOs based on their housing-price bubble
expectations.
Asymmetric information and credit-rating agencies
1. Due to non-disclosure of lending information, bank regulators who are supposed to monitor banks and their
loans on behalf of all CDO investors did not know whether those borrowers were able to afford the loans.
2. Credit-rating agencies who are supposed to provide accurate risk assessment of those securitized and structured
credit products to CDO investors had conflicts of interest as they also advised their banking clients on how to
structure credit products that could achieve the highest possible rating.
Effects of the 2008 Global Financial Crisis
Residential housing prices boom and bust
1. Financial innovation (securitized/structured products) and financial liberalization (excess liquidity and huge
capital inflows) helped spur subprime mortgage loans, which led to asset-price boom between 2001 and 2007.
2. When housing prices rose, subprime borrowers were unlikely to default and CDO investors were safe because
the securities were backed by subprime-mortgage cash flows that paid high returns, creating more housing
demand.
3. As profits from originating mortgages and underwriting structured products rose, banks lowered their lending
standards to allow high-risk borrowers to obtain credit almost without any down payment.
4. Until the housing prices were too far above the rental cost or the households medium income, they reached the
point where their bubble has to burst in 2006 with the housing values falling substantially below the mortgages.
Deterioration of financial institutions balance sheets
1. After a housing-price bubble, many banks underwent defaults in their mortgages that in turn led to a collapse in
their securitized and structured products. Losses in banks loan portfolios caused their net worth to decline.
2. To shore up their weakened balance sheets, banks started to deleverage, fire-sell assets, and curb new loans.
With credit crunch in the banking sector, financial frictions were widespread in a financial system.
Run on the shadow banking system
1. Shadow banking, which is an alternative to conventional banks, encompasses less-regulated financial
institutions (e.g., investment banks, hedge funds, and non-depository firms) and provides funds to borrowers
through short-term repurchase agreements (repos) that must be backed by liquid assets (e.g., MBSs) as
collateral (haircuts).
2. When MBS value collapsed, many shadow banking firms were faced with difficulties raising funds at the same
haircuts they had before and thus forced into fire sales of their assets to keep their balance sheets afloat.
3. However, fire sales had put more downward pressure on their asset values resulting in a quick depletion of their
liquidity levels, which lent a similar effect to bank runs. More deleveraging and financial frictions followed suit.
Credit shock in the global financial markets
1. The downgrading by S&P and Fitch credit-rating agencies of MBSs and CDOs sold internationally caused some
non-US shadow banks that held them to suffer substantial losses and shadow-bank runs.
2. Despite liquidity injections by the ECB and the Fed, banks were unwilling to lend among themselves and to their
shadow banking counterparts lest a downward spiral of MBSs would affect the haircuts that backed their repos.
Failure of high-profile firms
1. Bear Stearns, the fifth-largest investment bank in the US, had a run on its repo borrowing and was acquired by
JP Morgan in March 2008. The Fed had to take over $30 billion of Bear Stearnss opaque assets.
2. Fannie Mae and Freddie Mac, two privately-owned and government-sponsored enterprises, were put into
conservatorship in September 2008 after the MBSs that they insured lost their value over $5 trillion.
3. Lehman Brothers, the fourth-largest investment bank in the US, filed for bankruptcy in September 2008.
4. Merrill Lynch, the third-largest investment bank in the US, also suffered the MBS losses and was sold to Bank of
America in September 2008.
5. American Insurance Group (AIG) that wrote over $400 billion worth of CDSs was credit-downgraded and
suffered liquidity shock in September 2008. The Fed had lent $85-$173 billion to keep AIG afloat.
Height of the 2008 Global Financial Crisis
September 2008 was the height of the crisis when stock market crashed and financial frictions in the credit market
were most pronounced (i.e., credit spreads between the US Treasury bonds and the Baa corporate bonds averaged
about 550 basis points or 5.5 percent).
The annualized real GDP growth rate of the US fell by -1.3 percent in the third quarter of 2008 and by -5.4 percent
and -6.4 percent in the next two quarters. The unemployment rate rose over 10 percent by the end of 2009.
This round of economic contraction in the US was the worst since WWII and is known as the Great Recession.
Government Interventions and the Recovery
Compared with the 1930 Great Depression, the 2008 Great Recession was smaller in magnitude because the US
government had stepped in to support the financial markets and stimulate the whole economy.
The Fed injected liquidity into the banking system while easing monetary-policy measures to ensure that credit was
adequately available for households and firms to continue their consumption and investment activities.
The Treasury bailed out some financial institutions through the Troubled Asset Relief Plan (TARP) under the
Economic Recovery Act of 2008 while raising deposit-insurance ceiling to limit runs on banks.
The Bush administration, through the Economic Stimulus Act of 2008, provided a $78 billion fiscal-stimulus
package with a one-time $600 tax rebate to each taxpayer. The Obama administration, through the American
Recovery and Reinvestment Act of 2009, provided a bigger package of $787 billion, which is highly controversial.
Page 25 of 31
May 8, 2014
WHAT CAUSE FINANCIAL CRISES IN NASCENT ECONOMIES?

1)
2)
3)
Stage One: Initiation of Financial Crisis

Mismanagement of financial innovation or liberalization leads to the cycles of credit boom-bust in financial
industry and asset-price boom-burst in financial markets similar to what could happen in the advanced economies.
Severe fiscal imbalances due to a government excessive leverage (debt/GDP) and inability to finance its spending
cause it to force banks to buy its debt. With more government securities on their balance sheets, banks face a
similar problem to risky loans when investors who are less confident in the public sector sell their government
securities thereby reducing their market value. As banks overall assets decline in value, their net worth eventually
decreases.
Additional factors include rising interest rates as a result of credit crunch in the banking sector following the fiscal
imbalance in a nascent economy, declining asset prices due to interest payments difficulty in the non-banking
sectors following the credit crunch, and increasing uncertainties about returns on investments due to political
instability.
Stage Two: Currency Crisis
When a nascent economy is in trouble, its currency weakens against others thereby inducing speculative attacks.
Currency crisis triggered by deteriorated bank balance-sheet occurs when a government faces a dilemma between
raising the interest rate to defend its currency and keeping low to ease the credit conditions in its financial system.
Since speculators know that the government cannot intervene to raise domestic interest rate and buy domestic
currency in the long haul with a looming financial crisis, they will keep attacking the currency until it is devalued.
Currency crisis triggered by severe fiscal imbalance happens as investors in a nascent economy are less confident in
a governments ability to restore its fiscal balances and will then move their funds away to other countries thereby
causing domestic currency to depreciate against other foreign ones. Speculative attacks will help escalate the crisis.
Stage Three: Full-fledged Twin Crises
Since debt in a nascent economy is denominated in foreign currencies, a currency mismatch from an unanticipated
devaluation/depreciation fuels the financial crisis due to mismanagement or fiscal imbalance into a full-blown
scale.
When domestic currency weakens, foreign currency-denominated debt value rises relative to asset value causing
net-worth value to decline in the balance sheets of both banks and non-bank firms. As a result, credit crunch in the
banking sector and economic contraction in the non-banking sectors follow suit.
Inflation rate in a nascent economy also rises after the twin crises (i.e., currency plus financial crisis) hit it. Firms
shall face rising import costs as well as interest payments resulting in their inability to meet debt obligations. Banks
shall be unwilling to lend to firms that have cash-flow problems and shrinking net worth leading to economic
contraction.
HOW WAS THE SOUTH KOREAN FINANCIAL CRISIS OF 1997 DEVELOPED?

1)
2)
3)
4)
5)
6)
Financial Liberalization and Credit Deleveraging

Korean government had embarked since 1990 upon a liberalization of financial markets and a deregulation of
financial industry, which led to massive borrowing from foreign sources and domestic credit boom.
Due to weak banking supervision and borrower screening, banks suffered from loan losses and declining net worth.
Perversion of Financial Liberalization/Globalization Process
The push for Korean financial liberalization was attributed to its politically powerful conglomerates called
chaebols that were deemed too-big-to-fail (i.e., safety-net bailout), which always encourages risk-shifting
behavior.
Between 1990 and 1996, only five of those chaebols were profitable leaving eight of them with poor performance.
With government safety net on chaebols, banks continued to lend to those troubled firms.
Exploiting financial liberalization, the chaebols pursued growth through expansion by borrowing internationally
without any restriction on short-term capital inflow but with some limits on long-term one.
The chaebols also expanded into financial industry by converting their finance companies into merchant banks
that were allowed to lend short-term funds being raised from overseas to domestic firms in a wholesale manner.
Stock Market Decline and Failure of Firms
A lot of exporting chaebols were negatively affected by the shock in export prices of Korean manufactured goods.
When a currency crisis that originated in Thailand hit Korea in early 1997, many chaebols had to declare
bankruptcy sending the Korean stock market into a downward spiral.
Worsening of Adverse Selection and Moral Hazard Problems
As many chaebols failed, the value of assets and net worth of other still-healthy Korean firms fell substantially
causing the banks collateral value to decline.
With market uncertainties, stock market falls, and deteriorating banks balance sheets, deleveraging and credit
crunch started to rise thereby leading to a contraction in the whole Korean economy.
Ensuing Currency Crisis
Foreign funds that were lent to Korean banks, merchant banks, and many chaebols started to pull out their shortterm capital triggering a depreciation of the Korean currency, the won.
After a collapse of the Thai currency, the baht, in 1997, its widespread contagion affected other countries with
similar problems such as Korea. As a result, speculative attack on the won was inevitable.
Full-fledged Financial Crisis
As the wons value declined by almost 50 percent, foreign debts of Korean chaebols were doubled leading to their
loan-repayment problems and sharply declining net worth.
Korean banks also suffered another round of crisis (after the export crisis and the stock-market crisis), which was
induced by depreciating currency. They had to pay more won to foreign lenders while being unable to collect on
loans to domestic firms. As a result, banks started to deleverage despite government intervention.
The currency crisis also caused Korean inflation rate to rise since speculative attack on the won raised import prices
(i.e., more expensive foreign goods in domestic markets as the won continued to depreciate).
Page 26 of 31
May 8, 2014
7)
To fight inflation, the Korean central bank deployed a tighter monetary policy by raising domestic interest rate,
causing a drop in firms cash flows (due to higher interest payments) thereby forcing them to obtain external funds.
Since banks already deleveraged while chaebols and other firms struggled to get more loans to stay afloat, Korean
economy then experienced a full-fledged financial crisis that was triggered largely by a currency crisis.
Commencement of Recovery
A self-correcting mechanism by which aggregate demand in Korean economy that was shockingly shifted beyond
the countrys potential output level had been corrected by a corresponding shift in aggregate supply restoring longrun market equilibrium at a higher price level began to work after the crisis.
Domestic financial reforms to shore up investor confidence in Korean financial markets were launched so that asset
prices would pick up raising Korean firms net worth and allowing Korean banks to start lending to the public again.
HOW COULD FINANCIAL CRISES IN NASCENT ECONOMIES BE PREVENTED?

1)
2)
3)
4)
Beef Up Prudential Regulation and Supervision of Banks

The underlying nexus that caused a financial crisis in nascent economies is the financial industry, which can be
prevented by improving prudential regulation to limit banks risk-taking based on capital adequacy requirements.
Prudential supervision to promote safety and soundness of banks can be done by having a proper risk-management
system, including 1) risk measurement and monitoring, 2) risky-activity limiting policy, and 3) risk-control
procedure.
Both prudential regulation and supervision in nascent economies would be more effective if their agencies are more
resourceful and independent.
Encourage Disclosure and Market-based Discipline
Since financial institutions and financial-service firms have an incentive to hide their risky-activity information
from regulators and supervisors, financial-market participants must help in disciplining them from excessive risktaking.
Disclosure of banks balance-sheet information is used as a tool to encourage them to hold more capital and manage
their net worth more prudently through risk-taking limits and liquidity management.
Limit Currency Mismatch
Balance-sheet vulnerability due to foreign-currency-denominated debts and domestic-currency-denominated assets
could lead to a severe decline in net worth when domestic currency depreciates against foreign ones.
Nascent economies could limit such a currency mismatch by implementing monetary policy measures or tax
regulations that discourage foreign-currency-denominated debts issued by banking and non-banking firms.
Sequence Financial Liberalization
The process of financial liberalization should be properly managed, i.e., through prudential regulation/supervision
and market discipline/disclosure in order to prevent any nascent economy from developing into a financial crisis.
A well-designed financial infrastructure must be put in place before any liberalization program could take place.
Since building a strong financial infrastructure is time-consuming, financial liberalization may have to be
sequenced.
Page 27 of 31
May 8, 2014
LECTURE 11: THE INTERNATIONAL FINANCIAL SYSTEM

HOW ARE FOREIGN EXCHANGES STRUCTURED AND MANAGED?
1.
2.
3.
FX Rate Regimes in the International Financial System

Fixed FX Rate Regime
Floating FX Rate Regime
FX Intervention by a Central Bank
Foreign-securities Open Market Operations to Adjust FXd
Domestic-securities Open Market Operations to Offset FXd
Capital Controls to Reduce Short-term Impacts from FXd
FX Rate Targeting Policy Mechanisms
FX Rate Anchoring
FX Rate Pegging
Currency Boards
Dollarization
WHAT ARE THE FX REGIMES IN AN INTERNATIONAL SYSTEM?

The fixed FX regime is one that links FXd with the value of goods, services, assets, or FXf to regulate FXd through
some forms of official intervention.
Fixing FX with gold value (Gold Standard) until the dawn of World War I.
Fixing FX with international reserves that are kept at the Bratton Woods system, i.e., the International Monetary
Fund (IMF) and the International Bank for Reconstruction and Development (World Bank) after the World War II.
Fixing FX with a basket of several FXf within a region, e.g., the European Monetary System between 1979 and 1999.
The fixed FX regime has adapted to become more flexible and transparent.
2) The floating FX regime is one that allows FXd to adjust its value according to changes in other FXf to stabilize FXd
without any form of intervention.
Floating FX based on free market mechanisms in the international system.
Floating FX with market mechanisms but allowing FX changes to be within target boundaries (managed floating or
dirty floating regime) to be in line with a countrys economic policies (fiscal, monetary, macro, and micro).
The floating FX regime has evolved to facilitate monetary-policy coordination.
1)
HOW COULD FX BE FIXED UNDER THE GOLD STANDARD?

Prior to the WWI, international FX rates were convertible into gold directly at some fixed rates thus eliminating any
variability among them so that international trade and development could flourish.
2) But, fixing an FX rate to a gold value means a country would lose its ability to determine money supply to gold
movements instead of basing it on domestic cash circulation and deposit creation (i.e., monetary base).
3) Furthermore, the worlds quantity of gold was not stable as more of it had been discovered, which caused international
discrepancies and imbalances among countries that could and could not produce gold.
Whenever a domestic production of gold grew more slowly than the countrys gross domestic production (GDP), its
FXd value would fall leading to a deflation. When the opposite was true, inflation would result.
4) Thus, fixing FX with any kind of commodity is inappropriate insofar as there are uncertainties in supply and price level
of such a commodity.
Even if a commodity supply was stable which is conducive to FX stability, its disproportionate possession in the
hands of some nations would lead to international political tensions just like what had happened before WWI.
1)
HOW WAS FX FIXED IN THE BRETTON WOODS SYSTEM?

After the WWII, currencies of various countries were directly convertible into the US dollar (USD) at some fixed rates
while the USD itself had been fixed to a gold value of $35 per ounce, allowing an easy intervention to stabilize FX rates
through a trading of USD in the global market. In such a case, USD was treated as the fiat money for all nations to
use in cross-border activities without linking FX rates to the uncertain gold.
2) An institution in charge of that matter was the IMF, which was originated from the 1944 summit held at an American
town in the state of New Hampshire called Bretton Woods.
The IMF would grant short-term loans to any country that experienced a deficit in its USD reserve that was below
the level appropriate for its balance of payments (BoP).
With BoP deficits, the IMF helped to replenish USD reserves to restore fixed FX. If that failed, either an FXd would
have to be devalued or a central bank of such a country would have to pursue a contractionary monetary policy.
With BoP surpluses, the IMF had no power to make a country to revalue its FXd nor could it force the countrys
central bank to pursue an expansionary monetary policy.
With a devaluation of USD in 1971 following a recession in the US economy, many nations were reluctant to have
their FX appreciate against USD. That event had caused an abandonment of the Bretton Wood system in 1973.
1)
WHAT ARE THE COMPONENTS IN BALANCE OF PAYMENTS?

In the Bretton Woods system, an indicator of FX relative value is the BoP, which is derived from the sum of the
current-account (CA) balance and the capital-account (KA) balance.
2) The CA balance is the sum of
Net Trade Balance: a difference between exports and imports of goods
Net Service Balance: a difference between exports and imports of services
Net Investment Income: a difference between revenues and expenses due to rents, interests, dividends, and capital
gains derived from international asset investments
1)
Page 28 of 31
May 8, 2014
Net Transfer Payments: a difference between receipts and payments due to grants, gifts, donations, and subsidies
resulting from international policy programs
3) The KA balance is the sum of
Net Portfolio Investments: a difference between short-term capital inflows and outflows due to investments in
financial securities (e.g., stocks and bonds)
Net Direct Investments: a difference between long-term capital inflows and outflows due to investments in real
assets (i.e., productive resources)
4) If the sum of CA and KA rose (fell) from their original level, then the BoP would be surplus (deficit), causing the USD
reserve to rise (fall) accordingly.
HOW WAS FX FIXED AFTER THE BRETTON WOODS SYSTEM?
In 1969, the IMF initiated an issuance of the Special Drawing Rights (SDRs) to replace gold as an international reserve
asset due to the golds fluctuations before the USD was devalued in 1971. It then abolished the fixed FX regime and
allowed all FX rates to float freely in 1973.
2) The use of SDRs to stabilize international exchange rates in addition to lending to restore the BoP has led to a hybrid
regime between fixed and floating FX regimes since SDRs allowed any central bank to intervene to adjust its FXd
without being negatively affected by market mechanisms.
The SDRs themselves is simply a basket of such major currencies beside USD as DEM, JPY, and GBP. At present,
DEM had been replaced by EUR.
SDRs are not a currency for international trade and finance but the rights for any country to exchange its own
domestic currency with those four major currencies.
Any country that holds a lot of SDRs could let other countries to buy SDRs from it, allowing for voluntary
adjustments in any particular FXd.
Due to a free floating of many currencies and advances in global money and capital markets nowadays, the
importance of SDRs has gradually been lessened.
1)
HOW COULD FX BE FIXED WITHIN THE EUROPEAN SYSTEM?

1)
2)
3)
4)
5)
In 1979, eight nations within the European Economic Community (EEC) agreed to establish the European Monetary
System (EMS) to fix their own currencies through the European Currency Unit (ECU) by intervening to actively trade
their own FXd within the EMS but allowing ECU to float against USD.
Until 1992 after the German Unification, inflation hit Germany causing the Bundesbank to raise domestic interest rate
to curb its inflation. As a result, DEM appreciated beyond what ECU could preserve its parity, leading to speculative
attacks on some weaker European currencies.
GBP was attacked and depreciated by 10% relative to DEM while others e.g. Spanish peso (-5%) and Italian lira (-15%).
Those countries with depreciating FXd would intervene to shore up their value by buying their currency with FXf. As a
result, their fixed rates with ECU had collapsed causing the deficits in their BoP.
Central banks within the EMS had lost about USD4-6 billion from intervention.
Speculators like George Soros pocketed a profit of about USD 1 billion while Citibank earned about USD200
million during that European currency crisis.
Since 1999, the ECU has been effectively replaced by the euro (EUR) based on the Treaty of Maastricht (1992).
HOW DOES A CENTRAL BANK INTERVENE IN THE FX MARKET?

1)
2)
3)
Intervention through trading foreign securities to adjust FXd rate

Buying (selling) foreign securities using domestic currency makes domestic monetary base rise (fall) as it increases
(decreases) circulating currency or liquidity in the public hands.
As FXf reserve level rises (falls), FXd depreciates (appreciates).
Intervention through trading domestic securities to offset changes in FXd
Buying (selling) domestic securities would make monetary base rise (fall) causing FXd to depreciate (appreciate).
Yet, selling (buying) domestic assets while buying (selling) foreign assets would make FXd appreciates (depreciates).
Intervention through controlling capital flows in and out of the country
Controlling foreign capital inflows would restrict domestic credit volumes from excessive expansion, preventing MS
from rising and FXd from depreciating.
Controlling foreign capital outflows would prevent MS from contracting too rapidly thereby helping to slow down
the depreciation of FXd.
HOW DO OPEN MARKET OPERATIONS AFFECT FX CHANGES?

Buying (selling) foreign securities by a central bank would raise (reduce) the amount of circulating currency or total
reserves in the banking industry since the central bank must sell (buy) FXd in exchange for FXf.
Domestic currency circulating in the public or as demand deposits in the banks would rise (fall), causing domestic
monetary base (MB) to increase (decrease).
2) As foreign securities increased (decreased), FX reserve at the central bank would also rise (fall), resulting in an
expansion (contraction) in domestic money supply (MS). When MS expanded (contracted), interest rate id was
pressured to fall (rise), inflation rate d to rise (fall), and exchange rate to depreciate (appreciate).
Adjusting FXd through this method is known as an unsterilized FX intervention because it affects or yields the
consequences on domestic MB, MS, id, and d.
1)
HOW DO OPEN MARKET OPERATIONS OFFSET FX CHANGES?

1)
If the central bank doesnt wish to cause a change in domestic money supply or inflation rate due to its FX intervention,
it could offset such an effect through an opposite trading of domestic securities while it trades foreign securities.
This method of FXd adjustment is known as a sterilized FX intervention because it would not cause any effect
on domestic MB, MS, id, and d.
Page 29 of 31
May 8, 2014
2) In this case, the offsetting effect would lead to a counter-balanced repercussion in the central banks holdings of both
foreign and domestic securities.

As FXd depreciated (appreciated) due to an increase (decrease) in foreign securities, the central bank must sell (buy)
domestic securities to absorb (inject) domestic money supply from (into) domestic economy to nullify the impacts
on FXd.
HOW DO CAPITAL CONTROLS REDUCE SHORT-TERM IMPACTS?
When foreign capital freely flows into domestic economy, money supply will rise, causing domestic interest rate to fall
thus allowing credit to expand with ease. As a result, financial institutions tend to shift their risk to more risky loans.
Although capital inflows lead to short-term appreciation in FXd and higher FXf reserve level, they also lead to longterm fragility in domestic financial industry.
Despite its benefit in reducing negative impacts on financial industry, control of capital inflows would reduce the
countrys opportunity to tap into cheaper foreign funds to develop and grow its domestic economy more
sustainably.
2) When foreign capital freely flows out of domestic economy, domestic currency shall weaken resulting in domestic asset
prices to fall. As a result, financial markets tend to experience more uncertainty and higher investment risks.
Although capital outflows lead to short-term depreciation in FXd making export prices cheaper, they also lead to
long-term instability in domestic financial markets.
Despite its benefit in reducing negative impacts on financial markets, control of capital outflows would reduce the
countrys opportunity to restructure or modernize its financial system, making the country less competitive
financially.
1)
HOW COULD FX RATE AND ITS CHANGES BE TARGETED?

1)
2)
3)
4)
FX Rate Anchoring
Allowing FXd to vary with the value of the countrys trading partner on a one-to-one basis in order to eliminate any
deviation from both currencies relationship.
FX Rate Pegging
Allowing FXd to vary according to the changes in the countrys trading partners price levels (of either goods or
assets) so that FXd is kept relatively weaker than FXf.
Currency Boards
Targeting FXd in advance with a central bank standing-by to defend domestic currency at a pre-determined rate
irrespective of any speculative attack.
Dollarization
Accepting any given FXf as the countrys domestic currency to reduce any complication in FX intervention while
eliminating any fluctuation in FXd.
WHAT ARE THE PROS AND CONS OF FX RATE ANCHORING?

1)
2)
Advantages of FX Rate Anchoring

It eliminates all risks in currency convertibility between trading partners.
It automatically disciplines monetary-policy conduct with official commitment.
Both lead to high market confidence in both countries in short and long terms.
Disadvantages of FX Rate Anchoring
If there are more than two countries, FX anchoring would be more difficult.
As central bank must continuously intervene the market, it would incur exorbitant transactions costs.
If an unsterilized intervention is used, FX anchoring would bring about an unnecessary instability in domestic
money supply due to frequent adjustments.
If a sterilized intervention is used, FX anchoring would incur more costs in trading domestic securities in addition
to trading foreign securities.
WHAT ARE THE PROS AND CONS OF FX RATE PEGGING?

1)
2)
Advantages of FX Rate Pegging

It allows a country to control domestic price level relative to the global level.
It limits a central banks discretionary monetary-policy conduct in a short run.
Both lead to comparative advantage in trading and investment in a long run.
Disadvantages of FX Rate Pegging
If relative inflation rates are inconsistent, FX pegging would invite more speculative attacks since deviation in
relative price levels is observable.
A central bank would lose its policy control as it must coordinate domestic money supply with its trading partner to
keep relative price levels in check.
If any economic crisis hits its trading partner, the country would inadvertently import such a contagion effect since
both nations economies are interwoven.
If the correlation between inflation rate and FX rate is low, FX pegging would be prone to non-transparency issue
when the central bank intervenes.
WHAT ARE THE PROS AND CONS OF CURRENCY BOARDS?

1)
2)
Advantages of Currency Boards

It helps bolster market confidence in stabilizing domestic currency due to high level of policy transparency.
It allows a central bank to control inflation while preventing speculative attacks effectively.
Disadvantages of Currency Boards
A central bank has to sacrifice its capability to control FXd to satisfy its strategic goals since it has made an explicit
commitment to defend FXd.
Page 30 of 31
May 8, 2014
The money-creation and lender-of-last-resort roles of a central bank would diminish since all financial participants
would shift from domestic to international system.
Domestic economic and financial systems would be affected more by international events leading to higher level of
uncertainty. Financial participants cannot blame the authorities for any wrong decisions they made.
WHAT ARE THE PROS AND CONS OF DOLLARIZATION?
1)
2)
Advantages of Dollarization
It eliminates all non-transparency issues in FX intervention since there will not be any under dollarization.
It also eliminates all variability and fluctuation between currencies thereby entirely avoiding any speculative attack.
Disadvantages of Dollarization
A central bank loses all of its control over domestic monetary policy and ability to determine domestic interest rate
and fight inflation. In short, the country loses its financial sovereignty to a foreign country to which it dollarizes.
All negative impacts from the foreign country would be automatically passed on to domestic economy.
The country will lose its seignorage (i.e., benefits from creating money) such as interest income from the printed
money or cost-saving from not paying any interest on utilizing its own money.
Page 31 of 31
May 8, 2014

FIN3010 Banking and Credit Review Notes

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FIN3010 Banking and Credit Review Notes

Uploaded by

Copyright:

Available Formats

FIN3010 Banking and Credit

Subject Review Notes