CHAPTER OBJECTIVES

What you will learn in this chapter:

o What you will learn in this chapter:

o The functions of the central bank

o The functions of different types of commercial bank

o How banking activity can affect the quantity of money in

the economy

o How central banks can influence the money-creation

process.
 INTRODUCTION

o Though, no universally accepted method of classification:

• deposit-taking institutions (DTIs) and
• non-deposit-taking institutions (NDTIs).
o Reasons may include:
• Deposits are subject to pressure and influences.
• Deposit liabilities are money.
• Deposits are subject to supervision and regulation.
• Customers hold deposits for reasons which are rather
different from other financial products.
 INTRODUCTION

o Reasons may include:

Type of contract:
• Discretionary flow of funds for Depository Institutions.
• Contractual flows of funds for Non-deposit Institutions.
• The discretionary or contractual nature of flows has
important effects upon the way that DTIs and NDTIs
behave towards their assets.
• In other words, the balance sheets of DTIs and NDTIs
are very different.
INTRODUCTION
CENTRAL BANK
 CENTRAL BANK

o At various times central banks are responsible for some or

all of the following:
• the conduct of monetary policy;
• banker to the commercial banking system;
• banker to the government;
• supervisor of the banking system;
• manager of the national debt;
• manager of the foreign exchange reserves;
• issuer of the national currency.
 CENTRAL BANK

o Objectives of the Central Bank

• Price Stability
• Financial Stability
• High and stable real growth
• High Employment

Price Stability Vs. Other Objectives

 CENTRAL BANK

o The Conduct of Monetary Policy

• conduct monetary policy to achieve price stability
 Price stability low and stable inflation.
• Conduct of monetary policy must involve the setting of
short term interest rates,
• using its role in the money markets,
• exploiting its position as banker to the rest of the
banking system
 CENTRAL BANK

o Matter of Independence
Instrument independence:
• The freedom of the central bank to take whatever steps
it thinks necessary to achieve the goal laid down by
government.
Full independence:
• The freedom of the central bank to choose both the
goal (usually a target rate of inflation) and the steps
necessary to achieve it.
 CENTRAL BANK

Banker to the Commercial Banking System

• Bank deposits may be held as a form of saving.
• Many deposits will be held as their owners need them
as a means of payment.
Bank acts as a Clearing House
• Fund transfer from one Bank to another bank in the
system.
• customers of one bank will make payments to other
customers of the same bank, but also to customers of
other banks in the system.
 CENTRAL BANK

Banker to the Commercial Banking System

Lender of Last Resort
• The ultimate provider of reserves to the banking
system.
• To meet the Liquidity management.
• To meet an unexpectedly large demand for cash
withdrawals.
• Prevent Bank failure.
 CENTRAL BANK

Banker to the Commercial Banking System

Lender of Last Resort
• The ultimate provider of reserves to the banking
system.
• To meet the Liquidity management.
• To meet an unexpectedly large demand for cash
withdrawals.
• Prevent Bank failure.
 CENTRAL BANK

Banker to the Commercial Banking System

 CENTRAL BANK

Banker to the Government

• In some, but not all, financial systems the government
holds its accounts with the central bank rather than
with the commercial banks.
• Payments between the government and the private
sector will involve transfers inside the central bank
between the government’s accounts and the accounts
held by commercial banks
• For both Payments and Receipts.
 CENTRAL BANK

Supervisor of the Banking System

• Central banks are often responsible for the supervision
of the banking system.
• This involves some form of
• licensing,
• control over the appointment of directors of
commercial banks and
• the laying down and monitoring of key financial
ratios in commercial banks’ balance sheets.
 CENTRAL BANK

Supervisor of the Banking System

• The reason for all supervision of financial institutions
originates with ‘asymmetric information’ –
• the fact that customers of the institutions are less
well informed and
• thus more at a disadvantage about the affairs of the
intermediary than the intermediary is itself.
• Further strengthened by worries about the
consequences of bank failure.
• It is widely felt that bank failures are especially
serious and damaging to the economy.
 CENTRAL BANK

Supervisor of the Banking System

• For this reason, banks generally enjoy two advantages
over other financial institutions.
• They have access to a ‘lender of last resort facility’
provided by the central bank.
• The second is a system of deposit insurance, operated
by the banking supervisory body, whereby clients of a
bank which fails are guaranteed that at least a
proportion of their deposits will be safe.
 CENTRAL BANK

Supervisor of the Banking System

• Bank of England to exercise the following powers:
 licensing of all deposit-taking institutions
 ensuring that institutions have adequate capital,
liquidity and controls;
 ensuring they make adequate provision for bad
debts;
 checking that directors of banking institutions are ‘fit
and proper persons’.
 CENTRAL BANK

Supervisor of the Banking System

• Bank of England to exercise the following powers:
 licensing of all deposit-taking institutions
 ensuring that institutions have adequate capital,
liquidity and controls;
 ensuring they make adequate provision for bad
debts;
 checking that directors of banking institutions are ‘fit
and proper persons’.
 CENTRAL BANK

Management of the National Debt

• Another activity which is sometimes the responsibility
of the central bank is the management of the national
debt.
• Decisions have to be made therefore about both the
funding of new, annual deficits and the refinancing of
that fraction of the existing debt which matures each
year.
• Funding and Monetary Policy
 CENTRAL BANK

Manager of the Foreign Exchange Reserves

• Central banks frequently act as agents of their
government in the management of foreign exchange
reserves.
• ‘Management’ is necessary since governments normally
have some policy towards the exchange rate.
• Have to enter the foreign exchange market to value the
domestic currency.
 CENTRAL BANK
Currency Issue
• Central banks are commonly responsible for the issue of
some or all of a country’s notes and coin.
• The Bank designs, prints and issues the country’s
banknotes.
• There is no policy to limit the note issue. Notes are issued
on demand of money.
• Cost of producing a banknote is considerably less than its
face value, there is a substantial profit to be made from the
printing and issue.
• This known as ‘seignorage’ and is paid, in the UK, to the
Treasury.
BANKS
 BANKS

• The term ‘banks’ covers a wide variety of institutions

whose principal function is to accept deposits and
make loans.
• All deposit-taking institutions require a license which is
granted by the respective authority under Act.
• Banking activities fall into four main groups:
I. Retail Banking
II. Wholesale Banking
III. Investment Banks
IV. Merchant Banks
 BANKS
Bank’s Income
• Banks’ income is earned from two principal sources.
 The lending rates are higher than deposit rates
o This ‘spread’ forms the traditional source of profit for
banks.
 But increasingly banks earn income from charging fees
for advice and other services.
• Fee income is generally more important to wholesale
banks, and especially to investment banks, than it is to
retail banks where deposit taking and lending remains
a large part of the banks’ business.
BANKS
 BANKS
Retail Banking
• Involves the provision of loan and deposits facilities to the
personal or household sector.
• It also includes banks which provide similar services to
small and medium-sized firms.
• Both types of activity include payment services, and so
banks operating in both parts of the retail sector are heavily
involved in the payments mechanism.
• For example, Dahabshiil Bank, a commercial bank in
Somaliland.
 BANKS
Wholesale Banking
• Under the heading of wholesale banking we have
‘corporate banks’
• Corporate Banks provide
• loan and deposits facilities to large corporate clients and
• A large range of fee-based financial advice of relevance
to the major plcs.
• Large customers include mortgage brokers, large
corporate clients, mid-sized companies, real estate
developers and investors, international trade finance
businesses, institutional customers, etc.
 BANKS
Wholesale Banking
• Modern wholesale banks engage in:
 Finance wholesaling
 Underwriting
 Market making
 Consultancy
 Mergers and acquisitions
 Fund management
• Examples: Bank of China, HSBC, JPMorgan Chase & Co.
 BANKS
Investment Banks
• Principal activities have little direct contact with
conventional banking activity at all (loans and deposits).
• But are concerned mainly with the operation of security
markets.
• Neither category of wholesale bank is involved in the
operation of the payments mechanism
• Examples: Goldman Sacks, Bank of America, Citi Group..
 BANKS
Merchant Banks
• A merchant bank is a company that deals mostly in
international finance, business loans for companies and
underwriting.
• These banks are experts in international trade, which makes
them specialists in dealing with multinational corporations.
• Some among them were known as ‘acceptance houses’
• Because they made a large part of their income from
‘accepting’ or guaranteeing bills of exchange.
• Others began as ‘discount houses’ whose main purpose
was to discount the accepted bills for cash.
BANKS
BANKS & THE CREATION OF
MONEY
 BANKS & THE CREATION OF MONEY

• For the authorities, and for most economists too, the

significance of deposit-taking institutions lies in the fact
that the deposits which they hold function as money.
• An expansion of bank and building society activity
involves an expansion of deposits,
• This automatically involves an increase in the stock of
money with the possibility that this in turn leads to an
increase in aggregate demand and in output and/or
prices.
 BANKS & THE CREATION OF MONEY

• In this section we want to look

1. firstly at why banks have an interest in expanding
the volume of deposits and thereby the stock of
money.
2. Secondly, we shall look at how they are able to do it.
3. Lastly, we shall look some of the possible constraints
on deposits and monetary expansion.
 BANKS & THE CREATION OF MONEY
Why Banks Create Money
• The answer to the first, or ‘why’, question begins with a
recognition that banks are private sector,
• profit-making organizations with obligations to
shareholders to increase profits over time.
• Thus they will always be looking for ways of
expanding their balance sheets provided this leads to
extra profit.
• Profitability of the banking system depends upon
banks being able to make loans of varying terms to
maturity while holding deposits of shorter maturity.
 BANKS & THE CREATION OF MONEY
Why Banks Create Money
• Profitability demands the reserve ratio be kept to a
minimum
• while confidence in the banking system requires that it
should never fall too low.
• The ability of banks’ behavior to influence the money
stock thus focuses upon their ability to cause changes in
the quantity of customer deposits.
• Granted that the expansion of lending may be
profitable, how does it affect the money supply?
 BANKS & THE CREATION OF MONEY
Why Banks Create Money
• The changes have been entirely on the asset side of the
balance sheet.
• The change in the composition of assets came about
because the borrower used his loan facility.
• Other things being equal, an increase in lending
• Raises profits and
• Raises the supply of money
• Provided there is a demand for bank lending at a
profitable rate of interest, from customers that banks
think creditworthy.
 BANKS & THE CREATION OF MONEY
How Banks Create Money
• The answer to our question of how banks create money
is that
• they do so by increasing their lending, provided that
they are prepared to accept a change in their
portfolio composition.
• Specifically, this means provided they are prepared to
work with a smaller reserve ratio.
• If an individual bank increases its lending, other things
being equal, the money supply will expand.
• Let’s see Exercise 3.1
 BANKS & THE CREATION OF MONEY
Constraints on Banking Lending
• There are three sources of constraint:
• The first two we might call ‘demand’ constraints and
• The third we can think of as a ‘supply’ constraint.
• Both types of constraint can form the basis for
monetary control techniques.
• These constraints are:
1. The demand for bank lending
2. The demand for ‘money’
3. The monetary base.
 BANKS & THE CREATION OF MONEY
Constraints on Banking Lending
1. The Demand for Bank Lending
• The first limitation on banks’ ability to lend is the
demand for bank lending.
• As we just remarked, banks charge interest on bank
loans.
• In short, we should expect the demand for bank lending
to vary inversely with the rate of interest charged.
• In these circumstances, we can see the importance of
the central bank’s lender of last resort role.
 BANKS & THE CREATION OF MONEY

Constraints on Banking Lending

2. The Demand for Money
• A second factor limiting banks’ ability to expand the
total stock of bank deposits is the demand for money.
• As yields fall on non-money instruments the demand
for money will increase.
• Secondly, as these yields and therefore the cost of non-
bank borrowing fall, the demand for bank lending is
reduced.
 BANKS & THE CREATION OF MONEY

Constraints on Banking Lending

2. The Demand for Money
• A second factor limiting banks’ ability to expand the
total stock of bank deposits is the demand for money.
• As yields fall on non-money instruments the demand
for money will increase.
• Secondly, as these yields and therefore the cost of non-
bank borrowing fall, the demand for bank lending is
reduced.