International Banking and the Allocation of Capital.
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Transcript of International Banking and the Allocation of Capital.
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International Banking and International Banking and the Allocation of Capitalthe Allocation of Capital
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Daniels and VanHoose
Financial Architecture 2
Benefits of International Capital Market Liberalization
• Allows savings to flow to their most productive use.
• Domestic agents can borrow and lend abroad at more competitive rates.
• Diversification mitigates domestic downturns.
• Expanded investment increases standard of living.
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How is Saving Allocated?How is Saving Allocated?
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Daniels and VanHoose
Financial Architecture 4
Direct versus Indirect Financing
• Direct: Savers and borrowers link directly
• Indirect: An intermediary channels funds from saves to borrowers.
• Bank Borrowing:– UK 70%– Japan 65%– US 30% (Over 50% through foreign banks!)
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Daniels and VanHoose
Financial Architecture 5
Efficient Financial Intermediation
• An efficient system reduces x-inefficiency costs.
• Intermediaries make pooling of funds possible and, therefore, economies of scale.
• Intermediaries enable savers to pool funds.
• Intermediaries can reduce information asymmetries and other market failures.
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Daniels and VanHoose
Financial Architecture 6
Potential for Misallocation of Capital
• There is a potential for unfettered capital markets to misallocate capital– Intermediaries undermine domestic policy– Financial market shocks increase– Greater potential for contagion.– Loss of Economic Growth
• Evidence on the latter (p. 6)
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Daniels and VanHoose
Financial Architecture 7
Market Failures
• Asymmetric Information: Possession of information by one party that is not available to a another party of the transaction. Can lead to:– Adverse Selection: Those least worthy most
likely to borrow.– Herding Behavior: Savers follow someone
they feel is better informed.
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Daniels and VanHoose
Financial Architecture 8
Market Failures
• Moral Hazard: Borrower engages in riskier activity once the financing is in place.– Moral hazard can result from information
asymmetries or from national government or international organization guarantees.
• Policy Created Distortions: – Differential taxes, regulations, tariffs– Regulatory Arbitrage
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Daniels and VanHoose
Financial Architecture 9
Conclusion
• Potentially large allocative and efficiency gains to be enjoyed from capital market liberalization.
• Policy-created distortions and market failures must be addressed.
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Daniels and VanHoose
Financial Architecture 10
Payments Systems Risks
• Liquidity Risk: The risk of loss that may occur when a payment is not received when due.
• Credit Risk: The risk of loss that may occur when one party fails to abide by the terms of an agreement.
• Systemic Risk: The possibility that liquidity risk or credit risk may affect a third party.
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Daniels and VanHoose
Financial Architecture 11
System Risk
• Systemic Risk involves a negative externality.• Herstatt Risk: Liquidity, credit, and systemic risk
across international borders.• Term comes from the events surrounding the
failure of the Herstatt bank in 1974.• G10 nations developed a netting arrangement to
minimize Herstatt risk (early 1990s).
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Daniels and VanHoose
Financial Architecture 12
Central Bank Functions
• Fiscal Agents
• Bankers’ Bank
• Lenders of Last Resort
• Macroeconomic and Monetary Policy Makers– Exchange market intervention– Monetary policy
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The Monetary Base and the The Monetary Base and the Money StockMoney Stock
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Daniels and VanHoose
Financial Architecture 14
The Monetary Base
• A nation’s monetary base can be measured by viewing either the assets or liabilities of the central bank.
• The assets are domestic credit (DC) and foreign exchange reserves (FER).
• The liabilities are currency in circulation (C) and total reserves of member banks (TR).
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Daniels and VanHoose
Financial Architecture 15
Simplified Balance Sheet of the Central BankAssets Liabilities
Domestic Credit(DC)
Currency(C)
Foreign Exchange Reserves (FER)
Total Reserves(TR)
Monetary Base(MB)
Monetary Base(MB)
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Daniels and VanHoose
Financial Architecture 16
Money Stock
• There are a number of measures of a nation’s money stock (M).
• The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.
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Daniels and VanHoose
Financial Architecture 17
Money Multiplier
• Most nations require that a fraction of transactions deposits be held as reserves.
• The required fraction is determined by the reserve requirement (rr).
• This fraction determines the maximum change in the money stock that can result from a change in total reserves.
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Daniels and VanHoose
Financial Architecture 18
Money Multiplier
• Under the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only.
• In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement,
m = 1/rr.
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Daniels and VanHoose
Financial Architecture 19
Relating the Monetary Base and the Money Stock
• Under the assumptions above, we can write the money stock as the monetary base times the money multiplier.
M = mMB = m(DC + FER) = m(C + TR).
• Focusing only on the asset measure of the monetary base, the change in the money stock is expressed as
M = m(DC + FER).
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Daniels and VanHoose
Financial Architecture 20
Example - BOJ Intervention
• Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the private banking system.
• This action reduces the foreign exchange reserves and total reserves component of the BOJ’s balance sheet.
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Daniels and VanHoose
Financial Architecture 21
BOJ Balance Sheet
Assets Liabilities
DC C
FER TR
MB MB
-¥1 million -¥1 million
-¥1 million -¥1 million
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Daniels and VanHoose
Financial Architecture 22
BOJ Intervention
• Because the monetary base declined, so will the money stock.
• Suppose the reserve requirement is 10 percent. The change in the money stock is
M = m(DC + FER),
M = (1/.10)(-¥1 million) = -¥10 million.