1. International Banking and the Allocation of Capital

2. Daniels and VanHooseFinancial Architecture2 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.

3. How is Saving Allocated?

4. Daniels and VanHooseFinancial Architecture4 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!)

5. Daniels and VanHooseFinancial Architecture5 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.

6. Daniels and VanHooseFinancial Architecture6 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)

7. Daniels and VanHooseFinancial Architecture7 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.

8. Daniels and VanHooseFinancial Architecture8 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

9. Daniels and VanHooseFinancial Architecture9 Conclusion Potentially large allocative and efficiency gains to be enjoyed from capital market liberalization. Policy-created distortions and market failures must be addressed.

10. Daniels and VanHooseFinancial Architecture10 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.

11. Daniels and VanHooseFinancial Architecture11 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).

12. Daniels and VanHooseFinancial Architecture12 Central Bank Functions Fiscal Agents Bankers’ Bank Lenders of Last Resort Macroeconomic and Monetary Policy Makers –Exchange market intervention –Monetary policy

13. The Monetary Base and the Money Stock

14. Daniels and VanHooseFinancial Architecture14 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).

15. Daniels and VanHooseFinancial Architecture15 Simplified Balance Sheet of the Central Bank AssetsLiabilities Domestic Credit (DC) Currency (C) Foreign Exchange Reserves (FER) Total Reserves (TR) Monetary Base (MB) Monetary Base (MB)

16. Daniels and VanHooseFinancial Architecture16 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.

17. Daniels and VanHooseFinancial Architecture17 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.

18. Daniels and VanHooseFinancial Architecture18 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.

19. Daniels and VanHooseFinancial Architecture19 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 = m  MB = 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).

20. Daniels and VanHooseFinancial Architecture20 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.

21. Daniels and VanHooseFinancial Architecture21 BOJ Balance Sheet AssetsLiabilities DC C FER TR MB -¥1 million

22. Daniels and VanHooseFinancial Architecture22 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.