Essentials of Money, Banking and Financial Institutions: With Applications to the Developing World 9780739189535, 9780739189542, 2014023712

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Essentials of Money, Banking and Financial Institutions

Essentials of Money, Banking and Financial Institutions With Applications to the Developing World

Samuel K. Andoh With John Kuforiji and Benjamin Abugri

LEXINGTON BOOKS

Lanham • Boulder • New York • London

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2/17/16 10:18 AM

Published by Lexington Books An imprint of The Rowman & Littlefield Publishing Group, Inc. 4501 Forbes Boulevard, Suite 200, Lanham, Maryland 20706 www.rowman.com 16 Carlisle Street, London W1D 3BT, United Kingdom Copyright © 2014 by Lexington Books All rights reserved. No part of this book may be reproduced in any form or by any electronic or mechanical means, including information storage and retrieval systems, without written permission from the publisher, except by a reviewer who may quote passages in a review. British Library Cataloguing in Publication Information Available Library of Congress Cataloging-in-Publication Data Andoh, Samuel K. (Samuel Kojo), 1952- author. Essentials of money, banking and financial institutions : with applications to the developing world / Samuel K. Andoh.   pages cm Includes bibliographical references and index. ISBN 978-0-7391-8953-5 (cloth : alk. paper)—ISBN 978-0-7391-8954-2 (electronic) 1. Money market—Developing countries. 2. Banks and banking—Developing countries. 3. Economic development—Finance—Developing countries. I. Title. HG1496.A54 2014 332.091724—dc23 2014023712

∞ ™ The paper used in this publication meets the minimum requirements of American National Standard for Information Sciences—Permanence of Paper for Printed Library Materials, ANSI/ NISO Z39.48-1992. Printed in the United States of America

Contents

PART I: INTRODUCTION

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1 Money, Banking and Financial Markets PART II: MONEY

3 17

2 The Concept of Money

19

PART III: INTEREST RATE

33

3 The Concept of Interest Rates

35

4 Determination of Interest Rate

49

5 Risk & Term Structures of Interest Rates

63

PART IV: FINANCIAL INSTITUTIONS

77

6 Financial Markets and Institutions

79

7 Depository Institutions: The Business of Banking 

93

8 Managing Depository Institutions 

105

9 Regulating Depository Institutions 

123

PART V: MONEY CREATION, CONTROL & POLICY

135

10 Currency Boards and Central Banks 

137

11 The Money Supply Process

151

12 Demand for Money

163

13 The Goals and Tools of Monetary Policy

175

14 Conducting Monetary Policy

183

v

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Contents

15 Aggregate Demand and the Monetary Transmission Mechanism

201

16 Money, Inflation and Output

211

17 Foreign Exchange Market

225

PART VI: ISLAMIC BANKING

239

18 Islamic Banking 

241

Index251

Part I

INTRODUCTION

Chapter 1

Money, Banking and Financial Markets

In this chapter we give an overview of the financial system; its functions, its importance in the economy, the participants in it, what the financial markets trade and who the regulators are. At the end of the chapter you should be able to: 1.  Describe the financial system. 2.  Explain the role of finance in economic development. 3.  Discuss and explain the special role of money in the financial system.

MONEY, BANKING AND FINANCIAL MARKETS The financial system, which includes banks, financial institutions and non-banking financial institutions, is a very important sector of modern economies. Without the financial system, it is inconceivable that the high standards of living in the Western world could have been attained. It also means that without a good financial system, the underdeveloped countries of the world cannot hope to achieve or duplicate the high standards of living prevailing in the developed countries. Indeed the importance of the financial system is evidenced in the developed world by the daily and hourly reporting of financial data. Economists sometimes divide their field into two sectors: the real sector and the financial sector. The real sector has markets for real outputs (goods and services). The real side contains markets for inputs and outputs. The input market includes the demand and supply of labor, capital, land/raw materials and entrepreneurship. The output market contains the goods and services produced in the economy. The financial sector contains the markets for financial assets, such as shares, bonds and money. To produce the goods and services, producers need inputs. Unfortunately, sometimes those who are willing and able to produce do not own the inputs, and those who own the inputs are not willing and/or able to produce. When those who have the means to produce are not willing or able to produce, and those who are willing and able to produce do not have the means to do so, society suffers as fewer goods and services are produced. To remedy this situation,

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there must be a means of connecting the owners of the resources and those who have need of the resources. Now let us suppose that the owners of the resources agree to give their resources to those who need them to produce, with the promise that after selling what they have produced, they will then compensate the owners of the resources. As soon as these owners agree to let the entrepreneurs use their resources, and pay them afterwards, the two parties have entered into a contractual financial arrangement whose importance is enormous. The owners of the resources have loaned the services of their resources to the entrepreneur; they are creditors. The entrepreneurs have borrowed the services of the resources; they are borrowers. This simple arrangement enables resources to be brought to use, goods and services to be produced, income generated and wealth accumulated. The scenario described above takes place every day in many countries around the world especially in the less developed countries. In these less developed countries, this process may represent the principal means by which people obtain resources to produce the goods and services. There are many problems associated with this simple arrangement as described: 1.  What if the entrepreneur having produced the goods and sold them, does not reimburse the resource owner but instead absconds? 2.  What if the entrepreneur fails because she did not know much about what she was representing to the owner of the resource in the first place? 3.  How much reimbursement will the owner of the resources receive? These questions point to the need for some efficient structure to be in place in order for entrepreneurs to have access to the resources necessary to produce goods and services, and to assure the owners of the resources that they will recoup their investment and then some. In the absence of such structures or institutions, owners of resources will not be willing to part with them. Instead, they might hold on to them and attempt to produce all the goods and services they need to consume and eke out a subsistence living. They would rather live in an autarkic world than take the chance of parting with their resources and suffer losses. In the world we describe above, the owners of the resources will probably not be willing to give up their resources to people they do not know. In a small village of a few hundred people, the villagers will probably all know each other and are likely to know who is trustworthy and who is not. In a big city that may not be the case. Not knowing each other very well means not being able to determine who is trustworthy and who is not. Owners of resources would therefore not want to take chances. The institutions or arrangements which societies put in place to enable entrepreneurs obtain access to the resources to produce goods and services, constitute the essence of the world of finance. The arrangements may be formal or informal, written or verbal; the institutions may be physical or simply abstract. What is important is that through them, and by them, people without resources to produce, are able to obtain the resources and the owners of the resources benefit from allowing others to use them.



Money, Banking and Financial Markets 5

THE SCOPE OF BOOK In money, banking and financial markets, we study the markets, institutions and policies that are established to enable owners of resources to transfer these to those who need them to produce goods and services. Key to understanding how the financial system works is a thorough understanding of the instruments developed to make it possible for creditors and borrowers to interact with each other. In the course of the growth of the financial system, ways have been found to make it possible for the owners of the resources and those who need them to hardly meet in person. Instead, markets have developed, institutions have emerged and products have been developed that make it possible for owners of resources to efficiently transfer those resources to those who need them. The processes, the instruments and the rules and regulations governing how this works are what we study in this book. Although this book is about money, banking and financial institutions we pay special attention to the role played by banks. This is as it should be. Everywhere, banks play a major role in the process of making it possible for those without the resources to get the resources. Frequent comparisons are drawn between situations in the developed economies and the developing countries of the world to enable readers to see what is possible and doable. Although the theory of money, banking and finance are of universal application, the institutions through which the theory comes to life differ across countries; it is therefore important to draw and point out how these differences might affect the applicability of the theories. We hope that this book, in addition to being a good text for use in developing countries, will also be appealing to students in the developed countries who want to learn about how to apply the theory elsewhere. We are particularly excited about the chapter on Islamic Banking (IB). Islamic Banking is growing in importance in many parts of the world, yet there are few texts that devote much space to its discussion. We provide some of the basics in the last chapter of the book. Although woefully inadequate, we hope this will pique the interest of readers and goad them into finding out more about IB. THE FINANCIAL SYSTEM: MARKETS & INSTITUTIONS As complex as financial systems can be; their essence is the provision of an efficient mechanism for creditors to extend credit and for borrowers to borrow. Classical economics assumes that only the real side of the economy matters. While this may be true in some sense, just as a chemical reaction sometimes needs a catalyst to speed and boost the reaction, so does the real economy need the financial sector to boost its productive capacity. Without the financial sector, output of goods and services will be extremely low and societies will be very poor. The financial system consists of markets and institutions as well as rules, regulations and conventions; all intended to enable the system to perform efficiently. Financial systems can be very complex or very simple. In poor developing countries, the systems are generally very simple, comprising a few financial institutions (banks mostly, but also insurance companies), markets and instruments (government bonds).

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In the developed countries, there are several financial institutions and markets as well as several kinds of complicated instruments. As the complexity of the system increases, so will the number of regulatory bodies. One therefore sees more regulatory bodies in the developed countries than in the developing countries. Figure 1.1A and B below shows the financial systems of Ghana and Nigeria, both developing countries. The charts are shown from the viewpoint of regulators. There are three layers in Ghana: Bank of Ghana, Securities Exchange Commission and National Insurance Commission. There are six layers in Nigeria, three of them being the same as those in Ghana; The Central Bank of Nigeria, Securities and Exchange Commission, The Nigerian Insurance Supervisory Board, Nigeria Deposit Insurance Corp., The Federal Ministry of Finance and the Federal Mortgage Bank of Nigeria. Subordinate to these layers are the various institutions, which they regulate and supervise. Figure 1.2 below shows the financial system of the United States also from the perspective of regulators. As can be readily seen, there are many more regulators in the United States (in fact too many, some may say) than in Nigeria or Ghana. One may look at the structure of the financial systems above and conclude that Nigeria has a more complex financial system than Ghana. This will not be an inaccurate statement. There are many more financial institutions in Nigeria than in Ghana, requiring more supervision and as a result, the regulatory agencies are more specialized. This does not necessarily mean that the markets for the financial instruments are

Figure 1.1

Figure 1.2



Money, Banking and Financial Markets 7

absent in Ghana. The markets may be present but not yet sufficiently developed to warrant a separate regulatory agency. In contrast to the system in developing countries, that of a developed economy such as the United States, shown in Figure 1.2 above has many more regulatory agencies, much more so in the United States because of the different layers of government some of which duplicate tasks. The multiple layers of regulatory agencies are the primary result of the complex nature of the financial system in the developed countries. In recent times, there have been calls for changing the regulatory structure in the United States to reflect the changing financial system and to reduce the many layers of regulators.1 The financial institutions that regulators oversee are many and varied. Broadly, they can be divided into depository financial institutions and non-depository financial institutions. Depository financial institutions, as the name implies, take deposits from depositors. The deposits become assets for them. Since at some point in the future, the depositors will come and ask for their deposits, the very act of accepting the deposit also creates a liability for them. In the interim, the depository institutions transform the assets into other saleable assets, to earn income but with an eye towards maintaining enough liquidity to repay the depositor whenever she demands payment. Depository institutions include commercial banks, savings banks, and credit unions. We might also add to this the various forms of informal institutions such as susu the collection agencies found in the developing countries and among migrant communities in the developed countries. Non-depository financial institutions include pension funds, insurance companies, investment banks, finance companies and government-sponsored agencies (GSE) such as Federal Home Mortgage and Loan Association (FHMA). These institutions perform diverse financial service functions. Insurance companies accept premiums from customers and do not incur liability payments until a predetermined event occurs. These events may include loss of life and property and just about anything which involves uncertainty and the probability of a loss. Pension funds may be government- or privately-administered; they take contributions from employees and make repayments upon the employees’ retirement. Finance companies raise funds in financial markets and use these proceeds to make loans to borrowers for different purposes. Governmentsponsored agencies (GSE) raise funds to make loans or provide the guarantee for lenders to make loans to some specified groups of people. In the United States, examples of such agencies are Fannie Mae (Federal National Mortgage Association), Sallie Mae (originally Federal Family Education Loan Program (FFELP), it offers loans to students and their guardians), Ginnie Mae (Government National Mortgage Association) In Ghana for example, the Agricultural Development Bank (ADB) and the Bank for Housing and Construction (BHC) were originally set up by the government to make loans to those specific sectors; they are therefore government-sponsored agencies. Over time, they have become indistinguishable from other banks; they retain some of their original functions but have added other functions to them. Another class of financial institutions is referred to as investment bankers. These are the bankers businesses go to consult when they want to raise fresh capital or initial public offerings (IPOs). Investment bankers act as brokers or underwriters. Their functions are extremely important. Sometimes, they may simply arrange for borrowers

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Chapter 1

and savers to come together. In that respect, they are no different from other financial institutions. They are most effective when they act as underwriters. As underwriters, they play the important role of taking full control of the financial needs of companies seeking to raise new funds in the primary market. If a firm seeks to raise capital, these bankers will package the proposal, determine the price and market the issues. Sometimes, they may guarantee the price at which they will sell the new issues. They will then sell them at a higher price and the difference between the price they guarantee and the price they sell it, the spread, becomes their profit. Sometimes they may simply charge a fee and work with the firm to sell issues at the best price the market will pay. The new issues could be stocks or bonds and investment banks may specialize in specific bonds or equities. FINANCIAL SYSTEM: MARKETS Regulatory agencies, such as those listed in Figures 1.1, 1.2 and 1.3 supervise financial institutions, which issue financial instruments that are traded in financial markets. A financial instrument is the means by which savers’ funds are transferred from creditors to borrowers. These instruments come in various guises but they will be either a debt or an equity instrument. A debt instrument, also called a bond, is a contract with the following characteristics, and it will state: 1.  How much is being loaned or borrowed, the principal, 2.  When the principal is to be paid back, the maturity or term, 3.  The additional amount that must be paid, the interest, and how often it should be paid until maturity. A bond is an asset to the lender or creditor but a liability to the borrower or debtor. Bonds are bought and sold in what is called the Bond Market. There are many kinds of debt instruments. A car loan is an example of a debt instrument, as are home and personal loans. In all cases, a borrower receives funds from a lender then promises to repay what is received plus interest over time. The agreement constitutes the bond. Although the contract is often in writing, it need not be, to be enforceable. In English speaking parts of the world, there is a popular saying: “my word is my bond.” This means what I have said is binding even though it may not be in writing. A stock, equity or share on the other hand, is an instrument, which represents ownership in a business. It differs from a bond in the sense that the buyer or holder does not earn interest but rather dividends whenever the business makes profit. Unlike a bond, there is no redemption date. Just like a bond, it is an asset to the owner/buyer and a liability to the issuer. The market in which a stock is bought and sold is called the Stock Market. Financial markets and their instruments have evolved to meet the needs of borrowers and creditors. There are several ways of describing financial markets. One way is to look at the term of the instruments that are bought and sold. If the term is less than one year, the instrument is called a short-term instrument and the market in which it



Money, Banking and Financial Markets 9

is bought and sold is referred to as a money market. On the other hand, if the term of the instrument is a year or more, the market is a capital market. The term money market is in some sense a misnomer because what is bought and sold is not necessarily money, as we define it later, but financial instruments. It is called money market because in this market, the financial assets are very liquid compared to the assets traded in capital markets. An asset is liquid if it can be easily converted into cash with little or no loss in value. Assets that have shorter maturities are always preferred to assets that have longer maturities, everything else being the same. For that reason, money market instruments tend to be more liquid than capital market instruments. Banks typically deal in money market instruments. Many of the assets they buy and sell, such as certificates of deposit (CDs), have maturities of less than one year. Capital markets include equity or stock markets and bond or debt markets. Another way of looking at financial markets is whether the instruments are newly issued or outstanding. The market for newly issued stock or bond is called a primary market. After a bond or stock has been issued and bought, it can be resold and the market, in which it is resold and re-bought, is called a secondary market. The secondary market is therefore the market for the sale and purchase of outstanding financial instruments. The more easily the asset can be resold in the secondary market, the more people will prefer to hold it and thus the more liquid the asset will be. The secondary market is important for the economy because the more active it is, the easier it is for businesses to issue new instruments to raise new capital. If the secondary market is not very active, financial instruments will not be liquid and businesses will have a hard time issuing new instruments for expansion. The secondary market therefore acts as a barometer of how active the primary market is.

THE IMPORTANCE OF FINANCIAL MARKETS TO ECONOMIC DEVELOPMENT Financial markets are extremely important for economic development. As mentioned earlier, owners of resources may not have immediate use for the resources. Others might have immediate use for the resources but may not have them. If those who have the resources let them lie idle, and those who want to use them cannot have them, goods and services are not produced, and income will not be generated. Society as a whole will remain poor. This failure to connect may result from the inability of those who need the resources to locate those who have the resources. It may also be because those who have the resources do not care to give their resources to those who need them because they do not trust them. Indeed, one of the hallmarks of poor countries is the absence of good financial systems to connect the two. In a simple world, those who need the resources will go to the owners of the resources and ask to be allowed to use the resources with compensation coming later. This informal arrangement still works in developing countries. For projects that require many resources and where people are no longer connected by personal relationships, this arrangement will not work.

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Chapter 1

There are two principal ways in which surplus funds can be directed to those who need them. The first is direct lending and borrowing or direct finance. The situation described above, where an individual approaches the owner of the resource is an example. Direct finance is fraught with difficulties: 1.  It requires that the lender know enough about the borrower’s credit worthiness to judge him/her credit worthy. 2.  It requires that the lender understands enough about the proposed business for which the borrower wants the funds in order to be able to judge whether it is feasible or not. 3.  It requires that the lender has the expertise and the time to monitor the project to ensure that the borrower does not do something different from what she promised. For a small amount and a one-time lending and borrowing decision, these requirements may be too onerous to make the lending and borrowing profitable. The cost will be too high. This is one reason for the importance of an intermediary. If instead of lending directly, individuals could lend to an intermediary, who then lends to borrowers, costs could decrease. Costs could decrease because of the economies of scale that result from increasing production of service. The same set of procedures for lending to one person would be used in lending to the other thousands of borrowers. As a consequence, this lowers the cost per unit of lending. The intermediary, by enjoying economies of scale is able to lower the fees charged to borrowers and thus encourage more people to borrow. Another reason the one-time lender may not want to lend directly is explained by what is referred to in the economics and finance literature as asymmetric information (AI). Asymmetric information exists when one party to a transaction, has more information about the nature of the transaction than the other party. AI comes in two forms, adverse selection and moral hazard. In adverse selection, one party knows more about the nature of the transaction before it takes place. For example, a person applying to borrow funds for a project may know whether or not there are some special circumstances, which may make the project fail, and the probability that that special circumstance may emerge. She may however hide this from the lender and present the project in a much better light than it really is. If the lender knows about this special circumstance, she will probably not make the loan or may charge a higher interest. Moral hazard occurs when the borrower after securing the loan, acts in a way quite different from what was presented at the time of borrowing, and as a result, increases the risks that the project will fail. For example, once the borrower has secured the funds, she may embark on a new project, which, if successful, will give her a bigger payoff than the original project. This could mean taking on more risk than in the original project. A good example is a person who drives without car insurance. Because she has no insurance, she drives very carefully. Once the same person has bought car insurance, she no longer cares about being a defensive driver and drives recklessly. The lender is not ignorant, as she is aware of the fact that borrowers may present their projects in a much more favorable light than often warranted, and that borrowers may sometimes take more risks once they have the funds. Armed with all this



Money, Banking and Financial Markets 11

information, the lender may want to charge a higher interest rate. Borrowers who, in their own judgment are credit worthy, and are not likely to engage in risky behavior, may find the terms of borrowing too high and decline to borrow. Borrowers likely to engage in the risky behavior may not care; they want the funds at any cost. Borrowing and lending will shrink and with it economic activity. The presence of Asymmetric Information (AI) makes direct financing costly. Individuals with funds to loan will not want to lend directly to anybody and individuals who need funds for business will not want to borrow directly because the cost may be too high. This is the reason for the emergence of the second form of financing, indirect financing. Indirect financing takes place when entities (households, businesses, governments) with surplus funds do not lend directly to borrowers (households, businesses, governments) but instead lend to an intermediary, which specializes in collecting such surplus funds. Those with deficits or borrowing needs then approach the intermediary to borrow. Since a third party has been inserted between the initial/ original saver and the eventual borrower, the third party is acting as a financial intermediary. A financial intermediary therefore acts as a borrower from savers and a lender to borrowers. FINANCIAL INTERMEDIARIES The presence of financial intermediaries in the market place lowers the cost of borrowing and minimizes the risks associated with direct lending to borrowers. Financial intermediaries lower costs because, they borrow from many savers and lend to many borrowers. They thus achieve economies of scale, which lowers the cost per unit of each loan transaction. A one-time lender must incur the cost of executing the loan document and ensuring that the contract is written in a way which is acceptable to both parties. She must also incur the cost of checking the credit worthiness of the borrower and incur the cost of monitoring borrower behavior to ensure compliance with terms. A financial intermediary has to do these activities for several borrowers. The result is increasing returns to scale (economies of scale) which lowers the unit cost of the transaction. Financial intermediaries also lend to a large number of borrowers and as a result minimize risks of total default. In a one-time direct lending, even under the best of circumstances something could go wrong which could lead the borrower to default. If a borrower defaults, the one-time lender could lose all of his/her savings. A financial intermediary on the other hand, has the advantage that if one out of 1,000 borrowers defaults, not all is lost, there will still be the 999 borrowers who will repay. The loss is not crucial to the business of lending. More importantly, for the saver who has placed his funds with the intermediary, the funds represent a small portion of the total funds the intermediary has loaned to the defaulting borrower. The default of one borrower represents a small loss, first to the intermediary and an even smaller loss to the saver who in most cases would not even realize that a default has taken place. Financial intermediaries do for the small saver what only a big-time saver can do: they provide portfolio diversification. Borrowers from the intermediary will be diversified and will

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Chapter 1

be engaged in diversified business activities and so not all would default at the same time or rate. For these reasons, one would expect that financial intermediation would be more important than direct lending in the economy. The above discussions give us another way of describing the financial system. The system comprises Financial Markets and Financial Intermediaries. In financial markets, financial instruments are bought and sold directly as opposed to financial intermediation, where a third party, the financial intermediary comes between the borrower and the saver. These two ways also represent the flow of funds in the financial system. The two are not always separate and disjointed but can and do intersect in terms of participants and the sale and purchase of financial instruments. Savers come from all sectors of the economy: households, businesses, governments and the rest of the world. Borrowers also come from all sectors of the economy. Savers may choose to lend their surplus funds directly to borrowers in financial markets or indirectly to them through the intermediaries. Likewise, borrowers may borrow directly from savers or indirectly from them through the intermediaries. We can represent the interplay of fund flows and participation using Figure 1.3 below. The yellow banners show the participants, savers, borrowers and financial intermediaries. The light gray arrows show the sources of funds (savers) and point to their destinations (to the borrowers). The dark gray arrows show who is taking from the pool of funds or their destinations. As can be readily seen, both light and dark gray arrows emanate from and end in the same places, showing the intricate nature of financial markets.

Figure 1.3  Flow of Funds in the Financial System.



Money, Banking and Financial Markets 13

As stated above, borrowers can be households, businesses, governments and the rest of the world. Likewise, savers can be households, businesses, governments and the rest of the world. This should be easy to follow for, whenever one obtains funds or borrows one must have given a loan. The loan therefore is at once a liability (to the borrower) and an asset (to the lender) and thus the sum of the credits must be equal to the sum of the debts. One could say that this is a zero sum game. Yet, the impact on the economy is enormous, for through the financial markets and intermediaries, the power of the economy to produce goods and services is unleashed. The borrower by borrowing is able to generate economic activity, which adds to the total output of the economy. THE SPECIAL ROLE OF MONEY IN FINANCIAL MARKETS In the next chapter, we shall talk in greater detail about money; for now, however, it suffices to know that money occupies a special role in financial markets because it is the most liquid of all financial assets. Indeed as mentioned earlier, an asset possesses the characteristic of liquidity, if it can be readily converted into money with little or no loss in value. Those with an excess of income over expenditures have a choice as to how to hold the excess. They may choose to hold the excess by lending to somebody who has a deficit. If they choose to do so, they would have, for a while, at least, tied up their surplus and would not be readily able to use them to satisfy their needs whenever the needs arise. For a variety of reasons, which we shall explore later, they may choose not to lend them but rather hold the surpluses in a form, which will allow them to readily use them to satisfy their needs whenever the needs arise. The only form in which they can hold the surpluses to make them readily available for use whenever they choose to do so with little or no loss is in the form called money. Money is therefore a financial instrument with special characteristics. Its most important characteristic is that it is generally acceptable by everyone in a society. Those who want to buy resources to produce goods and services would actually prefer to have money because it gives them more flexibility: they do not have to take your land or machine, they can go buy somebody else’s land or machine which may in fact be better than what the lender has to offer. How much money is in the economy could therefore give an indication of the intensity of demand for goods and services in the economy. It is for that reason that we give a special place to money when we study financial markets and institutions. Money is also a financial asset; it is bought and sold just like any other financial asset and therefore has a price. The price of money affects the prices of all other financial assets in the economy. In the subsequent chapters, we shall learn more about money and its role in the economy. SOME FACTS ABOUT THE FINANCIAL SYSTEM ACROSS THE WORLD It would probably come as no surprise to anybody that the biggest financial institutions in the world are located in the more developed parts of the world. Highly

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developed economies demand efficient and complex financial institutions and instruments. In turn, these complex financial institutions and instruments are able to marshal large amounts of savings, which foster economic growth. Poor countries tend to have poorly developed financial systems and poorly developed financial systems hinder economic growth. This is one of the vicious cycles in economics. There is some good news, however, slowly but steadily, the poor countries are adopting policies, which are encouraging the development of the financial sectors. Libya’s Libyan Arab Foreign Bank, Nigeria’s Intercontinental Bank and Kazakhstan’s Bank TuranAlem are all now on the list of the top 1,000 banks in the world in terms of assets. The sharp distinction that existed among financial institutions is gradually being eroded by the tendency for each sector to encroach on each other’s territory. For example, one of the biggest diversified financial institutions in the world is GE, which is usually associated with manufacturing. Further, there is hardly any difference now between a savings bank and a commercial bank. In the United States, especially, commercial banks are now doing jobs that used to be in the exclusive domain of investment banks. Some banks also now offer services that used to be offered by other financial institutions. There is a movement towards establishing a one-stop shopping center for financial products, especially in the developed world. Financial institutions have greatly taken advantage of advances in information technology and communication. Virtual banks that exist only in cyberspace are emerging and the services of financial services are spreading rapidly. This is even so in developing countries where a decade or two ago some financial services were confined to only a small segment of the population or were utterly unknown.

CHAPTER SUMMARY The chapter gave a general overview of the financial system, describing what the financial system does, who the participants are and what they do. It also briefly touched on the various institutions that form a part of the system. The important idea in this chapter is that the financial system comprises the institutions, rules and regulations, which make it possible for entities with surpluses to transfer them to entities with deficits. Borrowers and savers may be households, businesses, or governments and they may also be foreign or domestic. Since the sum of what is loaned out cannot be greater than what is borrowed, the sum of the assets must be equal to the sum of the debits. However, because those who borrow often borrow to undertake productive activities, the result of the lending and borrowing is to increase economic activity and increase wealth beyond what is borrowed and loaned. Financial markets are more developed in the developed countries than in the developing countries; indeed it has been argued that part of the reason poor countries are poor is because they have underdeveloped financial markets. Because of this observation, several poor countries are making special efforts to develop their financial markets and to open them up to the rest of the world. In subsequent chapters, as we describe the workings of the financial system, we shall pay attention to the shortcomings that exist and persist in the poor countries.



Money, Banking and Financial Markets 15

KEY CONCEPTS Adverse selection Asymmetric information Borrower Capital market Creditor Debt

Direct finance Equity Financial institution Financial intermediaries Financial market Financial system

Money market Moral hazard Primary market Secondary market

PROBLEMS AND APPLICATIONS 1.  Briefly explain what the financial system is. 2.  What is the difference between direct finance and indirect finance? 3.  In your country, which form of financing might be dominant, direct or indirect? Please explain why that is the case. 4.  Imagine a world in which people who have ideas about making things do not have the resources to do so; and the people who have resources to make things do not know how to make them. Think of at least two ways in which the society might bridge the gap. 5.  If the gap above is bridged, what are the consequences for members of the society? 6.  What are the two ways of channeling surplus funds to potential borrowers? 7.  It has been argued that poor countries are poor because they have underdeveloped financial systems. What does this statement mean and how can it be remedied? 8.  In many places in the developing world, landowners lend their land to tenant farmers to farm. At the end of the farming season, the landowner shares in the produce with the tenant farmers. This is a financial arrangement, which has worked for centuries. In your opinion how effective or ineffective is this system and how can it be improved upon? 9.  How does the secondary market help in boosting the effectiveness of the primary market? 10.  How do you think advances in information and communication technology (ICT) has helped banking in the world and in developing countries in particular? NOTE 1. See U.S. Government Accountability Office Report to the Chairman, Committee on Banking, Housing, and Urban Affairs, US Senate, October 2004, Financial Regulation: Industry Changes Prompt Need to Reconsider U.S. Regulatory Structure, GAO-05-61.

APPENDIX Recent Developments in the Theory of Finance Traditionally, financial intermediation and the presence of financial intermediaries have been explained by two basic facts: financial intermediation

16

Chapter 1

i)  reduces transactions costs and ii)  minimizes the problems stemming from asymmetric information. In recent times, the theory of finance has taken note of some developments in the financial system and questioned whether these two factors alone suffice to explain the presence and importance of financial intermediation, especially in the developed world. In an article written in 1996, Franklin Allen and Anthony Santomero observe that between the mid-1960s and mid-1990s financial assets increased considerably in the United States. At the same time, the percentage holdings of traditional financial instruments by individuals dropped. This drop was accommodated by an increase in the holdings by financial intermediaries.2 Another trend is the introduction of new and complex financial instruments, and the repackaging of existing instruments in a process referred to as securitization. Allen and Santomero argue that the distinction in the financial system; where on the one hand, corporations issued securities which were bought by individuals, (direct financing), and on the other hand individuals deposited funds with intermediaries who then lent them out (indirect financing), has broken down. In a world where transaction costs have decreased considerably and information has become readily accessible and cheaper, all because of dramatic improvements in information technology, one would expect that the role of financial intermediation would decrease, on the contrary, the role of financial intermediaries seem to be getting bigger. The authors conclude that in the complex financial markets, which we now have, participation costs have become high. Understanding the new complex financial assets and correctly pricing them has become an increasingly difficult task and individuals do not have the skills to correctly do so. The financial intermediaries therefore provide the important task of facilitating participation by individuals in the financial markets. In addition, it is argued that in this complex environment, financial intermediaries have an added function of facilitating the transfer of risk. They do so through due diligence, holding diversified portfolios. They also through the repackaging of products into some other products are able to pass on the risk and they finally manage what cannot be eliminated. The above discussion still point to two important factors as accounting for the importance of financial intermediaries: the need to reduce costs and to minimize risk.

NOTE 2. Franklin Allen and Anthony Santomero, The Theory of Financial Intermediation, Wharton Financial Institutions Center, University of Pennsylvania, Philadelphia, Working Paper Series. August 31, 1996.

Part II

MONEY

Chapter 2

The Concept of Money

The average person often confuses money with wealth. This is the case when we say that somebody is rich, he has a lot of money. We shall find that a person can be very rich without having a lot of money. In this chapter, we formally introduce the concept of money; what it is, how we measure it and its importance in the economy. At the end of the chapter, you should be able to: 1.  Define money. 2.  Explain why some things are money and others are not. 3.  List the common measure of money. 4.  Explain the special role money plays in the economy. THE CONCEPT OF MONEY Money is one of those concepts, which the public appears to know very well, but which economists have difficulty defining and quantifying. Economists’ interest in money comes from the fact that there is a close association between money, whatever it is perceived to be or is, and the level of economic activity. We know, for example, that if there is too much money, it creates inflation; if there is too little of it, there could be deflation and a decline in economic activity. Exactly how much money is the right amount is an issue which economists and policy makers struggle with regularly? To answer this question satisfactorily, we must first know what money is and how to measure it. Let us begin by considering a society in which all members are self-sufficient, in the sense that each family unit produces all that it consumes. In such a society, there is no need to trade. Economists refer to such a society as being in autarky. With no reflection at all, we can all conclude that in autarky, output of goods and services will be very low. Not all members of the society will be equally adept at producing the goods and services they would like to consume. Indeed some members may not be able to produce any of the goods they would like to consume at all. Their satisfaction or utility levels would be correspondingly low. If we assume that each family would like to consume a wide variety of goods and services and more rather than less; then 19

20

Chapter 2

it would be beneficial if they could specialize in what they produce best, what they have a comparative advantage in producing, thereby producing more of it than they can consume and trade what they do not consume. This will give the family a bigger bundle of goods and services to consume and thus increase their utility. To trade, the family must find another family that wants what it has to offer, and has what it wants; that is the families must barter. In bartering, there is a need for a bilateral exchange of mutually desirable goods or services or a double coincidence of wants.1 The family that wants to barter must spend a considerable amount of time searching for a trading partner who wants what it can offer, and can offer what the trading partner wants. This is time which otherwise, could have been spent producing more goods and services. Let us now imagine that there exists a single commodity say cowry shells, (or a few commodities such as gold and silver), which everybody in the society accepts in trade because they know that whenever they want to get rid of it, somebody else would gladly accept it. Under such a scenario, if Adam has a surplus of what he produced, he can give it to Ben for cowry shells and use the shells to get what he really wants from Charles. Instead of a bilateral exchange of goods (between Adam and Charles), there is now a trilateral exchange: Adam gives something of value to Ben for cowry shells. Adam accepts the shells not because he particularly cares for it, but because he knows that he can give it to Charles and get from him what he really wants. This general acceptability of the cowry shells, confers value on it regardless of any other use (or lack of use) to which the commodity might be put. Since Adam does not have to spend a lot of time searching for an exchange partner in the trilateral exchange process, as he would have had to do in the bilateral exchange process, he can devote more time to producing what he is good at producing. So would everybody else. This increase in time devoted to production, makes everybody better off. Consumption bundles increase as do satisfaction levels in the society. The society has now moved from being a barter economy to a monetary economy. What does money, therefore do in the economy? We discuss this in the next section. FUNCTIONS OF MONEY Medium of Exchange The object or commodity, which everybody accepts or gives, in exchange, is making it easy for individuals to trade. The role of the object is to facilitate trade. Anything, which is generally acceptable as a medium of exchange performs the function of money. The fact that the object is desired for its own sake helps in its general acceptability but it is not critical. Objects that are desired for their own sake have, however, been often preferred. This explains why, in most societies, the things that emerged early as money were gold, silver, cowry shells and other ornamental commodities with intrinsic values. In many societies all over the world, such commodities have been used at one time or the other. In West Africa, cowry shells became the medium of exchange.2



The Concept of Money 21

Stones have been used in the Yap Islands and, in North America, tobacco and wampum have been used as money. In some of the northern parts of Ghana, people still use cowry shells as money. For instance, bride’s money (dowry) is sometimes paid in cowries.3 R.A. Radford discusses the interesting case of cigarettes as money in an article which every money and banking student should read.4 Beer has also been used in a similar manner elsewhere. All of these objects are commodity money. These commodities possessed characteristics, which made them suitable for use as money besides the fact that they were desired for their own sake. They are easily divisible into smaller portions and thus portable. They are durable and thus storable for long periods without deterioration. These kinds of money, called commodity money, are tangible and easily physically transferable. Money need not be tangible to be transferable for it to be a medium of exchange. Unit of Account In a society where there is no generally acceptable medium of exchange, theoretically every commodity is money. If every commodity is money, then it makes sense that in every trade, the trader must first determine the value of what he is offering for sale in terms of what he is proposing to buy. In a society with only two commodities, this is no problem; one orange might be equal to say two mangoes or one apple might be equal to one pear; there is only one price or term of trade. If there are three commodities there will be three different terms of trade or prices; each commodity must be valued in terms of the other two. As the number of traded commodities increases, the number of prices increases considerably.5 Imagine trading in a market where there are one hundred different goods each of which can trade against the other. The number of possible prices is an astonishing 4,950. It will be well-nigh impossible to keep track of the prices of the goods you buy and/sell. To solve this problem, a common measure is necessary. If all traders agree to a common measure for all goods and services then the number of prices in the society will drop quite significantly. This one common measure becomes the unit of account, a yardstick by which all other goods are measured. A commodity that performs this function is acting as money. For example, if ten ounces of gold can buy one sack of rice, five ounces can buy a sack of corn and three ounces can buy a sack of millet, then we are able to measure the prices of rice, corn and millet all in gold. This is easier than trying to figure out how many sacks of rice are needed to buy how many sacks of millet. Gold is the unit of account. This function of money makes it possible to add and subtract different commodities because they can all be expressed in the same units, gold, silver or cowry shells. If we had to account for all that we produce as a society in different units, it would pose some special challenges and it would be impossible to give one number representing all of them. By using a common unit of account, this difficulty is overcome: all the cows, sheep, goats, and yams we produce can be expressed in that common unit and then aggregated. As a unit of account, the object need not even have a physical existence. It can exist in the abstract; all we need is to use it as a measuring

22

Chapter 2

device. This is very convenient for evaluating our possessions and comparing ours to others. Store of Value Let us imagine a society where one lives for three periods. In the first period, one is young and incapable of working, and therefore dependent on the goodness of others, say parents and grandparents. In the second period, one acquires the ability to work, to produce enough to feed oneself and to accumulate a surplus to repay parents and grandparents for their generosity when one was an infant. In the third period, one is old and incapable of working. How does one transport some of the surplus from the second period to the third period so that one does not starve? If the goods produced while young and able to work (in period two) are non-perishable, then it will be a simple matter of storing them until period three for consumption. If the goods are perishable, then unless there is a charitable individual who, in the second period of his life has a surplus and is willing to donate this surplus to us, in our old age, individuals in period three of their lives will starve to death. Let us now assume that a convention develops, such that people in the second periods of their lives, enter into implicit or explicit contracts with those in the first periods of their lives. The contract says that “in consideration of my taking care of you now, while you are young (in your period one), you promise (on the pain of a deadly curse) to take care of me when I am old (period three).” In fact, this scenario is not farfetched. It still pertains to family structures in many developing countries especially in the rural areas. Parents take care of their young with the full expectations that when they are old, their young will return the favor.6 Conceptually, regardless of the time involved, what this contract does is to enable individuals to transfer purchasing power or current surplus from the present to the future, in this case, from the second period to the third. The advantage of such a system is obvious; individuals no longer starve in the third periods. Let us assume that the mechanism for transferring the purchasing power takes a form such that for each unit of surplus commodity transferred, an individual receives a receipt worth one commodity in period three. Using this receipt, the individual is then able to transfer wealth or surplus across time. The receipt, which entitles the individual to claim the goods and services at a future date, is acting as a store of value, another very important function of money. When individuals have command or claims over goods and services at a point in time, and seek to transfer the claims into the future, they require a means of storing the claims. Prior to the emergence of modern monetary economies, societies managed this process by using objects that possessed intrinsic values and were therefore desirable for their own sakes. A person in the second period of his life could therefore accumulate enough of these objects and spend them down during the third period. The object in which the value is stored is money. Milton Friedman refers to this important function of money as temporary abode of purchasing power.7 It enables individuals to separate the act of sale from that of purchase. You can sell something now, hold the value over time in an object, and exercise the purchasing power at some point in the future.



The Concept of Money 23

WHAT CONSTITUTES MONEY The next question we turn our attention to is what constitutes this object or objects, which perform the functions of (a) medium of exchange (b) unit of account and (c) store of value. This is not an easy question to answer. Some economists argue that the most important function of money is its use as a medium of exchange. If that is the case, then we can only count as money only the things used as such. While the medium of exchange function is very important, the object used as a medium of exchange also tends to have an intrinsic value, at least in the early days of the evolution of money, and therefore acts as a store of value. If an object cannot hold its value over time, individuals are less likely to accept it and may not want to hold it for any length of time. If that is the case, then the object will not be a good medium of exchange. As mentioned earlier, it is precisely why the objects which were used as money in most early monetary societies, tended to be precious commodities such as gold, silver or cowry shells; hence commodity money. Most modern day money is in fact fiat money. Fiat money, unlike commodity money, is not worth its value intrinsically; it is just a representation or token money. Its face value derives from a government decree and its actual value depends on social acceptances. Governments may decree that a given unit of money is worth one naira, shilling, dollar or euro. It is however, the general acceptance of the money in exchange for goods and services, which gives the naira, shilling, dollar or euro its actual value. A government fiat money simply says that it is “legal tender for the payment of debt, private and public.” If you wanted to buy a tuber of yam from the market place, how many units of the fiat money will the seller demand? This is what determines the actual value of the fiat money. The government cannot tell the seller how many units of the object to take (actually, the government can, and sometimes does, with disastrous consequences to the economy). The earliest use of paper money in place of commodity money is said to have occurred in China during the Tang Dynasty (618–907 AD). Copper was the commodity money then and, when it became short in supply, paper was used in its stead as representative money. Others suggest that the introduction of paper money was more for the convenience of travelers. Transporting large amounts of copper, gold or silver over long distances is not only laborious, but can be dangerous. At the onset of the journey, one converted all the metal money into paper money and redeemed them at the end of the journey from a designated agent. This lightened the burden of traveling and made robbery less likely.

SEPARABILITY OF THE FUNCTIONS OF MONEY In general, there is no reason for what is used as the medium of exchange to be also used as the store of value or the unit of account, although it is convenient to do so. Theoretically, one object can be used as the medium of exchange, another as the store of value and, yet a third as the unit of account. What this means is that the functions of money are distinct and separable. If the object used as the medium of exchange holds its value well

24

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over time, then there will be a tendency for it to be used as a store of value. If it is used as a store of value then people will be more likely to use it as a unit of account. Conversely, if the medium of exchange does not hold its value very well over time, then it may not be used as a store of value. As a result people will tend not to use it as a unit of account. Evidence of this separation of the functions of money abounds in many developing countries. For example, in the late 1990s and early 2000s, although the manat, was the official currency of Azerbaijan (the fiat money), the unit of account for most items (especially big ticket items and contracts) was the US dollar; menus were priced in dollars and converted to manats when payments were made. Further, the dollar was the preferred store of value: those who had dollars held onto them until they were ready to buy and then exchanged them into the medium of exchange, the manat. By law, one could not use any currency other than the manat to buy goods and services and one could not accept any other currency other than the manat for goods and services sold. Traders, however, found ways around the law: property owners who rented apartments to foreigners accepted (and in fact preferred) dollars, supermarkets and department stores circumvented the law by having bureau de changes (exchange bureaus) conveniently located in the stores, taxi drivers accepted them and so did merchants. The same was true in Ghana and other African countries during the period, as well as many Latin American and Caribbean countries. The morale is very simple: a government can decree what money is: the public decrees its acceptance and hence its value.

MEASURING MONEY The functional definitions given for money pose some difficulty when measuring exactly what constitutes money in the economy. As mentioned above some economists insist that the most important function of money is the medium of exchange. As such, only those objects used for transactions (in the purchase and sale of goods) should be counted as money. It can be argued that anytime one holds money, he or she is transferring purchasing power from one point in time to another, however brief the time period. If that is the case, then the store of value function is also very important and inseparable from the medium of exchange. Given these disagreements, it should come as no surprise that there are several definitions of money and that they are not the same from one country to another. In the United States, for example, the central bank, Federal Reserve Bank (Fed), used to report data for four different measures of money: M1, M2, M3 and L. The Fed now reports data for only M1 and M2 because those are the useful aggregates for policy purposes. Major components of M1 are currency (C) and demand deposits (DD) or current account deposits/checking account deposits. M1 = C + DD

(2.1)

M2 includes everything in M1 as well less liquid assets such as savings deposits (SD), time deposits (TD) under US $100,000 and retail money market mutual funds (RMMMF).



The Concept of Money 25

M2 = C + DD + SC + TD or M2 = M1 + SD + TD

(2.2)

It is important to emphasize that it is not the checks themselves which constitute money but rather the deposits in the banks. When a check is written, the deposits are what are transferred from one person or business to another. Essentially, the check authorizes the bank to transfer the ownership of the deposits from someone to somebody or to reduce someone else’s balances and increase somebody else’s. If the deposits do not exist in the bank in the first place, they cannot be transferred. In the developing countries, there is a tendency for people to refrain from accepting checks, sometimes for good reasons, sometimes for not-so-good reasons. On vacation in Ghana in 2003, the author wanted to buy a product that at the time cost 20,000,000 million cedis (about US$2,000.00). The highest denomination in the Ghanaian currency then, was a twocedi note. Carrying a million one- or two-cedi notes around at one time was certainly not wise or pleasant especially when one is on vacation. It required a sizeable suitcase (Ghana must go) and much heavy lifting. Leaving the bank with such a load only suggests that you are loaded and a good target for criminals; fortunately, it does not happen that often in Ghana. Even reputable business establishments mistrust checks and often do not accept them in payment for goods or services. The mistrust is sensible. Developing countries such as Ghana and Nigeria are societies in which asymmetric information exists to a greater degree than in the developed countries. A person writing a check knows whether she has sufficient funds in the bank or not to cover the check. The recipient of the check does not know and is taking a chance. Very often, one may not have the means of verifying the identity of the person issuing the check. To minimize the loss associated with non-payment when the check is presented, individuals and businesses simply refuse to take them and ask for cash only. These societies are often described as cash societies. In contrast, in developed countries, identities are easy to verify and increasingly there are means of verifying whether the individual writing the check has sufficient deposits or not at the time of issuing the check. There may be an even more devious reason for not accepting checks. To hide transactions from tax authorities and thus avoid paying taxes, it is better to deal in cash than accept checks. This is true in both developed and developing countries. As we move from M1 to M2, one encounters assets that are less liquid, such as savings accounts or deposits (SD) and certificates of deposit (CDs) or time deposits. These assets, unlike currency and demand deposits pay interest to the account holder and, as a result are better stores of value. Unfortunately, they are not as liquid as currency. One cannot buy a cup of coffee with a CD; one has to first convert it into currency. The other money measures M3 and L included assets that were even less liquid, such as institutional money market mutual funds, large denomination certificates of deposit, repurchase agreements and Eurodollars. These are all assets which play very little role in developing countries and therefore would not be included in any measure of money. A comparison of what constitutes money in Ghana, Nigeria and the USA should give a sense of what money can be. Tables 2.1, 2.2 and 2.3 show the various components of money in these countries and their percentages.

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Chapter 2

Table 2.1  Money Supply, Nigeria December 2012. Category

Billions of Naira

% age of M1

% age of M2

1,301.20 6,119.80 7,421.00 8,062.90

17.53 82.47 100

8.40 39.52 52.07

Currency outside banks Current Account/Demand Deposits Equals M1 Plus Savings and Time Deposits (Quasi Money) Equals M2

15,483.90

100.00

Source:  www.cenbank.org/rates/mnycredit.asp?year=2012

Table 2.2  Money Supply, Ghana December 2012. Category Currency outside banks Current Account/Demand Deposits Equals M1 Plus Savings and Time Deposits Equals M2 Plus Foreign Currency Deposits Equals M2+

Millions of Cedis

% age of M1

4,918.56 6,238.18

44.09 55.91

11,156.74 6,346.52

100

17,503.26 5,116.80

% age of M2

% age of M2+

28.10 35.64

21.74 27.58

36.26

28.06

100.00 22.62

22,620.06

100.00

Source:  www.bog.gov.gh/Publications/Statistical_Bulletin/2013/StatBulJune%201013c.pdf

Table 2.3  Money Supply, USA, December 2012. Category Currency outside banks Travelers checks Demand Deposits Other Checkable Deposits Equals M1 Plus Savings and Small Time Deposits Retail Money Market Mutual Funds Equals M2

Billions of Dollars

% age of M1

% age of M2

1,090.80

44.60

10.48

3.80 907.50 443.60 2,445.70 7,323.40 640.10 10,409.20

.16 37.11 18.14 100

.04 8.72 4.26 70.36 6.15 100.00

Source:  www.federalreserve.gov/releases/H6/Current/

The narrowest measure of money in all three countries is currency, comprising notes and coins circulating outside the banks (in pockets, wallets, purses and in drawers at home as well as in the offices of businesses) and current account or demand deposits. Current account or demand deposits are deposits created by and existing in the books of the banks. The ownership of these deposits can be changed by the owner, payer, writing a check authorizing the bank to transfer the deposits to another person, the payee. The payee can sometimes be the owner. This happens when the owner of the deposits goes to the bank and writes a check payable to himself.



The Concept of Money 27

You will observe that in the United States, in addition to the currency and demand deposits, there are also travelers’ checks and an item called other checkable deposits. Travelers’ checks are accepted worldwide because the companies issuing them have good international reputations. As a result, travelers’ checks are the closest to a global currency often used by travelers when they do not want to carry currency. Upon arrival at their destination, the traveler simply goes to a bank to obtain local currency. Alternatively, they can be used at hotels, restaurants or in shopping malls. In developing countries, sometimes there are not too many places that will accept traveler’s checks; banks will however, always exchange them for local currency. Another item found in the United States but not in Ghana and Nigeria is other checkable deposits. Other checkable deposits include any account that allows the owner to write a check against. An example is a Negotiable Order of Withdrawal (NOW) account. This account, unlike demand deposits, pays interest but, unlike a savings account, the owner can make withdrawals from them by writing checks. Consequently, they combine the features of a savings account and a checking account. One important characteristic of this narrow definition of money is that they are generally acceptable as means of payment, an important function of money. However, if you held all your wealth in the form of this narrow definition of money, you could incur some cost. At the very least, as the price level increases, currency, which does not pay any interest, loses value. As a hedge against this loss, one may prefer to hold some of her wealth in some other form. This is what the next category of items that make up the broader definition of money does. A broader definition of money, called M2, includes savings and time deposits (quasi money in Nigeria). In the United States time deposits include only those below $100,000.00. You might try to reason out why time deposits of $100,000.00 or more are not included in this definition. You might also take a shot at explaining why savings and time deposits are called quasi money in Nigeria. In the United States, M2 also includes retail money market mutual funds (RMMMF). RMMMFs are low risk, low return investment assets that are easily accessible by owners. The retail refers to the fact that the funds do not belong to institutions. Unlike the components of M1, narrow money, the components of M2 earn interest and, thus, if one wanted to store one’s purchasing power over time, these components might be better stores of value than the components in M1. The interest earned on the savings and time deposits accounts may prevent losses in the value of money due to inflation. You will observe that in Ghana there is an additional item called foreign currency deposits, which you do not see in the definition of money for Nigeria or the United States. Adding this item to the other components of M2 gives what the Central Bank of Ghana calls M2+. In general, the additional items added to M1 to obtain M2 (or M2+) are not as liquid as the items in M1. In giving up the general acceptability, one gets better stores of value. There is thus a trade-off between those functions of money, store of value and medium of exchange. If you wanted to buy a cup of tea, you could not do that if all you had was a time deposit in your bank account of 5,000.00 naira or cedis. You would first have to go to the bank to liquidate the time deposit, before you can go buy your cup of tea. If it has not matured, you must pay a penalty; time deposits are not generally accepted as medium of exchange.

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Chapter 2

Some facts stand out as we look at the components of money in the three countries as shown in tables 2.1, 2.2 and 2.3 above: 1.  Currency, comprising coins and paper money appear to be more important in the United States than in Ghana and Nigeria. In the United States, currency is about 45% of M1. In Ghana it is about 44% and it is a paltry 18% in Nigeria. One would have expected the percentage of currency to be smaller in the United States than in Nigeria, a country that does not have the financial technology of the United States. In general developing economies tend to be cash economies, more so than developed ones. This counterintuitive observation has been attributed to the fact that that a large portion of the US currency is held outside the United States.8 2.  In the United States, a bigger percentage of M2 is in the form of savings and small time deposits, 70%; in Nigeria it is 52%. In Ghana it is only 28% but the addition of the foreign currency deposits increases it to 51%. That a large portion of M2 is in time and savings deposits points to the importance of the store of value function of money. In countries with high inflation, people move into a more stable asset to hold as store of value. In Ghana, for those with access, it is foreign currency deposits; almost everywhere else, people move into interest-bearing deposits.

DEBIT AND CREDIT CARDS Debit and credit cards are not money. The reasons should be obvious. Whenever you use your debit card, you reduce the deposit balances you have at the bank. The card is a modern convenience, which allows you to transfer your money in a less obtrusive form. It is no different from a check. Whenever you write a check, your bank deposits decrease while some else’s increase. Advances in technology have created many efficient ways of accessing bank balances besides using debit cards. One can sit at home and use a personal computer to make payments and/or buy goods and services. Collectively they are called Electronic Banking (E-Banking). This technology has made it possible for the business of banking to be separated from its brick and mortar self. Some of these developments are still in their infancy in the developing countries but even there, they are found in the big cities such as Nairobi, Lagos, Enugu, Abuja Accra, Abidjan and Freetown. Credit cards are slightly different but nonetheless are not money either. Whenever you make a payment with a credit card, someone (a bank usually) is temporally making the payment on your behalf. That someone does so by reducing his balances at his bank. The important point is that credit cards are just a means of accessing loanable funds. Credit card balances are therefore not counted as part of the money supply. THE SPECIAL ROLE OF MONEY IN THE ECONOMY We suggested earlier that the role of the financial system is to facilitate the transfer of surplus funds from savers to borrowers. The borrowers are groups of people or



The Concept of Money 29

businesses who may have projects but lack the funds to bring them to fruition. For example, the borrower may need funds to buy seeds to plant or to buy cement to build houses for sale. The borrower needs the funds in a form, which will be acceptable to the seller offering the needed supplies at the lowest prices. In fact, a lender may have the seeds the borrower needs but the borrower may not like the quality or think he could get a better price or better quality elsewhere. It follows naturally that the borrower would rather have the funds in the most liquid form which is easily transferable, and that is money. It is for this reason that money is so important in the economy. Loan receipts are typically in the form of money rather than in bags of rice or sacks of corn. Similarly, repayments are made in the form of money rather than in commodities. Once a borrower has received the money, he can then turn it into any other asset he prefers. Money is therefore the most important of all the financial assets in the economy because of its liquid nature or the ease of conversion into other forms. It is for that reason that we study money and banking as a special course in economics. In money and banking, we study among other things: 1.  The nature of money, 2.  The demand for it, 3.  The supply of it, 4.  What makes the demand equal to the supply, 5.  The effect of money on the economy when there is too little or too much and 6.  How to control the amount of money so that it promotes economic growth and price stability. In the next chapter, we shall look at another important concept that goes with money, the interest rate or the price of money.

CHAPTER SUMMARY The chapter examined the idea of money and how it is measured. To economists, money is important because of its close association to economic activity. Policy makers therefore want to know exactly what money is so that they can provide the right quantity so that the economy can grow at its potential without inflation or deflation. Most early moneys were commodity moneys. These items were desired for their intrinsic values. Modern moneys are fiat moneys; they are money by government decree. The coins and paper notes circulating have no intrinsic values and are not redeemable for anything except what society agrees to. There are several measures of money, M0, M1, M2 etc. These classifications depend on the extent of liquidity of the component assets. The most liquid of all assets is currency because one can use it to buy goods and services without converting it into anything else. The same is true to a large extent for checking accounts /current account/demand deposits. On the other hand, certificates of deposit are not as liquid as currency because to use them one must convert them first into the generally acceptable medium of exchange, currency or demand deposits. There is also the possibility of a loss if the CD has not matured.

30

Chapter 2

Technology has introduced many conveniences for carrying money; these new developments make it easier to use the medium of exchange without physically carrying the medium of exchange around. KEY CONCEPTS Autarky Bank deposits Barter Checking account Commodity money Credit card Currency

Debit card Double coincidence of wants Fiat money M1 M2 Medium of exchange

Representative money Store of value Temporary abode of purchasing power Token money Unit of account

PROBLEMS AND APPLICATIONS 1.  Why is the concept of money important to economists? 2.  If you lived on an island alone, and you did not trade with anybody, would you need money? Please explain. 3.  What does the statement “the functions of money are separable” mean? 4.  Why are credit cards not considered as part of the money supply? 5.  Explain what debits cards do and their usefulness. Are they money? 6.  In your opinion, what is the most important function of money? 7.  Why might currency form a bigger component of the money supply in Ghana or Nigeria than say in the United States? 8.  A story is told about the Island of Yap, which used to have stones as money. The value of the stone depended on its size and quality. If one made holes in them they could be strung together to obtain greater value. It is also said that there was a huge stone that was so big that it was not movable. Yet this stone was used as money. 9.  Can you think of how the large immovable stone could still perform as money? 10.  What functions of money could the stones not perform? 11.  How do you think the money supply could be controlled in Yap? 12.  Is the island a monetary economy? 13.  There is a new form of carrying balances called “stored-value cards” and “e-cash.” Find out about them and describe what makes them money or not money. 14.  If an object is not a good store of value it will also not be a good medium of exchange and nobody will use it as a unit of account. Explain why this might or might not be so. NOTES 1. William Stanley Jevons, Money and the Mechanism of Exchange. New York: D. Appleton and Co., 1876. [Online] available from http://www.econlib.org/library/YPDBooks/Jevons/ jvnMME1.html; accessed 12 October 2006.



The Concept of Money 31

2. Nwani A. Okonkwo, “The Quantity Theory in the Early Monetary System of West Africa with Particular Emphasis on Nigeria, 1850–1895,” The Journal of Political Economy, vol. 83, no. 1, February 1975, 185–194. 3. For more details on the use of cowry shells in Ghana and elsewhere in West Africa, see Emmanuel Yiridoe, “Economic and Sociocultural Aspects of Cowrie Currency of the Dagaaba of Northwestern Ghana,” Nordic Journal of African Studies, vol. 4, no. 2, 1995, 17–32; Nwani A. Okonkwo, “The Quantity Theory in the Early Monetary System of West Africa with Particular Emphasis on Nigeria, 1850–1895,” The Journal of Political Economy, vol. 83, no. 1, February 1975, 185–194; and E. K. Hawkins, “The Growth of a Money Economy in Nigeria and Ghana,” Oxford Economic Papers, New Series, vol. 10, no. 3, October 1956, 339–354. 4. “The Economic Organization of a P.O.W. Camp,” Economica, vol. 12, November 1945, 189–201. 5. The formula for determining the number of possible prices is N(N − 1)/2, where N is the number of commodities. If there are five (5) commodities, there will be 10 different prices. 6. The Ghanaians have a saying, which literally says, “I have taken care of you for your teeth to grow; now you take care of me for my teeth to fall out.” 7. Milton Friedman, Money Mischief: Episodes in Monetary History, Harvest Books, 1992, p. 16. 8. M. Case Sprenkle, “The Case of the Missing Currency,” Journal of Economic Perspectives, vol. 7, no. 4, 1993, 175–184.

Part III

INTEREST RATE

Chapter 3

The Concept of Interest Rates

This chapter discusses the cost of lending and borrowing funds, the interest rate. The idea of interest rate is very important in financial markets as it determines how much of the surplus would be loaned out and how much would be borrowed. We give a brief overview of how the concept has evolved over the millennia and what different religions have had to say about it. At the end of the chapter, you should be able to: 1.  Define the concept of interest rate. 2.  Explain how it is measured. 3.  Describe how it is determined and the factors that affect it. THE CONCEPT OF INTEREST In just about every culture in the world, interest rates have always generated heated debates. In some cultures, it appears that there is an outright prohibition on interest rates. In others, there appear to be rules on what is acceptable to charge and what is unacceptable. Yet, in all of these cultures, people have found ways of charging interest. In Biblical times for example, the books of Exodus, Deuteronomy and Nehemiah appear to uphold not charging interest at all.1 In Islam, some scholars insist that the Koran proscribes interest rates. In an attempt to circumvent the proscription however institutions have emerged which appear to be able to make loans without charging interest rates. These institutions, espouse the principles of Islamic banking with specific conditions that must be met in order to make the loan agreement Islamiccompliant. Whether or not Islam forbids the charging of interest (Fa’eda) as opposed to usurious interest rates (riba) is still being debated.2 Buddhism and Hinduism, on the other hand, appear not to have any such proscriptions on interest. In Christianity and Judaism, it does appear that by the time of Jesus Christ, because of Roman influence, the concept of interest had become acceptable.3 This is without a doubt a major step forward in the development of finance. As the charging of interest became acceptable, it was the practice of usury that came under increasing attack. Without interest rates, economic activity would decrease considerably since there would be no incentive to lend. Interest ensures that individuals who are willing to 35

36

Chapter 3

forgo consumption to save and lend are rewarded, thereby providing the means for others who do not have the savings but have profitable investment opportunities to use the surplus funds to engage in productive activities. The higher the interest rate, the more incentive people will have to postpone consumption in order to save. On the other hand, the higher the interest rate, the less incentive people will have to borrow. As a result, interest rate will rise or fall as the supply of funds exceeds or falls short of the demand for the funds. Interest rate is the price borrowers pay for the funds they buy, and the price creditors receive for the funds they sell. The interest rate is therefore price of credit. It brings the demand for funds into equilibrium with the supply of funds. Just as there will be no product or service if there were no price for it so will there be no credit if there were no price for it. MEASURING INTEREST RATE: PRELIMINARY IDEAS Just how is this interest measured? In our discussion of money, we stated that one of the important functions of money is its use as a store of value. As a store of value, there is the implication that a claim on goods and services, which could have been exercised now, is being postponed into the future. Postponing a claim one has on the goods and services in society means that there are that many more goods and services for somebody else to lay claim to, if only that person could access the value or purchasing power that is being stored. In a simple world, where everybody knows and trusts each other, an individual with a surplus simply lends it to another who does not have enough to buy some of the goods and services, such as a new fishing net for his boat. Since somebody is using another’s hard earned surplus, the owner of the surplus would naturally want to be rewarded. The reward received for letting another person use the surplus to buy a net so that he can catch more fish and sell them and become rich, is what is referred to as interest. Interest is therefore an income received by the person who is allowing the other to use her funds and an expense to the person who uses the surplus funds. When this payment is expressed as a ratio of the original amount loaned out, it becomes a rate, the interest rate. Thus, if I let you use my $100.00 for one year and in return I ask for $110.00 back, the interest (income) is $10.00 and the interest rate is 10% (10/100*100). The link between money and the interest rate is very straightforward; money is one of the many ways in which one can store the postponed claim on goods and services. Indeed, as we saw in the previous chapter, there are better assets than the narrowest definition of money (say M1) for storing value. If instead of holding M1, one were to give out a loan to another who needed the surplus, the borrower would have to issue a promissory note, indicating, how much he wants to borrow, how much more than the loan he is willing to pay and when he proposes to pay back the original amount. Another name for this promissory note is a security. It does not matter who issues this promissory note; it is a promise made by one party to another, to pay a certain amount over a certain period with an additional payment for being allowed the privilege of having the funds. Since there is a reward for postponing the use of funds, one may



The Concept of Interest Rates 37

expect that the higher this reward, the more likely it is that individuals may want to postpone present consumption. The inverse of that is that the higher the rate, the fewer people would want to borrow because they have to repay a greater amount than they might prefer. The interest rate therefore acts as a means of encouraging the postponement of current consumption and at the same time discouraging borrowing. INFLATION AND OPPORTUNITY COST Two important considerations affect the interest rate. The first is the effect of inflation on the amount loaned and, the second is the deprivation of the use of one’s funds or the postponement of consumption. From the point in time when you lend somebody your surplus, you no longer have the use of it; the borrower has the use of the funds. Repayment does not begin instantaneously but at a future date. Since you are without the use of your funds between when you let it go and when you start receiving repayment, the important question to ask is this “would the funds I receive in the future buy the same amount of goods and services as I could have bought at the time I let the funds go?” Chances are that when the amount is repaid, the prices of goods and services may have increased and you are unable to buy the same quantities of goods as before. This erosion in purchasing power requires restoration. At the very least, the lender would want to charge an amount that will ensure that she gets back the same amount she gave out as a loan. This idea often discussed as the time value of money simply states that a given amount of money today is worth more than the same amount a year from today or an eco4 tomorrow is not the same as an eco today. The second, perhaps the most important consideration that affects interest rate is the opportunity cost. Unless you happen to be an altruist (someone, whose utility increases as others utility increase), you would and should ask yourself a question: if I had not provided the loan what would I have done with the funds; i.e. what is my opportunity cost? You could have bought some goods and services, which would have given you immediate satisfaction. Perhaps you could have put the funds under your bed and counted them every morning before you went out to work and enjoyed doing so. You could have used the funds to repair your broken bicycle so that you did not have to pay bus fare or to repair your tractor so that you could farm more efficiently and therefore increase your income. By loaning the funds to somebody else, you are denying yourself all these opportunities. Economists say that the cost you incur for selecting one object over another object is the next best alternative foregone. Because of sacrificing consumption, not repairing your bike and having to ride the bus, not repairing your tractor and foregoing the increased income, compensation becomes necessary. This is the real cost you incur for parting with your funds and it is called the real interest rate. What we call interest rate therefore has two parts: a)  A part which rewards you for postponing the use of funds; the real interest rate and b)  A part to ensure that changes in the prices of goods and services will not erode the purchasing power of the repayment.

38

Chapter 3

The sum of the two parts make up what is referred to as the nominal interest rate. Symbolically, we can represent the nominal interest rate as in equation 3.1 below i = r + p

(3.1)

Where i is the nominal interest rate, r is the real interest rate and p is the rate at which the price level is increasing or inflation. When a loan is contracted, nobody knows what the actual inflation rate, (∆P/P = p) is going to be. Ex ante, what we know is the expected inflation rate, pe. The nominal interest rate is therefore an expectation and is written as i = r + pe

(3.2)

From equation 3.2, the real interest rate r, r = i − pe

(3.3)

If pe = p, then the lender receives the expected r; (r = re); neither the borrower nor the lender gains or losses. If pe > p, then the lender gets less than the expected r; (r  FV, ytm  net income/assets => 133,811/3,010,318 = 0.04 or 4% 2.  Return on equity (ROE) => net income/capital => 133,811/335,693 = 0.40 or 40% 3.  Equity multiplier (EM) => total assets/capital => 3,010,318/335,693 = 8.97 How well did the bank do for the period? This is a question shareholders will want an answer to, but which we cannot provide. Shareholders may want to compare the ratios with the industry ratios or with the bank’s own past performance before they can decide whether the bank is doing well or not. For example, the ROA for all commercial banks in the United States between the second quarter of 2000 and the last quarter of 2009 was 10.32 and the ROE was 9.67. Before we leave the subject we can explore some other relationships from the ratios which might help explain how well a bank does.

ROE = ROA*EM*AU

You can set up a simple spreadsheet to explore how holding other factors constant, a change in the other factors can affect a bank’s ROE. If a bank is not doing well, management might look at which of the factors is contributing to the poor performance. Table 8.10 below show the factors that determine some of the more common ratios, ROE, ROA and EM. We know that the smaller the equity capital, the bigger equity multiplier (EM) for any amount of total assets. To make EM bigger therefore, owners might want to have as small an equity as they can get away with. We would therefore expect that profitable banks are those with high debt-to-equity ratios, which is what EM is. The down side is that, the higher the EM the more risk the bank is taking.3 Interest Rate Risks Banks face interest rate risks because the rate at which they obtain funds (their inputs costs), differ from the rate at which they lend (their outputs prices). Further, variations in these rates may not be positively correlated. You will recall that the costs of

Table 8.10  Factors Affecting ROE. Return on Equity (ROE) depends on Return on Assets (ROA) depends on Equity Multiplier (EM) depends on Managerial Decisions on •  Level of comfort with debt •  Dividend policy

Net Profit Margin (NPM) depends on Managerial Decisions on •  Mix of funds raised & used •  Size of bank •  Control of operating costs •  Pricing of services

Asset Utilization (AU) depends on



Managing Depository Institutions 117

the inputs is the interest paid on deposits and the price of the outputs is the interest and fees charged for the services banks provide. Since in the main, both sides of the balance sheet depend on the interest rate, banks must be acutely aware of what is happening to the interest rate they pay on deposits as well as the interest rates they receive as revenue for the loans they make. Maturities of bank assets and liabilities will usually not be the same. A bank may lend to a borrower to buy a house at a fixed interest rate of say 15% payable over a ten-year period. The funds for the loan, on the other hand will mostly have come from deposits, most of which have zero maturity. This practice is often referred to as borrowing short to lend long. Current and savings deposits can be withdrawn at any time. Time deposits have varying maturity dates. Since bank profit is the spread between the rate at which it buys funds and the rate at which it lends funds, changes in the interest rate on assets and liabilities could erode profit. A good case study of how borrowing short and lending long can cause problems for banks is the US Savings and Loans (S&LS) associations in the 1980s. Although several factors contributed to the collapse of the S&Ls in the United States, the primary culprit appears to have been Regulation Q. Under Regulation Q, enacted in 1933 and extended in 1966, the interest rate banks could pay on deposits was fixed and could not be changed. When interest rates went sky high in the late 1970s and early 1980s the S&Ls could not compete with other financial institutions to attract deposits. At the same time, the S&Ls had several long-term real estate loans at fixed interest rates. This resulted in financial disintermediation. Depositors withdrew their deposits from the intermediaries (S&LS) and sought high yielding financial products elsewhere in the financial markets. The result was that the interest rate spread for S&Ls became negative. From 1986 to 1995, 1,043 S&Ls, with combined assets of US$519 billion failed. The industry shrunk from a total of 3,234 to 1,645, almost 50%. The cost to US tax payers was US$124 billion and the surviving S&Ls had to pay another US$429 billion to shore up the industry.4 An important lesson from the crisis was that banks have to be good at managing risk on interest rate risk or they could fail. There are several ways to get a sense of the effect of interest change on a bank’s profitability. A common measure is the rate-sensitivity gap measure or more generally, gap analysis. The idea is very simple. We want to know how much the bank’s profit will change when interest rate changes. Since not all assets and liabilities are interest rate sensitive, we want to identify the liabilities and the assets that are interest rate sensitive and calculate how a change in the interest rate will affect the income and expense streams from the liabilities and assets. We can get a better understanding of this concept by looking at the income statement of our fictitious bank, FAB. Tables 8.11 and 8.12 show FAB’s profit, before and after interest rate changes. In Table 8.11, we see that FAB made 8,000.00 in the 3rd quarter with interest rate of 5% on government securities, 15% on the loans it has and paying 1% on savings deposits and 5% on time deposits. In the third quarter, rates on government securities rise from 5% to 70% and on savings deposits also rise from 15% to 3%. Note that only the short-term assets

118

Chapter 8 Table 8.11  FAB Income Statement 3rd Quarter. Asset 1 Government Securities 2 Loans 3 Interest Income Liability 4 Savings Deposits 5 Time Deposits 6 Total Int. Expense

Amount

Interest Rate

30,000.00 80,000.00

0.05 0.15

Amount

Interest Rate

Interest Expense

50,000.00 100,000.00

0.01 0.05

500.00 5,000.00 5,500.00

Net Interest Income (3–6)

Interest Income 1500.00 12,000.00 13,500.00

8,000

Table 8.12  FAB Income Statement 4th Quarter. Asset 1 2 3

Government Securities Loans Interest Income Liability

4 5 6

Savings Deposits Time Deposits Total Int. Expense

Amount

Interest Rate

Interest Income

30,000.00 80,000.00

0.07 0.15

2,100.00 12,000.00 14,100.00

Amount

Interest Rate

Interest Expense

0.03 0.05

1,500.00 5,000.00 6,500.00

50,000.00 1000,000.00

Net Interest Income (3–6)

7,600.00

and liabilities are interest rates sensitive. Table 8.12 shows what happens to FAB’s profit. We can see that as a result of the interest change, profit has declined by 400.00, from 8,000.00 to 7,600.00. The decline in profit was the result of the following two factors 1.  The different rate sensitive assets (30,000) and liabilities (50,000) 2.  The percentage changes in the interest rates on the assets (0.02) and on liabilities (0.02): We calculate the change in profit as follows: Change in income: (0.07 − 0.05)*30,000 = 600.00 Change in expenses: (0.03 − 0.01)*50,000 = −1,000.00 Change in profit: −400.00 You can see why management would be interested in the mix of assets and liabilities and the sensitivity of the mix to changes in interest rates.



Managing Depository Institutions 119

Duration Duration measures the sensitivity of the value of an asset to changes in interest rate. It is measured in years and the longer the number of years, the greater the interest rate risk. You can do this calculation in an Excel spreadsheet. The formula for duration d, is as follows: n  PV  d = ∑t  t   t =1  MV 



Where, PV is the present value of the cash flow from the security, MV is the market value of the security. A change in the interest rate will change PV and MV and therefore d. Let us assume that we have a bond with a face value of 1,000.00, coupon rate of 8% and it matures in five years. We can calculate the duration as follows: Table 8.13  Duration. Term 1 2 3 4 5 5 Sum Duration

Coupon 80.00 80.00 80.00 80.00 80.00 1,000.00

PV of Coupon*Term 74.07*1 = 74.07 65.89*2 = 137.17 63.51*3 = 190.52 58.80*4 = 235.21 54.45*5 = 272.23 680.58*5 = 3.402.92 4,312.13 4,312.31/1,000.00 = 4.31

PV 74.07 68.59 63.51 58.80 680.58 1,000.00

A bank seeking to avoid unpleasant changes to its profits as a result of interest rate changes, could arrange its balance sheet such that the duration on assets is the same as the duration on liabilities. This would be a way to hedge against interest rate risks. CHAPTER SUMMARY In this chapter, we learned that bank management is about managing the risks. Banks face many kinds of risks; liquidity risk, credit risk and interest rate risk. They must maintain liquidity to meet withdrawals. At the same time, they must create assets that earn income but which may not be liquid. Some of these assets, such as loans to businesses and households may lose value because of the probability of credit defaults. Further, changes in interest rates may cause the value of the assets and liabilities to change (and not by the same amount). To ensure that profit is not eroded they must carefully manage the assets and liabilities. Liquidity and profitability face trade-offs.

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KEY CONCEPTS Asset risk Asset transformation Asset utilization Credit risk Disintermediation

Duration Equity multiplier Gap analysis Interest rate risk Interbank lending rate

Liquidity risk Net worth Return on assets Return on equity

QUESTIONS AND PROBLEMS 1.  Explain what ROA and why a bank would want a higher ROA. 2.  Explain what ROE is and why a bank would want a higher ROE. 3.  What is EM and what determines its value? 4.  Briefly explain why ROE depends on ROA and EM. 5.  Obtain the financial statements of five commercial banks in your country. You can call the bank or go their websites. Calculate the ROE, EM and ROA. For each bank, write a brief report explaining why the ROE is greater than or less than the group’s average. Advise bank management on the steps it should take to improve its performance. 6.  Briefly explain what gap analysis is and how it might help a bank manage its earnings. 7.  From the balance sheets of the banks in problem 3 assume that the interest rate on the deposits is 2% for all the banks and the interest rate on the loan portfolios for all the banks is 10%. Assume that these are the only interest rate sensitive liabilities and assets. Find out the effect on each bank’s profit of an increase in interest rate on deposits to 3% and on loans to 15%. 8.  One way banks can minimize interest rate risks is to charge adjustable interest rates on the loans they make. Why might his be a good or bad idea? Who will benefit from such a change? 9.  Let us assume that the central bank of your country decides that any well- run bank can borrow unlimited amount from it at any time. How will this policy affect a bank’s management of its liabilities? 10.  Let us assume that the central bank of your country decides that the rate at which it will lend to banks, the discount rate, will be 0.25% and that any well-run bank can borrow unlimited amounts from its discount window. If the interbank lending rate is 1% what will happen to lending and borrowing in the interbank money market? 11.  Let us assume that the central bank decides to pay interest on bank reserves at a rate of 10%. If the rate at which banks can lend to households and businesses fall to 8%, what will happen to lending to households and businesses? 12.  Based on your answer to question 11, if the central bank wants to increase the money supply, what would you advise it should do about the rate it pays to banks on bank reserves?



Managing Depository Institutions 121

NOTES 1. A check is a bill of exchange, defined by Lord Chief Justice Cockburn as “an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to or to the order of a specified person, or to bearer.” Goodwin v. Robarts (1875), L.R. 10 Ex. pp. 346–358. 2. This is public information and most of the data on financials can be obtained on the internet or by calling the institution. 3. A thorough discussion can be found in Peter S. Rose and Sylvia C. Hudgins, Bank Management & Financial Services, McGraw Hill: New York, NY, 8th Edition, 2010. 4. Timothy Curry and Lynn Shibut, “The Cost of the Savings and Loan Crisis: Truth and Consequences,” FDIC Review, vol. 13, no. 2, Fall 2000, 26–35.

Chapter 9

Regulating Depository Institutions

Banks are among the most heavily regulated businesses in just about any economy. A major part of why they are so heavily regulated is that when they fail the ripple effect is often greater than that of most businesses; it spreads to other sectors of the economy. It is therefore important that they operate soundly and safely. In this chapter, we discuss reasons for regulating banks and how they are regulated. At the end of the chapter, you should be able to: 1.  List and explain at least three reasons for regulating banks. 2.  List and explain how banks are regulated. 3.  Argue for why banks should or should not be regulated. REGULATING DEPOSITORY INSTITUTIONS When a bank fails, its effects are not limited to shareholders alone; it spreads to other sectors of the economy in ways which the failure of few other businesses do. The primary reason is that bank deposits form a part of the money supply; therefore when a bank fails a part of the money supply disappears. Further, the failed bank is no longer operational to provide loans to existing and new businesses. Economic growth is negatively affected. For these reasons, banks are special and require special attention. This explains why banks are so heavily regulated in all countries. They are regulated to ensure that they do not fail. Regulators want to ensure that they operate soundly and safely so that the economy does not suffer. Whether banks should be free of regulations and subject only to the discipline of the market place or regulated by policy makers provides a lively and interesting debate among economists and policy makers alike. Some economists use the experience of the United States during the “free banking” era of 1837 to 1863 as a good reason to regulate banks. Others look at the same data, and see a relatively stable period and argue for no regulation, concluding that market discipline does a very good job of keeping banks well behaved.1 Regardless of which side one takes, the mere fact that, even the most prudent bank cannot withstand a bank run, suggests that, if there is a shock, which provokes a crisis of confidence, the most well-run bank faces the possibility of collapse. 123

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Why Regulate Banks The activities of banks in any economic system are not only important but special because of the services they provide through their intermediation role. Providing various services to savers and borrowers in efficient and less costly ways helps to create and sustain macroeconomic growth and stability. By the very nature of the services they provide and their general contribution to the soundness of an economy, the failure of banks can have devastating effects that reach beyond the financial sector. Several reasons are often given for regulating banks. Some of the more common reasons: 1.  To prevent bank panics, 2.  To ensure financial and economic stability, 3.  To protect depositors, 4.  To prevent fraudulent activities and 5.  To control macroeconomic activity. Bank Panics On July 7, 2004, depositors of Guta Bank in Russia descended in droves to withdraw their deposits. Security personnel had to be called in; there was a bank run. Bank runs and panics are rare but that does not mean that they do not occur. Usually, regulators try to prevent panics by closing the failing bank or, as in the case of Cyprus, closing all banks. In March 2013, Cyprus did just that; it closed its banks to prevent panic withdrawals and capital flight. In 2007, Northern Rock, Britain’s fifth largest mortgage bank suffered a run which ended only when the Bank of England announced that it would not let depositors lose their deposits. The last time a bank run had occurred in Britain was in 1866. We know that banks operate on the fractional reserve system, (i.e., they do not have to have 100% present in reserves to back the deposits they have created). This also means that if, for any reason, people suspect that their banks do not have sufficient cash on reserve to pay them, they would be the first to line up at the bank to demand payment. It makes sense to do so because of sequential service constraint or firstcome, first-served. If the bank has only 1,000 ecos2 for depositors with total deposits of 10,000 ecos in the bank, then only the first 1,000 eco withdrawals can be honored. Once word spreads that one bank is unable to repay its depositors it can create a contagion; the panic spreads to other banks. Deposits to banks may cease or slow down and, since deposits are the raw materials for banks, this would mean that loans can no longer be made. In the age of television and Twitter, a run-on-one bank can easily and rapidly spread to other banks. Financial and Economic Stability As previously mentioned, the consequences of a bank failure are not limited to the shareholders of that one bank. A part of the economy’s money supply disappears with the failed bank; businesses lose their ability to raise funds because of the heavy dependence of businesses in developing countries on bank loans. Further, the contagion effect spreads to other banks. Unsure as to whether a check issued by a business



Regulating Depository Institutions 125

or an individual will be honored by the bank on which it is drawn, households and businesses may refuse to accept checks altogether. The resulting distrust undermines the very foundation of the financial system. Interbank lending could suffer from the fact that other banks may not know which banks are in danger, and absent any other guarantees may not be willing to lend. Further, the interconnectedness in the financial system means that at any point in time, there may be counterparties to financial transactions, which counterparties may be harmed by the uncertainties caused by a bank failure. To Protect Depositors Opponents of regulation often cite the fact that market discipline could ensure that banks operate safely and soundly. Such will be the case if depositors always ensured that they only deposited with banks that are operating efficiently. It is almost inconceivable that the average depositor would know which bank would fail. Some depositors will always be hurt before any lesson is learned. To protect depositors it might be prudent to keep an eye on banks so that they do not engage in activities that could lead to failure and therefore hurt depositors. To Prevent Fraudulent Activities Banks are the primary conduit for the transfer of funds from savers to borrowers and for the transfer of funds from one place to another. This function makes banks a prime target where people with intentions to defraud others are likely to gravitate. It is easier to commit fraudulent activities from the inside than from outside. For example, in seeking to transfer ill-gained wealth to another country, banks can be very useful. Money laundering can place the ill-gotten wealth of criminals out of reach of law enforcement and encourage such activities. Some banks have units to detect such illegal activities. Unscrupulous bankers can direct loans to family members or to special friends for favors. All of these could negatively contribute to the economy. To Control Macroeconomic Activity One of the tools which central banks use to control the money supply is the required reserve deposit ratio. By increasing and decreasing this ratio, the central bank is able to change the money multiplier and therefore control the stock of money to achieve certain macro goals. How to Regulate Banks Regulations can be designed to achieve specific objectives, including, but not limited to the following: 1.  Deposit insurance 2.  Entry regulations 3.  Credit allocation

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4.  Screening 5.  Investor protection 6.  Capital requirements Deposit Insurance To create and maintain public confidence in the banking sector, and to prevent panics, a number of countries have instituted what is commonly referred to as deposit insurance. The purpose of a deposit insurance scheme is to assure depositors that, in the event of a bank failure, the insurance will pay for their deposits up to predetermined levels. This assurance gives depositors confidence in their banks and thus discourages them from running to their banks to withdraw deposits, which itself contributes to the panic and collapse. To accomplish this, banks are encouraged or forced to participate in the deposit insurance schemes by paying insurance premiums to the deposit insurance company. Banks which insure the deposits of their customers display information about their deposit insured status as a way of boosting the confidence of customers and would-be depositors. In Nigeria, following the failure of twenty-one of the twenty-five indigenous banks in the 1950s, recommendations were made for the establishment of national deposits insurance. It was not until 1989, when banks in Nigeria began to increase rapidly, that the Nigeria Deposit Insurance Corporation (NDIC) was established. In Africa, as of 2012, only nine out of the fifty-four countries had deposit insurance: Nigeria, Tanzania, Uganda, Sudan, Zimbabwe, Algeria, Kenya, Morocco and Lesotho. The United States has had one since 1933 and now insures deposits of up to US$250,000.00. The absence of explicit deposit insurance does not mean that it does not exist. In many countries, there is the implied assumption that, if a bank fails, the government will step in to rescue deposit holders. In recent times, this concept has been elevated to the status of a truism, in particular when it comes to big banks. It is expressed in the doctrine of too-big-to fail. An institution whose failure will bring calamity to a large segment of the economy is often rescued by the government. Critics often argue that the main goal of deposit insurance may be defeated because banks that are insured under the scheme, may in fact take on more risky activities because of the insurance policy. Also, they argue, depositors will now not do their due diligence on banks before selecting them. The discipline of the market will be lacking in such cases. Such an outcome defeats the intended purpose of the scheme, that is, to reduce the risk exposure of depositors to risks. Taking on more risk because of protection by an insurance policy is a classic case of moral hazard. To discourage insured banks from taking on higher risk, many deposit insurance schemes require a risk-adjusted insurance premium from the banks. A risk-adjusted insurance premium means that banks taking on high risky activities are required to pay higher deposit insurance. In the absence of risk-adjusted premiums, bank regulators may opt to restrict the types of activities that banks take on. Such restrictions may be considered as implicit premiums to the banks intending to undertake the highly risky activities. It is the too-big-to-fail doctrine which has now spawned what is known as the Volcker rule.3 The Volcker rule seeks to separate investment banking, private equity and proprietary trading from the lending sections of banks.



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Screening It is not easy to set up a bank in any country. In addition to the financial requirements, regulators want to know if any of the principals has “ever been convicted of any offence by a competent court of jurisdiction,” been “censured, disciplined or warned as to their conduct,” been “publicly criticized or made the subject of a court order at the instigation of any regulatory body in which s/he belongs.” In addition, regulators want a clean report from the police. They also want all capital sources identified and they may interview the principals.4 All these requirements are to ensure that only persons of good reputation engage in the important business of banking and thus minimize the potential for fraudulent activities. The regulations may not completely eliminate bad practices but they will reduce them by screening out potential fraudsters. Investor Protection Regulation As the trading books of many banks have grown in volume and complexity in recent times, the issue of market risk has been raised. Regulating banks to protect investors who deal in the securities held in the trading books has become increasingly important. The role of investment banks, mutual and pension funds in transmitting risk to investor has become very important and regulators have responded by requiring more disclosure and transparency of information from these institutions in order to help investors make guided investment decisions. Regulators for instance insist that the information be provided in a language which people can understand and in a uniform format for all banks. Credit Allocation Regulation With this type of regulation, banks may be required to provide credit to specific sectors of the economy considered strategically important. In Ghana for example, the Agricultural Development Bank is required to provide more loans to business activities related to agriculture. In some countries, interest rates which financial institutions can charge mortgage borrowers and other consumer loans are limited to specific maximum. The credit allocation regulation may also require that certain financial institutions should not lend to certain types of borrowers. In the 1970s, the Bank of Ghana introduced what was then known as the Credit Guarantee Scheme (CGS). Under the scheme, commercial banks were encouraged to lend to the agricultural sector under the assurance that, for a fee, the central bank would cover two-thirds of the losses the banks sustained. Nigeria has had a similar scheme called Agricultural Credit Scheme (ACS). The same criticism of deposit insurance scheme can be made of this scheme; it might encourage moral hazard behavior. Prohibition of Certain Types of Assets In many countries, banks are not allowed to buy stocks on the ground that stock prices are too volatile. There may also be limitations on what percentage of banks portfolio can be from certain specific industries. For example, until recently, the central bank of Nigeria did not allow banks to hold more than 5% of its portfolio in an unrated sector or industry of the economy with the exception of small & medium enterprises (SME).

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Banks are also prohibited by many countries from engaging in activities other than those defined as banking. For example, banks may not engage in agricultural, industrial or commercial activities. If they want to do so, they must establish a subsidiary established for that specific purpose. This is to prevent banks from engaging in preferential lending to themselves and making unwise lending decisions. Capital Requirements The different types of risks banks face have the potential of leading not only poor performance but also insolvency or failure of the institution. Insolvency in banks may be caused by a number of factors that are systemic in nature or bank specific. With the systemic driven factors, adverse macroeconomic movements are particularly important. Movements in interest rates, for example, can have serious consequences for banks with mismatches in the maturities of their liabilities and assets. In a similar fashion, a negative shock to the values of assets held by banks in their trading and banking books could cause a potential failure. In the 2008 financial crisis in the United States, banks that were heavily exposed to sub-prime mortgages through loans or trading assets experienced severe losses and were more likely to fail. The recession also revealed that the systemic exposure of banks was very high and led to the failure of many banks. For example, the failure of one large bank meant that other banks with exposure to the failed bank witnessed severe write-downs in their assets and, in some cases, failure. At the bank level, operational failures such as fraud, theft and lack of adequate internal supervision may cause a financial institution to fail. For example, operational weaknesses in the form of inadequate supervision, lack of proper internal controls and failure to follow standard practices may have the caused the collapse of Barings Bank in 1995. At the time, Barings was one of the oldest investment banks in the United Kingdom. An employee’s (Nick Leeson’s) ability to manipulate the internal control system enabled him to create a secret account which hid losses as he took highly speculative positions and sustained huge losses. After losses of US$1 billion which the bank could not cover, it collapsed and was sold for one pound. A similar lack of proper internal controls led to the Swiss Bank UBS, sustaining losses of US$2 billion when one of its traders, Kofi Adoboli, became the latest “rogue trader” in 2011 in London. In the pre-1988 period, banks under different jurisdictions were subject to different capital requirements, hence making the analysis and comparison of capital adequacy across countries very difficult. The capital adequacy ratio of a given bank in the pre1988 regulatory regime was computed as the core capital5 of the bank divided by total assets. The capital adequacy ratio computed this way is called the leverage ratio or capital-asset ratio. Leverage ratios for specific banks were compared with predetermined ratios considered to be acceptable by national regulators. Computing the capital adequacy this way implicitly assumed that all assets held by a given bank had similar risk. Such an approach also failed to take into consideration the fact that not all assets held by banks were risky. By ignoring the latter, the pre-1988 capital adequacy ratio penalized banks unintentionally by making them hold more capital than was needed to cover the holding of risky assets.



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The Basel Accords In 1995, member countries of the Bank for International Settlements (BIS) reached an agreement to standardize the regulation of banks across different countries. The agreement is what has been referred to as the Basel I Accord. The main requirement of Basel I was that capital adequacy should be computed using risk-weighted assets to account for the fact that different assets had different risk levels. More specifically, required capital was to be computed as 8% of total risk-weighted assets of a bank. By redefining what could be included as assets, the Basel I capital adequacy ratio had the effect of reducing the capital required for banks. Basel 1, initially focused solely on the traditional risk of banks, that is credit or default risk. However, it became apparent that banking activities had evolved over the years and led to the holding of assets for the purpose of trading rather than simply extending credit to borrowers. The BIS determined that risk posed by the trading activities of banks or market risk, deserved explicit recognition in the computation of required capital. Basel I was therefore revised to reflect this new risk exposure in what is now commonly known as the 1996 Amendment to the Basel Accord. The major weakness of Basel I was that it used standardized risk weights to calculate the risk-weighted assets. For example, all corporations had a risk weight of 100%, which meant that differences in banks risk exposure to different corporations were ignored. Furthermore, Basel I ignored operational risk of banks in the computation of the required capital. Following some banking crises and the identification of the weaknesses highlighted above, the BIS reached a new accord called Basel II in 2006. Basel II involves three important banking regulatory pillars that reinforce each other with the goal of achieving safety and financial soundness in the banking industry. The three pillars are listed below, but a detailed discussion of these pillars is beyond the scope of the current discussion. These are: a)  Minimum required capital of 2.5% common equity and 4% of Tier I capital of “risk-weighted assets,” b)  Supervisory review which provides bank regulators with better tools and framework for handling the banks’ risk management system and c)  Market discipline, which complements the minimum capital requirement and supervisory review process by making some sets of disclosures mandatory, which will allow the market participants to measure and know the capital adequacy and risk exposures of any bank. Basel III arose from the 2008 financial crisis that precipitated the great recession of 2008. The BIS in 2009 reached a new accord named Basel III, intended to address some weaknesses in Basel II which became apparent during the recession. Specifically, Basel III addresses three important issues that are expected to create more resilient, sound and safe banking practices across the world. These are: a)  Improved quality of required capital: banks are now required to maintain a leverage ratio in excess of 3%. The United States as of July 2013, wants 5% and 6%

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for its bank holding companies and eight systematically important financial institutions, respectively. b)  Higher quantity of required capital: banks are now to hold 4.5% common equity and 6% of Tier I capital of “risk-weighted assets”; both of which are 2% higher than Basel II requirements. Also, 2.5% additional capital buffers were required for each of the “mandatory capital conservation buffer” and “discretionary capital buffers.” c)  Macroprudential management of systematic risk: This is to protect the banking sector from periods of excess credit growth through two required liquidity ratios. The “Liquidity Coverage Ratio” requires having liquid assets that will cover the bank’s total net cash outflows for over thirty days. The Net Stable Funding Ratio is required to cover the banks’ stable funding for over a one-year period of the extended stress. CAMELS Ratings6 The CAMELS rating system is used by regulators to rank banks in terms of safety and soundness on the basis of six factors, namely, capital adequacy, asset quality, management, quality of earnings, liquidity and sensitivity to market risk. The use of CAMELS gives national regulators the opportunity to identify banks that may be facing difficulties and deserve attention from regulators. Under the CAMELS rating system, regulators assign a ranking on a scale of 1 to 5. The 5 ratings are defined below: 1.  Strong performance, sound management, no cause for supervisory concern, 2.  Fundamentally sound, compliance with regulations, stable, limited supervisory needs, 3.  Weaknesses in one or more components, unsatisfactory practices, weak performance but limited concern for failure, 4.  Serious financial and managerial deficiencies and unsound practices. Need close supervision and remedial action and 5.  Extremely unsafe practices and conditions, deficiencies beyond management control. Failure is highly probable and outside financial assistance needed. A ranking between 1 and 2 for a particular bank implies the bank is in a sound condition. Banks with serious problems generally fall between 4 and 5 and are considered to be institutions that require serious and immediate regulatory intervention. In the United States, for example, ratings are not publicly released but only given to the bank managers. Banks pay deposit insurance premium to the FDIC based on their rating. If a bank receives a rating of 1 or 2 it does not pay a premium since it is considered to be safe. For this reason, the private bank-rating companies use proprietary formulas in an attempt to replicate it.



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Capital We have seen how important bank capital is; it enables the bank to absorb negative shocks. If adequate, it promotes confidence in the bank, as we explained earlier the more capital owners have the less risk they are likely to take and, finally, for depositors, it gives them something to fall back on in the event of a bank failure. It is for that reason that regulators insist on minimum capital requirements. The capital portion of CAMELS assesses banks soundness with emphasis on a)  risk assets’ volume, b)  marginal and inferior assets’ volume, c)  bank’s growth experience, plans as well as its prospects and d)  bank’s management strengths. Based on the examination, banks are grouped into one of five categories. Each category conveys a message about what further action should or should not be taken. Table 9.1  Prompt Corrective Action Categories. Prompt Corrective Action Categories Leverage Ratio

Tier 1 Based-Risk Capital Ratio

Total Risk-Based Capital Ratio

Well Capitalized Adequately Capitalized

≥5% ≥4%

≥6% ≥4%

≥10% ≥8%

Undercapitalized

:

Y=

1  740  100i +  . 0.16  P 

From the LM equation we can solve for the interest rate i, 15.3 below.

i=

Ms 1  0.16Y −  P   100 

(15.3)



Aggregate Demand and the Monetary Transmission Mechanism 203

And plug it into the IS equation to obtain the equilibrium income (Y or GDP) Y = 4695 + 2.44



Ms (15.4) P

Equation 15.4 has all the policy variables (G and T are in the first term of the right hand side). More importantly, we observe that as P increases, Y decreases. There is a negative relationship between Y and P. We show Tables 15.1 and Table 15.2 below, one with a given value of P and different values of M and one with a given value of M and different values of P. In Table 15.1, we hold the price level constant and increase the nominal money supply M. As you can see, doing so causes GDP (the first column), to increase. This increase in GDP is due to the fact that real money balances (M/P) is increasing. In Table 15.2, below, we hold the nominal money balances constant and change the price level. Table 15.1 GDP/Y

M

P

M/P

4,939

500

5

100

5,183

1,000

5

200

5,427 5,671 5,915 6,159 6,403

1,500 2,000 2,500 3,000 3,500

5 5 5 5 5

300 400 500 600 700

Table 15.2 GDP/Y

M

P

M/P

4,939 4,966 5,000 5,044 5,102 5,183 5,305

500 500 500 500 500 500 500

5 4.5 4 3.5 3 2.5 2

100 111 125 143 167 200 250

You will observe from the last column in Table 15.2 that again, the real money balances is increasing. You also observe that as the real money balances increase, GDP also increases. Table 15.2 shows that as the price level, P, decreases, GDP increases. For those of you who have been paying attention, you recall that the negative relationship between P and a quantity (GDP), has to be a demand schedule. A quick explanation is that as the price level decreases, the real money supply increases; this causes the interest rate to decline; investment increases (not shown) and hence GDP (first column) increases. We can show the relationship between GDP and P graphically as in Figure 15.1, below. This is the economy’s aggregate demand (AD) curve.

204

Figure 15.1  Aggregate Demand Curve.

Figure 15.2  Aggregate Demand Curve.

Chapter 15



Aggregate Demand and the Monetary Transmission Mechanism 205

In Table 15.1, we held the price level constant and increased the money supply. Given the price level, this has the effect of increasing aggregate demand; the demand curve shifts to the right. This shift is shown in Figure 15.2, above. THE AGGREGATE DEMAND AND MONETARY POLICY It should be obvious to you by now that monetary and fiscal policies simply affect the aggregate demand curve and not necessarily the economy’s capacity to produce. If the economy is already at full employment, an increase in demand caused by an increase in the money supply or government expenditure (or reduction in taxes) will move the demand curve along a vertical aggregate supply curve. This will cause an increase in the price level and not in real GDP. On the other hand, if the economy is not at full employment, then the same policies could lead to an increase in output or an increase in both output and prices. Further, the effect of monetary policy depends on: i) Whether or not an increase in the money supply will reduce the interest rate, ii) Whether or not the reduction in interest rate will cause investment to increase, which in turn will cause GDP to increase and iii) Whether or not this increase in demand (caused by the increase in investment) will cause the economy to produce more. We shall have more to say about this in a later chapter when we talk about inflation. Thus far, the only transmission mechanism we have specified for monetary policy is through its effect on interest rate. In the next section we consider some other transmission paths. MONETARY TRANSMISSION MECHANISM Much has been written about how money impacts the economy. The general consensus among economists is that the effect of monetary policy on the economy is long, variable and not predictable. Further, some economists talk about the transmission mechanism as a “black box,” by which they mean it is uncertain what happens between when a change in money supply occurs and when its impact on the economy is felt. Several transmission mechanisms have been put forward. Most of the studies however, are about developed countries with well-developed financial markets. The consensus on how monetary policy works in developing countries is not yet fully understood; there are not as many studies on the subject. In this section, we describe the traditional and not so traditional mechanisms and then extend the discussions into how they may or may not work in developing countries. In theory, monetary policy could affect the economy through several mechanisms some of which are described below. The exact nomenclature may vary from writer to writer and sometimes the delineations are not quite clear.

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1. Interest rate effect 2. Exchange rate effect 3. Asset price effect 4. Credit Channel a) Bank lending effect b) Balance sheet effect 5. Expectations effect Interest Rate Effect The interest rate effect is one of the traditional ways through which money affects the economy. We have already talked about it in detail in this and in the previous chapter. An increase in the money supply first lowers nominal interest rates. In the short run, when prices are likely to be fixed, the real interest rate will fall as well. The decrease in the real interest rate lowers the cost of borrowing for expenditures that depend on the interest rate. Chief among the expenditures is business expenditure or investment. Consumer expenditures on durables are also affected by low interest rates, since most of them are (cars, furniture) are financed by financial institutions. It is argued that both long-term and short-term interest rates are affected. You would recall from an earlier chapter that our discussions on what determines interest rates included, in particular, the expectations hypothesis which states that the long-term interest rate is the average of the short-term rates expected to occur over the life of the long-term instrument. If that is the case, when short-term interest rates fall, long-term rates should do the same. Thus monetary policy affects both the short and long-term interest rates. Most investments, such as housing and factory buildings, are long-term in nature. Exchange Rate Effect In the interest rate effect mechanism described above, an increase in the money supply lowers the interest rate. If we assume that we live in an open economy; an economy with no restrictions on the movement of capital into and out of a country, then, everything else remaining constant, a higher or lower interest rate in any country will trigger an inflow or outflow of capital. This inflow or outflow of capital causes the real exchange rate to decrease or increase. A decrease in the real exchange rate will lead to an increase in exports and an increase in the exchange rate leads to a decrease in exports. In this way, changes in the money supply cause changes in the demand for goods and services since net exports is a part of GDP. Asset Price Effect Another way monetary policy is transmitted to the economy is through what is known as asset price effect. An increase in the money supply which lowers the interest rate also raises the net income flow from projects, or the internal rate of return of projects. This encourages investment. Another way to describe this is that lowering of interest rates makes the return on bonds lower. In investors search for higher returns, they may resort to equities, raising their prices, increasing wealth and ultimately aggregate demand either through



Aggregate Demand and the Monetary Transmission Mechanism 207

consumption or through investment. If a firm’s market valuation increases relative to the replacement cost of capital, it may be encouraged to buy new capital. This concept is referred to in the literature as Tobin’s q Theory.1 Tobin’s q is the ratio of a firm’s market value to the replacement cost of capital. From the discussion and the chain of causation, when interest rates go down, q goes up and firms buy more capital. Conversely, when interest rates go up, q goes down and firms do not buy capital. Credit Channel Effect The credit channel includes: bank lending and balance sheet a) Bank Lending Effect An increase in the monetary base (reserves) encourages banks to lend more. Small businesses and consumers are likely to be more dependent on banks for financing since their access to other sources of financing is limited. The increase in loans increases consumption and investment and hence aggregate demand. b) Balance Sheet Effect An increase in the money supply which causes the price of assets to increase will also increase the net worth of firms, as in the manner described in the asset price effect. The increase in net worth increases investment because banks may now easily lend to businesses (the less you need the more you can borrow) on the grounds that they have a higher net worth and therefore more capable of repaying debts. You would probably remember from an earlier chapter that the higher your net worth, the more likely you are perceived to be able to repay your debts and thus the more you can borrow. There is a decrease in adverse selection and therefore more lending. Similarly, businesses with high net worth are less likely to undertake risky projects because they have a lot to lose, moral hazard decreases and banks lend more. More lending means more expenditure. Expectations Effect If monetary policy increases prices, it means that, contractually, fixed debts will be repaid in money that is worth less. The expectations that prices will increase will therefore encourage borrowers to borrow more now and increase expenditure. The many ways in which monetary policy can affect the economy has naturally spawned a lot of research. In the next section, we discuss the applicability of the transmission mechanism in the developing countries.

THE TRANSMISSION MECHANISM IN DEVELOPING COUNTRIES All the mechanisms described above rely on the presence of financial markets with depth and breadth. If financial markets are not well developed, with the depth and breadth that

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makes it easy to buy and sell financial assets, the transmission process may not work very well. Such is often the case in developing countries. The result is that central banks and governments seeking to influence economic activity in developing countries are forced to use other tools which can be described as unconventional, such as price controls, government directed lending and forced sales of government securities to state banks. Huang and Wei argue that the poor quality of institutions in the developing countries make it difficult for central banks to conduct monetary policy in ways that are effective.2 In the absence of a developed financial sector, monetary policy works mainly through the banking sector. To begin with, in order for the central bank to conduct open market operations, there must be in existence an active primary and secondary financial market where securities are bought and sold. In many of the developing countries, the market comprises the government and commercial banks (sometimes state-owned). With central banks that are controlled by the governments, the actions of central banks tend not to exert the same influence as in the developed economies with strong independent central banks. In particular, central banks’ actions may not affect interest rates the same way as we have discussed in the traditional transmission mechanisms. There are some other considerations which call into question the issue concerning the discussion of monetary policy in developing countries in the same context as are discussed in developed countries. Some argue that monetary policy in developing counties should focus on long-term growth and not on short-term stabilization, as is the case in developed countries.3 Indeed, some have suggested that, in the developed countries, monetary policy should be used to “fine-tune” the economy. To fine-tune the economy, there needs to be present, a developed financial market, capable of absorbing and disgorging large amounts of securities. That is not the case in many developing countries. Some of the channels described in the monetary transmission mechanism do not work in the developing countries for the same reasons stated above. For example, the asset price effect with its emphasis on Tobin’s q, depends on businesses being able to issue stocks when their net-worth increase on account of a price increase resulting from an increase in the money supply. In an environment where businesses fund their activities mostly from retained earnings or bank loans, this effect will have little or no impact. By the same reasoning however, the bank lending effect would seem to be an appropriate channel for the transmission of monetary policy in the developing countries. There are times however, when this may not work either because interest rates are artificially set, or governments seek to direct lending to some sectors of the economy. CHAPTER SUMMARY In this chapter, we continued our discussion on how monetary policy affects the economy using a simplified model of the economy. We discovered that monetary policy affects the economy’s aggregate demand curve. The impact of monetary policy on aggregate demand depends on several factors; the sensitivity of money demand to income and to interest rate. It also depends on the sensitivity of investment expenditure



Aggregate Demand and the Monetary Transmission Mechanism 209

to the interest rate. We also discussed some of the channels of monetary policy transmission and with reference to developing countries. We concluded by saying that the traditional channels may not work the way as well in developing countries because of fledgling financial markets. In the next chapter, we shall continue our discussion by looking at money and inflation in the economy. KEY CONCEPTS Aggregate demand curve Asset price effect Balance sheet effect

Bank lending effect Exchange rate effect Expectations effect Interest rate effect

Monetary transmission mechanism Tobin’s q

PROBLEMS AND APPLICATIONS 1. Explain how an increase in the money supply can increase the GDP. 2. Given the following structural equations about an economy Y = C + I + G C = 240 + .5Yd Yd = Y − T T = 100 I = 100 − 20i G = 100 Md = (Y − 25i)P Ms = 500 P = 1 i) Solve for the IS equation. ii) Graph the IS curve using interest rate range from 1 to 8. iii) Solve for the LM equation. iv) Graph the LM equation using an interest rate range from 1 to 8. v) What are the equilibrium GDP and the interest rate? vi) Assume that full employment occurs at a GDP of 800. What policy options would you recommend to the government to bring the economy to the full employment GDP? vii) Explain the shortcomings of the policies you are recommending. 3. Select one of the monetary transmission mechanisms described in the text and explain why and how it may or may not work in your country. Please support your answer with data from the appropriate sources.

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4. Assume that the treasury or ministry of finance, on behalf of the government, sells government securities and the securities are bought by the central bank. Explain how this sale may affect the economy. 5. In question 4, above, assume that instead of the central bank buying the securities, the securities are bought by ordinary citizens. Explain how this sale will affect the economy. 6. Assume that the economy has a fixed capacity to produce goods, and that it is producing at that fixed capacity. Describe how an increase in the money supply will affect it. NOTES 1. W. C. Brainard and J. Tobin, “Pitfalls in Financial Model-Building,” American Economic Review, vol. 58, 1968, 99–122 2. Haizhou Huang, and Shang-jin Wei, “Monetary policies for developing countries: The role of institutional quality,” Journal of International Economics, 70, 2006, 239–252. 3. Milton Friedman, “Monetary Policy in Developing Countries,” in Nations and Households in Economic Growth: Essays in Honor of Moses Abramivitz, edited by Paul A. David and Melvin W. Reder, New York, Academic Press, 1973, pp. 265–278.

Chapter 16

Money, Inflation and Output

This chapter introduces an important topic we have been hinting at for some time now, inflation. Economists define inflation as a persistent increase in the price level and hyperinflation as increases that exceed 50%. Many countries have gone through bouts of inflation. In this chapter we examine the causes and consequences of inflation. At the end of the chapter, you should be able to: 1.  Define inflation and hyperinflation. 2.  Explain the causes of inflation. 3.  Describe the consequences of inflation. 4.  Prescribe remedies for inflation. INFLATION DEFINED Inflation is the persistent increase in the aggregate price level in the economy. This aggregate price level is often measured by the consumer price index (CPI), the Gross Domestic Product deflator (GDP deflator), or the Implicit Price deflator (IPD). The CPI is measured by taking the expenditure a typical consumer makes on a basket of goods and services and tracking that expenditure over time. For example, let us assume that that the typical consumer spent 200 cedis on a basket of goods and services in 2010. Let us further assume that in the following year, 2011, the consumer spent 239 cedis to obtain the same basket of goods and services. Between 2010 and 2011, prices must have risen by 19.61% because the consumer’s expenditure on the same basket of goods and services had risen by 19.61%. If we designate the year 2010 as the base year (the comparison year) and arbitrarily assign a price level (CPI) of 100 to it, then the price level in 2011 is 119.61. The change in the price level over time, divided by the previous price level gives us the rate at which the price level is changing or inflation. Following this process, we can construct the price level for the economy over time. The price index constructed this way is referred to as Laspeyres index.1 For how to calculate a hypothetical Laspeyres price index see appendix 1. 211

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Another way of calculating the price level and thus inflation is to use the Paasche index. These are the steps to calculate the Paasche Index

PY = MV

We first calculate the nominal GDP, which you will recall from your principles class, is the monetary value of the final goods and services produced in a country over a period of time. The second step is to find the real GDP. To do this, we need to break the economy into its component sectors; agriculture, manufacturing, construction etc. Each of these sectors experiences different rates of price and output growth over time. Further, each sector’s contribution to the nominal GDP is different. For details on the calculation of a hypothetical Implicit Price Deflator (IPD), see appendix 2. Again, the change in the deflator over time is a measure of the rate at which the price level is increasing. Countries report their aggregate price levels and their CPIs through their central banks or through special agencies such as government statistical services. Inflation can be a problem for countries, especially when it becomes excessive. In recent times, Zimbabwe has experienced one of the most pernicious bouts of inflation. It was so severe that, in March 2009, the government decided to abandon the use of the Zimbabwean dollar and use the US dollar instead. Table 16.1, below, shows how rapidly the price level was increasing. A rule of thumb states that if you divide 72 by the rate at which a series is growing, you obtain approximately how long it takes the series to double in value. According to that rule, by July 2008, the price level in Zimbabwe was doubling every 16 minutes.2 At this rate, nobody wanted to hold on to the Zimbabwean dollar because its value (dollar/price level) was eroding so quickly that it was not fulfilling one of the essential functions of money; store of value or temporary abode of purchasing power. You can see what was happening to the value of the Zimbabwean dollar in the last column of Table 16.1. Prior to abandoning the Zimbabwean dollar in favor of the US dollar, the government had redenominated the currency four times. Redenomination defines a new currency in terms of an old one. In the last redenomination exercise in 2009, Table 16.1 Year 2001 2002 2003 2004 2005 2006 2007 2008 (July)

CPI 100.00 233.20 1,084.50 4,880.30 16,486.40 184,101.00 12,562,581.70 3,550,056,691,248

Source: Reserve Bank of Zimbabwe

% Age Increase in CPI (Year on Year) 133.20 365.05 350.00 237.82 1,016.69 6,723.74 2,311,508

Value of 1.00 Zimbabwean $1.00 $ (1.00/P) 1.00 0.43 0.09 0.02 0.01 0.00 0.00 0.00



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one new Zimbabwean dollar (ZWR) was set at 10,000,000,000,000.00 (not so old) Zimbabwean dollars (ZWN). The number of zeros suggests that this was an accounting nightmare. Can you imagine multiplying that by twenty-three? In 2007, Ghana redenominated by making 10,000.00 old cedis equal to one new Ghana cedi. Mozambique went through the exercise in 2006, making 1,000 old meticals equal to one new metical. Russia did the same in 1998 and Azerbaijan did it in 2006 redefining 5,000 manats as being equal to one new manat. Countries redenominate due to inflation or in the case of Zimbabwe, hyperinflation. We shall come back to discuss why inflation can be bad and why hyperinflation is certainly bad after we have discussed the causes of inflation. CAUSES OF INFLATION A good place to begin our discussion of the causes of inflation is the equation of exchange. The equation of exchange shows the relationship that exists between the nominal GDP and the stock of money in the economy. The nominal GDP is the product of the price level, P, and the economy’s output of goods and services, Y; GDP = P*Y. To buy the goods and service produced, we need money, M. How much money do we need to buy the GDP? Let us assume that the stock of money in the economy is 10 shillings/nairas/cedis/ ecos. Let us further assume that the price level, P, is 2.00 and the output of goods and services, Y, is 10. Nominal GDP is then 2*10 = 20. Since the stock of money in the economy is 10 and we have to buy GDP worth 20 nairas, we can do that only if we use each of unit of currency two times. The number of times each unit of currency must be used to enable the given stock of money to buy the goods and services in the economy is called velocity of circulation, V3. From the discussion so far, we can come up with an identity involving the GDP (PY), the money stock, M and the velocity of circulation, V, as follows:

PY = MV

(16.1)

We know what determines Y, the output (the resources and technology in the economy), and what determines M, the stock of money (by the central bank), but what determines V, the velocity of circulation? You will recall from chapter 2, that money is a medium of exchange and as such we need it for transactions. This means that, if we do not intend to buy something in the near future, we do not need to hold money; we could hold some another asset which may be a better store of value. In fact, we only need to hold money when we want to make a purchase or when we sell something. If we sell something and do not intend to buy something immediately, we could convert the money into an asset which is a better store of value. There are some things we do regularly, such as pay our rent at the end of the month, buy a cup of tea every morning and take the bus to go to work. To do all these things we need the medium of exchange, money. As long as our expenditure patterns are predictable, we know how much money we want to hold. Given our expenditure behavior, we can more or less assume that velocity is constant.4

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If we rewrite 16.1 in terms of changes we get

∆P + ∆Y = ∆M + ∆V(16.2)

If ∆V = 0, then

∆M = ∆P + ∆Y

(16.3)

Equation 16.3 states that a change in the money stock, M, must be matched by a change in output, Y, or a change in P, the price level. We are nearing the point where we can see what causes inflation. We can rewrite equation 16.3 in terms of the rate at which all the variables in the equation change:

∆M ∆P ∆Y (16.4) = + M P Y

Equation 16.4 indicates that the rate at which the money supply grows, will determine the rate at which nominal GDP (P*Y) grows. The first part of the right hand side of 16.4 is inflation and the second part is the rate at which real GDP is growing. If the money supply grows at the same rate as real GDP is growing, inflation will be zero. If the money supply grows at a rate greater than the rate at which real GDP is growing, inflation will be positive and if it grows at a lesser rate, the price level will fall; there will be deflation. Inflation, from equation 16.4 is thus:

∆P ∆M ∆Y (16.5) = − P M Y

From equation 16.5, we see that inflation is the result of the money supply growing faster than the rate at which real GDP is growing. This, in fact, is true, especially in the long-run. Milton Friedman writes that “inflation is always a monetary phenomenon.”5 There is enough empirical evidence to show that whenever a country experiences serious bouts of inflation, it is the result of excessive money supply. Cost-Push and Demand-Pull Inflation Sometimes people distinguish between inflation initiated by the supply side of the economy and inflation initiated on the demand side of the economy. Cost-push inflation is inflation which comes from a real shock to the economy. For example, if the price of petrol or gas increases, everything else remaining constant, the cost of production increases. This increase in the cost of production will be shown by a leftward shift of the aggregate supply curve. There has been a one-time increase in the price level. Since most economists define inflation as a persistent increase in the price level, unless the shock which shifted the aggregate supply curve to left is repeated over and over, there is no persistence.



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Demand-pull inflation is defined as an increase in the price level which comes from the economy’s aggregate demand curve shifting to the right, given the aggregate supply curve. Just like the leftward shift of the aggregate supply curve, a one-time shift of the aggregate demand curve will result in a one-time increase in the price level and not a persistent increase in the price level. In other for inflation to be persistent, there must be an underlying cause, and that cause is usually a persistent increase in the money supply. Theoretically, it is possible for cost-push and demand-pull inflation to reinforce each other and lead to persistent increases in the price level. Let us assume that the wages and salaries of workers are indexed (at least partially). This means that an increase in the price level (which reduces the real wages of workers) must be offset by an increase in nominal wages. Further, let us assume that policy makers do not want output to decline, and so any negative supply shock is offset by an increase in government expenditure or an increase in money supply. Let us now assume that there is a supply shock which shifts the supply curve to the left; output goes down and the price level goes up. The increase in the price level triggers an increase in nominal wages, since wages are indexed to inflation. This is another supply shock. Employers respond by reducing supply. Policy makers increase aggregate demand through monetary policy and fiscal policy. Output returns to where it was before the initial shock but at a higher price level. Real wages decline and on and on it can go. It becomes difficult to tell after a point whether inflation is demand-pull or cost-push. Root Cause of Inflation: Seigniorage and Expectations If inflation is the result of excessive growth in the money supply, why do monetary authorities allow the money supply to grow so rapidly? The short answer is that governments need money to do the many things: build roads and hospitals, pay teachers, doctors and civil servants. Normally, governments finance these activities by taxing the citizenry. In many developing countries however, the tax base is very small and does not yield enough revenue. Further, many economic activities are outside the formal sector and cannot be easily taxed and there is only so much direct tax the government can extract from the formal sector. What if there was a way to tax everybody, regardless of whether they are in the formal sector or not? It turns out that there is a convenient way to do so; it is called seigniorage. Seigniorage is the revenue governments receive from the monopoly they have over the printing of domestic currency. To the government, the cost of printing money is essentially the cost of the paper on which it has to print money, or the metal used to mint the coins. When a government prints new money, it extracts goods and services from everybody in the economy because they all must accept the fiat money. As we found out, increasing the money supply increases the price level and a persistent increase in the money supply leads to a persistent increase in the price level. For somebody who used to buy a cup of tea at one naira before the government increased the money supply and, thus, the price level, but who now has to pay one naira and ten kobos, the increase in the price level by 10% is a tax, inflationary tax. It is often called taxation without representation because it is a sneaky way to tax people without their awareness and without

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the approval of parliament where their representatives might object. Thus, seigniorage appears to be a simple and painless way for governments to tax. It is possible for governments to collect this seigniorage without causing inflation. This can be done by allowing the money supply to grow at the rate at which the real economy is growing as in equations 16.4 and 16.5 above. If the economy is growing at 6%, the money supply can grow at 6% without causing an increase in the price level. If the money supply grows at more than 6%, then the price level increases by the difference. All governments obtain revenue from seigniorage. Computations by Cukierman et al. show that between 1971 and 1982, Ghana derived 28% of revenue from seigniorage, Kenya 4.5%, Nigeria 7.2%, Sierra Leone 9.5% and Uganda 24.8%.6 For the UK and the United States, comparable figures were 1.7% and 2.3% respectively over the same period. This suggests that poorer countries tend to depend more on seigniorage than the richer ones. Over the same period, inflation in the richer countries was also on average much lower than in the poorer countries. Sometimes inflation is caused by expectations. In general, prices increase because of excess demand (demand increased given the fixed supply, or supply decreased given the fixed demand). Let us assume that we continue to observe price increases over time. We would be naïve to expect that prices will not increase in the future after observing them increase for so long. In making our plans for the future, we would build into it the expected price increase. Instead of accepting 10.00 cedis a day for labor, we might ask for 12.00 cedis. Remember that the initial price increases were the result of excess demand. But now, in addition to the excess demand another element has been introduced, expectations. What then happens is that, after the excess demand has vanished, because of the expectations that prices will increase, prices do indeed increase. They increase not because there is excess demand, but because of the expectations we formed before the period. This is the fulfillment of our prophecy. Price increases could then continue for a while; how long will depend on how quickly it takes to adjust our expectations. CONSEQUENCES OF INFLATION Now that we know what causes inflation, let us turn our attention to the consequences of inflation. Inflation comes in one of two forms: it can be anticipated/expected or unanticipated/unexpected. The distinction is important because, if one expects something to happen, one can be prepared and not be pleasantly or unpleasantly surprised by its occurrence. On the other hand, if one does not expect something to happen then one can be pleasantly or unpleasantly surprised by its occurrence. Unanticipated Inflation Unexpected or unanticipated inflation may have pleasant or unpleasant has consequences depending on whether one is a debtor or creditor. For example, if you borrow money from a bank, you will be charged the nominal interest rate. The nominal interest rate is the real interest rate plus the expected inflation. Since at the time the loan is made, no one knows what the actual inflation will be, it is estimated based on



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information then available. Let us call the expected inflation by pe, the real interest rate r and the nominal interest rate i. The interest rate you contract to pay is i = r + pe(16.6) The real interest rate is, therefore, r = i − pe(16.7) The actual inflation rate, p, is unknown at the time of contracting the loan and must be estimated. There are three possibilities that can occur: a) p = pe b) p > pe c) p  I Falls

Falls

Increases

S = I No change S  0 No Change Export price increases, import price decreases, less exports, more imports; NX