Money and Banking

Learn how to understand Finance

 The goal of "Money and Banking" is to explain the most important monetary concepts in the most simple way possible.

 

Finance and financial transactions determine our everyday life, however, the financial industry likes to make easy concepts appear very complex. I think they are not as complex and it is important to understand the most basic concepts as the financial system affects all of us.

Who was hurt most during the financial crisis? The people that understood the system or the people that didn't? 

I will explain:

  • How can banks create money?
  • Why do we need central banks?
  • What is the discount rate?
  • How does a clearinghouse create monetary elasticity?

I will underline my explanations with hands-on quotes from the Financial Times to show you that these concepts actual explain what is going on right now in the financial industry and economy.

Introduction: Money and banking for everyone - learn how to understand Finance

 

My goal is to explain the most important concepts about Money and Banking in the most simple way possible.

 

Why should I care about a system I am not able to understand and about people that are way better in handling this chaotic system than I could possibly do?

 

 

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1. The Hierarchy of Money

“… the German construction group has sold assets, reduced debt and switched its focus away from winning orders and towards cash flow” (Financial Times, 2016).

 

There is a hierarchy of money, which was established due to many historical events and circumstances. Gold is on top of the hierarchy because you can not “make” more gold. This makes it a scarce commodity. Furthermore, back in the days, every merchant or country accepted gold as a means of payment.

What would you rather get paid in hundred of years ago? In real gold or a currency that is only worth something, because a government puts a stamp on the note, but that could be a worthless piece of paper depending on the government and whether it’s forged? What happens if there is an inflation or if you can’t pay with the foreign    currency in your home country?

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2. Why do we need banks?

 

“Without the well-developed capital markets of the US, European companies are reliant on bank lending.” (Financial Times, 2016)

 

Allyn Young, an American economist, wrote a very interesting and well-written paper about the mystery of money and credit. He argues that we not only need money for trading more easily but also to store value.

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3. Why do we need central banks?

 

“This is why the banking system is prone to panic even when people think banks are solvent: solvency is contingent on the environment and impossible to determine in real time. Only government backstops, including a lender of last resort and deposit insurance ultimately guaranteed by the monetary authority, can overcome the risk embedded in banks’ funding model.”

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4. How can banks create money out of thin air?

“Governments are willing to provide these backstops because banks run the payments system and create money — essential bits of infrastructure in any society that’s progressed beyond hunter-gathering.”

Banks can give you a loan to buy a car for let’s say 10.000$, without having 10.000$! Actually with only having 1.000$. How? 

 

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5. Why do we need central banks especially in a crisis?

“…they have had three core functions. They are the lenders of last resort to banks in trouble; they serve as banking regulators, and they act as their governments’ economic agents.”

 

When it comes to supporting the central banking system there are 2 important economists you should have heard of: Walter Bagehot and Hyman P. Minsky.

(They wrote two very interesting papers, definitely worth reading for a deeper understanding, but I will sum up the most important parts for you.)

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6. What are clearing houses?

“The idea is to provide centralized clearing infrastructure…”

What are clearing houses and why do they create even more elasticity for the monetary system? 

 

Let’s review the concept of elasticity. I can not stretch a 5$ note to make it a 10$ note. Currency is not elastic, but the bank can expand its balance sheet by creating a loan and a deposit. So even though I only have 5$, I can make a 10$ payment by taking credit. During an economic boom, everybody is happy and spends money. Credits are given away and the money market is expanding. During a recession, a time when the economy is doing badly, less money is being spent and less credit is being given away, so the system contracts again.

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7. What are Fed Funds?

“My view is that monetary policy should avoid deliberately stoking the risks that come with overheating the US economy and instead, slowly raise the federal funds rate to promote maximum employment commensurate with the economy’s long-run potential to increase production.”

 

What are Fed Funds?

Fed Funds are overnight loans from one bank to another bank. It is not the rate at which the Federal Reserve Bank (America's central bank) is lending money an American bank.

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8. What are Dealers, Brokers and Repos in the Financial World?

“A lack of good quality collateral, which market participants use to secure loans, has crippled the single currency area’s short-term funding (“repo”) markets.”

 

Brokers are helping two parties to get together and make a deal. They take a commission for that without barring any risk. They just bring together the person searching for a car and the one looking for a car. Whereas dealers are buyers and sellers at the same time. A dealer is like a car dealer, who owns cars. He tries to buy them at a cheap price and sell them at a higher price to make a profit. He barriers the risk of not being able to sell his cars.

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9. Quantitative Easing and Open Market Operations

“The single currency area’s recovery remains exposed to global risks, despite a large-scale quantitative easing package in which the region’s central bankers have spent €1.4tn on bonds and cut rates deep into negative territory.”

 

I was reading the two letters QE in the Financial Times, all the time and I were never sure what they actually mean.

I figured out that QE is quantitative easing or open market operations. Probably also not going to ring a bell. QE is done in crisis or during bad economic times to stir up the economy. It means that the Central Bank is pumping money into the system to support it. How does that work?

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10. Eurodollars

“In the opinion of Milton Friedman, eurodollars have always represented unsanctioned private money creation because they’re dollars which are transferred about without observation of the principles that govern dollar transfers in the US.”

 

Half euro, half dollar? No, Eurodollar is just a way of

funding, based on the belief that everyone wants to have the currency of the

world the US dollar. The US dollar is the currency of the world because it is

the most liquid one and the one most financial transactions are made in.

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11. Discounts, Discounts, Discounts

“Borrowing at the discount window is essentially a repurchase agreement — pledging collateral in exchange for cash.”

 

This blog article is not on sale, but I am going to explain the "discount mechanism". We are continuing to work with the dealer concept. The dealer was the person that takes the risk on his balance sheet to make transactions possible and receiving a risk premium for that.

I am buying the drinks for my party from the supermarket. Due to the fact that I can not pay for them right now, I make a deal with the supermarket to pay them in 90 days. After 20 days the supermarket realizes that it suddenly needs a lot of money to restock its warehouse. Unfortunately, it only has a “contract” from me that says I am paying him 500 $ in 90 days. It does not have 500$ in cash to buy new drinks from the wholesaler right now and the wholesaler does not accept the contract that the supermarket and I made as a mean of payment. Watson, we have a problem! ;)

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12. Why dealers provide liquidity?

“He thinks the Fed should extend its responsibilities beyond the lender of last resort for banks in need, and become the dealer of last resort, meaning it should provide short-term liquidity for the 23 primary dealers that help implement monetary policy. “

When we think of dealers, we probably think of shady guys selling drugs. Here we are talking about legal financial dealers providing liquidity for the monetary system. Imagine a bank runs into liquidity problems but it owns securities like treasury bills, which will mature in a year. The bank can sell these securities to a dealer to make cash. (Note: When we talked about the central bank being the lender of last resort we were talking about borrowing money to ensure liquidity and using an asset as security. Now we are going one step further and talk about selling a security to get cash).

 

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13. Rates and the Treynor Model

“Fed Raises Interest Rates for Third Time Since Financial Crisis”

 

Now we can bring everything together. How the Fed, the banks, the dealers, interest rates and assets prices are all linked together and what happens in a crisis. The central bank is supposed to keep the balance of elasticity and discipline in the monetary system and to control the flow of credit and to provide internal stability.

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14. Brexit

Even though markets have hit all time highs and Britain is doing quite well, the Brexit has far-reaching impacts on the British economy but they are hard to detect because the Bank of England has supported its economy tremendously. 

Before we start with the last entries of this blog series about money and banking, I want to show you, how you can use the concepts to understand what is going on in the real world. I have drafted that article 4 months ago but I have updated it and we are still not what happens. The decision about the Brexit made me sad. In my opinion, the European Union is about peace, freedom, stability and solidarity. Unfortunately, many different people voted for a change without really thinking about all the long term effects. England benefits a lot from being in the European Union, enjoying the passporting rights (I will explain what they mean later) and they are making a lot of money being the financial heart of Europe. Even though the Brexit happened half a year ago it is still in the process and I am going to explain what a Brexit most likely mean for the British (financial) economy.

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15. Banks and Capital Markets

"What is the Volcker Rule? - A federal regulation that prohibits banks from conducting certain investment activities with their own accounts, and limits their ownership of and relationship with hedge funds and private equity funds, also called covered funds. The Volcker rule’s purpose is to prevent banks from making certain types of speculative investments that contributed to the 2008 financial crisis."

 

The banking system has evolved, we are no longer living in a world, where banks only collect money from their customers and give away loans. Banks became an important intermediary for different purposes, which made them more profitable but they should be watched carefully, otherwise, we could slip into another financial crisis. 

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16. Welcome in the future - What are forwards and futures?

"Saudi Arabia has the ability to exert a similar influence over oil by hedging its long-term production through the oil derivatives market. In other words, it should concurrently cut output and sell long-dated oil futures and related contracts."

 

We talked about liquidity risk in the last blog entry, now I am going to show you how banks or companies can hedge liquidity risks. 

I will first explain interest rate forwards and futures, interest rate swaps and then credit default swaps. Believe me, it won't be as bad as it sounds right now.

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17. Interest Rate Swaps

“He (Mario Draghi) hinted markets were right to bet against the ECB increasing interest rates before 2019, saying repeatedly that low interest rates would remain in place […].” What are the impacts of high or low interest rates for companies that borrow money based on a floating rate and how can they hedge the risk of rising interest rates? Here is an easy explanation of how to hedge interest rate risk with an interest rate swap. 

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18. Credit Default Swaps

“AIG needed a $185bn taxpayer bailout after it was brought to its knees by financial products such as credit default swaps.” (Financial Times Article: AIG freed from ‘too big to fail’ regulation from 09.2017)

 

You think credit default swaps are none of your business? I promise that they do affect you at least indirectly. I have written an easy explanation what they are and why they triggered the financial crisis in 2008!

 

Credit derivatives like credit default swaps are comparable to an insurance that protects you from the risk of credit default (the risk that a credit that cannot be paid back). 

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19. Shadow Banking

I know the topic of shadow banking is hard to grasp but as it counts for over $45tn; you might want to give it a try.

 

““Shadow banking” grew by nearly 8 per cent globally to more than $45tn on a conservative measure […]Shadow banking — the parts of the financial system that perform bank like functions such as lending but do not have the same safeguards — accounted for 13 per cent of total global financial assets.” FT March 2018

 

Most people have probably never heard of shadow banking before. Shadow banking is often considered a synonym for unregulated banking. However, my professor at the Columbia University, Perry Mehrling, defines shadow banking as money market funding and capital market lending. But what is that supposed to mean? I will show you:  

 

What do we know about traditional banks (Find more information in the post: Why do we need banks? ). They borrow short (by getting money from their clients through deposits) and lend long (by giving away mortgages or long-term credits to companies). Due to the fact that they borrow short and lend long, the banks are exposed to maturity mismatches. These maturity mismatches are the reason that banks need to be able to extend debt obligations and borrow money to stay liquid. To stay liquid they can borrow money in the Fed Funds or Repo Markets (Click to recap FedFunds and Repos)and even if these are dried up, they would be able to borrow money from the central bank (Link to learn more about the role of central banks). The central bank is backstopping / supporting the banks. Therefore, the banks have the reassurance from the central bank to borrow money against good collateral. Good collateral means treasury bonds or bills.

If you think in balance sheets that is what it looks like:

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