Money and the Financial System

Lecture 1 ECN205
 Teaching Team

• Module Organiser
• Dr Thomai Filippeli
E – mail: [email protected]
Room: GC 5.19
Office Hours: Monday 12pm – 1pm (Teams) and Tueaday 12pm – 1pm GC5.19
• Teaching Assistants:
o Denys Iliasov [email protected] GC5.26
o Dennis Iweze [email protected] GC5.26
 Info about the Module
Lectures:
11x1 hour; Tuesday 10am – 12pm, Skeel LT
Tutorials:
10x1 hour F2F classes

Assessment:
3 online quizzes (week 3, week 5 and week 7) – 5%
Group presentation and report (2nd of December) – 25%
Final Exam (70%)

Lecture notes and tutorial questions can be downloaded from QMplus.

 Group Presentation

• Groups of 7 students

• 25% of the final mark

• Presentation video submission on Qmplus: 02 December 2022 (week 10)

• Presentation’s content should summarise your written report (2,000 – 2,500 words)

• Written Report submission on Qmplus: 02 December 2022 (week 10)

 Online Quizzes

• There will be 3 online quizzes

• End of week 3 (14/10/2022)
• End of week 5 (28/10/2022)
• End of week 7 (11/11/2022)

• 5% of the final mark

• Each quiz will be based on the material taught the previous weeks
 Learning Objectives

• Core principles of money and banking

• TRIPS: Time; Risk; Information; Prices; and, Stability

• Structure of the financial system

• Six Parts
 Why Care?

• Finance plays an important role in sustaining day-to-day business activity

• Complex web of interdependent institutions

• Financial systems have been at the centre of large economic downturns

• Great Depression of 1930s and Great Recession of 2000s
• Other examples: https://www.theguardian.com/money/2007/sep/19/business
 Five Core Principles

1. Time has value.

2. Risk requires compensation.

3. Information is the basis for decisions.

4. Markets determine prices and allocation resources.

5. Stability improves welfare.

Working and getting paid over
a period of time is an example.
1. Time has Value

• Time affects the value of financial instruments

• Interest is paid to compensate lenders for the time borrowers have their money

• Think: what is the opportunity cost of lending money?

• Does it stay the same?
So, dealing effectively with risk

2. Risk requires compensation

requires that you consider the full
range of possibilities in order to
eliminate some risks, reduce some
others, or pay someone to assume
particularly big risks instead of you

• In a world of uncertainty, individuals will accept risk only if they are compensated

• In the financial world, compensation comes in the form of explicit payments: the higher the
risk the bigger the payment
the bigger the return, as investors, we expect to get.

• Individual preferences matter: risk averse; and, risk neutral

• Why?
Bearing in mind that time has value and risk requires compensation,
we can start seeing the rationale behind the valuation of a broad set
Car insurance is a prime example of paying of financial instruments.
someone else to bear a risk that we do not want For example, a lender will charge a higher interest rate on a loan if
to take. Even if government didn’t require it as there is a chance that the borrower will not pay it back. The lender
compulsory, most of us drivers would be more must be compensated for the substantial risk that the company will
not repay the loan. So thus risk requires compensation.
than happy to buy car insurance
 3. Information is the basis for decisions

• The more important the decision, the more information we gather

• How much would you spend on deciding to buy a sandwich (£5) and a used car
(£8,000)?

• Collection and processing of information is the foundation of the financial system

• Mortgage broker checks credit score of potential borrowers

Financial intermediaries, and institutions like banks, try to gather as much information as possible through STANDARDIZED PROCEDURES.

They spent their sources in doing so. So, they try to gather information from savers to investors. So, before a bank decides to make a loan, a loan author will investigate
the financial condition of the individual or firm looking for that loan.

So banks want to provide the loans only to the highest quality borrowers. And for that reason they spent a great deal of time gathering the information to evaluate the
creditworthiness of loan applicants.
 4. Markets determine prices and allocate resources
Markets are the core of the economic system as they are the place, the physical or virtual world, where buyers and sellers meet at a common place.
And where firms, they issue stocks and bonds and sell them in order to get to gain some capital. And individual investors, they go to trade assets.

• Markets channel resources and minimize the cost of gathering information and making
transactions
Therefore, financial markets are essential for the economy.

• In general, the better developed the financial markets, the faster the economy will grow

• Think: What is the relationship between prices and resource allocation?

The reason for this connection between markets and growth is that markets determine prices and allocate
resources. So, the financial markets gather information from a large number of individual participants and
aggregate it into a set of prices that signals what is valuable and what's not.

So MARKETS ARE A SOURCE OF INFORMATION in another way. And buy adapting price in different stocks or
bonds, they provide a basis for the allocation of capital in that economy.
 5. Stability improves welfare
Stability is a desirable quality
this is related to the second core principle about risk
• A stable economy reduces risk and improves everyone's welfare
• How does this statement depend on individual preferences?

• Financial instability in 2008 triggered the worse global downturn since the Great Depression

volatility in an economy creates risk. Reducing volatility reduces the risk as well.

• A stable economy grows faster than an unstable one

• Will you consume more or less if you are not sure about your income?
• What about investment?
But while individuals can eliminate many risks on their own, some risks can be reduced only by government and policy makers. And
business cycle fluctuations are an example of the sort of instability that individuals can't eliminate if they want. So, stabilizing the
economy is a primary function of central banks, like the Bank of England here in UK, the Federal Reserve in the US, the European
Central Bank in the Euro area. So, the officials, the policymakers in these institutions are charged with controlling inflation and
reducing business cyclic fluctuations, which is a source of instability in economies.
 Question 1:

Which core principle(s) could you use to explain why credit card issuers charge such high rates
of interest?
 Question 2:

Suppose that IBM considers expanding its operations. The expansion will require $400 million
for two new factories which the corporation plans to raise by selling stock and bonds. Which of
the core principles will come into play as investors decide whether or not to buy the stock and
the bonds?
 MCQ1:

Car insurance shelters drivers from the possibility of losing all their wealth in the event that they
cause an accident in which someone is seriously injured. This best illustrates which core
principle?

A. Risk requires compensation.

B. Information is the basis for decisions.
C. Markets determine prices and allocate resources.
D. Time has value.
 MCQ2:

A central bank’s pursuit of policies that control inflation and reduce business cycle fluctuations
best illustrates which core principle?

A. Risk requires compensation.

B. Stability improves welfare.
C. Markets determine prices and allocate resources.
D. Time has value.
 Six Parts of the Financial System

Money
Use it to pay for our purchases and store our wealth

Financial Instruments
Transfer resources from savers to investors, and to transfer the risk to those who are best equipped to bear the risk.
Examples include: stocks, mortgages and insurance policies

Financial Markets
Allows us to buy and sell the financial instruments quickly and cheaply
Examples include: the London Stock Exchange, the Ney York Stock Exchange

Financial Institutions
Provides thousands of services, different services, including access to the financial market and collection of information about
prospective borrowers to ensure that they are credit worthy.
Examples include: banks, securities firms, insurance companies
Regulatory Agencies
Responsible for making sure that elements of the financial system operate in a safe and reliable manner

Central Banks
Monitor and stabilise the economy
Examples include: Bank of England (UK), Federal Reserve System (US), European Central Bank (Eurozone)
 Money: Some properties

• Unit of account
• Helps compare relative prices and, therefore, facilitates resource allocation
Used to quote prices and record debts

• Store of value
• You can save for future consumption
the means of payment has to be durable and capable of transferring purchasing power from one day to the next

• Money has changed from metallic coins to paper currency to electronic funds to …
cryptocurrency?
 Digital Currency?

• Cryptocurrency (e.g. Bitcoin): Most likely to be out of govts’ control

But

• Will it pass the test?

• Unit of account; store of value; ease of transaction; security; and, government etc!
Funds Flowing through the Financial System
 Financial Instruments and Financial Markets

• The international financial system exists to facilitate the design, sale, and exchange of a
broad set of contracts with a very specific set of characteristics

• We obtain financial resources through this system:

• Directly and indirectly through markets and institutions.
• Most transactions have pieces of both
 Financial Instruments and Financial Markets

• Indirect Finance: An institution stands between lender and borrower.

• We get a loan from a bank or finance company to buy a car.

• Direct Finance: Borrowers sell securities directly to lenders in the financial markets.
• Direct finance provides financing for governments and corporations.

• Asset: Something of value that you own.

• Liability: Something you owe.

 Financial Instruments

• Transfer resources from savers to borrowers

• Allow for the transfer of risk (unlike money)

• Futures and insurance contracts allow one person to transfer risk to another.

• Less liquid than money but sometimes also act as means of payment
• Employees take stock options as payment for working
• Govt bonds are sometimes used in large transactions

• Act as store of value

• but more volatile than money
 Characteristics of Financial Instruments

• These contracts are very complex.

• This complexity is costly, and people do not want to bear these costs.

• Standardization of financial instruments overcomes potential costs of complexity.

• For example, most mortgages feature a standard application with standardized terms.

• Financial instruments also communicate information, summarizing certain details about the
issuer.
• Continuous monitoring of an issuer is costly and difficult.
 Characteristics of Financial Instruments

• Mechanisms exist to reduce the cost of monitoring the behaviour of counterparties.

• A counterparty is the person or institution on the other side of the contract.

• The solution to the high cost of obtaining information is to standardize both the instrument
and the information about the issuer.

• Financial instruments are designed to handle the problem of asymmetric information.

• Borrowers have some information they don’t disclose to lenders.
 A Primer for Valuing Financial Instruments

Four fundamental characteristics:

1. Size of the payment:

• Larger payment - more valuable.

2. Timing of payment:
• Payment is sooner - more valuable.

3. Likelihood payment is made:

• More likely to be made - more valuable.

4. Conditions under with payment is made:

• Made when we need them - more valuable.
 Financial Markets: Objective

• Promote efficient allocation of financial resources

• Ensure resources are available to those who put them to their best use
• Keep transaction costs low
 Financial Markets

• Financial markets are places where buying and selling of financial instruments takes place
• Enable both firms and individuals to find financing for their activities

• Went from being in coffee houses and tavern to well organized markets like the New York
Stock Exchange

• Today most transactions take place electronically

 A Well-Run Financial Market

• Must be designed to keep transaction costs low

• Must pool accurate information and make it widely available

• Borrowers’ promises to pay lenders must be credible

• Lenders must be able to enforce their right of repayment quickly and at low cost
 Financial Institutions: Description

• Firms that provide access to financial markets, both

• to savers who wish to purchase financial instruments directly and
• to borrowers who want to issue them

• Also known as financial intermediaries

• Examples: banks, insurance companies, securities firms, and pension funds
• Important distinction between Bank and Non-Bank Financial Institutions (will be
discussed later)
 The Role of Financial Institutions

• To reduce transaction costs by specializing in the issuance of standardized securities

• To reduce the information costs of screening and monitoring borrowers

• They curb asymmetries, helping resources flow to most productive uses

• To give savers ready access to their funds

 Banks

• Banks began as vaults → developed into institutions that accepted deposits and gave loans →
evolved into today’s financial supermarket

• Subject to stronger government regulation than non-bank financial institutions

• Central Bank acts as a lender of last resort

• Therefore, less likely to suffer from Bank Run
 Interbank Lending

• Liquid, interbank loans are the marginal source of funds for many banks, with their cost
guiding other lending rates

• The financial crisis of 2007-09 strained interbank lending

• Anxious banks preferred to hold their liquid assets in case their own needs arose
• They also were concerned about the safety of their trading partners
 Central Banks: Lender of Last Resort

• Diamond-Dybvig model (1983)

• Liquidity mismatch can give rise to bank runs
• Two Nash Equilibira:
• No bank run;
• Bank run
• Outcome depends on self-fulfilling expectations
• See: https://en.wikipedia.org/wiki/Diamond%E2%80%93Dybvig_model

• Central Bank’s commitment to help banks during financial panic can eliminate the
equilibrium of ‘Bank Run’
• However, doing so also creates ‘moral hazard’
• See:
https://www.dallasfed.org/~/media/documents/research/eclett/2008/el0810.pdf
 Central Bank: Controls Money Supply

• Allows for Monetary Policy

• In the absence of control over money supply, there would be no monetary policy

• MP has been a core policy tool when it comes to managing business cycle fluctuations

• Many examples of governments’ abusing their ability to print money – Inflation tax
• E.g. Zimbabwe
• Theoretical motivation for having independent central banks
 Financial Stability

• Regulator of banks and systematically important financial institutions

• For Example, Prudential Regulation Authority of Bank of England

• Helps contain moral hazard
 MCQ 3:

Banks and insurance companies are examples of

A. central banks.
B. regulatory agencies.
C. financial institutions.
D. financial instruments.
 MCQ 4:

Financial instruments can transfer

A. neither resources nor risk between people.

B. resources between people but not risk.
C. both resources and risk between people.
D. risk but not resources between people.
 MCQ 5:

Stock prices are

A. set by the company issuing the stock.

B. set by the central bank.
C. determined by market transactions.
D. unrelated to the value of the company issuing the stock.
 MCQ 6:

How do financial institutions evaluate the creditworthiness of potential borrowers?

A. They offer high interest rates because only the best borrowers will be able to afford
them.
B. They gather information regarding the borrowers' finances.
C. They do not evaluate creditworthiness because everyone is treated the same.
D. They do not evaluate the creditworthiness because they know the borrower will
honor his/her obligation to repay the loan.
 MCQ 7:

Stocks and bonds that are held as wealth fulfil which one of the functions of money?

A. means of payment
B. store of value
C. unit of account
D. medium of exchange
 MCQ 8:

Which one of the following assets is the most liquid?

A. art
B. demand deposits
C. houses
D. stocks
 MCQ 9:

A financial intermediary

A. is an agency that guarantees a loan.

B. is a third-party that facilitates a transaction between a borrower and a lender.
C. would be used in direct finance.
D. must be a depository institution.
 Question 3:

What distinguishes commodity money from fiat money?

 Working with Data (1)

• Go to FRED website https://fred.stlouisfed.org

• You can register to set up your account

• Plot the CPI (FRED code: CPIAUCSL) and find the data of the latest monthly observation

• Plot the inflation rate as the % change from a year of this index.
 Working with Data (1)

• Plot the level of GDP (Fred code: GDPC1)

• Plot the rate of economic growth as the % change from a year ago of this index.

• Describe how real GDP behaves in recessions (these are denoted in FRED graphs by vertical
shaded bars).
• Do not forget to login to your account and save your graph. When new observation become
available you can update your graph.
 Working with Data (1)

• Examine nominal GDP (Fred code: GDP) based on a figure showing % change from a year ago.
• What was special about the behaviour of nominal GDP during the financial crisis 2007 – 2009
compared to previous decades?
• Plot the level of real GDP (FRED code: GDPC1) and the percent change from a year ago.
• Plot on one figure the % change from a year ago of both the GDP deflator (Fred code:
GDPDEF) and real GDP (Fred code: GDPC1).
• How does the GDP deflator link nominal and real GDP? Since the mid-1980s does it fluctuate
more or less than real GDP?
 Working with Data (2)

• The broadcast stock index in the US is the Wilshire 5000. Plot this index (FRED code:
WILL5000PR) over the period 1971 – present
• Plot the percent change from a year ago of the Wilshire 5000. What is the behaviour of the
index before, during and after recession periods?
• In your previous graph add the percent change from a year ago of the household net worth
(FRED code: TNWBWSHNO). Do changes in stock values affect the wealth of households?
• Aside from stock market wealth, what other assets contribute to household net worth?
 Sources of Financial News

• Daily • Data
• The Wall Street Journal • The Federal Reserve Board of St.
• Financial Times Louis (FRED)
• Bloomberg.com • Bureau of Labor Statistics
• Yahoo! Finance • Bureau of Economic Analysis

• Weekly • Personal Financial Information

• The Economist • www.choosetosave.org
• Business Week • www.dinkytown.net
• www.wsj.com