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AF1100 – Financial Institutions

Tutorial Questions – Week 5

Chapter 3 (H&B) – Questions for Discussion 1-9

Question 1 – Deposit taking financial institutions are the institutions normally called banks or building societies, and they main activities are to take deposits and give out loans. Non-deposit taking institutions provide other services (e.g. insurance, investment management), so when individuals or corporations transfer money to these institutions it is never solely for safekeeping (as when deposits are made in banks or building societies), but for other reasons, which are the products or services that these other institutions provide.

Sections 3.2 and 3.5 of the book contain details of the characteristics of banks and building societies and chapter 4 discusses the various types of non-deposit taking institutions and the different services/products they offer.

Regarding the difference between discretionary and contractual saving, it follows the meaning of the words, i.e. discretionary is down to the choice of the saver how much and when he/she saves, whereas contractual, the amount and frequency of the savings is still decided by the saver, but in this case, they enter into a contract by which there is an expectation of when and how much money is deposited in the savings plan. See page 18 of the book for definition.

Question 2 and Question 3

The table on page 66 and section 3.3 of the book detail what each of the money aggregates include and also how money is created in the system.

Important to notice the very large difference between M0 and M4, which is driven by the fact that M0 is essentially a metric of how much money had been issued, whereas M4 is a metric of how much money has been issued plus how much money has been created through subsequent depositing and lending.

Question 4 – The functions of the Bank of England (common with a number of other central banks) are listed and explained in section 3.1 of the book.

As with other organisation, there will be different “departments” of the BoE responsible for the different functions, and therefore situations of conflict will arise when actions taken or incentivised to achieve one function will clash with the actions taken or incentivised to achieve another objective.

For example, if the BoE is trying to promote growth of the economy through the conduct of monetary policy, it will incentivise banks to give out loans for investment and/or consumption, but this may lead to the reduction of the reserve ratios of banks, which may be problematic for the achievement of the role of supervisor of the banking system to ensure the banks are not taking too many risks.

Question 5 – As you can see in the box on page 68 of the book, Bank’s reserves are their holdings of notes and coins plus operational deposits at the central bank and the reserve ratio is calculated as the reserves over customer deposits.

Currently the reserve ratio agreed by all banks (mandatory) is a minimum of 12.5%, while finance houses have a minimum ratio of 10%.

Page 62 of the book includes the balance sheet of all banks in 2005 and if you calculate the ratio using the indicated metrics, you’ll find a reserve ratio of only approximately 0.3% (10,889/3,465,704), which is very low.

Some banks, if they feel their assets are particularly risky will choose to hold higher (prudential) reserve ratios.

Question 6 – The concept of lender of last resort is addressed in section 3.1.2 of the book, and it is a role that central banks in general have, which consists in ensuring banks who need cash but where unable to access it in the system, can borrow from the central bank.

Considering this lending is short term in nature, central banks have the opportunity to make money more or less accessible and/or more or less expensive in line with their objectives (monetary policy) and in so doing affecting the short term interest rates.

Question 7 – Interest rate rises makes money more expensive thus reducing the incentives for taking out loans, while making saving more rewarding. That is the reason why when a central bank is trying to grow the economy, it will keep rates low (borrowing is cheap => companies borrow for investment => more production capability => more jobs => more wealth), while if it still trying to slow down the economy (e.g. inflation is high) the central bank will increase interest rates.

Question 8 – The principle of the base multiplier is that but lending banks multiply the money available in the system. For example £100 are issued by the BoE and put into the system, one banks takes it and lends £80 to another bank, who then lends £64 and so on, thus creating money.

In this brief example, I’m assuming each bank lends 80% of the money they have and in reality the amount is driven reserve ratio, with the multiplier effect being calculated as 1/reserve ratio. Assuming the 12.5% reserve ratio mentioned in Q5 above, the multiplier would be 1/0.125, meaning that each £1 issued by the BoE, is multiplied and thus becomes £8 available in the system

Question 9 – In the two tables below are examples of a bank (first) and a building society (second) balance sheet. There is also an Income Statement for the building society. The most obvious different is the diversity of elements in the balance sheet of a bank compared to a building society.

Chapter 4 (H&B) – Questions for Discussion 1-7

Question 1 – See answer to Question 1 for chapter 3 above.

Question 2 – As seen in discussion the differences, customers look essentially for deposits and/or loans from banks/building societies, while looking for other products and/or services (e.g. insurance, pension savings, other savings) from NDTIs.

Question 3 – Please see section 4.2 in the book, with definitions in the box on page 100.

Question 4 – Holdings at the end of the year – stock of assets (or liabilities) at a particular moment. It is data that is used to compile a balance sheet.

Net acquisitions – quantity of assets (or liabilities) acquired during the period. This is flow data and for financial institutions it must match the inflow of funds from savers during the period in question.

Turnover – the total value of transactions (the sum of purchases and sales) during a period of time. The is also a flow data but the figures normally will be much larger than the net acquisitions.

Question 5 – mortality rates being less predictable implies an increase in uncertainty, including at what point in time payments will need to be made by the insurance company. In order to offset this increase in risk, the insurance company will need to hold a higher proportion of less risky assets (bonds and cash vs. shares) in order to ensure that when cash is needed, the loss of value (which can be very high if the market is in a downturn) is minimal when selling the assets. If the mortality rate is more predictable, the point in time when cash payments will occur will also be more predictable, allowing the company to withstand a downturn, as it knows the probability of the market recovering prior to the required payment is high.

Question 6 – As explained in the lecture (see slide 14 lecture 5), the two main tools at the disposal of the insurance companies are screening of potential customers and the implementation of penalty and rewards schemes, as for example no-accident discounts in car insurance.

Question 7 – Because closed-end funds trade on a public exchange, the price of the units will be determined by the market. As such, at any point in time the price may trade at either a premium or discount to the stated NAV. Over the longer term, the share price and the NAV should converge.

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