International Banking and International Banking and the Allocation of Capitalthe Allocation of Capital

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Benefits of International Capital Market Liberalization

• Allows savings to flow to their most productive use.

• Domestic agents can borrow and lend abroad at more competitive rates.

• Diversification mitigates domestic downturns.• Expanded investment increases standard of

living.

How is Saving Allocated?How is Saving Allocated?

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Direct versus Indirect Financing

• Direct: Savers and borrowers link directly• Indirect: An intermediary channels funds

from saves to borrowers.• Bank Borrowing:

– UK 70%– Japan 65%– US 30% (Over 50% through foreign banks!)

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Efficient Financial Intermediation

• An efficient system reduces x-inefficiency costs.

• Intermediaries make pooling of funds possible and, therefore, economies of scale.

• Intermediaries enable savers to pool funds.• Intermediaries can reduce information

asymmetries and other market failures.

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Potential for Misallocation of Capital

• There is a potential for unfettered capital markets to misallocate capital– Intermediaries undermine domestic policy– Financial market shocks increase– Greater potential for contagion.– Loss of Economic Growth

• Evidence on the latter (p. 6)

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Market Failures

• Asymmetric Information: Possession of information by one party that is not available to a another party of the transaction. Can lead to:– Adverse Selection: Those least worthy most

likely to borrow.– Herding Behavior: Savers follow someone

they feel is better informed.

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Market Failures

• Moral Hazard: Borrower engages in riskier activity once the financing is in place.– Moral hazard can result from information

asymmetries or from national government or international organization guarantees.

• Policy Created Distortions: – Differential taxes, regulations, tariffs– Regulatory Arbitrage

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Conclusion

• Potentially large allocative and efficiency gains to be enjoyed from capital market liberalization.

• Policy-created distortions and market failures must be addressed.

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Payments Systems Risks

• Liquidity Risk: The risk of loss that may occur when a payment is not received when due.

• Credit Risk: The risk of loss that may occur when one party fails to abide by the terms of an agreement.

• Systemic Risk: The possibility that liquidity risk or credit risk may affect a third party.

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System Risk

• Systemic Risk involves a negative externality.• Herstatt Risk: Liquidity, credit, and systemic risk

across international borders.• Term comes from the events surrounding the

failure of the Herstatt bank in 1974.• G10 nations developed a netting arrangement to

minimize Herstatt risk (early 1990s).

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Central Bank Functions

• Fiscal Agents• Bankers’ Bank• Lenders of Last Resort• Macroeconomic and Monetary Policy

Makers– Exchange market intervention– Monetary policy

The Monetary Base and the The Monetary Base and the Money StockMoney Stock

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The Monetary Base

• A nation’s monetary base can be measured by viewing either the assets or liabilities of the central bank.

• The assets are domestic credit (DC) and foreign exchange reserves (FER).

• The liabilities are currency in circulation (C) and total reserves of member banks (TR).

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Simplified Balance Sheet of the Central BankAssets Liabilities

Domestic Credit(DC)

Currency(C)

Foreign Exchange Reserves (FER)

Total Reserves(TR)

Monetary Base(MB)

Monetary Base(MB)

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Money Stock

• There are a number of measures of a nation’s money stock (M).

• The narrowest measure is the sum of currency in circulation and the amount of transactions deposits (TD) in the banking system.

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Money Multiplier

• Most nations require that a fraction of transactions deposits be held as reserves.

• The required fraction is determined by the reserve requirement (rr).

• This fraction determines the maximum change in the money stock that can result from a change in total reserves.

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Money Multiplier

• Under the assumption that the monetary base is comprised of transactions deposits only, the multiplier is determined by the reserve requirement only.

• In this case, the money multiplier (m) is equal to 1 divided by the reserve requirement,m = 1/rr.

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Relating the Monetary Base and the Money Stock

• Under the assumptions above, we can write the money stock as the monetary base times the money multiplier.M = mMB = m(DC + FER) = m(C + TR).

• Focusing only on the asset measure of the monetary base, the change in the money stock is expressed asM = m(DC + FER).

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Example - BOJ Intervention

• Suppose the Bank of Japan (BOJ) intervenes to strengthen the yen by selling ¥1 million of US dollar reserves to the private banking system.

• This action reduces the foreign exchange reserves and total reserves component of the BOJ’s balance sheet.

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BOJ Balance Sheet

Assets Liabilities

DC C

FER TR

MB MB

-¥1 million -¥1 million

-¥1 million -¥1 million

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BOJ Intervention

• Because the monetary base declined, so will the money stock.

• Suppose the reserve requirement is 10 percent. The change in the money stock is

M = m(DC + FER),M = (1/.10)(-¥1 million) = -¥10 million.