Chapter Seven1
CHAPTER 7
International Banking and the
Role of Central Banks
CHAPTER OVERVIEW
Chapter 7 is devoted to explaining some of the key institutional details of the international baking and payments system and the role central banks play in managing the economy. The chapter begins with a discussion of the role of financial intermediation, and discusses two important reasons for the existence of indirect finance thought intermediaries: (1) the existence of asymmetric information between borrowers and leaders, including situations that involve potential adverse selection and moral hazard problems, and (2) economies of scale.
The chapter also describes differences in national banking systems among industrialized countries. The chapter compares universal baking systems such as Germany’s with restricted banking systems such as that of the United States. The text points out that an important distinction between different systems also stems from the extent to which companies tend to finance their operations by directly issuing debt instruments for decentralized financial markets versus the extent to which companies tend to finance their operations through bank loans. The chapter also describes the various objectives of bank regulation and supervision, such as limiting the scope for insolvencies and failures, maintaining liquidity, and promoting efficiency. The chapter then addresses the concept of market based regulation to save governments considerable resources in bank regulation.
The next major section of the chapter is devoted to describing recent developing is global trading and payment systems. In particular, the section discusses various automated financial trading systems and both traditional and electronic global payment systems. The section ends with a discussion of the various risks associated with payment systems. It identifies and discusses liquidity risk, credit risk, systemic risk, and Herstatt risk.
The chapter continues to describe the role that central banks have come to play in modern industrialized economies, and begins with a description of typical central bank assets and liabilities. Also described are differences in the ownership, organization and management of the major central banks among industrialized countries. Central banks are described as performing functions that typically range from roles as government depositories, fiscal agents for the government, regulators of other banks, and monetary policymakers. For the last category, four different monetary policy instruments are discussed in detail: (1) interest rate policies on central bank advances, (2) open market operations, (3) reserve requirements, and (4) interest rate regulations and direct credit controls.
The next section discusses various perspectives on what ideally should be the primary function of a central bank. Tradeoffs includes questions about whether central banks should be multi-functional versus compartmentalized or even further streamlined, and whether they should be public or private. Another important consideration, referred to as the “assignment problem”, revolves around whether the central bank or the finance ministry should be primarily responsible for domestic versus international policy objectives.
OUTLINE
I. International Dimensions of Financial Intermediation
A. Financial Intermediation
B. Economies of Scale
C. Financial Intermediation Across National Boundaries
1. International Financial Intermediation
2. Economies of Scale ad Global Banking
II. Banking Around the Globe
A. Bank vs. Market Finance
B. Differences in Bank Market Structure
C. Universal Banking
D.Secrecy and Taxation
III. Banking Regulation and Capital Requirements
A. Goals of Bank Regulation
1. Limit Scope of Bank Insolvencies and Failures
2. Maintain Bank Liquidity
3. Promote Efficient Bank System
B. Bank Capital Requirements
1. Computing Required Capital
2. Market-Based Regulation
IV. Global Trading and Payment System
A. International Financial Trading System
B. Global Payments System
1. Non-Electronic
2. Electronic
V. Payment System Risks
A. Liquidity Risk
B. Credit Risk
C. Systemic Risk
VI.Central Bank Balance Sheets and Institutional Structures
A. Central Bank Balance Sheet
1. Assets
2. Liabilities
3. Net Worth
B. Central Bank Ownership and Organizational Structures
C. Central Bank Organization and Management
VII. Central Bankers
A. Government Banks
1. Government Depositories
2. Fiscal Agents
B. Bankers’ Banks
C. Monetary Policymakers
1. Interest Rates on Central Bank Advances
2. Open Market Operations
3. Reserve Requirements
4. Interest Rate Regulations and Direct Credit Controls
VIII. Alternative Perspectives on Central Banking
A. Multifunction Central Banks
B. Compartmentalized Central Banks
C. Streamlined Central Banks
D. Private Central Banks
E. Assignment Problem
IX. Summary
FUNDAMENTAL ISSUES
1. What accounts for international financial intermediation and how do national banking systems differ?
2. What objectives do national banking regulators seek to achieve and how do they implement their regulations?
3. What are the most commonly used financial trading and payment systems and what are their risks?
4. What are the main assets and liabilities of central banks and who owns and manages these institutions?
5. What are the primary functions of central banks?
6. What are key perspectives about the appropriate duties of central banks?
CHAPTER FEATURES
1. Policy Notebook: “What Happened to the Quest for Efficient Banking Markets in Europe?”‘
This notebook examines the interesting fact that European banking markets remain rather segmented despite the rally to create a single banking market. A study discussed illustrates that differences in bank loan rates have no obvious common link.
For Critical Analysis: Different tax rates across nations will affect returns on savings. Therefore, high tax countries will have to offer higher interest returns to attract funds to compensate depositors for interest income lost to higher taxes.
2. Policy Notebook: “Are the Days of Bank Secrecy Numbered?”
This policy notebook examines the recent developments in bank secrecy, and cites the increasing pressure for banks to reveal interest income earned by its depositors. Despite increasing government pressure to eliminate bank secrecy, many banks continue to maintain customer privacy.
For Critical Analysis: Banks which currently provide customer secrecy will look very unfavorably on the elimination of such secrecy especially when banks other countries continue to provide secrecy because a competitive edge will be eliminated for banks which can no longer provide secrecy to customers.
2. Management Notebook: “Already a Challenge in One Language, Monetary Policy Goes Multilingual”
This notebook discusses one of the oft-neglected subtleties of the European Central Bank (ECB): potential language problems. It notes that though the members discuss banking policy in English, they often require translators. Naturally, since there are various subtleties in the meanings of words, special care needs to be taken to translate words carefully, and in context.
For Critical Analysis: Any type of misunderstanding that affects a policy outcome could lead to a mistake. The notebook illustrates this with an example of the various shades of meaning of the word, “vigilance”.
ANSWERS TO END OF CHAPTER QUESTIONS
1. A key reason that an individual might hold a deposit with a bank that lends internationally, instead of making international loans directly, is the problem of asymmetric information, or the fact that potential international borrowers know more about their own prospects than the individual does. To avoid risks of loss arising from the adverse selection problem, or the likelihood that potential borrowers with high-risk projects will desire credit, the individual would have to screen international loan applicants carefully. Yet this could be difficult to do across national boundaries. In addition, if the individual were to extend to loan to a borrower in another nation, the individual would have to find a way to continue to monitor the borrower to avoid moral hazard problems arising from the possibility that the borrower could engage in more risky behavior after receiving the loan. Banks, on the other hand, may have lending officers who are physically located in other nations, and they may have information-processing and monitoring technology linking their offices. In this way also, banks may be able to take advantage of cost advantages accruing to their larger size. Consequently, banks may have an advantage in making loans across national boundaries.
2. One benefit that a Dutch resident experiences from the presence of fewer banking institutions is that comparing the types of and relative qualities of services is an easier task than it would be if there were many rival institutions. The Dutch resident also may gain from lower loan interest rates, higher deposit rates, and services prices resulting form economies of scale that relatively large banking institutions in the Netherlands may have attained. Nevertheless, there may be a definite disadvantage form having less choice among banking institutions, which is that these institutions may behave less competitively, which could in fact lead to higher loan rates, lower deposit rates, and higher prices of services.
3. Whether bank secrecy in locales such as Switzerland and Uruguay is or is not socially desirable is, of course, a matter of opinion. On the one hand, some bank depositors can use secrecy about banking transactions to hide illegal acts. On the other hand, the ability to conduct banking transactions without fear of publicity can protect an individual’s privacy. Thus, one’s stand on this issue depends on weighing of the public’s right to know versus the value of an individual’s privacy.
4. Because U.S. banking regulations have restrained competition in local banking markets, they arguably have led to the proliferation of many relatively smaller, isolated community banking markets, instead of a few larger, regional markets or even of a single national market for banking services. As a result, there may be many more banking institutions spread across many local markets, instead of a smaller number of banks competing in a few large regional markets or in a national market.
5. The bank’s capital-asset ratio is equal to it equity of 100 million yen divided by its total assets of 1,000 million yen, which equals 0.10, or 10 percent. Hence, the bank definitely meets the 4 percent capital-asset ratio requirement. Because cash assets and government securities receive a zero risk weight, this bank has 800 million yen in loans that it must count among risk-adjusted assets. Together with the assigned exposure of 400 million yen from derivatives trading, this yields a total amount of risk-adjusted assets equal to 1,200 million yen. Thus, the bank’s risk-adjusted core capital ration is equal to 100 million yen divided by 1,200 million yen, which is equal to just over 0.083, or 8.3 percent. Thus, the bank’s risk-adjusted core capital ratio also meets the 8 percent regulatory requirement.
6. The primary assets of commercial banks are securities. For monetary policy purposes, other key assets include loans to private banks and foreign exchange reserves. The main liabilities of central banks are currency and reserve deposits of private banks.
7. This is a question of informed opinion. The key roles that the student might choose include monetary policymaker, depository for government funds, and banker and regulator for private banking firms. Students’ answers could also focus on whether central banks should be compartmentalized, multifunction, or streamlined (single-goal) institutions.
8. This question highlights the kinds of issues that can arise when central banks are semi-public/semi-private institutions. The issues in this situation, of course, is whether or not it is appropriate for a central bank to own equity shares in institutions that it also is charged with regulating. The student’s position on this issue likely will hinge on their views about the potential for conflict-of-interest problems versus any possible gains from additional insider information that the central bank would achieve in its role as a public-interest regulator.
9. One example of a policy quandary would be a situation in which a central bank seeks to bring about a contracting in economic activity by inducing a rise in the general level of market interest rates. This would cause bond prices to decline, thereby exposing private banks to capital losses that could harm their longer-term viability. This could interfere with the central bank’s role as a bank regulator that aims for bank safety and soundness. In addition, falling prices of government bonds would raise the government’s expense in raising funds, which could conflict with the central bank’s role as fiscal agent. These are the kinds of trade-offs that students should seek to identify as they weigh the pros and cons of multifunction, compartmentalized, or streamlined central banks.
10. Other things constant, raising the value of the nation’s currency would bring about a reduction in the nation’s monetary base as it sells foreign exchange reserves. To offset this effect and thereby sterilize the monetary base, the central bank would need to reduce the rate(s) on advances, thereby inducing private banks to borrow more reserves, which would bring about a rise in reserve supply and an increase in the equilibrium quantity to total reserves. As a result, the monetary base would rise to offset the decline induced by foreign-exchange intervention.
MULTIPLE CHOICE EXAM QUESTIONS
1. Financial intermediation refers to
A. the dealings between private banks and the central bank of that nation.
B. legislation which is directed toward the regulation of the baking industry.
C. indirect finance through the services of financial institutions that channel funds from savers to investors.
D. the calculations involved in pricing financial instruments.
Answer: C
2. The fact that on party in a financial transaction often possesses information not available to another party is known as
A. moral hazard.
B. asymmetric information.
C. the double coincidence of wants.
D. uncertainty.
Answer: B
3. An example of adverse selection is when
A. only the least creditworthy firms will be willing to borrow.
B. the poorest run banks are mostly likely to be audited.
C. investors choose the riskiest financial instruments in an attempt to gain maximum returns.
D. banks display a bias in their dealings with customers.
Answer: A
4. An example of moral hazard is when
A. borrowed money is used to fund illegal activity.
B. the possibility of default on a loan is reduced by background checks.
C. the borrower engages in more risky behavior after receiving the funds than would have been the case prior to receiving the funds.
D. the risks associated with a floating rate loan far exceed those associated with a fixed rate loan.
Answer: C
5. Financial intermediaries most typically take advantage of economies of scale by
A. insisting upon only large deposits.
B. holding part of their portfolios in equities.
C. pooling the funds of many people together.
D. switching form human to automated systems.
Answer: C
6. International financial diversification can best be described as
A. holding financial instruments of various durations in order to spread portfolios risks.
B. investing in multinational firms traded on the domestic stock exchange.
C. holding financial instruments issued in various countries to spread portfolio risks.
D. using information on global trends to help forecast domestic trends.
Answer: C
7. An advantage to holding a world index fund is that it contains a group of globally issued financial instruments which historically have
A. displayed a tendency to move in offsetting directions.
B. had higher returns.
C. outperformed the S&P.
D. displayed a tendency to move together.
Answer: A
8. The world’s largest banks are located in
A. New York and Chicago.
B. South America and Eastern Europe.
C. Canada and the former Soviet Union.
D. Japan and Switzerland.
Answer: D
9. Megabanks can be characterized as
A. carrying out domestic functions while located while located in foreign countries.
B. reporting profits and paying taxes in their home country.
C. reporting profits and paying taxes in each of the countries they carry out transactions.
D. carrying out large-scale coordination for systems of smaller banks.
Answer: B
10. One way that British, German, and Japanese business differ form those in the U. S. is that
A. they use bank loans to finance significantly larger shares of their investment.
B. they are typically much smaller.
C. their integration in international financial markets is much more limited.
D. they do not deposit reserves with the central banks.
Answer: A
11. A key rationale for the traditional U.S. prohibition against universal banking is that
A. the specialty of banks is their ability to take in deposits and loans.
B. U.S. bank portfolios typically do not have the capacity to participate in equity markets.
C. equity shares tend to be riskier than government securities.
D. banks are ill suited to handle the foreign exchange risk inherent in universal banking.
Answer: C
12. An argument for allowing banks to hold equities in their portfolios is that
A. equity and bond returns have a tendency to move in opposite directions.
B. equities typically enjoy larger returns than bonds.
C. that banks already do in affect hold equities by virtue of the fact that they provide loans to private firms.
D. they would be able to gain access to additional investor information.
Answer: A
13. When a bank’s assets fall below the value of its liabilities it is referred to as
A. insolvent.
B. inseparable.
C. below par.
D. illiquid.
Answer: A
14. A fundamental difficulty typically involved in the regulation of banks is
A. how to gain access to their financial statements
B. how to balance the tradeoffs between solvency and normal profits.
C. determining which legislation is federal or state.
D. avoidance of adverse selection.
Answer: B
15. The Basel capital requirements, which established international banking standards stipulate that banks must keep the ratio of ______to risk-adjusted assets and the ratio of ______to risk-adjusted assets at 4% and 8%, respectively.
A. core capital; total capital
B. supplementary capital; total capital
C. deposits; loans
D. bonds; equities