19.4 - Banks, Credit, Capital & Bonds - notes
19.4 - Banks, Credit, Capital & Bonds
How commercial banks create credit and money
Commercial banks play a key role in expanding the money supply within an economy by issuing loans. This process effectively generates new money through the creation of deposits.
The process of credit creation
- When a bank approves a loan, it adds the amount to the customer's account as a new deposit, which counts as fresh money in the economy.
- The customer then owes this sum back to the bank, plus an additional amount in interest, making them a debtor.
- For the bank, the loan represents an asset because it is money owed to them.
- The deposit in the customer's account is recorded as a liability for the bank, as they must honour withdrawals of this amount.
- This system allows banks to increase the overall money supply, as the new deposit can be used for spending or further lending.
Inter-bank lending between banks
Banks often need to borrow from each other to manage daily fluctuations in their cash holdings. This takes place in a specialised financial environment.
Features of inter-bank lending
- Inter-bank lending occurs in the money market, where banks provide short-term loans to one another.
- These loans are typically very brief, lasting less than a week and frequently just overnight.
- On any given day, some banks may have surplus funds (excess liquidity), while others face temporary shortages.
- Banks with shortages borrow to ensure they can meet customer demands, such as withdrawals.
- Lenders earn interest on these loans, helping them make use of idle funds.
- The interest rate applied is known as the inter-bank lending rate or overnight rate.
The structure of bank balance sheets
Banks, like other businesses, maintain balance sheets to track their financial position. These documents provide a clear picture of what the bank owns and owes.
Key elements of a bank balance sheet
A balance sheet shows a bank's assets and liabilities at a specific point in time, with total assets always matching total liabilities.
Assets on a bank balance sheet
Assets are items owned by or owed to the bank, categorised by how easily they can be converted to cash (liquidity):
- Highly liquid assets - Include cash holdings, reserves held at the central bank, and funds available on short notice.
- Medium liquidity assets - Such as government or commercial bills and various investments.
- Low liquidity assets - Comprise loans to customers (advances), mortgages, and fixed items like buildings or equipment.
Liabilities on a bank balance sheet
Liabilities are amounts the bank owes to others:
- Customer deposits - Money held in savings or current accounts.
- Borrowings - Short-term loans from other banks or long-term debts.
- Other items - Such as reserves built from profits and share capital from investors.
The importance of capital levels for banks
A bank's capital is essential for its stability and ability to lend. It acts as a buffer against financial losses.
Components and role of bank capital
- Bank capital consists of share capital (funds raised from initial share sales) and reserves (accumulated from undistributed profits).
- The level of capital limits how much a bank can lend, as banks maintain a specific ratio of loans to capital for safety.
- If an asset's value drops (e.g., due to a loan default), the bank's capital decreases by the same amount to keep the balance sheet equal.
- A major fall in asset values can deplete capital entirely, making assets worth less than liabilities and leading to insolvency.
- Insolvent banks cannot continue operating and typically close, as central banks rarely provide support in such cases.
Balancing liquidity, security, and profitability
Banks must carefully manage their assets to meet competing goals. This involves selecting a mix that ensures they can operate effectively while minimising risks.
Factors banks consider in asset management
- Liquidity - Assets need to be convertible to cash quickly to handle withdrawals or unexpected demands.
- Security - Safer assets reduce the risk of losses; for example, secured loans (backed by collateral like property) allow the bank to seize the asset if the borrower defaults, unlike unsecured loans which carry higher risk but offer greater profits.
- Profitability - Higher-risk assets, such as unsecured loans, generate more interest income but increase the chance of defaults.
Banks aim for a diverse portfolio to balance these elements, ensuring they can pay out when needed without sacrificing earnings.
The inverse relationship between interest rates and bond prices
Bond prices and interest rates move in opposite directions due to how investors compare returns. This affects the market value of bonds.
How interest rates affect bond prices
- A bond's yield (effective return) tends to align with prevailing interest rates on similar-risk investments.
- When interest rates increase, existing bond prices decrease to make their yields competitive, and the reverse occurs when rates fall.
- Bonds have a fixed coupon (annual payment) based on their nominal value, but market prices adjust with rate changes.
Formula for calculating bond market price
Where:
- Market price = Current value of the bond (£)
- Coupon = Fixed annual payment (£)
- Yield = Current market interest rate (% expressed as a number, e.g., 5 for 5%)
Worked example - Calculating bond market price with interest rate changes
A bond has a nominal value of £750 and an annual coupon of £45. Initially, the market yield is 7.5%. Later, the yield falls to 4.5%. Calculate the market price at both yields.
Step 1: Identify the values
- Coupon = £45
- Initial yield = 7.5 (for 7.5%)
- New yield = 4.5 (for 4.5%)
Step 2: Calculate initial market price
Step 3: Calculate new market price
Step 4: Interpretation
The bond's price rises from £600 to £1000 as the yield falls from 7.5% to 4.5%, illustrating the inverse relationship with interest rates.