2300 words economic and finance rearch paper

Task I

Introduction

In the article “Basics of Banking: Loans Create a Lot More Than Deposits”, the writer illustrate the basic concepts of broad money creation and an overview that how both of the banks and customers’ balance sheet would be affected by the money creation. However, in the article, not all of the opinions of the writer are correct. Therefore, this assignment would focus on analysing the correct arguments as well as incorrect arguments within the article.

Section A

Loans create deposits

First of all, in the article, the author briefly illustrates a very important concept of modern banking system, which is “loan creates deposits” (Carney, 2013). There is a universal misapprehension that is commercial banks are only playing a role of mediator in the modern financial system—— loaning out the money that they collected from their depositors (Carney, 2013). However, in fact, the loan made by commercial banks is one of major sources of quantity of money supply. For better understanding the concept of “loan creates deposits”, the distinction or property between the different type of money has to be clarified. In this case, the money could be separated to two different type which are base money (central bank money) & broad money (private money). In the reality, in the most of time, central bank money is issued by central bank and would be only traded between bank to bank, and the money that people usually use are belongs to private money, which is created by commercial banks themselves. In another article “Money creation in the modern economy”, as showed in figure 1, it specifically explained that loans made by commercial banks would increase quantity of broad money but have no impacts on quantity of base money which is issued by central bank (McLeay, 2014). Therefore, the money that is often used by people in real life is created by commercial banks, which indicated the concept of loan create deposits is correct.

Figure 1

(McLeay, 2014)

The loan would increase both of the banks and customers’’ asset and liability.

Figure 2

A Bank L+E

Loan: + 100 Deposit: +100

A Customer L+E

Deposit: +100 Loan: +100

Section B

This section will focus on the parts of the argumentation are incorrect in the target article with evidence.

Misunderstanding of reserve and regulatory capital

The loan to Mr. Parker

In this case, scratch bank lends $100 to Mr. Parker so the bank needs to satisfy the reserve requirement and capital requirement. The bank implements a great idea of charge ten percent origination fee from Mr. Parker, the bank can earn $10 and keep it as bank’s retained earnings. Since $100 loan can create $100 deposit which means $10 bank capital can meet the capital requirement of 10% to offer this loan. However, that also means that the loan actually creates $90 deposit in Mr. Parker’s account. Refer to the 10% of reserve requirement, this deposit require $9 bank reserve. The bank can raise the reserve through borrowing funds from Fed funds market at a very low interest rate. According to the article, the $100 loan create $119 liabilities which include $9 required reserve and $10 regulatory capital, however, there is a same mistake as above example to mix reserve and regulatory capital up and classify into liabilities. The process of funds channelling can be recorded in the bank’s balance sheet as follow:

Reserve belong to asset not liability which means the bank’s current asset is $9 reserve plus $100 loan. Moreover, the $10 regulatory capital belongs to bank’s equity. The total liabilities include $90 of Mr. Parker‘s bank deposit and $9 that borrowed from Fed funds market. So, the sum of liabilities and equity of the bank is $109 instead of $119 liabilities.

Conclusion

In short, the article outlined the main ideas of money creation in modern banking system. The writer has some decent argumentations and illustrations on basic understanding of money creation in general level such as private money is created by loans and the loan would rises both bank and customer’s balance sheet. However, the writer got wrong concepts, which caused by misunderstanding of regulatory reserve and capital, that resulted in some mistakes in his example such as the balance sheet of bank are not balanced if there is an additional loan.

Reference List:

Bridges, J., Gregory, D., Nielsen, M., Pezzini, S., Radia, A. & Spaltro, M. (2014). "The impact of capital requirements on bank lending", Bank of England.Quarterly Bulletin, vol. 54, no. 1, pp. 103.

Feinman, J.N. (1993). "Reserve requirements: History, Current Practice, and Potential Reform", Federal Reserve Bulletin, vol. 79, no. 6, pp. 569.

McLeay, M., Radia, A., & Thomas, R. (2014). Money creation in the modern economy. Quarterly Bulletin. Available at http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

Task II

After the global financial crisis, many countries’ regulators have strengthened macro-prudential supervision of their financial systems, and UK also has intensified the reform. It not only kept improving the regulation system, but also kept publishing relative instruments for implementing macro-prudential supervision policies. As one of the most important macro-prudential instruments, Countercyclical Capital Buffer (CCyB) applies to all banks, housing associations and investment companies established in UK, and Financial Policy Committee (FPC) should set CCyB rate every quarter. Furthermore, FPC should consider four key indicators when deciding CCyB rate, which are balance sheet conditions of non-bank sectors, the measurement of market conditions and terms, the balance sheets of banking system and stress measurement of banking system respectively (Bank of England 2016). This report provides the details of the implementation of CCyB and the rationale for the implementation of this policy in UK. This report is divided into three sections: Section A describes the implementation of CCyB, which includes the process of CCyB rate declines and raises, Section B analyses the reasons for that implementation, and Section C makes a conclusion.

On April 2016, FPC has published a policy statement of implementation, which has stated that FPC could require regulated institutions increase their capital requirements to all loans and risk exposures of UK’s borrowers above normal micro-prudential requirement (Bank of England 2016). According to the financial stability report on July 2016, Bank of England (2016) has released a series of new measures to reduce the influence of EU referendum on UK’s financial environment and decreased CCyB rate from 0.5% to 0%, which means that the capital buffer has declined by 5.7 billion. Although UK’s economy showed a slowdown tendency in 2017, the performance of UK’s economy was better than expectation and some of central bank’s decision makers of interest rate thought it was the time to increase CCyB rate. According to the financial stability report on June 2017, Bank of England (2017) has raised CCyB rate from 0% to 0.5% with a one-year implementation period, which means that the capital buffer has increased by 5.7 billion. Besides, CCyB rate is expected to increase to 1% on November 2017.

With regard to the rationale of implement, CCyB rate reflects risk of banking system varying with time. When FPC considers risk accumulates in banking system, it will raise CCyB rate to add extra capital buffer for absorbing potential losses, strength flexibility of banking system for withstanding pressure, ensure banking system plays a role as financial intermediary. When risk of financial instability decreases or credit is tight, capital buffer will be considered as far exceeding potential losses in future. In this situation, FPC will reduce CCyB rate to help banks release part of capitals and avoid banks further tightening credit conditions (Bank of England 2015). Furthermore, the specific reasons for the adjustment of CCyB rate could be found on annual financial stability reports of Bank of England. As Bank of England has worried about EU referendum would cause a downturn of UK’s economy, it has reduced the capital buffer in order to improve banks’ ability of providing loans to households and corporations (Bank of England 2016). In 2017 financial stability report, Bank of England (2017) has stated that in order to survive in the competition, banks vigorously promote credit card consumption service and personal loan service. As a result, year-on-year increase in consumer credit has reached a peak at 10% in past decade, and the rapid increasing of borrowing and debt levels has caused FPC rethink current CCyB rate. Therefore, FPC has raised CCyB rate from 0% to 0.5% in order to gently restrain the growth speed of credits, especially consumer credit.

In conclusion, FPC has released an announcement for implementing CCyB on April 2016, reduced CCyB rate from 0.5% to 0% on July 2016 because of EU referendum, and increased CCyB rate from 0% to 0.5% due to the rapid increasing of consumer credit. As an important macro-prudential instrument, the raising of capital buffer during economic boom could strength flexibility of banking system for withstanding pressure, and the reduction of capital buffer during economic downturn could loosen credit conditions and improve banks’ lending capacity. For future adjustment by FPC, CCyB rate is expected to increase to 1% on November.

Reference List:

Bank of England (2016) The Financial Committee’s Approach to Setting the Countercyclical Capital Buffer, A Policy, Available at <http://www.bankofengland.co.uk/financialstability/Documents/fpc/policystatement050416.pdf> (Last Access: 24 October 2017)

Bank of England (2016) Financial Stability Report, July 2016, Available at <http://www.bankofengland.co.uk/publications/Documents/fsr/2016/fsrjul16.pdf> (Last Access: 27 October 2017)

Bank of England (2017) Financial Stability Report, June 2017, Available at <http://www.bankofengland.co.uk/publications/Documents/fsr/2017/fsrjun17.pdf> (Last Access: 27 October 2017)

Bank of England (2015) The Bank of England’s Approach to Stress Testing the UK Banking System, Available at <http://www.bankofengland.co.uk/financialstability/Documents/stresstesting/2015/approach.pdf> (Last Access: 27 October 2017)

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