IFM CHEATSHEET CHAPTER 2

 CHAPTER 2: CENTRAL BANKS & MONETARY POLICY

TYPES OF BANKS

1. Retail bank: works with ordinary people. 

2. Wholesale bank (The Big Whales): works with large scale financing and investment projects (Big Banks, Companies or Financial participants). Are the ones involved in interbank markets. 

3. Central Banks (The Bank of banks): every bank must have a current account in CB to:

• Settle payments

• Access liquidity. 

Their functions are:

1. Lender of last resort.

2. Monetary policy

3. Ensure stability

INDEPENDENCE OF BANKS

Politicians cannot order day-to-day policy to:

• Anchor credibility and inflation expectations. 

• Avoid political cycles. 

• Build investor trust & financial stability. 

GOALS OF EUROPEAN CENTRAL BANK

• MAINTAIN PRICE STABILITY → maintain INFLATION lower, but close, to 2% + support general economic policies. 

Short term markets (Monetary markets) – affects interest rates (i). 

** To compute i you always need a reference risk premium.

Types of  i : 1) MRO  i  2) Credit  i  3) Deposit  i

GENERAL FORMULA FOR COMPUTING AMOUNTS OF FINANCIAL PRODUCTS

ACTUAL – you usually choose it to pay less	BASE 30
c(amount)*i * Real days365	c(amount)*i * 30* nº of months360

INSTRUMENTS – MONETARY SHORT TERM

1. OPEN MARKET OPERATIONS – Liquidity operations

Regular and ad-hoc operations the ECB uses to add & drain liquidity. 

• MRO (MAIN REFINANCING OPERATIONS): weekly standard, collateralized. 

• LTRO (LONG TERM REFINANCING OPERATIONS): 3 months liquidity usually.

***LTRO (3 years): not for controlling inflation, but for stability of the bank. 

2. OFFERS STANDING FACILITIES – The Lender of Last Resort

• Margin Lending Facility: overnight loan (1 day) from ECB to solvent banks. Needs collaterals too. 

The   i  is deliberately higher than market funding, like a penalty to discourage their use.  

Deposit < MRO < Marginal Lending

COLLATERALS 

Are financial assets pledged as security when a bank borrows from ECB (so they only fulfill the objective of keeping inflation low). 

• Must be an eligible asset → liquid and easy to value

MECHANISM

1. Bank ask for a loan

2. ECB requires more than just the loan. Must cover:

• Loan amount – given by the professor

• Interest – given by the professor

• Initial Margin  = Loan amount * %

Total amount collateralized on first day (t) = Loan amount + Initial Margin

3. Haircut is applied → when CB discounts the market value of collateral to be conservative

Adjusted collateral=market value - (% haircut  * market value)

4. Total number of collaterals given by the firm (for example of T-Bills)

Nº of Collaterals=total amount collateralizedadjusted collateral value

3. RESERVE REQUIREMENTS

Requires credit institutions to hold MINIMUM RESERVE on accounts within the Eurosystem. 

• MB (Monetary Base)= cash in circulation + reserves at ECB (we divided into reserves too for the m)

• MS (Money Supply) = cash in circulation + deposits from people

• Money Multiplier

m=MONEY SUPLYDeposits MONETARY BASE Deposits m=1+ cash deposits cash deposits + Reserve Requirements

• KEY IDEA: when people deposit money in banks and that money is lent Money Supply increases & Monetary Base decreases thanks to the Money Multiplier. → This make Reserve Requirements a monetary instrument. 

MONEY SUPPLY = m * MONETARY BASE

• If ECB – increases the Monetary Base → this will increase the Money Supply 

• If ECB – increases the Reserve Requirements → this will decrease the Money Supply 

• If Commercial Banks – increases loans → this will increase the Money Supply (key idea)

• If Commercial Banks– increases the Reserves in CB → this will decrease the Money Supply (they can give less loans → less supply)

• If people – increases cash → this will  decrease the Money Supply (because they are taking out money from the monetary system)

• If people– increases the bank deposits→ this will increase the Money Supply (More money to lend)