FINANCIAL SYSTEMS HISTORY AND THEIR ROLE Hasan Ersel

FINANCIAL SYSTEMS: HISTORY AND THEIR ROLE Hasan Ersel HIGHER SCHOOL OF ECONOMICS, MOSCOW May 20, 2011

I. HISTORY OF FINANCE IN A NUTSHELL

THE BIRTH OF FINANCE 3000 BC: Banking originated in Babylonia: Temples and palaces were used as safe places for the storage of valuables. Initially the valuable that can be deposited was only grain, but later cattle and precious materials are also included. In the Sumerian city Uruk in Mesopotamia (population 10. 000) trade was supported by lending. Interest was paid.

“INTEREST” IN ANCIENT CULTURES In Sumerian “interest” was mas, which also meant calf. In Greece and Egypt the words used for interest (tokos and ms respectively) also meant “to give birth”. In these cultures interest indicates an increase in something. They seem to consider it from lenders point of view.

EARLY STATE INTERVENTION TO FINANCE • 2250 -2150 BC: Cappadocian rulers guaranteed the weight and purity of silver ingots. • 1792 -1750 BC : Reign of Hammurabi in Babylon (the capital city of Babylonia). The famous Code of Hammurabi includes laws governing banking operations; e. g. Article 100 on the timely payment of interest. • The Babylonians, were accustomed to charge interest at the rate of 20 per cent per annum. Nearly, if not quite, all of their contract tablets show this rate of increase.

OLD TASTEMENT AND INTEREST 1300 BC: The Old Testament takes a negative attitude against interest: If you lend money to any of my people with you who is poor, you shall not be him as a creditor, and you shall not exact interest from him. “ The Old Testament-Exodus 22(25), The Bible, Standard Version, New York: William Collins, p. 67. “ 25 However the following quotation implies that taking interest is forbidden among Jews, but Jews are allowed to take interest from others (Gentile): “ 19 You shall not lend upon interest to your brother, interest on money, interest on victuals [foodstuff] interest on anything that is lent for interest. 20 To a foreigner you may lend upon interest , but to your brother you shall not lend upon interest…” The Old Testament-Deuteronomy 23(19 -20), The Bible, Standard Version, New York: William Collins, p. 176.

WHY RECEIVING INTEREST FROM GENTILE IS NOT PROHIBITED FOR JEWS? • The reason for the non-prohibition of the receipt by a Jew of interest from a Gentile, and vice versa, is held by modern rabbis to lay in the fact that the Gentiles had at that time no law forbidding them to practice usury; and that as they took interest from Jews, the Torah considered it equitable that Jews should take interest from Gentiles. • Conditions changed when Gentile laws were enacted forbidding usury; and the modern Jew is not allowed by the Jewish religion to charge a Gentile a higher rate of interest than that fixed by the law of the land.

INTEREST IN HEBREW • In Hebrew, interest is neshek. • It also means a bite… Something taken apart… • In contrast to ancient civilizations “interest is considered from borrowers point of view.

1200 BC-570 BC • 1200 BC: Cowrie shell is used as “money” in China. • 640 -630 BC: Lydians started to use coin money. Lydia was the first place where permanent retail shops opened. [Herodotus mentioned the use of crude coins in Lydia in an earlier date, i. e. 687 BC. ] • 600 BC: Pythius became identified as the first banker that had records. He was operating both in Western Anatolia and in Greece. • 600 -570 BC: Coin usage became widespread: (1) Chinese started to use coins made of base metal. The city-states (2) Aegina (595 B. C. ), Athens (575 B. C. ) and Corinth (570 B. C. ) started to mint their own coins

VIEWS ON INTEREST IN ANCIENT GREECE • 427 -348 BC: Platon in his Laws (Book V; paragraph 742) opposed receiving interest. • 405 BC: First known statement of the Gresham Law, i. e. bad money drives out good: Aristophanes’ The Frogs • 384 -322 BC: Aristotoles in his Politics (paragraph 1258) characterized interest as the most unnatural category of earning.

INTEREST AND FINANCE IN ANCIENT GREECE • 350 BC: According to Demosthenes in Greece the interest rate was 10% for ordinary business. For risky business, such as shipping, lending rates were between 20 -30%. • 200 BC: The Greek island Delos became the first financial center.

THE VIEWS ON INTEREST IN THE ROMAN EMPIRE • Leading thinkers and statesmen, such as Marcus Pocius Cato Censorius [Cato the Elder] (234 BC-149 BC) and Marcus Pocius Cato Uicensis [Cato the Younger] (95 BC-46 BC) as well as Marcus Tallius Cicero (106 BC-43 BC), Lucius Annaeus Seneca (4 BC-AD 65) and Masterius Plutarch (46 AD-120 AD) were against usury. • In Republican Rome (340 BC) interest was outlawed altogether. [Lex Genucia reforms] • Under the banner of Julius Caesar, a ceiling on interest rates of 12% was set, and later under Justinian, it was lowered even further to between 4% and 8%

JESUS CHRIST AND INTEREST 30 AD: Jesus Christ reacted against usury: “And Jesus entered the temple of God and drove out all who sold and bought in the temple and overturned the tables of the money changers and the seats of those who sold pigeons. He said to them “It is written ’My house shall be called a house of prayer’; but you make it a den of robbers. ” The New Testament-Mathew 21(12 -13), The Bible, Standard Version, New York: William Collins, p. 21.

MONETARY POLICY IN ROME • 250 AD: Silver content of Roman coins reduced down to 40%. Inflation in Rome… • 295 AD: Gresham’s Law proves itself: The almost pure silver coins issued by Aurelian were driven out by the old, impure coins… Inflation accelerates… • 301 AD: Emperor Gaius Aurelius Valerius Diocletianus (244 -311), [commonly known as Diocletian], introduced direct controls on prices and wages. This move defeated by markets… First unsuccessful incomes policy experiment!… • 305 AD: Diocletian introduced world’s first system of annual budgets to Rome…

INFLATION AND THE FALL OF ROME • 307 AD: The value of Denarii (the coin that was introduced by Diocletian in 301 AD) declined to half of its original value… One pound of gold is 100. 000 Denarii… • 324 AD: Inflation further accelerates in Rome: One pound of gold is 300. 000 Denarii… • Then towards 350 AD Denarii loses its value dramatically: one pound of gold 2 120 000 Denarii!!! • 410 AD: Rome falls to the Visigots… (No wonder why!!!)

KORAN’s ATTITUTE TOWARDS USURY AD 610 -632: Koran prohibits usury (riba): “ 2: 275 Those that live on usury shall rise before Allah like men whom Satan has demented by his touch; for they claim that usury is like trading. But Allah has permitted trading and forbidden usury…” Koran, Al. Baqara, 2: 275, translated by N. J. Dawood, Hammondsworth, Middlesex: Penguin Books, 1974, p. 363.

HINDU AND BUDDHIST VIEWS ON INTEREST-1 • Vedic texts of Ancient India (2, 000 -1, 400 BC) in which the “usurer” (kusidin) is interpreted as any lender at interest. More frequent and detailed references to interest payment are to be found • In the later Sutra texts (700 -100 BC), as well as the also made detailed references to interest. • Vasishtha, a well known Hindu law-maker of that time, made a special law which forbade the higher castes of Brahmanas (priests) and Kshatriyas (warriors) from being usurers or lenders at interest.

HINDU AND BUDDHIST VIEWS ON INTEREST-2 • In the Buddhist Jatakas (600 -400 BC), usury is referred to in a demeaning manner: “hypocritical ascetics are accused of practicing it”. • By the 2 nd century AD, however, usury had become a more relative term, as is implied in the Laws of Manu of that time: “Stipulated interest beyond the legal rate being against (the law), cannot be recovered: they call that a usurious way (of lending)” • The dilution of the concept of usury seems to have continued through the remaining course of Indian history so that today, while it is still condemned in principle, usury refers only to interest charged above the prevailing socially accepted range and is no longer prohibited or controlled in any significant way.

FINANCIAL INNOVATIONS: PAPER MONEY and FOREIGN EXCHANGE CONTRACT • 806 -821 AD: In China, Emperor Hien-Tsung is reigning… Shortage of copper causes emperor to issue paper money… Chinese liked the idea. • In 1032 AD there were 16 note-issuing houses in China. Paper money increased so much that in 1166 China went into hyperinflation…. In 1455 China abandoned paper money. • 1156: First foreign exchange contract: two brothers borrowed 115 Genoa pounds and agreed to pay 560 bezants in Constantinople one month after their arrival to the that city.

INTEREST IN CHRISTIANITY-1 • The Church, declared any extra return upon a loan as against the divine law, and this prevented any mercantile use of capital by pious Christians. • As the canon law 1 did not apply to Jews, these were not liable to the ecclesiastical punishments which were placed upon usurers by the popes • ------------1 Canon law is the body of laws and regulations made by or adopted by ecclesiastical authority, for the government of the Christian organization and its members. It is the internal ecclesiastical (of or relating to the Christian Church or its clergy) law governing the Roman Catholic Church, the Eastern and Oriental Orthodox Churches and the Anglican Communion Churches

INTEREST IN CHRISTIANITY-2 • Pope Alexander III, in 1179, having excommunicated all manifest usurers. • Christian rulers gradually saw the advantage of having a class of men like the Jews who could supply capital for their use without being liable to excommunication, and the money trade of western Europe by this means fell into the hands of the Jews.

EARLY MODERN BANKING IN EUROPE • Banking in the modern sense of the word can be traced to medieval and early Renaissance Italy, to the rich cities in the north like Florence, Venice and Genoa. • The Bardi and Peruzzi families dominated banking in 14 th century Florence, establishing branches in many other parts of Europe.

MEDIEVAL BANKING IN EUROPE • 1151 The first bank in Venice was established. • 1255, Orlando Bonsignori formed a consortium called the Gran Tavola ("Great Table"), which soon became the most powerful bank in Europe. • 1345 first bank was established in Geneva • 1397 The Medici Bank (1397– 1494) was created by the Giovanni Medici in Florance, Italy.

XVth CENTURY DEVELOPMENTS IN FINANCE (1) • 1401: Bank of Barcelona founded. • 1403: The lawyer and theologian Lorenzo di Antonio Ridolfi won a legal case which led to legalization of the interest payments by the Florentine government. • 1407: Fugars Bank is founded in Augsburg. • 1407 The earliest known state deposit bank, Ufficio di San Giorgio in Genoa (Casa di San Giorgio) was established as a financial institution of the Republic of Genoa

XVth CENTURY DEVELOPMENTS IN FINANCE (2) • 1444: Fatih Sultan Mehmet’s debasement of “akçe”. He was the first Ottoman Sultan who used debasement to raise public revenue. [see Pamuk (1999; Chapter III)] • 1472 Monte dei Paschi di Siena was established in Siena, Italy. (Still Operating) • 1494: First book on double entry bookkeeping is published in Italy: It is Friar Luca Pacioli’s Summa di Arithmetica, Geometrica, Proportioni et Proportionalita…

XVIth CENTURY THOUGHT ON FINANCE-1 • 1515: John Egk from Bologna University published a thesis that advocated the freeing certain types of interest. His research financed by the rulers of Augsburg was competing with Florence in controlling trade in that region. Egk was a student of Conrad Summenhart who advocated the abandonment of Aristotoles’ views on interest. • 1526: Nicholas Copernicus published his Treatise on Debasement. He argued that the buying power of currency depends on the total number of coins in circulation rather than the weight of metal they contain.

XVIth CENTURY THOUGHT ON FINANCE-2 • 1536: John Calvin ended the discussion on prohibiting interest by arguing that “If I buy a piece of land, isn’t it still true that money will bear money? ” • [NOTE: Obviously any scholastic can challenge this idea by pointing out that, what bears money is the land labor not money. John Calvin, anyway, won the case -not because of his intellectual superiority but because of the support he got from traders and his followers military superiority] .

XVIth CENTURY DEVELOPMENTS • 1542 -1551: Henry VIII debases the coinage of England • 1545: Henry VIII legalizes interest charges on loans (An upper limit of 10% per annum is set) • The first English joint stock company is founded • Queen Elisabeth I recalled the debased coins. • 1585: Bank of Genoa founded • 1587: Banco della Piazza del Rialto, first government bank in Europe, founded • 1590 Barenbank was established in Hamburg (Still operating)

XVIIth CENTURY-1 • 1615: Sir Lionell Cranfield and Mr. Wolstenholme made the first balance of trade and balance of payments calculations for England. • 1661: Bank of Stockholm issued banknotes and became first chartered bank in Europe to do so. • 1668: Swedish Parliament established world’s first central bank: Rikens Ständers Bank (today known as Svierges Riksbank).

XVIIth CENTURY-2 • 1682: Sir William Petty published Quantulumcuque Concerning Money that argues development of banking is a major stimulus to the English economy and world trade. • 1694: Bank of England is established as a quasicentral bank.

XVIIIth CENTURY-1 • 1705: John Law published Money and Trade Reconsidered and advocated the view that the banknotes issued and managed by a public bank would remove the brakes on the economy… • 1729: Benjamin Franklin published Modest Inquiry into Nature and Necessity of Paper Currency. Following that publication, he was awarded the contract for printing Pennsylvania Land bank’s third issue of notes.

XVIIIth CENTURY-2 • 1762: Baring Bank was founded (When it went bankrupt after a scandal in 1995, it was the oldest merchant bank in Britain) • 1768: Catherine the Great of Russia established two state owned banks to finance the war against Ottomans. The Assignat Bank was entrusted to issue paper money. • 1776: Adam Smith, in his famous book The Wealth of Nations defended paper money on the ground that it stimulated business in Scotland American colonies. • 1781 The first American bank, Bank of North America, was founded. • 1792: The Dollar is adopted as the money unit in the United States.

XIXth CENTURY-1 • 1800: Bank de France established as the central bank of France. • 1856: Bank-ı Osmani (Ottoman Bank) established. • 1857: World wide banking crisis started in the USA (contagion problem) • 1863: Bank-ı Osmanii Şahane started to play the role of a central bank • 1873: The Great Depression in Britain (Continued until 1885)

XIXth CENTURY-2 • 1875: Deutsche Reichsbank is established as Germany’s central bank. • 1882: Nippon Ginkō (Bank of Japan) was established as Japan’s central bank. • 1886: Ziraat Bankası was established. (Although the date for the establishment of the Ziraat Bankası is given as 1863 it is not exactly correct. That date refers to the establishment of Menafi Sandıkları, which were rather simple credit institutions for farmers. ) • 1890: (First) Baring Bank crisis in England, Uruguay and Argentina.

FIRST HALF OF XXth CENTURY-1 • 1913: U. S. Federal Reserve System was established. • 1923: Inflation in Weimar Germany reached to 3, 25 x 106 %! • On November 15, 1923 Rentenbank introduced a new currency, Rentenmark (Security Mark), which was equal to 1. 1 trillion Papiermarks. The Papiermark was pegged to US Dollar with a parity of one US$ = 4, 2 trillion Papiermarks! (It even climbed up to 11, 7 trillion papiermarks in French occupied Cologne)]

FIRST HALF OF XXth CENTURY-2 • 1924: Reichmark became the legal tender in Germany • 1924: Türkiye İş Bankası was established. • 1929: Great Depression • 1930 Bank of International Settlements (BIS) was founded • 1931: On October 3, Türkiye Cumhuriyet Merkez Bankası became operational.

POST II. WW DEVELOPMENTS-1 • 1944: Bretton Wood international monetary agreements. • 1947: International Monetary Fund became operational. • 1971: United States devalues dollar and gold convertibility for all currencies ends. • 1973: The US abandons the gold standard • 1979: European Monetary System created

POST II. WW DEVELOPMENTS-2 • • 1982: Mexican Debt Crisis 1985: Savings and Loan Association Crisis 1991: BCCI scandal- biggest banking fraud 1992: Maastrich Treaty 1994: Financial Crisis in Turkey 1995: Barings Bank fails for a second time. 1997: East Asian Financial Crisis

LAST DECADE-1 • 1998: Russian Financial Crisis • 1999: Eleven European countries introduced Euro as an accounting currency • 2001: Turkish Financial Crisis • 2002: Euro banknotes and coins are launched

LAST DECADE-2 • 2005: China emerged as a major player in the global financial system • 2006: Problems in the US Mortgage Market • 2007: US Mortgage Crisis and Recession • 2008 -? : Global Economic Crisis

ON THE DANGERS OF BANKING! "I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. “ Thomas Jefferson 1802

MACROFINANCIAL SYSTEM-1 Goods Market Goods Expenditure Households Firms Factors Market Labor Wages

II. THE ROLE OF THE FINANCIAL SYSTEM

MACROFINANCIAL SYSTEM-2 Goods Market Goods Expenditure Households Firms Factors Market Labor Wages Savings Investment

MACROFINANCIAL SYSTEM-3 Goods Market Goods Expenditure Households Firms Factors Market Labor Wages Savings Investment Financial System

STRUCTURE OF THE FINANCIAL SYSTEM Financial Markets Households Firms Banks

COMPONENTS OF FINANCIAL SYSTEM 1. Money To pay for purchases and store wealth 2. Financial Instruments To transfer resources from savers to investors and to transfer risk to those best equipped to bear it. 3. Financial Markets 4. Financial Institutions. Buy and sell financial instruments Provide access to financial markets, collect information & provide services 5. Central Banks Monitor financial Institutions and stabilize the economy

FINANCIAL MARKETS • Markets in which funds are transferred from people who have an excess of available funds to people who have a shortage of funds.

FUNCTIONS OF FINANCIAL MARKETS • Perform the essential function of channeling funds from economic players that have saved surplus funds to those that have a shortage of funds • Promotes economic efficiency by producing an efficient allocation of capital, which increases production • Directly improve the well-being of consumers by allowing them to time purchases better

STRUCTURE OF FINANCIAL MARKETS • Debt and Equity Markets • Primary and Secondary Markets – Investment Banks underwrite securities in primary markets – Brokers and dealers work in secondary markets • Centralized vs. and Over-the-Counter (OTC) Markets • Money and Capital Markets – Money markets deal in short-term debt instruments – Capital markets deal in longer-term debt equity instruments and

THE BOND MARKET AND THE INTEREST RATE • A security (financial instrument) is a claim on the issuer’s future income or assets • A bond is a debt security that promises to make payments periodically for a specified period of time • Interest rate is the cost of borrowing or the price paid for the rental of funds

THE STOCK MARKET • Common stock represents a share of ownership in a corporation • A share of stock is a claim on the earnings and assets of the corporation

INTERNATIONALIZATION OF FINANCIAL MARKETS • Foreign Bonds—sold in a foreign country and denominated in that country’s currency • Eurobond—bond denominated in a currency other than that of the country in which it is sold • Eurocurrencies—foreign currencies deposited in banks outside the home country – Eurodollars—U. S. dollars deposited in foreign banks outside the U. S. or in foreign branches of U. S. banks • World Stock Markets

THE FOREIGN EXCHANGE MARKET • The foreign exchange rate is the price of one currency in terms of another currency • The foreign exchange market is where funds are converted from one currency into another and the foreign exchange rate is determined.

BANKING AND FINANCIAL INSTITUTIONS • Financial Intermediaries—institutions that borrow funds from people who have saved and make loans to other people • Banks—institutions that accept deposits and make loans • Other Financial Institutions—insurance companies, finance companies, pension funds, mutual funds and investment banks • Financial Innovation—in particular, the advent of the information age and e-finance

FUNCTION OF FINANCIAL INTERMEDIARIES: INDIRECT FINANCE • Lower transaction costs – Economies of scale – Liquidity services • Reduce Risk – Risk Sharing (Asset Transformation) – Diversification • Asymmetric Information – Adverse Selection (before the transaction)—more likely to select risky borrower – Moral Hazard (after the transaction)—less likely borrower will repay loan

WELL KNOWN (!) “CORE PRINCIPLES” FROM MICROECONOMICS 1. 2. 3. 4. Time has value Risk requires compensation Information is the basis for decisions Markets determine prices and allocation of resources 5. Stability improves welfare

TIME HAS VALUE – Time affects the value of financial instruments – Interest payments exist because of time properties of financial instruments

RISK REQUIRES COMPENSATION – In a world of uncertainty, individuals will accept risk only if they are compensated in some form.

INFORMATION IS THE BASIS FOR DECISIONS – The collection and processing of information is the basis of foundation of the financial system. – Information Theory and Economics: Ø John Maynard Keynes/Frank Knight Ø Kenneth. J. Arrow Ø Joseph E. Stiglitz/Michael Spence/Geoge Akerlof Ø Claude Elwood Shannon/Christopeher Sims

MARKETS DETERMINE PRICES AND ALLOCATE RESOURCES Ø Markets are “places” where buyers & sellers “meet”. Ø In a market based system prices (as well as quantities) are determined by markets. Therefore markets allocate resources.

STABILITY IMPROVES WELFARE Ø A stable economy is believed to reduce risk. Lowering risk may lead to an improvement in everyone's welfare. Ø Is the competitive market mechanism stable? Kenneth J. Arrow, Leonid Hurwicz, Frank Hahn et. al. ’s contributions: What they really show? Stability of the competitive equilibrium or its general instability? )

MONEY

MONEY AND THE PAYMENTS SYSTEM 1. What is money? 2. How do we use money? 3. How do we measure money?

DEFINITION OF MONEY Money is an asset that is generally accepted as payment for goods and services or repayment of debt.

MONEY: CHARACTERISTICS 1. Means of payment: Used in exchange for goods & services 2. Unit of account: Used to quote prices 3. Store of value: Used to move purchasing power into the future

HOW WE PAY FOR THINGS-1 • Commodity Money: Objects with intrinsic value • Fiat Money: Value comes from government decree (or fiat) • Checks: Instructions to the bank to shifts funds from your account to that of the person or firm whose name is written in the “Pay to the Order of” line.

HOW WE PAY FOR THINGS-1 • • • Credit Cards Debit Cards Electronic Funds transfers: Stored Value Cards E-Money

CREDIT AND DEBIT CARDS • Credit cards: – Deferred payment – Issuer makes payment for you – You have to pay it back • Debit cards: – Like a check – Electronic message to your bank to transfer funds immediately

THE FUTURE OF MONEY Question: Which function of money will be with us for a long time? Answer: – Means of payment: disappearing – Unit of account: likely to remain – Store of value: disappearing

TECHNOLOGICAL ADVANCES AND PAYMENT METHODS • Technological advances create new methods of payment. • Cell phones and other types of hand-held mobile devices are providing access to the payments system. • What will be next?

MEASURING MONEY • Changes in the quantity of money are related to – Interest Rates – Economic Growth – Inflation • How do we measure money?

DEFINITION OF LIQUIDITY Liquidity a measure of the ease an asset can be turned into a means of payment (Money).

THE LIQUIDITY SPECTRUM

MEASURING MONEY Different Definitions of money are based upon degree of liquidity. M 1: Narrowest definition, only most liquid assets M 1 (TURKEY)= Currency in Circulation + Sight Deposits M 2: Broader definition , includes assets, in general, not used as means of payment. M 2 (TURKEY)= M 1+ Time Deposits

MONEY AND BUSINESS CYCLES • Evidence suggests that money plays an important role in generating business cycles • Recessions (unemployment) (inflation) affect all of us and booms • Monetary theory ties changes in the money supply to changes in aggregate economic activity and the price level

INFLATION • Inflation: The rate at which the general price level is increasing over time • Inflation rate: The measure of the inflation process

MONEY AND INFLATION • The general (aggregate) price level is the average price of goods and services in an economy • Question: Asset prices? • A continual rise in the price level (inflation) affects all economic players • Data shows a connection between the money supply and the price level

CONSUMER PRICE INDEX (CPI) • The CPI answers the question: "How much more would it cost for people to purchase today the same basket of goods and services that they actually bought at some fixed time in the past? “

MONEY AND INTEREST RATES • Interest rate is the price of money • In the USA prior to 1980, the rate of money growth and the interest rate on long-term Treasury bonds were closely tied • Since then, the relationship is less clear but still an important determinant of interest rates

MONETARY AND FISCAL POLICY • Monetary policy is the management of the money supply and interest rates – Conducted by the TCMB in Turkey [by the Federal Reserve Bank (Fed) in the USA] • Fiscal policy is government spending and taxation – Budget deficit is the excess of expenditures over revenues for a particular year – Budget surplus is the excess of revenues over expenditures for a particular year – Any deficit must be financed by borrowing

III. WHAT IS A BANK? A CLOSER LOOK

What is robbing a bank compared to founding one. .

Bertold Brecht (1898 -1956)

BANK CONCEPT IN A NUTSHELL A Bank is an institution whose current operations consist in granting loans and receiving deposits from the public.

ANALYSIS OF THE DEFINITION i) “Current”: “Temporary Landing is not counted” ii) “and”: Mutual Funds only collect “deposits”, they do not extend loans, instead they hold portfolios, “finance companies” only lend by issuing equity or debt instruments. iii) “public”: Service is given to “general public” and not to specialists.

BANKING FUNCTIONS I. Liquidty and Payment Services i) Money Changing ii) Payment Services II. Asset Transformation i) Convenience of Denomination (unit size) ii) Quality Transformation (better risk return characteristic) iii) Maturity Transformation III. Managing Risk i) Estimating Risk on Bank Loans ii) Managing Interest Rate and Liquidity Risk iii) Off-Balance Sheet Operations IV. Monitoring and Information Processing

BANKS AND THE REAL ECONOMY • Do banks really play an important role in an economy? Are banking services indispensable? • In order to answer this question one needs to formulate the working mechanism for an economy and examine the role of banks in it. • The general equilibrium approach to the market economy may serve the purpose. • This approach was initiated by Leon Walras (1834 -1910) and became a major tool of economists after the contributions made, notably, by Kenneth J. Arrow & Gerard Debreu in early 1950 s.

Leon WALRAS (1834 -1910)

Kenneth ARROW (1921)

Gerard DEBREU (1921 -2004)

ARROW-DEBREU ECONOMY 1) Consider a two period, competitive economy with three type of agents: i) consumers, ii) firms and iii) banks. 2) Suppose that there is one physical good which is initially owned by households. Households can consume part (or all) of it in the first period or it can be invested by firms to produce consumption in the second period. 3) Firms finance their investments either by issuing bonds (Bf) or through loans (credits) from banks (L-) (Loan Demand). 4) Banks finance their loans (L+) (Loan Supply) by collecting deposits (D-), or issuing bank bonds, (Bb). 5) Households hold their savings (S) either in the form of bonds (Bh) or deposits (D+) (Deposit Supply).

MARKETS IN AN ARROW-DEBREU ECONOMY In this economy there are four markets: 1) Goods Market (Equilibrium Condition: I=S) 2) Deposit Market (Equilibrium Condition: D+= D-) 3) Loan (Credit) Market (Equilibrium Condition L+= L-) 4) Financial Market (Equilibrium Condition Bh= Bf+Bb) In the (Walras-) Arrow-Debreu framework the general equilibrium of an economy is achieved when all four markets are in equilibrium.

Financial Markets Bh Bf Bb Households Firms L+ D+ Banks D- L-

CONSUMER-1 Consumer maximizes her utility by allocating her savings (S) between securities (Bh) and bank deposits (D+).

CONSUMER-2 • Consumer’s instruments are bonds and deposits. • Her problem is to maximize her utility. • She will determine optimum levels of bonds and deposits, given her initial wealth, interest rates and profits she expects to get at time 2.

CONSUMER-3

FIRM-1 The firm chooses its investment level (I) and its mode of financing; i. e. by bank credit (L) or through issuing securities Bf. The firm’s problem is, then, can be formulated as:

FIRM-2

BANK-1 • Bank determines its credit volume (L+), and finances it through collecting deposits (D-) or issuing securities (Bb).

BANK-2 • Substituting (1) and (11) into (9) and taking derivatives with respect to D- and Bb, the following two equations are obtained:

EQUILIBRIUM • • • By definition in equilibrium all markets clear, i. e. I=S (Goods market) D+=D- (Deposit market) L+=L- (Credit market) Bh= Bf +Bb (Financial market) Consider the profit function of a bank in equilibrium. Using (4) and (8) and equilibrium conditions one gets that is in equilibrium, bank profit is zero!

BANKS IN AN ARROW-DEBREU ECONOMY: CONCLUSION • Moreover, notice that bank decisions have no impact on other agents, since: 1) Consumers are indifferent between making deposits and holding securities; 2) Firms also do not make any distinction between financing themselves by bank credit or through issuing bonds. • Are banks useless?