Monetary Policy and Banking

I should clarify my intent. I’m writing these posts because although I am acquainted with the topic, my background is not in finance, so the idea is to have them as a reference for me to go back to and remember how banking works (or doesn’t) and the simple and universal banking mechanisms and the market imperfections driving it. This is not a series of posts on financial engineering or agency capture. I will not be rambling on about how ABCSs, CDSs, NINJAS, debt rollovers, restructurings or political corruption works.

The first post describes the channel system of monetary policy. It offers a very interesting model of the impact of central bank policy on interbanking interest rates. These in turn matter because they are the basis for the interest rates charged to you and me and to small and medium entreprises, and whoever else that does not have the ability to issue debt in financial markets. The main conclusion is that an increase in liquidity caused by QE does not necessarily have to lead to zero interest rates, due to the fact that the deposit rate creates a minimum below which interest rates cannot fall. Therefore the effect of Quantitative easing can be managed if the central bank uses a channel approach.

The second post focuses on the relationship between bankers and depositors. It describes fractional reserve lending and models bank runs with the assistance of a washed up version of the Diamond 1997 model. The rather self -evident conclusion that is reached is that if the market valuation of illiquid assets falls a lot, if the probability of a liquidity crisis increases a lot or if  the asset market shock is very high or happens with a very high probability then, depending on the size of these effects, a bank run may occur. I also discuss the ways in which this might be avoided.

The third post discusses the interaction between banks and investors. It shows how asymmetries of information can cause overinvestment or credit rationing, depending on the available liquidity in the banking sector and on the cost of investment projects.

The fourth post considers a more sophisticated approach to modelling the banking sector, known as Value at Risk (VaR). I decided to add this at the last minute, because it actually seemed like the most relevant model. VaR helps understand why banks do not decrease leverage as asset growth increases, as is the case for households. It explains, instead, how banks match any increase in asset growth with leverage, leading to procyclical movements in balance sheets (when economy is well banks expand, when economy is bad, banks buy less). It also helps to understand systemic risk in the banking sector. The post concludes with a discussion of regulatory policies and how these compare with the ones described in the post about bank runs.

The last post is purely descriptive and limited to describing the balance sheet differences and effects of Debt Monetisation, Qualitative and Quantitative Easing.

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