1.1 Financial institutions

her additional deposit into something else (new books, perhaps), the new deposit is

not destroyed. It passes to the bookshop, as a bankdeposit. It cannot escape (unless

the recipient chooses to exchange some of it for notes and coin, which simply increases

the quantity of money in another way). The deposit created by the loan stays on the

collective balance sheet of the banking system. If only one bank lends, of course there

is no guarantee that the deposit stays on itsbalance sheet, but if all banks expand

their lending, then all banks receive corresponding additional deposits. Collectively,

therefore, an expansion of bank loans (assets) is automatically accompanied by the

creation of deposits (liabilities).

This is not true for other nancial intermediaries. Imagine that a life assurance

company were prepared to make me a loan. It creates a loan for me by lending me

some of its bank deposits. When I draw on that loan I pass what were the life com-

pany’s deposits to someone else, and that someone else is most unlikely to be another

life company. For the loan to create a matching liability for the life company, I should

need to borrow from the life company in order to buy a life policy from them. This is

not impossible, but it is unlikely and very far removed from the fact that a borrower

from a bank has virtually no alternativebut to ‘redeposit’ the loan somewhere in the

banking system.

Secondly, and much simpler to understand, even if I did use my life company

loan to buy a policy and expand the life company’s business, what is expanded

is the total number of life insurance policies. And life insurance policies, while they

are certainly nancial assets and have some degree of liquidity, are certainly not

money.

We deal with banks, and their ability to create money, at some length in section 3.3.

1.1.4Portfolio equilibrium

Another characteristic which nancial institutions of all kinds have in common is

the need to arrange their portfolios of assets and liabilities so as to maximise some

objective – usually, we assume, prot. As private sector rms they will be motivated by

prot. At any given volume of business, therefore, it follows from this that rms will

be looking to minimise their costs and maximise their revenue. Costs for nancial

institutions include staff, premises and the cost of attracting deposits. Revenue comes

from interest, dividends and other income from their assets, together with other

charges which they make to users of the services they provide. We want here to

consider the implications of this for the management of institutions’ balance sheets.

Portfolio:A collection of assets (or liabilities).

On the deposit side, they will be looking to borrow as cheaply as they can. This is

not necessarily the same thing as borrowing at the lowest rate of interest, however.

Some very low- or even zero-interest deposits may have substantial costs attached to

them if they are held in accounts which themselves are expensive to service. People

hold non-interest-bearing sight deposits with banks, for example, but the deposits

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Chapter 1 • Introduction: the nancial system

are paid for by the banks via the cost of the money transmission and other services

that go with such accounts.

Attempts to minimise the costs of deposits take many forms. For example, nancial

institutions are often willing to pay marginally higher interest rates on ‘whole-sale’

deposits, say sums of over £100,000, on the grounds that the cost per pound

attracted is ultimately less than would be the case if the £100,000 were attracted

in several small amounts. This results from the administrative costs of ‘servicing’

customer accounts, even where these are time deposits involving no cheque book

or other facilities.

Another example is a variation on the practice of ‘price discrimination’. Some-

times, rms calculate that it is worth paying a higher rate of interest in order to

attract marginal deposits, provided that the higher rate is conned largely to those

marginal deposits alone and does not have to be paid on all those deposits they

already have. Thus they offer a higher rate on a new type of account offering in effect

a new product. The new product has rules and other features which differentiate

it slightly from existing products, and rms hope the different features, combined

with depositors’ inertia, will prevent a large-scale switch out of existing deposits into

the new, higher-yielding ones.

On the asset side of the balance sheet rms will be looking to maximise revenue.

Other things being equal, rms will prefer to hold assets with high yields to those

with low. Later, in Table 3.3, we shall see for example that a large proportion of

bank assets take the form of advances or loans to the public. By comparison, their

holdings of other assets are very small indeed. This reects the fact that the yield

on advances is comparatively high. Borrowers are likely to have to pay interest of

between 1 and 4 per cent more than banks themselves pay for wholesale deposits.

By comparison the current yield on ‘investments’ is likely to be very close to whole-

sale deposit rates while notes and coin and deposits at the Bank of England yield

nothing at all.

In the circumstances, it seems sensible to ask why institutions bother to hold low-

or zero-yielding assets at all. The answer introduces a general principle which plays

a part in the behaviour of all nancial institutions and of lenders and borrowers.

This is that while they will be looking to hold assets which yield a high income,

they will also want to hold some assets at least which can be turned very quickly

into money should they have to meet an unexpected demand for withdrawals by

depositors. Unfortunately, the more liquid an asset, the lower its yield is likely to

be. There is thus a trade-off involved, and people will be looking all the time for

an ‘optimum’ mixture of assets and liabilities where ‘optimum’ means balanced

for liquidity and yield or, as it is more frequently put, balanced for risk and return.

When people are holding their preferred distributions of assets and liabilities, their

portfolios are said to be in equilibrium. The idea that portfolios are generally in

equilibrium and that disturbances are very quickly accommodated is important in

understanding the voluntary behaviour of agents. It is also crucial to an understand-

ing of how the authorities try to inuence the behaviour of agents (for monetary

policy purposes, for example). For both these reasons we shall be looking in more

detail at the structure of institutions’ portfolios in Chapters 3 and 4.

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