2.5 Summary

economic growth. In short, the average productivity of the potential projects will be

lower than it would be if the test rate were set higher (say, at the market-clearing level).

The question then is: how are lenders to allocate the limited funds? They may do it

by lending to the lowest risk projects (which are also likely to be low productivity);

they may lend ‘by name’, i.e. to borrowers with an established reputation for being

creditworthy; they may lend to rms whose owners occupy a powerful political

position and may be able to bring more business in future; or they may lend to rms

whose owners are prepared to pay bribes. From an economic viewpoint, it does not

matter much which method is used. The point is that the average productivity of the

potential projects is low and lenders have no mechanism at their disposal which is

bound to select only the few genuinely high-productivity schemes.

So, not only will the quantity of investment funds be limited, they are likely to

be channelled into relatively poor-qualityprojects. Even if the nancial repression is

well-meant (i.e. to encourage development) it is more likely to do the opposite.

2.5Summary

The nancial system and the ‘real’ economy can interact in a number of ways.

Firstly, it is in the real economy that people earn and spend incomes. Earning and

spending generates surpluses and decits, and it is a prime function of a nancial

system that it can reconcile those surpluses and decits by creating for lenders and

borrowers those assets and liabilities which most closely match their preferences for

risk and return. Secondly, in doing this job, the nancial system creates both liq-

uidity and money proper. An expanding real economy requires additional liquidity,

but it is at least theoretically possible that the nancial system can generate addi-

tional spending power, in advance of the growth of output, which has the effect of

raising the level of aggregate demand, with an effect on the price level or on output

which depends on circumstances.

Thirdly, by making lending and borrowing easier, a nancial system must also

make it cheaper. Either more funds are available at the going price (than would oth-

erwise be) or the same funds are available at a lower price. The price here is the rate

of interest. Whichever effect dominates, the result will be an increase in the level of

saving and investment. This changes the compositionof aggregate demand, and may

increase the future rate of growth of output.

Finally, regardless of the volumeof lending and borrowing which it encourages,

the nancial system may be efcient in directing the funds to their most productive

use or it may not. The system is not perfect. Not everyone knows the opportunities

available; not everyone can get access to them. The tax system is not always neutral

between different types of lending/borrowing, and government regulation, designed

to protect lenders and borrowers, may also create distortions. Furthermore, we cannot

be certain that nancial markets always price nancial assets ‘correctly’, in relation

to their fundamental values. Where this happens, the ownership of the underlying

assets may change for no good reason.

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Chapter 2 • The nancial system and the real economy

Questions for discussion

1	Distinguish between ‘saving’, ‘lending’ and a ‘nancial surplus’.

2	A nancial surplus mustresult in the net acquisition of nancial assets. Assume that you are in normal employment and that you regularly run a nancial surplus. Assume further that you make no conscious decision to buy nancial assets. What nancial assets will you inevitably acquire?

3	If your income and capital account showed that you had made a ‘negative net acquisition of nancial assets’, what would this mean in practice?

4	Using the latest available gures, nd the value of households’ net acquisition of UK ordinary company shares. How does this acquisition gure compare with the stock of ordinary company shares already held? What were the most popular assets acquired by households?

5	Outline three ways in which the behaviour of the nancial system could affect the level of aggregate demand in the economy.

6	Suppose that prices in the US stock market suffer a major collapse. What effect would you expect this to have upon the rest of the US economy and the economies of other developed countries?

7	Why does a company’s share price matter in a takeover battle? If you were the nancial director of a predator rm, what would you want to happen to your rm’s share price? Might you be able to inuence it in any way?

8	Why might nancial systems fail to allocate resources to their most desirable use?

Further reading

AD Bain, The Financial System(Oxford: Blackwell, 2e, 1992) ch. 2

M Buckle and J Thompson, The UK Financial System(Manchester: Manchester UP, 4e, 2004)

chs. 1 and 16

PGA Howells and K Bain, The Economics of Money, Banking and Finance(Harlow: Financial

Times Prentice Hall, 3e, 2005) ch. 1

PJ Montiel, Macroeconomics in Emerging Markets(Cambridge: CUP, 2003) ch. 12

AM Santomero and DF Babbell, Financial Markets, Instruments and Institutions(McGraw-

Hill, 2e, 2001) chs. 1 and 2

Answers to exercises

2.1	(a) £83.8 million (or 16.8%); (b) £7m; (c) £76.8 million.
2.2	(a) Initial velocity was 0.888; (b) it was expected to fall to about 0.870 (i.e. by about 2 per cent).

2.3	Initial average holdings of money are £2,000 and velocity is 1.0. After the change, money holdingsare £1,100 and velocity is 1.82. The loan will nance £1,636 of spending.

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CHAPTER3

Deposit-taking institutions

Objectives

What you will learn in this chapter:

lThe functions of the central bank

lThe functions of different types of commercial bank

lHow banking activity can affect the quantity of money in the economy

lHow central banks can inuence the money-creation process

lThe functions of building societies

l	How competition between deposit-taking institutions has led to the practice of ‘liability management’ and how this has made the conduct of monetary policymore difcult

There is no universally accepted method of classication where nancial intermediaries

are concerned. However, it is quite common to distinguish between deposit-taking

institutions (DTIs) and non-deposit-taking institutions (NDTIs). There are three reasons

for this. Firstly, the deposit liabilities of DTIs (or at least a large subset of them) usually

form the bulk of a country’s money supply. The quantity and growth of these deposits

are often of considerable policy interest to the government and central bank and so DTIs

are often subject to pressures and inuences which do not apply to NDTIs. Secondly,

because deposit liabilities are money, the failure of a DTI means that people lose, at

least temporarily, access to the means of payment. This can be very serious and so DTIs

are usually subject to supervision and regulation which is not applied to NDTIs. Lastly,

customers hold deposits for reasons which are rather different from the reasons which

cause them to hold other types of nancial product. For example, changes in the

quantity of bank and building society deposits which people hold are often the result

of uctuations in their income and day-to-day spending (uctuations in their ‘net

nancial surplus’) and the fact that they have long-term commitments to holding or

buying other types of nancial asset. In that sense deposit holdings are a residual and

act as a buffer, increasing when there is a surplus and declining when there is a decit.

Deposit holdings are sometimes said to be discretionarybecause people are free to make

decisions about the quantity they can hold, from day to day. By contrast, the decisions

to acquire other types of nancial asset (pension funds, life assurance, etc.) often involve

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Chapter 3

• Deposit-taking institutions Table 3.1The classication of nancial intermediaries

Banks (under the FSMA, 2000)				J		J
				Kf		K
The Banking Department of the	Bank	of	England		MFIs
				L		Kf
Building societies						DTIs
						K
Credit unions
						L
Friendly societies

Insurance companies	–	‘Life’ or long-term	J
			K
	–	‘General’
			Kf
Pension funds			NDTIs
			K
Unit trusts
			L
Investment trusts

entering into a contract which stipulates regular payments to the NDTI and the

terms on which withdrawals can take place. The ow of funds into and out of NDTIs

is therefore often described as contractual.The discretionary or contractual nature of

ows has important effects upon the way that DTIs and NDTIs behave towards their

assets. In other words, the balance sheets of DTIs and NDTIs are very different.

It should be clear from what we have just been saying that ‘DTIs’ is a phrase which

must overlap substantially with ‘banks’. Table 3.1 shows the relationship between these

terms more precisely. Note that some DTIs are notbanks. In the UK, the obvious

example is building societies. They differ from banks in their legal status and in the

regulations to which they are subject. Nonetheless, their deposits have been part of

the ofcially dened money supply since July 1989 and their clients certainly use

them in the same way that they would use banks. This means that their balance sheets

also closely resemble those of banks. Hence, it is very useful to have a category which

enables us to put banks and building societies together. We do this with the term

‘monetary nancial institutions’ or MFIs. Table 3.1 shows how banks t within the

broader category of MFIs, which in turn t within the broader category of DTIs.

Together with NDTIs, DTIs make up what we are calling ‘nancial institutions’.

Before we begin looking at any specic type of nancial institution, however, a

few further words of clarication are necessary. One consequence of the liberalisa-

tion of nancial market activity in Europe during the 1980s has been the merger of

specialist nancial institutions into conglomerates offering a wide range of nancial

services. This in turn has led non-merging rms to diversify their own activities

by setting up subsidiaries. Thus banks have taken on insurance, fund management

and market-making roles while insurance companies have become deposit-takers.

‘Bankassurance’ is a term sometimes used to describe this conglomerate activity. In

short, it is no longer possible to nd a rm which functions uniquely as a bank.

Similarly, it is impossible to nd a rm which functions uniquely as an insurer or

fund manager. Rather than thinking about different types of ‘institution’, we should

probably be thinking about different types of nancial activity, all or most of them

being hosted within a major nancial rm.

By way of illustration, Box 3.1 shows the structure and activities of the Royal Bank

of Scotland (RBS) Group in 2006.

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Deposit-taking institutions

Corporate banking
	Banking services	derivatives, forex
			money market,	market making	Corporate and
				bond and gilt
and nancial
					investment
		to rms,			banking

Ulster Bank				NI nancial
			services to
	Retail and	wholesale
			clients inNorthern
			banking	services

	banking services	Banking services
	Private banking
management	and offshore	for overseas

Wealth

Manufacturing
	Technologysupport andmechanisms
	payment
	Supportservices

	insurance via
Direct Retail
		the internet
		phone and
	Retail andwholesale
		Internetbanking

RBS Insurance		and wholesalethe telephone,intermediaries.
		insurance on
	underwrites	commercialthe internet,and throughbrokers and
	Sells and	Insurance

The RBS Group in 2006

retail,

banking activities

the northeasternUS and through

branch network

ofces in other

in 13 states in

non-branchUS banking

through its

Retail andcorporate

Citizens

states.

	nancial services
insurance and		for individuals
			UK nancial
		businesses
		and small
Banking,
banking			services
Box 3.1
Retail

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Chapter 3 • Deposit-taking institutions

In the days when banks were the only institutions whose liabilities were counted

as ‘money’, one used to be able to group the rest of the private sector (in effect, banks’

clients) as the ‘non-bank private sector’ or NBPS. Since 1989, however, when the

ofcial measure of broad money became M4 and included building society deposits,

the corresponding expression became the ‘non-bank, non-building society private

sector’! Fortunately, this has come to be shortened to ‘M4 private sector’ or M4PS.

It might loosely be translated as ‘the general public’.

In the remainder of this chapter, we shall focus on the Bank of England and then

on banks and building societies. In Chapter 4, we shall focus on the behaviour of

non-deposit-taking institutions. In both chapters we begin with descriptive material

and then move to issues of economic importance.