3.6 Liability management

bank advances. In some cases this made bank borrowing seem preferable to using

accumulated savings. As a result of what we might call the rise in money’s own rate,

therefore, both the demand for bank borrowing andthe demand for money increased.

Both of these trends were associated with the fall in velocity of M3 in the early 1980s

which led to the end of broad money targeting in 1985.

The second consequence of liability management was that money’s own rate came

to be more market-related. Thus, when the authorities raised (for example) short-

term interest rates, money’s own rate went up more or less in step. The implications

of this for monetary control were profound, since controlling the growth of bank

lending and the money supply by changing the level of ofcial interest rates relies

heavily upon being able to change relativeinterest rates. Consider again what we said

in sections 3.4.1 and 3.4.2 about constraints on bank lending. To reduce the ow

of new loans (and new deposits), the central bank raises its ofcial dealing rate and

banks raise the rates they charge (and pay) to customers. In section 3.4.1, we noted

that this should reduce the demand for new loans since the rate of interest is the

‘price’ of the loan. However, the demand for new loans will be reduced much more

sharply if the rate charged on loans rises not just in an absolute sense but relativeto

the rate paid on deposits. If this happens, people will be more inclined to nance their

spending by the use of existing deposits than by taking out new loans. Furthermore,

if the rate on non-money assets (bonds, bills, etc.) increases along with the loan

rate, non-money assets become more attractive than deposits at the margin. This

causes people to be more willing to buy bonds (than hold money – we move now to

section 3.4.2). But bonds which many of us hold as assets are issued by rms and

government as a means of borrowing. Borrowing by selling new bonds to an eager

public is a partial alternative to borrowing from banks. Thus, not only do bank loans

become dearer, non-bank nance becomes easier to get. Two forces act to reduce

the demand for new loans (and the ow of new deposits). Notice how a change in

the demand for moneyaffects the supply of non-bank nance. But it happens only if

interest rates on loans and on non-money assets change, while money’s own rate stays

unchanged (or changes only slightly or with a long delay). If liability management

leads to money’s own rate being very exible, an increase in interest rates has com-

paratively little effect on the demand for loans (and the creation of new deposits).

Liability management, and the inability to manipulate relative interest rates, was one

of the developments behind the decision to abandon monetary targets in 1985.

Like most nancial practices, liability management is a worldwide phenomenon

and like many nancial practices it has often been encouraged by regulations which

deposit-taking institutions have found irksome. In the US, for example, the Federal

Reserve imposes mandatory reserve ratios on bank deposits, the ratios varying between

different types of deposit. For obvious reasons, sight deposits carry the highest reserve

requirement while time deposits carry a lower requirement, diminishing as the term

of the deposit lengthens. Recall that we noted earlier the desire of banks to hold

the minimum of reserves, since reserves are not interest-earning. Clearly in the US

system it would suit banks to encourage customers to hold time rather than sight

deposits. The problem with this from the customer’s point of view is that she needs

sight deposits in order to make payments, and from the bank’s point of view this

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Chapter 3 • Deposit-taking institutions

poses a problem in that the extra interest which will have to be paid to induce

her to manage with fewer sight deposits will reduce the prots available from being

able to switch reserves to income-earning use. The ‘sweep account’ is the answer.

Under this arrangement a customer holds both a sight and time deposit and both

are monitored continuously by a computer program which automatically sweeps any

surplus sight deposits into the time deposit account and can be set if necessary to

sweep the whole of the sight deposit account into the time deposit account overnight.

On average, therefore, the customer holds, and the bank is liable for, a lower level of

sight deposits, and funds that would otherwise be non-interest-earning reserves can

be switched to more protable use.

While prot can be earned from nancial innovation, which means while there

is competition between nancial institutions and while governments and central

banks impose regulations on nancial activity, liability management seems bound

to continue.

Questions for discussion

1	Distinguish between deposit-taking and non-deposit-taking institutions and explain the difference between ‘discretionary’ and ‘contractual’ saving.

2	Explain what is meant by the ‘M4 private sector’. What is the relevance of this concept to the denition of ‘broad money’?

3	Distinguish between M0 and M4.
4	Why might conicts arise between some functions of the central bank?

5	Distinguish between ‘mandatory’ and ‘prudential’ reserve ratios. Using a simplied balance sheet, show how (a) the stock of money and (b) the reserve ratio of the com- mercial banking system are affected by an expansion of bank loans.

6	Explain what is meant by ‘lender of last resort’ and show how this role enables the central bank to inuence the level of short-term interest rates.

7	How does a rise in interest rates affect the ow of new loans and the creation of new deposits?

8	Give a brief account of the base–multiplier model of money supply determination.

9	Compare and contrast (a) the functions and (b) the balance sheets of banks and build- ing societies.

Further reading

A Alesina and LH Summers, ‘Central bank independence and macroeconomic performance’,

Journal of Money, Credit and Banking, 25 (2), 1993, 151–62

R Bade and M Parkin, ‘Central bank laws and monetary policy’, Department of Economics,

University of Western Outario, 1985, mimeo

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Answers to exercises

Bank of England, The Bank of England, Bank of England Fact Sheet, August 1998 (also available

at the Bank’s web site)

Bank of England, ‘The Bank of England Act’, Bank of England Quarterly Bulletin, 38 (2), May 1998

(also available at the Bank’s web site)

Bank of England, ‘The transmission mechanism of monetary policy’, Bank of England Quarterly

Bulletin, 39 (2), May 1999 (also available at the Bank’s web site)

Bank of England, ‘Reform of the Bank of England’s operations in the sterling money markets’,

Bank of England Quarterly Bulletin, 44 (2), Summer 2004 (also available at the Bank’s web site)

CR Bean and N Jenkinson, ‘The formulation of monetary policy at the Bank of England’, Bank

of England Quarterly Bulletin, 41 (4), November 2001 (also available at the Bank’s web site)

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

chs. 3–5

A Budd, ‘The role and operations of the Bank of England Monetary Policy Committee’, The

Economic Journal, 108 (451), November 1998, 1783–94

A Cukierman, ‘Central bank independence and monetary control’, Economic Journal, 104 (427),

November 1994, 1437–48

CAE Goodhart, ‘What should central banks do? What should be their macroeconomic

objectives and operations?’, Economic Journal, 104 (427), November 1994, 1424–36

CAE Goodhart, The Central Bank and the Financial System(Basingstoke: Macmillan, 1995)

V Grilli, D Maciandaro and G Tabellini, ‘Political and public nance policies in the industrial

countries’, Economic Policy, 13, October 1991, 341–76

PGA Howells and K Bain, The Economics of Money, Banking and Finance: A European Text

(Harlow: Financial Times Prentice Hall, 3e, 2005) chs. 3 and 12

http://www.bankofengland.co.uk

http://www.dmo.gov.uk

http://www.fsa.gov.uk/bank

http://www.apacs.org.uk

Answers to exercises

3.1	(a)1,000 1,000 1,000 500 3,500. (b)50/1,000 5%; 150/3,000 5%. (d)10. (e)A: 40/1,000 4%; B: 55/1,005 5.47%; C: 55/1,005 5.47%; Agg: 150/3,010 4.98%.(f)1,010 1,010 1,010 500 3,530. (g)50/1,010 4.95%. (h)150/3,030 4.95%.

3.2	(a)Initially, (50/1,000 0) (300/1,000 0) (200/1,000 5) (150/1,000 6) (50/1,000 4)  (250/1,000 7) 3.85%. (b)Afterwards, (50/1,000 0) (300/1,000 3) (200/1,000 5) (150/1,000 4) (50/1,000 4) (250/1,000 7) 4.75%.

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Appendix to Chapter 3

A history of UK monetary

aggregates

Name	Components	First	Discontinued	Targeted
		published

DCE	Changes in £ bank	Dec. 1972	March 1986	1967–9
(domestic credit	lending to the NBPS1			1976–9
expansion)	£ bank lending to the
	public sector

M0	Notes and coin in	June 1981	1984–present
(wide monetary	circulation banks’
base)	operational balances

NIBM1	Notes and coin in	June 1975	Feb. 1991
(non-interest	circulation NBPS
bearing M1)	non-interest bearing £
	bank sight deposits

M1	NIBM1 NBPS interest	Dec. 1970	July 1989	1982–4
	bearing £ sight bank
	deposits

M2	NIBM1 NBPS interestSept. 19822 bearing retail £ deposits with banks and building societies National Savings ordinary accounts

M3		March 19773	July 1989	1976–86
	M1 NBPS £ bank time
(£M3 until May 1987)	deposits NBPS holdingsof £ CDs with banks

M3c	M3 NBPS foreign
(M3 until		Dec. 19703	July 1989
	currency bank deposits

May 1987)

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A history of UK monetary aggregates

Name	Components	First	Discontinued	Targeted
		published

PSL1	M3 NBPS £ bank time	Sept.	1979	May	1987
	deposits original maturity
	2yrs NBPS holdings of
	bank bills, treasury bills,
	local authority deposits
	and certicates of tax
	deposits

PSL2	PSL1 NBPS building	Sept. 1979	May 1987	1982–4
	society £ deposits
	(excl. term shares) 
	short-term National
	Savings instruments

M4	M3 NBPS building	May	1987
	society £ shares, deposits
	and CDs – building
	society holdings of bank
	deposits, CDs and notes
	and coin

M4c	NBNBSPS4bank	May 1987	May 1991
	M4
	and building society foreign currency deposits

M3H	M4c publicAugust 1992 corporations’ holdings of bank and building society foreign currency deposits

M5	M4 NBPS holdings of	May	1987	May	1991
	bank bills, treasury bills,
	local authority deposits
	and certicates of tax
	deposits short-term
	National Savings
	instruments – building
	society holdings of bank
	deposits. CDs and notes
	and coin

Notes:

¹NBPS non-bank private sector.

²Not to be confused with an earlier M2 aggregate (Dec. 1970–Dec. 1971) which was midway between

M1 and M3 in the range of deposits included.

³M1 and M3 included public sector £ bank deposits until March 1984.

⁴NBNBSPS Non-bank non-building society private sector (‘M4 private sector’).

Source:Bank of England Quarterly Bulletin, various issues.

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CHAPTER4

Non-deposit-taking institutions

Objectives

What you will learn in this chapter:

l	What services are provided by each of the main categories of non-deposit-taking intermediary

l	What assets are held by each
l	The comparative size of each as measured by total assets and inows of funds
l	Where they directed their funds in 2004/5

l	How some NDTIs have become involved recently in a number of controversial issues

At the beginning of Chapter 3, we divided nancial institutions into two groups: those

whose liabilities were largely deposits (DTIs) and those whose liabilities took some

other form (NDTIs). In this chapter we devote sections 4.1–4.4 to an examination

of each of the major types of non-deposit-taking institution. We shall describe the

services offered by each NDTI, look at its balance sheet, and explain the regulatory

framework to which it is subject. Remember, as we said in the opening to Chapter

3, that ‘nancial institution’ does not correspond to ‘nancial rm’; a particular type

of nancial institution is better understood as a particular type of nancial activity

undertaken by a specialist subsidiary of a large nancial corporation which may be

engaged in a wide variety of activities.

We are familiar (since Chapter 2) with the distinction between stock and ow

data. Balance sheets show us the (asset) stock position for each type of NDTI and this

gives us an indication of what each type of institution has done with the funds it

has received in the past. Stock data is the basis of the pie charts distributed through-

out this chapter. However, we are also interested in the magnitude of new funds

which NDTIs receive each year and in the destination of these funds. These funds

are used to buy additional assets, or to make what is called in the ofcial statistics

‘net acquisitions’ of assets (see Box 4.1). In section 4.5, therefore, we compare the

ows of funds passing through different types of NDTI in recent times. By looking at

the assets which they acquire we can tell which NDTIs are mainly responsible for

nancing different types of activity.

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