5.2 The ‘parallel’ markets

For example, imagine a situation of a ‘tight’ domestic monetary policy, in which

UK banks are operating at or near the limit of their desired reserve ratio. An overseas

bank then raises its interest rate to attract (euro)sterling deposits. These are with-

drawn from a UK bank by the M4 private sector (M4PS): M4PS bank deposits, the UK

money supply and bankers’ balances all fall by an equal amount. The foreign bank

gains the sterling deposits. Suppose now that it lends 90 per cent of that deposit

in sterling to a UK resident who spends it in such a way that it is redeposited with

the UK bank; also that the remaining 10 per cent is held by the overseas bank as an

interest-bearing deposit with the UK bank. The UK bank’s deposits and balances are

restored; it continues as before. However, the original stock of bankers’ balances has

nanced an additional round of spending. In actual fact this has been achieved even

though the measured money stock has fallen! Remember, when the sterling was

redeposited with the UK bank only 90 per cent of it was credited to the M4PS; 10 per

cent was deposited in the name of the overseas bank and is not included in normal

denitions of the money supply. This shows how intermediation via euromarket banks

can increase the volume of spending for a given monetary base. Since it does this

without increasing the money supply, it is raising the velocity of the existing stocks.

To this extent it is a further indication of the way in which continuous innovation

affects the ‘information content’ of key indicators. Here, the recorded money supply

falls while spending increases.

Another difculty for monetary control is posed by the very narrow ‘spread’ (between

borrowing and deposit rates) that exists in these competitive markets. Given that

borrowed funds can always be placed on deposit, the spread could be regarded as the

real cost of borrowing. Granted that there is always an advantage in having liquid

funds available, if the spread is low enough customers may choose to hold large

volumes of funds on deposit rather than repay outstanding borrowing. The demand

for money and the recorded money supply gures rise accordingly. This increase

is clearly associated with an increase in liquidity but it is no longer clear what this

implies. It may be a preliminary to higher levels of spending or may be simply a shift

in portfolio preferences towards more liquid forms of wealth.

The second and obvious consequence of the growth of the parallel markets is the

widening of lending and borrowing opportunities that have been created. We should

expect this to reduce the cost and increase the volume of lending and borrowing with

possible consequences for both the balance between consumption and saving and

the level of aggregate demand. The consequences are difcult to prove quantitatively.

The ratio of saving to aggregate income changes for several reasons; the level of

aggregated demand generally increases over time, again for reasons other than the

volume and cost of nancial transactions. All we can say is that ceteris paribuswe

should expect consequences of these kinds and then look at specic developments

which would seem to illustrate the possibilities.

One obvious example is the market for (sterling and eurocurrency) CDs. We said

earlier that CDs brought clear advantages to both sides of the market. Lenders could get

a rate of interest very close to that available on corresponding time deposits knowing,

nonetheless, that they could recover use of the funds by selling the CDs. Banks, and

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Chapter 5 • The money markets

eventually borrowers, had the advantage that the rate of interest they paid for the

deposit would be slightly less than that on a conventional time deposit.

A second example is provided by the interbank market. Before the development

of the interbank market, there were signicant gaps in the maturity structure of

many banks’ asset portfolios. Put simply, it was difcult to nd outlets for short- to

medium-term lending whose self-liquidation at a denite time could be relied upon.

It was possible to lend overnight to the traditional market and in theory at short

term through overdrafts. However, the termination of overdrafts is a painful process.

The development of the interbank market enabled banks to lend for specied periods

of time, repayment to coincide with what they expected to be periods of shortage.

They could match their lending more closely with their borrowing, much of which

was for specied periods of time. This ‘maturity matching’ reduces risk and therefore

the need for low- or zero-yielding reserves. Once again, the tendency is to reduce

costs and expand the ow of business.

This growth of alternative markets for short-term money and the instruments that

go with them has made the supply and demand for short-term money extremely

competitive. As we have said many times in this section, ‘wholesale’ deals are often

done on extremely small commissions or to prot from extremely small interest

rate differentials. With such a variety of similar instruments and competitive rates

it is difcult and costly in time for all participants to know exactly the best terms

and rates. This has stimulated the development of two professions. The rst is that

of money brokers, rms which offer for very small commissions on very large

deals to put lenders and borrowers in touch with their most advantageous counter-

parts. Indeed, it is normal practice for money brokers to search out, by phoning

round, those institutions with funds to lend and borrow. It has also encouraged

interest arbitrageurs. Arbitrage involves making a prot by borrowing from one

source solely to lend to another to take advantage of interest differentials. Notice

that, in contrast to speculation, no gamble is being taken on future events. The rate

of interest on the borrowed funds is known, as is the rate at which the funds can be

lent. The only possible risk is that one or both might change while the deal was

being made. By directing funds from low-interest source to higher-interest outlets,

interest arbitrage, like money broking, should help to remove anomalous interest

rate differentials.