Over the last several decades the monetary system has undergone many changes. In 1694 the Bank of England, which is nowvaccording to Will Hutton "the fulcrum upon which the financial system turns", was founded but its functions have altered greatly since then, its current role is to exercise discretionary monetary management while also regulating and supporting the banking system. The Bank is greatly important within the financial system since it chooses the terms on which it issues notes and coins to the banking sector; the level of legal tender supplied, however, has to be decided upon by the government; it also manages the financing ofthe government debt by issuing treasury bills and long term government bonds. Recently there has been a decline in the importance attached to money supply targets and an increase in the importance attXhed to interest rates. Every month the Governor of the Bank of England, Eddie George, meets with the Chancellor, Kenneth Clarke, to discuss interest rate policy and the minutes from this meeting are then published. The final decision as to the level of interest rates lies with the Chancellor but the Governor's views are becoming more and more important and there is much debate at present as to whether the responsibility of setting their level should be completely handed to the Bank in hope of reducing political bias. When the level of interest has been decided it is up to the Governor to decide when the new rate should be introduced. The Bank of England can only influence interest rates by changing the rate at which it buys Treasury Bills, seven or fourteen days from maturity, and this change cascades through the money markets to result usually in an alteration in interest rates. t Ace w 2?>~
,~ Sy ~_/z~sS S An y In
The Bank of England's other function is to ensure that the City works as a series of related markets in which financial assets of any type are readily tradable for cash. The banking system has experienced a high degree of deregulation over the last several decades. At first changes included the abolition of quantitative credit ceilings and a greater reliance on short term interest rates as a means of affecting credit and money growth. These measures, however, led to economic expansion which required an unacceptable level of interest to conkol the monetary expansion and the "Corset" was introduced. This existed from 1973
to 1980 and involved banks being set target rates of growth for their deposits and they were penalised if they overshot them. From 1979 onward there was according to Eddie George a "more radical and far-reaching programme of financial deregulation". The "Corset" was abandoned in 1980, foreign exchange controls were also abandoned in 1979 and the Bank lobbied for the abolition of reserve requirements in 1980. All central banks in the industrialised world, except for the UK and Luxembourg, have a minimum reserve requirement which ensures that all banks lodge a certain percentage of their total deposits with them as a "float". The Bank now relies on the desired ratios of cash and liquid assets to total deposits that commercial banks adopt in their own self interest. Banks, because of well developed markets for liquid assets survive offcash reserves as low as 1-2% of deposits. The setting of broad money targets was also abandoned in 1985/6 as they were continually overshot, although now the Government and Bank "monitor" the money supply; M0, for example, has a monitoring range of 1-4%. The financial liberalisation has led to an important change in the transmission mechanism which refers to the way in which interest rates influence the behaviour of the economy, they act as a major monetary tool in the UK The Bank acts as a "lender of last resort" although it no longer sets a minimum lending rate and instead banks have to guess, and therefore represents an ultimate source of liquidity and support to the individual commercial banks. The protection that the Bank offers may lead to banks adopting careless or very risky strategies and as a consequence the Bank is involved also in regulation and supervision.
A characteristic ofthe U.K monetary system that has helped greatly in attracting over 500 foreign banks to London is liquidity. Liquidity has become such a major part of the British financial system that there tends to be a great lack of commitment to the long term health of underlying investments- short-termism. The discount houses are an important part ofthe monetary system that have not yet been mentioned. They act as an intermediary between the Bank of England and the other banks or financial institutions; assembling the necessary cash from institutions to but Treasury Bills and other Government IOU's, and looking for cash on the markets for the banks to be able to "square" their books overnight and if the markets cannot provide the cash they liaise with the Bank of England.
Bank's have the ability to "create" money, increase the money supply, because all their customers do not try and convert their deposits into notes and coins at the same time. The money multiplier gives the value of new deposits that can be created for every t1 of new reserves that become available to the retail banking system and the level ofthe money multiplier is greatly dependant on the reserve ratio which determines how much cash the bank actually keeps from all its deposits and the cash it does not keep in reserve it loans out.
The money multiplier can be seen in its simplest form if several large assumptions are made. Banks can only hold two kinds of assets, cash and advances to customers, there is only one kind of deposit, a sight deposit and it earns no interest and can be withdrawn on demand and there is only one bank in
the system. If a bank receives a deposit of t100, and hence its assets have risen by t100 and its deposit liabilities have also risen by t100, it is no longer in equilibrium for a profit maximising bank. It will want to make loans in order to make money from the interest payments but it will also have to keep 10% ofthe deposit of i100 for reserves. Therefore it will make an(~on,pf i10 to existing reserves and increase its lending by t90. If it is Assumed that individuals save everything then this £905once it has been spent by the borrowers will be deposited in a bank, which may not be the same bank. The process will, however, repeat itself and the byÑt9 to reserves and increasing lending by t81. A new deposit thus sets up a long sequence of new
deposits, new loans, new deposits, new loans within the banking system.
From this simple example a basic formula for the money multiplier can be
R = rD R:- reserves D:- deposits r:- reserves ratio and therefore if this equation is true:
AR = rAD
AD = (l/r)AR MONEY MULTIPLIER -in simplest form _ Ala
Therefore from the formula it can be seen that a new deposit of t100 will increase the money supply by t1000 in total if the reserve ratio is 0.1.
In reality, however, there is a cash drain from the banking system and therefore the ratio of what the private sector wishes to hold in cash to what it wishes to deposit must also be considered. This ratio will be influenced by many factors such as how trustworthy people believe the banks to be and how they are paid, in cash or by cheque. The money multiplier in the real world is thus dependent on the private sector's desired ratio of cash to bank deposits and the bankls desired ratio of cash to deposits. Its formula can be derived as follows:
R = rD and
C = fD C:- cash held in circulation by the private sector. f.- fraction of bank deposits held in circulation.
H = C + R = (r + f)D H:- monetary base ( quantity of notes
in private circulation plus quantity held by
M = C + D = (r + 1)D M:- money supply ( monetary base *
Therefore by comparing the last two equations the money supply can be
expressed as a function of the monetary base and the desires of both the banks and the private sector.
M = ((f + l)l(r + f))H
MONEY MULTIPLIER = If + l)l(r + f)
The money multiplier will increase if either the private sector's desired ratio of cash to bank deposits falls or if the reserve ratio falls for the banks. Deposit money, created by banks is by far the largest contributor to the money supply and therefore the money multiplier is very useful in predicting what will happen in the monetary system.
Disintermediation is defined by Charles Goodhart as being the process that "occurs when some intervention, usually by government agencies for the purpose of controlling, or regulating, the growth of financial intermediaries lessens their advantages in the provision of financial services, and drives
financial transfers and business into other channels". As the banking system, which used to be the main intermediary between savers and borrowers, has recently become more open to competition from the capital markets and other non-bank lenders, traditional client groups have begun accessing the capital and money markets directly. Over the past decade for example users of capital have chosen to finance short term capital needs in the world's commercial paper markets where they are in effect obtaining short-term funds directly from savers, this situation can arise when banks have to raise the margin between deposit and lending rates to maintain their profitability, as a result of higher reserve requirements. From the borrowers point of view the act of avoiding the banking system by dealing with the bond or commercial paper markets may mean substantial cost savings. Lending rates are also more competitive in open markets and creditworthy borrowers are able to choose the most economical from a wide range of domestic and international sources of capital. From a fixed-income investofls point of view the act of lending direct to the users of capital may result in a portion of the cost savings realised by the borrowers being passed on to the investor in the form of marginally higher returns compared with bank deposits. The(@ markets are also more operationally flexible than short term bank borrowing. Borrowers are bypassing the traditional banking system by issuing securities in the public debt markets and hence transfers of funds that would have gone through the books of financial intermediaries now pass directly from saver to borrower.
Disintermediation also refers to financial flows which pass through channels which would usually be less efficient if it was not for certain constraints and regulations that have been imposed on certain domestic financial institutions. The development of the Euro-markets illustrates how in the absence of exchange controls constraints on domestic services encourages institutions to provide the same services abroad. Therefore usually as a result of controls put on financial intermediaries which prevent them acting in the way they would most desire they seek escape through disintermediation.