BANKING SYSTEM

Instructor:

Prof. Insukindro, Ph.D

 COMMERCIAL BANKS
The reason of studying commercial banks
(or banks)
1. Banks are one particular subset of financial
intermediaries /institutions.
In most countries, they make up a large subset of
financial intermediaries
2. The liabilities of banks are the principle components of
any country’s money supply and so the behavior of
banks is intimately connected with changes in supply of
money. As we pointed out before that one general effect
of any increase in financial intermediation is the
creation of liquidity, but if the increased activity
involves primarily Banks, then the increase in liquidity
takes the specific form of ‘money’.
Flow of funds
from savers to
borrowers

Source:
Ritter at al. (2009:196)
 Size of Bank and Stock Markets
(percentage of GDP), 2007

Source:
Ritter at al. (2009: 318)
Assets of financial inst. in indonesia
79.5 B ANK UMUM

(Commercial banks)
AS UR ANS I

(Insurance Company)
S E K UR ITAS

(Securities)

P E NS IUN

(Pension Funds)

P E MB IAY AAN

(Investment Inst)

8.8 BPR
(Rural credit banks)
Source: BI, 2009a 4.4
0.4 3.1 P E G ADAIAN
1.1 2.7

(Pawn shop)
3. Many economists take the view that changes in the money
supply have important effects upon the economy,
especially if the changes are large or sudden. What these
effects are temporary or permanent, are matters of
controversy. However, the banks behavior may have
effects upon the economy which is rather different from
that of other intermediaries.
4. Even if one doubts the importance of money in the
economy, anyone interested in finance has to recognize
that government and central banks certainly behave as if it
matters.

Howells & Bain (2008, Ch. 12)

 Key Services Provided 7
by the Financial System
Financial System
Risk Sharing Liquidity
Returns Financial Returns
Funds Market Funds

Households Firms Government Households Firms Government

Savers / Suppliers Borrowers / Demanders

Funds Funds
Financial
Returns Returns
Intermediaries

Information
Source: Hubbard (2008:39, 41), modified
 THE ROLE OF BANKS
The economic and financial life of a country
depends on banks in three important
respects.
1. They occupy a central place in the payments mechanism
for households, government and business.
2. They accept deposits, which are widely regarded as
“money”; which are expected to be repaid in full, either
on demand or at their due term; and which constitute
part of society’s financial assets.
3. Banks in market economies play a major role in the
allocation of financial resources, intermediating between
depositors of surplus funds and would-be borrowers, on
the basis of active judgments as to the latter’s ability to
repay.
Ware (1996)
 BALANCE SHEET OF A
COMMERCIAL BANK
Assets Liabilities
Currency held by the bank Cb Demand deposits Dd
Deposits at the central Db Saving deposits Sd
bank Time deposits Td
Loans to the public sector Lg
Loans to the private sector Lp Capital & shareholders’ Sf
Loans to the money Lm funds
Markets
Investments Ib
Other assets Oa Other liabilities Ol
Monetary base = Reserve Money = B = Cp + Cb + Db
where: Cp is currency held by the public
or B = Cp + R, where: R is bank’s reserve

Looking at the structure of assets of the bank, we may draw

two conclusions. Firstly, yields are likely to increase as we
read down the list (Cb pays no interest, nor in most system do
Db); secondly, banks will wish to maximize their loans and
their holding of reserves and investments.

Like any other firm, a bank makes profits which are the
difference between revenues and costs. Revenues will consist
of interest, fees and commissions charged for its services, etc.
Costs will consist of interest paid to depositors, wages,
salaries and premises, etc.
Howells & Bain (2008, Ch. 12)
 RESERVE RATIO
The public’s confidence requires that deposits convertible
into cash on demand and thus banks have to maintain
sufficient cash or central bank balances which they can
exchange for cash. In order to ensure convertibility, the
level of bank reserves is usually expressed as a ratio to its
deposits. This is known as the reserve ratio or the reserve
requirement. In some countries, this ratio is set down by
central bank (a mandatory ratio), and in others it is left to
bank’s own judgement (a prudential ratio). In the latter
case, banks are obligated to inform the central bank if the
banks want to change the ratio.

Now, letting M1 and M2 stand for narrow money and broad

money, therefore we have:
M1 = Cp + Dp and M2 = M1 + Sd + Td
LOANS BY A MULTI-BANK
SYSTEM
Bank A Bank B
Assets Liabilities Assets Liabilities
Cb Dp Cb Dp
Db Sp Db Sp
Lg Tp Lg Tp
Lp Sf Lp Sf
Lm Lm
I I
Oa Ol Oa Ol
 MONEY SUPPLY
DETERMINATION
As mentioned before, money in circulation can be
measured using many different concepts or definitions,
such as the narrow or broad money. It depends on how
closely substitutable various assets are for definitive
money.

In general, it can be analyzed using two approaches

(Howell & Bain, 2008: Ch.12)
1. Base-Multiplier Model
2. Flow of Fund Model
BASE-MULTIPLIER MODEL
The model has several characteristics.
a. The model concentrates on stocks
b. The stock are the stock of monetary base
and the stock of deposits at commercial
banks.
c. The monetary base is under control of
the monetary authorities.
d. The authorities’ decisions are central to
any change in the quantity of money.
 BASE-MULTIPLIER MODEL
Let begin with definitions as follows:
B is the monetary base
Cp is the currency held by the public
Dp is the banks’ costumer deposits
R is the bank reserves at the central bank
M1 is the money in circulation
Therefore:
B = R + Cp and M1 = Cp +Dp
M1/B = (Cp + Dp)/(R+Cp)
BASE-MULTIPLIER MODEL
M1/B = {(Cp/Dp)+(Dp/Dp)}/{(R/Dp)+(Cp/Dp)}
= {α+1}/{β+α}
M1 = {α+1}/{β+α}B or M1 = m1.B
The quantity of money is equal to the monetary base
(B) multiplied by money multiplier m1 .
α = α (rm, T) and β = β (rr, ro, rd, RR, σ)
- ? + - + + +
M1 = M1 (α, β, B}
= M1 (B, rm, T, rr, ro, rd, RR, σ)
+ + ? - + - - -
Where: rm is the rate of interest on bank deposits, T denotes
technical considerations relating to the ease and convenience
of replenishing cash from holdings from cash dispensers and
the efficiency of the money (that is, deposits) transmission
mechanism operated by the banks, rr is the rate of interest
earned on reserve assets, ro is the interest rate paid on other
assets, rd is rediscount rate charged for lender of last resort
facilities, RR is reserve requirement and γ is variability of
inward and outward flows of funds.

From equation above, we may identify a number of variables

Over which the central banks have some influence and than
Can use to control the supply of money:
M1 = M1 (B, rb, rd, RR, r)
+ + - - -
 FLOW OF FUNDS MODEL
The model has some characteristics
1. This model concentrates on flows.
2. The flows are flows of new lending.
3. The demand for new loans is generally
positive.
4. Control of the money supply means
controlling its growth rate.

Note: Discuss some cases in developed and

developing countries.
The demand for new lending is assumed as a rule to be
positive because the demand for loans, at any given rate of
interest rate, is determined by the level of economic activity
and the level of prices. The demand for loans is endogenous
which is determined by key variables within the economic
system. In order to control supply of money in this model,
we require either that the central banks control demand for
loans or that they control banks’ ability to respond to the
demand. For example, the central banks can control or set
reserve ratio, short-run interest rate and discount rate.

Discuss: the effect of economic activity and interest rate on

demand for loans using inter-temporal choice.
 FLOWS THAT CHANGE THE
STOCK OF MONEY
1. Central bank loans to government (∆CBLg)
2. Central bank sales or purchases of government
debt (∆Bg) from: the government, banks and non-
bank private sector.
3. Central bank holding of foreign currency (∆F) as a
results of transactions with government or foreign
exchange market intervention.
4. Bank loans to the non-bank private sector (∆Lp)
5. Bank loans to the public sector (∆Lg)
6. Bank purchases/sales of government debt (∆Bg)
from the non-bank private sector
7. Bank purchases of government debt (∆Bg) directly
from government to finance a government deficit.
 THE NATURE OF BANKING-
INHERENT INSTABILITY
The business of banking has a number of
attributes which have the potential to
generate instability.
1. High gearing (or “leverage”) results from banks’ financial
intermediation between depositors and borrowers; by
comparison with the generality of industrial and
commercial companies, a bank’s capital is small in relation
to the size of its balance sheet. Therefore, any loss can
have a profound effect on the bank’s viability.
2. Typically, the term structures of assets and liabilities are
fundamentally mismatched, with assets tending to have a
longer maturity than liabilities - again a virtually inevitable
consequence of the role of the banks as intermediaries.
3. Flowing from these observations, a bank’s solvency
depends on its ability to retain the confidence of
both its depositors and the financial markets or
institutions on which it may rely for funding.
4. Sometimes, the lack of transparency in published
financial statements hinders, or even defeats,
counterparties’ efforts at rational analysis of a
bank’s strengths and weaknesses; banks’ balance
sheets and off-balance sheet positions can change
more rapidly than industrial and commercial
companies’, and customers’ knowledge of their
banks is inevitably imperfect.
Ware (1996)
 GENERAL PRINCIPLES OF
SUPERVISION
Underlying the diversity of supervisory regimes
and practices which exist in different
countries are some common objectives and
judgments.
As objectives, supervisors seek to ensure that
banks are:
1. financially sound,
2. well managed, and
3. not posing a threat to the interests of their
depositors
 GENERAL PRINCIPLES OF
SUPERVISION
In pursuing these objectives supervisors are
trying to form three judgments:
1. how much risk is each bank undertaking?
2. what resources are available to manage that risk?
The resources may be tangible (eg capital,
liquidity) or intangible (eg quality of management
and control systems).
3. whether the identified level of resources is
sufficient to balance the risk.
 BANKING RISKS
The risks can be categorized as follows
1. Credit risk - the risk that the bank’s counterparty
might not pay on the due date. Though most often
associated with lending, credit risk arises
whenever another party enters into an obligation
to make payment or deliver value to the bank, eg
in foreign exchange or securities transactions.
2. Liquidity risk - the risk that the bank might itself
fail to meet its obligations when they fall due.
3. Yield risk - the risk that the bank’s assets may
generate less income than the expense generated
by its liabilities.
 BANKING RISKS
4. Market risk - the risk of loss resulting from
movements in the market price of financial
instruments in which the bank has a position. Such
instruments include bonds, equities, foreign
exchange and associated derivative products.
5. Operational risk - the risk of a failure in the bank’s
procedures or controls, whether from external
causes or as a result of error or fraud within the
institution.
6. Ownership/management risk - the risk that
shareholders, directors or senior management might
be unfit for their respective roles, or actually
dishonest.
 ECONOMIC ANALYSIS OF
BANKING REGULATIONS
SEVEN BASIC CATAGORIES OF
BANKING REGULATIONS:
1. Government safety net
2. Restrictions on bank asset holdings
3. Capital requirements
4. Chartering and bank examination
5. Disclosure requirements
6. Consumer protection
7. Restrictions on competition
(Mishkin, 2003:279-288)
 REFERENCES
Howells, P.G.A. and K. Bain (2008), The Economics of
Money, Banking and Finance: A European Text,
Prentice Hall
Hubbard, R.G. (2008), Money, the Financial System, and
the Economy, Pearson Education, Inc
Mishkin, F.S. (2003), The Economics of Money, Banking
and Financial Markets, Addison Wesley
Ritter, L.S., W.L. Silber and G.F. Udell (2009), Principles
of Money, Banking & Financial Markets, Pearson
Education, Inc.
Ware, D. (1996), Basic Principles of Banking Supervision,
in S. Gray, Handbook in Central Banking, No. 7, Bank
of England.