BRIEF TABALE OF CONTENTS
Principles of Money, Banking, & Financial Markets, Tenth Edition (with L.S. Ritter as a whole, as well as with the behavior of financial institutions and markets. at the relationship between financial markets and intermediated markets, the. The relationship between the BIS and SUERF goes far back in time and has been industry in general, and between markets and financial institutions in particular. What are the implications of these structural trends for the. They possess knowledge about the product and relationships with financial institutions. What is the difference between banks and financial institutions? In the fixed income markets there are banks and bond brokerage houses that trade.
For instance, a recent survey conducted by the BIS-based Committee on the Global Financial System CGFS suggests that, since the events of autumnsome key market participants have become less inclined to respond automatically to risk limit violations because they now have a better awareness and understanding of the strategic interdependencies among players, and the impacts on market prices.
This is an area that, by its very nature, falls naturally within the remit of prudential authorities, whose task is precisely that of internalising such externalities.
Markets and institutions: Managing the evolving financial risk
Implications for prudential authorities and standard setters To a considerable extent, the implications of the changing nature of financial risk for prudential authorities mirror those for the private sector. In the limited time that remains, let me briefly highlight four points: First, the wide-ranging convergence process in the financial industry naturally calls for greater consistency in the supervisory treatment of financial risk across sectors, be they geographical jurisdictions or functional segments of the industry.
Greater consistency of prudential rules enhances the efficiency of the financial system by removing any distortions embedded in the policy framework, notably by promoting a level playing field and reducing the scope for regulatory arbitrage.
As you are well aware, substantial progress has been made here.
Across geographical jurisdictions, progress is most advanced in banking, less so in insurance. Across functional lines, it has clearly proceeded much further within national jurisdictions, not least helped by the increasingly common practice of consolidating financial sector supervision into a single agency. At the same time, some steps have also been taken internationally. Witness the work of the Joint Forum, which brings together representatives of the international regulatory authorities in banking, securities and insurance.
Increasingly, the benefits to prudential authorities from developing a common view are becoming evident. Second, improving the safeguards against instability for a financial system that is larger and more interconnected, and where the endogenous component of risk is more prominent, naturally calls for a strengthening of the macroprudential orientation of prudential frameworks.
Investigating the relationship between the financial and real economy
After all, it is now well accepted that a system-wide perspective and a focus on the endogenous component of risk are precisely the distinguishing features of such an approach. It involves the same shift in focus that a stock analyst is required to make in order to become a portfolio manager. In evaluating financial system vulnerabilities, a macroprudential approach would focus on the commonality in the risk exposures of the different segments of the financial system.
In calibrating policy instruments, it would stress the need to establish cushions as financial imbalances build up, in order to give more scope to run them down as the imbalances unwind. This would act as a kind of self-equilibrating mechanism.
The logic is analogous to that of calling for fiscal consolidation in good times to allow an effective countercyclical fiscal policy in bad times. By now, the importance of the macroprudential perspective as a complement to the more traditional microprudential focus is widely recognised.
As a result, steps have been taken to put it into practice. For instance, as regards the task of identifying vulnerabilities, macroprudential analysis is now routinely carried out in various forums, including the IMF and the World Bank, the Financial Stability Forum, and the CGFS; and, of course, in many national jurisdictions.
As regards the calibration of policy instruments, too, there are signs of a keener awareness. In banking, for instance, one such illustration is the various adjustments that were made to Basel II, at least partly with a view to addressing concerns about procyclicality. And banking supervisors here in Spain have gone one step further, by adopting statistical provisioning in loan accounting.
This provides a long-term anchor to loan provisioning that is independent of the state of the business cycle.
Please explain how financial markets may affect economic performance.
Efforts to strengthen the macroprudential perspective should be pursued further, but they may well need to await the development of additional analytical tools to help measurement and calibration.
Third, in a highly interconnected and innovative financial system the prudential framework should work as far as possible with private incentives. This means empowering, rather than numbing, the natural incentive of market participants to instil discipline.
An excessively prescriptive approach is an invitation for regulatory arbitrage and for practices that respect the letter of the standards but violate their spirit. Hence the major efforts by regulators to develop standards in close cooperation and consultation with the regulated communities in the private sector, to stress the adequacy of risk management processes and to strengthen disclosures. These are all welcome trends that should be encouraged further. Fourth, the financial convergence process has put a premium on a common set of financial reporting standards; hence the current efforts of international accounting standard setters to put one in place.
This is a worthy goal that has profound implications for the financial system and for financial risk. The measurement of value for accounting purposes has a first-order effect on the behaviour of financial institutions and their risk management, given the intimate link between valuations and risk.
The stakes are high. At the same time, the process of establishing such standards has brought to the fore significant differences of views between accounting standard setters on the one hand, and prudential authorities on the other. It is important that these differences be reconciled. I wanted to flag this issue because of its importance, although I know full well that I cannot do it justice in my remarks today.
In a recent speech to the International Conference of Banking Supervisors, I have discussed the key ingredients of the debate and offered a sketch of a possible solution. Here, let me simply make three points. This would mean avoiding reliance on deliberately conservative estimates of value as a means of establishing safety cushions.
Second, the portrayal of the financial condition of a firm should cover not just its profitability, cash flows and balance sheet, as it does today, but also its risk profile, including some indication of the margin of error surrounding point estimates. This is an area where prudential authorities have taken the lead, by encouraging greater risk disclosure by regulated firms. Finally, it is essential that at all stages during the transition towards this long-run goal, the prudential authorities are in a position to redress any adverse implications which changes in accounting standards that are desirable in the long term may have for the safety and soundness of regulated financial intermediaries over the near to medium term.
In other words, the transition should be properly coordinated. It is my hope, and my expectation, that the dialogue between prudential supervisors and accounting authorities will intensify and become more institutionalised.
I have argued that the trends in the financial system have brought about a transformation in the nature of financial risk. These trends have put a premium on the links and interactions between different types of risk, largely reflecting a tighter relationship between financial institutions and financial markets.
- Markets and institutions: Managing the evolving financial risk
This transformation requires adapting risk management both at the level of individual firms and in the financial system as a whole. Essential dimensions of this adaptation are greater consistency in the treatment of similar types of risk, greater analysis of the interaction between different types of risk and a keener recognition of the endogenous component of risk.
Progress has been made in many of these dimensions, but there is clearly scope for further improvements. The academic community can play an important role in supporting and shaping this adaptation. More research is needed in understanding the interactions between different types of risk and the way they, in turn, are shaped by the structure of markets and institutions.
The same is true for the analysis of the mechanisms that underpin the endogeneity of financial risk. And ways need to be found to turn this greater understanding into operational solutions. These are not easy questions and they often require skills that transcend disciplinary boundaries.
Policymakers are eagerly awaiting the answers. Financial markets play a critical role in the accumulation of capital and the production of goods and services.
The price of credit and returns on investment provide signals to producers and consumers—financial market participants. Those signals help direct funds from savers, mainly households and businesses to the consumers, businesses, governments, and investors that would like to borrow money by connecting those who value the funds most highly i.
In a similar way, the existence of robust financial markets and institutions also facilitates the international flow of funds between countries. In addition, efficient financial markets and institutions tend to lower search and transactions costs in the economy. By providing a large array of financial products, with varying risk and pricing structures as well as maturity, a well-developed financial system offers products to participants that provide borrowers and lenders with a close match for their needs.
Individuals, businesses, and governments in need of funds can easily discover which financial institutions or which financial markets may provide funding and what the cost will be for the borrower. This allows investors to compare the cost of financing to their expected return on investment, thus making the investment choice that best suits their needs. In this way, financial markets direct the allocation of credit throughout the economy—and facilitate the production of goods and services.
As it turns out, most of what we call money in the United States is represented by the deposits issued by banks. Consequently, banks serve as the principal caretakers of the payments system because we write checks on our bank accounts to pay for things we buy. Moreover, because money has linkages to the overall performance of the economy, banks are intimately involved in how the central bank of the Unites States, called the Federal Reserve, influences overall economic activity.
In particular, the Federal Reserve directly influences the lending and deposit creation activities of banks. This, in turn, helps determine how much people are willing to save and how much businesses are willing to invest and whether the prices of stocks and bonds go up, down, or sideways in the financial markets.
How does this work?Financial Institutions and Markets
For the complete answer, you have to read the rest of this book! But here's a preview of what you will find.
The remaining chapters in Part I set the stage. We define money and look at its relationship with economic performance. Then we'll provide an overview of financial institutions, instruments, and markets and how they serve as a mechanism for the flow of saving and investment. In Part II we examine the performance and behavior of financial markets where funds move directly from those who have funds to those who need funds. We pay special attention to how all types of securities are valued, how interest rates are determined, and how complicated markets, such as derivatives and foreign exchange, actually work.
In Part III we look at intermediated markets where funds move between borrowers and lenders via financial intermediaries, such as banks, insurance companies, pension funds, and some institutions you may not have heard of.
In Part IV we examine the overall financial system. This will involve looking at the relationship between financial markets and intermediated markets, the regulation of these markets, and an international comparison across different financial systems. Part V begins this process by discussing the art of central banking.