Question

Use economic theories and terminologies you learned to analyze and explain the questions step by step.  A single strong paragraph (not less than 200 words) for each question should be sufficient as long as it is done well.

What are the two conflicting goals of bankers? How do these conflicting goals get resolved in the federal funds market?

Answer 1

First, banks are in business to make a profit just as are other businesses. They earn profits primarily on loans and by buying and selling securities. Second, banks must seek safety by having liquidity to meet the cash needs of depositors and to meet transactions as checks clear. Banks can borrow from one another to meet short-term needs for cash or reserves in the federal funds market. In this market banks borrow available reserves from other banks on an overnight basis. The rate paid is called the federal funds rate.

Banks are generally limited companies whose main aim is to create profit to its shareholders. They work under the licence of Bank of England. Most of the profit comes out of lending the money, which is received from depositors, out to the customers. So the more depositors bank has the more it can lend out, thus it can make more profit and pay higher dividends to its shareholders. It follows that the banks try to be as attractive to potential savers as possible. They can offer two things: a high interest rate and a high liquidity. Both are very important, because depositors want to be able to draw their money out any time they want and have profit by receiving interest.

Now there is a clash for the bank between these two objectives. If they would want to maximize the liquidity they would keep their assets in cash, which is the most liquid form of assets, but the bank cannot earn any interest on that, so it cannot give any interest to its depositors.

In the other extreme, if they would aim on high profits, they could lend out their money on long-term basis. The highest interest rate will come from the loans lent out to companies, which are secured only by the business plan. Depositors can then have big interest, but if they would like to take out their money, banks would not have it. It might also happen that the company the bank lent its money out will go into liquidation, then the depositors might not have their money at all.

In real life banks have to balance the amount of liquid assets and the amount of investments in a way most suitable for the potential depositors, although identifying this suitability is very hard.

The other type of assets bank can turn into money fairly quickly (liquid assets) are loans to local authorities to cover the gap in the money supply they have due to taxes being unevenly distributed over the year; Treasury Bills which government issues every month for the period of 91 days and which are very secure and bills issued by other businesses. To make the bills more liquid banks usually buy them about 5-6 weeks before they mature, so they can earn interest and be liquid at the same time.

Liquid assets form ~9-12% of all the assets. They are unprofitable compared to the other type of assets that are less liquid: medium‑term loans, investments and advances.

Investments are usually less secured, but their interest rate is higher. They are loans to corporations in he basis of business plan or to overcome problems (in that case banks usually require something for security). They are usually issued for period under 5 years. Only long-term loans are mortgages that are given for the purchase of houses (which is security as well) and last ~25 years. Their interest rate is (only) 8% at present.

The main part of banks' assets is advances to its customers. They form ~55% of the total assets and are formed from overdrafts and loans of various types.

Government stocks are another very common type of  profitable assets. They are loans to government, who issues interest-bearing bonds (e.g. Exchequer stock, Treasury stock), which banks can then buy. In order to maintain liquidity banks have invested their money over the period of time so, that each week some stock or bill etc. will mature. The freeing money can be then used to restore liquidity, or if there is no problems with liquidity, then this money is reinvested.

Banks have to make decisions which proportion of these assets described above to choose to make profits and maintain liquidity. They do not have absolutely free choice, because great part of their liabilities (~56%) is controlled by the Bank of England (eligible liabilities). In the other hand, if one bank gets into difficulties, other banks will help it, because the collapse of one bank will affect the trust to all the banking system.