Economizing on Notes: Deposits, Acceptances

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From the course by Columbia University

Economics of Money and Banking

501 ratings

Columbia University

Economics of Money and Banking

501 ratings

The last three or four decades have seen a remarkable evolution in the institutions that comprise the modern monetary system. The financial crisis of 2007-2009 is a wakeup call that we need a similar evolution in the analytical apparatus and theories that we use to understand that system. Produced and sponsored by the Institute for New Economic Thinking, this course is an attempt to begin the process of new economic thinking by reviving and updating some forgotten traditions in monetary thought that have become newly relevant. Three features of the new system are central. Most important, the intertwining of previously separate capital markets and money markets has produced a system with new dynamics as well as new vulnerabilities. The financial crisis revealed those vulnerabilities for all to see. The result was two years of desperate innovation by central banking authorities as they tried first this, and then that, in an effort to stem the collapse. Second, the global character of the crisis has revealed the global character of the system, which is something new in postwar history but not at all new from a longer time perspective. Central bank cooperation was key to stemming the collapse, and the details of that cooperation hint at the outlines of an emerging new international monetary order. Third, absolutely central to the crisis was the operation of key derivative contracts, most importantly credit default swaps and foreign exchange swaps. Modern money cannot be understood separately from modern finance, nor can modern monetary theory be constructed separately from modern financial theory. That's the reason this course places dealers, in both capital markets and money markets, at the very center of the picture, as profit-seeking suppliers of market liquidity to the new system of market-based credit.

From the lesson

Banking as Market Making

"Market liquidity" is supplied by dealers who stand ready to absorb temporary imbalances in supply and demand by taking the imbalance onto their own balance sheets, for a price. From this point of view, banks can be considered a special kind of dealer, since they absorb imbalances in payment flows. The first lecture is meant to build intuition by using our familiar balance sheet method to make sense of how this all worked in a system much simpler than our own. The second lecture introduces a formal model of the economics of the dealer function, which we will be using throughout the rest of the course.

FT: Depreciation of Iran's Currency3:39

Reading: John Hicks3:38

Bagehot's World, Wholesale Money Market7:57

Economizing on Notes: Deposits, Acceptances8:28

Managing Cash Flow: Discount, Rediscount7:29

Meet the Instructors

Perry G Mehrling
Professor
Economics, Barnard College

One.

I've shown, this is the extreme case where firm B gets notes.

Okay.

There's another case, which I'll show over here.

let's just think about alternative relations between firm B and the bank,

just to introduce two other concepts here. Okay.

So, let's just keep our timing.

So this is step one, this step two and this step three.

[COUGH]

and I suppose this is step four down here.

So, I'm talking here about ste alternative forms of step two.

So I'll put them at the same level here.

Okay, still Firm B is still going to get rid of the bill

[SOUND].

But it may be that the bank, instead of

paying out notes, pays out by expanding his balance sheet.

if, if firm B is willing to accept a deposit instead of notes.

If the bank Doesn't want to get rid of its

notes or maybe it doesn't even have any notes, okay.

If the firm is willing to accept deposits at the bank, as a means a payment okay.

This is a way to do the discounting okay, without using any notes.

You can economize on your notes in this, in this,

in this way, if the firm is willing to accept

deposits instead of notes.

Remember notes aren't Deposits aren't promises to pay notes.

They're not notes themselves, but perhaps you would accept that, conceivably.

So this is a way of economising

on the note issue.

But it is still, it's still confronting the bank with some liquidity risk.

Right.

Before, by getting rid of the notes, well notes are

the most liquid thing, and now you don't have 'em anymore.

Here you have more deposits, and this person, presumably they

discounted the bill, because they wanted to spend this money.

So they, they're going to spend it, and they may transfer it to somebody else.

Now if they transfer it, to another customer of the

bank, no problem. You just do it all in your book.

Right.

But if they transfer it, you know, to

France, you're in trouble, okay, because you're going to

have to come up with notes and there's

more down that road which we're going to see.

There's going to be gold, there's going to be all kinds of stuff.

So, but this, but, but in the short run, this can be an economizing measure

and, and you can see it's different from the notes, in terms of the kind

of liquidity risk, but it still does involve liquidity risks.

There's a second way of doing step two

[COUGH]

that involves econamizing on notes.

In this case it may be that firm

B okay instead of discounting says, you know,

also realizes the advantages of holding this bill to maturity.

Maybe he doesn't need actual money right now.

He says, you know what, if I take it to the bank, I'm actually

getting paid less for my goods, right, I'm getting paid 95 instead of 100.

If I hold this to maturity, I get paid

in full, so there's an interest there and if I

don't need the money right now, I would just as

soon hold on to that bill as an earning asset.

But I better be careful because maybe I'm going to need the money, so

let me take this to the bank And make the bank endorse this bill.

So that they are, they're standing behind it.

They're promising to pay this bill in case firm A doesn't.

And that will make the bill much easier to sell if I ever need it.

So if I need cash, the bank will stand behind this.

And this will help.

It's not just firm A's signature on this.

It's now the banks signature on this.

And so that, that there's two, there's,

there's a separate thing called an acceptance.

And I'm writing that as an asset

of the firm and the liability of the bank. This

is actually a contingent liability, right? And

it's a contingent asset.

And what it is, is a, is a liability.

This is for the bank saying, if Firm A doesn't pay, I will pay.

Okay?

So it's a guarantee If firm A If

firm A If firm A doesn't pay in 90 days, I will pay.

So in essence, the bill becomes a 90-day bill on this bank.

It's like

a time deposit. Right?

It's like saying, it's like you have the banks promise to pay you in 90 days.

And so this acceptance is actually you know,

physically the way this worked in the 19th century,

this acceptance is actually a signature and it

says accepted with the bankers signature on it, okay.

But, I'm writing it as if it's a separate little piece of asset.

So it was right on, right on the bill, the bill was a physical thing.

okay, with descriptions

of goods and everything, and a legal document,

enforceable in court, and that sort of thing.

And it was an acceptance.

You write across it, accepted with the name of the banker .

I'm writing it as a separate balance sheet entry, just to get us ready thinking of it

as a separate thing, because in the modern world, it is a separate thing.

The modern world, this is in early form of

a credit default swap.

If they don't pay I'll pay.

So, this also obviously is economizing on notes.

This, this second thing, this acceptance.

Because it allows Firm B to say, you know what,

I'd rather not have notes, I'd rather have a time deposit.

I'd rather have an earning asset. So, you don't need as many notes.

So, both, both of these things, the first one, paying out a

deposits, allows you know the bank doesn't have to pay out notes

because the bank the bank can keep them by expanding it's balance sheet and the

second case it's firm B that doesn't

doesn't require the notes, doesn't demand the notes.

Okay, so the question is the bank is doing this as a favor or does it cost?

It costs something.

Yes. Yes.

I'm in order to make the balance sheets

simple, I'm not putting all the prices in here.

But just as the discount, here, you know, I'm putting

this bill of exchange in all these three places, okay?

But the price is different, you know.

When you're selling this bill. It's at 95 say, okay, instead of 100.

I said that, okay.

Now for this acceptance, you're going to be paying, firm B will

be paying the bank some fraction of the total of the bill.

Okay, it's like an insurance premium, okay, that you're paying.

It's just won't be as much as they would have paid in the discounts.

So yo, It's a guarantee of the final

payment, it's not an investment for 90 days.

So, it'll be 1% instead of 5% or something like that.

So, yes there's a payment, there's a payment there.

And this can be a profitable business, you know, so long as you are, are, are good at

judging whether firm A pays, because if firm A

pays You don't have to pay, and you just got

money for nothing, you know.

These are contingent liabilities, and so they may expire worthless.

Okay, If firm A pays, you got money for nothing and that's a good business.

Now typically, these things You know you know who firm A

is the typically problems that firms run into is not that

they that they are unable not that they just default on

something that there bad guys cause there known to the bankers.

its that they the cust they don't sell their goods

so they don't get the notes so they can't pay

so there's some delay in payment the typical problem that

bankers are worried about is not outright default but delay.

Okay that's a liquidity issue.

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