Characteristics of financial instruments

Banks

Banks are responsible for managing the flow of money in the economy. To see how they do that, it helps to break banks into a few main types and then look at one key banking activity: credit creation.

Investment banks

The following are their functions:

• Overseeing the major acquisitions
• Underwriting new shares
• Major involvement in the capital and money markets
• Advising on acquisitions

Commercial banks

These are further broken down into two:

• Wholesale banks
• Retail banks

Wholesale banks

The following are functions performed by the wholesale banks:

• High-value loans which are in low volumes due to the fact that they normally lend to businesses
• Managing loans and debt of large companies
• Managing large deposits

Retail bank

The following are the functions offered by the retail banks:

• Low-value-high-value transactions which include deposits and loans.
• Managing small deposits and loans for its vast majority of customers.

Credit creation

Credit creation is a function performed by both retail and wholesale banks. It describes how banks can increase the amount of money circulating in the economy by lending out a portion of the deposits they receive.

There are a few terms you will need to get used to in this area.

Cash ratio
This is the percentage of customer deposits the bank keeps as cash (rather than lending out). The cash ratio is kept to meet customer withdrawals.

A smaller cash ratio means higher credit creation, because the bank keeps less cash and has more money available to lend.

Change in total deposits
This is the total increase in deposits in the banking system that can result from an initial deposit being repeatedly re-deposited after loans are made.

For example, a $10 deposit can grow to $100 as the bank lends money, that money is spent, and then it returns to the bank as new deposits. That overall increase is the change in total deposits.

An examination question will come as follows:

KTA Bank has total deposits of $\$100,000$ and a cash ratio of $10\%$. Calculate the total change in deposits in the cash position of the bank.

Formula

$$X=\frac{\text{Initial cash deposits}}{\text{Cash ratio}}$$

Solution

$$\begin{array}{rlr}X& =\frac{100000}{0.1}& \\ & =1000000& =\$1,000,000\end{array}$$

Here’s a step-by-step example of how credit creation can work inside a single bank.

KTA and a few other investors open a banking entity, and the cash ratio is deemed to be $10\%$.

On day 1, a friend of KTA made a deposit of $\$100$.

On day 2, a certain customer comes to the bank to ask for a loan, and the bank gave her $\$90$ (because the bank needs to keep the cash ratio of $10\%$, which is $\$10$, and this should be available in case the depositor might want to withdraw some).

On the very same day, that customer who took a loan happened to owe the first customer who made the initial deposit of $\$100$, and on the $\$90$ borrowed, she decided to pay $\$50$ toward that loan.

Notice what happens next: when $\$50$ is paid, it stays in the same bank because it’s being paid to someone who also banks there. That payment becomes a new deposit.

• The bank originally kept $\$10$ as cash (the $10\%$ cash ratio on the initial $\$100$ deposit).
• The bank now receives an additional $\$50$ deposit.
• The cash ratio on the new $\$50$ deposit is $\$5$.
• So the bank’s total cash kept becomes $\$15$ ($\$10+\$5$).

Now let’s total the deposits the bank has received:

• Initial deposit: $\$100$
• New deposit from the $\$50$ payment: $\$50$
• Total deposits received: $\$150$

Because the bank must keep $10\%$ of the new $\$50$ deposit as cash ($\$5$), it can lend out the remaining $\$45$ (that is, $\$50-\$5$).

That additional lending increases total credit created:

• First loan: $\$90$
• Additional loan possible: $\$45$
• Total credit created so far: $\$135$

If the next borrower spends that $\$45$ and the money is deposited back into the same bank (for example, by paying someone who also uses that bank), the process can repeat. Each cycle can increase deposits and lending, while the bank continues to keep the required cash ratio.

Yield/Cost

To an investor, this is considered yield or growth. When an investor lends money, they expect it to grow.

• In debt instruments, growth could be in terms of interest receivable or market value.
• In equity instruments, growth can be in the form of dividends received as well as market growth of shares.

Those same items are costs to the organizations that pay them. For example, what is interest receivable to an investor is interest payable to the borrower.

Risk

Risk is the possibility that the investor may not get the money back or may end up receiving less than invested.

In stock markets, company values fluctuate up and down. When that happens, the wealth of investors also moves up and down to reflect market movements. Some instruments therefore have higher risk than others.

Value of investments

This focuses on how much money is tied up in the investment.

It’s common for short-term instruments to involve lower amounts compared to long-term instruments. This concept also includes the minimum and maximum amounts that can be invested in an instrument.

For example:

• Shares can be traded at $\$100$ per share.
• Futures can be traded at $\$200,000$ per contract.

These are standard sizes for those particular instruments.

Maturity period

This is the time taken until the asset is realized.

• Short-term instruments are normally for a period under one year.
• Long-term instruments can extend to over 50 years.

Liquidity

Liquidity focuses on how easy it is to convert an instrument into cash.

It’s normally easier for instruments that are traded on a market, and harder for instruments that are not listed.

Transaction cost

Transaction costs differ depending on the instrument and the risk coverage it has.

Some instruments are difficult to obtain while others are easier, and that affects the costs involved. Some of these fees include legal fees, and if you are buying a derivative then you will pay a certain upfront fee.