1. The Role of Banking

In this chapter, the terms ‘bank’ and ‘commercial bank’ are used synonymously to refer as (1) a depository institution overseen and insured by a regulatory authority or (2) the holding company.

https://​www.​fdic.​gov/​consumers/​banking/​facts/​.

See Box ‘Case Study Bank of America’.

In December 2022, the FDIC reported that there were 4,715 US banks. The average total domestic deposits across the top 250 banks listed were about $65 billion. The top five banks by total domestic deposits were: JPMorgan Chase Bank: $2 trillion, Bank of America: $1.9 trillion, Wells Fargo Bank: $1.4 trillion Citigroup: $777 million.

The movie “It’s a Wonderful Life shows a classic example of a bank run: https://​www.​youtube.​com/​watch?​v=​iPkJH6BT7dM.

This is why after the global financial crisis of 2008, the European Union (EU) has created the European Systemic Risk Board or ESRB and its mission is to be responsible for the macroprudential oversight of the EU financial system and the prevention and mitigation of systemic risk. The ESRB therefore has a broad remit, covering banks, insurers, asset managers, shadow banks, financial market infrastructures, and other financial institutions and markets. In pursuit of its macroprudential mandate, the ESRB monitors and assesses systemic risks and, where appropriate, issues warnings and recommendations.

https://​www.​imf.​org/​en/​Publications/​GFSR/​Issues/​2018/​09/​25/​Global-Financial-Stability-Report-October-2018.

For more details, see Chap. 2.

See also Chap. 2.

Figure 1.3 is adapted from Mishkin and Eakins (2006).

Historically, banks have been the primary providers of essential financial services. However, since the 1980s, there has been a significant expansion of financial markets and a proliferation of financial innovations. As a result, many of the services that were once the exclusive domain of banks are now available through other channels. For example, non-financial firms can now use futures markets to hedge against currency fluctuations, bypassing traditional bank contracts. Some of these firms have become major players in an area that was once dominated by banks.

Clearing involves network operators routing messages and other information among financial institutions to facilitate payments between payers and payees. Interbank settlement is the discharge of obligations that arise in connection with faster payments either in real-time or on a deferred schedule.

See Box: Monetary Policy Pass Through Banks.

In early August 2021, Chinese archaeologists from the State University of Zhengzhou announced the discovery of the world’s oldest known, securely dated coin minting site in Guanzhuang, Henan Province, China. The site, which is dated to around 640 BCE, contains evidence of the production of spade coins, one of the earliest forms of standardised metal coinage: https://​www.​cambridge.​org/​core/​journals/​antiquity/​article/​abs/​radiocarbondatin​g-an-early-minting-site-the-emergence-of-standardised-coinage-in-china/​178ECC2B245A017B​F684BE1EFC732BD1​.

For example, within the euro area, only the euro has the status of legal tender. Article 128 (1) TFEU (Treaty on the Functioning of the European Union) lays down the legal tender status of euro banknotes, and article 11 of Regulation EC/974/98 does so with regard to euro coins. According to the Commission recommendation on the scope and effects of legal tender of euro cash (2010/191/EU) and as confirmed in a judgment by the European Court of Justice in January 2021, legal tender entails, in principle, the mandatory acceptance of cash, at full face value, with the power to discharge from a payment obligation. This means that the creditor is obliged, in principle, to accept a payment made in euro which subsequently discharges the debtor from his payment obligation. There can be exceptions to this principle of mandatory acceptance, for instance where the parties to a contract agree on another means of payment, or where a refusal of cash is made in good faith. Limits to cash payments are also possible for example to combat tax evasion and money laundering.

The Chinese began using paper money around 700 CE. By the time Marco Polo visited China in approximately 1271 CE, the emperor of China had a sophisticated system for managing the money supply, including a variety of denominations (Prasad, 2017).

Many scholars attribute the historical origins of the modern banking system to medieval and Renaissance Italy, particularly the wealthy cities of Florence, Venice, and Genoa. The Bardi and Peruzzi families were prominent banking dynasties in fourteenth-century Florence, with branches throughout Europe (Hoggson, 1926).

Free banking is a monetary system in which banks are free to issue their own paper currency (banknotes) without government regulation. For example, in the United States from 1837 to 1862, there was a period of ‘free banking’. During this time, only state-chartered banks were allowed to operate, and they were free to issue banknotes that were backed by specie (i.e. gold and silver coins). The states heavily regulated these banks, by setting inter alia, reserve requirements, interest rates, and capital ratios.

Today, electronic funds transfers (EFTs) are known by different names in different countries. In the United States, they are often called electronic checks. In the UK, they are called ‘BACS Payments’. In Canada, they are called ‘e-transfers’. And in several other European countries, they are called ‘giro transfers’.

For example, LCH (originally London Clearing House) is a British clearing house group that provides clearing services to major international exchanges and over-the-counter (OTC) markets. LCH provides clearing services for a large set of asset classes such as commodities, securities, interest rate swaps, credit default swaps, and exchange traded derivatives. Like other central counterparty (CCP), LCH acts as a buyer to every seller and a seller to every buyer of cleared contracts.

For instance, in Europe, TARGET2 is a real-time gross settlement (RTGS) system operated by the Eurosystem for central and commercial banks. It settles payments for monetary policy operations, interbank, and commercial transactions, with a value nearly equivalent to the euro area GDP processed every five days. TARGET2 directly involves over 1,000 banks, but its current reach, in 2023, extends to approximately 52,000 global banking entities and their clientele.

https://​www.​federalreserve.​gov/​paymentsystems.​htm.

In general, information asymmetry refers to the situation where one party to a transaction has more information than the other party. In the case of loans, borrowers typically have more information about their own financial situation than lenders. This can lead to problems, as borrowers may have an incentive to withhold negative information from lenders. Banks can overcome these problems by pooling the deposits of many individuals and using this information to assess the quality of loans. This allows banks to offer loans to borrowers and it also helps to reduce the risk of lending.

https://​www.​bis.​org/​publ/​bcbs18.​htm.

The Basel Committee on Banking Supervision (BCBS) has issued guidelines on the management of OBS activities. These guidelines aim to ensure that banks have a comprehensive understanding of their OBS activities and that they are adequately managing the associated risks. Supervisory and prudential authorities round the world have also issued and adopted guidance on the management of OBS activities. The idea is to focus on the risks associated with specific types of OBS activities, such as derivative contracts and securitization products.

For more details, see Chap. 2.

The Financial Stability Board (FSB) warned in April 2020 that a major cyber incident, if not properly contained, could have serious implications for financial stability. Such an incident could disrupt financial systems, including critical financial infrastructure and have significant economic costs and damage public trust and confidence.

Recently and in response to the Russian invasion of Ukraine, many governments have imposed a range of financial sanctions on Russia, including asset freezes and the exclusion of Russian banks from the Society for Worldwide Interbank Financial Telecommunication (SWIFT). These sanctions aim to disrupt Russia’s financial system and economy and to pressure the government to end the war.

Generally, moral hazard occurs when one party to a contract has an incentive to behave in a way that is not in the best interests of the other party, because the first party is not fully exposed to the consequences of its actions. This can happen in a variety of contexts, including financial markets. For example, a borrower may be more likely to take on excessive risk if he knows he will be bailed out in case of default. To mitigate moral hazard risks, contemporary banking literature suggests that policymakers need to put in place appropriate regulations and monitoring mechanisms.

We define risk premium as the additional return that investors demand for bearing the risk of an investment. Mathematically, it is computed as the difference between the expected return on an investment and the risk-free rate of return. Put simply, the risk premium is compensation for the possibility that the investment’s return could be lower than expected, or that the investor could lose money altogether.

Generally, non-diversifiable risks are those risks that cannot be eliminated through portfolio diversification. These risks include for example market risk—which reflects systemic fluctuations in asset prices, or geopolitical risk, which is the risk that events such as wars, natural disasters, or political instability.

Open market operations (OMOs) are a tool used by central banks to manage the money supply and interest rates. OMOs involve the purchase or sale of government securities in the open market. When a central bank buys securities, it injects money into the economy, which can lead to lower interest rates. When a central bank sells securities, it withdraws money from the economy, which can lead to higher interest rates. OMOs can be used to achieve a variety of policy goals, such as stimulating economic growth, controlling inflation, or stabilising the exchange rate. The effectiveness of OMOs depends on a number of factors, including the size of the purchase or sale, the interest rate environment, and the expectations of market participants.

Monetary base equals currency in circulation plus reserve balances.

https://​www.​ecb.​europa.​eu/​pub/​pdf/​other/​monetarypolicy20​11en.​pdf.

In the context of the euro area, the ECB sets three key administered interest rates: (i) the main refinancing operations (MRO), which provide the bulk of liquidity to the banking system, and it is the rate banks pay when they borrow money for one week, (ii) the deposit facility rate (DFR), which banks may use to make overnight deposits, and (iii) the marginal lending facility rate (MLFR), which offers overnight credit to banks.

The idea of monetary neutrality can be traced back to David Hume in the eighteenth century, but it gained widespread attention after von Hayek (1951). Keynes et al. (1971), on the other hand, rejected the neutrality of money both in the short term and in the long term. He argued that changes in the money supply could have real effects by affecting investment and employment. As of today, the New Keynesian school emphasises models in which money is not neutral in the short run, and therefore monetary policy can affect the real economy.

In June 2014, the ECB became the first major central bank to introduce negative interest rates. This meant that banks were charged negative interest rates for putting their reserves at the ECB. The move was a radical departure from conventional monetary policy, and the decision for this shift was motivated by a number of factors, including low inflation and the threat of deflation. Negative interest rates were seen as a way to encourage banks to lend more in order to stimulate output and employment. From a theoretical perspective, the existence of an arbitrage relationship between the return on short-term nominal bonds and the return on cash has long been known in the academic literature. To quote (Hicks, 1935): ‘[…] So long as rates of interest are positive, the decision to hold money rather than lend it, or use it to pay off old debts, is apparently an unprofitable one’.

CBDC is a digital form of central bank money that could be used by households and businesses to make payments. CBDC is not a new currency, but rather a digital version of the existing fiat currency. A report by the Bank for International Settlements (BIS) states that, although the term CBDC is not well-defined, ‘it is envisioned by most to be a new form of central bank money […] that is different from balances in traditional reserve or settlement accounts’ (Bech and Garratt,2017).

According to Brunnermeier et al. (2019), the ongoing digital revolution is reshaping the way we think about money. We may see an unbundling of the traditional roles of money, with separate currencies emerging to fulfil each role. For example, a currency may be used primarily for payments, while another currency may be used primarily for storing value. Alternatively, we may see a re-bundling of money, with digital currencies associated with large platform ecosystems offering a variety of payment and financial services. This could lead to a more fragmented and complex monetary system. Digital currencies could also have a significant impact on the international monetary system. Countries that are socially or digitally integrated with their neighbours may face digital dollarization, as their citizens and businesses increasingly use the US dollar for payments and savings. Additionally, the prevalence of systemically important platforms could lead to the emergence of digital currency areas that transcend national borders. They also claim that CBDCs can help to mitigate some of these risks. By providing a safe and reliable digital form of central bank money, CBDCs can help to ensure that public money remains a relevant unit of account and that the international monetary system remains stable.

Historically, PayPal was founded in 1998 as Confinity, a security software firm for handheld devices. It pivoted to a digital wallet in 1999 and merged with X.com, an online finance venture, in 2000. The combined entity was renamed PayPal in 2001 and went public in 2002. It was acquired by eBay for $1.5 billion later that year. As part of eBay, PayPal expanded its reach and security measures. It also launched new products and services, such as the PayPal Secure Card and partnerships with MasterCard and Discover Card. In 2015, PayPal separated from eBay and pursued a strategy of acquisitions, partnerships, and technological advancements. It acquired Xoom Corporation, launched the peer-to-peer platform ‘PayPal.Me’, and purchased Honey for over $4 billion in 2020. In 2023, PayPal launched its US dollar stablecoin, known as PayPal USD.

For example, see the US Congressional report entitled ‘Libra: A Facebook-led Cryptocurrency Initiative’ from 2019.

https://​www.​bloomberg.​com/​news/​articles/​2019-06-18/​france-calls-for-central-bank-review-of-facebook-cryptocurrency.

https://​web.​archive.​org/​web/​20190710233742/​https://​www.​nytimes.​com/​2019/​07/​10/​technology/​fed-chair-facebook-cryptocurrency-libra.​html.

During this episode, Diem Association (formerly Libra Association) also encountered legal obstacles because the name and logo of the digital currency were already in use in various jurisdictions.

https://​www.​bloomberg.​com/​news/​articles/​2023-03-08/​silvergate-plans-to-wind-down-bank-operations-and-liquidate.

https://​remittanceprices​.​worldbank.​org/​.

Stablecoins are a type of cryptocurrency whose value is supposed to be pegged to a reference asset. However, in practice, stablecoin issuers have yet to be proven to maintain adequate reserves to support a stable value. This is a potential risk to financial stability, as stablecoins are increasingly being used in a variety of financial applications. For example, the Terra blockchain was temporarily suspended in May 2022 following the collapse of the TerraUSD (UST) stablecoin and its sister token Luna. The event wiped out USD 45 billion in market capitalisation in a matter of days. The collapse of UST and Luna had a ripple effect throughout the cryptocurrency market, causing prices of other tokens to fall. It also raised concerns about the stability of stablecoins, which are seen as a key building block of the crypto ecosystem.