Welcome to the money and banking video series. ... 00:00
What makes an economy vulnerable to a financial crisis? ... 00:11
How can a small shock trigger a large-scale crisis? ... 00:14
How to manage a crisis? ... 00:16
How to prevent it? And who should be in charge of it? ... 00:21
In this video series you will learn about ... 00:24
money creation by banks, liquidity spirals and ... 00:26
the debt disinflation spiral as well as ... 00:30
the paradox of prudence. You will study ... 00:33
macro-prudential policy and monetary ... 00:35
policy, contrasting the money view with ... 00:38
the credit view. You will become familiar ... 00:41
with monetary dominance, fiscal ... 00:43
dominance and financial dominance. ... 00:45
In addition, you will be exposed to various ... 00:48
stability concepts and to the diabolic or ... 00:50
doom loop between banking and sovereign risk. ... 00:53
This video series is based on two ... 00:56
articles I wrote with Yuliy Sannikov, ... 00:59
titled the I Theory of Money and ... 01:01
Redistributive Monetary Policy. Our research sheds new light ... 01:07
on these questions and studies the interaction ... 01:10
between monetary policy, financial regulation ... 01:12
and fiscal policy. Part one of ... 01:15
this video series studies how the ... 01:19
financial sector works. Lets start by ... 01:21
setting up a simple economy with a ... 01:24
financial sector. In our simple economy ... 01:26
there is a bank and someone we call end-borrower ... 01:29
who might want to buy a house. He goes to ... 01:32
a bank and takes out a mortgage, lets say ... 01:35
a million dollars. The bank which grants him a mortgage will ... 01:38
credit the end-borrower one million ... 01:42
dollars as deposit as soon as the ... 01:44
mortgage is agreed upon. ... 01:46
This creates credit on the asset side of the banks ... 01:50
balance sheet and deposits on the ... 01:52
liability side of the banks balance ... 01:54
sheet. When the end-borrower finally buys a ... 01:56
house and makes a payment to the seller ... 01:58
he transfers his deposit to the seller of the house. ... 02:00
As long as the seller holds a deposit ... 02:04
he essentially, through the bank, lends funds ... 02:08
to the end-borrower. ... 02:11
Notice that after the purchase of the house ... 02:13
the credit, the mortgage to the end-borrower, ... 02:16
is risky to the bank while the savers ... 02:19
deposit is supposedly risk-free. ... 02:21
Second, the mortgages are long-term commitments ... 02:26
to the bank while the savers deposits are short term. ... 02:28
For these reasons the bank faces two risks. ... 02:32
First, on the asset side there is a ... 02:35
possibility that the end-borrower does not ... 02:38
pay back his debt. The bank faces credit ... 02:40
or default risk, represented graphically by the ... 02:44
fluctuating curve. Second, the bank faces ... 02:48
liquidity funding risk or run risk ... 02:51
which stems from the fact that the credit is ... 02:54
long term while deposits are short term. ... 02:57
If suddenly all savers withdraw their deposits ... 03:00
the bank will not be able to repay them. ... 03:03
In order to cover default risk the bank ... 03:05
should have an equity cushion to ... 03:08
protect the depositors, savers in our example. ... 03:10
In order to fend off liquidity run risk ... 03:13
some of these funds are invested ... 03:15
in safe assets, for example reserves. ... 03:19
The banks balance sheet now has reserves on ... 03:22
the asset side in addition to credit. ... 03:26
On the liability side it has the equity of ... 03:29
the bank in addition to savers own ... 03:31
deposits, IOUs against the bank. ... 03:34
Of course, the bank has many end-borrowers on ... 03:39
the asset side and many savers, deposit holders, ... 03:42
on the liability side. ... 03:45
Granted these risky loans to the ... 03:47
end-borrowers do not default all at the same time. ... 03:51
The risks of each end-borrower partially ... 03:54
offset each other. The bank diversifies ... 03:59
risk across various end-borrowers. ... 04:02
And putting various credits together into a single ... 04:06
portfolio which is like merging the fluctuating ... 04:09
curves into a single one, ... 04:13
fluctuations are largely averaged out. ... 04:14
Also, notice that although the bank ... 04:17
grants many forms of credit the bank ... 04:21
issues standardized IOUs in form of deposits. ... 04:23
So on the asset side there are ... 04:27
long-term assets which are risky and ... 04:30
illiquid, while on the liability side there are ... 04:32
standardised deposits, IOUs, issued by ... 04:34
the bank, the latter which are much more liquid. ... 04:38
In a sense, liquid deposits are ... 04:40
one of the outputs of the banks production function. ... 04:43
These standardized deposits, IOUs, are inside money that ... 04:48
is created by the banking sector. ... 04:54
Since they are short term they are readily available. ... 04:58
Due to the protection from the ... 04:60
equity of the bank the default probabilities are ... 05:03
