This textbook builds upon extant textbooks such as Frederic Mishkin, The Economics of Money, Banking, and Financial Markets [Pearson numerous editions and variants], and Stephen G. Cecchetti and Kermit L. Schoenholtz, Money, Banking and Financial Markets [McGraw-Hill Irwin 2011]. These textbooks, and many others, provide well-established precepts within this large domain. This textbook does not repeat what is found in these classic texts. The approach is to start where they left off and to question the wisdom of assertions they make, particularly the claim that financial intermediation efficiently and effectively allocates capital and that market failure is an exception.
The textbook starts from the observation that we live in a new world of finance. Low interest rates are not correlated to higher inflation. Quantitative easing, originally an exceptional Central Bank instrument, is the new norm. Domestic and international payment systems are broken, in spite of the post-2009 innovations introduced by challenger banks or FinTechs. Digital ledger technology and decentralised finance contain potential to alter the existing financial framework. A single, seamless global financial system cannot exist.
In 2021, banks still require wet signatures, visits to physical branches, use checking systems, limit withdrawal amounts, and offer less than exciting investment and borrowing instruments. Governments, through their financial regulators, fearing the unknown are bent on oppressing or co-opting innovative payment systems, currencies and new markets for novel instruments.
The attachments contain material specific to issues covered in the Chapter.
DefinitionsIn the world of international banking/finance, there is no single agreed upon vocabulary. For purposes of this book, the term "international banking" refers to banking transactions that cross political frontiers and territories. Banking transactions generally, but exclusively, involve taking deposits and lending. However, it is commonplace that banks serve primarily four functions: payments, lending, investment, and risk management. Legacy banks do not perform these functions without friction and fees.
Banks have several modes to enter foreign markets. But the following are commonplace: acquisition, establishment of a subsidiary, branching, and cross-border delivery of digital financial services. The key to an international transaction as opposed to a domestic transaction is the involvement of a foreign element or the crossing of distinct political frontiers.
International banking also may mean taking advantage of loosely or lightly regulated jurisdictions for purposes of tax minimisation or asset protection. In addition, the term may refer to non-bank financial institutions, such as hedge funds, that are not as highly regulated as banks. However, this textbook does not deal with "shadow banking" however important it may be within the global financial system.
Further, the distinction between an international banking transaction and a domestic banking transaction often is not clear cut. For example, take an individual that has a multiple currency account with a bank in the individual's jurisdiction of residence. The mere fact of having a multiple currency account does not invoke the concept of international banking in terms of anything crossing borders. However, assume that this account owner instructs the bank to convert one currency to another. Does that transaction constitute an international banking transaction?
The term "financial markets" suffers from the same lack of a globally accepted taxonomy. Financial markets do not differ substantially from any market where buyers and sellers have a venue to trade and exchange. The distinguishing feature is what is being traded or exchanged. Financial markets deal with creating a market for financial instruments. But that statement simply states the obvious; it is a tautology. We may go deeper and distinguish between highly organised and transparent markets trading in "listed" securities whether it be the NYSE, Nasdaq OMX, the London Stock Exchange, or the numerous other well-known exchanges, and the OTC market where "unlisted" securities are traded. Then, we must consider electronic communication networks, such as NYSE arca. This regression may go on.
In contrast, we may understand financial markets by dividing them into boxes characterised by the type of instrument primarily traded on the exchange: equity, debt, derivatives, commodities, futures, and now cryptocurrency. The same result is produced: lack of clarity. Financial instruments are the product of imagination and legal restraint.
This discussion brings us to the question: what is a "financial instrument". Consensus states that financial instruments are contracts related to an object of value -an asset - or a claim. Take for example, common equity traded on the secondary market. There is a contract between the issuer and holder. But what are the terms; it depends. But, for simplicity's sake, take the ordinary instrument. A holder has a right to vote, via a proxy statement, a right to dividends if declared by the Board of directors, and that right is subordinate to preferred shareholders, and a right to alienate or sell the security. Common equity is a far cry from what is usually deemed ownership of an asset.
Debt instruments, such as corporate bonds, take on the cloak of contracts more precisely. The relationship between issuer and holder is governed by an instrument - the indenture. The latter is enforced by a trustee. The issuer must adhere to the terms of the contract and the holder has a right to a stream of payments at the coupon rate plus repayment of principal at maturity, subject to recall, if provided in the indenture. An interesting project would be to analyse diverse financial instruments within the frame of contracts or another construct.
Nevertheless, despite these insufficiencies, the foregoing definitions provide a starting point to understand and analyse financial services.
Financial MarketsThere are numerous financial markets but the discussion starts with the major well-known exchanges. The Intercontinental Exchange
[ICE] is a publicly traded company that owns the largest exchange network in the world: NYSE Euronext,
NYSE Arca, various future exchanges in
Europe, Singapore, and Abu Dhabi. ICE also owns clearing and settlement houses throughout the world.
The next largest market is Nasdaq Inc., formerly Nasdaq OMX.