The Economics of Money, Banking and Finance Visit the Economics of Money, Banking and Finance, third edition Companion Website at www.pearsoned.co.uk/howells to find valuable student learning material including: Learning objectives for each chapter n Multiple choice and written answer questions to help test your learning n Annotated links to relevant sites on the web n An online glossary to explain key terms n We work with leading authors to develop the strongest educational materials in economics, bringing cutting-edge thinking and best learning practice to a global market. Under a range of well-known imprints, including Financial Times Prentice Hall, we craft high quality print and electronic publications which help readers to understand and apply their content, whether studying or at work. To find out more about the complete range of our publishing, please visit us on the World Wide Web at: www.pearsoned.co.uk THIRD EDITION The Economics of Money, Banking and Finance A European Text PETER HOWELLS and KEITH BAIN iv CONTENTS Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk First published 1998 by Addison Wesley Longman Limited Second edition published 2002 Third edition published 2005 © Pearson Education Limited 1998, 2002, 2005 The rights of Peter Howells and Keith Bain to be identified as authors of this work have been asserted by the them in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP. ISBN-13: 978-0-273-69339-0 ISBN-10: 0-273-69339-5 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Howells, P. G. A., 1947– The economics of money, banking and finance : a European text / Peter Howells and Keith Bain.–– 3rd ed. p. cm. Includes bibliographical references and index. ISBN 0-273-69339-5 1. Finance––Europe. 2. Banks and banking––Europe. 3. International finance. I. Bain, K., 1942– II. Title. HG925.H695 2005 332.1’094––dc22 2005040733 10 9 8 7 6 5 4 3 2 10 09 08 07 06 Typeset in 9/11.5 Sabon by 35 Printed by Ashford Colour Press Ltd, Gosport The publisher’s policy is to use paper manufactured from sustainable forests. Contents Preface xi 2.4 Non-deposit-taking institutions Acknowledgements xiii – insurance companies and Symbols, abbreviations and other pension funds 41 conventions xvi 2.5 Non-deposit-taking institutions – mutual funds 63 2.6 Summary 67 Key concepts in this chapter 68 Part 1 Introduction Questions and problems 68 Further reading 69 1 The role of a financial system 3 3 The UK financial system 70 1.1 Introduction 4 Murray Glickman with Peter Howells 1.2 Lenders and borrowers 5 3.1 Introduction 71 1.3 Financial institutions 10 3.2 Banks in the UK 71 1.4 Financial markets 19 3.3 Building societies in the UK 78 1.5 The financial system and the 3.4 Insurance companies 81 real economy 20 3.5 Pension funds 83 1.6 Summary 24 3.6 Unit trusts 91 Key concepts in this chapter 25 3.7 Investment trusts 94 Questions and problems 25 3.8 Summary 95 Further reading 25 Key concepts in this chapter 96 Questions and problems 96 Further reading 96 Part 2 Financial Institutions and 4 The US financial system 98 Systems 4.1 Introduction 99 4.2 Deposit-taking institutions 2 An introduction to financial in the USA 99 systems 29 4.3 The Federal Reserve System 106 4.4 Non-depository institutions Murray Glickman in the USA 109 2.1 Introduction 30 4.5 Summary 111 2.2 Classification of financial systems 30 Key concepts in this chapter 112 2.3 Banks and other deposit-taking Questions and problems 112 institutions 32 Further reading 112 vi CONTENTS 5 The German financial system 113 Part 3 Theory 5.1 Introduction 114 5.2 Banks and other deposit-taking institutions 115 8 Portfolio theory 171 5.3 Non-deposit institutions 119 5.4 The use of bond and equity markets 8.1 Introduction 172 in Germany 120 8.2 Risk and return 172 5.5 Summary 122 8.3 Diversification 173 Key concepts in this chapter 123 8.4 ‘Market’ and ‘specific’ risk 177 Questions and problems 123 8.5 The capital asset pricing model 178 Further reading 123 8.6 Summary 180 Key concepts in this chapter 181 Questions and problems 181 6 The French and Italian Further reading 181 financial systems 125 9 The determination of 6.1 Introduction 126 6.2 The French banking system 127 short-term interest rates 182 6.3 Specialist and non-deposit 9.1 Introduction 183 institutions 132 9.2 Interest rates defined and classified 183 6.4 Financial markets in France 137 9.3 ‘Market’ theories of interest rate 6.5 The development of the Italian determination 184 financial system 139 9.4 The role of central banks – 6.6 The current position of the Italian ‘administered’ interest rates 192 financial system 141 9.5 A synthesis 196 6.7 Summary 149 9.6 Summary 197 Key concepts in this chapter 150 Key concepts in this chapter 197 Questions and problems 150 Questions and problems 198 Further reading 150 Further reading 198 7 Financial systems in 10 The structure of interest rates 199 Northern Europe 152 10.1 Introduction 200 Hans-Michael Trautwein 10.2 The effect of term 200 10.3 The effect of risk 203 7.1 Introduction 153 10.4 Expectations and government 7.2 Banking systems in the Nordic borrowing 204 countries 154 10.5 Summary 208 7.3 Other financial intermediaries Key concepts in this chapter 208 in the Nordic countries 158 Questions and problems 209 7.4 The evolution and integration of Further reading 209 financial systems in Scandinavia 160 7.5 Monetary policy strategies in the 11 The valuation of assets 210 Nordic countries 163 7.6 Summary 166 11.1 Introduction 211 Key concepts in this chapter 167 11.2 Supply and demand in asset markets 211 Questions and problems 167 11.3 Asset valuation 213 Further reading 167 11.4 The ‘fundamentals’ of asset valuation 218 CONTENTS vii 11.5 An alternative interpretation 219 14.6 Governments, inflationary incentives 11.6 Summary 221 and independent central banks 278 Key concepts in this chapter 222 14.7 The independence of the Bank Questions and problems 222 of England 281 Further reading 223 14.8 Transparency in the conduct of Appendix to Chapter 11 223 monetary policy 282 14.9 Summary 285 Key concepts in this chapter 285 Questions and problems 285 Part 4 Money and Banking Further reading 286 12 Banks and the supply of money 227 Part 5 Markets 12.1 Introduction 228 12.2 The definition of money 228 15 Money markets 289 12.3 Banks’ balance sheets 235 12.4 Models of money supply 15.1 Introduction 290 determination 240 15.2 Money market instruments: 12.5 Controlling the money supply 244 characteristics and yields 291 12.6 Summary 248 15.3 Characteristics and use of the Key concepts in this chapter 248 money markets 296 Questions and problems 249 15.4 Official intervention in the money Further reading 249 markets 297 15.5 The Eurocurrency markets 303 13 The demand for money 250 15.6 Summary 305 Key concepts in this chapter 305 13.1 Introduction 251 Questions and problems 306 13.2 The demand for money – an Further reading 306 introduction 251 13.3 The transmission mechanism of 16 Bond markets 308 monetary policy 252 13.4 The demand for money – a more 16.1 Introduction 309 complete approach 254 16.2 Bonds: types and characteristics 309 13.5 The implications for monetary policy 264 16.3 Bond prices and yields 311 13.6 Summary 264 16.4 Risk and fixed interest bonds 319 Key concepts in this chapter 265 16.5 The term structure of interest rates 322 Questions and problems 265 16.6 Characteristics of the bond markets 330 Further reading 265 16.7 International bonds 336 16.8 Summary 340 14 Monetary policy 266 Key concepts in this chapter 340 Questions and problems 341 14.1 Introduction 267 Further reading 341 14.2 The simple Phillips curve 267 14.3 The ‘expectations-augmented’ 17 Equity markets 343 Phillips curve 269 14.4 The policy irrelevance theorem 272 17.1 Introduction 344 14.5 The transmission mechanism of 17.2 Company shares: types, monetary policy 275 characteristics and returns 345 viii CONTENTS 17.3 Equity pricing 346 Key concepts in this chapter 440 17.4 Share price movements 356 Questions and problems 440 17.5 Equity market characteristics 359 Further reading 441 17.6 Summary 366 Key concepts in this chapter 367 Questions and problems 367 Further reading 368 Part 6 Current Issues 18 Foreign exchange markets 369 21 The single European market 445 18.1 Introduction 370 18.2 The reporting of foreign exchange 21.1 Introduction 446 rates in the Financial Times 373 21.2 The objectives and achievements 18.3 The efficient market hypothesis 381 of the Single European Act 446 18.4 Exchange rate arbitrage 387 21.3 The single financial market 18.5 Foreign exchange risk and (European Financial Common speculation 388 Market – the EFCM) 448 18.6 Forecasting foreign exchange rates 390 21.4 Progress towards the EFCM 454 18.7 Summary 393 21.5 Enlargement to 25 461 Key concepts in this chapter 393 21.6 Summary 461 Questions and problems 394 Key concepts in this chapter 462 Further reading 395 Questions and problems 462 Further reading 463 19 Derivatives – the financial futures markets 396 22 The European Monetary System and monetary union 464 19.1 Introduction 397 19.2 The nature of financial futures 398 22.1 Introduction 465 19.3 Reading the Financial Times 401 22.2 The Treaty on European Union 19.4 The pricing of futures 405 and the plans for monetary union 467 19.5 Summary 413 22.3 The problems of the 1990s 468 Key concepts in this chapter 413 22.4 The movement to monetary union 469 Questions and problems 414 22.5 Monetary union developments 470 Further reading 415 22.6 Future membership of the monetary union 472 20 Options, swaps and other 22.7 Summary 476 Key concepts in this chapter 477 derivatives 416 Questions and problems 477 20.1 Introduction 417 Further reading 477 20.2 Options 417 20.3 Reading the Financial Times 420 23 The European Central Bank 20.4 The pricing of options 425 and euro area monetary policy 478 20.5 Exotic options 430 20.6 Swaps 431 23.1 Introduction 479 20.7 Comparing different types of 23.2 Inflation, exchange rate risk and derivatives 434 default risk in monetary union 481 20.8 The use and abuse of derivatives 435 23.3 Monetary institutions and policy 20.9 Summary 439 in the single currency area 482 CONTENTS ix 23.4 The form of monetary policy in 25.4 The impact of globalization and the euro area 485 financial innovation – the Basel 23.5 ECB monetary policy and the euro 489 Committee 529 23.6 Possible reforms at the ECB 493 25.5 The regulation of universal 23.7 Summary 493 banking in the EU 535 Key concepts in this chapter 494 25.6 Summary 536 Questions and problems 494 Key concepts in this chapter 537 Further reading 495 Questions and problems 537 Further reading 538 24 Financial innovation 496 26 Financial market efficiency 539 24.1 Introduction 497 24.2 Theories of innovation 497 26.1 Introduction 540 24.3 Three case studies 501 26.2 The efficient market hypothesis 541 24.4 The demand for money and 26.3 Implications of the EMH 543 monetary policy 508 26.4 Testing the EMH 547 24.5 Summary 513 26.5 Market rationality 550 Key concepts in this chapter 513 26.6 Behavioural finance 552 Questions and problems 514 26.7 Summary 555 Further reading 514 Key concepts in this chapter 555 Questions and problems 556 25 The regulation of financial Further reading 556 markets 516 Case Studies 1–8 557 25.1 Introduction 517 Glossary of terms 584 25.2 The difficulties of regulation 519 Answers to Exercises 590 25.3 Banking regulation 527 Index 594 Supporting resources Visit www.pearsoned.co.uk/howellsto find valuable online resources: Companion Website for students n Learning objectives for each chapter n Multiple choice and written answer questions to help test your learning n Links to relevant sites on the web Convenience. Simplicity. Success. n An online glossary to explain key terms For instructors n Complete, downloadable Instructor’s Manual n PowerPoint slides that can be downloaded and used as OHTs Also:The Companion Website provides the following features: n Search tool to help locate specific items of content n E-mail results and profile tools to send results of quizzes to instructors n Online help and support to assist with website usage and troubleshooting For more information please contact your local Pearson Education sales representative or visit www.pearsoned.co.uk/howells