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Investment Banking

Investment Banking – Starting with the Basics

Investment banking trading division uses fundamental analysis, technical analysis, prudent money management strategies, and knowledge of the central bank’s monetary policy determination and implementation along with knowledge of the markets to create trading strategies.

In order to completely understand all these aspects of trading we need to begin with the fundamentals of banking, since intermediaries such as banks have an impact on money supply and in turn interest rates.

Banking Basics – Fractional Reserve Banking, Central Banks, and Money Supply

In the fractional reserve banking section we mentioned that banks influence the money supply through loanable funds which in turn impacts the interest rates in the economy – a function far too important to be left to banks to monitor and influence.

The government therefore forms a central bank, a banker for banks, that sets policies to regulate the influence of banks on the supply of money. The central bank’s use tools such as reserves, open market operations, Fed funds rates etc that we need to understand so that when the Fed makes changes in their policies we can decipher its impact on the markets.

In 1913, the Congress created the Federal Reserve System in the US for implementing the monetary policy. Policy changes also influences the pace of money creation, which in turn affects growth and inflation.

Central Bank’s Monetary Policy

Investment Bankers also need to understand what exactly the central bank’s can and cannot control, the tools it uses, the economic data it monitors, how it implements monetary policy and much more.

In addition they understand macroeconomic indicators, how indicators affect the behaviours of economic entities causing shifts in money supply or demanded, in turn causing shifts in interest rates and in turn affecting growth and inflation. Factors that determine monetary policy such as economic indicators and tools that are used in implementing monetary policy are essential to know by traders and investors.

The final objective is to decipher the signals the Federal Reserve Bank sends to the market about the desired levels of short term rates. Understanding how the monetary policy works is key to understanding the direction of short term interest rates. Any changes in policy can then be spotted to provide us early warning signals that interest rates are going to change, allowing us to position ourselves accordingly.

Banking Foundations

We still need to build on some more foundations before we can begin to understand the central bank’s monetary policy determination and implementation. When introducing banking in our fictitious economy we had introduced the term reserves when discussing fractional reserve banking. With the invention of fractional reserve banking the one-to-one correspondence between bank deposits and cash in vaults no longer held true. Deposits were created when loans were sanctioned. Cash in vaults is a small percentage of deposits and now represent reserves required for servicing cash or cheque withdrawals.

In order for central bank’s to influence the banking sector to impact interest rates, it needs to influence the quantity of loans created by the banking system. The question that therefore beckons is how can the central bank’s influence loan creation by the banking system? What are the parameters of banks that can be influenced to alter their behaviour?

Banking Loans, Deposits and Reserves

To understand this we need to understand a bit more about how a bank functions.

Lets revisit our fictitious economy Metrocity and its evolved banking structure to understand how banks function.

Lets assume that the banking system in Metrocity is now flourishing with banks being highly profitable. We too decide to open a bank – Bank of Metrocity to join this highly profitable market. In order to open a bank we decide to raise 10million in capital. At this point the bank’s balance sheet will look like

 

Debit

Credit

Assets

Cash

10

Liabilities and Equity

Capital

10

The banking system in Metrocity has evolved to a point where it has a central bank that regulates the banking system to some extent. Lets call this the Reserve Bank of Metrocity – RBM. As we saw in warehouse banking, banks deposit reserves at the central bank to facilitate payments of cheques.

When cheques are presented to the clearing house the banks account at the clearinghouse is debited or credited by the net amount. For now lets assume that the only purpose for banks to keep reserves at the central bank are for the purposes of clearing cheques. For our bank lets keep a reserve of $5million. The balance sheet would look like

 

Debit

Credit

Assets

Cash

5

Deposit at Central Bank

5

Liabilities and Equity

Capital

10

Now that we’ve opened a bank our main objective is to make money so lets start disbursing loans and accepting deposits. A prospective clients comes into the bank seeking an approval for a $1 million loan to open a business. The bank’s credit department approves the loan after the due diligence process. Once the loan is sanctioned, the loan is initiated by creating a deposit . The balance sheet now changes to

Debit

Credit

Assets

Cash

5

Deposit at Central Bank

5

Loans

1

Liabilities and Equity

Checking Deposit

1

Capital

10

We see here that effect of increasing banking loans has an immediate effect of increasing deposits that adds to the money supply in Metrocity.

If by the end of the year the client repays half the amount of the loan the balance sheet would look like

Debit

Credit

Assets

Cash

5

Deposit at Central Bank

5

Loans

0.5

Liabilities and Equity

Checking Deposit

0.5

Capital

10

Since the objective of the bank is to make profits, the cash in bank earns no interest the bank decides to increase its loans to customers. By the end of the year the balance sheet of Bank of Metrocity would start looking like

Debit

Credit

Assets

Deposit at Central Bank

5

Loans

25

Liabilities and Equity

total Deposit

20

Capital

10

 

Next we understand how bank’s compute their profitability and the constraints they face.

Related Topics

Fractional Reserve Banking

Central Bank’s Monetary Policy

Bank Profitability

Technical Analysis

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