AG991 International Financial Markets and Banking

2023

– Revision help -
This document contains notes reflecting issues raised in the workshop
discussions. They should serve as a reminder and starting point for your own
answers. They do not replace the required readings or your own thoughts on
the questions!

This document is for your own personal study only, you

may not distribute it in any way.

Lecturer: Juliane Thamm

e-mail: juliane.thamm@strath.ac.uk ext.: 3889

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AG991 workshop 1

1. Why do financial markets exist?

Bring together investors (savers) and borrowers - direct finance (no intermediaries exist yet)

Buying and selling of financial assets

Matching different preferences/needs between surplus and deficit units

Facilitate channelling of funds in the economy

Time Saving

Transaction Costs

2. How would the economy function without them?

Higher Research Cost (both for investors and companies)

Higher Transaction Cost

Barriers in matching preferences

Lower value transactions

Slowdown of Economic Development/ Slower growth rate

Limited flow of wealth from surplus to deficit units

Fewer options for lenders and borrowers

3. Why do financial intermediaries exist?

Facilitate transactions between investors and firms – indirect finance

Create information -> less information asymmetry

Terms of transaction are better for both lender and borrowers

Risk management (risk averse investors)

Expertise – better knowledge

Diversification

Financial Claims Transformation

Maturity

Risk (economies of scale, diversification, expertise)

Size

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Lower search/transaction costs

Time efficiency

Increased liquidity

Monitoring

4. How would the economy function without them?

Direct financing

Obstacles in matching needs

Less money supply in the market -> Limits on investment potential

Fewer options for both parties

Lower growth rate

Less liquidity

Higher information asymmetry -> higher risk -> lack of trust between investors and firms

Transaction costs (negotiation, search, contracting)

Borrowers: search, negotiation costs, higher interest rates…

Lenders: monitoring, screening costs, contracting, default risk, legal enforcement

costs.

Time inefficiencies

Lack of monitoring

5. What are the potential disadvantages of financial intermediaries?

Lack of transparency / In possession of information that can be used to their advantage

Manipulation of information -> Market manipulation

Create inequalities via concentration of wealth to certain groups

Insider trading (not explicitly found only on financial intermediaries though)

Extremely risky financial products/ instruments

Potential for monopolies

Who monitors the monitor?

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AG991 workshop 2

1. Compare and contrast the functions of banks and building societies.

Banks Building Societies

ownership Owned by shareholders / paying Members (mutual society)

dividends
Each member has one vote
Voting power proportional to share
ownership

business Maximise value for shareholders Provide value to customers/ members

goals (lower net interest rate margins => lower
borrowing rates & higher rates on deposit)

business Variety of services / higher range of Most of lending is for mortgages/ buying
activities options for customers houses

Can include investment banking Less range of products/ services

Individual and business customers Focus on individual customers, but also

provide services to small businesses

size Generally larger in size Generally smaller in size

The UK banking sector is dominated by a As of financial year end 2019/20 the 43 UK

few very large banks, including the
Lloyds Group (£833.89billion), Barclays
(£1,140.23billion), NatWest/RBS
(£723,04billion), and HSBC
(£2,049.58billion)1.
building societies had assets ranging from
£245,732million for the largest to
£113million for the smallest.2

regulation No limit on mortgage provision 75% of business should be focused on

No limit of where funding can come
from (as long as minimum capital
requirements etc. are met)
Can operate internationally
mortgage provision to individuals
Only up to a maximum of 50% of funds can
be from wholesale markets (predominant
funding source must be deposits)
Barred from international business

areas in Both financial intermediaries – bringing together lenders and borrowers

common
Deposit taking institutions

1
Amounts in brackets are total assets as of yearend 2019, source: https://www.statista.com/statistics/386948/uk-banks-
total-assets-ranking/
2
https://www.bsa.org.uk/document-library/consumers/assets_website-(1).aspx

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Give loans out of deposits - both make money through interest rate margins (difference
in borrowing and lending rates)

both are dual-regulated, which means that they are regulated by the Financial Conduct
Authority (FCA) and by the Prudential Regulation Authority (PRA) in the UK

Note: Accepting deposits is a regulated activity where such deposits are lent to third
parties, or where any other activity is financed wholly or to a material extent out of
capital or interest on deposits. Banks and building societies must therefore obtain
authorisation under the Financial Services and Markets Act 2000 to accept deposits. As
of 2020 there are 137 UK banks and building societies (and a further 264 international
institutions) that are authorised to do so.3

Legislation The primary statute governing banking
(selection) in the UK is Financial Services and
Markets Act (FSMA) 20004 . Extensive
amendments were made to FSMA 2000
by the Financial Services Act 20125 and
further changes were made by the
Financial Services (Banking Reform) Act
20136 to implement key reforms such as
e.g. ring-fencing requirements for the
banking sector.
The Building Societies Act 19867 gave
building societies what, at the time, was a
completely new legal framework for the first
time since the initial comprehensive building
society legislation in 1874. That Act has
subsequently been amended on numerous
occasions, and was substantively revised by
the Building Societies Act 19978, by the
FSMA 20009 and by the Financial Services
Act 201210 (which also amended the 2000
Act). Other relevant laws are e.g. the
Butterfill Act 200711, allowing transfer of
business to another mutual society, and
Banking Act 200912, which provides a range
of tools to deal with building societies that
are failing. (for further optional information
see e.g.
https://www.bsa.org.uk/information/consu
mer-factsheets/general/the-building-
societies-act-1986-a-bsa-summary-fift)

Building society fact sheet: https://www.bsa.org.uk/information/consumer-factsheets/for-people,-

not-shareholders

3
https://www.bankofengland.co.uk/statistics/data-collection/institutions-in-the-uk-banking-sector
4
https://www.legislation.gov.uk/ukpga/2000/8/contents
5
https://www.legislation.gov.uk/ukpga/2012/21/contents/enacted
6
https://www.legislation.gov.uk/ukpga/2013/33/contents/enacted
7
https://www.legislation.gov.uk/ukpga/1986/53/contents
8
https://www.legislation.gov.uk/ukpga/1997/32/contents
9
https://www.legislation.gov.uk/ukpga/2000/8/contents
10
https://www.legislation.gov.uk/ukpga/2012/21/contents/enacted
11
https://publications.parliament.uk/pa/pabills/200607/building_societies_funding.htm
12
https://www.legislation.gov.uk/ukpga/2009/1/contents

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2. Are there any non-bank financial institutions in your country that offer a current account
to members of the public? If so, what are they called and what are the main characteristics that
distinguish them from banks?

Use your own research here

3. What is an investment bank? What do they do? (Include some recent examples of activity
by investment banks, e.g. from the FT, in your notes for future reference.)

Advice / help in raising funds such as Equity/Bonds issuance

Advice on Mergers and Acquisitions

Advice on Capital Restructuring

They are financed via fees for advice / consultancy services

Further activities may include: Asset management, Valuation of firms, advice on privatisation of
state-owned assets, Risk Management (advice, diversification, derivatives [hedging strategies]),
Derivatives Trading, Brokerage (securities trading on behalf of their clients), Proprietary trading (for
their own profitability), Securitisation (creation of new financial products), Market Makers: “make”
the market for financial instruments

4. Should a bank be allowed to be both a retail and an investment bank?

Universal banks = retail + investment banking + wholesale banking

PROS (unite): CONS (break up):

Economies of Scales (higher options for Depositors’ money may be used to finance
investors/borrowers at better terms) extremely risky investment banking activities

“Too big to fail” Conflict of interest (borrowers – investment

bank – lenders)
First banks to fail (financial crisis) were retail
banks “Contagion” Effects

Diversification (antidote to risk) Too large/complex to manage/ “Too big to fail”

Better/more complete service to customers Lack of competition (control the market)

(one institution to do everything e.g. HSBC)
Bailed out with taxpayers’ money (remove
Expertise / Better knowledge / information subsidies for risky investment banking)

Higher risk of collapse without the “safe” retail

banking part of the business

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AG991 workshop 3

1. What role do hedge funds play in financial markets?

Free to employ a number of different (innovative) investment strategies (e.g. short selling,
derivatives) and can employ more complex investment strategies

Subject to less regulation

Limited information / lack of transparency

Potential for high return / high risk

Lower tax – off shore “tax havens”

Can identify and correct price discrepancies -> contribute to market efficiency

Liquidity (e.g. buying shares of distressed companies)

Can use Leverage

Potential manipulation of the market / “control prices”

Information (they may be possessing more knowledge VS information asymmetry)

Need for higher investor protection

“Contagion”/ domino effect if an important hedge fund collapses / Risk to financial institutions

2. Based on Kotter & Lel (2011), what kind of influence do sovereign wealth funds have on
the firms they invest in?

the authors study 417 announcements of SWF investments in 326 unique firms from 45 countries
from 1980 to 2009

they find that SWFs’ investments have a positive effect on target firms’ stock prices around the
announcement date but no substantial effect on firm performance and governance in the long run

more transparent SWF’s have a greater positive value impact than opaque SWFs

Self-study question: Why is short selling seen as a problematic practice? Please refer to Appendix A.

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AG991 workshop 4

1. Why are IPOs “underpriced”?

Be able to discuss one theory of your choice. Have a view on how useful it is in explaining the
underpricing phenomenon; also be able to clearly define what underpricing actually is.

Information on the underpricing theories can be found in:

Ibbotson, R.G., and Ritter, J.R. (1995) ‘Initial Public Offerings’, in Jarrow, R., Maksimovic, V. and
Ziemba, W. (eds.) Handbooks of Operations Research and Management Science: Finance,
Amsterdam: North-Holland, pp. 993-1016. Available at:
http://www.sciencedirect.com/science/article/pii/S092705070580074X

2. Why are secondary markets important for the economy?

Enable primary markets to operate

Facilitate trading / Liquidity

Economic barometer /Promote efficiency (capital allocation)

“Fair” valuation / price discovery/ price formation

Evaluate the quality of managerial decisions via market reaction (share price movements) / Improve
corporate behaviour

Provide investment choices to individuals/ savers / lenders of capital/ institutional investors

3. Compare order-driven and quote-driven equity markets. What are the advantages and
disadvantages of each?

Order driven Quote driven

characteristics Displays all incoming buy and sell Displays the bid (buy) and ask (sell)
orders, i.e. shows the total of the quotes of market makers
market orders (also known as the
order book)

Orders detail the quantity and price Orders go directly to market maker –
at which the share may be traded individual orders are not seen

No guarantee of order execution Guarantee of order execution - market

makers are required to meet their
quoted prices, either buying or selling

Price transparency No price transparency

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Counterparty is unknown Counterparty is known as it is the market

maker

automated trading system that has mainly conducted through proprietary

order matching rules, which match computer communications networks or
buy and sell orders, and trade pricing by phone
rules, which determine the price of
the matched trades

advantages Order-driven markets offer greater Quote-driven markets offer a guarantee

transparency. Transaction costs can
be lower due to use of automation.
of order fulfilment, as market makers are
required to meet their quoted bid and
ask prices. This also enables you know in
advance the price at which your order
will be completed.

disadvantages Only works well if sufficiently large
numbers of orders arrive to ensure
matches are possible without orders
sitting on the system waiting for long
periods of time for a match.
Transaction cost can be higher as the
market maker will need to cover their
own costs (staff, inventory etc.). Lacks
transparency e.g. about market depth.

Exact price at which order is

executed is not known with certainty
in advance.

For further information on SETS on the LSE please also consider reading:
https://www.londonstockexchange.com/securities-trading/equity-trading/sets

For further information on SETSqx and SEAQ on the LSE please also consider reading:
https://www.londonstockexchange.com/securities-trading/equity-trading/trading-services/setsqx-
and-seaq

Questions for self-study: What are the steps in going public in the UK?

What role do investment banks play in an IPO?

Please refer to Appendix A for self-study question guidance.

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AG991 workshop 5

Please ensure you read the entire Hull (2009) paper!

1. Based on Hull (2009), how could the recent subprime crisis have been avoided?

The interests of the originators of loans should be aligned with the interests those who ultimate bear
the credit risk. It can be achieved by requiring originators of loans to keep some of the risks in each
instrument created from the loans.

The compensation plans within financial institutions should be changed so that there is much less
emphasis on short-term performance.

The transparency of traded product should be improved so that their risks are widely understood.

Risk management should involve a heavy dose of managerial judgment, not just the mechanistic
application of models.

Either through clearinghouses or through bilateral collateralization agreements should become a

compulsory feature of derivatives markets.

2. Do credit rating agencies do a good job at assessing credit risk?

No – (e.g. subprime crisis) Yes – (e.g. plain vanilla bonds)

Not a proper assessment of risk Reduce information asymmetry / cost-effective

information services
Increasing the complexity of the financial
products/instruments -> increasing instead of Increase participation of uninformed investors
reducing information asymmetry
Promote liquidity
Perverted incentives (they get paid by the companies
they evaluate) Increase financial activity

Conflict of interests between: a) credit ratings Good long-term track records

agencies and banks/financial institutions b) credit
rating agencies and the public/ individual investors
(shareholders’ interests VS regulatory role).

Oligopoly

Questions for self-study: What types of restrictions should appear in a bond indenture?

What factors would you consider in deciding whether or not to

invest in a corporate versus a government bond?

Why are well-functioning, decentralised, money markets a crucial

component of the financial system, according to Benoît Cœuré,
Member of the Executive Board of the ECB?

Please refer to Appendix A for self-study question guidance.

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AG991 workshop 6

1. Why are derivatives markets important to the financial system and the economy?

Derivative instruments can be exploited either to reduce risk or to go in search of high returns.
Their main benefit is to enable risk management that would otherwise not be feasible; they
allow the transformation of future risks into tradable instruments and also provide new
investment opportunities; they contribute to increased operational, informational, price,
valuation and allocative efficiency. There are three types of uses of the derivatives markets:
hedging, speculation and arbitrage. In addition to risk management, derivatives markets play
a very useful economic role in price discovery.

2. Review the “derivatives disasters” of LTCM, Barings, Sumitomo, and Metallgesellschaft

(article allocation based on your student registration number). How could these problems
have been avoided?
Metallgesellschaft Barings

- fuel and electricity provider in the - Singapore office single trader

US, subsidiary of a German firm
- wrong business strategy
- wrong use of derivatives
- issues of reporting; corporate
governance; consolidated balance
sheet
- inadequate risk management
Illustrates risk of use of wrong derivatives in
conjunction with a flawed business plan;
highlights inefficiencies in corporate
governance
- duties mingled; front, middle and
back office in one person
- lack of supervision and adequate
risk management policies
- Kobe earthquake triggered
discovery of problems, losses
came too big to hide
FRAUD case that illustrates the risk of not
separating roles of front, middle and
back office; highlights inefficiencies in
corporate governance

LTCM Sumitomo

- Hedge fund specialising in bond - copper trading & mining

price arbitrage
- highly reliant on
statistical/mathematical models
- fund highly leveraged (1:25)
- strategies unravel as Russia
defaulted on its bonds in 1998
Illustrates risk of overreliance on models
that in turn rely on past data to predict the
future; highlights the magnifying effect of
leverage on problems and is considered the
first example of “To-big-to-fail”
corporation single trader
- manipulation of spot & forward
copper markets
- lack of separation of duties; lack
of supervision
- fraud may have continued for
more than 10 years
FRAUD case that illustrates the risk of not
separating roles of front, middle and
back office; highlights inefficiencies in
corporate governance

Please ensure you are familiar with the details of your own case, i.e. the one based on your student
number you prepared for the workshop. Optional further information on each case is available on
myplace.

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AG991 workshop 7

1. What is meant by the operational, informational and allocative efficiency of financial markets?

Operational Efficiency

Refers to the cost, speed and safety of transferring funds between savers and borrowers

Charges to investors, Transaction costs, Commission fees, Bid-asks spreads

Restrictions in moving funds both within and outside countries. e.g. capital controls
(also related to Allocative Efficiency).

Level of Competition, Liquidity

Informational Efficiency

The extent at which prices reflect information

Weak form: All past information is incorporated in prices (rules out successful
technical analysis)

Semi-Strong Form: Prices reflect all past and public information (rules out successful
fundamental analysis)

Strong Form: Prices include all past, public and private information (rules out
successful insider trading)

Allocative Efficiency

How well the scarce capital is allocated within the economy

All profitable (positive NPV) projects/ investments should be provided with financing

Pareto Efficiency

2. To what extent is the UK financial system efficient by these criteria? Linton (2011) may provide
some ideas.

Please note you will not need to use the Linton (2011) paper in your answer, it is meant as a potential
example; you are free to choose other sources.

3. How does that compare to other countries you have experience of? You can also use for
instance Patel et al (2012), Sheefeni (2015), or Simões et al (2012) to arrive at an answer to this
question.

Please record your own ideas.

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AG991 workshop 8

Please ensure you read the entire Llewellyn (1999) paper!

1. Why do we need financial regulation?

Main issues:

Avoid systemic risk stemming from the banking system

e.g. by setting minimum capital reserve requirements

High interrelation between financial institutions -> contagion / Domino effect

[“low probability - high seriousness” risk]

Protect the payment system

Consumer/ investor protection

Difficulties / lack of skills (knowledge) to assess the real values/ risk of investments

Reduce Information Asymmetry (e.g. by setting minimum disclosure standards) / inadequate

information

Consumer Demand for Regulation

Additional issues:

Improve security in financial markets/ reduce uncertainty; Reduction of agency costs; Increase
Transparency; Reduce the risk of fraud; Relation of moral hazard to “safety net arrangements”;
trade-off between benefits and costs of regulation: Regulation has a cost / can be expensive for the
investors (costs are likely to be passed to them), Compensation for regulators, Compliance Costs,
possible adverse impact on competition if firms are deterred from entering a market due to high
compliance costs and regulatory standards.

2. What is the role of the Financial Policy Committee (FPC) under the new regulatory
framework introduced in the UK?

Protect the stability of financial system

Enhance the resilience of the UK financial system

Two major objectives:

1. Contribute to the achievement of the financial stability objective (BoE)

a. Identifying

b. Monitoring

c. Reducing systemic risks

2. Support the economic policy of the Government

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Directions and Recommendation to Financial Conduct Authority (FCA) and Prudential Regulation
Committee (PRC) (“comply or explain”)

Provide clear messages and reports about future regulation action and its impact -> reduce
uncertainty / boost confidence

Need to have regard to UK’s international obligations -> cooperate with EU institutions and agencies

Setting leverage ratio standards (loan value based on debt to income ratio) / borrowing limits

Countercyclical Capital Buffets (CCB)

Sectoral Capital Requirements (SCR)

For all regulatory authorities in the UK the current system is based on the Bank of England and
Financial Services Act (2016). This latest law changes the landscape of regulation as it ends the
Prudential Regulation Authority (PRA) as a subsidiary of the Bank of England (BoE) and establishes
the Prudential Regulation Committee (PRC) within the BoE. From 1 March 2017, the BoE’s new PRC
will take control of the PRA’s most important financial stability supervision and policy decisions. The
PRC replaces the PRA board but there are no changes to the PRA’s objectives or functions. These
changes will mean the BoE is better equipped to fulfil its vital role of overseeing monetary policy and
financial stability for the whole of the UK by strengthening the governance and accountability of the
Bank. So the previous structure vanishes, however, it is not entirely clear when or if the name PRA
will completely cease to be used. Chapter 14, section 12, of the 2016 Act states that: “The
“Prudential Regulation Authority” is the Bank of England. [..] The Bank’s functions as the Prudential
Regulation Authority [..] are to be exercised by the Bank acting through its Prudential Regulation
Committee“.

You will find the most up to date information on the organisations’ own web-sites:

Bank of England http://www.bankofengland.co.uk/Pages/home.aspx

FPC https://www.bankofengland.co.uk/about/people/financial-policy-committee

PRC http://www.bankofengland.co.uk/pra/Pages/default.aspx

FCA http://fca.org.uk/

Question for self-study:

What can be learnt from Gregoriou & Lhabitant (2009)?

Please refer to Appendix A for self-study question guidance.

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AG991 workshop 9

1. Briefly, what are the main arguments for fixed versus flexible exchange rate regimes?

Fixed FX rates

+ Reduce uncertainty (less or limited need for hedging exchange rate risk at company level)

+ Lower transactions costs

+ Higher stability

- Require high foreign currency reserves

- Subject to speculative attacks

- Exposed to changes in other country’s economic conditions

Sensitive to the relevant credibility / competency of central banks (Kenen, 2000). Can be
either beneficial (when monetary policy shocks are neutralized through increased
competency) or harmful (when importing inefficiencies from less-competent banks).

Kenen, P.B. (2000) Fixed versus Floating Exchange Rates, Cato Journal 20(1), pp.109-113.

Flexible FX rate / Floating FX rates

+ [Hoffman, 2005] “shock absorber” -> provide smoother adjustments of macroeconomic

variables to external shocks, as transmission of shocks to real economy is mitigated

+Autonomy/ independence of monetary policy

+ Free Capital Flows / fewer restrictions

- Subject to short-term volatility & long-term misalignments (Helleiner, 2007)

- Instability / uncertainty / Subject to market volatility

- Adverse impact on trade growth and investment activity

- ‘Casino Capitalism’ => foreign exchange market is dominated by speculators (Susan

Strange, 1986)

Generally trying to decide what regime is best for a country involves the impossible trinity

Exchange rate stability - Monetary policy autonomy - Capital Mobility

Hoffmann, M. (2005) Fixed versus Flexible Exchange Rates: Evidence from Developing Countries, University of
Cologne working paper. Available at: http://www.cfr-cologne.de/download/workingpaper/cfr-05-03.pdf

Strange, S. (1986) What Theory? The Theory in Mad Money, CSGR Working Paper No. 18/98. Available at:
http://wrap.warwick.ac.uk/2107/1/WRAP_Strange_wp1898.pdf (see also: Strange, S. (1997) Casino
Capitalism, Manchester: Manchester University Press, ISBN 9780719052354)

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2. Currently some central banks are actively intervening in financial markets to stimulate their
economies, for example using QE. Are there any insights offered by Greenwood (2017) as to
whether or not this is likely to be successful?

Quantitative easing is a creative open market activity by central banks when they wish to encourage
spending and economic growth but they cannot achieve this by traditional tools, i.e. lowering key
interest rates, instead the central bank creates money and buys assets in the open market, thereby
increasing liquidity; the assets they buy can be anything, but usually the focus is on highly rated
bonds – the ideas is that by buying these they become less attractive investments and the sellers will
look for new investments with the cash they have received
Problem in the UK, the sellers of the bonds were predominately banks who keep the cash rather
than lending/investing it

Greenwood (2017) provides an overview of the three episodes of quantitative easing (QE) pursued
by the Bank of Japan (BOJ) since 2001: QE1 (2001-6), QE2 (2010-13), and QQE (since 2013), where
QQE refers to “quantitative and qualitative easing”.
The author argues that: “None of these attempts at QE has been successful in raising the broad
money growth rate for M2 sustainably above the 2–3 percent per annum range where it has
languished for the past 25 years. Consequently, Japan’s attempts at QE have all failed to raise the
equilibrium level of Japanese nominal GDP by any material magnitude, and so far, attainment of the
2 percent inflation target under QQE has remained elusive. At the time of writing (October 2016), the
Japanese economy therefore continues to grow at a low rate with periodic lapses into deflation.”
(Greenwood, 2017, p, 17)
Greenwood (2017) criticises the Japanese QE programmes for failing to purchase exclusively assets
held by nonbanks. He argues that the BoJ has failed to acknowledge that the traditional transmission
mechanism for monetary policy is broken and that is should therefore operate a version of QE that
circumvents the banking system by creating new deposits independently of the banks.

Some economics terms used in the paper are clarified below – please note that you do not need to
remember these for the exam!

ZIRP Zero interest rate policy – this is when a central bank lowers the key interest rate to
zero, i.e. eligible institutions are charged that rate when borrowing from the central
bank and this rate also works as a reference rate for other interest rates in the
country; see e.g. Bank of England base rate
(https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate )

Helicopter money Central banks making payments directly to individuals when interest rates near
zero and the economy remains in recession – often seen as an unconventional
policy that could be an alternative to QE (see e.g.
https://www.ft.com/content/491e6bd2-cef5-11e9-99a4-b5ded7a7fe3f )

Monetary base also known in the UK as narrow money; is the total amount of bank notes and coins
circulating in the economy

broad money / a measure of the amount of money, or money supply, in a national economy
money supply including both highly liquid "narrow money" and less liquid forms; central banks
use different specific definitions of this

M1, M2, and M3* OECD definitions:

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M1 (aka narrow money) - covers currency, i.e. banknotes and coins, as well as
balances which can immediately be converted into currency or used for cashless
payments, i.e. overnight deposits
(https://stats.oecd.org/glossary/detail.asp?ID=1568 )

M2 (aka intermediate money) - comprises narrow money (M1) and, deposits with a
maturity of up to two years and deposits redeemable at a period of notice of up to
three months (https://stats.oecd.org/glossary/detail.asp?ID=1569 )

M3 (aka broad money) - comprises M2 and marketable instruments issued by the

MFI sector. Certain money market instruments, in particular money market fund
(MMF) shares/units and repurchase agreements are included in this aggregate
(https://stats.oecd.org/glossary/detail.asp?ID=7348 )

M4

*specific usage of these terms again depends on the country’s central bank and can differ, e.g. in the UK there is a measure
called M4; further information can be found here: http://www.oecd.org/sdd/fin-stats/2372334.pdf and
https://webarchive.nationalarchives.gov.uk/20160601184656/http://www.bankofengland.co.uk/statistics/Documents/ms
/articles/art2jul03.pdf

Question for self-study: Explain the basic concept of purchasing power parity and comment
on the practicality of it as well as available empirical evidence.

Central banks are the lender of last resort for domestic banks. How
effective are they in this role? Use Jacome et al. (2011) in your
answer.

Please refer to Appendix A for self-study question guidance.

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AG991 workshop 10

1. What is meant by “bank-based” and “market-based” financial systems? Give examples of each
and also describe the financial system in your country.

There are multiple ways of answering this question; the following notes offer only a starting point:

Bank based Market based

- banks are firms’ key sources of financing
- historically civil-law courts less effective
in conflict resolution as laws give less
flexibility → banks emerge as contract
enforcers (see Ergungor, 2004*)
- conglomerates more common
- bank represented on boards. Banks
good monitors; also allows stage-
financing
Examples: Japan, Argentina, Germany
- firms fund themselves mainly via
financial markets
- common-law system flexible and
effective in enforcing laws→ more
detailed creditor & shareholder
protection (see Ergungor, 2004)*
- fewer cross holdings
- better at diversifying and managing risk;
better at funding innovation
Examples: U.S.A., UK

*Ergungor, O.E. (2004) Market- vs. bank-based financial systems: Do rights and regulations really matter?,
Journal of Banking & Finance 28 (12), pp.2869–2887.

further information (optional):

Demirguc-Kunt, A., and Levine, R. (2001) Bank-based and market-based financial systems: Cross-
country comparisons, in: Demirguc-Kunt, A. and Levine, R. (eds.), (2001) Financial Structure and
Economic Growth: A Cross-Country Comparison of Banks, Markets, and Development, MIT Press,
Cambridge, pp. 81–140. working paper version available at:
http://elibrary.worldbank.org/doi/pdf/10.1596/1813-9450-2143

Levine, R. (2002) Bank-Based or Market-Based Financial Systems: Which is Better?, NBER Working
Paper No. 9138, available at http://www.nber.org/papers/w9138.pdf

2. Is the categorisation between bank and market-based systems sufficient to describe financial
systems in different countries?

You should mention the major points of the debate on this and also add your own views. Below are
suggestions from the literature.

“For over a century, economists and policy makers have debated the relative merits of bank-based
versus market-based financial systems. Recent research, however, argues that classifying countries as
bank-based or market is not a very fruitful way to distinguish financial systems.” (Levine, 2002, p.398)

“The financial systems of countries exhibit significant differences. There are bank-based (Eurozone)
and market-based (US and UK) systems, classifications that are based on the shares of banks and
other intermediaries in total financing. A long-standing debate is which system is superior in

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elevating aggregate credit extension and real-sector economic growth. Our findings cast doubt on
the usefulness of such “banks versus markets” distinctions.” (Song and Thakor,2010, online)

Sources:

Levine, R (2002) Bank-Based or Market-Based Financial Systems: Which is Better?, Journal of Financial
Intermediation 11(4), pp.398-428.

Song, F. and Thakor, A. (2010) Banks and capital markets as a coevolving financial system, VOX blog post, 1
December 2010, http://www.voxeu.org/article/banks-and-capital-markets-coevolving-financial-system

3. Define the following terms:

RIBA Interest and usury; one of the prohibitions in Islam

GHARAR Risk and uncertainty, including speculation; one of the prohibitions in Islam

HALAL Permissible under Sharia’a

HARAM Prohibited under Sharia’a

MURABAHA Cost-plus sale contract, usually with deferred payment

IJARA Leasing contract

MUDARABA Profit-sharing contract similar to a silent partnership

MUSHARAKA Profit-sharing contract similar to a partnership set-up in UK

SUKUK Islamic bond

4. How does the concept of riba alter the design of a mortgage contract to make it permissible
under Islamic law?

Under Sharia’a, the earning of money on money is prohibited, so traditional interest payments in a
mortgage contract are not permissible. In a Sharia’a compliant mortgage contract, the bank will
typically purchase the property on behalf of the client and then arrange to sell the property to the
client on a deferred payment basis. The bank has to be the legal owner of the property and it can sell
the property at a profit. This contract is an example of a murabaha, however, mortgages can also be
designed using musharaka contracts.

5. Is investing in shares permitted under Islamic law?

Yes, it is if the business is halal. For example, investing in a car company is allowed, but investing in a
producer of alcoholic beverages is not permitted. If the company’s business is halal, but they are
known to use for instance interest bearing bank accounts, which would be haram, the issue is less
clear. Some argue that if you can identify how much the company earns from this haram activity, say
2%, then you should donate 2% of your earnings from investing in this company to charity and this

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“purifies” the investment. This idea is not uncontroversial and if in any doubt the advice usually is:
do not invest. In practice, Islamic funds and Islamic Indices employ a cut-off rule, i.e. up to x% of
non-halal (or unidentifiable activities) are permitted for the investment overall to be considered
permissible. The Sharia’a board of the financial institution will issue guidance as to what x should be
and has to approve all such investments.

(link to optional info from State Bank of Pakistan: https://www.sbp.org.pk/IB/FAQ.asp )

Remember: This document contains notes reflecting issues raised in the

workshop discussions. They should serve as a reminder and starting point for
your answers. They do not replace the required readings or your own
thoughts on the questions!

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Appendix A
Guidance for workshop 3 self-study question

Why is short selling seen as a problematic practice?

Short selling is a trading strategy that allows market participants to use their knowledge (or guess) of
negative news about an issuer. In essence they bet that the price of a stock, bond, or other financial
instrument will fall. Most commonly, short sellers borrow the shares (or other financial instruments)
from an existing owner and immediately sell them, in the hope that the price will fall before they
buy back the shares and return them to the lender, pocketing the difference. This is known as
covered short selling. It is important to note that there is no guarantee that the share price will
indeed fall, your information (guess) could be wrong. If the share price goes up rather than down it
will cost more to buy back the shares and return them.

And therein lies the first concern – a short seller could be tempted to “ensure” the share price falls
by spreading negative news/rumours etc. i.e. manipulate the market. Even if the short seller does
nothing other than sell the shares, the simple fact of the sale could be seen as a signal to the market
that something is wrong with the issuer of the shares (particularly if the identity of the seller
becomes known and they have a reputation for accurate market knowledge). This may then trigger
further sales and might in extreme cases cause a panic. So even without instigating any manipulation
the short sales can cause volatility in markets, which is a second concern. For instance, during the
2008 financial crisis, regulators globally decided to ban short selling of stocks, due to fears the
trading strategy would exacerbate the steep drop in stock prices. Most recently, restrictions on short
selling activity were introduced in several European markets due to increased volatility and concerns
about market confidence at the height of the global coronavirus pandemic. Some, however, argue
that the bans themselves are detrimental and disruptive to markets and ultimately ineffective, see
e.g. Beber et al (2018) and Losada & Martinez (2020).

In the UK, short selling and certain aspects of credit default swaps (CDS) have been regulated since 1
November 2012, under the Short Selling Regulation (SSR)13. The SSR applies to people undertaking
short selling of shares, sovereign debt, sovereign CDS and related instruments that are admitted to
trading or traded on an EEA trading venue (unless they are primarily traded on a third country
venue). It requires holders of net short positions in shares or sovereign debt to make notifications
once certain thresholds have been breached. The SSR also outlines further restrictions on investors
entering into uncovered short positions in shares or sovereign debt. For more information (optional)
see: https://www.fca.org.uk/markets/short-selling

13
EU Short Selling Regulation (Regulation 236/2012) (SSR)
https://www.esma.europa.eu/regulation/trading/short-selling

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Helpful optional sources:

Beber, A., Fabbri, D., Pagano, M., and S. Simonelli (2018) “Short-selling bans and bank stability”,
European Systemic Risk Board (ESRB) Working Paper No. 64. Available at:
https://www.esrb.europa.eu/pub/pdf/wp/esrb.wp64.en.pdf

FCA (2020) “FCA statement on short selling bans and reporting”, Financial Conduct Authority (FCA)
statement, 15 June. Available at: https://www.fca.org.uk/markets/short-selling/statement-short-
selling-bans-and-reporting

IOSCO (2009) “Regulation of Short Selling”, Report of the Technical Committee of the International
Organization of Securities Commissions (IOSCO), 19 June 2009. Available at:
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD292.pdf

Losada, R., and A. Martinez (2020) “Analysis of the Effect of Restrictions on Net Short Positions on
Spanish Shares between March and May 2020”, Comisión Nacional del Mercado de Valores (CNMV)
Working Paper. Available at: https://ssrn.com/abstract=3684501

McDowell, H. (2020a) “Short selling restricted across Europe due to coronavirus pandemic”, The
TRADE [online], 17 March. Available at: https://www.thetradenews.com/short-selling-restricted-
across-europe-due-coronavirus-pandemic/

McDowell, H. (2020b) “Short selling bans lifted in Europe”, The TRADE [online], 18 May. Available at:
https://www.thetradenews.com/short-selling-bans-lifted-in-europe/

Prosser, D. (2008) “The Big Question: What is short selling, and is it a practice that should be
stamped out?”. The Independent [online], 23 July. Available at:
https://www.independent.co.uk/news/business/analysis-and-features/the-big-question-what-is-
short-selling-and-is-it-a-practice-that-should-be-stamped-out-874717.html

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Guidance for workshop 4 self-study questions

What are the steps in going public in the UK?

Firstly, the company needs to decide that an IPO is the best way to raise funds. It will change the
nature of the company from a private firm to a public company. That entails higher levels of
disclosure and scrutiny as well as additional company owners who will wish to have their say in how
the company is run. If indeed an IPO is the best way forward, then secondly, the company will
typically appoint advisors to assist with the process and the preparation of all necessary
documentation. The type and number of advisors varies and can also depend on which market you
which to list on, but typically includes: lawyers (to co-ordinate the legal work including the due
diligence and verification process), accountants (to undertake financial due diligence, review
working capital and the company’s financial procedures and report on the historic financial
information), investment bank(s) (to manage the IPO process), and if the shares are to be listed on
AIM a Nomad (AIM nominated advisor) is required.

In the UK there are principally two markets14 that you can list on. On the London Stock Exchange
there are two, known as the Main Market15 and the Alternative Investment Market (AIM)16. Each
market has their own listing requirements (you must know the ones that apply for the LSE main
market) and the company needs to meet them prior to listing. An IPO on the main market will
usually take at least 6 months to complete, although listings on AIM can be achieved in a shorter
time-frame. To apply for listing the company must, thirdly, send the required documentation to the
FCA17. This will include the Prospectus18 with financial information on the company, reasons for the
IPO and about the offer itself. As the prospectus will need to be reviewed and approved by the FCA
before the float can take place, several drafts may be required.

Fourthly, and often concurrent with step 3, the company and its advisors will market the new shares
to potential investors and chose a method of selling the shares which shapes the next steps. This can
include book building and roadshows, but other forms of selling are possible (please ensure you are
familiar with the main ones). At the end of whichever sales process is chosen, the final IPO price will
be determined and the shares distributed to the new shareholders and in return the company is
getting the money it was trying to raise.

Finally, the stock exchange is informed of the final IPO price and the new total number of shares and
trading can begin. The company is now responsible for maintaining the post-listing requirements for
disclosure and transparency and the public can see the company’s share price, annual report etc.

14
There is also the new NEX Exchange (https://www.aquis.eu/aquis-stock-exchange ) but we will focus on the LSE.
15 https://www.londonstockexchange.com/raise-finance/equity/main-market
16 https://www.londonstockexchange.com/raise-finance/equity/aim
17 Previously, the UK Listings Authority (UKLA) was responsible, however, the FCA will be phasing out the UKLA name

entirely. Since 2019, the FCA is gradually removing it from their website and other external communications and will
instead refer to the FCA’s ‘primary market’ functions. https://www.fca.org.uk/publication/newsletters/primary-market-
bulletin-20.pdf
18 For an AIM listing a prospectus is not required, the company will instead need to produce an AIM admission document

under the AIM Rules. The AIM admission document contains similar information to that set out in a prospectus.

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More detailed descriptions of listing in the UK can found from various sources online19 , however, for
this class you should focus on knowing the main steps.

What role do investment banks play in an IPO?

The role of the investment bank depends on the way in which the new shares are being sold and on
what has been agreed between the company and the chosen investment bank(s). For instance, it
could simply act as the company’s agent for selling the shares (offer for sale by tender) or it could
purchase all the shares and then sell them on (offer for sale). The investment bank generally helps to
manage the IPO process. It may also take on some of the following roles or separate advisors may be
appointed:

● sponsor – required for a premium listing on the main market;

● Book runner and underwriter – to build an order book for the shares and underwrite any
shares not taken up;

● Broker – to act as the main interface between the company and the stock market;

● Analysts and PR Consultants – to conduct research on the company and promote

awareness of the company and the IPO on the market.

It is also possible to undertake an IPO without an investment bank by offering the new shares
directly to the public, this is known as a direct public offering (DPO). There are advantages and
disadvantages to a DPO. Since investment banks charges fees for their help with the IPO, by
eliminating them from the offering, an issuing company can save money. (Fees for a typical IPO tend
to be approx. 7% of the total proceeds raised). On the other hand, investment banks usually have
strong networks of potential institutional and individual investors. Through a road show, an
investment bank can also make the company more familiar to the general public and, thus, hopefully
more attractive to investors. This can ultimately result in higher proceeds for the issuer.

Examples of DPOs include corporate messaging app developer Slack in 201920 and music streaming
service Spotify Technology in 201821. Whether an IPO or a DPO is appropriate will depend on the
situation of the company going public.

19
e.g.: https://financialmarketstoolkit.cliffordchance.com/en/financial-markets-resources/resources-by-type/guides/a-
guide-to-the-uk-listing-regime.html
20
https://fortune.com/2019/06/20/slack-stock-ipo-dpo-direct-listing/
21
https://www.fool.com/investing/2018/02/28/its-official-spotify-files-for-direct-listing.aspx

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Guidance for workshop 5 self-study questions

What types of restrictions should appear in a bond indenture?

A bond indenture is a legal document that outlines terms and conditions of the bond issue, such as
the face value, issuer, coupon rate etc. To protect the bond holders interests several restrictions can
be included such as:

- subordination of debt
- collateral
- a sinking fund
- dividend restrictions
- other restrictions on the issues activities while the bond is outstanding

Convertibility is not necessarily a restriction but also offers bondholders protection. The first two on
the above list should definitely be included in the indenture, as subordination of debt will prevent
the company from giving bondholders from other bonds the company may issue in future priority of
you in case of bankruptcy, and collateral offers specific assets as security for the bond which can be
used in case of repayment difficulties.

What factors would you consider in deciding whether or not to invest in a corporate versus a
government bond?

This is admittedly a trick question as the factor are the same regardless of issuer. You should
consider the return on your investment and the riskiness of your investment. When and how are you
being repaid and how sure can you be that you will get your money back? If you are happy with the
risk-return balance go ahead, if not search for other investment opportunities that better met your
requirements.

Why are well-functioning, decentralised, money markets a crucial component of the financial
system, according to Benoît Cœuré, Member of the Executive Board of the ECB?

Money markets deal with short term borrowing with maturities of 1 year or less. They are a form of secondary
market as existing debt instruments are traded. So everything we have previously discussed about the
importance of secondary markets applies here. Cœuré (2012, online) says: “Three factors explain the
importance of money markets: their contribution to market efficiency and market discipline; their impact on
financial stability and on financing conditions in the economy at large; and their role as an initial link in the
chain of monetary policy transmission.” They do the first via information aggregation and price discovery and
the second by being an essential source of bank funding according to Cœuré (2012). “If liquidity dries up, it can
force banks to de-leverage, thus affecting the supply of bank credit, or to acquire liquidity by liquidating or
selling assets.” (Cœuré, 2012, online) Well-functioning money markets allow central banks to influence the
longer-maturity interest rates in the economy. They “are relevant for determining bank lending rates, by
steering very short-term money market rates to keep them close to its official rates. A smooth functioning of
money markets therefore guarantees that the impulse of monetary policy is transmitted across the financial
system and to the real economy without impairments.” (Cœuré, 2012, online)

Cœuré, B. (2012) “The importance of money markets”, speech at the Morgan Stanley 16th Annual Global Investment
seminar, Tourrettes, Provence, 16 June 2012, available at:
http://www.ecb.int/press/key/date/2012/html/sp120616.en.html

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Guidance for workshop 8 self-study question

What can be learnt from Gregoriou & Lhabitant (2009)?

Gregoriou & Lhabitant (2009) point out several issues that would have allowed investors and
authorities to question Madoff’s activities and could have allowed the Ponzi scheme to be
uncovered much sooner. Specifically, they mention the following:

- a lack of segregation amongst service providers

- obscure auditors
- an unusual fee structure
- heavy family influence
- lack of staff
- promotional materials of feeder fund never name Madoff
- lack of SEC registration
- extreme secrecy
- paper tickets
- conflict of interest
- a black-box strategy
- questionable style exposures
- incoherent 13F filings
- market size

Gregoriou & Lhabitant (2009, p. 16) conclude: “The reality is that the warning signals were there and
the salient operational features common to best-of-breed hedge funds were missing. Let us hope that
this will serve as a reminder that the reputation and track record of a manager, no matter how
lengthy or impressive, cannot be the sole justification for investment.”

The Madoff case is an example where more financial regulation would not have helped, as there is
sufficient existing legislation that can be used to deal with this kind of fraud. Regulating more is not
necessarily the best way forward.

Greorgiou, G.N., and Lhabitant, F.-S. (2009)’Madoff: A Flock of Red Flags’, Journal of Wealth
Management 12(1), pp. 89-98. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1335639

further optional reading:

Markopolos, H. (2005) ‘The world's largest hedge fund is a fraud’, Letter to the SEC. Available at:
https://www.sec.gov/news/studies/2009/oig-509/exhibit-0293.pdf

Links to further optional materials on Madoff are on myplace and information on “form ADV” can be
found here: http://www.sec.gov/answers/formadv.htm - optional!

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Guidance for workshop 9 self-study questions

Explain the basic concept of purchasing power parity and comment on the practicality of it as well
as available empirical evidence.

Purchasing power parity (PPP) is based on the law of one price, i.e. the same basket of goods should
have the same price in different countries after prices are expressed in the same currency. Absolute
PPP focuses only on the price level ratio whereas Relative PPP considers inflation in addition to the
price level ratio. A third related concept, the international Fisher effect considers prices, inflation,
and interest rates when determining what exchange rates should be.

Problems with PPP centre on the restrictiveness of its assumptions. For PPP to hold the following
must be absent: transaction costs (e.g. shipping), trade barriers/restrictions, taxes, differences in the
goods/products in different countries, product availability problems, etc. Additionally, one can
imagine problems for instance with exploiting price differences of perishable goods, even without
transport cost and import/export rules, some goods may not be suitable for travelling. The empirical
evidence in the literature is generally supportive of PPP in the long-term but not short-term (e.g.
Rogoff, 1996). Engle & Rogers (1996) study the US and Canada and find that the difference in prices
increases by distance and it’s higher between different countries. Taylor & Taylor (2004) report
similar findings for the UK and US. Open questions remain about the lack of strong evidence to
support PPP and about the speed/time of adjustment (affected by: transaction costs, heterogeneity
in opinions, intervention by central banks).

Engel, C., and Rogers, J.H. (1996) “How wide is the border?”, American Economic Review 86(5), pp. 1112-1125.

Rogoff, K. (1996) “The Purchasing Power Parity Puzzle”, Journal of Economic Literature 34(2), pp. 647–68.

Taylor, A.M., and M.P. Taylor (2004) ‘The Purchasing Power Parity Debate’, Journal of Economic Perspectives 18(4), pp. 135-
158.

Central banks are the lender of last resort for domestic banks. How effective are they in this role?
Use Jacome et al. (2011) in your answer.

According to Jacome et al. (2011) central banks acting as lender of last resort were effective in
Europe and US (averted financial meltdown without causing macroeconomic instability) but
ineffective in Latin America (1995-2007). Their main findings are: large injections of money from
central banks to financial institutions led to macroeconomic instability and currency depreciation;
1% increase in credit/GDP ratio led to 2.5% depreciation (total sample). The authors identify three
main problems:

1. Large scale of lending to too many institutions in the same period.

2. Lending money not only to cope with systemic crisis but also to deal with
idiosyncratic events.

3. The countries were net-importers with substantial debt denominated in foreign

currencies.
Jacome H., L.I., Sedik, T.S., and Townsend, S. (2011) ‘Can Emerging Market Central Banks Bail Out Banks? A Cautionary Tale
from Latin America’, IMF Working Paper WP/11/258. Available at:
http://www.imf.org/external/pubs/ft/wp/2011/wp11258.pdf

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