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Electronic Payment Systems 20-763 Lecture 2 Banking Systems

Electronic Payment Systems 20-763 Lecture 2 Banking Systems. Outline. What banks do Their role in money movement Foreign exchange. World Banking System. PRIVATE BANKS AND CREDIT INSTITUTIONS. PRIVATE BANKS AND CREDIT INSTITUTIONS. PRIVATE BANKS AND CREDIT INSTITUTIONS. PRIVATELY OWNED

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Electronic Payment Systems 20-763 Lecture 2 Banking Systems

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  1. Electronic Payment Systems20-763Lecture 2Banking Systems

  2. Outline • What banks do • Their role in money movement • Foreign exchange

  3. World Banking System PRIVATE BANKS ANDCREDIT INSTITUTIONS PRIVATE BANKS ANDCREDIT INSTITUTIONS PRIVATE BANKS ANDCREDIT INSTITUTIONS PRIVATELY OWNED CENTRAL BANKS U.S. FEDERAL RESERVE DEUTSCHE BUNDESBANK MIXED-OWNERSHIP CENTRAL BANKS BELGIUM BANK OF JAPAN GOVERNMENT-OWNED CENTRAL BANKS BANQUE DE FRANCE BANK OF ENGLAND BANK FOR INTERNATIONAL SETTLEMENTS (A BANK FOR 45 CENTRAL BANKS, $130B) BASEL, SWITZERLAND INTERNATIONAL MONETARY FUND (PUBLIC POLICY LENDER $300B) 182 MEMBER COUNTRIES WASHINGTON, DC SOURCE: TRANSACTION.NET

  4. Central Banks • Legal tender (“real money”) is issued by authorized central banks • Government-owned • Privately owned • Joint private-government • Other banks cannot hold legal tender (except in cash form). Why? (Consider what form it would be in.) • Other banks must maintain accounts in the central bank • Banks transfer real money via transactions through the central bank

  5. Movement of Money • World economic product ~$30T • Time to circulate $30T ~ 6 days • Money supply (U.S., July 31, 2001) • M1 (spendable now; money for payments) $1.1T (liquid = cash + non-interest deposits + travelers checks) • M2 (M1+ short-term investments < $100K) $5.3T (M1 + time deposits + money market funds) • M3 (M2 + long-term investments) $7.7T (M2 + big deposits: institutional money funds) • Cash (U.S, July 31, 2001) $554B • 0.1% counterfeit (in the U.S., only 0.03% is counterfeit) • Over 70% held outside the U.S. (but counted in M1 because it can be spent in the U.S.)

  6. The U.S. Money Supply In billions on July 31, 2001 Currency554 Non-bank travelers checks9 Demand deposits313 Other checkable deposits 260. M1 Total 1136 Savings 2087 Small time deposits <100K 1116. Retail money market funds 984 M2 Total5323 Large time deposits >100K 812. Institutional money funds986 Bank agreements379 Eurodollars197 M3 Total7697 • . SOURCE: FEDERAL RESERVE

  7. Function of Banks • Central banks: • Issue fiduciary money (both token and notational) • All other (non-central) banks: • Issue notational scriptural money (bank accounts) • Not fiduciary (“real money”), not token • Non-central banks • Move notational money • Accept deposits (loans from depositors) • Loan deposits to others (borrowers)

  8. What is a Bank Account? • Notational representation of a loan to the bank from a depositor • Once the depositor puts money in his account, it becomes the bank’s money, not the depositor’s • When the bank deposits its money in the central bank, it becomes fiduciary (real) money • The bank then owes the depositor real money • Effect of deposit: bank ends up with more real money I HAVE $800. BANK OWES ME $200 (MY “ACCOUNT”) BANK HAS $200 MORE MONEY NOW I DEPOSIT $200 IN THE BANK BANK DEPOSITS $200 IN CENTRAL BANK I HAVE $1000 MY ASSETS: $1000 CASH BANK’S ASSETS: +$200 REAL MONEY - $200 DEBT MY ASSETS: $800 CASH +$200 OWED BY BANK

  9. Benefit of a Bank Deposit • Bank can • loan the money (more than was deposited!) • invest the money • move the money, e.g. make payments • buy foreign currency with the money

  10. Payment Orders (Checks) CHECK NUMBER DATE MAKER (DRAWER) PAYEE AMOUNT CURRENCY DRAWEE BANK DRAWEE BANK NUMBER ACCOUNT NUMBER AUTHORIZED SIGNATURE OF MAKER’S AGENT THIS CHECK IS AN ORDER TO MELLON BANK TO PAY $100 TO PAYEE OR HIS TRANSFEREE FROM THE CARNEGIE MELLON UNIVERSITY ACCOUNT

  11. Checks • U.S. -- 63 billion checks per year, average $1100 • 80% of noncash payments made by check • “On-Us” (payor and payee in same bank -- 30%) • Interbank (payor and payee in different banks) --requires settlement • Direct presentment (“direct sends”) • Correspondent banks • Clearing house associations (150) • Federal Reserve system (15 billion checks/year, 27%) • Complex laws re bank liability in check processing

  12. Check Check Sort/Balance Encode Deposit Ticket Deposit Ticket Clearing House Check Check Cash Letter Cash Letter Check Processing “On-Us” BANK A’S DEPOSITS “Clearing House” OTHER BANKS “Direct Sends” SOURCE: PNCBANK BANK B

  13. 9. MELLON SENDS CHECK BACK TO CMU 2. SHAMOS DEPOSITS CHECK AT CITI CITIBANK CUSTOMER A CUSTOMER B . . . SHAMOS CUSTOMER Z 8. CLEARING HOUSE SENDS CHECK TO MELLON MELLON BANK CUSTOMER A CUSTOMER CMU . . . CUSTOMER Y CUSTOMER Z 4. CITI SENDS CHECK TO CLEARING HOUSE CLEARING HOUSE (FEDERAL RESERVE) MELLON BANK A . . . BANK Z CITIBANK 6. CLEARINGHOUSE SENDS MELLONDEBIT INFO Clearing Payment Orders (Check) 1. CMU SENDS CHECK TO SHAMOS CUSTOMER CMU OF MELLON BANK CUSTOMER SHAMOS OF CITIBANK “PAY SHAMOS $100” -100 +100 -100 3. CITIBANK CREDITS SHAMOS WITH $100 7. MELLON DEDUCTS $100 FROM CMU ACCOUNT +100 5. CLEARING HOUSE ADDS $100 TO CITI, SUBTRACTS $100 FROM MELLON

  14. REAL-TIME GROSS SETTLEMENT SYSTEM (FEDWIRE) MELLON BANK A . . . BANK Z CITIBANK CLEARING HOUSE • 6. CLEARING HOUSE PAYS • MELLON $34,299,321 • 4. CITI PAYS THE CLEARING • HOUSE THROUGH RTGS CITIBANK CUSTOMER A CUSTOMER B . . . SHAMOS CUSTOMER Z MELLON BANK CUSTOMER A CUSTOMER CMU . . . CUSTOMER Y CUSTOMER Z +2786 -15085 CLEARING HOUSE (FEDERAL RESERVE) MELLON BANK A . . . BANK Z CITIBANK -988713 +3167 +100 +728103 -31872 +35529 +34,299,321 3. CLEARING HOUSE INFORMS CITI IT MUST PAY $107,071,775 • 5. CLEARING HOUSE ADVISES • MELLON IT WILL • RECEIVE $34,299,321 -107,071,775 Settling Payment Orders (Checks) 1. AT END OF DAY, EACH BANK HAS A NET POSITIVE OR NEGATIVE CLEARING HOUSE BALANCE • 2. BANKS WITH NEGATIVE • BALANCES MUST PAY; • THOSE WITH POSITIVE • BALANCES RECEIVE • MONEY +34,299,321 -107,071,775 +107,071,775

  15. 0 6 1 3 0 0 1 8 1 8 4 3 1 0 1 4 3 7 0 0 0 0 0 0 0 0 1 0 0 0 0 0 U S D 0 6 1 2 0 0 3 5 6 4 2 5 0 2 0 0 1 0 1 3 0 CHECK NUMBER DRAWER ACCOUNT NUMBER DRAWEE BANK NUMBER PAYEE BANK NUMBER AMOUNT CURRENCY PAYEE ACCOUNT NUMBER DATE Only the information is sent to the clearing house Electronic Clearing MAKER (DRAWER) DATE The paper cheque is just a carrier of information. Electronic transmission is better. We dematerialize the cheque (remove the paper). CHEQUE NUMBER PAYEE AMOUNT CURRENCY DRAWEE BANK AUTHORIZED SIGNATURE OF MAKER’S AGENT DRAWEE BANK NUMBER DRAWER ACCOUNT NUMBER

  16. Foreign Exchange • Currency = token fiduciary money of a central bank • Every bank account is denominated in one currency • Most banks allow accounts in only one currency • All currencies have three-letter ISO currency codes: • USD (U.S. dollar) JPY (Japan yen) • GBP (Great Britain pound) CHF (Swiss franc) • HKD (Hong Kong dollar) EUR (Euro) • Usually, the first two letters indicate the country; third letter is the first letter of the currency name • Foreign exchange is a barter transaction • To buy GBP for USD, buyer has to find someone with GBP who wants USD

  17. Foreign Exchange • Every bank must have an account at the central bank (or with another bank that has one) • The account is (usually) denominated in that country’s currency and is used to settle obligations in that currency • A foreign exchange transaction requires two settlements, one in each currency • Therefore, two countries’ central banks are involved

  18. Foreign Exchange Example • Bank B (buyer) in the U.S. buys 1 million GBP for 1.44 million USD from Bank S (seller) in the UK • Bank B must have an account denominated in GBP somewhere, probably at Bank C in the UK • Bank S must have an account denominated in USD somewhere, probably at Bank T in the US

  19. BANK T (US) BANK S USD ACCOUNT BANK C (UK) BANK B GBP ACCOUNT US FEDERAL RESERVE BANK THE BANK OF ENGLAND BANK B USD ACCOUNT BANK S GBP ACCOUNT BANK T USD ACCOUNT BANK C GBP ACCOUNT Foreign Exchange Example US BANKS (NOSTRO ACCOUNT) BANK S (UK) WILLING TO SELL 1 MILLION GBP FOR USD BANK B (US) WANTS TO BUY 1 MILLION GBP FOR USD (NOSTRO ACCOUNT) UK BANKS SETTLEMENT ONE: BANK B TRANSFERS 1.44 MILLION USD TO BANK T BY FEDWIRE SELLER S NOW HAS 1.44 MILLION USD IN BANK T SETTLEMENT TWO: BANK S TRANSFERS 1 MILLION GBP TO BANK C BY CHAPS (BOE RTGS) BUYER B NOW HAS 1 MILLION GBP IN BANK C

  20. The Euro – A Basket Currency • Single currency for 11 European countries • Issued by the European Central Bank (ECB) • 1 euro (EUR) = • 1.95583 DEM (German deutschmark) • 6.55957 FRF (French franc) • 1936.27 ITL (Italian lira) • 166.386 ESP (Spanish peseta) • 2.29371 NLG (Netherlands guilder) • 40.3399 BEF (Belgian franc) • 13.7603 ATS (Austrian schilling) • 200.482 PTE (Portuguese escudo) • 5.94573 FIM (Finnish markka) • 0.787564 IEP (Irish punt) • 40.3399 LUF (Luxembourg franc)

  21. Q A &

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