Finance

Bonds and the banking sector

In effect the supply chain of money, described the way a wheat supply chain would be — but with an administered upstream price (the policy rate) instead of a market-driven commodity price.

Money and credit intermediation system

A system that prices, creates, allocates and stabilises money and credit through the interaction of policy institutions, profit-seeking intermediaries, and households and firms.

Flow

  1. 1. Central bank sets short-term policy rates → shapes yields on Treasuries and money-market instruments.
  2. 2. Commercial banks fund via deposits, wholesale markets and central-bank facilities.
  3. 3. Funding is transformed into loans, securities portfolios and payment services.
  4. 4. Households and firms deposit savings and borrow, generating interest, principal and fees.
  5. 5. Bond markets reflect the term structure of nominal and real rates, encoding expectations.
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Elements

  • Central bank, Treasury, commercial banks, bond investors, depositors and borrowers, regulators.
  • Instruments: policy rates, Treasuries and TIPS, deposits, loans.
  • Metrics: policy rate, yield curves, HHI, NIM and ROE, inflation and breakevens.

Interactions

  • Policy → markets: the central bank sets short-term rates, shaping nominal and real yield curves.
  • Markets → banks: market yields set the opportunity cost of funds and the pricing of loans and securities.
  • Banks → customers: wholesale and policy rates translate into retail deposit and loan rates, plus fees.
  • Banks → structure: profits fund M&A, lobbying and tech, which change concentration (HHI).
  • Regulators → structure and conduct: rules and enforcement shape entry, mergers, pricing freedom and risk-taking.

Purposes

  • Central bank: Match the flow of money to the wealth created as closely as possible to avoid devaluation; maintain price stability, employment and financial stability.
  • Commercial banks: Highly bottom-line driven — maximise risk-adjusted ROE within constraints.
  • Customers: Place money at the bank in exchange for convenience, security and stability; access credit for consumption and investment.
  • Regulators: Preserve system solvency, competition and public trust.

Dynamics and feedback loops

  • R1 — concentration and profits. Higher HHI → wider margins and spreads → higher performance (ROE/NIM) → more rival acquisition, lobbying and tech investment → higher HHI.
  • B1 — regulatory response. High performance → complacency and tacit collusion → regulator's attention → regulatory changes, merger control, windfall taxes → lower or capped HHI.
  • Policy transmission. Rate shocks → change in margins and spreads via loan and deposit repricing → affect performance → alter risk appetite and lending volumes → feed back into the macro conditions that inform future policy.

The four lenses

  • Stock of trust. Depositors and investors trust banks and the currency, which makes cheap, sticky funding and credit creation possible.
  • Specialisation peril. A bank can specialise in particular products, sectors or funding sources to maximise ROE, but must hold capital and liquidity buffers and diversify funding and assets to survive rate, credit and funding shocks.
  • Scale symbiosis. Fragile and actively governed: unchecked profit-seeking can destabilise the system, while over-tight stability-seeking kills useful credit and innovation.
  • Innovation window. Spreads, rates and competition are allowed to move so new products and models emerge, while capital rules, supervision and lender-of-last-resort support keep crises from destroying the system.

Concepts

  • Money as a supply chain: administered upstream price, profit-seeking mid-stream processors, downstream users.
  • Structure–Conduct–Performance as a lens on banking spreads and competition.
  • Innovation versus stability: both full centralisation and full deregulation mute innovation, for different reasons.
  • Bounded instability: deliberate design of safe volatility inside global constraints.

Breakthrough questions

  • What level of instability is optimal for innovation in a financial system?
  • How do changes in HHI quantitatively affect spreads and NIM over time?
  • Can we design regulation that preserves the positive spread incentive but caps pure rent extraction?