Economics of Banking and Money

Economics of Banking and Money
(ECOBAM) Yaseen Ghulam

BANKING AND ECONOMICS Traditional banking----taking deposits and making loans Modern bank is a complex financial institution staffed by multi-skilled individuals conducting multi-task operations Focus of the talk in next few days is on studying bank behaviour (optimisation subject to constraints) and bank management practices Understanding the behaviour of banks using basic tools of economic analysis

Question to Answer Why banks exists?
How to check bank financial health? Is the merger of banks beneficial to society and banks? Size: Bigger banks are better for the society? How to measure degree of competition in banking Why banks need more regulations compare to NBFI’s ? Are the banking regulations laws same in different countries ? What are the managerial issues in banking ? Risk management and prudential regulation

Question to Answer Is the banking industry structure same across globe ? Why banks go abroad or merge? Has the globalisation changed the way banks operate now? Why some countries banks are more dominant internationally ? Can a bank fail, if yes, then why? Is the bank failure new phenomenon or historical ? Are there some qualitative and quantitative techniques developed to know beforehand a bank failure ? Yes, you will be able to answer all these questions in next 10 days?

Aims and Outcome of Course
How economics can explain the existence, nature and operation of retail, wholesale and international banking OUTCOME demonstrate a historical development of banking evaluate of public policy argument for prudential regulation identify risks and explain how banks can manage these risks describe and interpret trend and innovations in banking efficiency and competition relate the importance of banking to the national and international economy

Teaching and Learning Activities and Strategies
Lectures 11 Seminars 11 Assessment coursework assignment 40% end of unit examination 60%

Approach First main text book:
Modern Banking by Shelagh Heffernan John Wiley & Sons, Ltd ISBN: (new edition) Abbreviation: MB Second main text book:Microeconomics of Banking by Freixas & Rochet MIT Press Abbreviation: MOB Third main text book: Commercial Bank Management: International Edition by Peter S. Rose Mcgraw-Hill Abbreviation: CBM

Approach Supplementary Text Books and Magazine
The Economics of Money Banking and Financial Markets F. Mishkin, AWL 5th edition, 1996 Financial Markets and Institutions F. Mishkin, AWL 3rd edition, 2000 Global Financial Institutions and Markets H. Johnson, Blackwell, 2000 Commercial Banks Financial Management Sinkey, Prentice Hall, 5th edition, 1998 Internet, magazines and journals (i.e. Journal of Banking and Finance). Weekly reading of “The Economist” and “Banker” is desirable for all students

The Modern Banking Firm
A review of financial markets and reasons for banks existence Modern banking in the context of traditional model Types of banks and their operations Moral Hazard and asymmetric information in banking Modern activities in banking: Off-balance sheet and securitisation Reading MB ch.1, ch.2 MOB ch.1 pp 1-8, ch.2 pp 15-20 CBM ch.1 pp 4-23 F. Allen and A.M. Santomero (February 2001) What do financial intermediaries do? Journal of Banking and Finance Volume 25, Issue 2, Pages

Banking Structure Around the World
Main features of the banking systems in the following countries: UK USA Germany Reading MB ch.1,ch.2,ch.6 International Banking: text and cases Financial Times Edition ISBN: ch.3 Some journal articles

Managing Risks in Banking
Types of risk a modern day bank faces: Credit risk Liquidity and funding risk Interest rate risk Market or price risk Foreign exchange risk Sovereign or political risk Approaches to the management of risks: Gap analysis Duration analysis Duration gap analysis Securitisation, derivatives and options Conclusion (summary)

Managing Risks in Banking
Reading MB ch.3 International Banking: text and cases Financial Times Edition ISBN: ch.11 CBM ch.6,7,8,9,10 MOB ch.8

Banking Laws: Prudential Control in Banking
Introduction: Why banking regulation? Types of risks envisaged in banking and its relations to banking regulation Arguments for prudential control/regulation Problems with external prudential regulations and a case for free banking Prudential control and regulations in the UK Prudential control and regulations in the USA Reading MB ch.4,ch.5 CBM ch.2 pp 33-58 MOB ch.9

Empirical Work on Efficiency and Competition Issues in Banking
Why we study competitive issues in banking? Are competitive banks good for us? Measuring bank output How to estimate productivity and efficiency in banking? Empirical test of economies of scale and scope in banking Empirically testing how banks price their products Empirical test of price discrimination in banking Empirical models of test of competition in banking market Reading MB ch.9 CBM ch.5 pp MOB ch.3

Banking Failures Why banks fail? Case studies of bank failure
The determinants of bank failure Management incompetence Fraud Regulatory tolerance Global recession Solutions of bank failure Reading MB ch.7,ch.9 International Banking: text and cases Financial Times Edition, Ch.9 MOB ch.7

The modern banking firm
Outline A review of financial markets and reasons for banks existence Modern banking activities in the context of traditional model Types of banks and their operations Asymmetric information, moral hazard and adverse selection in banking 4 Major developments in banking Industry Deregulation Globalisation Financial innovations Strengthening in the degree of competition

Banks: what and why? Operational definition used by regulators
“A bank is an institution whose current operation consists in granting loans and receiving deposits from the public” “Banks act as intermediaries b/w depositors and borrowers” Banks are different from other financial firms in that they provide deposit and loan products The deposit products pay out money on demand or after some notice Thus banks manage liabilities and creates assets by lending money

Financial Markets Funds Funds Indirect Finance Financial
intermediaries Funds Funds Funds Borrower-Spenders Business firms Government Households Foreigners Lender-Savers Household Business firms Government Foreigners Financial Markets Funds Funds Direct Finance

Why do banks exist? The traditional theory of banking
Answer: Due to liquidity and payment services Money evolved from commodity money (e.g. gold coin) Now Money lubrication of trade frees us from bother exchange the goods we want Efficient medium of exchange and payment Paper Money not SUFFICIENT BANKS came into actions –bank drafts, LOC, etc There are different type of banks. But role of banks is same “perform intermediary role by accepting deposits and making loans” “Bank receives interest margin in term of compensation for this service”

Banks: what and why? Why not borrowers and lenders come together w/o an intermediary? Answer: presence of information cost and borrowers and lenders have different liquidity preferences Four types of information costs may incur to lender w/o intermediation i. Search cost contact of two parties ii. Verification cost verification of information provided by borrower iii. Monitoring costs monitoring of activities of borrower vi. Enforcement cost in case of default

Information costs Lenders will go to bank for intermediation if intermediary cost is less than the four costs components. Bank may also enjoy “informational economies of scope” Economies of scope are said to be exist when two or more products can be jointly produced at a lower cost than if the same products are produced individually Informational economies of scope in lending mean banks can pool a portfolio of assets which have a lower default risk but the same expected return on investment Banks can pool funds from different lenders (depositors) and can give liquidity at cheaper prices. This makes intermediation cost for the banks even less In additions, firm may take loan from the banks to send the signal to others that firm is likely to be staying in the business and thus encouraging customers and suppliers to enter into long term relationship largely due to creditworthiness

Modern Banks

Modern Day Banks Broadly speaking modern day banking consists of two types of banks Specialist investment /wholesale banks focus on investment market Generalist (retail and universal) banks offer wide range of products such as: Deposit account Loan product Real estate services Stock broking Life insurance

Wholesale Banking Wholesale banking may be described as “small number of very large customers” i.e. corporate and governments These banks are firms, which act as “private bankers” accepting deposits from high net worth individuals and investing in broad range of financial assets These banks with small deposit base have an access of a wide range of funds from the equity, bond and syndicated loan markets Wholesale banking is largely interbank Example ABN AMRO, MORGAN STANLAY

Wholesale Banking Modern wholesale (particularly USA investment banks) banks are engaged in: Finance wholesaler Underwriting Market making Consultancy Mergers and acquisition Fund management Merchant banks in UK traditional functions also include the same as that of their cousins in USA There had been a rapid growth in wholesale banking for the last two decades-Reason Relationship banking had reduced cost of contracting Delegation of tasks of evaluation and monitoring of borrower to a credit rating firms to avoid the cost of each time evaluating borrower profile

Retail Banking Retail banking may be described as “large number of very small customers” i.e. households Such system of banking is usually characterised with small number of banks with extensive branches network (with exception of USA) Retail banking is largely intrabank (the bank itself makes many small loans) NATWEST, BARCLAY, HSBC Services provided are: Safe store Payment mechanism (money transmission system) Financial intermediation (savings and lending) Other wide services such as financial advice, FOREX, share dealing and insurance etc.

Retail Banking Retail banking has witnessed a rapid “process innovation” for the last two decades specifically: Replacement of cashier with machine cost reduced to 25% of cashier ATM facility domestically as well as worldwide Telephone banking Video linked financial services Electronic cash e-cash Debit and credit cards Visa and master Virtual banking by internet

Universal Banking Universal banking refers to the provision of most or all financial services under a single, largely unified banking structure-Very common in Germany Walter (1994) identified four types of universal banks: Fully integrated universal banks- supplying all financial services from one entity Partially integrated financial conglomerates and able to supply all services but some like mortgage, leasing and insurance are provided through subsidiaries Bank subsidiary structure -bank concentrates on retail banking and remaining activities like investment banking and insurance through legally separate subsidiary of the bank Bank holding company structure - financial holding company owns both banking and non-banking subsidiaries. Holding company may be non-financial firm or holding company itself may be an industrial concern

Universal Banking Universal banking may include: Intermediation
Trading of financial instruments, foreign exchange and their derivative Underwriting new debts and equity Brokerage Corporate advisory services(mergers and acquisition advice) Investment, management, insurance Banks all around the world are trying to become universal Natwest, Barclays and HSBC are offering a broad range of services, ranging from deposit taking and loan making to investment advices

Why banks are like a firm or why they exhibit organisational structure?
Banks are like firms. Coase (1937) explained that a firm need an organisational structure because some procedures are more efficiently performed by “command” i.e. assigning tasks to workers and coordinating the work than reliance on market prices. A traditional bank with intermediary and liquidity function fits in well with Coase theory. Loans and deposits are internal to bank and they need command and control (CC) system. This intermediary role of banks and CC system will lead to principal and agent structure.

Principal-agent problem in banking
Bank activities are usually collection of contracts b/w principal and agents. Whenever these contracts are not honoured properly, principal-agent problem will arise. This principal-agent problem may exists b/w shareholders of a bank (principal) and its management (agent), the bank (principal) and its officers (agents) and the bank (principal) and its debtors (agents), depositor (principal ) and bank (agent) due to different priorities and incentives. Principal agent problem may arise due to the fact that agent has more information about his/her characteristics than the principal.

Moral hazard problem in banking
Bank activities are usually collection of contracts b/w principal and agents. Moral hazard is another problem in case of depositors (principal) and bank (agent) Moral hazard occurs when incentive changes for any party, which are core of the contract Example Depositors do not monitor bank activities and bank may go to risky ventures/businesses. Investors may take loans and intentionally default. Deposit insurance scheme may be exploited by banks

Adverse selection problem in banking
Moral hazard problem can lead to incentives problems because the principal cannot observe the agent action (i.e. bank shareholders and management) or the principal has inferior information compared to agent (i.e. managers and borrowers) Differences in information held by principal and agent can give rise to adverse selection Examples: Banks giving wrong and/or incomplete advice Rip-off of customers in UK See the “Economist” article

Relationship banking Relationship banking can help to minimise the principal-agent, adverse selection and moral hazard problem arising b/w a bank and borrowers and bank and depositors. Under relational banking lenders and borrowers have a relational contract Bank and borrower and bank and depositors will try to give full information to each others (better flows of information). Further an understanding b/w both parties that in future there may be need of some monitoring

Relationship banking Example
A good example in this regard is bringing of new product in the market. If an investor goes to bank for loan, the bank will see her/his record, no financial difficulty, no default, loan granted and a clause may be introduced for monitoring or altering the clauses of contract. Relationship banking is very common in Japan and Germany However, some time relationship banking may go wrong. Example: Jurgen Schneider/Duetche Bank

Arms’ length banking An extreme opposite is an arms’ length transactional or classical contract where many banks compete for the costumers business and customers shop around several banks. Both parties will try to disclose bear minimum information and stick to the contract clauses. UK and USA banking system is working under this system

4 Major Developments in Banking Industry
Deregulation of financial institutions i.e. banks in regard to their pricing decisions i.e. variable interest rate lending Financial innovations New processes (new markets i.e. Eurocurrency Market, securitisation) New financial instruments (i.e. Certificate of Deposits (CD’s), Floating Rate Notes (FRN) and Asset Backed Securities (ABS)) Globalisation (most banks operate throughout the world now) Strengthening in the degree of competition Forcing banks to: Re-structure Diversify Improve efficiency Absorb greater risk

Deregulation A major change in term of how modern day banks are behaving is the direct result of deregulation Deregulation has come in three phases Phase 1: lifting of quantitative controls on bank assets and ceiling on interest rate on deposits Phase 2: Relaxation of the specialisation of business between banks and other financial intermediaries allowing both to compete in each other’s markets (i.e. investment banking, mortgage and insurance products) Phase 3: Allowing competition from new entrants as well as increasing competition from incumbent and other financial intermediaries

Financial Innovation Deregulation in turn has brought in financial innovation Financial innovations are the direct result of technological advancement and ever rising demand and expectation of customers 3 major structural changes as a result of innovations Shift of focus on liability management rather than asset management Shift to variable rate lending (from fixed) Introduction of cash management techniques (helping banks to reduce average transaction cost)

Post WWII focus on asset management due to: Heavy public sector debt to carry out reconstruction and control on lending Asset management subject to constraints in term of Duration Now the focus is on liability management Ability to create liability ---borrowing in inter bank market (USA banks have been borrowing from offshore centres) 1970s volatile inflation and interest rate led to culture of variable interest rate lending linked to LIBOR (London Inter Bank Offer Rate) Variable rate determined by LIBOR, riskiness of customer, competitive pressure and marginal cost of lending

Hence stock of bank loans = f(demand for bank credit) Modern day banking involves liability management by altering interest rate on deposits and borrowing from Inter Bank Market Technological innovation has seen the development of new financial products such as: Credit card Electronic Fund Transfer (EFT) Automated Teller Machines (ATM) Point of Sale (POS) All this has led to better cash management on the part of consumer and significant cost reduction for the provider of these products-banks

Globalisation Globalisation of financial system generally and banking system particularly is on the rise In post WWII however banks getting more global due to: Push factors- interstate banking regulation in USA Pull factors- following prime customer---creation of branch network in foreign countries by City Bank and Bank of America Few other factors helping banks to go global include: Mergers,takeover and relaxation of capital control Increasing trend in securitisation Harmonisation of banking laws (European banking laws by ECB)

Banking Structure Around the World
Main features of the banking systems in the following countries: UK USA Germany

UK Banking Sector Overall Retail banking-dominates.
Investment banking and overseas expansion- Poor record. Concentration is high. Switch of status by the building societies. High profit-poor management. Bank of England The Bank of England is the central bank Responsible for: Monetary stability. Management of national debt. Banker to government and monetary sector. Assist to FSA.

Banking structure Retail banking (app. 20)
Financial Services Authority (FSA) Replaced 9 regulatory authorities Main responsibilities are: Maintaining market confidence Promoting public understanding of FI Protection of consumers Fighting of financial crime Retail banking (app. 20) Small number of banks with extensive branches network Large number of accounts. Cash ratios above minimum High degree of leverage/ credit creation. Bulk of business in £ sterling.

Retail Banking (app. 20) Retail banking Wholesale banking (app. 480)
Services provided Safe store Payment mechanism (money transmission system) Financial intermediation (savings and lending) Other wide services such as financial advice, FOREX, share dealing and insurance etc. Wholesale banking (app. 480) Services provided and main features Large accounts and small number of minimum deposits i.e. £250k, £500k. Large foreign currency business-most of them are foreign. Advice on privatisation-portfolio management-services to corporate sector. Not involved in payment mechanism.

Building Societies (75) Building Societies (75)
Very significant, but share declined after 1986 Products offered: Mortgage Life Insurance Pensions Investment products International Banks in UK Government encourages foreign banks operations London is the most famous banking centre with New York and Tokyo. Very significant share 375 foreign banks, 200 representative offices and 100 foreign securities houses

USA Banking System Important Features
US banking system has over 27,000 deposits taking institutions compared to 500 banks and 83 building societies in UK Banking system is concentrated as 76% total assets are held by commercial banks Over the time US banking sector has lost its dominance US banks weaknesses include developing country debt problems and decline in agriculture commodity and real estate prices

Structure and regulations of the US commercial banking industry
There are around 2800 commercial banks in the USA, for more than in any other country in the world In Canada or UK usually five or six major banks dominates the industry but in USA ten largest banks hold only 36% of the assets in their industry Restrictions and regulations on branches had resulted in more banks Two-third deposits are held by commercial banks, and remaining by thrift institutions In the past, it had been a case that an American bank could open a branch in foreign country easily than domestically The McFadden Act 1927, had effectively prohibited larger banks to open branches across states

Structure and regulations of the US commercial banking industry
The McFadden Act and state branching regulates constituted strong anticompetitive forces in the commercial banking industry But from late 1990s, situation has changed Regulation on branches particularly are being eased The restriction on branches had resulted in three developments: Bank holding companies Nonbank banks Automated Teller Machines (ATM)

Bank holding companies
A holding company is a corporation that owns several different companies The growth of holding companies over the time had been dramatic to avoid the branching restrictions B/c the holding company can own a controlling interest in several banks These holding companies had been and can involve in investment banking activities can purchase a failed bank in even other states and thus effectively avoid the branching restriction

Nonbank banks Another way banks can avoid branching restrictions was due to loopholes in the bank holding Act of 1956, which defined a bank as a financial institution that accepts deposits and makes loans Once bank holding companies had recognized this loophole, they opened branches with one function only (means offering loan facility or taking deposits only) However, the Competitive Act passed in 1981 had effectively filled this loophole

ATM The modern day facility of ATM was originally invented to avoid branching restrictions in USA Banks recognized that even if they don’t had ATM machines by their own but could use rented machines, they can easily avoid branching restrictions A number of these shared facilities such as Cirrus and NYCE have been established nationwide States also had encouraged these ATM machines rather than “brick and mortar branches” These ATM machines had got popularity with the advent of cheap computers

USA- Commercial banks consolidation
Banks failures in late 1980s and early 1990s had provided the base for banks consolidation Mergers and consolidations had been an important part of bank failure strategy Banks consolidation was further stimulated by the passage of Riegle-Neal Interstate Banking and Branching Efficiency Act This legislation expands the regional compacts to the entire nation and overturn the McFadden Act of prohibited interstate banking This Act had almost ensured the interstate banking roughly in all 50 states

It is anticipated that after consolidation there will be roughly 4000 commercial banks rather than present 8500 Another important feature of the USA commercial banking industry had been the separation of commercial banking from investment banking such as securities, insurance and real estate business Glass-Steagall Act 1933 had prohibited them from underwriting corporate securities or from engaging in brokerage activities. In turn, this Act had also prohibited investment banks and insurance companies from engaging in commercial banking activities In 1997, however, the Federal Reserve allowed holding companied to underwrite securities and stocks Initially it was insured that the revenue from these activities should be 10%, raised to 25% later on

Restrictions on commercial banks securities and insurance activities put American banks at a comparative disadvantage relative to foreign banks In 1999, the Congress had passed a bill, which effectively abolished the Glass-Steagall Act This legislation, which is called Gramm-Leach-Bliley Financial Services Modernisation Act of 1999, had allowed securities firms and insurance companies to purchase banks and allowed banks to underwrite insurance and securities and engage in real estate activities

Thrift industry in USA Savings and loans association (S&Ls) Just as there is dual banking for commercial banks, savings and loan association can be charted by the Federal government or by the states Most of the S &Ls whether state or federally charted or member of Federal Home Loan Bank System (FHLBS) The Savings Association Insurance Fund (SAIF), a subsidiary of FDIC, provides Federal Deposit Insurance (up to $100,000 per account) for S &Ls The branching regulations for S&Ls were more liberal than for commercial banks: From 1980s federally charted S&Ls were allowed to branch state-wide in all states

Thrift industry in USA Mutual saving banks
These S&Ls usually provides loans for mortgages, FHLBS makes loans on soft terms (low interest rates and longer repayment period). In late 1980s, these S&Ls started involving in commercial banking activities Mutual saving banks Of the around 400 mutual banks around half are chartered by the states Their deposits are ensured by the FDIC up to a limit of $100,000 per account The branching regulations for mutual saving banks are determined by the states in which they operate B/c restrictions on branching are not severe there are fewer mutual saving banks with vast branching structure

Credit unions Credit unions
Credit unions are small cooperative lending institutions They are the only financial institutions which are tax exempted and can be chartered either by the state or the federal government The National Credit Union Share Insurance Fund (NCUSIF) provides insurance for deposits Since the majority of the credit union lending is for consumer loans with fairly short term of maturity, they do not suffer the financial difficulties of S&Ls and mutual saving banks These unions are permitted to do branching in all states w/o any problem

International banking in USA
In 1960s eight US banks operated branches in foreign countries and their total assets were less than $4 billion. Currently there are more than 100 American banks working abroad with assets totalling over $500 billion US banks had most of their branches in Latin America, the Far East, the Caribbean and London Due to trade expansion, foreign banks had been encouraged to do the business in USA . These foreign banks had been overall very successful These foreign banking are roughly lending the same amount of money to corporations as the US banks These foreign banks are operating by using the agency offices, subsidiary banks and branches. Before 1978, foreign banks were under fewer regulations with no reserve requirements. However, 1978 International Banking Act put foreign and domestic banks on equal footing

German Banking System Features
German banks are typically universal ones A universal bank is one, which provides a complete range of commercial and investment banking services The German Banking Act implicitly provides a legal definition of a universal bank in the wider sense- a bank, which offers the whole range of commercial, and investment banking services. Enterprise type-offering banking business Banking Act: banking business comprises of: acceptance of funds w/wo interest paid (deposit business) granting of loans and acceptance credits (lending business)

German Banking System Banking Act: banking business comprises of:
purchase of bills of exchange and cheques (discount business) purchase and sale of securities for others (securities business) safe custody/admin. of securities for (safe custody business) guarantees and warrantees of others (guarantee business) performing of cashless payment/clearing (giro business) Wide definition and consequently; some activities considered non-banks in UK, are banking activities in Germany. Generally speaking, German financial system is characterised as ‘bank based’ due to broad legal definition of banking business

German Banking System The group of universal banks in Germany can be divided into three categories on the basis of ownership and legal form. These categories are: commercial banking sector; saving bank sector; and credit cooperative sector Building and loans associations are treated separate from the banking system Three categories of universal banks together accounted for roughly 80% of the volume of business in Germany This confirms the fact that German banks are really universal banks. All the banks are able in principle to conduct the whole range of banking business as specified in the banking Act.

Commercial banks in Germany
Commercial banks in Germany as a whole, account for roughly 25% share in the total volume of banking business There are four different classes of banks under commercial banks category: The big banks Regional and other commercial banks Foreign banks Private banks Duetsche Bank, Dresdner Bank, Commerzbank and their Berlin subsidiaries operate nationally through network of local branch offices Although these banks are major banks in term of their balance sheet volume, however, their share is not as significant in overall banking business

Regional/commercial/ foreign banks
These banks concentrate on providing universal banking services in their particular regions, but some maintain their system of branches which had allowed them to operate on interregional or national basis. Two such banks with an extensive branch network are the Bayerische Vereinsbank and the Hypo-Bank. These two large banks are even permitted to engage in mortgage business. Foreign banks in the German banking system had not been significant Foreign banks are permitted to engage in those sorts of businesses, which are allowed to domestic banks Private banks consists of limited partnership private bankers specialize in export finance, securities trading, industrial finance, and housing finance etc.

Saving bank sector Savings bank sector had the largest share in the domestic volume of business Saving banks were originally conceived non-profit making concerns: to serve relatively less well-off members of the community; to give credit on favourable terms to public authorities; to finance local investment in the region These banks do follow these obligations but now they have become universal banks which compete with the commercial banks for most forms of banking business There are three tiers within the saving bank sector. These are: Local savings banks State saving banks Central saving banks

Local saving banks These are municipal or district institutions incorporated under public law as independent legal entities Each state had its own Savings Bank Act, which specifies the structure and organisation of the saving banks in that state A local saving bank is usually permitted to operate only in its own region and its investment in securities and other assets are subject to restrictions.

State savings banks (Central Giro Institutions)
Each state saving bank is incorporated under public law and is owned by its respective state government and state saving bank association Works as clearing houses for their member local savings banks. They are state bankers in their respective states and can conduct their business on interregional and international basis. The largest state saving bank is the Westduetsche Landesbank girozentrale, which is roughly comparable to Commerzbank in terms of balance sheet assets

Central savings banks Deutsche Girozentrale (DGZ) serves as the central clearing bank for the saving bank system and holds the liquidity reserves for the state saving banks This is similar to state saving banks in term of business it conducts, but it is smaller in size than many of them. Although, both local saving banks and state savings banks are universal banks, some activities such as securities trading underwriting and international business are more important for state saving banks.

Credit cooperative sector
The credit cooperative originated simply as cooperative banks Provides credit to their members, but now have developed to universal banks The organisation of the credit cooperative sector is similar to that of the saving bank sector There are large numbers of local credit cooperatives and a system of larger regional banks headed by a central clearing- house institution There are three tiers within the credit cooperative sector. These are: Local cooperative banks,regional central cooperative banks and federal clearing house institutions

Local and regional cooperative banks
Local cooperative banks The first tier of this sector comprises local banks organised as cooperatives, whose members are local individuals and businesses. Members of the local credit cooperatives contribute capital. Regional central cooperative banks The local credit cooperative are headed by a second tier consisting of regional central cooperative banks, which are either stock corporations or registered cooperatives owned by the local credit cooperatives.

Federal clearing house institutions
Third tier consists of federal clearing-house institution, which is a stock corporation owned by the regional credit cooperatives This is the most important category of credit cooperative banks in terms of volume of business (among top 10) The relationship between the local credit cooperatives and the regional institutions of the credit cooperative is similar to that between the local savings banks and the regional giro institutions. The local credit cooperatives raise relatively large amount of funds in the form of personal saving deposits, while regional institutions of the credit cooperatives do relatively little deposit banking and raise the funds by borrowing from other banks

Mortgage banks Among those banks in Germany, which provides a specialised range of banking services rather than universal services, the most important group consists of the mortgage banks. These banks are owned by public or private sectors and the law in Germany generally limits mortgage banks to make long term mortgage loans and loans to municipalities and other public authorities. These banks finance through bonds and long term deposits. Most private mortgage banks are usually owned by commercial banks, which are interested to enter into this market

Banks with specialised functions
The group of banks offering specialised banking services comprises various public and private institutions Their share in total volume of banking business in Germany has been in the range of 10-12%. These banks provides loans finance such as: export finance; finance of projects in less developed countries; environmental programmes; and small and medium sized German firms

Management of Risk in Banking
All profit maximising firms face two types of risks: Microeconomic risk (new competitive threat); Macroeconomic risk (the effect of recession) Additional potential risks include: Breakdown in technology; Commercial failure of a supplier or customer; Political interference;National disaster Banker on the other side face some additional risks bankers job is to manage these risks. Risk management is the primary responsibility of bank management. Some risk are easy to think, calculate and manage, but some are difficult to even calculate. Additionally, banks manage the risk arising from on and off-balance sheet business.

Types of risk a modern day bank face Credit Liquidity and funding Settlement and payment Interest rate Foreign exchange Gearing or leverage Market or price Approaches to the management of risks Credit risk Credit risk analysis/credit evaluation

Approaches to the management of risks Interest rate risk (through assets liability management (ALM)) Gap analysis Duration analysis Duration gap analysis Liquidity and funding Foreign exchange Hedging Market or price VaR and Stress Testing Asset securitisation and derivatives

Definition of risks a bank face
Credit risk probability of default on a loan agreement. risk that an asset or a loan will become irrecoverable due to outright default. Liquidity and funding risk Liquidity risk of insufficient liquidity for normal operating requirements financing wage bills etc. the ability of the bank to meet its liabilities when they fall due. It simply means shortage of liquid assets Funding risk bank is unable to finance its day-to-day operations smoothly.This is called maturity mismatching

Interest rate risk Interest rate risk arises from interest rate mismatches in both the value and maturity of interest sensitive assets, liabilities and off-balance sheet items. Asset-Liability Management (ALM) manages interest rate risk. If banks have excess fixed rate assets they are vulnerable to rising interest rate and if excess fixed rate liabilities they are vulnerable to falling rates. Typically banks are asset sensitive meaning a fall in interest rates will reduce net interest income by increasing the banks’ cost of funds relative to its yield on assets.

Market or Price risk Banks face market (or price) risk on instruments traded in well-defined markets. equities, bonds holding by bank (price incr./decr.) Two types- General (systematic) and unsystematic A bank can be exposed to market risk (general and specific) in relation to debt and service fixed and floating rate debt instruments such as: bonds, debt derivatives, futures and options on debt instruments, interest rate and cross country swaps and forward foreign exchange positions, equities and equity derivatives (equity swaps), futures and options on equity indices, options and futures warrants.

Foreign exchange or currency risk Under flexible exchange rates a bank with global operation face such type of risk and it arises usually due to adverse exchange rate fluctuation which effects the bank foreign exchange position taken on its own account or on the behalf of its customers. Banks engage in spot, forward, and swap dealing faces this risk. Banks have large positions, which changes dramatically within minutes. Gearing or leverage risk Banks are highly geared (leveraged) than other businesses. Suppose banks confirm to a risk asset ratio of 8%. An 8% capital ratio translates into a 1250% ratio of “debt” (liabilities) to equity in contrast to 60-70% debt-equity ratio for commercial firms.

Credit Risk Management
Credit risk techniques are probably among the best –developed tools available to bankers and they have long experience of assessing and managing this risk. Essentially, following are the widely used techniques to manage credit risk. Screening Monitoring Long-term customer relationships Loan commitments Collateral Compensating balances The credit risk analysis departments usually use two types of methods. Qualitative & Quantitative

Approaches to the management of credit risks
Qualitative Banks usually use four ways to minimise credit risk. Accurate pricing of loans---more risky loans may be priced higher than the less risky loans. Credit limits----credit limit may be imposed on the borrower according to their wealth or potential income in near future. Collateral or security----loans should be properly secured against the wealth or assets of the borrower (houses or shares etc.) Diversification---risky loans can be backed up through new capital injection or diversification through finding new loans markets.

For firms or big borrowers banks can assess annual report of the company or debt-credit record. judgement is made on the basis of past credit history (through credit rating agencies), the borrower gearing (leverage) ratio, wealth of borrower, volatility of the borrowers’ income, and whether or not collateral is a part of the loan agreement. Sometime credit rating team will look on the forecasted macroeconomic indicators such as: inflation, interest rates and future economic growth.

Quantitative method of credit risk analysis requires the use of financial data to predict the probability of default by the borrower. The methods, which are usually commonly used, are Discriminant Analysis and Logit and Probit models These methods are statistical techniques and involve regression The probability of defaults is calculated on the basis of some important predetermined variables i.e age, marital status, residence and qualification etc.

Approaches to the management of interest rate risks
Interest rate risk managed through asset liability management. Two types of method are very common in analysing and minimising the interest rate risk. These are gap analysis and duration analysis Gap analysis Gap analysis is the most well known ALM technique used to manage the interest rate risk. The gap is the difference between interest sensitive assets and liabilities for a given time interval say six months. In gap analysis each of the bank assets and liabilities is classified according to the date the asset or liability is going to be re-priced, and the “time buckets”

normally overnight-3 months, 3-6 months 6-12 months, 12 months and more and so son. Analyst will compute incremental and cumulative gaps results. An incremental gap is defined as earning assets-funding sources in each time buckets, while cumulative gaps are the cumulative subtotals of the incremental gaps. By definition incremental and cumulative gaps should be zero for complete interest risk aversion scenario. A negative gap means sensitive liabilities are > sensitive assets. A positive gap means sensitive assets are > sensitive liabilities.

GAP Analysis-Example

More on Interest-Sensitive Gap Measurements
Dollar Interest-Sensitive Gap Interest-Sensitive Assets – Interest Sensitive Liabilities = Relative Interest-Sensitive Gap Interest Sensitivity Ratio

Interest-Sensitive Assets-Liabilities
Short-term securities issued by the government and private borrowers Short-term loans made by the bank to borrowing customers Variable-rate loans made by the bank to borrowing customers Liabilities Borrowings from money markets Short-term savings accounts Money-market deposits Variable-rate deposits

Gap Positions and the Effect of Interest Rate Changes on the Bank
Asset-Sensitive Bank Interest rates rise NIM rises Interest rates fall NIM falls Liability-Sensitive Bank

Important Decision Regarding IS Gap
Management must choose the time period over which NIM is to be managed Management must choose a target NIM To increase NIM management must either: Develop correct interest rate forecast Reallocate assets and liabilities to increase spread Management must choose dollar volume of interest-sensitive assets and liabilities NIM Influenced By: Changes in interest rates up or down Changes in the spread between assets and liabilities Changes in the volume of interest-sensitive assets and liabilities Changes in the mix of assets and liabilities

Problems with Interest-Sensitive Gap Management
Interest paid on liabilities tend to move faster than interest rates earned on assets Interest rate attached to bank assets and liabilities do not move at the same speed as market interest rates Point at which some assets and liabilities are repriced is not easy to identify Interest-sensitive gap does not consider the impact of changing interest rates on equity position

Duration analysis Duration analysis allows for the possibility that the average life (duration) of an asset or liability differs from their respective maturities which makes matching of sensitive assets with sensitive liabilities quite difficult. Suppose the maturity of a loan is six months and the bank opts to match this asset with a six months certificate of deposit (CD). If part of the loan is repaid each month, then the duration of the loan will differ from its maturity. The formula for duration is as: Duration= Time to redemption {1-[coupon size//MPV*r)]}+(1+r)/[1-(DPV of redemption/MPV)]---(1) Where: r: market or nominal interest rate; MPV: market present value; DPV: discounted present value; Present value is calculated as: Sum of cash flows/(1+r)n ……..(2)

Approaches to the management of risks- Example
Bond life: 10 years, Value: £100, Coupon rate: £5 annually, Redemption value: £100, Market interest rate: 10%. Present value is calculated as: DF CF PV 69.27

Approaches to the management of risks- Example
Duration is calculated: D= 10[1-5/6.9277)]+(1.1/0.1) {1-[100(1.1) -10/69.277]}. D= 7.6 years rather than 10 years. Similarly duration of equity can be calculated as: DE= {(MPVA*DA)-(MPVL*DL)] (MPVA-MPVL) (3) The computed duration of equity is used to analyse the effect of a change in interest rate on the value of bank

More on Duration Duration of an Asset/Liability portfolio
Where: wi = the dollar amount of the ith asset divided by total assets DAi = the duration of the ith asset in the portfolio Duration of a Liability Portfolio Where: wi = the dollar amount of the ith liability divided by total liabilities; DLi = the duration of the ith liability in the portfolio

Duration Gap Overall Duration Gap is:
Change in the Value of a Bank’s Net Worth:

Impact of Changing Interest Rates on a Bank’s Net Worth
Positive Rise Decrease Gap Fall Increase Negative Zero No Change

Approaches to the management of liquidity risk
Triggered when majority of the customers are interested to get their money back due to bad management or perception of bank failure All the times the bank must be able to meet the cash flow obligation arising from deposit withdrawals (normal case as well as in stress) The best way to deal with this type of risk in modern banking is to use the gap analysis.

Approaches to the management of liquidity risk
To control this risk, banks usually plan cash flows (in and out) over a short interval (e.g. one week)

Market Risk Management
Banks participate in buying and selling of financial instruments in various and diverse markets around the globe. Adverse changes in the price of these instruments can expose the banks significantly and effect the value of their portfolio. This is called market risk. Two widely methods to calculate the exposure of market risk are: Value at Risk (VaR): calculates market risk faced by a bank in everyday normal market condition. Stress testing: calculates market risk in abnormal market condition. In the following discussion we discuss each approach in detail.

Market Risk Management
Value at Risk (VAR) Approach Relatively new approach for measuring the market risk. VaR calculates the worst possible loss that a bank could expect to suffer over a time interval, under normal market conditions, on the basis of some specific confidence level. E.g., a bank might calculate that the daily VaR of its trading portfolio is $35 million at a 99% confidence interval. This means that there is only 1 chance in 100 that a loss > $35 million would occur on any given day. VaR can be calculated for any portfolio of assets or liabilities whose market values are available on a periodic basis and price volatilities () can also be estimated.

JP Morgan’s VaR VaRx = Vx * dV/dP * Dpi
JP Morgan general definition for VaR is the maximum estimated losses in the market value of a given position that may be incurred before the position is neutralized or reassessed. VaRx = Vx * dV/dP * Dpi Vx = market value of position x dV/dP = sensitivity to price move per $ market value Dpi = adverse price movement over time i; e.g, if the time horizon is one day, then VaR becomes daily earnings at risk DEAR = Vx x dV/dP x DPday

Portfolio Stress Testing
Relatively new technique that relies on computer modeling of different worst case scenarios and computation of effects of those scenarios on a bank’s portfolio position (Sept. 11 bombing). The advantage of this technique is that it can allow risk managers to evaluate possible scenarios that may be completely absent from historical data. For example Sept. 11 bombing of WTC: All assets in portfolio are revalued using changed environment and a modified estimate for the return on the portfolio is created. Many such scenarios can lead to many exercises and a range of values for return on the portfolio is derived. By specifying the probability for each scenario, mangers can then generate a distribution of portfolio returns, from which VaR can be measured.

Financial Futures Contract
An agreement between a buyer and a seller which calls for the delivery of a particular financial asset at a set price at some future date The Purpose of Financial Futures To shift the risk of interest rate fluctuations from risk-averse investors to speculators Most Common Financial Futures Contracts U.S. Treasury Bond Futures Contracts U.S. Treasury Bill Futures Contracts Three-Month Eurodollar Time Deposit Futures Contract 30-Day Federal Funds Futures Contracts One Month LIBOR Futures Contracts

The World’s Leading Futures and Option Exchanges
Chicago Board of Trade (CBOT) Financial Exchange (FINEX) New York Futures Exchange (NYFE) Marche a Terme International De France (MATIF) Singapore Exchange LTD. (SGX) Chicago Mercantile Exchange (CME) London International Financial Futures Exchange (LIFFE) Sydney Futures Exchange Toronto Futures Exchange (TFE)

Hedging with Futures Contracts
Avoiding higher borrowing costs and declining asset values Use a short hedge: sell futures contracts and then purchase similar contracts later Avoiding lower than expected yields from loans and securities Use a long hedge: buy futures contracts and then sell similar contracts later

Interest Rate Option It grants the holder of the option the right but not the obligation to buy or sell specific financial instruments at an agreed upon price. Types of Options Put Option - Gives the holder of the option the right to sell the financial instrument at a set price Call Option - Gives the holder of the option the right to purchase the financial instrument at a set price Principal Uses of Option Contracts Protection of the bond portfolio Hedging against positive or negative gap positions Most Common Option Contracts Used By Banks U.S. Treasury bill futures options; Eurodollar futures option; U.S. Treasury bond option; LIBOR futures option

Using Swaps and Other Asset-Liability Management Techniques
Swap contracts and selected other asset-liability management techniques can be used to eliminate or at least reduce a bank’s potential exposure to the risk of loss as market conditions change. Swap contracts and other hedging tools can also generate additional revenues for banks by providing risk-hedging services to their customers. Interest Rate Swap A contract between two parties to exchange interest payments in an effort to save money and hedge against interest-rate risk Currency Swap An agreement between two parties, each owing funds to other contractors denominated in different currencies, to exchange the needed currencies with each other and honor their respective contracts.

Other Instruments (OTC)
Interest Rate Cap Protects the holder from rising interest rates. For an up front fee borrowers are assured their loan rate will not rise above the cap rate Interest Rate Floor A contract setting the lowest interest rate a borrower is allowed to pay on a flexible-rate loan Interest Rate Collar A contract setting the maximum and minimum interest rates that may be assessed on a flexible-rate loan. It combines an interest rate cap and floor into one contract.

Off-Balance Sheet Financing in Banking and Credit Derivatives
Securitization of Assets The pooling of a group of similar loans and issuing securities against the pool whose return depends on the stream of interest and principal payments generated by the loans Advantages/Problem of Securitization Diversifies a bank’s credit risk exposure Creates liquid assets out of illiquid assets Allows the bank to better manage interest rate risk Allows the bank to generate fee income Problems with Securitization May not reduce a bank’s capital requirements Not available for all banks May increase competition for the best quality loans May increase competition for deposits

Types of Securitized Assets
Residential mortgages Home equity loans Automobile loans Commercial mortgages Small business administration loans Mobile home loans Credit card receivables Truck leases Computer leases

Loan Sales Marketing loan contracts held by an institution in order to raise new cash Types of Loan Sales Participation loans Where an outside party purchases a loan. They generally have no influence over the loan terms Assignments Ownership of the loan is transferred to the buyer of the loan. The buyer has a direct claim against the borrower.

Reasons/Risk Behind Loan Sales
Way to rid the bank of low yield securities Way to increase liquidity of assets Way to eliminate credit and interest rate risk Way to generate fee income Purchasing bank can diversify loan portfolio and reduce risk Risks In Loan Sales Best quality loans are the easiest to sell which may increase volatility of earnings for the bank which sells the loans Loan purchased from another bank can turn bad just as easily as one from their own bank Loan sales are cyclical

Standby Letters of Credit (SLCs)
A financial instrument that guarantees performance or insures against default in return for payment of a fee. It is a contingent obligation Reasons for Growth of SLCs Rapid growth of direct financing worldwide Perception among banks and their customers that the risk of economic fluctuations has increased Opportunity SLCs offer banks to use their credit evaluation skills to earn fee income and the relatively low cost of issuing SLCs Sources of Risk with SLCs Default risk of issuing bank Beneficiary must meet all conditions of letter to receive payment Bankruptcy laws can cause problems for slcs Issuer faces substantial interest rate and liquidity risks

Credit Derivatives Financial contracts offering protection to a designated beneficiary in case of loan default Types of Credit Derivatives Credit swaps Credit options Credit default swaps Credit linked notes

Prudential control in banking
Risks in Banking Systematic risk------bank runs/contagion Default risk credit risk Price risk asset prices can change Fraud or incompetence risk operation risk Unwise diversification of assets Competition and excess risk taking Outline Arguments for prudential control/regulation Arguments against prudential control/regulation Case studies UK USA

Prudential control in banking
All firms have to ensure for capital adequacy (keep capital reserves (money) to offset any losses) In addition, banks have to ensure sufficient liquidity. Prudential control is more important for banking. due to two conflicting objectives on asset side of balance sheet. Profit high to keep shareholders happy Liquidity-----low/high to earn profit/serve better and insure depositors Bank has also self-interest in term of long-term survival But then question arises Should prudential controls/regulation be compulsory set by state bank? or bank management themselves

FINANCIAL REGULATION OF BANKS
WHY REGULATE? All Markets Financial Markets 1. Protect consumer  The investor 2.  Monopoly power  Conc. of fin.firms 3. Externalities  Threat of systemic collapse 4. Illegal Activity  M- laundering, tax evasion. Externalities: one agent engages in actions which affect the utility of others but it is NOT reflected in the Price mechanism Positive Externality: lighthouse; neighbors keep house and property tidy: adds to value of all houses (so partly reflected in p–mechanism) but there is the daily aesthetic side to living in a well kept house. Negative Extarnality: pollution in one country (UK) drfits north and ruins forests in Sacandinavia. Global warming: everyone is going to suffer but it is in no one country’s interest to do anything unless every country does something. Every country has to agree to action and even then there would be cheating. Threat of systemic collapse: the social cost of bank failure which banks DO NOT include when they are estimating Expected Returns. LTCM: hedge fund: takes calculated risks: does not take into acct any effect its failure would have on the financial system as a whole.

Benefits/Costs of prudential control/regulation
Protection of the public’s savings Control of the money supply Adequate and fair supply of loans Maintain public confidence Curb monopoly powers Support of government activities Help for special segments of the economy/society Costs Hampers competition and innovation. Cost of regulation high-compliance cost Complexity of activities------innovation of modern finance --Competence of supervisor Modern ALM makes it redundant. Deposit insurance alone has ended risk of systematic bank failure. Capital adequacy has ended credit risk.

Who Bears the Cost: Cost of Higher Capital Ratio on Spread

SUM: Prudential Regulation of Banks
The Challenge: strike the right balance:  Minimise the social costs of bank failure/financial crisis AND  Minimise MORAL HAZARD problems Evidence of MH: Managers assume extra risks because of: (1) Deposit Insurance - if provided (2) Looting hypothesis (Akerlof & Romer, 1993): Management: undertake riskier activities to boost short-term profits - then cash in on dividends/ shareholdings,etc. Gambles likely to be sizeable. (3) Bank deemed "too big to fail”: The costs from bank failures and/or bank induced financial crises can be considerable. Examples: Crédit Lyonnais: single most costly bail out in history: $20 to $22 billion Cost of dealing with crisis in Indonesia – 50-60% of GDP: : part of the Asian financial crises, which began with Thailand, then spread to other Asian countries including Indonesia. Cost as a % of GDP for Philippines: 7%; Malaysia: 10%, Korea: 15%; Thailand: 24%. Main point: cost is variable: for developed economies, cost will look lower because of big GDP. E.G.: cost of thrift crisis: $120 bn but 5-7% of GDP; Cost of Japanese bk problems: 20% of GDP. The challenge get the balance right between: reducing the chance of financial instability/meltdown AND keeping the problems created by special treatment (e.g. Moral Hazard – where is the info asymmetry here? ) of banks and other FIs Looting hypothesis: what can they do to boost short-term profits? Buy junk bonds, offer higher deposit rates- If the go under they will have “NEST EGG”; if not, they will be praised for their innovative strategies. Too big or too complex to fail: a major bank in a country with sizeable no. of deposit holders. Bank will not be allowed too fail no matter what.

UK Financial Structure - Key Regulations
The Evolution of UK regulation is best assessed by looking at 6 Acts: The UK Banking Act, 1979; Amended 1987 Financial Services Act, 1986 The Building Societies Act, 1986,1996 (no. of BS: 131 in ‘89 ; 63 in ’03) 1998 Banking Act Financial Services & Markets Act, 2000

Prudential control and regulations in the UK
Bank of England creation in 1694 Overall BoE is the regulatory authority (now combined with FSA) Role of BoE is Monetary control Prudential control Government debt through reserve ratio Often role contradictory with each other Major Banking Regulation Pre-1979 No specific banking law in the UK Private banks treated like other commercial concerns Individual agents or firms could accept deposits without any formal licence

1979 Act Identified two classes of institutions-recognised banks and licensed deposit takers Act created a Deposit Protection Fund, to which all recognised banks to contribute. Funds to compensate 75% of any deposit upto £10,000 Collapse of Johnson Matthey Bank (JMB) paved the way for amendment in the Act 1987 Banking Act Basically an amendment in 1979 Act Created supervisory board headed by the Governor of BOE and members outside of the bank

1987 Banking Act Eliminated the distinction between deposit takers and banks Act clarified that a firm seeking as a recognised bank status from BOE must offer a broad range of services including current (checking) deposit accounts, overdraft and loan facilities, atleast one of the foreign exchange facilities, foreign trade documentation (in the form of bills of exchange), investment management services, or alternatively very specialised services Private auditors were given greater access to BOE information Any exposure to a single borrower, which exceeds 10% of banks’ capital should be reported to BOE and supervisor should be consulted beforehand of any lending which exceeds 25% of bank capital to a single borrower Act specified BOE control over foreign banks entry Act increased the deposit insurance limit to £20,000

Under Act BOE acts as a regulator. The asset side of a bank balance sheet is regulated through measure of capital adequacy and liability side through liquidity adequacy BOE Capital Adequacy How much capital is there to pay back liabilities Two measures are used: Gearing or leverage ratio and Risk assets ratio BOE Liquidity Adequacy Funding risk through liquidity gap analysis Interest rate risk through gap analysis Foreign exchange rate risk through a look on dealing and structural positions Counter party risk through Euromarket monitoring

Capital Adequacy and the BOE
1. Gearing ratio: Deposits+ Ext. Liabilities Capital + Reserve Lower the GR, lower the risk that a bank will lose its capital and fails Example1: Suppose a bank balance sheet is as: Bank deposits + ext. liabilities = £1 mil. Bank’s capital + reserve = £1 mil. GR= 1/1=1 Implications: if bank lends £2 mil. and 50% of borrowers default, bank loses all its capital but depositors get back their money.

Example 2: Suppose a bank balance sheet is as: Bank deposits + ext. liabilities = £2 mil. Bank’s capital + reserve = £1 mil. GR= 2/1=2 Implications: if bank lends £3 mil. And 50% of borrowers default, bank loses 1.5 mil (more than its capital) and all depositors not get back their money. Usually ratio is set by the bilateral agreement between the bank and the BoE.The precise gearing ratio considered acceptable to both parties varies according to the nature of bank business and its assets. Some qualitative factors are also given some consideration.

2. Risk asset ratio Weighting is used for different assets It allows heterogeneous set of assets to be valued Now called Basle risk assets ratio It is calculated by taking into account tier one or core capital (equity capital plus reserves) and tier two capital or supplementary capital (subordinated long-term debt) Weights are pre-determined Ratio is defined as: Tier one capital+ tier two capital Risk adjusted assets

Example: Suppose a hypothetical bank assets, and weights prescribed by BOE and Basle. Cash £500 (0%) T. bills £2000 (0%) Mortgage £ (50%) Commercial loans £ (100%) Unadjusted value of assets £27000 Adjusted value of assets= 500*(.0)+2000*(.0)+15000*(.5)+10000*(1.0)=17500 Risk assets ratio= (tier1 capital+tier2 capital) 17500 If tier1 and tier2=1500, Then risk assets ratio= 1500/17500= 8.6%

Capital Adequacy and the BOE-extended example

Financial Services & Markets Act- June 2000
Required a merger of numerous regulators: banking supervision division of BE, Friendly Societies regulators, Insurance Directorate (DTI), UK Listing Authority, Credit Unions Statutory Requirements of FSA: Ensure Confidence in the UK financial system (fin.stability). Educate the public- risks of investing. Protect consumers - but encourage greater responsibility. Reduce financial crime. ALSO: Be cost effective: C/B analysis on all new regs. Major Initiative: a “risk based” approach to regulation. ALL firms assigned impact score, RTO: “risk to our objectives”: IMPACT SCORE = [Impact of the problem] X [prob of problem arising] Score ranges from A (very high risk) to D (low risk). High Risk: major banks, large insurance firms, stock exchanges, big broker-dealers. Signals a move away from rules for each type of institution. Emphasis: effect of a firm’s actions ON the FSA’ ability to meet statutory objectives, NOT financial/systemic risk per se.

USA - Bank Structure & Regulation
Emphasis on protecting small depositors. Concern about potential collusion as important as issues related to financial stability – reflected in their legislation. Major Banking Laws National Bank Act (1863/64) Banks must opt for a state or national charter (OCC) 1913: Federal Reserve Act: FED to provide an “elastic” currency: FRS – 12 regional FR banks FDIC: created in 1933; administers deposit insurance ($100,000) Glass Steagall section of the Banking Act: 1933 Riegle Neal Interstate Banking & Branching Efficiency Act: 1994 Gramm Leach Bliley Financial Markets Act: 1999

US Regulation: Multiple Regulators
Regulators Financial Firms OCC (1863) National commercial banks FED (1913) FHCs/BHCs, FDIC (1933) Any bank (nat/ state) covered by FDIC insurance OTS (1989) Savings & loans (national or state) NCUA (1970) Credit unions- national or state State Regs State chartered banks licensed by the state FTC Uninsured state banks or savings & loans, credit unions, foreign branches of US or foreign banks SEC (1934) Securities firms/investment banks, investment advisors, brokers NAIC, DTI Insurance firms

USA banking regulation
Overall Evolved through time Different to UK banking regulation by: Seeking help from legislation whenever crises Protection of small depositors more important Concern about potential collusion National bank act passed in 1863 and amended in 1864 Federal Reserve Act 1913 created central bank regional Federal Reserve Banks and a Board of Governors Banks must get license either by the Comptroller of the Currency or by a state official

USA banking regulation
Banks performance is monitored on a scale bases ranging from 1 to 5. 1-2 are considered good score for a bank, while 5 is bad which signals bank failure is just around the corner Since 1991, Federal Deposit Insurance Corporation (FDIC) regulates capitalisation of the banks Fed normally examines the state member banks, the Comptroller of the currency examines the national member banks and FDIC examines the non-member (of the FRS) insured banks Member banks of FRS must comply a tier one capital asset or leverage ratio of at least 5%.

Major USA banking regulation
National Banking Act (1863,1864) Passed during the civil war to help fund the war Created the treasury and the comptroller of the currency Created national banks with a federal charter Federal Reserve Act of 1913 Passed after a series of financial panics at the beginning of the century Created the federal reserve system. Gave the fed the authority to act as the lender of last resort Created to provide a number of services to member banks. Today the fed controls the money supply

McFadden-Pepper Act 1927 Prevented banks from expanding across state lines Made national banks subject to the branching laws of their state Glass-Steagall Act 1933 Passed during the great depression Separated investment and commercial banking Created the FDIC Fed given the power to set margin requirements Prohibited interest to be paid on checking accounts

FDIC Act 1935 Addressed the issues left out of the glass-steagall act Gave the FDIC the power to examine banks and take necessary action Bank Holding Company Acts Federal reserve given the power to regulate bank holding companies Amendment reduced the tax burden of bank holding companies Amended the definition of bank holding companies to include one-bank holding companies

Bank Merger Acts All mergers must be approved by the appropriate regulating body Mergers must be evaluated in three areas Effect on competition Effect on the convenience and needs of the community Effect on the financial condition of the banks Social Responsibility Acts 1968 – full information on terms of loans must be given 1974 – cannot be denied a loan based on age, sex, race, national origin or religion 1977 – cannot discriminate based on the neighborhood in which borrower resides 1987 and 1991 – banks must disclose full terms on deposit and savings accounts

Gramm-Leach-Bliley Act 1999 Permits banking-insurance-securities affiliations Consumer protections for consumers purchasing insurance through a bank Must disclose policies regarding the sharing of customers’ private information Customers are allowed to ‘opt out’ of private information sharing Fees for ATM use must be clearly disclosed It is a federal crime to use fraud or deception to steal someone’s account or personal information

US: common to answer to more than one regulator
Debate Single vs Multiple Regulators: The Debate (Based on UK/US experience) Growth of financial conglomerates - functional supervision is costly; may leave gaps FSA: has a Major Financial Groups Division for the 50 most complex firms operate in UK, even if HQed elsewhere (eg: big 5 UK bks). Each conglomerate has a micro regulator: coordinates supervision in the FSA FED: has control over FHCs that own banks: Since 1989: US Fed has led supervision of Large Complex Banking Corporations (LCBOs): 2-12 supervisors monitor each of the 50 leading organisations. THUS: not part of debate - both systems have developed ways of dealing with FCs. Single regulation eliminates functional regulation, which can raise compliance costs. But does it? US: common to answer to more than one regulator

Debate Single vs Multiple Regulators: The Debate (Based on UK/US experience)
(3) Product boundaries less well defined: e.g. derivatives & securitisation Alternative to single regulator: assign a lead regulator (solo consolidation)?- UK - has caused problems in the past (3) FSA: Single regulation creates Scale and Scope Economies : - Single system of reporting (?) - Better communication - firms report to single regulator - Single point of contact: firms and consumers (?) - Common methodology -e.g. RTO (?) - Pool resources/efficient resource allocation(?) - Single system for authorisation (?), supervision, discipline, training,etc. - Easier to recruit from pool of experts US authorities: Are scale/scope economies achieved? Competition between regulators encourages comp/inn. (Greenspan) Monopoly power gives single regulator too much power, leading to reg. forbearance and inefficiency.

Debate Single vs Multiple Regulators: The Debate (Based on UK/US experience)
(4) Cost of regulation - Early study (2002): cost of FSA 10% of US reg; (5) Cost of Compliance: firms under both systems complain but may be more difficult to measure under multiple regs. (6) Overlap between organisations. Likely to be more of a problem in the US –e.g. Citigroup case. Could raise compliance costs. (7) Accountability: FSM Act makes FSA highly accountable- annual reports to Parliament, etc. Also true of the FED chair. Other US regulators do not have such a high profile. (8) FSA’s 4 statutory duties - could aggravate conflicts of interest by scarce resources. Not the case in the US where each regulator (except the FED) has a single set of related duties. (9) Moral hazard: a problem under both regimes. (10) Split between supervision (FSA) and monetary control (BE): Raises question of responsibility for financial stability.

Bank Failure Case Studies
Why Banks Fail?

Why Banks Fail? Banks are more Vulnerable, fragile and open to contagion Compared to other commercial firms- Why? Low capital to assets ratio (high leverage)-leaves little room for losses Low cash to assets ratio- may require sale of earning assets to meet deposit obligation High demand debt and short term debt to total debt (deposits) ratios-that brings high potential for a run- may require hurried assets sale at cheap prices Banking crises starts with run (mob of depositors appear at the bank and its branches, demanding their money) To fulfil their demand, banks may call loans, may refuse to lend new credit or sell assets Having said all banks do not fail- then why some banks fail?

Introduction Some modern best known cases are: Bankhaus Herstatt
Franklin National Bank Banco Ambrosiano Continental Illinois and Pen Square Johnson Matthey Bankers US Thrift Bank of New England Baring Bank of Credit and Commerce International (BCCI)

Banks Failures If not all banks are prone to failure then why study bank failure and bother about that? Bank failure or crashes are important to understand b/c crises spread (contagion disease) Indonesia, Thailand and Korea- Failure spread through out the banking system as sick institutions infected the healthy and dragged them down into insolvency. Banking crises not new- Italian, Dutch English, Scots, French, Austrians, Germans, Japanese and American—all faced the banking crises/failure.

Cost of Bank Failures The cost of bank failure in OECD as well as in developing countries is enormous. And sometime difficult to estimate Few examples are given below:

Barings (1995) Background A well known British bank, very good in mergers and acquisition and quite powerful in emerging Far East market. About 1/3 employees based in Asia and more than half outside UK. The banking and market making arm of the bank (Baring Securities was a leading equity broker in Asia and Latin America) The fund management operation had a reputation for its expertise in Eastern Europe.

Barings (1995) Reasons of Downfall
Exposure in Far East was the main reason for Baring downfall (unlimited exposure in the derivative market). Mr Leeson was the culprit. He was head of the department, leading a team of 15 employees. Smart and manipulative person. He was an arbitrageur whose job was to spot differences in the prices of future contracts and profits from buying futures on one market and simultaneously selling them on another. Mr Leeson was suppose to earn benefit out of this business for subsidiary of Baring Securities. Margins in these types of contracts are small but volume traded large. Mr Leeson was supposed to have been trying to profit by spotting differences in the prices of Nikkei-255 future contracts listed on Osaka securities Exchange (OSE) and the Singapore Monetary Exchange (SIMEX). SIMEX attracts stock markets futures b/c Osaka exchange is subject to more regulation and hence is more costly.

Barings (1995) Rather than hedging his position Lessons seems to have decided to bet on the future direction of the Nikkei index. The move proved costly for Mr Leeson. Mr Leeson used a secret error account to hide trading losses and exaggerated his earnings to get maximum bonus. Baring London was deceived into thinking that Mr Leeson made profits from arbitrage. But losses were accumulating in the account. It was reported that more than ¾ profits was earned through this Mr Leeson business. All the time auditors failed to detect any wrongdoing. During the process of selling and buying Mr Lesson’s action brought £827m losses.

Barings (1995)-Responsibles
Low internal control in the area of risk management. Regulatory authorities share the blame. The SIMEX and Osaka exchange failed to act despite the rapid growth of contracts at Baring. BOE was also deficient in its supervision of Baring. BOE granted Baring solo status (mean Baring bank and Baring securities required to meet a single set of capital and exposure standard). It means BOE was supposed to supervise trading business of Baring (not a good idea, given the fact that it had no expertise in this area), hence depositors were exposed to trading losses. European rule of not taking more than 25% maximum equity capital exposure into single investment was ignored and BOE had not spotted this. Coopers and Lybrand (external auditors of Baring) failed to conduct comprehensive tests that would have detected large funding requests from Singapore.

Franklin national bank (1974)
Background 20th largest bank in USA. Reasons of Downfall Large foreign exchange losses. Quick expansion. Unsound loans as a part of expansion strategy. Story Refused by FR to take over another bank. Large depositor’s withdrawal. Refused by other bank to lend. Borrowed $1.75 billion from FR. Taken over by a consortium of seven European banks Did not fail completely due to deposit insurance.

Banco Ambrosiano(1982) Background Italian bank based in Milan.
Quoted on the Milan stock exchange. Subsidiary companies overseas. Luxembourg subsidiary called Banco Ambrosiano Holding (BAH) 60% of this subsidiary owned by BA Milan. BAH active on the interbank market. Taking Euro currency deposits from international banks. Money from Euro currency was lent to non Italian companies in BA group.

Banco Ambrosiano(1982) Reasons of Downfall
Massive fraud by chairman of the bank. Chairman departed Milan for London after receiving a letter from BOI to reduce and explain overseas exposure. Deposit withdrawal after confidence lost due to chairman death in London after hanging on the bridge. Former Italian PM was also involved in fraud. Bank of Italy launched life boat operation. Seven banks provided money. Later declared bankrupt by Italian court and taken over by another bank. BAH also suffered from losses of deposits , but refused by bank of Italy to launch life boat operation. BAH defaulted on loans and deposits.Weak relation b/w senior management and Bank of Italy are considered the root cause of this bank failure. Significant supervisory changed after this failure.

Continental Illinois and Pen Square (1982)
Background Two American investment banks. Penn square energy loans passed to CI . Involved in heavy lending in real estate and energy sector. CI relying on overseas market to fund its loans portfolio 60% of them were short term foreign deposits. Reasons of Downfall Lack of procedures to vet new loans. Poor quality loans to US corporate sector and CI failed to classify bad loans as nonperforming. Rumours spread of difficulty faced by bank and bank run started, made it difficult to raise funds.

Continental Illinois and Pen Square (1982)
US Comptroller of Currency intervened but it made the matter worse and bank borrowed money from Chicago Reserve Bank (CRB). Private life boat was organized, but not sufficient Run got worse and $6b disappeared within few days. FDIC and Comptroller announced assistance. All CI directors were asked to resign in return.

Johnson Matthey Bankers (JMB) (1984)
Background An arm of Johnson Matthey, dealer in gold bullion. JM was the fifth largest gold dealer in London. Involved in lending to third world countries. Reasons of Downfall Significant Loans exposure to a single country (Nigeria). Auditors did not show responsibility. They agreed with director presentation of accounts. Bank of England showed soft approach. Private auditors not given full authority to check. No communication between auditors and BOE. Return submitted by management not subject to independent audit.

Johnson Matthey Bankers (JMB) (1984)
Lifeboat operation launched by BOE with the help of private banks. Use of “Too Big to Fail”. Lifeboat operation launched by BOE suggests regulator will be willing to accept too big to fail if the bank failure poses a real danger in term of widespread bankruptcies. JMB affair prompted the establishment of committee. The committee involved the Treasury, BOE, and external experts. Amendment of Banking Act (1987).

Bank of Credit and Commerce International (BCCI)
Background Founded by the Pakistani financier and incorporated in Luxembourg with small amount of capital $2.5m (less than BOE $5m requirements). Initially given the status of deposit taker but later on after amendment in banking act became full bank with authority to open branches across UK. When closed negative net worth of about $7b. Customers included Manuel Noriega (Panamian dictator) and international terrorist Abu Nidal. Reasons of Downfall Fraud and illegal dealings. BCCI bought a Colombian bank with branches in Medellin and Cali (centre for the cocaine trade and money laundering). International repute for capital flight, tax fraud and money laundering.

Bank of Credit and Commerce International (BCCI)
Indicated in Florida, raided by British customs and executive imprisoned in Florida for money laundering. BOE and pricewaterhouse failed to communicate with American regulatory authorities. Bingham report criticised BOE and pricewaterhouse. BOE set up a special investigation unit to look into suspected cases of fraud or financial malpractice as well as setting up a special legal unit. Amendment of Act (closing UK branches of an international bank if deemed necessary). Cross border supervision very important.

Summary

Common Lessons from Bank Failure Case Studies
A number of qualitative conclusions can be drawn from the individual bank failure case studies. Bank may fail due to: Weak asset management Low quality loans with inappropriate collateral arrangement. Excessive exposure to one sector or single firm/country. This exposure overlooked by regulatory authorities. Inexperience with new products (FNB, Bankhaus Herstatt). Managerial inefficiency in term of herd instinct (Barings). Bank fraud and dishonesty (BA, FNB, BCCI) Supervisors, bank inspectors and auditors missed important signal of problem banks (JMB, BA, BCCI, Barings). Too big to fail may lead to moral hazard and resultant bank failure (JMB)

Competitive Issues in Banking
Outline Competitive issues in banking Productivity measurement Efficiency measurement Economies of scale and scope Test of competition in banking market Contestable banking markets Interest equivalence for non-price features Qualitative tests for price discrimination and firms survival Notes: For this topic, chapter 4 from the text book “Modern Banking in Theory and Practice” by Shelagh Heffernan John Wiley and Sons is a must reading.

Measuring of bank output
Measurement of output of services produced by financial institutions has special difficulties b/c they are not physical quantities. Difficult to account for quality in a banking service. i.e. ATM may improve the quality of payment services as well reduce the costs of transactions considerably but benefits are difficult to measure. Increase in frequency of transactions by a customer may increase the costs per customer. Hence difficult to measure the net benefits per customers. Two common approaches to measure banks outputs: The production approach The intermediation approach

The production approach Banks are treated as firms for measuring output. Banks use capital and labour to produce deposits and loan accounts and output is measured as: Number of accounts/number of transaction per account. Uses bank output as flows. Problem How to weight each bank service in the computation of output. The method ignores interest costs. Difficult to compare data from different banks, thus making accurate measure of efficiency difficult.

The intermediation approach This approach recognises intermediation as the core activity. Output is measured by the value of loans and investment. Cost is measured as operating costs (the cost of factor inputs such as labour and capital) plus interest costs. Bank output is treated as a stock. Neither the intermediation nor the production approach takes account of the multi-product nature of banking. Most bank productivity studies used intermediation approach. because this has fewer data problems than with the production approach.

Next Step: Productivity and Efficiency Measures
Two types of productivity measures are used. Partial and Total Partial measures are based on financial ratios. They show partial picture. Assets per employee Loans per employee Profit per employee Cost per employee Admin. Cost as a % of total cost Whereas, total measures take into account multiple nature of outputs and inputs in banking i.e. Total Factor Productivity (TFP)

Productivity and Efficiency Measurement
Efficiency Estimation Empirical research is based on two methods of efficiency estimation Stochastic Frontier Analysis (SFA) Data Envelopment Analysis (DEA) DEA employs a efficiency ratio by using multiple inputs and outputs. DEA compares the observe output (yjp) and inputs (xip) of several banks. It then identifies the relatively more efficient bank with the relatively less efficient bank.

Efficiency Estimation The model is run repetitively with each bank appearing in the objective function once to derive individual efficiency rating. The decision about efficiency or inefficiency is based on the following: E=1 relative efficient, E<1 relative inefficient However, efficient does not mean top of the level efficient in absolute terms but efficient compared to other banks in the data set.

Productivity Estimation Malmquist productivity index is a popular method to estimate TFP TFP is computed by taking into account efficiency change and technical change The Malmquist index will be able to determine levels of change in technical efficiency and change between time periods The Malmquist index is calculated as follows (as outlined in Fare et al, 1994). This formula can be further decomposed into efficiency and technical change as follows

Where the first part of the equation (that which lies outside of the parenthesis) represents efficiency change and the second part (contained within the parenthesis) represents technical change. The Malmquist index provides a measure of changes in total factor productivity (TFP) from year to year. The values are concentrated around 1, which implies no change. A TFP index value which is greater than 1 implies an improvement, while a value less than 1 implies a decrease in productivity. The efficiency change relates to how the firms performed relative to the production frontier.

An efficiency change index value which is greater than 1 implies that the firms are operating closer to the frontier than in the previous time period, while if the index figure is less than 1, the bank in question is operating further below from the frontier. The other component, technical change (TC), indicates a shift in the frontier. This can be affected by technology or also changes in the economic or regulatory environment. A technical change index value which is less than 1 means the frontier has shifted inwards, while a TC index value which is greater than 1 implies that the frontier has shifted outwards. Again, this index is a relative measure intended to indicate any movement in the frontier. A TC value of 1 indicates a static frontier in the relevant time period.

The Malmquist index can be estimated as a function of a set of distance functions, which, in turn, can be estimated using DEA. This is a methodology proposed, again, by Fare et al (1997). SFA is also used to estimate efficiency and productivity!

Empirical Studies on Productivity and Efficiency
Numerous studies used DEA method to measure the efficiency of banks. Some selection of studies is given below: Rangan et.al. (1988,90) used this approach by using the data on 215 US banks.They break down the efficiency score into technical inefficiency (wasted resources) and scale inefficiency (non-constant return to scale). Bank output was measured with intermediation approach. The study showed the efficiency score of 0.7 implying 30% wastage, all due to technical inefficiency. Field (1990) applied DEA to a cross section of 71 UK building societies in The results were that 80% were found to be inefficient due to scale inefficiencies. Unlike Rangan ((1988,90) bank size was positive with TE.

Some selection of studies is given below: Drake et.al. (1991) used DEA to building societies in 1988 after deregulation in % of these societies showed increase in their overall efficiency. Humphrey (1992) measured productivity and scale economies using flow and stock measures of banking output. He applied both non-parametric growth accounting procedure and an econometric estimation of cost function. A structural model of bank production was used which incorporated both the production of intermediate deposit outputs as well as final loan outputs. He obtained two measures of total factor productivity by using 202 US banks.

Some selection of studies is given below: Humphrey key findings were as follows: Banking productivity had been flat (only 0.4% p.a. GR) Real value of total assets: declined (the average TFP GR was –1.4% p.a) The author identifies a number of possible reasons for decline in TFP.Some of these are: Banks lost low cost deposit accounts, as corporate and retail customers switched to corporate cash management accounts and interest earning check accounts.

Economies of Scale and Scope
There is an extensive literature on the degree to which scale economies exist in banking. The term economies of scale or scope are a long run concept when all the factor inputs, which contribute to a bank production process, can be varied. Assuming all factor inputs are variable, bank is suitable to exhibit scale economies mean equi-proportionate increase in factor inputs yields a greater than equiproportionate increase in output or the banks are operating on the falling portion of their average cost curve. Consider a bank with three factors of inputs capital (deposits), labour (the bank employee) and property in the form of branch network and 3 outputs like loans, investment and off balance sheet business .

The economies of scale are said to exist if, as a result of doubling each of three inputs, the bank is able to more than double its outputs. Even this simple example is problematic in case of banks b/c all factor inputs are not variable. In short run it is really difficult to double inputs such as deposits. Even if inputs are doubled and loans are doubled, then risk portfolio is bound to change, a critical important consideration for a bank wanted to maximize shareholder value added. All this implies that it is really difficult to apply the concept of economies of scale in financial sector. Hence it negates the underlying concept of mergers and acquisition on the basis of hope of economies of scale and scope.

Economies of scope exist if the joint production cost of producing two or more outputs is lower than if the products are produced separately. For example a bank offers three services to customers (deposits, loans and payment services). Then, if a bank can supply these services more cheaply through a joint production process than producing and supplying them independently, it is said to be enjoying economies of scope. From the strategic standpoint the question of whether or not economies of scale and scope are present in the banking is important. Evidence of economies of scale will mean large banks have cost advantage over small one. If cost complementries are present, multiproduct banks will be more efficient than the financial boutiques.

In term of empirical work, most of researcher uses cost function approach to measure SCALE and SCOPE economies i.e. This more general model specification of cost function, which focuses upon scale economies and technological change, is specified as C(yit,wit,t):

Overall economies of scale are derived from differentiating the translog cost function with respect to output. Where MCi is the marginal cost with respect to the ith output and is the cost elasticity of the ith output. If OES >1, bank experiences diseconomies of scale, and increasing returns are apparent if OES<1. If OES=1 then, there is evidence of constant returns to scale. Scope economies are said to be exist if: C(yit,wit,t)<[c(y1t,wit,t)+c(y2t,wit,t)+c(y3t,wit,t)]

Empirical Studies on Scale and Scope Economies in Banking
Empirical studies of economies of scale and scope in financial institutions showed mixed results. USA studies Shaffer and David (1991) examined the question of economies of scale for very large US multinational banks. Traditional translog cost function with two and three factors was used with and without hedonic terms (qualitative factors). In the absence of hedonic terms they found evidence of scale economies. In the translog equation with the hedonic terms included, scale was reduced from the level of without hedonic terms.

Humphrey (1992) obtained estimates of scale economies for US banks. The author used flow measure of output. His study results suggested diseconomies of scale. However, when alternatives measures of output were used, Humphrey found significant economies of scale for small banks, constant costs for medium sized banks and scale diseconomies in large banks. This study however raised an important question. which measure of output should be used? The author suggested that stock measure was more accurate than flow measure of output. The study overall results suggest there are slight economies of scale for small banks, but slight diseconomies for large US banks.

Numerous US studies have tested for economies of scope in banking with mixed results. Gilligan and Smirlock (1984) study supported the hypothesis of economies of scope. Mester (1987) concluded there was no strong evidence to either support or refute the presence of economies of scope. Lawrence (1989) found cost complementarities (economies of scope) to be present. Hunter, Timme and Yang (1990) found no evidence to support the presence of cost complementarities.

British studies Hardwick (1990) tested for scale and scope economies using UK building societies data. The author employed multi-product statistical cost analysis. He tested for overall and product specific economies of scale by using a marginal cost approach. Overall economies of scale were found except for very large building societies. Significant diseconomies were found in the use of capital in large building societies. For small banks cost saving was attributable in the use of labour compared to capital. Hardwick did not find evidence either for or against economies of scope for large building societies.

However, he found significant diseconomies of scope for building societies with assets worth £1.5 billion. The results of the study virtually showed no case for diversification of building societies into broader banking market. Drake (1992) using a multi-product translog cost function found evidence for economies of scale for medium sized banks. He found no evidence to support the earlier Hardwick study of diseconomies of scale for building societies with assets in excess of £1.5 billion. Nor did Drake find economies or diseconomies of scope for the building society industry except for the group with assets in the range of £500m-5 billion which showed significant diseconomies of scope.

European studies Altunbas and Molyneux (1993) examined the cost structure in four European countries (France, Germany, Italy and Spain). They found overall scale economies to exist in all four countries. Italy showed significant scale economies over all levels of output. In Spain they were present only for smallest banks. France showed significant scale economies over a range of bank sizes. In Germany diseconomies of scale were found at all assets levels. The presence of economies of scope results were mixed. In Spain significant economies of scope were evident for banks with assets of < $1.5 billion. In France it is middle sized banks which showed economies of scope. Diseconomies of scope were found for all Italian banks. In Germany, largest banks showed scope economies, smaller banks showed scale diseconomies.

Empirical Model of Competition in Banking
The Structure Conduct Performance (SCP) model Since the Second World War, SCP model has been popular in industrial economies. Applied to the financial sector SCP says, “a change in the market structure or concentration of banks effects the way banks behave and performs”. There is a well-developed link b/w structure, conduct and performance. Market structure is determined by the interaction of cost (supply) and demand.

The Structure Conduct Performance (SCP) model Conduct is a function of number of sellers and buyers, barrier to entry and cost structure. Conduct in a market is determined by market structure that is number or size distribution of banks in the market and the condition of entry. The conduct in term, result in bank taking decisions about prices, advertising etc. The outcome is market performance (profitability).

The Structure Conduct Performance (SCP) model In simple words less number of firms (structure: high concentration), higher prices (conduct) and higher profit (performance) Thus conduct links market structure and performance as: Structure Conduct Performance

Empirical model of competition in banking
The Efficient Market or Relative Efficiency model This model challenges the SCP approach. Some banks earn supernormal profit b/c they are more efficient than others. This bank specific efficiency is exogenous and reflected in higher market share. Therefore it is market share than concentration correlated with profit. The relative efficiency model predicts the same positive profit concentration relationship as the SCP model. However, the positive relationship is not explained by collusive behaviour in SCP case but greater efficiency and higher market share (and concentration).

According to SCP, concentration is exogenous, resulting in higher prices for consumers and higher bank profitability. In the relative efficiency model however, , exogenous bank specific efficiencies results in more concentrated markets b/c of market dominance of these relatively efficient banks. If the relative efficiency model is found to hold, it would suggest markets are best left alone.

Empirical tests of SCP and Relative Efficiency in Banking
Berger and Hannan (1989) conducted the direct tests of SCP and relative efficiency models using the equation rjit : the interest paid at time t on one category of retail deposits by bank i located in the local banking market, ji. CONSjt: a measure of concentration in local market j at time t. xijt: vector of control variables that may differ across banks, market or time periods; :error term. If SCP hypothesis hold,  < 0 (negative relation between concentration and deposit rate “the price of bank services”). If relative efficiency model is hold, then  >0. The results show that SCP hypothesis hold for their data.

Empirical Results of SCP and Relative Efficiency in Banking
Jackson (1992) key finding was that price is non-linear U shape over the relevant range and support the relative efficiency type model, where high level of market concentration signal the gaining of market share by the most efficient firm. They found a negative  for low concentration group and positive  for high concentration. In response to Jackson study Berger and Hannan concluded the price concentration relationship is negative for some range of concentration. Molyneux Forbes (1993) tested the SCP and relative efficiency hypothesis using European data. Their main finding was a significant positive concentration price relationship, but the market share variable was negative. The authors concluded that the SCP hypothesis is supported by this European sample.

Contestable Banking Markets
Some empirical studies have considered the question of whether banking markets are contestable. A contestable market is one in which existing firms are “vulnerable to hit and run” entry. For this type of market to exist sunk costs should be largely absent. Sunk costs is an economic term which means that cost which cannot be recovered if firms stop producing and leaves industry. Sunk cost is different to fixed cost. Lot of banking experts believe that bank markets are contestable. It implies new firms can enter the banking market, hit and then run (offering lower prices).

Empirical Studies on Contestable Banking Markets
This has very important policy implication because it implies that banks due to fear of hit and run feature of the market, will set the price according to marginal cost and consumer surplus will be maximised. Shaffer (1982) used the Rosse-Panzer Statistics (RPS) to test for contestability in US banking. He concluded that banks in the sample behave neither as monopolists nor as perfect competitors in the long run. In Nathan and Neave (1989), a similar methodology was applied for Canadian banking market. Authors derived a positive but significantly different from both zero and unity RPS confirming the absence of monopoly power among Canadian banks and trust companies.

Empirical Studies on Contestable Banking Markets
Nathan and Neave concluded that their results were consistent with a banking structure exhibiting some features of monopolistic, contestable competition. Molyneux, Lloyd, Williams and Thornton (1994) tested for contestability in German, British, French, Italian and Spanish markets The authors found the RPS for Germany, the UK, France and Spain, to be positive and significantly different from zero and unity. Their conclusion was that in these markets, commercial bank revenues behaved as if they were earned under monopolistic competition. For Italy, the authors could not reject a hypothesis of monopoly.

Pricing Non-Price Characteristics in Banking
Non-price characteristics are an important feature of modern day banking Some of these characteristics are: Number of ATM machine Number of branches Interest paid monthly, quarterly, biannually or annually Maximum withdrawal limits Minimum investment limits Insurance on loans Security on loans Checking accounts facility and guarantees

Some characteristics are positive and some are negative Nominal interest rate paid by/to customers may be low or high compared with actual interest rate Questions is how banks price these characteristics and is it possible to measure it and further how interest on deposits and loans are adjusted by banks To do this type of analysis, one needs series on interest rate on deposits and loans and non-price characteristics attached to these deposits and loans To compute interest equivalence of the non-price features of bank products, product interest rate is regressed on market interest rate (usually LIBOR: £ London Interbank Offer Rate). LIBOR is used in levels as well as with lagged. Non price features comes as a regressors in the equation Statistically significantly variables are identified through such regression

Hefferenan (1992) used the following equation to estimate the interest equivalence of banks non-price characteristics of major British retail banks and building societies. r =  + ixi + coLIBOR + ciLIBOR-i + eTT+Ui r= rate of interest offered/levied on deposits/loans xi: banks non-price characteristics LIBOR: 3 months £ London Interbank Offer Rate LIBOR-i: LIBOR lagged by i, i=0,1,2… TT: Time trend Ui: error term

For deposits products, negative and significant coefficients on non price characteristics is an indication of less interest is being paid in presence of these characteristics For loans positive and statistically significant coefficients means customers are being charged more compared to competitive rate due to other non-price characteristics Case Study: See British Retail Banking

Testing price discrimination in Banking
When a bank practice price discrimination, it offers same product at different prices to different customers Price discrimination is possible when bank is able to separate customers to their different price elasticities of demand But precondition of price discrimination in banking is that customers are being offered same product at different prices Testing of price discrimination is done through adjusting for non-price features of the product. Once done, then it becomes possible to compare the difference between ordinary products prices and the products where price discrimination is thought to be happening In banking jargon, in the absence of price discrimination, price paid on ordinary accounts should be equal to special accounts

Testing Price Discrimination in Banking
Hefferan (1992) used the following relationship to calculate the magnitude of price discrimination in new products in British retail banking (High interest deposits and High interest checking accounts compare to traditional 7 Day Accounts). The author used the following relationship PDj= ADJINTj-7DAY/BASIC ACCOUNTS Where, PDj= Price discrimination by bank j; ADJINTj= net interest paid by a bank on deposits adjusted for non price features; 7DAY/BASIC ACCOUNTS- the traditional 7-DAY or basic accounts interest paid If PDJ > 0: New products customers are being discriminated positively. IF PDj < 0: New products customers are being discriminated negatively Case Study: British Retail Banking

Measurement of Degree of Imperfect Competition in Banking
If one knows from H-statistics that banking market in the country is subject to imperfect competition, next step is to find how much retails banking in the country deviate from a perfectively competitive market How much is the influence of individual banks on price setting In simple words finding which bank is not giving a good deal to customers for deposits and loans and how much is rip-off (bad deal: loss). To answer these questions a generalized linear pricing model is used Heffernan (1992) used the following model to find out the degree of imperfect competition in British retail banking INTi= a0+ajDj+bk[LIBOR-k]+cFIRMS+dMOS+eTT+Ui

Measurement of Degree of Imperfect Competition in Banking
INTi= a0+ajDj+bk[LIBOR-k]+cFIRMS+dMOS+eTT+Ui INTi: interest paid/received on deposits/loans LIBOR: 3 months £ London Interbank Offer Rate LIBOR-k: 3 months £ London Interbank Offer Rate lagged by say 0,1,2 months FIRMS: Number of firms in sample (industry) MOS: Number of months since product was introduced TT: Time trend Sum of LIBOR coefficients will give an indication of deviation from perfect competition It can also give the value of rip-off/ bargain to customers Case Study: British Retail Banking

BANKING STRUCTURES- BY COUNTRY
Stylised Facts Table 1-2: Top 10 bks (by assets and/or tier 1 K) Top position has gone to Japan or the US since ‘69. Major differences in US/UK structures UK bks (’02): £2.5 tn in assets (with foreign: £4.7 tn); US bks (’04): $9.7 tn - note differences in distribution. To Class: this slide summarises the next two: tables 1.2, 1.4, 1.5) Why change ranking from assets to Tier 1 K?

7 1 3 2 6 USA Japan UK France Germany Netherlands Switzerland China
Table 1-2: Top 10 Banks, (2005 Added) 1969 Assets 1994 1997 Tier 1 capital 2002 2004 2005 Tier 1 K USA 7 1 3 2 Japan 6 UK France Germany Netherlands Switzerland China Note: US had 7 of the top 10 banks in 1969; 0 by 1997; Japan has 6 of the top 10 by 1997 – WHY??? Note: up-dated since book – has 2005 figures Though the same number of banks appear in the tier 1 K and assets category, the ranking is not necessarily the same: Tier 1 K: Citi, JP M-Chase, HSBC, B-America, Credit Agricole, RBS, MTFG, MFG, HBOS, BNP-P Assets: Citi, Mizuho, HSBC, Credit Agricole, BNP-P, JPM-Chase, RBS, Bk of America, Mitsubishi-Tokyo FG, HBOS In 2004: Tier 1: Us – 3, J- 3, UK – 2, F-2 Assets: US-1, UK-2, J-3, F-2, Deutsche-1, Suisse Thus close but not perfect correlation between the two: correlation likely to increase because of consolidation – often undertaken to strenghten capital base (eg Japan) but at the same time, assets get bigger. Bank of China: came 11th in terms of tier 1, 35 by assets.

BANKING STRUCTURES- Types of Banking
Universal Banking - the German hausbank  One legal entity (though it can have subsidiaries)  Investment, wholesale, retail banking services.  Non-banking fin. services (e.g. insurance, consultancy).  Links between banking & commerce. E.G. Deutsche Bank, Dresdner Restricted Universal: different variations E.G. each part legally separate and individually capitalised; no significant cross-shareholdings Dresdner now owned by Alliance

Structure-Commercial & Investment Banks
Terms originated in US due to regulation. Commercial bks: : restricted to wholesale&retail banking Wholesale banking: core services for large customers, e.g.: big corporations and governments. Most US commercial banks also have retail customers. Retail banking: core banking services to numerous personal customers and SMEs. High volume, small accts. Largely intra-bank and domestic. BUT In 1987, allowed “section 20 subsidiaries” to underwrite corporate debt and equities 1987: section 20 subs: Supreme CT ruled in their favour in 1981: section 20 of Glass Steagall Act (1933) did not extend to a subsidiary of a commercial bank offering investment bking services provided it it not their principal function. “principal” defined in terms of % of revenue the section 20 subsidiary Contributes to a BCH’s Total Revenue: 5% raised to 25% in 1996, then distinction abandoned with Gramm Leach Bliley Act 1999 – allowed Fed approved FHCs: insurance, banking, securities –all this covered in subsequent slides

Banking Structure (continued)
US Investment bks: for a fee: Underwrite bond/equity issues to raise capital for large corporations and government (b) arrange mergers and acquisitions. Modern US Inv. Bks: as above plus: trading: equities, fixed income (bonds), proprietary fund management consultancy global custody UK Merchant bks: now very similar to investment banks Q: Is an investment bank a “bank”? UK merchant banks: Barings – Francis baring a general merchant who began to finance the import and export of goods. Began to check on frims’ credit standing, then charge a “fee” to guarantee or accept merchant’s bills of exchange. Gradually the bills themselves were traded (at a discount) on the market. Traders: got liquidity: did not have to wait til goods were bought. After London’s Big Bang of 1986: can enter stock market, market making introduced, became like US investment banks. By contrast: GS: got started by issuing Commercial paper – expanded from there – see case

US Investment Bks and Conflict of Interest Issue: bk analysts: not a profit centre. IBDs: inv. bk divisions: underwrite primary/secondary issues; provide other services – is profit centre Accusation: analysts talk up the share prices of IBD’s clients. Investigation: initiated in 11/02 by NY AG- Spitzer - began at ML; widened to include others. Settlement: 4/ Inv bks to pay $1.4 bn: penalties, investor compensation, independent research body, firewalls, etc. Note: covered in Q 10 (a) of case, in the context of GS. So not much detail here – concentrate on UK. Analysts: prepare reports on firms: advise “buy”, “sell”, hold” Other accusations: Conflict of interest prevalent in other parts of the bk, e.g.: broker recommendations Citigroup response: retail broking and research to be separate businesses. Banks accused of inflating prices in IPOs and stock firms (e.g. Enron, WorldCom) Self regulation criticised: NYSE, NASDAQ, SEC For full list of changes in operations, see text but they include: Changes in Operations: Separation of research division IBDs cannot rate analysts Firewalls: no link between analyst compensation/ IBD’s performance no unnecessary communication between them Public notification of IBD clients if being rated by analysts Spinning/use of analysts in marketing banned Some bks have imposed additional restrictions Do not raise these in lectures – to be covered by question 10 (a) in case study.

UK Investment Bks and Conflict of Interest (FSA) No specific accusations of bias. Inst. Investors play a more dominant role in the UK. BUT: the UK market has the same firms; also: corporate finance or equity brokerage parts of an IB generate revenue: underwriting/advisory/brokerage fees. US: “prescriptive”/ UK: “principles”. Same inv bks operating in the UK: therefore could the same problems be occurring London?

UK Investment Bks - Sources of Conflict of Interest: (1) If analysts involved/influence other functions in the IBD E.G. - Analysts’ reports “altered” to improve IPO outcome Analysts pressured to issue more buy/sell rather than hold recommendations to increase trading in shares of a particular firm. FSA (2002) study: Proportion of buy recommendations made by IBs providing both analysts reports on a company AND acting as corporate brokers/advisors to that company (FTSE 100) was double that of independent corporate brokers.

UK Investment Bks - Sources of Conflict of Interest: (2) Remuneration of analysts E.G. Analysts salaries are dependent on generating IBD revenues (3) Analysts or IBD hold shares themselves: temptation to issue reports to boost the share price; the opposite if planning to buy a stock. Covered by FSA’s code of conduct and conduct of business rules. (2) EG: analysts work for corporate finance division

UK Investment Bks - Sources of Conflict of Interest: (4) Relations between IB and companies: E.G. firm threatens to take CF business elsewhere, OR Vice-Versa: IB will withdraw research coverage of a firm unless they get the business. (5) If “Chinese walls” ineffective: analyst may use info from CF or trading & sales not yet in public domain. Covered by insider trading laws, Conduct of Business, and Code of Market Conduct. Chinese walls: rules to prevent sensitive info flows between depts, subsidiaries, and other firms

Central Banking The term 'central bank' normally refers to a state institution with responsibility for Monetary control, and possibly: (2) Prudential control, and/or (3) Government Debt Placement This part of the banking lectures considers these 3 functions. Background: Central Banks usually begin life as profit maximising banks, with a special responsibility for note issue. Bank of Sweden Riksbank: founded in 1668 – monopoly over issue of notes and coins in 1904: oldest, followed by Bank of England: founded in 1694 was a commercial bank, gradually took on responsibility for note issue, placement of govt debt, nationalised in 1946, “independence” in 1997

P: rate of inflation: rate of change in p level over time
(1) Monetary Control Monetary control: the stabilisation of the price level, or controlling inflation. Money supply: currency in circulation + deposits held at bks. Simple monetary model    P = MS - y, where:  P: rate of inflation: rate of change in p level over time MS: the rate of growth in the money supply y : the rate of growth of real output (e.g. real GNP) MS definition: shows LINK between banks and central bank – a key relationship Extension to Exchange Rates (e.g. EMS: pre Euro: must have stable exchange rate) Rate of Growth of Price level: quarterly; annually. e = p – p* e > o: depreciation rate of HOME country P* = Ms* – y* FIXED EXCHANGE RATES: mean e=0, so P* = P, thus MS*- y* = Ms- y. IF MS* > y* and MS = y, then P* > P. Since e = P-P*, and P* > P: puts upward pressure on exchange rate

TRADITIONAL methods include:
Control of the MS/monetary targets: see inflation equation Reserve ratios: require banks to hold deposits (that may/may not earn interest) as reserves at central bank. Increasing the reserve ratio takes money out of circulation - MS Open Money Market Operations Reserve ratios: “Increase” the discount rate: rate banks pay to borrow from the central bank – originally designed to take money out of circulation by getting banks to cut back on their credit they extend. UK (1971): 12.5% Today: 0.15% of eligible liabilities. Open Money Market Ops: Buy (expands MS: govt. prints new money to purchase the bonds- expands the MS in circulation)/sell (contracts MS: govt sells bonds: MS goes back to central bank) GOVT securities/bonds in the fin markets to expand/reduce MS NB:all 3 methods NO LONGER used by most central banks

CURRENT METHOD of Monetary Control Central bank:
- Raises or lowers interest rates used to lend to banks, which, in turn, raises or lowers aggregate demand, and through it the rate of inflation. Some (developed) countries also use monetary targets: more the exception than the rule. This slide shows the current method adopted by most developed economies: EU, UK, US, Japan. Japan uses BOTH – most just use the first one Current Dilemma faced by Bank of England: rising oil prices – inflationary (but will also cause recession); but decline in retail sales, “iffy” property market. Decision on 6/10 to keep interest rates at 4.5%.

Falling MS: macro effects
(2) Prudential Control To protect the economy from the effects of a financial crisis: periods of excessive volatility in the financial markets, resulting in problems of illiquidity/insolvency among financial firms - especially banks. Why worry?: A widespread banking collapse - rapid decline/withdrawal of bank core services- inefficient allocation of resources. Falling MS: macro effects NOTE BK crisis can lead to financial crisis (1) Also known as a systemic collapse – discussed in slide 53 (2) Fall (rise) in MS must be continuous to have a deflationary (inflationary) effect on the economy.

The bank soon runs out of cash (due to fractional reserve lending)
Suppose customers are concerned about the ability of a bank to meet their liquidity demands: as a result of a rumour a bank becomes, increasingly illiquid: The bank soon runs out of cash (due to fractional reserve lending) Contagion sets in: (1) asymmetric info means clients/investors unable to judge which bks are healthy (2) runs on bks reduce their value: agents will want to liquidate before this happens. All deposit taking bks : subject to runs - face illiquidity. As a core service, a problem of illiquidity soon becomes one of insolvency (liabilities>assets) Illiquidity: can’t offer a core service – can lead to insolvency.

Financial System Collapse?
Yes, if enough banks fail, because the core banking services: intermediation, liquidity, payments system - no longer available. Systemic risk: risk of a collapse in the financial system Thus, governments treat banks as special: The central bank can: Act as Lender of Last Resort: central bank supplies liquidity to solvent but illiquid banks. OR Launch a Lifeboat Rescue NB: difference between systemic and systematic (general market) risk.

Problem: Moral Hazard Inevitable if private banks know they will be bailed out. Response: take higher risks, especially if the bank encounters difficulties - “goes for broke” Moral hazard (and bks’ contributory role to systemic collapse) result in close regulation: prudential regulation. Increasingly, the regulatory function is being removed from central banks. E.G. UK: The Financial Services Authority (FSA): regulates/supervises ALL financial institutions. MH: an insurance term: if 2 parties enter into a contract and, as a result of the contract, the incentives Will return to role of FSA – bk regulation outside the central bank.

(3) Government Debt Placement
(does not normally apply to central bks: developed world) Central bk: expected to place govt debt on favourable terms. Raises seigniorage income through: A reserve ratio: bks deposit reserves at central bank - an implicit bk tax if no interest is paid. Issuing new currency at a rate of exchange that effectively lowers the value of old notes. Liberal monetary policy: inflation reduces the real value of debt German reunification: Against the wishes of the Bundesbank< the Ostmark was set at part with the DM even though it was worth far less: more like 5:1 than 1:1 1998: BE given its “independence” and made responsible for price stability under the Bank of England Act, In addition to regulation of bks being transferred to the FSA, the placement of government debt was transferred from the BE to the Debt Man Office: an executive agency of the UK govt. HM Treasury sets the Agenda for the CEO of the DMO.

Issue 1: Potential Conflict of Interest - (1) and (2)
Issue: Supervision/Lender of Last Resort: MAY conflict with goal of price stabilisation/monetary control. Many countries assign function (2) to another government body - UK, Australia, Canada, China, the EU, Japan (?). NOT the US. Goodhart & Schoenmaker (1995): Sample: 26 countries. No evidence to support separation or combination of 3 functions. Note: even though resp for regulation might transfer another govt agency, central bank remains LLR, so conflict does not really go away, though usually there are built in mechanisms G&S: no evidence in terms of failing to achieve price stability objectives if they were also regulators.

Issue 2: Independence of Central Bk from Government
Politicians have a short time horizon AND Govts: conflicting objectives: unemployment, commitment to a fixed/managed exchange rate regime. BUT Many years to build a credible reputation for price stability. UK, Japan: granted some “independence” to their central banks E.G. UK:. Treasury appoints/approves all the members of the Monetary Policy Committee. Fixed/Managed ex rate regime: can be maniputated to create inflation. Under a fixed rate, e=o, cannot have inflation that exceeds inflation of govts party to the agreement; if flexible: it can. UK: MPC: Governor, 2 deputy govs, 2 senior bk employees, 4 outside experts: HMT/ govt appoints: Gov, 4 outside experts. Treasury: sets target inflation rate: so not entirely “independent” Japan: govt appoints Gov, V-Gov, and POLICY board but cannot dismiss them.

SUMMARY:LINK BETWEEN BANKS & CENTRAL BANK
Central banks: responsible for price (and financial) stability. The MS is linked with inflation: banks (via deposits) hold the MS MS affected by fractional reserve lending: if banks lend more, the MS increases Central banks can reduce bank activity through, for e.g, reserve ratios (a potential tax on banks) Runs on banks can quickly reduce liquidity and add to instability unless the central bank intervenes. Fixed/Managed ex rate regime: can be maniputated to create inflation. Under a fixed rate, e=o, cannot have inflation that exceeds inflation of govts party to the agreement; if flexible: it can. UK: MPC: Governor, 2 deputy govs, 2 senior bk employees, 4 outside experts: HMT/ govt appoints: Gov, 4 outside experts. Treasury: sets target inflation rate: so not entirely “independent” Japan: govt appoints Gov, V-Gov, and POLICY board but cannot dismiss them.

Economics of Banking and Money

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Economics of Banking and Money

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