1 Financial Institutions & Services – Week 3 Presented By David Kilgour

2 Learning Objectives On completion of this week students should be able to understand: the classification of banks and their main roles; contemporary retail banking; the main functions, assets and liabilities of retail banks; the conflict within banks between liquidity and profitability; the main aspects of banking regulation and capital adequacy.

3 Classification of Banks Understanding the classification of deposit- taking institutions is essential in order to appreciate the role of individual banks. The development and contemporary role of banks enable us to understand the functions of such institutions. By examining the assets and liabilities on a bank’s balance sheet it is possible to see the continuous conflict between liquidity and profitability objectives within such organisations.

4 primary and secondary banks; unit and branch banking; functions of banks; deposits, capital, investments and advances; bank regulation and the international capital accord Covered in this note

5 UK Retail Banks A bank is a business that provides banking services for profit. Traditional banking services include receiving deposits of money, lending money and processing transactions. Some banks (called Banks of Issue) issue banknotes as legal tender –RBS & HBOS The word ‘bank’ is derived from the Italian word ‘banco’ meaning table ( which is derived from a Germanic language and means bench ) at which Italian money lenders used to conduct business in the Middle Ages (1200−1500AD) - Money lenders in Northern Italy originally did business in open areas, or big open rooms, with each lender working from his own bench or table. These banks operate large branch networks and are prepared to deal in small and large sums of money.

6 Wholesale Banks In the main, wholesale banks do not operate branch networks. They deal in large sums of money and operate in London’s money markets. An alternative approach is to classify banks on the basis of their balance sheets according to the kind of deposits they accept. This approach divides banks into primary and secondary banks.

7 Primary Banks Primary banks are those which operate the payments mechanism within the country; they offer a system for transferring money by means of demand/current accounts with cheque book facilities. In the UK this group consists of the main banks such as Barclays Bank, Royal Bank of Scotland, Standard Chartered Bank, etc.

8 Secondary Banks Secondary banks do not form part of the payments mechanism or take part in the cheque clearing system. The term SECONDARY BANKS covers a broad range of institutions, so generalisations should be treated with caution. While most of their deposits are term deposits (with a high proportion in foreign currencies) this varies from bank to bank. In the UK this group consists of the following main categories: Merchant (or Investment) Banks British Overseas Banks Foreign Banks in the UK

9 In the UK the Banking Act, 1979 established a formal system for the supervision and control of deposit taking institutions in Britain. A Bank Deposit Protection Fund was also established under the 1979 Act in order to protect consumers of banking services. The Banking Act, 1987 further strengthened powers for supervising and authorising banks. The Banking Acts

10 The Banking Act 1979 The Banking Act 1979 laid down the criteria for recognised bank status and thus in a legalistic sense answered the question of what is a bank. The following factors are taken into account. (i) A deposit-taking institution must have a good reputation and provide a wide range of banking services, specialist or otherwise. (ii) Such services must cover deposit facilities and the provision of loans, along with foreign exchange facilities and the provision of financial advice. (iii) A minimum amount of capital and reserves is required to maintain adequate solvency at all times together with a reputable management in the bank.

11 Liquidity versus Profitability As operators of the payments systems, the clearing banks cannot allow their liquidity to fall too low, even though liquid assets offer a poor return. The more the banks lend, the more interest and profits they can make. This pursuit of profit conflicts with the need for liquidity since the most profitable loans tend to be the least liquid. As liquidity decreases, profitability increases

12 CAPITAL ADEQUACY Capital must be adequate because a bank’s assets are subject to risks of depreciation in value from three main factors: CREDIT RISK − the possibility of outright or partial default by borrowers on the total loan amount (the use of collateral can reduce such losses). INVESTMENT RISK − the possibility that assets will depreciate in value, involving the bank in a capital loss. FORCED SALE RISK − this occurs when a bank is forced to sell an asset at a time when its market value is less than it appears in the bank’s books.

13 Financial Services Authority (FSA) In May 1997 the government announced the reform of financial services regulation in the UK and the creation of a new regulator. It was decided to merge banking supervision and investment services regulation into the Financial Services Authority (FSA).

14 The reform’s first stage was completed in June 1998 when responsibility for banking supervision was transferred to the FSA from the Bank of England. The Financial Services and Markets Act 2000 was fully implemented on 1 December 2001 and provided the FSA with its statutory powers. It also transferred to the FSA the responsibilities of several other organisations such as the Building Societies Commission. The Act also made the FSA responsible for regulating mortgage advice and monitoring various codes of conduct. FSA

15 References - Web Top ten banking groups in the world ranked by tier 1 capital Figures in U.S. dollars, and as at end Citigroup — 79 billion 2.HSBC — 75 billion 3.Bank of America — 73 billion 4.JP Morgan Chase — 72 billion 5.Mitsubishi UFJ Financial Group — 64 billion 6.Credit Agricole Group — 60 billion 7.Royal Bank of Scotland — 48 billion 8.Sumitomo Mitsui Financial Group — 40 billion 9.Mizuho Financial Group — 39 billion 10.Santander Central Hispano — 38 billion

16 Top ten banking groups in the world ranked by assets Figures in U.S. dollars, and as at end UBS — 1,533 billion 2.Citigroup — 1,484 billion 3.Mizuho Financial Group — 1,296 billion 4.HSBC Holdings — 1,277 billion 5.Crédit Agricole — 1,243 billion 6.BNP Paribas — 1,234 billion 7.JPMorgan Chase & Co. — 1,157 billion 8.Deutsche Bank — 1,144 billion 9.Royal Bank of Scotland — 1,119 billion 10.Bank of America — 1,110 billion

17 Top ten bank holding companies in the world ranked by profit Figures in U.S. dollars, and as Citigroup — 21 billion 2.Bank of America — 15 billion 3.HSBC — 10 billion 4.Royal Bank of Scotland — 8 billion 5.Wells Fargo — 7 billion 6.JP Morgan Chase — 7 billion 7.UBS AG — 6 billion 8.Wachovia — 5 billion 9.Morgan Stanley — 5 billion 10.Merrill Lynch — 4 billion