1. Topic 2: Theoretical Concepts in Banking

2. Some Theoretical Concepts in Banking Principal-agent problem Adverse selection Moral hazard problem The implications of the above to:  Relationship banking  Arm’s length banking

3. 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, rather than reliance on market prices. A traditional bank with intermediary and liquidity function fits in well with Coase’s theory.

4. Why banks are like a firm or why they exhibit organisational structure? Making loans and accepting deposits is an internal process – to do this, they need a command and control (CC) system in place. The intermediary role of banks and the CC system will lead to structures containing principals and agents to different extents.

5. 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 with debtors usually arise due to the fact that agent has more information about his/her characteristics than the principal.

6. Adverse selection problem in banking The issue of adverse selection can lead to problems in banking because the principal has inferior information compared to the agent. This obviously has repercussions when it comes to forming agreements based on this information. It can also mean that the highest risk groups are the most likely to enter into the contract. Examples:  Rip-off of customers in UK  Banks making bad loans to customers who, on the surface, seem to have an acceptable risk profile.

7. Moral hazard problem in banking Bank activities are usually collection of contracts b/w principal and agents. 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 or engage in risky activities.  Deposit insurance scheme may be exploited by banks  Managers may consider their own objectives and agendas are more important than that of the firm.

8. 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).  There is an understanding b/w both parties that in future there may be need of some monitoring.

9. Relationship banking Example  A good example in this regard is when a firm wants to bring a new product to market. If an investor goes to a bank for a loan, the bank will see her/his record indicating no financial difficulty and no default history. Hence, the loan is granted and a clause may be introduced for monitoring or altering the clauses at a later date. Relationship banking is very common in Japan and Germany However, sometimes relationship banking may go wrong.  Example: Jurgen Schneider / Deutsche Bank

10. 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. The UK and USA banking is more akin to this system.

11. Banks mergers and acquisition Arm’s length banking, global competition and integration of financial markets has made increasingly difficult for small investment or wholesale banks using relationship banking to survive. This led to wide spread mergers and takeovers. Examples of recent such takeovers are: i.JP Morgan Chase and Bank One ($58bn) ii.HSBC and Bank of Bermuda ($1.3bn) iii.Hokuriku Bank and Hakkaido Bank ($31bn)