E XT
M
RN
E
AL PROG RA
Principles of banking
Economics, Management, Finance
and the Social Sciences
M. Buckle, J. Thompson
2000 2790094
This guide was prepared for the University of London by:
M. Buckle, MSc, PhD, Senior Lecturer in Finance, European Business
Management School, University of Wales, Swansea
J. Thompson, Emeritus Professor of Finance, Liverpool John Moores University.
This is one of a series of subject guides published by the University. We regret that
due to pressure of work the authors are unable to enter into any correspondence
relating to, or arising from, the guide. If you have any comments on this subject
guide, favourable or unfavourable, please use the form at the back of this guide.
This subject guide is for the use of University of London External students registered
for programmes in the fields of Economics, Management, Finance and the Social
Sciences (as applicable). The programmes currently available in these subject areas are:
Access route
Diploma in Economics
BSc Accounting and Finance
BSc Accounting with Law/Law with Accounting
BSc Banking and Finance
BSc Business
BSc Development and Economics
BSc Economics
BSc Economics and Management
BSc Information Systems and Management
BSc Management
BSc Management with Law/Law with Management
BSc Politics and International Relations
BSc Sociology.
Contents
Introduction ..............................................................................................................1
The subject ................................................................................................................1
How to use this subject guide ....................................................................................1
Essential reading ........................................................................................................2
Further reading ..........................................................................................................2
Format of the examination ........................................................................................3
How to use this subject guide ....................................................................................3
Chapter 1: Introduction to the financial system ....................................................5
Essential reading ........................................................................................................5
Further reading ..........................................................................................................5
Introduction ................................................................................................................5
The role of the financial system ................................................................................5
The nature of financial claims ..................................................................................6
The structure of financial markets ............................................................................9
Financial system accounting ....................................................................................10
Learning outcomes ..................................................................................................11
Sample examination questions ................................................................................12
Chapter 2: Financial intermediation ....................................................................13
Essential reading ......................................................................................................13
Further reading ........................................................................................................13
Introduction ..............................................................................................................13
The nature of financial intermediation ....................................................................13
The process of financial intermediation ..................................................................16
The implications of financial intermediation ..........................................................18
What is the future for financial intermediaries? ....................................................20
Learning outcomes ..................................................................................................21
Sample examination questions ................................................................................21
Chapter 3: Retail banking ....................................................................................23
Essential reading ......................................................................................................23
Further reading ........................................................................................................23
Introduction ..............................................................................................................23
What is retail banking? ............................................................................................23
What services and products do retail banks provide? ............................................25
Joint provision of intermediation and payments services ......................................29
Competition in retail banking ..................................................................................29
Future developments in retail banking ....................................................................30
Learning outcomes ..................................................................................................32
Sample examination questions ................................................................................32
Chapter 4: Wholesale and international banking ..............................................33
Essential reading ......................................................................................................33
Further reading ........................................................................................................33
Introduction ..............................................................................................................33
Wholesale banking ..................................................................................................33
Certificates of deposits ............................................................................................35
Rollover credits ........................................................................................................35
i
Principles of banking
ii
Contents
iii
Principles of banking
Notes
iv
Introduction
Introduction
The subject
Principles of banking is a compulsory foundation unit for the BSc. Banking and
Finance degree. Our aim in this subject is to introduce you to the nature of banking
and the main financial markets in which banks operate. This is an important subject as
it establishes many of the fundamental concepts and ideas which will be developed in
later subjects in the degree, in particular, the intermediate unit of Banking operations
and risk management.
The kind of issues you will study in this subject are:
• Why do banks exist?
• Why is banking so heavily regulated?
• What are the essential differences between retail and wholesale banking?
• How does the structure of the banking industry differ between different countries?
• How can the derivative markets be used by banks and their customers to manage
financial risk?
Many exciting changes are taking place in banking and financial markets. The
internet, and other developments in information technology are changing the nature of
banking. New derivative products offer new possibilities for managing financial risk
as well as bringing new risks for users. After studying this course, not only will you
be better prepared for studying the intermediate and advanced courses in the degree of
Banking and Finance but you will also have gained knowledge and insight which will
help you make sense of many of the developments affecting banking and financial
markets that you read about in newspapers or see on television.
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Principles of banking
Essential reading
One textbook covers approximately 90 per cent of this syllabus and this book is:
You will be referred to specific sections and tables in this book throughout this guide
and therefore you need to have access to a copy when you are using the guide. It is
therefore recommended that you purchase a copy.
This recommended text does not cover all of the last topic of the syllabus: banking
structure around the world. The essential reading for this topic also includes:
and
Mishkin, F.S. and S.G. Eakins Financial Markets and Institutions. (Addison-Wesley,
1998) second edition [ISBN 0-321-01465-0].
For most of the chapters additional reading is suggested. These are other books and
journal articles. This additional reading will contain information and analysis not
contained in the main text which may help you further understand some of the topics
in this subject. It is not essential that you read this material but will be helpful if you
do so. A full bibliography of the additional reading is provided below:
Further reading
Bain, A.D. The Economics of the Financial System. (Blackwell, 1992) second edition
[ISBN: 0-631-18197-0].
Brearley, R., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance.
(McGraw-Hill, 1995) [ISBN 0-07-113853-6].
Copeland, L.S. Exchange rates and international finance. (Addison-Wesley, 1994)
second edition [ISBN: 0-201-62429-X].
Davis, P. ‘The Eurobond market’ in Cobham, D. (ed.) Markets and Dealers: The
Economics of the London Financial Markets. (Longman, 1992)
[ISBN 0-582-07853-2].
Dow, S ‘Why the banking system should be regulated’, Economic Journal (1996), 106:
698–707.
Dowd, K ‘The case for financial laissez-faire’, Economic Journal (1996), 106:
679–687.
Gosling, P. Financial Services in the Digital Age: The future of banking, finance and
insurance. (Bowerdean Publishing Company Ltd, 1996) [ISBN: 0-906097-54-1].
Hefferman, S. Modern Banking in Theory and Practice. (John Wiley, 1996)
[ISBN: 0-471-96209-0].
Howells, P. and K. Bain The Economics of Money, Banking and Finance. (Harlow:
Longman, 1998) [ISBN 0-582-27800-7].
Lewis, M.K. and Davis, K.T. Domestic and international banking. (Philip Allan, 1987)
[ISBN: 0-86003-144-6].
Mester, L. ‘What’s the point of credit scoring?’, Business Review, (Federal Reserve
Bank of Philadelphia) (September/October 1997).
Mishkin, F.S. and S.G. Eakins Financial Markets and Institutions. (Addison–Wesley,
1998) second edition [ISBN 0-321-01465-0].
Russell, S. ‘The government’s role in deposit insurance’, Federal Reserve Bank of St.
Louis Review (1993) 75: 3–9.
2
Introduction
Each chapter in the subject guide is split into two columns. The right hand column
contains the guidance on the subject matter of that topic. This will include
summaries and explanations of the main points and advice about what you are
expected (and not expected) to know. There are also boxes that contain questions or
activities which are designed to test your understanding of the material you have just
read. The left-hand column contains references to the recommended reading,
elaborations of points made in the right-hand column and cross-references to other
chapters of the guide where relevant.
3
Principles of banking
Notes
4
Chapter 1: Introduction to the financial system
Chapter 1
Further reading
Brearley, R., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance.
(McGraw-Hill, 1995) [ISBN 0-07-113853-6] Chapter 9.
Howells, P. and K. Bain The Economics of Money, Banking and Finance. (Harlow:
Longman, 1998) [ISBN 0-582-27800-7] Chapter 1.
Mishkin, F.S. and S.G. Eakins Financial Markets and Institutions. (Addison–Wesley,
1998) second edition [ISBN 0-321-01465-0] Chapter 2.
Introduction
In this chapter we investigate three things.
• Firstly, we look at the role of a financial system in a modern economy, using a
simple circular flow mode.
• Secondly, we examine the nature of the main financial claims in existence,
focusing on the attributes or characteristics of those claims.
• Finally, we examine the main financial accounting systems for an economy. These
are sector balance sheets which show the stocks of physical and financial assets
and liabilities in existence at a point in time, and financial transaction accounts
which show the financial transactions that take place between different sectors of
an economy over a period of time.
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Principles of banking
Savings
Households Firms
Consumption of outputs
1
The term financial instrument is The nature of financial claims1
also used. A financial claim is a claim to the payment of a sum of money at some future date or
dates. Using Lancaster’s approach to consumer demand, financial claims can be
categorised according to the various attributes of that claim. The term attributes, or
characteristics, refers to the various features you would look for when making an
investment decision (i.e. when deciding whether to purchase a financial claim). The
following features are some of the attributes most commonly used when describing a
financial claim:
Risk
This refers to the uncertain future outcome of a financial claim. For example, the
future price of a share is not known with certainty. Another example of financial risk
is default risk. This refers to the risk of debt instrument (e.g. a loan) not being repaid.
Other examples of financial risk are interest rate risk and exchange rate risk. These
risks refer to the unpredictability of future interest rates or exchange rates.
As risk is a concept of fundamental importance in finance we will devote more
2
Please read Brearley et al. attention to this characteristic.2 Risk, in general terms, is a measure of the variation
(1995), Chapter 9 for a good around some average (expected) value. If an investor is considering whether to invest
discussion of the nature of risk.
in an ordinary share s/he needs a measure of the expected return on the share as well
as a measure of the variation around the expected return. This measure of variation is
a measure of how far the actual return may differ from what we expect. Figure 1.2
shows a typical distribution for historical returns on corporate bonds (see below for a
description of a bond).
6
Chapter 1: Introduction to the financial system
15
10
% rate
-10 0 10 20 30
of return
The average annual return on corporate bonds, according to the distribution presented
in figure 1.2, is six per cent. If we believe the future will be like the past the best
estimate of the expected return on corporate bonds next year is six per cent. This does
not imply that the actual return next year will be six per cent. To provide a measure of
the risk of the actual return being different from what we expect we normally use a
measure of the dispersion of the distribution: the variance or standard deviation. The
standard deviation of a distribution of historica returns is a statistical measure of how
variable the returns have been around the average return. The higher the standard
deviation the greater the variability and hence the greater the risk that the actual return
in the future will be different from what we expect. This provides us with a
quantitative measure of risk that we can use to compare the riskiness associated with
different securities.
3
Source: ‘Historical returns on The risk (as measured by the standard deviation of historical returns) and the return
major asset classes, 1926-1992,’ (as measured by the average return) for three different US financial instruments,
Stocks, Bonds and Inflation 1993 calculated from annual data over the period 1926 to 1992 are presented in table 1.
Yearbook. (Ibbotson Associates)
(reported in Brearley, R., S.C.
Myers and A.J. Marcus Table 1: Risk and return for US financial instruments3
Fundamentals of Corporate
Finance. (McGraw-Hill, 1995)
[ISBN 0-07-113853-6].). Average return (%) Standard deviation (%)
Treasury Bills 3.8 3.3
Corporate bonds 5.8 8.5
Common stocks 12.4 20.6
Table 1 clearly demonstrates a positive relationship between risk and return. Common
stocks (an equity instrument – see below) earned the highest average return but also
experienced the highest risk. Treasury bills (a money market instrument – see below)
had the lowest risk but earned the holder the lowest return. The positive relationship
between risk and return exists because investors require compensation for bearing
risk. The higher the risk associated with a financial instrument, the higher the return
they require to induce them to hold the asset.
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Principles of banking
Liquidity
Liquidity is the ease and speed with which a financial instrument can be turned into
cash without loss. For example a bank deposit is easily and quickly turned into cash
and so is seen as very liquid. However, a stock in a small company may not be easy
to sell at short notice so is deemed to be illiquid.
Real value certainty
This means the susceptibility to loss in value of the claim due to a rise in the general
level of prices.
Expected return
For many claims, such as a bank deposit, there is an explicit cash return to the holder.
For claims where the return is not known with certainty in advance (i.e. there is an
associated risk) then it is expected return that is used.
Term to maturity
This refers to the remaining time to maturity for a financial instrument. At maturity
the instrument is repaid by the borrower. Term to maturity ranges from zero in the
case of bank deposits that are withdrawable on demand to instruments such as shares
which have no maturity date.
These attributes or features are fully discussed in section 1.3 of Buckle and Thompson
(1998), which should now be read carefully.
Activity
Financial claims can be divided into two broad groups, debt and equity. A debt
instrument is a contractual arrangement whereby a borrower normally agrees to make
regular payments (interest payments) of a fixed amount until a specified date when the
debt matures. On maturity the amount borrowed is repaid. There are exceptions to this
general definition. For example, a deposit contract may have no specified maturity
date (it may be repayable on demand). Examples of debt instruments are deposits,
loans, bills and bonds.
Deposit
This is a loan by an individual or company to a financial institution such as a bank.
Loan
A loan is a sum of money lent, normally by a financial institution such as a bank, to a
company or individual.
Bill
A bill is a short-term paper claim issued by a company or government. The bill is
bought by an investor at a discount to face value (i.e. at a price lower than face
value). The issuer of the bill then pays the investor the face value at the maturity date
of the bill. The difference between the rate paid for the bill and its face value
represents an interest payment or return to the investor.
Bond
A claim that normally pays a fixed rate of interest (known as coupon payments) until
the maturity date and then at the maturity date the issuer pays the holder the par value
(face value) of the bond. Bonds are issued by governments and companies and
represent a long-term debt instrument compared to bills which are short-term.
8
Chapter 1: Introduction to the financial system
The common feature of debt is that the amount is fixed; (e.g. a deposit of £140 at a
bank or the purchase of a £100 bond). This contrasts with equity (e.g. ordinary shares)
where the value of the financial claim varies according to its market price.
Equity
This is a claim to a share in the net income and assets of a firm. Unlike with debt,
firms are not contractually obliged to make regular payments to equity holders. In
years when firms make sufficiently high profits then equity holders are paid a
dividend. Equity holders will rank lower than debt holders in a firm in the event of
liquidation. Equity holders are therefore regarded as the bearers of business risk.
Finally, equity claims have no maturity date.
A number of differing types of these two categories of claims exist and these are also
discussed in section 1.3 of Buckle and Thompson (1998). You should study this
discussion carefully.
Activity
If a company wishes to raise long-term finance what kind of financial claims can it issue?
9
Principles of banking
10
Chapter 1: Introduction to the financial system
• The sum of transactions in a particular financial instrument will equal zero. This
again follows from the fact that increased holdings of an asset of one sector will
be balanced by increased liabilities of another.
• The sum of saving across sectors, that is, for the economy, will equal the sum of
investment across sectors. In other words all saving will find its way into investment.
Section 1.6 in Buckle and Thompson (1998) provides an explanation of how such
accounts are derived using a simple numerical example of a two-sector economy to
illustrate the process. This simple example also demonstrates the difference between
stocks and flows. The hypothetical balance sheet for households shown in tables 1.8
and 1.9 (of Buckle and Thompson) show an increase in net wealth of £200 million
(i.e. a change in stocks). This matches the saving (i.e. a flow) by households of £200
million, shown in table 1.12. This example should be carefully studied as it assumes
the same format as the more complicated accounts prepared by government statistics
departments in different countries.
Activity
If the household sector had a saving of £300 million (instead of £200 million), in table
1.12 in Buckle and Thompson [1998] and the extra £100 million was used by households
to acquire an additional £100 million of equities and the additional funds raised by firms
was used to finance investment, rework the financial account matrix (table 1.12) using
these new figures and also construct the new balance sheet for the household sector and
the companies sector for the end of the period (tables 1.9 and 1.11).
Table 1.13 shows the UK accounts for the second quarter of 1997. You should be able
to interpret the figures shown in the rows and columns of this account – see section
1.8 of Buckle and Thompson (1998) for examples of the explanation of the figures
contained in this account. If you experience difficulty in doing this, go back to
studying the simple illustrative example, as the two accounts are prepared on exactly
the same basis.
The various accounts provide a useful source of data for studying the portfolio
behaviour of the various sectors of the economy. They are, however, subject to the
problems listed below:
The figures are derived from a number of sources so the total of financial transactions
may not equal the financial surplus/deficit for the sector concerned. Details of the
necessary ‘balancing item’ are shown in table 1.14.
Figures are published on a ‘net’ basis.
Learning outcomes
By the end of this chapter and the relevant reading you should be able to:
• Describe at an introductory level the role of money in an economy.
• Explain the nature of financial claims and their differing features which appeal to
agents with differing circumstances.
• Explain the main functions of a financial system.
• Explain the nature and construction of the sectoral balance sheets.
• Explain the nature and construction of financial transactions accounts.
• Interpret the information provided by financial transactions accounts.
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Principles of banking
12
Chapter 2: Financial intermediation
Chapter 2
Financial intermediation
Essential reading
Buckle, M. and J.L. Thompson The UK Financial System. (Manchester University
Press, 1998) third edition [ISBN: 0-7190-5412-5] Chapter 2.
Further reading
Bain, A.D. The Economics of the Financial System. (Blackwell, 1992) second edition
[ISBN: 0-631-18197-0] Chapters 3 and 4.
Heffernan, S. Modern Banking in Theory and Practice. (Wiley, 1996)
[ISBN 0-471-96209-0] Chapter 1.
Mishkin, F.S. and S.G. Eakins Financial Markets and Institutions. (Addison–Wesley,
1998) second edition [ISBN 0-321-01465-0] Chapter 12.
Introduction
In this chapter we introduce the process of financial intermediation. We consider its
nature and explain why most lending/borrowing takes place through intermediaries
rather than lenders lending directly to borrowers. In considering this issue we are also
considering the fundamental reasons for the existence of banks. We identify the
advantages that institutions such as banks have which enable them to undertake
intermediation. However we also argue that traditional intermediation services
provided by banks have declined in many countries in recent years and banks have
sought to maintain profits by expansion into other areas of business. We will examine
these other areas in more detail in later chapters of this subject guide.
13
Principles of banking
Figure 2.1: Sources of external funds for UK non-financial firms for the period 1970–96
%
50
30
10
(Note: definitions of the items of external sources of funds are given in Buckle and
Thompson (1998) page 35)
You will see from figure 2.1 that bank loans (i.e. intermediated finance) are the most
important source of external funding for firms. Mishkin and Eakins (1998) report a
similar finding for the US, France, Germany and Japan. It should also be noted that
shares and bonds have become more important sources of finance over recent years.
We leave a discussion of why this might be the case until the end of this chapter.
To ask the question why does most lending/borrowing take place through a financial
intermediary is to also ask the question of why financial intermediaries exist. There
are three main reasons why financial intermediaries exist:
1. different requirements of lenders and borrowers
2. transaction costs
3. problems arising out of information asymmetries.
We now cover each of these reasons in turn.
Different requirements of lenders and borrowers
Firms borrowing funds to finance investment will tend to want to repay the borrowing
over the expected life of the investment. In addition the claims issued by firms will be
have a relatively high default risk reflecting the nature of business investment. In
contrast, lenders will generally be looking to hold assets which are relatively liquid
and low-risk. To reconcile the conflicting requirements of lenders and borrowers a
financial intermediary will hold the long-term, high-risk claims of borrowers and
finance this by issuing liabilities, called deposits, which are highly liquid and have
low default risk. Figure 2.2 illustrates the role of a financial intermediary.
14
Chapter 2: Financial intermediation
Funds lent
Financial claim
Activity
If you wanted to lend money (i.e. acquire a financial asset) what characteristics would
you look for in the financial asset you hold).
Transaction costs
The presence of transaction costs makes it very difficult for a potential lender to find
an appropriate borrower. There are four main types of transaction costs:
1. Search costs: both lender and borrower will incur costs of searching for, and
finding information about, a suitable counterparty.
2. Verification costs: lenders must verify the accuracy of the information provided by
borrowers.
3. Monitoring costs: once a loan is created, the lender must monitor the activities of
the borrower, in particular to identify if a payment date is missed.
4. Enforcement costs: the lender will need to ensure enforcement of the terms of the
contract, or recovery of the debt in the event of default.
Activity
Identify which of the four categories of costs described above are incurred when a
physical good, such as a car, is purchased. Hence identify which costs are usually only
incurred with financial transactions.
Asymmetric information
This is an important concept in finance and needs to be fully understood. Asymmetric
information refers to the situation where one party to a transaction has more
information than the other party. This is a problem with most types of transactions,
not just financial, and a classic example is provided by the sale/purchase of a second
hand car. In this case the seller has more information about the condition of the car
than the buyer. This is likely to make the buyer reluctant to purchase the car unless
he/she can obtain more information, perhaps from a mechanic’s inspection. In the
case of a financial transaction, the borrower will have more information about the
potential returns and risks of the investment project for which funds are being
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Principles of banking
Why does the existence of asymmetric information mean that ‘good risks’, like Sally,
may not get loans.
The second problem that arises out of asymmetric information is moral hazard. This is
a problem that occurs after the loan is made and refers to the risk that the borrower
might engage in activities that are undesirable (immoral) from the lenders point of
view, because they make it less likely that the loan is repaid. A person is more likely
to behave differently when using borrowed funds compared to when using their own
funds. In particular they may take more risks with the funds. To understand the nature
of moral hazard please read the case of Joe in section 2.2.1 of Buckle and Thompson
(1998) and then undertake the following activity.
Activity
If you know that Joe is putting some of his own savings into the investment project are
you more likely to lend to him ?
16
Chapter 2: Financial intermediation
17
Principles of banking
1. Explain how asking the borrower to provide security (collateral) against the loan
reduces the problem of adverse selection?
2. Explain how the loan contracts created by banks are better at reducing the free-rider
problem than the bond contracts traded in capital markets?
18
Chapter 2: Financial intermediation
Figure 2.3: Hirschleifer model: optimal allocation of consumption over periods 0 and 1
PIL
Y1
B
A
C
1
Co Y0 Period 0
If we now introduce a financial system into the analysis then the economic agent is
now able to lend or borrow. The borrowing/lending opportunities are represented by
the financial investment opportunities line (FIL). It is assumed that lending and
borrowing can be achieved at the same rate of interest, r. Utility is maximised where
the agent’s indifference curve just touches the FIL. This can occur by borrowing
against future production, by moving down the FIL (to say, point D), or by lending
to finance future consumption, moving up the FIL (to say, point E). This is shown
in figure 2.4.
Figure 2.4: Hirschleifer model: borrowing or lending to increase utility
PIL
A
C*
1
D
FIL
C* Period 0
0
19
Principles of banking
where both the quantity demanded and supplied are equal to OZ. Clearly transaction
costs do occur and in the absence of a financial intermediary, we assume that
transaction costs equal CD, so that the quantity of credit demanded and supplied
equals OY. The gap between the rates of interest paid by the borrower and lender is
termed the spread. The introduction of a financial intermediary reduces these costs so
the spread narrows to EF (from CD) and the quantity of credit demanded and
supplied rises to OX. Provided the increased credit is used to finance investment then
it is reasonable to suppose that gross domestic product (GDP) will have increased. In
any case, if the increased credit had been used to finance consumption, it is
reasonable to assume that utility will have risen.
Figure 2.5: The effects of the existence of financial intermediaries on the quantity
of credit supplied and demanded
Rate of D
Interest S
C
E
F
D
S D
O Y X Z Quantity of credit
20
Chapter 2: Financial intermediation
1. Expanding into new riskier areas of lending, for example, lending to property (real
estate) companies. One example of this comes from Japan where over the 1980s
the banking system was deregulated and as a consequence banks expanded their
lending rapidly. In particularly they lent aggressively to the property (real estate)
sector. When property prices in Japan collapsed in the early 1990s most Japanese
banks were left with a large amount of ‘bad’ loans (i.e. loans that would not be
repaid in full, if at all). In recent years a number of Japanese banks have failed as
a consequence of these ‘bad’ loans including Hokkaido Takushoku, the tenth
largest commercial bank in Japan, in late 1997.
2. Pursuing new off-balance-sheet activities. These are non-traditional banking
activities that earn the bank fee income rather than interest income.8 One area of
8
Off-balance-sheet activities are
covered in more detail in
Chapter 4 of this subject guide. concern here is the expansion of derivatives business, for example, banks acting as
9
Financial derivatives are
dealers in over-the-counter derivatives.9 A classic example here is the case of
contracts that are ‘derived’ from Barings Bank which, in 1995, failed (and was taken over by ING group) as a
a financial instrument (e.g. a result of losses arising out of ‘betting’ with derivatives by a ‘rogue trader’ Nick
share option is an option
contract derived from a share Leeson. For more information on the case of Barings failure see Buckle and
financial instrument.) These Thompson (1998), Chapter 14 and 18.
contracts can be very risky. See
Chapter 8 of this subject guide Please read Mishkin and Eakins (1998) at this point for further discussion of the
for a discussion of derivatives.
decline of traditional banking. This section is designed to introduce you to some of
the issues relating to the future of banking. Many of the issues touched on here will
be taken up in the rest of this subject guide so it is a good idea to return to this section
when you have completed the subject guide in order to gain a better understanding.
Learning outcomes
By the end of this chapter and the relevant reading you should be able to:
• Explain why most lending/borrowing takes place through financial intermediaries
rather than directly.
• Describe the main costs involved in lending/borrowing.
• Explain how asymmetric information can cause problems for the lender.
• Explain how financial intermediaries can reduce transaction costs for lenders
and borrowers.
• Explain how financial intermediaries are able to transform the characteristics of
funds as they pass from lender to borrower.
• Explain how financial intermediaries can reduce the problems associated with
asymmetric information.
21
Principles of banking
1. Introduction
2. A description of the process of direct lending between lenders and borrowers.
3. Explain why lenders and borrowers, in general, do not lend directly – that is to
say, discuss the problems of:
a. conflicting requirements
b. transaction costs
c. asymmetric information.
4. Explain how financial intermediaries are able to reduce these problems for
lenders and borrowers.
5. Discuss the future of financial intermediation – in particular the evidence that
financial intermediation is in decline at the wholesale end of banks’ business.
6. Conclusion.
22
Chapter 3: Retail banking
Chapter 3
Retail banking
Essential reading
Buckle, M. and J.L. Thompson The UK Financial System. (Manchester University
Press, 1998) third edition [ISBN: 0-7190-5412-5] Chapter 3.
Further reading
Bain, A.D The economics of the financial system. (Blackwell, 1992) second edition
[ISBN: 0-631-18197-0] Chapter 3.
Gosling, P. Financial Services in the Digital Age: The future of banking, finance and
insurance. (Bowerdean Publishing Company Ltd, 1996) [ISBN: 0-906097-54-1].
Lewis, M.K. and K.T. Davis Domestic and international banking. (Philip Allan,
1987) [ISBN: 0-86003-144-6] Chapter 3 and Chapter 6.
Mester, L. ‘What’s the point of credit scoring?’ Business Review, (Federal Reserve
Bank of Philadelphia) September/October 1997.
Introduction
Retail banks have traditionally provided intermediation and payments services to
individuals and small businesses with all the components of those services supplied
by the bank. However it is becoming increasingly difficult to identify the nature of a
retail bank. Firstly because many banks now combine both retail and wholesale
activities. Secondly because technological developments have enabled banks to
supply a wide range of retail financial services to its customers but not supply all the
sub-components of those services.
In this chapter we begin by examining the nature of traditional retail banking. In
particular we investigate the provision of intermediation services and how banks
manage the risks involved in that provision. We also examine the nature of payments
services provided by retail banks and discuss why banks have traditionally combined
provision of intermediation and payments services. Finally we investigate recent
developments in retail banking and discuss the impact of these on the future
organisation of retail banks. We focus in particular on how it is now possible to
separate the components of a financial service/product and the trend towards
outsourcing or sub-contracting the supply of components of a financial
service/product.
23
Principles of banking
substantial branch network to collect the deposits of the public, facilitate repayment of
deposits and other account payments and make loans. The widespread use of
automated teller machines and the growth in telephone banking, postal accounts and
more recently internet banks has allowed new types of retail bank to emerge that do
not require extensive investment in branches. To make sense of the many
developments in retail banking it is helpful to see retail banking as a set of processes
rather than institutions. We leave this analysis until the end of this chapter.
It is helpful to begin our analysis of retail banking by examining the aggregate
balance sheet for retail banks in the UK for the year ending December 1996. This
table is taken from Buckle and Thompson (1998), Chapter 3.
Table 3.1 The combined balance sheet of UK retail banks at 31 December 1996
(£ billion)
Liabilities Assets
Notes outstanding 2.7 Notes and coins 4.8
Total sterling deposits 467.8 Balances with the Bank of England 1.7
(of which, sight deposits 210.1) Market loans 102.1
Total bills 12.2
Foreign currency deposits 148.6 Investments 50.7
Items in suspense and transmission Advances 338.5
plus capital and other funds 100.0
Other currency and
miscellaneous assets 186.5
Total liabilities 711.0 Total assets 711.0
Table 3.1 shows us that retail banks main liabilities are deposits (approximately 88
per cent of total liabilities. Of these deposits, 76 per cent are sterling and 24 per cent
are foreign currency, and of the sterling deposits 45 per cent are sight deposits. Sight
deposits are deposits that are repayable on demand. The other main items of liabilities
are items in suspense and transmission which refer, for example, to cheques drawn
and in the course of collection and capital which is made up principally of the bank’s
issued share capital and reserves (reserves are mainly profits retained by the bank and
not distributed to shareholders). These capital funds represent the bank’s shareholders
interest in the bank.
On the assets side of the balance sheet, the main item is advances which make up 65
per cent of sterling assets. There will also be foreign currency advances in the item
other currency asset. Liquidity is provided by a small amount of cash accounting for
approximately 0.7 per cent of total assets. This is a very small cash base. However,
additional liquidity is provided by market loans which refer mainly to short-term
loans made through the inter-bank market. A bank that is short of funds can borrow
funds from other banks for a short period through the inter-bank market. Likewise, a
bank that has a surplus of funds can lend short-term through the inter-bank market.
Short-term can be as short as overnight or one day. Further liquidity is provided by
the item of bills (these are debt instruments issued by firms and the government with
an original maturity of less than one year – typically one month or three months) A
bank can sell these bills quickly if it needs additional liquid funds. Finally, a bank
holds investments, which are mainly government bonds. These provide an alternative
source of return for a bank when there are no good lending propositions. Also,
because government bonds can be sold in a market before maturity they can be
classed as another source of liquidity.
24
Chapter 3: Retail banking
The main feature that emerges from a study of the balance sheet in table 3.1 is that
banks’ liabilities are mainly short-term deposits but their main assets are advances
which have a much longer term. The other main assets held by banks are assets that
can be turned into cash at short notice, known as liquid assets. We examine the risks
that mismatching of the term to maturity of liabilities and assets creates, and the
reasons why banks hold a large amount and variety of liquid assets in the next section.
Read Chapter 2 of this guide and identify the main features of asset transformation
undertaken by a financial intermediary.
25
Principles of banking
Cash inflows (from new deposits and loan repayments) would normally fund cash
outflows (deposit withdrawals and new loans). However, the stock of liquid assets held
by the bank acts as a buffer which can be drawn on when there is an imbalance of
outflows over inflows. Normally liquid assets are held according to a maturity ladder
with assets running from cash to overnight deposits to bills and short-term deposits etc.
The bank will obtain some return on its liquid asset holdings (other than cash) but this
will be lower than on its main earning asset of advances. Therefore banks will be
looking to hold just enough liquid assets to meet unexpected cash outflows.
Liability management
In the last 30 years banks in most developed countries have moved away from reserve
asset management towards liability management. Liability management involves a
bank managing its liabilities to meet loan commitments or replenish lost liquidity.
One form that this could take is simply to adjust interest rates on its deposits.
However if a bank is reliant solely on retail deposits then increasing deposit rates is
costly because it has to be done for existing deposits as well as new deposits attracted.
However, the development of wholesale deposit markets (market loans in table 3.1),
in particular an overnight interbank market, has allowed banks to use such markets as
a marginal source and use of funds. For example, if a bank at the end of a working
day has made more loan commitments than it can meet from current funding then it
can borrow funds from another bank in the overnight market. Conversely, if a bank
1
See Buckle and Thompson has a surplus of funds at the end of a working day then it can lend these overnight.1
(1998), section 10.3 for a The existence of the interbank markets allows banks to exploit profitable lending
discussion of the interbank
markets in the UK. opportunities as they arise without being too concerned about raising the funding to
meet the loan.
Managing asset risk
Many of the assets held by a retail bank are subject to the risk of a fall in value below
that recorded in the balance sheet. The main asset held by a retail bank is advances
and these are subject to the risk of default (or credit risk). Credit risk is exacerbated
2
See Chapter 2 of this guide. by the problems of adverse selection and moral hazard.2 Credit risk is influenced by
the stage of the economic cycle. Clearly when the economy is growing then credit
risk will be low for banks. If the economy goes into recession then credit risk
increases. The influence of the economic cycle represents the systematic (or macro-
economic) component of the credit risk facing banks. In addition, banks face a
borrower-specific component of credit risk. This is the risk that derives from the
individual decisions of the borrower. Banks are able to manage specific risk by using
the techniques outlined below.
26
Chapter 3: Retail banking
3
Read Buckle and Thompson Banks can manage default risk in a number of ways.3
(1998), section 3.5.2 for further
detail. Screening
Banks can minimise the risk of default for each individual loan by considering the
purpose of the loan and the financial circumstance of the borrower. The bank should
be aiming to select good risks only. Credit scoring is increasingly being used by banks
in this process of risk analysis and the advantage of credit scoring is that it can be
4
See Buckle and Thompson largely automated.4 Credit scoring is a method of evaluating the credit risk of loan
(1998), section 3.4 for further applications using a scoring model. The scoring model is developed using historical
discussion of this. Also see
Mester (1997). data to identify which borrower characteristics provide a good prediction of whether a
loan performed well or badly. Each characteristic will be weighted in the model
according to its importance in predicting default. Characteristics which might be used
in a credit scoring model for personal loans include the length of time the applicant
has been in the same job, monthly income, outstanding debt etc. Fair, Isaac and
Company in the US were the pioneers of credit scoring models. In the past, banks
used credit reports, personal histories and the bank manager’s judgement to determine
whether to grant a loan. Credit scoring is now widely used in personal lending,
especially credit card lending and is increasingly being used in mortgage lending. The
use of credit scoring has enabled banks to make lending decisions over the telephone
and so has helped facilitate the establishment of telephone-based banks, discussed
later in this chapter.
Pooling
Banks can undertake a large number of small loans rather than a small number of
large loans. This is an application of the law of large numbers to the loan portfolio,
which reduces the variability of loan loss, so increasing the predictability of loss
5
See Bain (1992), pp.54–56 for through default.5
more discussion.
Diversification
Banks can diversify the loan portfolio by lending to a wide range of different types of
borrowers. For example a bank should lend to both individuals and businesses and
within lending to businesses should lend to businesses in different industries. This has
the effect of offsetting the firm specific-risks within the portfolio. A simple example
illustrates the principle of diversification. A bank may lend to a number of firms
producing ice cream and a number of firms producing raincoats and umbrellas. If a
particular summer is mainly rainy then not much ice cream will be sold and some ice
cream producing firms may default on their loans to the bank. However, the firms
producing raincoats and umbrellas will prosper during a rainy summer and the
incidence of loan default amongst these firms will be low. If the summer is mainly hot
then the reverse will occur with ice cream firms prospering and raincoat and umbrella
firms doing badly and the incidence of loan default will be the reverse. So by
spreading its loans, the bank will not suffer high default risk across its whole portfolio
of loans in the event of either an extremely hot or extremely rainy summer. By
diversifying its loan portfolio a bank makes its borrower-specific loan risks more
independent. It should be noted that banks that specialise in lending to one particular
sector, region or industry, will be limited in their ability to diversify. Examples
include banks that specialise in mortgage lending or lending to a particular region or
industry (e.g. agricultural banks).
Collateral
A bank may ask for collateral (or security) to be provided by the borrower. If the
loan then goes to default then the bank is able to sell the collateral and so recover
6
See Chapter 2 of this guide for some or all of the loan. Collateral also has the effect of reducing moral hazard6 as
discussion of moral hazard. the threat of loss has the effect of reducing the incentive of the borrower to engage in
undesirable activities.
27
Principles of banking
Capital
Finally, a bank should hold capital. This provides a cushion against loss in the event
of default losses which protects depositors from its effects. Regulators impose
requirements on banks regarding the amount of capital a bank should hold in relation
to the riskiness of its assets. See Chapter 9 of this guide.
Activity
How does the use of credit scoring reduce the adverse selection problem and reduce
entry costs into the banking industry?
Payments services
Most retail banks also provide payments services. A payments service is defined in
Buckle and Thompson (1998), section 3.3 as:
an accounting procedure whereby transfer of ownership of certain assets are carried out
in settlement of debts incurred.
A payments service can be separated into three components:
1. a medium of exchange enabling customers to acquire goods
2. a medium of payment to effect payment for the goods acquired
3. a temporary store of purchasing power since income and expenditure are generally
not synchronised.
Paper money, issued by governments fulfils these three functions. A bank cheque
account, that is the liabilities of a bank, also provides these three functions. It is
widely accepted as a medium of exchange and a medium of payment. Funds can also
be stored in the account until purchases are made.
Recent developments
Recent developments in payments services technology are reducing the use of paper
7
Read Lewis and Davis (1987), cheques. The new methods of payments7 are as follows.
pp.158–169 for further
information of non-cash methods Debit card
of payments. This allows a customer to make a payment directly from a bank account. However the
transfer of funds between customer and retailer takes place electronically and the
transfer could take place immediately or could be delayed with the information
transmitted to the bank by the retailer in batches. The debit card can therefore be seen
as a form of electronic cheque.
Automated clearing house (ACH) debit
Allows for direct crediting of pay or for direct debiting of customer’s accounts for
regular payments such as mortgage repayment or utility bills. Transfers are normally
effected electronically.
Credit card
A credit card also allows a customer to pay for a purchase however a credit card only
performs the function of medium of exchange as, from the customers point of view,
payment is only made in the future when he/she settles the credit card account.
Future developments
Developments in payments services in the near future will include the following.
Smart cards (stored value cards)
Smart cards are effectively prepaid cards the size of a debit or credit card. An
electronic chip embedded into the card allows a customer to transfer value to the card
from a bank account, possibly from an Automate Teller Machine or specially
equipped telephone or personal computer. The smart card can then be used for
payment at a shop point of sale terminal. Funds are directed directly from the card to
28
Chapter 3: Retail banking
the retailer’s terminal. The retailer may then transfer the accumulated balances to their
own accounts. It is predicted that the smart card will reduce the amount of cash in use
although its take up will depend on to what extent shop and other service providers
(e.g. taxis, train operators) will introduce appropriate terminals.
Internet cash
Internet cash is a development further into the future. It will be an account held on the
internet that can be instantly debited or credited following an internet transaction. For
example, a customer may purchase a book over the internet and pay for it using his
internet cash account. To realise the value of this internet cash it will need to be
converted into traditional money. In this form then internet cash simply represents a
medium of exchange and payment but one which is separate from the actual transfer
of money.
Payments risk
You also need to be aware of the risks that banks (and their customers face) in
8
Please read Buckle and providing a payments service.8 A payments system provides for the transfer of funds
Thompson, section 3.5.3. between accounts at two institutions. There are essentially two types of systems for
making settlement payments between two banks:
1. end of day net settlement
2. real time gross settlement
With the first of these, at the end of each working day, final debit and credit balances
are calculated for each member bank in the settlement system and net settlement
transfers are made through settlement accounts, normally held at the central bank.
This gives rise to receiver risk whereby a bank may provide funds to a customer
having received payment instructions from another bank. The receiving bank then has
an exposure to the bank that sent the instructions, until final settlement occurs at the
end of the day. Those customers that have received payments may initiate further
payments and this can be repeated throughout the day, building up large exposures in
the banking system. If one of the settlement banks fail then this could lead to
9
The systemic risk problem as a settlement failures at other banks. This is an example of the systemic risk problem.9
justification for regulating banks One solution to this problem is to move to real time gross settlement whereby
is discussed in Chapter 9 of this
guide. payment instructions and settlement are more closely aligned. Such a system has been
developed in many of the major banking systems including the US and UK.
29
Principles of banking
10
Institutions in the UK, known 1. Savings and mortgage institutions:10 the 1986 Building Societies Act in the UK
as building societies, that permitted building societies to offer current accounts and make unsecured loans to
specialise in providing mortgage
loans for house purchase. persons, to a limited extent. The Act also allowed larger building societies to
convert into banks. Most of the larger Societies have since taken up this option.
2. Insurance companies: a number of insurance companies in the UK have
established banking subsidiaries. These include Legal and General, Prudential and
Standard Life.
3. Retailing organisations: in the UK a number of supermarkets now offer selected
banking products alongside groceries.
The majority of new entrants under categories 2 and 3 have so far chosen to offer
only a subset of retail banking products, namely credit cards, savings accounts,
personal loans and mortgages. The main retail banking product missing from this list
is the current (or cheque) account. In addition, many of the new entrants from the
insurance industry have chosen to offer retail banking services/products through new
delivery channels. In most cases the establishment of these new banks has only come
about as a consequence of the ability to offer banking services through non-traditional
channels. Retail banks have traditionally operated through branch networks. These are
costly to establish and to maintain. The introduction of automated teller machines
(ATMs) was the first development that allowed delivery of certain elements of retail
banking services outside the branch. ATMs were first located inside or on the outside
wall of the branch. They are now located in shopping malls, workplaces, universities,
petrol stations etc. Telephone banking was the next innovation in delivery channels
and many of the recent entrants into the banking industry are based completely on
telephone transactions. The pioneer in the UK was First Direct, a subsidiary of Hong
Kong and Shanghai Banking Corporation (HSBC). The most recent innovation in
delivery channels is the internet. Many retail banks in the UK have introduced online
banking allowing customers access to account information, to make payments and to
transfer money between accounts. As more households gain access to the internet and
gain confidence in using it to conduct banking transactions, then new banks are likely
to emerge basing their delivery of banking services solely on the internet.
Developments in interactive digital television also offer a new means of delivering
retail banking services.
All these developments do not imply an early demise for branch networks. First,
many customers will resist using the new technology. Second, branches allow banks
to cross-sell other financial products to customers who go into the branch to undertake
a banking transaction. In addition, a danger with telephone or internet based banking
is that it is likely to encourage customers to trade more on price so becoming more
fickle. This has implications for banks’ ability to manage liquidity risk.
Activity
What are the implications of the growth in internet banking for a bank’s ability to
manage liquidity risk?
30
Chapter 3: Retail banking
• Portfolio management
• Stockbroking
• Foreign exchange services.
Activity
Banks have increasingly used sophisticated marketing techniques to help target these
other financial products at certain types of customer. In particular, banks have
segmented personal customers according to wealth, income and a host of other social
and demographic factors.
In the future, banks may have to consider diversifying into non-financial business.
Banks have developed certain core competencies or comparative advantages from
their traditional business that could be applied elsewhere. These
competencies/advantages include:
• information advantages (banks have access to financial information on customers)
• risk analysis expertise
• expertise in the monitoring and enforcement of contracts
• delivery capacity.
Activity
Banks have traditionally been fully vertically integrated firms, that is they supply all
of the components of a product or service within the organisation. However
developments in new technology are changing the nature of the financial firm. You
need to read Buckle and Thompson (1998), section 3.4. The important points to
understand are:
1. It is now possible to separate (or deconstruct) a financial product or service into its
component parts which can then be supplied separately.
An example of this is a mortgage loan. This can be separated into the following
component processes:
a. origination – the mortgage is brokered to a customer
b. administration – paperwork processed
c. risk analysis – assessment of the credit worthiness of the borrower
d. funding – finance raised and asset held on the balance sheet and capital
allocated to the risk.
2. A firm may have a comparative advantage in certain parts of the whole process
but not every part. For example, a bank with a branch network may have a
comparative advantage in origination of mortgage loans but may not be the most
11
In Chapter 9 of this guide we efficient in terms of funding the loan, perhaps because of a capital constraint.11 It
show that banks must set a is becoming increasingly common in the US for banks to securitise their mortgage
certain amount of capital against 12
loans. loans and issue the subsequent securities into the capital market. When an asset
12 is securitised it is effectively packaged into a security and sold to investors.
In Chapter 4 of this guide we
introduce the concept of asset Securitisation allows a bank to turn an illiquid asset (like a mortgage loan - which,
backed securities which are
securitised loans which allow the we saw in Chapter 2 of this guide is a non-traded loan) into a liquid security
bank to take the loan off the which the bank can sell.
balance sheet.
31
Principles of banking
3. A new entrant to banking can sub-contract (outsource) some part of the process
involved in delivering a financial product. This allows them to obtain the
economies of scale for that process without having to invest. This makes it easier
for new firms to enter into banking. New entrants can therefore offer a wide range
of financial products/services to customers but not be involved in every
component of the delivery of the product/service.
4. The organisation of a retail bank will probably become more like the organisation
of firms in other industries where the degree of vertical integration is lower. For
example a car manufacturer like Toyota supplies finished Toyota cars to its
customers but many of the components of Toyota cars are supplied by other firms.
Activity
Read Buckle and Thompson (1998) section 3.3, and describe the organisation of a
virtual bank.
Learning outcomes
By the end of this chapter and the relevant reading you should be able to:
• Describe the main features of the balance sheet of a retail bank.
• Describe the main services provided by retail banks.
• Contrast the two main strategies retail banks can adopt to manage liquidity risk.
• Describe the main techniques that a retail bank can use to manage credit risk.
• Discuss the main developments in payments services provided by banks.
• Identify why retail banks have traditionally combined intermediation and
payments services.
• Explain why the retail banking sector is experiencing a growth in the number of
new entrants and hence increased competition.
• Discuss the implications of new technology for the organisation of a retail bank,
especially in terms of deconstruction of the delivery of financial products into its
component parts.
32
Chapter 4: Wholesale and international banking
Chapter 4
Further reading
Howells, P. and K. Bain The Economics of Money, Banking and Finance. (Harlow:
Longman, 1998) [ISBN 0-582-27800-7] Chapter 23.
Lewis, M.K. and K.T. Davis Domestic and international banking. (Philip Allan, 1987)
[ISBN 0-86003-144-6] Chapters 4, 8, 9 and 10.
Introduction
In Chapter 3 of this guide we discussed the nature and role of retail banking. The
subject for this chapter is wholesale and international banking. The difference
between retail and wholesale banking is essentially one of size. Retail banks deal with
a large number of small value transactions whereas wholesale banks deal with a
smaller number of larger value transactions. International banks are wholesale banks
that also deal with international customers involving different currencies. In practice a
particular banking firm may be involved with all three activities but with separate
subsidiaries dealing with the various aspects. Thus, while it is useful to distinguish
between retail, wholesale and international banking, it should be remembered that this
distinction refers to different functions rather than different firms.
In this chapter we investigate the nature of wholesale banking, focusing in particular
on the strategies adopted by wholesale banks for managing liquidity risk. We also
examine the nature of off-balance-sheet business and the reasons for its growth in
recent years. The business of international banking, and eurocurrency banking in
particular, is then investigated. One form of eurocurrency banking is sovereign
lending which refers to lending directly to sovereign countries. This type of lending
proved to be disastrous for international banks. We therefore finish this chapter by
examining the reasons for the growth of this type of lending by banks over the 1970s
and the subsequent international debt crisis of the 1980s.
Wholesale banking
You should note that the wholesale banks are a heterogeneous group of financial
1
In the US wholesale banks institutions consisting in the UK of British merchant banks and foreign banks.1 The
consist of mainly US investment assets held by wholesale banks operating in the UK, in aggregate, at the end of 1996
banks and foreign banks.
are shown in table 4.1 below, which reproduces table 4.2 in Buckle and Thompson
(1998). Note, the figures in parenthesis represent the percentage of total assets.
33
Principles of banking
Table 4.1 Assets of wholesale banks operating in the UK at end December 1996
(£million)
Wholesale banks
Sterling
Notes and coins & balances
at the Bank of England 714 (0.1)
Market loans 118,899 (10.2)
Bills 1,430 (0.1)
Advances 141,287 (12.1)
Investments 29,138 (2.5)
Total sterling assets 291,468 (25.0)
Foreign Currency
Market loans 500,266 (42.9)
Advances 219,266 (18.8)
Bills, investments etc. 154,959 (13.3)
Total foreign currency assets 874,491 (75.0)
Total Assets 973,780 (100.0)
This table is discussed in detail in Buckle and Thompson (1998), Chapter 4. The
definitions of the items in the table are provided there and in Chapter 3 of this subject
guide in relation to the balance sheet of retail banks.
The main features, which distinguish wholesale from retail banks, are:
1. The smaller proportion of sight deposits (deposits are deposits that are withdrawn
on demand) for wholesale banks. Most deposits with wholesale banks are inter-
bank or sourced from other money markets.
2. The larger size of individual transactions, a minimum £250,000 for a deposit and
£500,000 for a loan. In practice much larger transactions are undertaken.
3. The high proportion of assets and liabilities denominated in foreign currency. In
table 4.1 we can see that 75 per cent of assets of wholesale banks are denominated
in a foreign currency. This is because most banks located in the UK are foreign
based (mainly Japanese, US and European) and the main reason they have located
in London is to gain access to the eurocurrency markets. As we will see in the
section on international banking, later in this chapter, a eurocurrency transaction
(borrowing or lending) in London would be in a currency other than sterling.
4. The extent of their dealing in the inter-bank market. Table 4.1 shows us that
approximately 50 per cent of assets (sterling plus foreign currency) are market
loans, which are mainly inter-bank.
5. The extent of their off-balance-sheet business (see next section for more discussion).
6. They do not involve themselves in the payments mechanism to any great extent so
that cash holdings are minimal.
Features 1. and 2. above are even more pronounced for foreign as opposed to
domestic wholesale banks such as merchant banks in the UK.
The developments in wholesale banking largely originated with the development of
eurocurrency banking in London (see later in this chapter). The US investment banks
located in London were the main innovators in this area and the practices developed
spread to other financial centres as eurocurrency markets developed in other
countries. Lewis and Davis (1987) identify three practices in particular that form the
basis of wholesale banking, namely:
34
Chapter 4: Wholesale and international banking
• the development and use of interbank markets (in both domestic and
international currencies)
• the issuing of domestic and foreign currency certificates of deposit (CDs)
• lending by means of term loans at variable rates of interest (rollover credits).
We consider the nature of interbank markets and their use in liquidity management
below. Before this we will examine the nature of the market in CDs and rollover credits.
2
See Buckle and Thompson Certificates of deposits2
(1998) sections, 10.2 and 10.3. Certificates of deposits are bearer securities issued by a bank (or building society in
the UK) as evidence of an interest-bearing time deposit. They are negotiable
instruments and since they are bearer securities, their ownership can be transferred
prior to maturity. The original maturity of CDs is normally under 12 months, with the
most common issue being three months. However, maturities up to five years are
obtainable. Secondary markets exist in such instruments which allow the holder to
sell the CD before maturity and thus improve the liquidity of such instruments.
Rollover credits
As a large proportion of wholesale banks funding is relatively short-term, the banks
interest costs rise and fall in line with market interest rates generally. As a
consequence of this banks developed rollover credits which are loans that are repriced
periodically in line with market rates of interest. The ‘price’ of the loan is set as a
predetermined spread or margin over an agreed reference rate. In the UK this
reference rate is LIBOR (the London Interbank Offered Rate). LIBOR is the rate of
interest at which banks lend to each other corresponding to the interest rate
adjustment period of the loan. Where the rollover credit is adjusted every three
months then three-month LIBOR would be used as the reference rate. The spread
covers the costs and risks of the intermediation to the bank and will vary from
customer to customer mainly according to the perceived risk. Note that the spread is
not adjusted after the loan is made. In the UK, all wholesale loans are linked to
LIBOR whereas small and medium-sized loans are linked to the base rate.
The evidence discussed in section 4.2 of Buckle and Thompson (1998) suggests that
wholesale banks do not completely match their assets with their liabilities and that
therefore they do engage in maturity transformation by borrowing for a shorter period
than that for which the loans are made.
This raises the question as to how wholesale banks manage their liquidity position.
They do this by:
1. Using the inter-bank market – this market involves banks lending and
borrowing from each other. If a wholesale bank receives a deposit and has no
immediate outlet for a loan, it can deposit the funds in the inter-bank market for
periods varying from overnight to up to three months. Conversely if the bank has
35
Principles of banking
a request for a loan from a customer, and has no spare funds available, it can
borrow in the inter-bank market. In a similar manner, certificates of deposit (CDs)
could be purchased or sold to raise funds. For a discussion of the inter-bank
market see section 10.3 of Buckle and Thompson.
2. Sale of ‘asset-backed securities’ (ABS). An ABS is a tradeable financial
instrument, which is supported (backed) by a pool of loans. The sale removes
assets from the balance sheet of the bank and provides funds for alternative uses.
Hence the sale of an ABS assists the bank in the management of its liquidity
3
Read Buckle and Thompson position. This is an example of the process of securitisation.3 An example of the
(1998), section 4.2.
4
creation of an ABS is where a bank makes (originates) mortgage loans but then
In Chapter 3 of this guide we creates an ABS based on those loans. The ABS is then sold to investors effectively
noted that securitisation allows
banks to separate the various changing what was an illiquid asset into a liquid (marketable) asset.4
sub-components of the provision
of a loan so that a bank can 3. The process of securitisation has developed furthest in the US where there is a
provide those sub-components highly developed market for mortgage-backed securities.5 The origins of
where it can do so efficiently and
out-source (sub-contract) those securitisation in the US goes back to the 1930s when the Federal government
sub-components where it is less began offering insurance for mortgages made to certain disadvantaged groups.
efficient.
5 This provided a guarantee which made the mortgages attractive to other investors.
Read Howells and Bain (1998),
Chapter 28 for further It wasn’t until the 1970s that an active secondary market in mortgage-backed
discussion of the process of securities developed. At this time the Federal government reorganised the Federal
securitisation. National Mortgage Association (FNMA or ‘Fannie Mae’) and established two new
agencies; the Government National Mortgage Association (GNMA or ‘Ginnie
Mae’) and the Federal Home Loan Corporation (FHMLC or ‘Freddie Mac’). The
purpose of these two agencies was to issue securities backed by both insured and
uninsured mortgages. In the US the basic security is known as the ‘passthrough’.
Figure 4.1 illustrates the steps in the securitisation process.
Figure 4.1: The securitisation process
Loan
Source/Originator Borrower
Transfers
mortgages Forwards interest and principal
Trust Trustee
Issues securities
Passes through
Underwriter payments of interest
and principal
Distributes
securities
Investors
Functions
Cash flows
36
Chapter 4: Wholesale and international banking
A wider range of loans other than mortgage loans have been securitised in recent
years. These include credit card loans, car loans and student loans.
Activity
What do you think are the advantages to a bank, other than providing liquidity, of
securitising part of its loan portfolio?
The management of the liquidity position discussed above differs from the traditional
strategy adopted by retail banks discussed in Chapter 3 of this guide.
You should now read section 4.2 of Buckle and Thompson noting as background
information the details given of their asset holdings given in Table 4.2. We now turn
to a discussion of their off-balance-sheet business.
Off-balance-sheet business
Off-balance-sheet business can be defined as any activity that does not lead to an
entry on the institution’s balance sheet. Off-balance-sheet business includes both
contingent claims and other fee generating financial services. Contingent claims are
claims that are not captured on the balance sheet under normal accounting
conventions but which involve the bank in an obligation should a particular
contingency occur. Some examples of contingent claims are:
• Loan commitments: advance commitment for provision of a loan, which will
only appear on the balance sheet when the loan is made. Otherwise it remains as a
commitment to provide credit when the firm’s need arises.
• Guarantees: provision of commitment to guarantee the obligation of customer’s
liability to a third party. Liability only occurs if the customer defaults so that no
entry occurs on the balance sheet unless the default occurs.
• Underwriting security issues. When a company makes a share (or bond) issue, a
bank may guarantee to buy any shares (bonds) which are not purchased by
investors. This is similar to b above as the obligation only arises if the securities
are not purchased by other parties.
• Swap and Hedging transactions: these are discussed in Chapter 8 of this guide.
The other off-balance-sheet items are financial services provided by banks.
These include:
• Loan related services: loan origination and acting as an agent for syndicated
loans.
• Trust and advisory services: portfolio management, arranging mergers and
acquisitions, trust and estate management, safekeeping of securities.
• Brokerage and agency services: share and bond brokerage, unit trust (mutual
fund) brokerage, life insurance brokerage, travel agency.
• Payments services: clearing house services, credit/debit cards, home banking.
In all these transactions the bank obtains a payment for the services it provides. This
income is called fee income and is an alternative source of income from a bank’s
traditional income, interest income, which comes from the difference between the
interest the bank receives from loans and the interest it pays on deposits. Fee income
has grown relative to interest income in recent years – for details see table 4.4 in
Buckle and Thompson (1998). This trend reflects the decline in traditional banking
activities discussed in Chapter 2 of this guide.
Off-balance-sheet business has seen a large growth in recent years due mainly to the
following factors.
37
Principles of banking
1. Since 1972, asset prices have been more volatile. The early 1970s saw the
breakdown of the Bretton Woods agreement which fixed exchange rates for most
developed countries. The breakdown led to a general move to floating exchange
rates, except for some countries in Europe which have fixed the exchange rates
between each other’s currency (although not against currencies outside the
arrangement) for much of the time since the 1970s. In addition, the policy change
to targeting monetary aggregates and later inflation using the instrument of interest
rates has resulted in greater fluctuations in interest rates. The greater volatility in
exchange rates and interest rates is illustrated in figures 14.1 and 14.2 in Buckle
and Thompson (1998). The resulting uncertainty has led to a greater demand for
the hedging instruments such as swaps, futures and options.
2. In some cases banks’ credit ratings have fallen making it difficult for them to raise
deposits at rates of interest, which permit a satisfactory margin over the rate they
pay on deposits. In fact some large firms have better credit ratings than some
banks thus enabling the firm to obtain long-term finance at a more favourable rate
than through a loan from a bank. This phenomenon is referred to as
disintermediation and is discussed in Chapter 7 of this guide.
3. Arbitrage potential in capital markets. Although barriers between different
financial markets have been slowly breaking down as markets have become more
global (i.e. banks, other institutions and companies operating in markets other than
just their own domestic market), the process of globalisation is not yet complete.
This has allowed banks and others to exploit arbitrage possibilities. For example a
UK company may have comparative advantage in borrowing (i.e. obtain a better
rate of interest) in the UK bond market, but wants to raise dollars. A bank
therefore can arrange a swap to take place with the UK company swapping its UK
issued bond with a US company that has a comparative advantage in the issue of
dollar bonds but which wants to raise sterling. In some cases the bank may take
the position of the US company and become the counterparty to the swap.
4. The imposition of higher capital requirements on banks by regulators (see Chapter
9) since the late 1980s has led banks to attempt to escape such requirements. This
has led banks to develop and pursue off-balance-sheet activities, although many of
these activities (as described below) are now captured in capital ratios imposed.
Another consequence of increased capital pressures has been the growth of
securitisation (discussed above) whereby banks package assets and sell them off
as securities. In most cases the assets released from the balance sheet do not
require capital backing.
You will need to understand how contingent commitment banking is analogous to
traditional banking. For example, where a bank accepts a bill (i.e. enters into a
contingent commitment) it is providing a guarantee that the bill will be honoured if
the issuer defaults. The bank gains a fee for accepting the bill and the issuer benefits
as the acceptance means the bill can be issued with a lower rate of interest than would
otherwise be the case. From the bill holder’s point of view the bank’s acceptance has
lowered the risk of the instrument but at the expense of a lower rate of interest. This is
analogous to a deposit contract issued by a bank. From the depositor’s point of view,
the bank is able to reduce the risk of the security compared to holding a primary
security, but this risk reduction is in return for a lower rate of interest earned. So a
bank is performing a similar role both on and off the balance sheet, transforming risk
by using its skills in information collecting and risk analysis.
38
Chapter 4: Wholesale and international banking
This growth of off-balance-sheet business has led to fears by the regulatory authorities
that the banks may be undertaking excessive risks. Off-balance-sheet business
involves new instruments about which knowledge of their riskiness may be
incomplete. As you will see in Chapter 9 of this guide, the regulatory authorities have
tried to overcome this danger in determining how much capital a bank should hold by:
1. converting off-balance-sheet business into on-balance sheet equivalents and then
2. applying standard risk weights.
Please now carefully read section 4.3 of Buckle and Thompson (1998).
Activity
What are the essential differences between the traditional on-balance sheet activities of
banks and their off-balance-sheet activities?
International banking
International banking involves cross-border business. Thus, for example, a US bank
located in London may accept a dollar deposit from a French institution and make a
loan in dollars to a German firm. The bank may also switch currency by accepting a
deposit denominated in one currency and making a loan in another currency. London
is a major centre for international banking.7
7
Read Buckle and Thompson
(1998), section 7.2 for further
discussion of this. Much of the business is in what is called a eurocurrency. As distinct from the new
European currency the ‘Euro’, a eurocurrency is a deposit or loan denominated in
8
The term ‘eurocurrency’ is used a currency other than that of the host country.8 Hence a dollar deposit in London is
because the first deposits of this a eurocurrency whereas a sterling deposit is not. Similarly a sterling deposit in
type were placed in banks
located in Europe, mainly New York is a eurocurrency but a dollar deposit there is not. The main currency in
London, in the late 1950s and the eurocurrency market is the dollar with the Deutsche Mark as the second most
early 1960’s. Further discussion
of the origins of the used currency.
eurocurrency markets is provided
in Chapter 7 of this guide. Activity
The market for eurocurrencies is essentially a short-term market with the maturity of
deposits averaging less than three months. Lending is mainly for longer periods. The
short-term international loans are generally connected with short-term trade financing.
The main non-bank depositors and borrowers are governments and multinational
corporations. The size of longer term loans is generally large so that in many cases
loans are ‘syndicated’ (i.e. spread among many banks). The maturities of the
medium/long-term loans range from three to 15 years. Normally loans are made at
floating rates of interest using a key interest rate, such as LIBOR, as a reference point.
The interest rate will be adjusted at regular intervals as the reference rate changes.
US$ syndicated loans are the most popular currency type. Syndication of loans
permits the risk of default to be spread among many banks. This in turn lowers the
risk premium that would be charged to the interest rate thereby benefiting the
borrower. There are a number of participants in the syndicate:
• lead manager: the bank that negotiates with the borrower and organsises the
syndication
• managers: along with the lead manager, a number of banks will organise the
syndicate participants and underwrite the loan
• participants: the other banks that participate in the making of the loan
39
Principles of banking
• agent: the bank that carries out the mechanical tasks of collecting funds from
syndicate members and collects interest and repayment of principal from the
borrower. This could be the same as the lead manager.
The analysis in Buckle and Thompson (1998), section 4.4 is carried out in terms of
eurodollars but can easily be extended to any other eurocurrency. You should
understand the method of creation of eurodollar deposits and loans and the procedure
is demonstrated in tables 4.5, 4.6 and 4.7. Read the associated narrative carefully.
The market has grown rapidly in recent years and a number of reasons have been put
forward for this growth:
• Originally (before the end of the cold war), the desire of the Eastern Bloc
countries to hold dollars for the purposes of international trade but away from the
control of the US.
• Lower costs of the eurocurrency market due to lower regulatory requirements.
• The growth in world trade which necessitated a growth of international banking.
• Greater balance of payments imbalances which increased the availability of funds
for international investment.
Activity
Why do you think the dollar is the main currency of the eurocurrency markets?
You should now read section 4.4 of Buckle and Thompson (1998).
Sovereign lending
You should have a basic understanding of the nature of sovereign lending and the
reasons for, and consequences of, the international debt crisis that emerged in the
9
Read Buckle and Thompson 1980s. The main points are summarised here.9
(1998), section 4.5 for further
discussion of these points. Sovereign lending refers to lending to sovereign governments, either directly to the
government or government agency or to a company within the country where the loan
is guaranteed by the government. This form of lending by banks grew rapidly
following major oil price rises in 1973 and 1974. Oil producing countries placed their
receipts on deposit in the eurocurrency markets and these funds were on-lent by
banks, mainly to developing countries. The loans were mainly made with a floating
rate of interest in US dollars. When US interest rates were increased sharply at the
end of the 1970s and at the same time, a worldwide recession lead to a reduction in
export receipts for developing countries, most developing countries with sovereign
debt exposure found it increasingly difficult to continue repaying the loans. Many
Western banks had large exposures to developing countries debt and the effect of
several large debtor countries defaulting on debt repayments would have caused a
number of banks to become insolvent. Faced with a potential threat to the World
banking system a number of solutions to the sovereign debt problem were tried over
the 1980s:
• 1982–1985 IMF management of the problem
• 1985–1989 The Baker plan
• 1989– The Brady plan.
Alongside the ‘official solutions’ a number of market based solution to the debt crisis
emerged over the 1980s. These were:
40
Chapter 4: Wholesale and international banking
• Selling the debt, facilitated by a secondary market in developing country debt. The
debt would trade at a discount to face value. The price of the debt in the secondary
market would reflect the markets view of the likelihood of the debt being serviced
by the borrower.
• Debt–equity swap, whereby a bank would swap the developing countries debt for
local currency (at a discount). This local currency would then be invested in an
industry in the developing country.
• Debt–debt swap, whereby the loans held by banks would be swapped for bonds
issued by the developing country government. The bonds would be issued at a
discount to par or paying an interest rate below the market rate.
The Brady plan essentially gave official approval to the market solutions described
above. In particular, the Brady deals that have since been negotiated with developing
countries have mainly utilised debt-debt swaps.
The threat to the international banking system has receded over the 1990s
mainly because:
• The Brady plan has been successful in reducing the debt owed by
developing countries.
10
Referred to as loan loss • Banks have made provisions against the debt10 (set aside funds to protect
provisions in the US. themselves from the effects of default).
Learning outcomes
By the end of this chapter and the relevant reading you should be able to:
• Identify the main features of wholesale banks that distinguish them from retail banks.
• Describe the main products and services provided by wholesale banks.
• Describe the two main ways in which wholesale banks manage liquidity risk.
• Describe the main types of off-balance-sheet business of banks.
• Identify the main features of eurocurrency deposits and loans.
• Discuss the reasons for the growth of the eurocurrency markets.
• Discuss the reasons for the sovereign lending crisis and the main solutions
adopted to solve the problem.
41