economics of banking and money (ecobam) yaseen ghulam email:...

Economics of Banking and Money

(ECOBAM)

Yaseen Ghulam

Email: [email protected]

BANKING AND ECONOMICS

Traditional banking----taking deposits and making loans

Modern bank is a complex financial institution staffed by

multi-skilled individuals conducting multi-task operations

Focus of the talk in next few days is on studying bank

behaviour (optimisation subject to constraints) and bank

management practices

Understanding the behaviour of banks using basic tools

of economic analysis

Question to Answer Why banks exists?

How to check bank financial health?

Is the merger of banks beneficial to society and

banks?

Size: Bigger banks are better for the society?

How to measure degree of competition in banking

Why banks need more regulations compare to NBFI’s ?

Are the banking regulations laws same in different

countries ?

What are the managerial issues in banking ?

Risk management and prudential regulation

Question to Answer Is the banking industry structure same across globe ? Why banks go abroad or merge? Has the globalisation changed the way banks operate now? Why some countries banks are more dominant

internationally ? Can a bank fail, if yes, then why? Is the bank failure new phenomenon or historical ? Are there some qualitative and quantitative techniques

developed to know beforehand a bank failure ? Yes, you will be able to answer all these questions in next

10 days?

Aims and Outcome of Course

AIM How economics can explain the existence, nature and

operation of retail, wholesale and international banking

OUTCOME demonstrate a historical development of banking evaluate of public policy argument for prudential

regulation identify risks and explain how banks can manage

these risks describe and interpret trend and innovations in

banking efficiency and competition relate the importance of banking to the national

and international economy

Teaching and Learning Activities and Strategies

Lectures 11 Seminars 11 Assessment

coursework assignment40%

end of unit examination60%

Approach First main text book:

Modern Banking by Shelagh HeffernanJohn Wiley & Sons, Ltd ISBN: 0-470-09500-82005 (new edition) Abbreviation: MB

Second main text book:Microeconomics of Banking by Freixas & Rochet MIT Press

Abbreviation: MOB Third main text book:

Commercial Bank Management: International Edition by Peter S. Rose Mcgraw-Hill

Abbreviation: CBM

Approach

Supplementary Text Books and Magazine The Economics of Money Banking and Financial

Markets F. Mishkin, AWL 5th edition, 1996 Financial Markets and Institutions F. Mishkin, AWL 3rd edition, 2000 Global Financial Institutions and Markets H. Johnson, Blackwell, 2000 Commercial Banks Financial Management

Sinkey, Prentice Hall, 5th edition, 1998 Internet, magazines and journals (i.e. Journal of

Banking and Finance). Weekly reading of “The Economist” and “Banker” is desirable for all students

The Modern Banking Firm

A review of financial markets and reasons for banks existence

Modern banking in the context of traditional model Types of banks and their operations Moral Hazard and asymmetric information in banking Modern activities in banking:

Off-balance sheet and securitisationReading

1. MB ch.1, ch.2 2. MOB ch.1 pp 1-8, ch.2 pp 15-203. CBM ch.1 pp 4-234. F. Allen and A.M. Santomero (February 2001) What do

financial intermediaries do? Journal of Banking and Finance Volume 25, Issue 2, Pages 271- 294

Banking Structure Around the World Main features of the banking systems in the

following countries: UK USA Germany

Reading MB ch.1,ch.2,ch.6 International Banking: text and cases Financial

Times EditionISBN: 0-201-75666-8ch.3

Some journal articles

Managing Risks in Banking

Types of risk a modern day bank faces: Credit risk Liquidity and funding risk Interest rate risk Market or price risk Foreign exchange risk Sovereign or political risk

Approaches to the management of risks: Gap analysis Duration analysis Duration gap analysis Securitisation, derivatives and options

Conclusion (summary)

Managing Risks in Banking

Reading MB ch.3 International Banking: text and cases Financial

Times EditionISBN: 0-201-75666-8ch.11

CBM ch.6,7,8,9,10 MOB ch.8

Banking Laws: Prudential Control in Banking

Introduction: Why banking regulation? Types of risks envisaged in banking and its

relations to banking regulation Arguments for prudential control/regulation Problems with external prudential regulations and

a case for free banking Prudential control and regulations in the UK Prudential control and regulations in the USA Reading MB ch.4,ch.5 CBM ch.2 pp 33-58 MOB ch.9

Empirical Work on Efficiency and Competition Issues in

Banking Why we study competitive issues in banking? Are

competitive banks good for us? Measuring bank output How to estimate productivity and efficiency in banking? Empirical test of economies of scale and scope in banking Empirically testing how banks price their products Empirical test of price discrimination in banking Empirical models of test of competition in banking marketReading MB ch.9 CBM ch.5 pp 149-175 MOB ch.3

Banking Failures Why banks fail? Case studies of bank failure The determinants of bank failure

Management incompetence Fraud Regulatory tolerance Global recession

Solutions of bank failureReading MB ch.7,ch.9 International Banking: text and cases Financial Times

Edition, Ch.9 MOB ch.7

The modern banking firm

Outline A review of financial markets and reasons for banks

existence Modern banking activities in the context of traditional

model Types of banks and their operations Asymmetric information, moral hazard and adverse

selection in banking 4 Major developments in banking Industry

Deregulation Globalisation Financial innovations Strengthening in the degree of competition

Banks: what and why?

Operational definition used by regulators “A bank is an institution whose current

operation consists in granting loans and receiving deposits from the public”

“Banks act as intermediaries b/w depositors and borrowers”

Banks are different from other financial firms in that they provide deposit and loan products

The deposit products pay out money on demand or after some notice

Thus banks manage liabilities and creates assets by lending money

Financial Markets

Funds Financial intermediaries

Funds

Borrower-SpendersBusiness firmsGovernmentHouseholdsForeigners

Lender-SaversHousehold

Business firmsGovernmentForeigners

Financial Markets

FundsFunds

Direct Finance

Indirect Finance

Funds

Why do banks exist? The traditional theory of banking Answer: Due to liquidity and payment services Money evolved from commodity money (e.g. gold coin) Now Money lubrication of trade frees us from

bother exchange the goods we want Efficient medium of exchange and payment Paper Money not SUFFICIENT BANKS came into actions –bank drafts, LOC, etc There are different type of banks. But role of banks is

same“perform intermediary role by accepting deposits and

making loans” “Bank receives interest margin in term of compensation

for this service”

Banks: what and why?

Why not borrowers and lenders come together w/o an intermediary?

Answer: 1. presence of information cost and2. borrowers and lenders have different liquidity

preferences Four types of information costs may incur to lender w/o

intermediationi. Search cost contact of two partiesii. Verification cost verification of information

provided by borroweriii. Monitoring costs monitoring of activities of

borrowervi. Enforcement cost in case of default

Information costs

Lenders will go to bank for intermediation if intermediary cost is less than the four costs components.

Bank may also enjoy “informational economies of scope” Economies of scope are said to be exist when two or more

products can be jointly produced at a lower cost than if the same products are produced individually

Informational economies of scope in lending mean banks can pool a portfolio of assets which have a lower default risk but the same expected return on investment

Banks can pool funds from different lenders (depositors) and can give liquidity at cheaper prices. This makes intermediation cost for the banks even less

In additions, firm may take loan from the banks to send the signal to others that firm is likely to be staying in the business and thus encouraging customers and suppliers to enter into long term relationship largely due to creditworthiness

Modern Banks

Modern Day Banks

Broadly speaking modern day banking consists of two types of banks

1. Specialist investment /wholesale banks focus on investment market

2. Generalist (retail and universal) banks offer wide range of products such as:

1. Deposit account2. Loan product3. Real estate services4. Stock broking5. Life insurance

Wholesale Banking

Wholesale banking may be described as “small number of very large customers” i.e. corporate and governments

These banks are firms, which act as “private bankers” accepting deposits from high net worth individuals and investing in broad range of financial assets

These banks with small deposit base have an access of a wide range of funds from the equity, bond and syndicated loan markets

Wholesale banking is largely interbank Example

ABN AMRO, MORGAN STANLAY

Wholesale Banking Modern wholesale (particularly USA investment banks) banks are

engaged in:i. Finance wholesalerii. Underwritingiii. Market makingiv. Consultancyv. Mergers and acquisitionvi. Fund management

Merchant banks in UK traditional functions also include the same as that of their cousins in USA

There had been a rapid growth in wholesale banking for the last two decades-Reason

i. Relationship banking had reduced cost of contractingii. Delegation of tasks of evaluation and monitoring of

borrower to a credit rating firms to avoid the cost of each time evaluating borrower profile

Retail Banking

Retail banking may be described as “large number of very small customers” i.e. households

Such system of banking is usually characterised with small number of banks with extensive branches network (with exception of USA)

Retail banking is largely intrabank (the bank itself makes many small loans)

NATWEST, BARCLAY, HSBC Services provided are:

Safe store Payment mechanism (money transmission system) Financial intermediation (savings and lending) Other wide services such as financial advice,

FOREX, share dealing and insurance etc.

Retail Banking

Retail banking has witnessed a rapid “process innovation” for the last two decades specifically:

i. Replacement of cashier with machine- cost reduced to 25% of cashier

ii. ATM facility domestically as well as worldwide

iii. Telephone bankingiv. Video linked financial servicesv. Electronic cash e-cashvi. Debit and credit cards Visa and mastervii. Virtual banking by internet

Universal Banking Universal banking refers to the provision of most or all

financial services under a single, largely unified banking structure-Very common in Germany

Walter (1994) identified four types of universal banks: Fully integrated universal banks- supplying all financial

services from one entity Partially integrated financial conglomerates and able to

supply all services but some like mortgage, leasing and insurance are provided through subsidiaries

Bank subsidiary structure -bank concentrates on retail banking and remaining activities like investment banking and insurance through legally separate subsidiary of the bank

Bank holding company structure - financial holding company owns both banking and non-banking subsidiaries. Holding company may be non-financial firm or holding company itself may be an industrial concern

Universal Banking

Universal banking may include: Intermediation Trading of financial instruments, foreign

exchange and their derivative Underwriting new debts and equity Brokerage Corporate advisory services(mergers and

acquisition advice) Investment, management, insurance

Banks all around the world are trying to become universal

Natwest, Barclays and HSBC are offering a broad range of services, ranging from deposit taking and loan making to investment advices

Why banks are like a firm or why they exhibit organisational structure?

Banks are like firms. Coase (1937) explained that a firm need an organisational structure because some procedures are more efficiently performed by “command” i.e. assigning tasks to workers and coordinating the work than reliance on market prices.

A traditional bank with intermediary and liquidity function fits in well with Coase theory.

Loans and deposits are internal to bank and they need command and control (CC) system.

This intermediary role of banks and CC system will lead to principal and agent structure.

Principal-agent problem in banking

Bank activities are usually collection of contracts b/w principal and agents.

Whenever these contracts are not honoured properly, principal-agent problem will arise.

This principal-agent problem may exists b/w shareholders of a bank (principal) and its management (agent), the bank (principal) and its officers (agents) and the bank (principal) and its debtors (agents), depositor (principal ) and bank (agent) due to different priorities and incentives.

Principal agent problem may arise due to the fact that agent has more information about his/her characteristics than the principal.

Moral hazard problem in banking

Bank activities are usually collection of contracts b/w principal and agents. Moral hazard is another problem in case of depositors (principal) and bank (agent)

Moral hazard occurs when incentive changes for any party, which are core of the contract

Example Depositors do not monitor bank activities and bank

may go to risky ventures/businesses. Investors may take loans and intentionally default. Deposit insurance scheme may be exploited by

banks

Adverse selection problem in banking

Moral hazard problem can lead to incentives problems because the principal cannot observe the agent action (i.e. bank shareholders and management) or the principal has inferior information compared to agent (i.e. managers and borrowers)

Differences in information held by principal and agent can give rise to adverse selection

Examples: Banks giving wrong and/or incomplete advice Rip-off of customers in UK See the “Economist” article

Relationship banking Relationship banking can help to minimise the

principal-agent, adverse selection and moral hazard problem arising b/w a bank and borrowers and bank and depositors.

Under relational banking lenders and borrowers have a relational contract

Bank and borrower and bank and depositors will try to give full information to each others (better flows of information).

Further an understanding b/w both parties that in future there may be need of some monitoring

Relationship banking Example

A good example in this regard is bringing of new product in the market. If an investor goes to bank for loan, the bank will see her/his record, no financial difficulty, no default, loan granted and a clause may be introduced for monitoring or altering the clauses of contract.

Relationship banking is very common in Japan and Germany

However, some time relationship banking may go wrong.

Example: Jurgen Schneider/Duetche Bank

Arms’ length banking An extreme opposite is an arms’ length

transactional or classical contract where many banks compete for the costumers business and customers shop around several banks.

Both parties will try to disclose bear minimum information and stick to the contract clauses.

UK and USA banking system is working under this system

4 Major Developments in Banking Industry1. Deregulation of financial institutions i.e. banks in regard to

their pricing decisions i.e. variable interest rate lending

2. Financial innovations

New processes (new markets i.e. Eurocurrency Market,

securitisation) New financial instruments (i.e. Certificate of

Deposits (CD’s), Floating Rate Notes (FRN) and Asset Backed

Securities (ABS))

3. Globalisation (most banks operate throughout the world now)

4. Strengthening in the degree of competition Forcing banks to:Re-structureDiversifyImprove efficiencyAbsorb greater risk

4 Major Developments in Banking IndustryDeregulation A major change in term of how modern day banks are

behaving is the direct result of deregulation Deregulation has come in three phases

Phase 1: lifting of quantitative controls on bank assets and ceiling on interest rate on deposits

Phase 2: Relaxation of the specialisation of business between banks and other financial intermediaries allowing both to compete in each other’s markets (i.e. investment banking, mortgage and insurance products)

Phase 3: Allowing competition from new entrants as well as increasing competition from incumbent and other financial intermediaries

4 Major Developments in Banking Industry

Financial Innovation Deregulation in turn has brought in financial innovation Financial innovations are the direct result of

technological advancement and ever rising demand and expectation of customers

3 major structural changes as a result of innovations Shift of focus on liability management rather than asset

management Shift to variable rate lending (from fixed) Introduction of cash management techniques (helping

banks to reduce average transaction cost)


Post WWII focus on asset management due to: Heavy public sector debt to carry out reconstruction and

control on lending Asset management subject to constraints in term of Duration Now the focus is on liability management

Ability to create liability ---borrowing in inter bank market (USA banks have been borrowing from offshore centres)

1970s volatile inflation and interest rate led to culture of variable interest rate lending linked to LIBOR (London Inter Bank Offer Rate)

Variable rate determined by LIBOR, riskiness of customer, competitive pressure and marginal cost of lending


Hence stock of bank loans = f(demand for bank credit) Modern day banking involves liability management by altering

interest rate on deposits and borrowing from Inter Bank Market Technological innovation has seen the development of new

financial products such as: Credit card Electronic Fund Transfer (EFT) Automated Teller Machines (ATM) Point of Sale (POS)

All this has led to better cash management on the part of consumer and significant cost reduction for the provider of these products-banks

4 Major Developments in Banking IndustryGlobalisation Globalisation of financial system generally and banking system

particularly is on the rise In post WWII however banks getting more global due to:

Push factors- interstate banking regulation in USA Pull factors- following prime customer---creation of branch

network in foreign countries by City Bank and Bank of America Few other factors helping banks to go global include:

Mergers,takeover and relaxation of capital control Increasing trend in securitisation Harmonisation of banking laws (European banking laws by

ECB)

Banking Structure Around the World

Main features of the banking systems in the

following countries:

UK

USA

Germany

UK Banking Sector

Overall Retail banking-dominates. Investment banking and overseas expansion- Poor

record. Concentration is high. Switch of status by the building societies. High profit-poor management.

Bank of England The Bank of England is the central bank Responsible for:

Monetary stability. Management of national debt. Banker to government and monetary sector. Assist to FSA.

Banking structure

Financial Services Authority (FSA) Replaced 9 regulatory authorities Main responsibilities are:

Maintaining market confidence Promoting public understanding of FI Protection of consumers Fighting of financial crime

Retail banking (app. 20) Small number of banks with extensive branches network Large number of accounts. Cash ratios above minimum High degree of leverage/ credit creation. Bulk of business in £ sterling.

Retail Banking (app. 20)

Retail bankingServices provided Safe store Payment mechanism (money transmission system) Financial intermediation (savings and lending) Other wide services such as financial advice, FOREX,

share dealing and insurance etc.Wholesale banking (app. 480)Services provided and main features Large accounts and small number of minimum deposits i.e.

£250k, £500k. Large foreign currency business-most of them are foreign. Advice on privatisation-portfolio management-services to

corporate sector. Not involved in payment mechanism.

Building Societies (75)Building Societies (75) Very significant, but share declined after 1986 Products offered:

Mortgage Life Insurance Pensions Investment products

International Banks in UK Government encourages foreign banks operations London is the most famous banking centre with New York

and Tokyo. Very significant share 375 foreign banks, 200 representative offices and 100

foreign securities houses

USA Banking System

Important Features US banking system has over 27,000 deposits

taking institutions compared to 500 banks and 83 building societies in UK

Banking system is concentrated as 76% total assets are held by commercial banks

Over the time US banking sector has lost its dominance

US banks weaknesses include developing country debt problems and decline in agriculture commodity and real estate prices

Structure and regulations of the US commercial banking industry

There are around 2800 commercial banks in the USA, for more than in any other country in the world

In Canada or UK usually five or six major banks dominates the industry but in USA ten largest banks hold only 36% of the assets in their industry

Restrictions and regulations on branches had resulted in more banks

Two-third deposits are held by commercial banks, and remaining by thrift institutions

In the past, it had been a case that an American bank could open a branch in foreign country easily than domestically

The McFadden Act 1927, had effectively prohibited larger banks to open branches across states

Structure and regulations of the US commercial banking industry The McFadden Act and state branching regulates

constituted strong anticompetitive forces in the commercial banking industry

But from late 1990s, situation has changed Regulation on branches particularly are being

eased The restriction on branches had resulted in three

developments:

Bank holding companies

Nonbank banks

Automated Teller Machines (ATM)

Bank holding companies

A holding company is a corporation that owns several

different companies

The growth of holding companies over the time had been

dramatic to avoid the branching restrictions

B/c the holding company can own a controlling

interest in several banks

These holding companies had been and can involve in

investment banking activities

can purchase a failed bank in even other states and

thus effectively avoid the branching restriction

Nonbank banks

Another way banks can avoid branching restrictions was

due to loopholes in the bank holding Act of 1956, which

defined a bank as a financial institution that accepts

deposits and makes loans

Once bank holding companies had recognized this

loophole, they opened branches with one function only

(means offering loan facility or taking deposits only)

However, the Competitive Act passed in 1981 had

effectively filled this loophole

ATM

The modern day facility of ATM was originally invented to avoid branching restrictions in USA

Banks recognized that even if they don’t had ATM machines by their own but could use rented machines, they can easily avoid branching restrictions

A number of these shared facilities such as Cirrus and NYCE have been established nationwide

States also had encouraged these ATM machines rather than “brick and mortar branches”

These ATM machines had got popularity with the advent of cheap computers

USA- Commercial banks consolidation

Banks failures in late 1980s and early 1990s had provided the base for banks consolidation

Mergers and consolidations had been an important part of bank failure strategy

Banks consolidation was further stimulated by the passage of Riegle-Neal Interstate Banking and Branching Efficiency Act

This legislation expands the regional compacts to the entire nation and overturn the McFadden Act of prohibited interstate banking

This Act had almost ensured the interstate banking roughly in all 50 states


It is anticipated that after consolidation there will be roughly 4000 commercial banks rather than present 8500

Another important feature of the USA commercial banking industry had been the separation of commercial banking from investment banking such as securities, insurance and real estate business

Glass-Steagall Act 1933 had prohibited them from underwriting corporate securities or from engaging in brokerage activities. In turn, this Act had also prohibited investment banks and insurance companies from engaging in commercial banking activities

In 1997, however, the Federal Reserve allowed holding companied to underwrite securities and stocks

Initially it was insured that the revenue from these activities should be 10%, raised to 25% later on


Restrictions on commercial banks securities and

insurance activities put American banks at a comparative

disadvantage relative to foreign banks

In 1999, the Congress had passed a bill, which effectively

abolished the Glass-Steagall Act

This legislation, which is called Gramm-Leach-Bliley

Financial Services Modernisation Act of 1999, had allowed

securities firms and insurance companies to purchase

banks and allowed banks to underwrite insurance and

securities and engage in real estate activities

Thrift industry in USA

Savings and loans association (S&Ls) Just as there is dual banking for commercial banks, savings

and loan association can be charted by the Federal government or by the states

Most of the S &Ls whether state or federally charted or member of Federal Home Loan Bank System (FHLBS)

The Savings Association Insurance Fund (SAIF), a subsidiary of FDIC, provides Federal Deposit Insurance (up to $100,000 per account) for S &Ls

The branching regulations for S&Ls were more liberal than for commercial banks:

From 1980s federally charted S&Ls were allowed to branch state-wide in all states

Thrift industry in USA

These S&Ls usually provides loans for mortgages, FHLBS makes loans on soft terms (low interest rates and longer repayment period). In late 1980s, these S&Ls started involving in commercial banking activities

Mutual saving banks Of the around 400 mutual banks around half are chartered by the

states Their deposits are ensured by the FDIC up to a limit of $100,000

per account The branching regulations for mutual saving banks are determined

by the states in which they operate B/c restrictions on branching are not severe there are fewer mutual

saving banks with vast branching structure

Credit unions

Credit unions Credit unions are small cooperative lending

institutions They are the only financial institutions which are tax

exempted and can be chartered either by the state or the federal government

The National Credit Union Share Insurance Fund (NCUSIF) provides insurance for deposits

Since the majority of the credit union lending is for consumer loans with fairly short term of maturity, they do not suffer the financial difficulties of S&Ls and mutual saving banks

These unions are permitted to do branching in all states w/o any problem

International banking in USA

In 1960s eight US banks operated branches in foreign countries and their total assets were less than $4 billion. Currently there are more than 100 American banks working abroad with assets totalling over $500 billion

US banks had most of their branches in Latin America, the Far East, the Caribbean and London

Due to trade expansion, foreign banks had been encouraged to do the business in USA . These foreign banks had been overall very successful

These foreign banking are roughly lending the same amount of money to corporations as the US banks

These foreign banks are operating by using the agency offices, subsidiary banks and branches. Before 1978, foreign banks were under fewer regulations with no reserve requirements. However, 1978 International Banking Act put foreign and domestic banks on equal footing

German Banking System

Features German banks are typically universal ones

A universal bank is one, which provides a complete range of commercial and investment banking services

The German Banking Act implicitly provides a legal definition of a universal bank

in the wider sense- a bank, which offers the whole range of commercial, and investment banking services. Enterprise type-offering banking business

Banking Act: banking business comprises of: acceptance of funds w/wo interest paid (deposit business) granting of loans and acceptance credits (lending business)


Banking Act: banking business comprises of: purchase of bills of exchange and cheques (discount

business) purchase and sale of securities for others (securities

business) safe custody/admin. of securities for (safe custody

business) guarantees and warrantees of others (guarantee

business) performing of cashless payment/clearing (giro

business) Wide definition and consequently; some activities

considered non-banks in UK, are banking activities in Germany. Generally speaking, German financial system is characterised as ‘bank based’ due to broad legal definition of banking business


The group of universal banks in Germany can be divided into three categories on the basis of ownership and legal form. These categories are:

commercial banking sector; saving bank sector; and credit cooperative sector

Building and loans associations are treated separate from the banking system

Three categories of universal banks together accounted for roughly 80% of the volume of business in Germany

This confirms the fact that German banks are really universal banks. All the banks are able in principle to conduct the whole range of banking business as specified in the banking Act.

Commercial banks in Germany

Commercial banks in Germany as a whole, account for roughly 25% share in the total volume of banking business

There are four different classes of banks under commercial banks category:

The big banks Regional and other commercial banks Foreign banks Private banks

Duetsche Bank, Dresdner Bank, Commerzbank and their Berlin subsidiaries operate nationally through network of local branch offices

Although these banks are major banks in term of their balance sheet volume, however, their share is not as significant in overall banking business

Regional/commercial/foreign banks

These banks concentrate on providing universal banking services in their particular regions, but some maintain their system of branches which had allowed them to operate on interregional or national basis.

Two such banks with an extensive branch network are the Bayerische Vereinsbank and the Hypo-Bank.

These two large banks are even permitted to engage in mortgage business.

Foreign banks in the German banking system had not been significant

Foreign banks are permitted to engage in those sorts of businesses, which are allowed to domestic banks

Private banks consists of limited partnership private bankers specialize in export finance, securities

trading, industrial finance, and housing finance etc.

Saving bank sector

Savings bank sector had the largest share in the domestic volume of business

Saving banks were originally conceived non-profit making concerns: to serve relatively less well-off members of the community; to give credit on favourable terms to public authorities; to finance local investment in the region

These banks do follow these obligations but now they have become universal banks which compete with the commercial banks for most forms of banking business

There are three tiers within the saving bank sector. These are:

Local savings banks State saving banks Central saving banks

Local saving banks

These are municipal or district institutions incorporated under public law as independent legal entities

Each state had its own Savings Bank Act, which specifies the structure and organisation of the saving banks in that state

A local saving bank is usually permitted to operate only in its own region and its investment in securities and other assets are subject to restrictions.

State savings banks (Central Giro Institutions)

Each state saving bank is incorporated under public law and is owned by its respective state government and state saving bank association

Works as clearing houses for their member local savings banks.

They are state bankers in their respective states and can conduct their business on interregional and international basis.

The largest state saving bank is the Westduetsche Landesbank girozentrale, which is roughly comparable to Commerzbank in terms of balance sheet assets

Central savings banks

Deutsche Girozentrale (DGZ) serves as the central clearing bank for the saving bank system and holds the liquidity reserves for the state saving banks

This is similar to state saving banks in term of business it conducts, but it is smaller in size than many of them.

Although, both local saving banks and state savings banks are universal banks, some activities such as securities trading underwriting and international business are more important for state saving banks.

Credit cooperative sector

The credit cooperative originated simply as cooperative banks

Provides credit to their members, but now have developed to universal banks

The organisation of the credit cooperative sector is similar to that of the saving bank sector

There are large numbers of local credit cooperatives and a system of larger regional banks headed by a central clearing- house institution

There are three tiers within the credit cooperative sector. These are: Local cooperative banks,regional central cooperative banks and federal clearing house institutions

Local and regional cooperative banks

Local cooperative banks The first tier of this sector comprises local banks organised

as cooperatives, whose members are local individuals and businesses.

Members of the local credit cooperatives contribute capital.

Regional central cooperative banks The local credit cooperative are headed by a second tier

consisting of regional central cooperative banks, which are either stock corporations or registered cooperatives owned by the local credit cooperatives.

Federal clearing house institutions

Third tier consists of federal clearing-house institution, which is a stock corporation owned by the regional credit cooperatives

This is the most important category of credit cooperative banks in terms of volume of business (among top 10)

The relationship between the local credit cooperatives and the regional institutions of the credit cooperative is similar to that between the local savings banks and the regional giro institutions.

The local credit cooperatives raise relatively large amount of funds in the form of personal saving deposits, while regional institutions of the credit cooperatives do relatively little deposit banking and raise the funds by borrowing from other banks

Mortgage banks

Among those banks in Germany, which provides a specialised range of banking services rather than universal services, the most important group consists of the mortgage banks.

These banks are owned by public or private sectors and the law in Germany generally limits mortgage banks to make long term mortgage loans and loans to municipalities and other public authorities.

These banks finance through bonds and long term deposits.

Most private mortgage banks are usually owned by commercial banks, which are interested to enter into this market

Banks with specialised functions

The group of banks offering specialised banking

services comprises various public and private

institutions

Their share in total volume of banking business in

Germany has been in the range of 10-12%.

These banks provides loans finance such as:

export finance;

finance of projects in less developed countries;

environmental programmes; and small and

medium sized German firms

Management of Risk in Banking

All profit maximising firms face two types of risks: Microeconomic risk (new competitive threat);

Macroeconomic risk (the effect of recession) Additional potential risks include:

Breakdown in technology; Commercial failure of a supplier or customer; Political interference;National disaster

Banker on the other side face some additional risks bankers job is to manage these risks. Risk

management is the primary responsibility of bank management.

Some risk are easy to think, calculate and manage, but some are difficult to even calculate.

Additionally, banks manage the risk arising from on and off-balance sheet business.


Types of risk a modern day bank face Credit Liquidity and funding Settlement and payment Interest rate Foreign exchange Gearing or leverage Market or price

Approaches to the management of risks Credit risk

Credit risk analysis/credit evaluation


Approaches to the management of risks Interest rate risk (through assets liability management

(ALM)) Gap analysis Duration analysis Duration gap analysis

Liquidity and funding Gap analysis

Foreign exchange Hedging

Market or price VaR and Stress Testing

Asset securitisation and derivatives

Definition of risks a bank face

Credit risk probability of default on a loan agreement.

risk that an asset or a loan will become irrecoverable due to outright default.

Liquidity and funding risk Liquidity risk

of insufficient liquidity for normal operating requirements

financing wage bills etc. the ability of the bank to meet its liabilities

when they fall due. It simply means shortage of liquid assets

Funding risk bank is unable to finance its day-to-day

operations smoothly.This is called maturity mismatching


Interest rate risk Interest rate risk arises from interest rate

mismatches in both the value and maturity of interest sensitive assets, liabilities and off-balance sheet items.

Asset-Liability Management (ALM) manages interest rate risk.

If banks have excess fixed rate assets they are vulnerable to rising interest rate and

if excess fixed rate liabilities they are vulnerable to falling rates.

Typically banks are asset sensitive meaning a fall in interest rates will reduce net interest income by increasing the banks’ cost of funds relative to its yield on assets.


Market or Price risk Banks face market (or price) risk on instruments

traded in well-defined markets. equities, bonds holding by bank (price

incr./decr.) Two types- General (systematic) and unsystematic A bank can be exposed to market risk (general

and specific) in relation to debt and service fixed and floating rate debt instruments such

as: bonds, debt derivatives, futures and

options on debt instruments, interest rate and cross country swaps and forward foreign exchange positions, equities and equity derivatives (equity swaps), futures and options on equity indices, options and futures warrants.


Foreign exchange or currency risk Under flexible exchange rates a bank with global

operation face such type of risk and it arises usually due to adverse exchange rate

fluctuation which effects the bank foreign exchange position taken on its own account or on the behalf of its customers.

Banks engage in spot, forward, and swap dealing faces this risk. Banks have large positions, which changes dramatically within minutes.

Gearing or leverage risk Banks are highly geared (leveraged) than other

businesses. Suppose banks confirm to a risk asset ratio of 8%.

An 8% capital ratio translates into a 1250% ratio of “debt” (liabilities) to equity in contrast to 60-70% debt-equity ratio for commercial firms.

Credit Risk Management Credit risk techniques are probably among the best –

developed tools available to bankers and they have long experience of assessing and managing this risk. Essentially, following are the widely used techniques to manage credit risk.

Screening Monitoring Long-term customer relationships Loan commitments Collateral Compensating balances

The credit risk analysis departments usually use two types of methods.

Qualitative & Quantitative

Approaches to the management of credit risks

Qualitative Banks usually use four ways to minimise credit risk.

Accurate pricing of loans---more risky loans may be priced higher than the less risky loans.

Credit limits----credit limit may be imposed on the borrower according to their wealth or potential income in near future.

Collateral or security----loans should be properly secured against the wealth or assets of the borrower (houses or shares etc.)

Diversification---risky loans can be backed up through new capital injection or diversification through finding new loans markets.


For firms or big borrowers banks can assess annual report of the company or debt-credit record.

judgement is made on the basis of past credit history (through credit rating agencies), the borrower gearing (leverage) ratio, wealth of borrower, volatility of the borrowers’ income, and whether or not collateral is a part of the loan agreement.

Sometime credit rating team will look on the forecasted macroeconomic indicators such as: inflation, interest rates and future economic growth.


Quantitative method of credit risk analysis requires the use of financial data to predict the probability of default by the borrower.

The methods, which are usually commonly used, are Discriminant Analysis and Logit and Probit models

These methods are statistical techniques and involve regression

The probability of defaults is calculated on the basis of some important predetermined variables i.e age, marital status, residence and qualification etc.

Approaches to the management of interest rate risks

Interest rate risk managed through asset liability management. Two types of method are very common in analysing and minimising the interest rate risk. These are

gap analysis and duration analysis

Gap analysis Gap analysis is the most well known ALM technique

used to manage the interest rate risk. The gap is the difference between interest

sensitive assets and liabilities for a given time interval say six months. In gap analysis each of the bank assets and

liabilities is classified according to the date the asset or liability is going to be re-priced, and the “time buckets”


normally overnight-3 months, 3-6 months 6-12 months, 12 months and more and so son.

Analyst will compute incremental and cumulative gaps results.

An incremental gap is defined as earning assets-funding sources in each time buckets, while cumulative gaps are the cumulative subtotals of the incremental gaps.

By definition incremental and cumulative gaps should be zero for complete interest risk aversion scenario.

A negative gap means sensitive liabilities are > sensitive assets.

A positive gap means sensitive assets are > sensitive liabilities.

GAP Analysis-Example

Gap analysis for interest rate risk

Overnight-3 months

> 3-6 months

> 6-12 months

> 1-2 years

> 2-5 years

> 5 years or not stated

Earning assets notes and coins £100 3-month bills £20 interbank loans £20 5 years bonds overdrafts £20 5-years loans £20 property £30 Funding sources (Liabilities) retail deposits £100 £50 £45 3-months wholesale deposits £5 Capital £10 Net mismatch gap £35 £20 -£50 -£55 £20 £30 Cumulative mismatch gap £35 £55 £5 -£50 -£30 £0

More on Interest-Sensitive Gap Measurements

Dollar Interest-Sensitive Gap

Interest-Sensitive Assets – Interest Sensitive Liabilities

=

Relative Interest-

Sensitive Gap SizeBank

Gap ISDollar

Interest Sensitivity

RatiosLiabilitie SensitiveInterest

Assets SensitiveInterest

Interest-Sensitive Assets-Liabilities

Assets Short-term securities issued by the government and

private borrowers Short-term loans made by the bank to borrowing

customers Variable-rate loans made by the bank to borrowing

customers

Liabilities Borrowings from money markets Short-term savings accounts Money-market deposits Variable-rate deposits

Gap Positions and the Effect of Interest Rate Changes on the Bank

Asset-Sensitive Bank Interest rates rise

NIM rises Interest rates fall

NIM falls Liability-Sensitive Bank

Interest rates rise NIM falls

Interest rates fall NIM rises

Important Decision Regarding IS Gap

Management must choose the time period over which NIM is to be managed

Management must choose a target NIM To increase NIM management must either:

Develop correct interest rate forecast Reallocate assets and liabilities to increase spread

Management must choose dollar volume of interest-sensitive assets and liabilities

NIM Influenced By: Changes in interest rates up or down Changes in the spread between assets and liabilities Changes in the volume of interest-sensitive assets and liabilities Changes in the mix of assets and liabilities

Problems with Interest-Sensitive Gap Management

Interest paid on liabilities tend to move faster than interest

rates earned on assets

Interest rate attached to bank assets and liabilities do not

move at the same speed as market interest rates

Point at which some assets and liabilities are repriced is not

easy to identify

Interest-sensitive gap does not consider the impact of

changing interest rates on equity position


Duration analysis Duration analysis allows for the possibility that the

average life (duration) of an asset or liability differs from their respective maturities which makes matching of sensitive assets with sensitive liabilities quite difficult. Suppose the maturity of a loan is six months and

the bank opts to match this asset with a six months certificate of deposit (CD). If part of the loan is repaid each month, then the duration of the loan will differ from its maturity.

The formula for duration is as: Duration= Time to redemption {1-[coupon

size//MPV*r)]}+(1+r)/[1-(DPV of redemption/MPV)]---(1)

Where: r: market or nominal interest rate; MPV: market present value; DPV: discounted present value;

Present value is calculated as: Sum of cash flows/(1+r)n ……..(2)

Approaches to the management of risks- Example

Bond life: 10 years, Value: £100, Coupon rate: £5 annually, Redemption value: £100, Market interest

rate: 10%. Present value is calculated as: DF CF PV0.91 5 4.550.83 5 4.130.75 5 3.760.68 5 3.420.62 5 3.100.56 5 2.820.51 5 2.570.47 5 2.330.42 5 2.120.39 105 40.48

69.27

Approaches to the management of risks- Example

Duration is calculated:D= 10[1-5/6.9277)]+(1.1/0.1) {1-[100(1.1) -

10/69.277]}. D= 7.6 years rather than 10 years. Similarly duration of equity can be calculated as:

DE= {(MPVA*DA)-(MPVL*DL)] (MPVA-MPVL)---------(3)

The computed duration of equity is used to analyse the effect of a change in interest rate on the value of bank

More on Duration Duration of an Asset/Liability portfolio

n

1 iAiA i

D *w D

Where:wi = the dollar amount of the ith asset divided by total assets

DAi = the duration of the ith asset in the portfolio

n

1iLiL i

D * w D

Duration of a Liability Portfolio

Where:

wi = the dollar amount of the ith liability divided by total liabilities; DLi = the duration of the ith liability in the portfolio

Duration Gap

TA

TL * D - D D LA

Change in the Value of a Bank’s Net Worth:

L * i) (1

i * D- - A *

i) (1

i * D- NW LA

Overall Duration Gap is:

Impact of Changing Interest Rates on a Bank’s Net Worth

Positive Rise Decrease

Gap Fall Increase

Negative

Rise Increase

Gap Fall Decrease

Zero Rise No Change

Gap Fall No Change

Approaches to the management of liquidity risk

Triggered when majority of the customers are

interested to get their money back due to bad

management or perception of bank failure

All the times the bank must be able to meet

the cash flow obligation arising from deposit

withdrawals (normal case as well as in stress)

The best way to deal with this type of risk in

modern banking is to use the gap analysis.

Approaches to the management of liquidity risk

To control this risk, banks usually plan cash flows (in and out) over a short interval (e.g. one week)Assets Liabilities Loans 300 Deposits 400 Bonds 250 Interbank 100 Equity 50 Total 550 550 Liquidity Profile One week Two week interest income 1.0 1.0 interest expenses -0.7 -0.7 operating expenses -0.1 -0.1 tax 0.0 0.0 reimbursement of principal Loans and bonds 30 30 estimated new lending -25 -35 reimbursement of deposits -40 -10 estimated new deposits 10 10 new cash flow -24.8 -4.8 cumulative net cash flow -24.8 -29.6

Market Risk Management Banks participate in buying and selling of

financial instruments in various and diverse markets around the globe. Adverse changes in the price of these instruments can expose the banks significantly and effect the value of their portfolio. This is called market risk.

Two widely methods to calculate the exposure of market risk are:

Value at Risk (VaR): calculates market risk faced by a bank in everyday normal market condition.

Stress testing: calculates market risk in abnormal market condition.

In the following discussion we discuss each approach in detail.

Market Risk ManagementValue at Risk (VAR) Approach

Relatively new approach for measuring the market risk. VaR calculates the worst possible loss that a bank could

expect to suffer over a time interval, under normal market conditions, on the basis of some specific confidence level.

E.g., a bank might calculate that the daily VaR of its trading portfolio is $35 million at a 99% confidence interval. This means that there is only 1 chance in 100 that a loss > $35 million would occur on any given day.

VaR can be calculated for any portfolio of assets or liabilities whose market values are available on a periodic basis and price volatilities () can also be estimated.

JP Morgan’s VaR JP Morgan general definition for VaR is the

maximum estimated losses in the market value of a given position that may be incurred before the position is neutralized or reassessed.

VaRx = Vx * dV/dP * Dpi

Vx = market value of position x

dV/dP = sensitivity to price move per $ market value

Dpi = adverse price movement over time i; e.g, if the time horizon is one day, then VaR becomes daily earnings at risk DEAR = Vx x dV/dP x DPday

Portfolio Stress Testing

Relatively new technique that relies on computer modeling of different worst case scenarios and computation of effects of those scenarios on a bank’s portfolio position (Sept. 11 bombing).

The advantage of this technique is that it can allow risk managers to evaluate possible scenarios that may be completely absent from historical data.

For example Sept. 11 bombing of WTC: All assets in portfolio are revalued using changed

environment and a modified estimate for the return on the portfolio is created.

Many such scenarios can lead to many exercises and a range of values for return on the portfolio is derived.

By specifying the probability for each scenario, mangers can then generate a distribution of portfolio returns, from which VaR can be measured.

Financial Futures Contract An agreement between a buyer and a seller which calls for

the delivery of a particular financial asset at a set price at some future date

The Purpose of Financial Futures To shift the risk of interest rate fluctuations from risk-

averse investors to speculators

Most Common Financial Futures Contracts U.S. Treasury Bond Futures Contracts U.S. Treasury Bill Futures Contracts Three-Month Eurodollar Time Deposit Futures Contract 30-Day Federal Funds Futures Contracts One Month LIBOR Futures Contracts

The World’s Leading Futures and Option Exchanges

Chicago Board of Trade (CBOT)

Financial Exchange (FINEX)

New York Futures Exchange (NYFE)

Marche a Terme International De France (MATIF)

Singapore Exchange LTD. (SGX)

Chicago Mercantile Exchange (CME)

London International Financial Futures Exchange (LIFFE)

Sydney Futures Exchange

Toronto Futures Exchange (TFE)

Hedging with Futures Contracts

Avoiding higher borrowing costs and declining asset values

Use a short hedge: sell

futures contracts and then purchase

similar contracts later

Avoiding lower than expected

yields from loans and securities

Use a long hedge: buy

futures contracts and

then sell similar contracts later

Interest Rate Option It grants the holder of the option the right but not the

obligation to buy or sell specific financial instruments at an agreed upon price.

Types of Options Put Option - Gives the holder of the option the right to sell

the financial instrument at a set price Call Option - Gives the holder of the option the right to

purchase the financial instrument at a set pricePrincipal Uses of Option Contracts Protection of the bond portfolio Hedging against positive or negative gap positionsMost Common Option Contracts Used By Banks U.S. Treasury bill futures options; Eurodollar futures option;

U.S. Treasury bond option; LIBOR futures option

Using Swaps and Other Asset-Liability Management

Techniques

Using Swaps and Other Asset-Liability Management

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

Other Instruments (OTC)

Interest Rate CapProtects the holder from rising interest rates. For an

up front fee borrowers are assured their loan rate will not rise above the cap rate

Interest Rate Floor A contract setting the lowest interest rate a

borrower is allowed to pay on a flexible-rate loanInterest Rate Collar A contract setting the maximum and minimum

interest rates that may be assessed on a flexible-rate loan. It combines an interest rate cap and floor into one contract.

Off-Balance Sheet Financing in Banking and Credit Derivatives

Securitization of Assets The pooling of a group of similar loans and issuing securities

against the pool whose return depends on the stream of interest and principal payments generated by the loans

Advantages/Problem of Securitization Diversifies a bank’s credit risk exposure Creates liquid assets out of illiquid assets Allows the bank to better manage interest rate risk Allows the bank to generate fee incomeProblems with Securitization May not reduce a bank’s capital requirements Not available for all banks May increase competition for the best quality loans May increase competition for deposits

Types of Securitized Assets

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

Loan Sales Marketing loan contracts held by an institution in

order to raise new cash Types of Loan Sales Participation loans

Where an outside party purchases a loan. They generally have no influence over the loan terms

Assignments Ownership of the loan is transferred to the buyer

of the loan. The buyer has a direct claim against the borrower.

Reasons/Risk Behind Loan Sales

Way to rid the bank of low yield securities Way to increase liquidity of assets Way to eliminate credit and interest rate risk Way to generate fee income Purchasing bank can diversify loan portfolio and reduce riskRisks In Loan Sales Best quality loans are the easiest to sell which may increase

volatility of earnings for the bank which sells the loans Loan purchased from another bank can turn bad just as easily as

one from their own bank Loan sales are cyclical

Standby Letters of Credit (SLCs) A financial instrument that guarantees performance or insures

against default in return for payment of a fee. It is a contingent obligation

Reasons for Growth of SLCs Rapid growth of direct financing worldwide Perception among banks and their customers that the risk of

economic fluctuations has increased Opportunity SLCs offer banks to use their credit evaluation skills

to earn fee income and the relatively low cost of issuing SLCsSources of Risk with SLCs Default risk of issuing bank Beneficiary must meet all conditions of letter to receive

payment Bankruptcy laws can cause problems for slcs Issuer faces substantial interest rate and liquidity risks

Credit Derivatives

Financial contracts offering protection to a designated beneficiary in case of loan default

Types of Credit Derivatives Credit swaps Credit options Credit default swaps Credit linked notes

Prudential control in banking

Risks in Banking Systematic risk------bank runs/contagion Default risk---------credit risk Price risk---------asset prices can change Fraud or incompetence risk--------operation risk Unwise diversification of assets Competition and excess risk taking

OutlineArguments for prudential control/regulation Arguments against prudential control/regulation Case studies

UK USA

Prudential control in banking

All firms have to ensure for capital adequacy (keep capital reserves (money) to offset any losses)

In addition, banks have to ensure sufficient liquidity.

Prudential control is more important for banking. due to two conflicting objectives on asset side of balance

sheet. Profit---------high to keep shareholders happy Liquidity-----low/high to earn profit/serve better and

insure depositors Bank has also self-interest in term of long-term survival But then question arises

Should prudential controls/regulation be compulsory set by state bank?

or bank management themselves

FINANCIAL REGULATION OF BANKSWHY REGULATE?

All Markets Financial Markets1. Protect consumer 1. The investor

2. Monopoly power 2. Conc. of fin.firms

3. Externalities 3. Threat of systemic collapse

4. Illegal Activity 4. M- laundering, tax evasion.

Benefits/Costs of prudential control/regulation

Benefits1. Protection of the public’s savings2. Control of the money supply3. Adequate and fair supply of loans4. Maintain public confidence5. Curb monopoly powers6. Support of government activities7. Help for special segments of the economy/societyCosts

1. Hampers competition and innovation. Cost of regulation high-compliance cost

2. Complexity of activities------innovation of modern finance --Competence of supervisor

3. Modern ALM makes it redundant. Deposit insurance alone has ended risk of systematic bank failure. Capital adequacy has ended credit risk.

Who Bears the Cost: Cost of Higher Capital Ratio on SpreadLet take the competitive model. The balance sheet of the banks is given by:

L+R=D+E (1) where L= loans; R= reserves; D= deposits and E=equity Let the capital asset ratio defined as: e= (E/L) and the reserves to deposits ratio k= (R/D) The balance sheet constraints can be expressed in an alternative way as:

L(1-e)= D(1-k) (2) The bank wants to maximize profit (objective function) in term of maximum rate of returns on equity rE. Profit function can be explained as:

Π= rLL-rEE-rDD (3) Now substituting (2) into 3, we get

Π= rLL-rEeL-rD(1-e/1-k)L (4) Differentiating Π with respect to L and setting to zero gives:

d Π/dL=rL-rEe-rD(1-e/1-k)=0 rL(1-k)-rEe(1-k)-rD(1-e)=0

rL-rD=rEe(1-k)+krL-rDe Now let define the spread as: s= rL-rD, then we can see that:

∂S/∂e=r E(1-k)-rD >0

SUM: Prudential Regulation of Banks The Challenge: strike the right balance:

Minimise the social costs of bank failure/financial crisisAND

Minimise MORAL HAZARD problems

Evidence of MH: Managers assume extra risks because of:(1) Deposit Insurance - if provided

(2) Looting hypothesis (Akerlof & Romer, 1993): Management: undertake riskier activities to boost short-term profits - then cash in on dividends/ shareholdings,etc. Gambles likely to be sizeable.

(3) Bank deemed "too big to fail”:

UK Financial Structure - Key Regulations

The Evolution of UK regulation is best assessed by looking at 6 Acts:

The UK Banking Act, 1979; Amended 1987 Financial Services Act, 1986 The Building Societies Act, 1986,1996 (no. of BS:

131 in ‘89 ; 63 in ’03) 1998 Banking Act Financial Services & Markets Act, 2000

Prudential control and regulations in the UK

Bank of England creation in 1694 Overall BoE is the regulatory authority (now combined with

FSA) Role of BoE is

Monetary control Prudential control Government debt through reserve ratio

Often role contradictory with each otherMajor Banking Regulation Pre-1979

No specific banking law in the UK Private banks treated like other commercial concerns Individual agents or firms could accept deposits without

any formal licence


1979 Act Identified two classes of institutions-recognised

banks and licensed deposit takers Act created a Deposit Protection Fund, to which all

recognised banks to contribute. Funds to compensate 75% of any deposit upto £10,000

Collapse of Johnson Matthey Bank (JMB) paved the way for amendment in the Act

1987 Banking Act Basically an amendment in 1979 Act Created supervisory board headed by the

Governor of BOE and members outside of the bank


1987 Banking Act Eliminated the distinction between deposit takers and banks Act clarified that a firm seeking as a recognised bank status

from BOE must offer a broad range of services including current (checking) deposit accounts, overdraft and loan facilities, atleast one of the foreign exchange facilities, foreign trade documentation (in the form of bills of exchange), investment management services, or alternatively very specialised services

Private auditors were given greater access to BOE information Any exposure to a single borrower, which exceeds 10% of

banks’ capital should be reported to BOE and supervisor should be consulted beforehand of any lending which exceeds 25% of bank capital to a single borrower

Act specified BOE control over foreign banks entry Act increased the deposit insurance limit to £20,000


Under Act BOE acts as a regulator. The asset side of a bank balance sheet is regulated

through measure of capital adequacy and liability side through liquidity adequacy

BOE Capital Adequacy How much capital is there to pay back liabilities

Two measures are used: Gearing or leverage ratio and Risk assets ratio

BOE Liquidity Adequacy Funding risk through liquidity gap analysis Interest rate risk through gap analysis Foreign exchange rate risk through a look on dealing

and structural positions Counter party risk through Euromarket monitoring

Capital Adequacy and the BOE

1. Gearing ratio:Deposits+ Ext. LiabilitiesCapital + Reserve

Lower the GR, lower the risk that a bank will lose its capital and fails

Example1: Suppose a bank balance sheet is as:Bank deposits + ext. liabilities = £1 mil.Bank’s capital + reserve = £1 mil.

GR= 1/1=1Implications: if bank lends £2 mil. and 50% of

borrowers default, bank loses all its capital but depositors get back their money.


Example 2: Suppose a bank balance sheet is as:Bank deposits + ext. liabilities = £2 mil.Bank’s capital + reserve = £1 mil.

GR= 2/1=2 Implications: if bank lends £3 mil. And 50% of

borrowers default, bank loses 1.5 mil (more than its capital) and all depositors not get back their money.

Usually ratio is set by the bilateral agreement between the bank and the BoE.The precise gearing ratio considered acceptable to both parties varies according to the nature of bank business and its assets. Some qualitative factors are also given some consideration.


2. Risk asset ratio Weighting is used for different assets It allows heterogeneous set of assets to be valued Now called Basle risk assets ratio It is calculated by taking into account tier one or core

capital (equity capital plus reserves) and tier two capital or supplementary capital (subordinated long-term debt)

Weights are pre-determined

Ratio is defined as: Tier one capital+ tier two capitalRisk adjusted assets

Capital Adequacy and the BOEExample: Suppose a hypothetical bank assets, and weights prescribed by

BOE and Basle. Cash £500 (0%)T. bills £2000 (0%)Mortgage £15000 (50%)Commercial loans £10000 (100%)

Unadjusted value of assets £27000Adjusted value of assets=

500*(.0)+2000*(.0)+15000*(.5)+10000*(1.0)=17500Risk assets ratio= (tier1 capital+tier2 capital)

17500 If tier1 and tier2=1500,Then risk assets ratio= 1500/17500= 8.6%

Capital Adequacy and the BOE-extended example

Risk Asset ratio -an illustrative calculationAssets £ m Weight fraction Weighted assets(£m)Cash 25 - -Treasury bills 5 0.1 0.50Other eligible bills 70 0.1 7.00Secured loans to discount market 100 0.1 10.00UK government stocks 50 0.2 10.00Other investment -government 25 0.2 5.00 -companies 25 1 25.00Commercial loans 400 1 400.00Personal loans 200 1 200.00Mortgage loans 100 0.5 50.00Total assets 1000 707.50Off-balance sheet risksGuarantess of commercial loans 20 1 20.00Standby letters of credits 50 0.5 25.00

752.50Total risk weighted assetsCapital ratio (8%)Capital required to satisfyregulation 0.08*752.50=£60.2m

Source: Bank of England

Financial Services & Markets Act- June 2000

Required a merger of numerous regulators: banking supervision division of BE, Friendly Societies regulators, Insurance Directorate (DTI), UK Listing Authority, Credit Unions

Statutory Requirements of FSA: Ensure Confidence in the UK financial system (fin.stability). Educate the public- risks of investing. Protect consumers - but encourage greater responsibility. Reduce financial crime. ALSO: Be cost effective: C/B analysis on all new regs. Major Initiative: a “risk based” approach to regulation. ALL firms

assigned impact score, RTO: “risk to our objectives”: IMPACT SCORE = [Impact of the problem] X [prob of problem arising] Score ranges from A (very high risk) to D (low risk). High Risk: major

banks, large insurance firms, stock exchanges, big broker-dealers. Signals a move away from rules for each type of institution.

Emphasis: effect of a firm’s actions ON the FSA’ ability to meet statutory objectives, NOT financial/systemic risk per se.

USA - Bank Structure & Regulation

Emphasis on protecting small depositors. Concern about potential collusion as important as issues related to financial stability – reflected in their legislation.

Major Banking Laws National Bank Act (1863/64) Banks must opt for a state or national charter (OCC) 1913: Federal Reserve Act: FED to provide an

“elastic” currency: FRS – 12 regional FR banks FDIC: created in 1933; administers deposit insurance

($100,000) Glass Steagall section of the Banking Act: 1933 Riegle Neal Interstate Banking & Branching Efficiency

Act: 1994 Gramm Leach Bliley Financial Markets Act: 1999

US Regulation: Multiple Regulators

Regulators Financial FirmsOCC (1863) National commercial banksFED (1913) FHCs/BHCs, FDIC (1933) Any bank (nat/ state) covered by FDIC

insuranceOTS (1989) Savings & loans (national or state)NCUA (1970) Credit unions- national or stateState Regs State chartered banks licensed by the state

FTC Uninsured state banks or savings & loans, credit unions, foreign branches of US or foreign banks

SEC (1934) Securities firms/investment banks, investment advisors, brokers

NAIC, DTI Insurance firms

USA banking regulation

Overall Evolved through time Different to UK banking regulation by:

Seeking help from legislation whenever crises Protection of small depositors more important Concern about potential collusion

National bank act passed in 1863 and amended in 1864

Federal Reserve Act 1913 created central bank regional Federal Reserve Banks and a Board of Governors

Banks must get license either by the Comptroller of the Currency or by a state official

USA banking regulation

Banks performance is monitored on a scale bases ranging from 1 to 5.

1-2 are considered good score for a bank, while 5 is bad which signals bank failure is just around the corner

Since 1991, Federal Deposit Insurance Corporation (FDIC) regulates capitalisation of the banks

Fed normally examines the state member banks, the Comptroller of the currency examines the national member banks and FDIC examines the non-member (of the FRS) insured banks

Member banks of FRS must comply a tier one capital asset or leverage ratio of at least 5%.

Major USA banking regulation

National Banking Act (1863,1864) Passed during the civil war to help fund the war Created the treasury and the comptroller of the

currency Created national banks with a federal charter

Federal Reserve Act of 1913 Passed after a series of financial panics at the

beginning of the century Created the federal reserve system. Gave the fed the

authority to act as the lender of last resort Created to provide a number of services to member

banks. Today the fed controls the money supply


McFadden-Pepper Act 1927 Prevented banks from expanding across state lines Made national banks subject to the branching laws

of their stateGlass-Steagall Act 1933

Passed during the great depression Separated investment and commercial banking Created the FDIC Fed given the power to set margin requirements Prohibited interest to be paid on checking accounts


FDIC Act 1935 Addressed the issues left out of the glass-steagall act Gave the FDIC the power to examine banks and take

necessary actionBank Holding Company Acts

Federal reserve given the power to regulate bank holding companies - 1956

Amendment reduced the tax burden of bank holding companies - 1966

Amended the definition of bank holding companies to include one-bank holding companies - 1970


Bank Merger Acts All mergers must be approved by the appropriate regulating

body Mergers must be evaluated in three areas

Effect on competition Effect on the convenience and needs of the community Effect on the financial condition of the banks

Social Responsibility Acts 1968 – full information on terms of loans must be given 1974 – cannot be denied a loan based on age, sex, race,

national origin or religion 1977 – cannot discriminate based on the neighborhood in

which borrower resides 1987 and 1991 – banks must disclose full terms on deposit

and savings accounts


Gramm-Leach-Bliley Act 1999 Permits banking-insurance-securities affiliations Consumer protections for consumers purchasing

insurance through a bank Must disclose policies regarding the sharing of

customers’ private information Customers are allowed to ‘opt out’ of private

information sharing Fees for ATM use must be clearly disclosed It is a federal crime to use fraud or deception to

steal someone’s account or personal information

DebateSingle vs Multiple Regulators: The Debate

(Based on UK/US experience)

(1) Growth of financial conglomerates - functional supervision is costly; may leave gaps

FSA: has a Major Financial Groups Division for the 50 most complex firms operate in UK, even if HQed elsewhere (eg: big 5 UK bks). Each conglomerate has a micro regulator: coordinates supervision in the FSA

FED: has control over FHCs that own banks: Since 1989: US Fed has led supervision of Large Complex Banking Corporations (LCBOs): 2-12 supervisors monitor each of the 50 leading organisations.

THUS: not part of debate - both systems have developed ways of dealing with FCs.

Single regulation eliminates functional regulation, which can raise compliance costs. But does it?

US: common to answer to more than one regulator



(3) Product boundaries less well defined: e.g. derivatives & securitisationAlternative to single regulator: assign a lead regulator (solo consolidation)?- UK - has caused problems in the past

(3) FSA: Single regulation creates Scale and Scope Economies :- Single system of reporting (?)- Better communication - firms report to single regulator- Single point of contact: firms and consumers (?)- Common methodology -e.g. RTO (?)- Pool resources/efficient resource allocation(?)- Single system for authorisation (?), supervision, discipline, training,etc.- Easier to recruit from pool of expertsUS authorities: - Are scale/scope economies achieved? - Competition between regulators encourages comp/inn. (Greenspan) - Monopoly power gives single regulator too much power, leading to reg.

forbearance and inefficiency.



(4) Cost of regulation - Early study (2002): cost of FSA 10% of US reg; (5) Cost of Compliance: firms under both systems complain but

may be more difficult to measure under multiple regs. (6) Overlap between organisations. Likely to be more of a

problem in the US –e.g. Citigroup case. Could raise compliance costs.

(7) Accountability: FSM Act makes FSA highly accountable- annual reports to Parliament, etc. Also true of the FED chair. Other US regulators do not have such a high profile.

(8) FSA’s 4 statutory duties - could aggravate conflicts of interest by scarce resources. Not the case in the US where each regulator (except the FED) has a single set of related duties.

(9) Moral hazard: a problem under both regimes.(10) Split between supervision (FSA) and monetary control (BE):

Raises question of responsibility for financial stability.

Bank Failure Case Studies

Why Banks Fail?

Why Banks Fail?

Banks are more Vulnerable, fragile and open to contagion Compared to other commercial firms- Why? Low capital to assets ratio (high leverage)-leaves little room for

losses Low cash to assets ratio- may require sale of earning assets to meet

deposit obligation High demand debt and short term debt to total debt (deposits)

ratios-that brings high potential for a run- may require hurried assets sale at cheap prices

Banking crises starts with run (mob of depositors appear at the bank and its branches, demanding their money)

To fulfil their demand, banks may call loans, may refuse to lend new credit or sell assets

Having said all banks do not fail- then why some banks fail?

Introduction Some modern best known cases are:

Bankhaus HerstattFranklin National BankBanco AmbrosianoContinental Illinois and Pen SquareJohnson Matthey BankersUS Thrift Bank of New EnglandBaringBank of Credit and Commerce International (BCCI)

Banks Failures

If not all banks are prone to failure then why study bank failure and bother about that?

Bank failure or crashes are important to understand b/c crises spread (contagion disease)

Indonesia, Thailand and Korea- Failure spread through out the banking system as sick institutions infected the healthy and dragged them down into insolvency.

Banking crises not new- Italian, Dutch English, Scots, French, Austrians, Germans, Japanese and American—all faced the banking crises/failure.

Cost of Bank Failures

The cost of bank failure in OECD as well as in developing countries is enormous. And sometime difficult to estimate

Few examples are given below:

Country Years loss % of GDP Norway 1987-90 4% USA 1984-91 3% Japan 1990-Cont. Huge Venezuela 1980-00 14% Bulgaria 1980-00 14% Mexico 1980-00 14% Hungary 1980-00 10%

Barings (1995)

Background A well known British bank, very good in mergers and

acquisition and quite powerful in emerging Far East market.

About 1/3 employees based in Asia and more than half outside UK.

The banking and market making arm of the bank (Baring Securities was a leading equity broker in Asia and Latin America)

The fund management operation had a reputation for its expertise in Eastern Europe.

Barings (1995)

Reasons of Downfall Exposure in Far East was the main reason for Baring downfall (unlimited

exposure in the derivative market). Mr Leeson was the culprit. He was head of the department, leading a team of 15

employees. Smart and manipulative person. He was an arbitrageur whose job was to spot differences in the prices of future

contracts and profits from buying futures on one market and simultaneously selling them on another.

Mr Leeson was suppose to earn benefit out of this business for subsidiary of Baring Securities.

Margins in these types of contracts are small but volume traded large. Mr Leeson was supposed to have been trying to profit by spotting differences in the prices of Nikkei-255 future contracts listed on Osaka securities Exchange (OSE) and the Singapore Monetary Exchange (SIMEX). SIMEX attracts stock markets futures b/c Osaka exchange is subject to more regulation and hence is more costly.

Barings (1995)

Rather than hedging his position Lessons seems to have decided to bet on the future direction of the Nikkei index.

The move proved costly for Mr Leeson. Mr Leeson used a secret error account 88888 to hide trading

losses and exaggerated his earnings to get maximum bonus. Baring London was deceived into thinking that Mr Leeson

made profits from arbitrage. But losses were accumulating in the 88888 account. It was reported that more than ¾ profits was earned through

this Mr Leeson business. All the time auditors failed to detect any wrongdoing. During the process of selling and buying Mr Lesson’s action

brought £827m losses.

Barings (1995)-Responsibles Low internal control in the area of risk management. Regulatory authorities share the blame. The SIMEX and Osaka

exchange failed to act despite the rapid growth of contracts at Baring.

BOE was also deficient in its supervision of Baring. BOE granted Baring solo status (mean Baring bank and Baring

securities required to meet a single set of capital and exposure standard). It means BOE was supposed to supervise trading business of Baring (not a good idea, given the fact that it had no expertise in this area), hence depositors were exposed to trading losses.

European rule of not taking more than 25% maximum equity capital exposure into single investment was ignored and BOE had not spotted this.

Coopers and Lybrand (external auditors of Baring) failed to conduct comprehensive tests that would have detected large funding requests from Singapore.

Franklin national bank (1974)

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

Banco Ambrosiano(1982)Background Italian bank based in Milan. Quoted on the Milan stock exchange. Subsidiary companies overseas. Luxembourg subsidiary called Banco Ambrosiano

Holding (BAH) 60% of this subsidiary owned by BA Milan.

BAH active on the interbank market. Taking Euro currency deposits from international

banks. Money from Euro currency was lent to non Italian

companies in BA group.

Banco Ambrosiano(1982)

Reasons of Downfall Massive fraud by chairman of the bank. Chairman departed Milan for London after receiving a letter from

BOI to reduce and explain overseas exposure. Deposit withdrawal after confidence lost due to chairman death in

London after hanging on the bridge. Former Italian PM was also involved in fraud.

Bank of Italy launched life boat operation. Seven banks provided money.

Later declared bankrupt by Italian court and taken over by another bank. BAH also suffered from losses of deposits , but refused by bank of Italy to launch life boat operation. BAH defaulted on loans and deposits.Weak relation b/w senior management and Bank of Italy are considered the root cause of this bank failure.

Significant supervisory changed after this failure.

Continental Illinois and Pen Square (1982)

Background Two American investment banks. Penn square energy loans passed to CI . Involved in heavy lending in real estate and energy

sector. CI relying on overseas market to fund its loans portfolio

60% of them were short term foreign deposits.Reasons of Downfall Lack of procedures to vet new loans. Poor quality loans to US corporate sector and CI failed to

classify bad loans as nonperforming. Rumours spread of difficulty faced by bank and bank run

started, made it difficult to raise funds.

Continental Illinois and Pen Square (1982)

US Comptroller of Currency intervened but it made

the matter worse and bank borrowed money from

Chicago Reserve Bank (CRB).

Private life boat was organized, but not sufficient

Run got worse and $6b disappeared within few

days.

FDIC and Comptroller announced assistance.

All CI directors were asked to resign in return.

Johnson Matthey Bankers (JMB) (1984)

Background An arm of Johnson Matthey, dealer in gold bullion. JM was the fifth largest gold dealer in London. Involved in lending to third world countries.Reasons of Downfall Significant Loans exposure to a single country (Nigeria). Auditors did not show responsibility. They agreed with

director presentation of accounts. Bank of England showed soft approach. Private auditors not given full authority to check. No

communication between auditors and BOE. Return submitted by management not subject to independent audit.

Johnson Matthey Bankers (JMB) (1984)

Lifeboat operation launched by BOE with the help of private banks. Use of “Too Big to Fail”. Lifeboat operation launched by BOE suggests regulator will be willing to accept too big to fail if the bank failure poses a real danger in term of widespread bankruptcies.

JMB affair prompted the establishment of committee.

The committee involved the Treasury, BOE, and external experts.

Amendment of Banking Act (1987).

Bank of Credit and Commerce International (BCCI)

Background Founded by the Pakistani financier and incorporated in

Luxembourg with small amount of capital $2.5m (less than BOE $5m requirements).

Initially given the status of deposit taker but later on after amendment in banking act became full bank with authority to open branches across UK.

When closed negative net worth of about $7b. Customers included Manuel Noriega (Panamian dictator) and

international terrorist Abu Nidal.Reasons of Downfall Fraud and illegal dealings. BCCI bought a Colombian bank with branches in Medellin and

Cali (centre for the cocaine trade and money laundering). International repute for capital flight, tax fraud and money

laundering.

Bank of Credit and Commerce International (BCCI)

Indicated in Florida, raided by British customs and executive imprisoned in Florida for money laundering.

BOE and pricewaterhouse failed to communicate with American regulatory authorities.

Bingham report criticised BOE and pricewaterhouse. BOE set up a special investigation unit to look into

suspected cases of fraud or financial malpractice as well as setting up a special legal unit.

Amendment of Act (closing UK branches of an international bank if deemed necessary).

Cross border supervision very important.

SummaryBank Name Derivative

market exposure

Foreign exchange market exposure

Lack of internal control

Weak asset management

Overseas exposure

Lack of regulatory control

External auditor role

Unsound policies (bad loans, aggressive expansion etc.)

Management fraud

Baring X X X X X X X

Franklin National Bank X X X X

Banco Ambrosiano X X X

CI and Pen Square X X X X

JMB X X X X

BCCI X X X

Common Lessons from Bank Failure Case Studies

A number of qualitative conclusions can be drawn from the individual bank failure case studies.

Bank may fail due to:1. Weak asset management

a. Low quality loans with inappropriate collateral arrangement.b. Excessive exposure to one sector or single firm/country. This

exposure overlooked by regulatory authorities. 2. Inexperience with new products (FNB, Bankhaus Herstatt).3. Managerial inefficiency in term of herd instinct (Barings).4. Bank fraud and dishonesty (BA, FNB, BCCI)5. Supervisors, bank inspectors and auditors missed important signal of

problem banks (JMB, BA, BCCI, Barings).6. Too big to fail may lead to moral hazard and resultant bank failure

(JMB)

Competitive Issues in Banking

Outline Competitive issues in banking

Productivity measurement Efficiency measurement Economies of scale and scope Test of competition in banking market Contestable banking markets Interest equivalence for non-price features Qualitative tests for price discrimination and

firms survival

Notes: For this topic, chapter 4 from the text book “Modern Banking in Theory and Practice” by Shelagh Heffernan John Wiley and Sons is a must reading.

Measuring of bank output

Measurement of output of services produced by financial institutions has special difficulties b/c they are not physical quantities.

Difficult to account for quality in a banking service.

i.e. ATM may improve the quality of payment services as well reduce the costs of transactions considerably but benefits are difficult to measure. Increase in frequency of transactions by a customer may increase the costs per customer. Hence difficult to measure the net benefits per customers.

Two common approaches to measure banks outputs:

The production approach The intermediation approach


The production approach Banks are treated as firms for measuring output.

Banks use capital and labour to produce deposits and loan accounts and output is measured as: Number of accounts/number of transaction per account.

Uses bank output as flows.

Problem How to weight each bank service in the computation of

output. The method ignores interest costs. Difficult to compare data from different banks, thus

making accurate measure of efficiency difficult.


The intermediation approach This approach recognises intermediation as the core

activity. Output is measured by the value of loans and

investment. Cost is measured as operating costs (the cost of

factor inputs such as labour and capital) plus interest costs.

Bank output is treated as a stock. Neither the intermediation nor the production

approach takes account of the multi-product nature of banking.

Most bank productivity studies used intermediation approach.

because this has fewer data problems than with the production approach.

Next Step:Productivity and Efficiency

Measures

Two types of productivity measures are used. Partial and Total

Partial measures are based on financial ratios. They show partial picture.

Assets per employee Loans per employee Profit per employee Cost per employee Admin. Cost as a % of total cost

Whereas, total measures take into account multiple nature of outputs and inputs in banking i.e.

Total Factor Productivity (TFP)

Productivity and Efficiency Measurement

Efficiency Estimation Empirical research is based on two methods of

efficiency estimation1. Stochastic Frontier Analysis (SFA)2. Data Envelopment Analysis (DEA)

DEA employs a efficiency ratio by using multiple inputs and outputs.

DEA compares the observe output (yjp) and inputs (xip) of several banks.

It then identifies the relatively more efficient bank with the relatively less efficient bank.

p = ipijpj Xv/Yu subject to p 1 for all p and weights vi,uj >0, p represents several banks


Efficiency Estimation

The model is run repetitively with each bank appearing in the objective function once to derive individual efficiency rating.

The decision about efficiency or inefficiency is based on the following:

E=1 relative efficient, E<1 relative inefficient However, efficient does not mean top of the level

efficient in absolute terms but efficient compared to other banks in the data set.

p = ipijpj Xv/Yu subject to p 1 for all p and weights vi,uj >0, p represents several banks


Productivity Estimation Malmquist productivity index is a popular method to estimate

TFP TFP is computed by taking into account efficiency change and

technical change The Malmquist index will be able to determine levels of change

in technical efficiency and change between time periods The Malmquist index is calculated as follows (as outlined in

Fare et al, 1994).

This formula can be further decomposed into efficiency and technical change as follows

2/1

10

111

0

0

11011 ),(

),(

),(

),(),,,(

ttt

ttt

ttt

ttt

tttt xud

xud

xud

xudxuxum


Where the first part of the equation (that which lies outside of the parenthesis) represents efficiency change and the second part (contained within the parenthesis) represents technical change.

The Malmquist index provides a measure of changes in total factor productivity (TFP) from year to year.

The values are concentrated around 1, which implies no change.

A TFP index value which is greater than 1 implies an improvement, while a value less than 1 implies a decrease in productivity.

The efficiency change relates to how the firms performed relative to the production frontier.

2/1

10

0

111

0

110

0

111

011 ),(

),(

),(

),(

),(

),(),,,(

tt

ttt

t

ttt

ttt

ttt

ttt

tttt xud

xud

xud

xud

xud

xudxuxum


An efficiency change index value which is greater than 1 implies that the firms are operating closer to the frontier than in the previous time period, while if the index figure is less than 1, the bank in question is operating further below from the frontier. The other component, technical change (TC), indicates a shift in the frontier.

This can be affected by technology or also changes in the economic or regulatory environment. A technical change index value which is less than 1 means the frontier has shifted inwards, while a TC index value which is greater than 1 implies that the frontier has shifted outwards.

Again, this index is a relative measure intended to indicate any movement in the frontier. A TC value of 1 indicates a static frontier in the relevant time period.


The Malmquist index can be estimated as a function of a set of distance functions, which, in turn, can be estimated using DEA. This is a methodology proposed, again, by Fare et al (1997).

SFA is also used to estimate efficiency and productivity!

The index requires 4 DEA models to be estimated, which respectively spe cify

efficiency in the current time period, ),(0 ttt xud ; efficiency in the next time

period, ),( 111

0

ttt xud ; efficiency of a firm operating in this time period relative to

firms operating in the next time period, ),(10 ttt xud ; and the efficiency of firms

operating in the next time period relative to the frontier in this time period,

),( 110 ttt xud . The TFP index is then calculated using Equation (1), above.

Empirical Studies on Productivity and Efficiency

Numerous studies used DEA method to measure the efficiency of banks.

Some selection of studies is given below: Rangan et.al. (1988,90) used this approach by using

the data on 215 US banks.They break down the efficiency score into technical inefficiency (wasted resources) and scale inefficiency (non-constant return to scale). Bank output was measured with intermediation approach. The study showed the efficiency score of 0.7 implying 30% wastage, all due to technical inefficiency.

Field (1990) applied DEA to a cross section of 71 UK building societies in 1981. The results were that 80% were found to be inefficient due to scale inefficiencies. Unlike Rangan ((1988,90) bank size was positive with TE.


Some selection of studies is given below: Drake et.al. (1991) used DEA to building

societies in 1988 after deregulation in 1987. 37% of these societies showed increase in their overall efficiency.

Humphrey (1992) measured productivity and scale economies using flow and stock measures of banking output. He applied both non-parametric growth accounting procedure and an econometric estimation of cost function. A structural model of bank production was used which incorporated both the production of intermediate deposit outputs as well as final loan outputs. He obtained two measures of total factor productivity by using 202 US banks.


Some selection of studies is given below: Humphrey key findings were as follows:

Banking productivity had been flat (only 0.4% p.a. GR)

Real value of total assets: declined (the average TFP GR was –1.4% p.a)

The author identifies a number of possible reasons for decline in TFP.Some of these are:

Banks lost low cost deposit accounts, as corporate and retail customers switched to corporate cash management accounts and interest earning check accounts.

Economies of Scale and Scope

There is an extensive literature on the degree to which scale economies exist in banking.

The term economies of scale or scope are a long run concept when all the factor inputs, which contribute to a bank production process, can be varied.

Assuming all factor inputs are variable, bank is suitable to exhibit scale economies mean equi-proportionate increase in factor inputs yields a greater than equiproportionate increase in output or the banks are operating on the falling portion of their average cost curve.

Consider a bank with three factors of inputs capital (deposits), labour (the bank employee) and property in the form of branch network and 3 outputs like loans, investment and off balance sheet business .

Economies of Scale and Scope The economies of scale are said to exist if, as a

result of doubling each of three inputs, the bank is able to more than double its outputs.

Even this simple example is problematic in case of banks b/c all factor inputs are not variable. In short run it is really difficult to double inputs such as deposits.

Even if inputs are doubled and loans are doubled, then risk portfolio is bound to change, a critical important consideration for a bank wanted to maximize shareholder value added.

All this implies that it is really difficult to apply the concept of economies of scale in financial sector.

Hence it negates the underlying concept of mergers and acquisition on the basis of hope of economies of scale and scope.


Economies of scope exist if the joint production cost of producing two or more outputs is lower than if the products are produced separately.

For example a bank offers three services to customers (deposits, loans and payment services). Then, if a bank can supply these services more cheaply through a joint production process than producing and supplying them independently, it is said to be enjoying economies of scope.

From the strategic standpoint the question of whether or not economies of scale and scope are present in the banking is important.

Evidence of economies of scale will mean large banks have cost advantage over small one.

If cost complementries are present, multiproduct banks will be more efficient than the financial boutiques.


In term of empirical work, most of researcher uses cost function approach to measure SCALE and SCOPE economies i.e.

This more general model specification of cost function, which focuses upon scale economies and technological change, is specified as C(yit,wit,t):

mTm

3

1m

iTi

3

1i

2TTTmiim

3

1m

3

1i

nmmn

3

1n

3

1mmm

3

1m

jiij

3

1j

3

1iii

3

1ii

w~lnT

y~lnTT2/1Tw~lny~ln2/1

w~lnw~ln2/1w~ln

y~lny~ln2/1y~lnconst)Cln(

Economies of Scale and Scope Overall economies of scale are derived from

differentiating the translog cost function with respect to output.

Where MCi is the marginal cost with respect to the ith output and is the cost elasticity of the ith output. If OES >1, bank experiences diseconomies of scale, and increasing returns are apparent if OES<1. If OES=1 then, there is evidence of constant returns to scale.

Scope economies are said to be exist if: C(yit,wit,t)<[c(y1t,wit,t)+c(y2t,wit,t)+c(y3t,wit,t)]

iti

ititiiti

yln/Cln)t,w,y(C/MCyOES

Empirical Studies on Scale and Scope Economies in Banking

Empirical studies of economies of scale and scope in financial institutions showed mixed results.

USA studies Shaffer and David (1991) examined the question of

economies of scale for very large US multinational banks.

Traditional translog cost function with two and three factors was used with and without hedonic terms (qualitative factors). In the absence of hedonic terms they found evidence of scale economies.

In the translog equation with the hedonic terms included, scale was reduced from the level of without hedonic terms.

Empirical Studies on Scale and Scope Economies in Banking Humphrey (1992) obtained estimates of scale economies

for US banks. The author used flow measure of output. His study results suggested diseconomies of scale. However, when alternatives measures of output were

used, Humphrey found significant economies of scale for small banks, constant costs for medium sized banks and scale diseconomies in large banks.

This study however raised an important question. which measure of output should be used? The author suggested that stock measure was

more accurate than flow measure of output. The study overall results suggest there are slight

economies of scale for small banks, but slight diseconomies for large US banks.


Numerous US studies have tested for economies of scope in banking with mixed results.

Gilligan and Smirlock (1984) study supported the hypothesis of economies of scope.

Mester (1987) concluded there was no strong evidence to either support or refute the presence of economies of scope.

Lawrence (1989) found cost complementarities (economies of scope) to be present.

Hunter, Timme and Yang (1990) found no evidence to support the presence of cost complementarities.

Empirical Studies on Scale and Scope Economies in BankingBritish studies

Hardwick (1990) tested for scale and scope economies using UK building societies data.

The author employed multi-product statistical cost analysis.

He tested for overall and product specific economies of scale by using a marginal cost approach.

Overall economies of scale were found except for very large building societies. Significant diseconomies were found in the use of capital in large building societies. For small banks cost saving was attributable in the use of labour compared to capital.

Hardwick did not find evidence either for or against economies of scope for large building societies.


However, he found significant diseconomies of scope for building societies with assets worth £1.5 billion.

The results of the study virtually showed no case for diversification of building societies into broader banking market.

Drake (1992) using a multi-product translog cost function found evidence for economies of scale for medium sized banks.

He found no evidence to support the earlier Hardwick study of diseconomies of scale for building societies with assets in excess of £1.5 billion.

Nor did Drake find economies or diseconomies of scope for the building society industry except for the group with assets in the range of £500m-5 billion which showed significant diseconomies of scope.

Empirical Studies on Scale and Scope Economies in BankingEuropean studies Altunbas and Molyneux (1993) examined the cost structure in

four European countries (France, Germany, Italy and Spain). They found overall scale economies to exist in all four countries. Italy showed significant scale economies over all levels of

output. In Spain they were present only for smallest banks. France showed significant scale economies over a range of bank sizes. In Germany diseconomies of scale were found at all assets levels.

The presence of economies of scope results were mixed. In Spain significant economies of scope were evident for banks with assets of < $1.5 billion. In France it is middle sized banks which showed economies of scope. Diseconomies of scope were found for all Italian banks. In Germany, largest banks showed scope economies, smaller banks showed scale diseconomies.

Empirical Model of Competition in Banking

The Structure Conduct Performance (SCP) model

Since the Second World War, SCP model has been

popular in industrial economies.

Applied to the financial sector SCP says, “a change

in the market structure or concentration of banks

effects the way banks behave and performs”. There

is a well-developed link b/w structure, conduct and

performance.

Market structure is determined by the interaction of

cost (supply) and demand.


The Structure Conduct Performance (SCP) model

Conduct is a function of number of sellers and

buyers, barrier to entry and cost structure.

Conduct in a market is determined by market

structure that is number or size distribution

of banks in the market and the condition of

entry. The conduct in term, result in bank

taking decisions about prices, advertising etc.

The outcome is market performance

(profitability).


The Structure Conduct Performance (SCP)

model

In simple words less number of firms

(structure: high concentration), higher prices

(conduct) and higher profit (performance)

Thus conduct links market structure and

performance as:

Structure Conduct

Performance

Empirical model of competition in banking

The Efficient Market or Relative Efficiency model This model challenges the SCP approach. Some banks earn supernormal profit b/c they are more

efficient than others. This bank specific efficiency is exogenous and reflected in higher market share.

Therefore it is market share than concentration correlated with profit.

The relative efficiency model predicts the same positive profit concentration relationship as the SCP model.

However, the positive relationship is not explained by collusive behaviour in SCP case but greater efficiency and higher market share (and concentration).


According to SCP, concentration is exogenous,

resulting in higher prices for consumers and

higher bank profitability.

In the relative efficiency model however, ,

exogenous bank specific efficiencies results in

more concentrated markets b/c of market

dominance of these relatively efficient banks.

If the relative efficiency model is found to hold,

it would suggest markets are best left alone.

Empirical tests of SCP and Relative Efficiency in Banking

Berger and Hannan (1989) conducted the direct tests of SCP and relative efficiency models using the equation

rjit : the interest paid at time t on one category of retail deposits by bank i located in the local banking market, ji. CONSjt: a measure of concentration in local market j at time t. xijt: vector of control variables that may differ across banks, market or time periods; :error term.

If SCP hypothesis hold, < 0 (negative relation between concentration and deposit rate “the price of bank services”). If relative efficiency model is hold, then >0.

The results show that SCP hypothesis hold for their data.

ij tijj tij t txCONCr

ijt

Empirical Results of SCP and Relative Efficiency in Banking

Jackson (1992) key finding was that price is non-linear U shape over the relevant range and support the relative efficiency type model, where high level of market concentration signal the gaining of market share by the most efficient firm.

They found a negative for low concentration group and positive for high concentration.

In response to Jackson study Berger and Hannan concluded the price concentration relationship is negative for some range of concentration.

Molyneux Forbes (1993) tested the SCP and relative efficiency hypothesis using European data.

Their main finding was a significant positive concentration price relationship, but the market share variable was negative.

The authors concluded that the SCP hypothesis is supported by this European sample.

Contestable Banking Markets

Some empirical studies have considered the question of whether banking markets are contestable.

A contestable market is one in which existing firms are “vulnerable to hit and run” entry.

For this type of market to exist sunk costs should be largely absent.

Sunk costs is an economic term which means that cost which cannot be recovered if firms stop producing and leaves industry. Sunk cost is different to fixed cost.

Lot of banking experts believe that bank markets are contestable.

It implies new firms can enter the banking market, hit and then run (offering lower prices).

Empirical Studies on Contestable Banking Markets This has very important policy implication because it

implies that banks due to fear of hit and run feature of the market, will set the price according to marginal cost and consumer surplus will be maximised.

Shaffer (1982) used the Rosse-Panzer Statistics (RPS) to test for contestability in US banking. He concluded that banks in the sample behave neither as monopolists nor as perfect competitors in the long run.

In Nathan and Neave (1989), a similar methodology was applied for Canadian banking market.

Authors derived a positive but significantly different from both zero and unity RPS confirming the absence of monopoly power among Canadian banks and trust companies.

Empirical Studies on Contestable Banking Markets

Nathan and Neave concluded that their results were consistent with a banking structure exhibiting some features of monopolistic, contestable competition.

Molyneux, Lloyd, Williams and Thornton (1994) tested for contestability in German, British, French, Italian and Spanish markets

The authors found the RPS for Germany, the UK, France and Spain, to be positive and significantly different from zero and unity.

Their conclusion was that in these markets, commercial bank revenues behaved as if they were earned under monopolistic competition. For Italy, the authors could not reject a hypothesis of monopoly.

Pricing Non-Price Characteristics in Banking

Non-price characteristics are an important feature of modern day banking

Some of these characteristics are: Number of ATM machine Number of branches Interest paid monthly, quarterly, biannually or

annually Maximum withdrawal limits Minimum investment limits Insurance on loans Security on loans Checking accounts facility and guarantees


Some characteristics are positive and some are negative Nominal interest rate paid by/to customers may be low or high

compared with actual interest rate Questions is how banks price these characteristics and is it

possible to measure it and further how interest on deposits and loans are adjusted by banks

To do this type of analysis, one needs series on interest rate on deposits and loans and non-price characteristics attached to these deposits and loans

To compute interest equivalence of the non-price features of bank products, product interest rate is regressed on market interest rate (usually LIBOR: £ London Interbank Offer Rate). LIBOR is used in levels as well as with lagged. Non price features comes as a regressors in the equation

Statistically significantly variables are identified through such regression


Hefferenan (1992) used the following equation to estimate the interest equivalence of banks non-price characteristics of major British retail banks and building societies.

r = + ixi + coLIBOR + ciLIBOR-i + eTT+Ui

r= rate of interest offered/levied on deposits/loansxi: banks non-price characteristics LIBOR: 3 months £ London Interbank Offer RateLIBOR-i: LIBOR lagged by i, i=0,1,2…TT: Time trendUi: error term


For deposits products, negative and significant coefficients on non price characteristics is an indication of less interest is being paid in presence of these characteristics

For loans positive and statistically significant coefficients means customers are being charged more compared to competitive rate due to other non-price characteristics

Case Study: See British Retail Banking

Testing price discrimination in Banking

When a bank practice price discrimination, it offers same product at different prices to different customers

Price discrimination is possible when bank is able to separate customers to their different price elasticities of demand

But precondition of price discrimination in banking is that customers are being offered same product at different prices

Testing of price discrimination is done through adjusting for non-price features of the product.

Once done, then it becomes possible to compare the difference between ordinary products prices and the products where price discrimination is thought to be happening

In banking jargon, in the absence of price discrimination, price paid on ordinary accounts should be equal to special accounts

Testing Price Discrimination in Banking

Hefferan (1992) used the following relationship to calculate the magnitude of price discrimination in new products in British retail banking (High interest deposits and High interest checking accounts compare to traditional 7 Day Accounts).

The author used the following relationshipPDj= ADJINTj-7DAY/BASIC ACCOUNTS

Where, PDj= Price discrimination by bank j; ADJINTj= net interest paid by a bank on deposits adjusted for non price features; 7DAY/BASIC ACCOUNTS- the traditional 7-DAY or basic accounts interest paid

If PDJ > 0: New products customers are being discriminated positively. IF PDj < 0: New products customers are being discriminated negatively

Case Study: British Retail Banking

Measurement of Degree of Imperfect Competition in Banking If one knows from H-statistics that banking market in the

country is subject to imperfect competition, next step is to find how much retails banking in the country deviate from a perfectively competitive market

How much is the influence of individual banks on price setting

In simple words finding which bank is not giving a good deal to customers for deposits and loans and how much is rip-off (bad deal: loss).

To answer these questions a generalized linear pricing model is used

Heffernan (1992) used the following model to find out the degree of imperfect competition in British retail banking

INTi= a0+ajDj+bk[LIBOR-k]+cFIRMS+dMOS+eTT+Ui

Measurement of Degree of Imperfect Competition in Banking

INTi= a0+ajDj+bk[LIBOR-k]+cFIRMS+dMOS+eTT+Ui1. INTi: interest paid/received on deposits/loans2. LIBOR: 3 months £ London Interbank Offer Rate3. LIBOR-k: 3 months £ London Interbank Offer Rate

lagged by say 0,1,2 months4. FIRMS: Number of firms in sample (industry)5. MOS: Number of months since product was introduced6. TT: Time trend

Sum of LIBOR coefficients will give an indication of deviation from perfect competition

It can also give the value of rip-off/ bargain to customers Case Study: British Retail Banking

BANKING STRUCTURES- BY COUNTRY

Stylised Facts

• Table 1-2: Top 10 bks (by assets and/or tier 1 K)

• Top position has gone to Japan or the US since ‘69.

• Major differences in US/UK structures

• UK bks (’02): £2.5 tn in assets (with foreign: £4.7 tn);

• US bks (’04): $9.7 tn - note differences in distribution.

Table 1-2: Top 10 Banks, 1999-05(2005 Added)

1969Assets

1994Assets

1997Assets

1997Tier 1 capital

2002Tier 1 capital

2002Assets

2004 Tier 1 capital

2004Assets

2005Tier 1 K

2005Assets

USA 7 1 0 3 3 2 3 1 3 3

Japan 0 6 6 3 3 3 3 3 2 2

UK 1 1 1 1 1 1 2 2 3 3

France 1 1 1 1 1 1 2 2 2 2

Germany 0 0 1 1 1 0 0 1 0 0

Netherlands

0 0 0 1 0 2 0 0 0 0

Switzerland

1 0 0 0 0 1 0 1 0 0

China 0 1 1 0 1 0 0 0 0 0

BANKING STRUCTURES- Types of Banking

Universal Banking - the German hausbank One legal entity (though it can have subsidiaries)

Investment, wholesale, retail banking services.

Non-banking fin. services (e.g. insurance, consultancy).

Links between banking & commerce. E.G. Deutsche Bank, DresdnerRestricted Universal: different variations E.G. each part legally separate and individually capitalised; no significant cross-shareholdings

Structure-Commercial & Investment Banks

Terms originated in US due to regulation.

Commercial bks: 1933-99: restricted to wholesale&retail banking

• Wholesale banking: core services for large customers, e.g.: big corporations and governments. Most US commercial banks also have retail customers.

• Retail banking: core banking services to numerous personal customers and SMEs. High volume, small accts. Largely intra-bank and domestic.

BUT• In 1987, allowed “section 20 subsidiaries” to underwrite corporate debt and equities

Banking Structure (continued)US Investment bks: for a fee: (a) Underwrite bond/equity issues to raise capital for large

corporations and government (b) arrange mergers and acquisitions.

Modern US Inv. Bks: as above plus: trading: equities, fixed income (bonds), proprietary fund management consultancy global custody

UK Merchant bks: now very similar to investment banks

Q: Is an investment bank a “bank”?

Banking Structure (continued)US Investment Bks and Conflict of Interest

Issue: bk analysts: not a profit centre. •IBDs: inv. bk divisions: underwrite primary/secondary issues; provide other services – is profit centre Accusation: analysts talk up the share prices of IBD’s clients.• Investigation: initiated in 11/02 by NY AG- Spitzer - began at ML; widened to include others. • Settlement: 4/03 - 10 Inv bks to pay $1.4 bn: penalties, investor compensation, independent research body, firewalls, etc.

Banking Structure (continued)

UK Investment Bks and Conflict of Interest (FSA)• No specific accusations of bias.

• Inst. Investors play a more dominant role in the UK.

• BUT: the UK market has the same firms; also: corporate finance or equity brokerage parts of an IB generate revenue: underwriting/advisory/brokerage fees.• US: “prescriptive”/ UK: “principles”.


UK Investment Bks - Sources of Conflict of Interest:(1) If analysts involved/influence other functions in the IBDE.G.- Analysts’ reports “altered” to improve IPO outcome- Analysts pressured to issue more buy/sell rather than hold recommendations to increase trading in shares of a particular firm.

FSA (2002) study: Proportion of buy recommendations made by IBs providing both analysts reports on a company AND acting as corporate brokers/advisors to that company (FTSE 100) was double that of independent corporate brokers.


UK Investment Bks - Sources of Conflict of Interest:

(2) Remuneration of analystsE.G. Analysts salaries are dependent on generating IBD revenues

(3) Analysts or IBD hold shares themselves: temptation to issue reports to boost the share price; the opposite if planning to buy a stock. Covered by FSA’s code of conduct and conduct of business rules.


UK Investment Bks - Sources of Conflict of Interest:

(4) Relations between IB and companies: E.G. firm threatens to take CF business elsewhere, OR Vice-Versa: IB will withdraw research coverage of a firm unless they get the business.

(5) If “Chinese walls” ineffective: analyst may use info from CF or trading & sales not yet in public domain. Covered by insider trading laws, Conduct of Business, and Code of Market Conduct.

Central Banking

The term 'central bank' normally refers to a state institution with responsibility for

(1) Monetary control, and possibly:

(2) Prudential control, and/or

(3) Government Debt Placement

This part of the banking lectures considers these 3 functions.

(1) Monetary Control

Monetary control: the stabilisation of the price level, or controlling inflation. Money supply: currency in circulation + deposits held at bks.

Simple monetary model

P = MS - y, where: P: rate of inflation: rate of change in p level over time MS: the rate of growth in the money supply y : the rate of growth of real output (e.g. real GNP)

TRADITIONAL methods include:

• Control of the MS/monetary targets: see inflation equation

• Reserve ratios: require banks to hold deposits (that may/may not earn interest) as reserves at central bank. Increasing the reserve ratio takes money out of circulation - MS

• Open Money Market Operations

CURRENT METHOD of Monetary Control

Central bank: - Raises or lowers interest rates used to lend to banks, which, in turn, raises or lowers aggregate demand, and through it the rate of inflation.

-Some (developed) countries also use monetary targets: more the exception than the rule.

(2) Prudential Control

To protect the economy from the effects of a financial crisis: periods of excessive volatility in the financial markets, resulting in problems of illiquidity/insolvency among financial firms - especially banks.

Why worry?:

1. A widespread banking collapse - rapid decline/withdrawal of bank core services- inefficient allocation of resources.

2. Falling MS: macro effects

Suppose customers are concerned about the ability of a bank to meet their liquidity demands: as a result of a rumour a bank becomes, increasingly illiquid:

• The bank soon runs out of cash (due to fractional reserve lending)

• Contagion sets in:

(1) asymmetric info means clients/investors unable to judge which bks are healthy

(2) runs on bks reduce their value: agents will want to liquidate before this happens.

All deposit taking bks : subject to runs - face illiquidity.

• As a core service, a problem of illiquidity soon becomes one of insolvency (liabilities>assets)

Financial System Collapse?

• Yes, if enough banks fail, because the core banking services: intermediation, liquidity, payments system - no longer available.

Systemic risk: risk of a collapse in the financial system

Thus, governments treat banks as special: The central bank can:

• Act as Lender of Last Resort: central bank supplies liquidity to solvent but illiquid banks.

OR

• Launch a Lifeboat Rescue

Problem: Moral Hazard

Inevitable if private banks know they will be bailed out. Response: take higher risks, especially if the bank encounters difficulties - “goes for broke”

Moral hazard (and bks’ contributory role to systemic collapse) result in close regulation: prudential regulation.

Increasingly, the regulatory function is being removed from central banks. E.G. UK: The Financial Services Authority (FSA): regulates/supervises ALL financial institutions.

(3) Government Debt Placement

(does not normally apply to central bks: developed world)

Central bk: expected to place govt debt on favourable terms.

Raises seigniorage income through:• A reserve ratio: bks deposit reserves at central bank - an implicit bk tax if no interest is paid.

• Issuing new currency at a rate of exchange that effectively lowers the value of old notes.

• Liberal monetary policy: inflation reduces the real value of debt

Issue 1: Potential Conflict of Interest - (1) and (2)

Issue: Supervision/Lender of Last Resort: MAY conflict with goal of price stabilisation/monetary control.

Many countries assign function (2) to another government body - UK, Australia, Canada, China, the EU, Japan (?). NOT the US.

Goodhart & Schoenmaker (1995): Sample: 26 countries. No evidence to support separation or combination of 3 functions.

Issue 2: Independence of Central Bk from Government

• Politicians have a short time horizon AND

• Govts: conflicting objectives: unemployment, commitment to a fixed/managed exchange rate regime.

BUT

• Many years to build a credible reputation for price stability.

• UK, Japan: granted some “independence” to their central banks E.G. UK:. Treasury appoints/approves all the members of the Monetary Policy Committee.

SUMMARY:LINK BETWEEN BANKS & CENTRAL BANK

• Central banks: responsible for price (and financial) stability.

• The MS is linked with inflation: banks (via deposits) hold the MS

• MS affected by fractional reserve lending: if banks lend more, the MS increases

• Central banks can reduce bank activity through, for e.g, reserve ratios (a potential tax on banks)

• Runs on banks can quickly reduce liquidity and add to instability unless the central bank intervenes.

economics of banking and money (ecobam) yaseen ghulam email:...

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