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Financial Institutions & Services – Week 3

Presented By David Kilgour

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Learning Objectives

On completion of this week students should be able to understand:

• the classification of banks and their main roles;• contemporary retail banking;• the main functions, assets and liabilities of

retail banks;• the conflict within banks between liquidity and

profitability;• the main aspects of banking regulation and

capital adequacy.

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Classification of Banks

• Understanding the classification of deposit-taking institutions is essential in order to appreciate the role of individual banks.

• The development and contemporary role of banks enable us to understand the functions of such institutions.

• By examining the assets and liabilities on a bank’s balance sheet it is possible to see the continuous conflict between liquidity and profitability objectives within such organisations.

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• primary and secondary banks;• unit and branch banking;• functions of banks;• deposits, capital, investments and

advances;• bank regulation and the

international capital accord

Covered in this note

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UK Retail Banks

•A bank is a business that provides banking services for profit. •Traditional banking services include receiving deposits of money, lending money and processing transactions. •Some banks (called Banks of Issue) issue banknotes as legal tender –RBS & HBOS•The word ‘bank’ is derived from the Italian word ‘banco’ meaning table (which is derived from a Germanic language and means

bench ) at which Italian money lenders used to conduct business in the Middle Ages (1200−1500AD) - Money lenders in Northern Italy originally did business in open areas, or big open rooms, with each lender working from his own bench or table.

•These banks operate large branch networks and are prepared to deal in small and large sums of money.

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Wholesale Banks

• In the main, wholesale banks do not operate branch networks. They deal in large sums of money and operate in London’s money markets.

• An alternative approach is to classify banks on the basis of their balance sheets according to the kind of deposits they accept. This approach divides banks into primary and secondary banks.

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Primary Banks

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

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Secondary Banks

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

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

The Banking Acts

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The Banking Act 1979

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

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Liquidity versus Profitability

• As operators of the payments systems, the clearing banks cannot allow their liquidity to fall too low, even though liquid assets offer a poor return.

• The more the banks lend, the more interest and profits they can make.

• This pursuit of profit conflicts with the need for liquidity since the most profitable loans tend to be the

least liquid.• As liquidity decreases, profitability increases

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CAPITAL ADEQUACY

Capital must be adequate because a bank’s assets are subject to risks of depreciation in value from three main factors:

• CREDIT RISK − the possibility of outright or partial default by borrowers on the total loan amount (the use of collateral can reduce such losses).

• INVESTMENT RISK − the possibility that assets will depreciate in value, involving the bank in a capital loss.

• FORCED SALE RISK − this occurs when a bank is forced to sell an asset at a time when its market value is less than it appears in the bank’s books.

http://en.wikipedia.org/wiki/Reserve_requirement

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Financial Services Authority (FSA)

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

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

• The Act also made the FSA responsible for regulating mortgage advice and monitoring various codes of conduct.

FSA

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References - Web

Top ten banking groups in the world ranked by tier 1 capital

Figures in U.S. dollars, and as at end-2005

1. Citigroup — 79 billion

2. HSBC — 75 billion

3. Bank of America — 73 billion

4. JP Morgan Chase — 72 billion

5. Mitsubishi UFJ Financial Group — 64 billion

6. Credit Agricole Group — 60 billion

7. Royal Bank of Scotland — 48 billion

8. Sumitomo Mitsui Financial Group — 40 billion

9. Mizuho Financial Group — 39 billion

10. Santander Central Hispano — 38 billion

http://www.economist.com/markets/indicators/displaystory.cfm?story_id=7141354

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Top ten banking groups in the world ranked by assets

Figures in U.S. dollars, and as at end-2004

1. UBS — 1,533 billion

2. Citigroup — 1,484 billion

3. Mizuho Financial Group — 1,296 billion

4. HSBC Holdings — 1,277 billion

5. Crédit Agricole — 1,243 billion

6. BNP Paribas — 1,234 billion

7. JPMorgan Chase & Co. — 1,157 billion

8. Deutsche Bank — 1,144 billion

9. Royal Bank of Scotland — 1,119 billion

10. Bank of America — 1,110 billion

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Top ten bank holding companies in the world ranked by profit

Figures in U.S. dollars, and as 2003

1. Citigroup — 21 billion

2. Bank of America — 15 billion

3. HSBC — 10 billion

4. Royal Bank of Scotland — 8 billion

5. Wells Fargo — 7 billion

6. JP Morgan Chase — 7 billion

7. UBS AG — 6 billion

8. Wachovia — 5 billion

9. Morgan Stanley — 5 billion

10. Merrill Lynch — 4 billion http://www.euromoney.com/article.asp?ArticleID=1079885