principle of banking

Principles of bankingEconomics, Management, Financeand the Social Sciences

2000 2790094

M. Buckle, J. Thompson

EXTER N A L P R O G R A M

M E

This guide was prepared for the University of London by:

M. Buckle, MSc, PhD, Senior Lecturer in Finance, European BusinessManagement School, University of Wales, Swansea

J. Thompson, Emeritus Professor of Finance, Liverpool John Moores University.

This is one of a series of subject guides published by the University. We regret thatdue to pressure of work the authors are unable to enter into any correspondencerelating to, or arising from, the guide. If you have any comments on this subjectguide, favourable or unfavourable, please use the form at the back of this guide.

The External Programme

Publications OfficeUniversity of London34 Tavistock SquareLondon WC1H 9EZUnited Kingdom

Web site: www.londonexternal.ac.uk

Published by: University of London Press

© University of London 2000

Reprinted 2003

Printed by: Central Printing Service, University of London, England

This subject guide is for the use of University of London External students registeredfor programmes in the fields of Economics, Management, Finance and the SocialSciences (as applicable). The programmes currently available in these subject areas are:

Access route

Diploma in Economics

BSc Accounting and Finance

BSc Accounting with Law/Law with Accounting

BSc Banking and Finance

BSc Business

BSc Development and Economics

BSc Economics

BSc Economics and Management

BSc Information Systems and Management

BSc Management

BSc Management with Law/Law with Management

BSc Politics and International Relations

BSc Sociology.

i

Contents

ContentsIntroduction ..............................................................................................................1

The subject ................................................................................................................1How to use this subject guide ....................................................................................1Essential reading ........................................................................................................2Further reading ..........................................................................................................2Format of the examination ........................................................................................3How to use this subject guide ....................................................................................3

Chapter 1: Introduction to the financial system ....................................................5Essential reading ........................................................................................................5Further reading ..........................................................................................................5Introduction ................................................................................................................5The role of the financial system ................................................................................5The nature of financial claims ..................................................................................6The structure of financial markets ............................................................................9Financial system accounting ....................................................................................10Learning outcomes ..................................................................................................11Sample examination questions ................................................................................12

Chapter 2: Financial intermediation ....................................................................13Essential reading ......................................................................................................13Further reading ........................................................................................................13Introduction ..............................................................................................................13The nature of financial intermediation ....................................................................13The process of financial intermediation ..................................................................16The implications of financial intermediation ..........................................................18What is the future for financial intermediaries? ....................................................20Learning outcomes ..................................................................................................21Sample examination questions ................................................................................21

Chapter 3: Retail banking ....................................................................................23Essential reading ......................................................................................................23Further reading ........................................................................................................23Introduction ..............................................................................................................23What is retail banking? ............................................................................................23What services and products do retail banks provide? ............................................25Joint provision of intermediation and payments services ......................................29Competition in retail banking ..................................................................................29Future developments in retail banking ....................................................................30Learning outcomes ..................................................................................................32Sample examination questions ................................................................................32

Chapter 4: Wholesale and international banking ..............................................33Essential reading ......................................................................................................33Further reading ........................................................................................................33Introduction ..............................................................................................................33Wholesale banking ..................................................................................................33Certificates of deposits ............................................................................................35Rollover credits ........................................................................................................35

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Principles of banking

Matching and liquidity in wholesale banking ........................................................35Off-balance-sheet business ......................................................................................37International banking ..............................................................................................39Sovereign lending ....................................................................................................40Learning outcomes ..................................................................................................41Sample examination questions ................................................................................41

Chapter 5: Financial markets ................................................................................43Essential reading ......................................................................................................43Further reading ........................................................................................................43Introduction ..............................................................................................................43London as a financial centre ....................................................................................44The functions of markets ........................................................................................45The efficient markets hypothesis (EMH) ................................................................46Learning outcomes ..................................................................................................49Sample examination questions ................................................................................49

Chapter 6: The foreign exchange market ............................................................51Essential reading ......................................................................................................51Further reading ........................................................................................................51Introduction ..............................................................................................................51Quotation of exchange rates ....................................................................................51Key relationships within exchange rate theory ......................................................52The nature of the foreign exchange markets ..........................................................54Relationship between foreign exchange markets and eurocurrency markets ........55Speculation in foreign exchange markets ..............................................................55The efficiency of the forex ......................................................................................56Learning outcomes ..................................................................................................57Sample examination questions ................................................................................57

Chapter 7: Euro-securities markets ......................................................................59Essential reading ......................................................................................................59Further reading ........................................................................................................59Introduction ..............................................................................................................59Eurobonds ................................................................................................................59Reasons for the growth of eurocurrency markets ..................................................60Euronotes ..................................................................................................................62Euro-equities ............................................................................................................63Disintermediation ....................................................................................................63Learning outcomes ..................................................................................................64Sample examination questions ................................................................................64

Chapter 8: Derivatives and risk management ....................................................65Essential reading ......................................................................................................65Further reading ........................................................................................................65Introduction ..............................................................................................................65The nature of risk ....................................................................................................65Types of derivatives ................................................................................................67Financial futures ......................................................................................................68Options ....................................................................................................................69Forward rate agreements (FRAs) ............................................................................71Swaps ......................................................................................................................71Managing risk ..........................................................................................................72Learning outcomes ..................................................................................................74Sample examination questions ................................................................................74

iii

Contents

Chapter 9: Regulation of banks ............................................................................75Essential reading ......................................................................................................75Further reading ........................................................................................................75Introduction ..............................................................................................................75Free banking ............................................................................................................75The risks faced by banks ........................................................................................76Arguments for bank regulation ................................................................................77Costs of regulation ..................................................................................................78How are banks regulated? ......................................................................................78Disclosure-based regulation of banking ..................................................................81International harmonisation of banking regulation ................................................82Learning outcomes ..................................................................................................83Sample examination questions ................................................................................83

Chapter 10: Banking structures around the world ............................................85Essential reading ......................................................................................................85Introduction ..............................................................................................................85Banking in industrialised countries ........................................................................85Banking structures in developing countries ............................................................87Financial crises in developing countries ................................................................88Learning outcomes ..................................................................................................89Sample examination questions ................................................................................90


iv

Notes

1

Introduction

Introduction

The subjectPrinciples of banking is a compulsory foundation unit for the BSc. Banking andFinance degree. Our aim in this subject is to introduce you to the nature of bankingand the main financial markets in which banks operate. This is an important subject asit establishes many of the fundamental concepts and ideas which will be developed inlater subjects in the degree, in particular, the intermediate unit of Banking operationsand risk management.

The kind of issues you will study in this subject are:

• Why do banks exist?

• Why is banking so heavily regulated?

• What are the essential differences between retail and wholesale banking?

• How does the structure of the banking industry differ between different countries?

• How can the derivative markets be used by banks and their customers to managefinancial risk?

Many exciting changes are taking place in banking and financial markets. Theinternet, and other developments in information technology are changing the nature ofbanking. New derivative products offer new possibilities for managing financial riskas well as bringing new risks for users. After studying this course, not only will yoube better prepared for studying the intermediate and advanced courses in the degree ofBanking and Finance but you will also have gained knowledge and insight which willhelp you make sense of many of the developments affecting banking and financialmarkets that you read about in newspapers or see on television.

How to use this subject guideThis subject guide is written for those of you studying Principles of banking. Theaim is to help you interpret the syllabus. It tells you what you are expected to knowfor each area of the syllabus and suggests the reading which will help you understandthe material. It needs to be emphasised that this guide is intended to supplement therelevant texts, not replace them.

A different chapter is devoted to each major section of the syllabus and the chapterorder of this guide follows the order of the topics as they appear in the syllabus.

It is important to appreciate that the different topics are not self-contained. There is adegree of overlap between the topics and you are guided in this through cross-referencing between different chapters in the guide. For example, there is a significantoverlap between the topics of retail banking and wholesale banking and between boththese topics and the regulation of banks. Both retail and wholesale banks face similarrisks in their operations, which they have to manage. The regulator of the bankingsystem is also concerned with ensuring that banks manage these risks so as tominimise the risk of bank failure. However, in terms of studying this subject thechapters of this guide are designed as self-contained units of study but forexamination purposes you need to have an understanding of the subject as a whole.

Essential readingOne textbook covers approximately 90 per cent of this syllabus and this book is:

Buckle, M. and J.L. Thompson The UK Financial System. (Manchester University

Press, 1998) third edition [ISBN: 0-7190-5412-5].

You will be referred to specific sections and tables in this book throughout this guideand therefore you need to have access to a copy when you are using the guide. It istherefore recommended that you purchase a copy.

This recommended text does not cover all of the last topic of the syllabus: bankingstructure around the world. The essential reading for this topic also includes:

Hefferman, S. Modern Banking in Theory and Practice. (John Wiley, 1996)

[ISBN: 0-471-96209-0].

and

Mishkin, F.S. and S.G. Eakins Financial Markets and Institutions. (Addison-Wesley,

1998) second edition [ISBN 0-321-01465-0].

For most of the chapters additional reading is suggested. These are other books andjournal articles. This additional reading will contain information and analysis notcontained in the main text which may help you further understand some of the topicsin this subject. It is not essential that you read this material but will be helpful if youdo so. A full bibliography of the additional reading is provided below:

Further reading

Bain, A.D. The Economics of the Financial System. (Blackwell, 1992) second edition

[ISBN: 0-631-18197-0].

Brearley, R., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance.

(McGraw-Hill, 1995) [ISBN 0-07-113853-6].

Copeland, L.S. Exchange rates and international finance. (Addison-Wesley, 1994)

second edition [ISBN: 0-201-62429-X].

Davis, P. ‘The Eurobond market’ in Cobham, D. (ed.) Markets and Dealers: The

Economics of the London Financial Markets. (Longman, 1992)

[ISBN 0-582-07853-2].

Dow, S ‘Why the banking system should be regulated’, Economic Journal (1996), 106:

698–707.

Dowd, K ‘The case for financial laissez-faire’, Economic Journal (1996), 106:

679–687.

Gosling, P. Financial Services in the Digital Age: The future of banking, finance and

insurance. (Bowerdean Publishing Company Ltd, 1996) [ISBN: 0-906097-54-1].

Hefferman, S. Modern Banking in Theory and Practice. (John Wiley, 1996)

[ISBN: 0-471-96209-0].

Howells, P. and K. Bain The Economics of Money, Banking and Finance. (Harlow:

Longman, 1998) [ISBN 0-582-27800-7].

Lewis, M.K. and Davis, K.T. Domestic and international banking. (Philip Allan, 1987)

[ISBN: 0-86003-144-6].

Mester, L. ‘What’s the point of credit scoring?’, Business Review, (Federal Reserve

Bank of Philadelphia) (September/October 1997).

Mishkin, F.S. and S.G. Eakins Financial Markets and Institutions. (Addison–Wesley,

1998) second edition [ISBN 0-321-01465-0].

Russell, S. ‘The government’s role in deposit insurance’, Federal Reserve Bank of St.

Louis Review (1993) 75: 3–9.

2


3

Introduction

Each chapter in the subject guide is split into two columns. The right hand columncontains the guidance on the subject matter of that topic. This will includesummaries and explanations of the main points and advice about what you areexpected (and not expected) to know. There are also boxes that contain questions oractivities which are designed to test your understanding of the material you have justread. The left-hand column contains references to the recommended reading,elaborations of points made in the right-hand column and cross-references to otherchapters of the guide where relevant.

Format of the examinationThe examination consists of 10 questions and you will be required to answer four ofthese questions. You will have three hours in which to complete the examination.

The questions will be mainly essay type questions. Examples of this type of questionare provided at the end of each chapter of this subject guide. You may find thefollowing suggestions helpful when it comes to sitting the examination:

1. Read the questions carefully. Make sure you understand the meaning of a question.

2. For essay-type questions it is helpful to prepare a brief plan of your essay. Thisshould set out the main issues you want to discuss and the order of the discussion.A sample plan is provided at the end of Chapter 2 of this guide.

3. Remember that the examination lasts for three hours and you have to answer fourquestions giving you 45 minutes per question. Make sure that you keep to thistime limit for each question so you are not rushing to complete your fourth essay.

4. Each essay should begin with an introduction which sets out the aims of the essay.The essay should also end with a conclusion which brings together the mainpoints you make through the essay. The conclusion generally should not introducenew points.

The examiners will be looking for answers that are clearly expressed, relevant to thequestion and where applicable, contain relevant examples that demonstrate thecandidate understands the material. Answers that contain a large amount of irrelevantmaterial are likely to be given a fail mark. Answers that are simply a repeat of thesubject guide material, in a relevant way, may achieve a bare pass. Answers that showoriginality of thought and a clear understanding of the material will be rewarded witha good mark.

How to use this subject guideI suggest that for each topic in the syllabus you first read through the whole of thechapter in this guide to get an overview of the material to be covered. Then re-read itfollowing up the suggestions for reading in the main or additional texts and answeringthe activity questions. At the end of each chapter you will find a checklist of the mainpoints that you should understand having covered the material in that topic. If you feelthere are points that you do not understand then re-work the material as it is importantthat you fully understand each section of the syllabus before moving on to the next.Use the sample questions at the end of each chapter to test your understanding.

We hope that you find your study of the Principles of banking interesting andenjoyable. Good luck!


4

Notes

5

Chapter 1: Introduction to the financial system

Chapter 1

Introduction to the financialsystem

Essential reading


Press, 1998) third edition [ISBN: 0-7190-5412-5] Chapter 1.

Further reading

Brearley, R., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance.

(McGraw-Hill, 1995) [ISBN 0-07-113853-6] Chapter 9.


Longman, 1998) [ISBN 0-582-27800-7] Chapter 1.


1998) second edition [ISBN 0-321-01465-0] Chapter 2.

IntroductionIn this chapter we investigate three things.

• Firstly, we look at the role of a financial system in a modern economy, using asimple circular flow mode.

• Secondly, we examine the nature of the main financial claims in existence,focusing on the attributes or characteristics of those claims.

• Finally, we examine the main financial accounting systems for an economy. Theseare sector balance sheets which show the stocks of physical and financial assetsand liabilities in existence at a point in time, and financial transaction accountswhich show the financial transactions that take place between different sectors ofan economy over a period of time.

The role of the financial systemThis chapter commences by examining the role of the financial system in acting as alubricant to the real economy. You should understand the simple model of theeconomy presented in figure 1.1 below and how finance helps the operation of thissimple financial system. The inner flows are real flows and in the absence of money,households would need to undertake barter to satisfy all their wants. Note the problemof ‘double coincidence of wants’ in the practice of barter. In other words, a bartersystem is dependent on finding someone who has the goods you want and who wantsthe goods you are trying to exchange. To understand this point, consider how youwould be paid your salary/grant if a system of barter existed in the activities in whichyou are involved. The middle flows represent the introduction of money into theeconomy. Note that the introduction of money means that the act of sale can now beseparated from the act of purchase. Finally, the outer flows represent lending andborrowing transactions in the economy. The ability to borrow allows firms to invest inexcess of their current income. This clearly encourages economic development.

A financial system comprises financial institutions and financial markets. From figure1.1 we can discern some of the roles of a financial system. The main roles are:

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• to facilitate lending and borrowing (outer flows)

• to enable wealth holders to adjust the composition of their wealth (throughfinancial markets)

• to provide a payments mechanism (middle flows)

• to provide specialist services such as insurance and pensions.

Figure 1.1: A simple circular flow model of an economy

The nature of financial claims1

A financial claim is a claim to the payment of a sum of money at some future date ordates. Using Lancaster’s approach to consumer demand, financial claims can becategorised according to the various attributes of that claim. The term attributes, orcharacteristics, refers to the various features you would look for when making aninvestment decision (i.e. when deciding whether to purchase a financial claim). Thefollowing features are some of the attributes most commonly used when describing afinancial claim:

RiskThis refers to the uncertain future outcome of a financial claim. For example, thefuture price of a share is not known with certainty. Another example of financial riskis default risk. This refers to the risk of debt instrument (e.g. a loan) not being repaid.Other examples of financial risk are interest rate risk and exchange rate risk. Theserisks refer to the unpredictability of future interest rates or exchange rates.

As risk is a concept of fundamental importance in finance we will devote moreattention to this characteristic.2 Risk, in general terms, is a measure of the variationaround some average (expected) value. If an investor is considering whether to investin an ordinary share s/he needs a measure of the expected return on the share as wellas a measure of the variation around the expected return. This measure of variation isa measure of how far the actual return may differ from what we expect. Figure 1.2shows a typical distribution for historical returns on corporate bonds (see below for adescription of a bond).

Households Firms

Savings

Incomes (rent, wages, etc.)

Inputs of land, labour, etc.

Consumption of outputs

Payments for outputs

Issuance of financial claims

1The term financial instrument isalso used.

2Please read Brearley et al.(1995), Chapter 9 for a good

discussion of the nature of risk.

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Figure 1.2: A typical distribution of historical annual returns on corporate bonds

The average annual return on corporate bonds, according to the distribution presentedin figure 1.2, is six per cent. If we believe the future will be like the past the bestestimate of the expected return on corporate bonds next year is six per cent. This doesnot imply that the actual return next year will be six per cent. To provide a measure ofthe risk of the actual return being different from what we expect we normally use ameasure of the dispersion of the distribution: the variance or standard deviation. Thestandard deviation of a distribution of historica returns is a statistical measure of howvariable the returns have been around the average return. The higher the standarddeviation the greater the variability and hence the greater the risk that the actual returnin the future will be different from what we expect. This provides us with aquantitative measure of risk that we can use to compare the riskiness associated withdifferent securities.

The risk (as measured by the standard deviation of historical returns) and the return(as measured by the average return) for three different US financial instruments,calculated from annual data over the period 1926 to 1992 are presented in table 1.

Table 1: Risk and return for US financial instruments3

Average return (%) Standard deviation (%)

Treasury Bills 3.8 3.3

Corporate bonds 5.8 8.5

Common stocks 12.4 20.6

Table 1 clearly demonstrates a positive relationship between risk and return. Commonstocks (an equity instrument – see below) earned the highest average return but alsoexperienced the highest risk. Treasury bills (a money market instrument – see below)had the lowest risk but earned the holder the lowest return. The positive relationshipbetween risk and return exists because investors require compensation for bearingrisk. The higher the risk associated with a financial instrument, the higher the returnthey require to induce them to hold the asset.

-10 0 10 20 30% rate

of return

No. of years

20

15

10

5

3Source: ‘Historical returns onmajor asset classes, 1926-1992,’Stocks, Bonds and Inflation 1993Yearbook. (Ibbotson Associates)

(reported in Brearley, R., S.C.Myers and A.J. Marcus

Fundamentals of CorporateFinance. (McGraw-Hill, 1995)

[ISBN 0-07-113853-6].).

8


LiquidityLiquidity is the ease and speed with which a financial instrument can be turned intocash without loss. For example a bank deposit is easily and quickly turned into cashand so is seen as very liquid. However, a stock in a small company may not be easyto sell at short notice so is deemed to be illiquid.

Real value certaintyThis means the susceptibility to loss in value of the claim due to a rise in the generallevel of prices.

Expected returnFor many claims, such as a bank deposit, there is an explicit cash return to the holder.For claims where the return is not known with certainty in advance (i.e. there is anassociated risk) then it is expected return that is used.

Term to maturityThis refers to the remaining time to maturity for a financial instrument. At maturitythe instrument is repaid by the borrower. Term to maturity ranges from zero in thecase of bank deposits that are withdrawable on demand to instruments such as shareswhich have no maturity date.

These attributes or features are fully discussed in section 1.3 of Buckle and Thompson(1998), which should now be read carefully.

Activity

What is the relationship between:

1. liquidity and term to maturity and

2. liquidity and expected return?

Financial claims can be divided into two broad groups, debt and equity. A debtinstrument is a contractual arrangement whereby a borrower normally agrees to makeregular payments (interest payments) of a fixed amount until a specified date when thedebt matures. On maturity the amount borrowed is repaid. There are exceptions to thisgeneral definition. For example, a deposit contract may have no specified maturitydate (it may be repayable on demand). Examples of debt instruments are deposits,loans, bills and bonds.

DepositThis is a loan by an individual or company to a financial institution such as a bank.

LoanA loan is a sum of money lent, normally by a financial institution such as a bank, to acompany or individual.

BillA bill is a short-term paper claim issued by a company or government. The bill isbought by an investor at a discount to face value (i.e. at a price lower than facevalue). The issuer of the bill then pays the investor the face value at the maturity dateof the bill. The difference between the rate paid for the bill and its face valuerepresents an interest payment or return to the investor.

BondA claim that normally pays a fixed rate of interest (known as coupon payments) untilthe maturity date and then at the maturity date the issuer pays the holder the par value(face value) of the bond. Bonds are issued by governments and companies andrepresent a long-term debt instrument compared to bills which are short-term.

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The common feature of debt is that the amount is fixed; (e.g. a deposit of £140 at abank or the purchase of a £100 bond). This contrasts with equity (e.g. ordinary shares)where the value of the financial claim varies according to its market price.

EquityThis is a claim to a share in the net income and assets of a firm. Unlike with debt,firms are not contractually obliged to make regular payments to equity holders. Inyears when firms make sufficiently high profits then equity holders are paid adividend. Equity holders will rank lower than debt holders in a firm in the event ofliquidation. Equity holders are therefore regarded as the bearers of business risk.Finally, equity claims have no maturity date.

A number of differing types of these two categories of claims exist and these are alsodiscussed in section 1.3 of Buckle and Thompson (1998). You should study thisdiscussion carefully.

Activity

If a company wishes to raise long-term finance what kind of financial claims can it issue?

The structure of financial marketsWe have seen the distinction between debt and equity claims and therefore debt andequity markets, above. Other ways of classifying markets include separating them into:

1. primary and secondary markets and

2. money and capital markets.

Primary and secondary marketsA primary market is one in which the new issues of a security, both debt and equity,are sold to initial buyers. A secondary market is a financial market in which securitiesthat have been previously issued can be resold. Most trading in financial marketstakes place on secondary markets (as wealth holders adjust their portfolios), yet it isthe primary markets that facilitate the financing of investment projects by firms. Somecommentators on financial markets have argued that secondary market trading islargely irrelevant to the financing function of a financial system. However, theexistence of a secondary market for a financial claim enhances the liquidity of thatclaim. The enhanced liquidity of these claims makes them more desirable to investorsand therefore easier for the issuer to sell in the primary market. A secondary marketalso performs a role in setting the price of a primary market issue. That is, the price ofthe claims issued into the primary market (and hence the amount of capital raised bythe issue) will be partly determined by the price of similar claims traded in thesecondary market.

Money and capital marketsThe categorisation of financial markets into money and capital markets is essentiallybased on the maturity of the claims traded in each. A money market is a market whereshort-term debt instruments (maturity of less than one year) are traded. Moneymarkets are mainly wholesale markets (large size transactions) where firms andfinancial institutions manage their short-term liquidity needs. So a firm or bank withtemporary surplus funds would purchase a money market instrument to earn interest.In Chapter 3 of this subject guide we will examine how banks make use of moneymarkets to manage liquidity risk.

A capital market is a market for long-term financial instruments. These long-terminstruments include company shares, government bonds and corporate bonds.Company shares, as noted above, have a theoretically infinite life. Corporate andgovernment bonds are issued with initial maturities of between five and 30 years.

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Financial system accountingIn preparing accounts of the financial system it is useful to break down the totaleconomy into a series of sectors (i.e. disaggregate). This makes it easier to highlightthe salient features of the economy. Of course division of the economy into anexcessive number of sectors would not be helpful since the salient features would beobscured by excessive detail. The UK follows conventional practice by dividing theeconomy into five broad categories; namely the public sector, the personal sector, thefinancial sector, industrial and commercial companies and the overseas sector. Furthersubdivisions of categories are carried out and these are noted in section 1.4 of Buckleand Thompson, which you should now study.

Two separate sets of accounts can be prepared. The first shows the stock of wealthexisting at a particular point of time. The basis of this analysis is the ‘balance sheet’.The second type records the flow of funds between the various sectors over a periodof time. Clearly the two sets of accounts are closely connected since the changes in asector’s stocks of wealth between two points of time represent the flow of funds toand from that sector over the time period between the two points. Tables 1.3 to 1.6 inBuckle and Thompson (1998) provide details of the UK sectoral balance sheets at theend of 1996. You should be aware of the general features of the sectors as revealed bythese balance sheets. The key features are that:

• The sector with the largest net wealth is the personal sector.

• The industrial and commercial companies sector is a net debtor.

• The public sector shows a small net wealth.

• For the financial institutions sector, assets and liabilities balance each other, so netwealth is approximately zero.

The second type of account shows the sector financial transactions. This is perhapsthe more important of the two types of account examined in this section. Any sector’sfinancial transactions results from the excess/deficit of expenditure over income. Thusif the sector spends less than its income, it is saving. A sector’s saving can be used toinvest in fixed assets (e.g. houses, factories) or to acquire financial assets. Thedifference between a sector’s saving and investment is termed the financial balance.Where a sector saves more than it invests in a period then it has a financial surplus.The surplus can be used to acquire financial assets such as, for example, notes andcoins, bank deposits, shares or to pay off previous debt (i.e. reducing its liabilities).Conversely if there is an excess of investment over saving in a period then the sectorhas a financial deficit which must be financed by selling assets or borrowing. Thefinancial transactions accounts show the various financial transactions, which havebeen undertaken as a result of the financial surplus/deficit.

The convention of financial accounts is:

• A positive value implies an increase in financial assets or a decrease in financialliabilities (i.e. saving is greater than investment).

• A negative sign implies an increase in financial liabilities or a decrease in financialassets (i.e. investment is greater than saving).

The accounting rules underlying the construction of all financial accounts are:

• The sum of the financial surpluses and deficits equals zero, which reflects the fact thatthe financial assets of one sector are by definition the financial liabilities of another.

• The net financial transactions of a sector will equal its financial balance.

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• The sum of transactions in a particular financial instrument will equal zero. Thisagain follows from the fact that increased holdings of an asset of one sector willbe balanced by increased liabilities of another.

• The sum of saving across sectors, that is, for the economy, will equal the sum ofinvestment across sectors. In other words all saving will find its way into investment.

Section 1.6 in Buckle and Thompson (1998) provides an explanation of how suchaccounts are derived using a simple numerical example of a two-sector economy toillustrate the process. This simple example also demonstrates the difference betweenstocks and flows. The hypothetical balance sheet for households shown in tables 1.8and 1.9 (of Buckle and Thompson) show an increase in net wealth of £200 million(i.e. a change in stocks). This matches the saving (i.e. a flow) by households of £200million, shown in table 1.12. This example should be carefully studied as it assumesthe same format as the more complicated accounts prepared by government statisticsdepartments in different countries.

Activity

If the household sector had a saving of £300 million (instead of £200 million), in table

1.12 in Buckle and Thompson [1998] and the extra £100 million was used by households

to acquire an additional £100 million of equities and the additional funds raised by firms

was used to finance investment, rework the financial account matrix (table 1.12) using

these new figures and also construct the new balance sheet for the household sector and

the companies sector for the end of the period (tables 1.9 and 1.11).

Table 1.13 shows the UK accounts for the second quarter of 1997. You should be ableto interpret the figures shown in the rows and columns of this account – see section1.8 of Buckle and Thompson (1998) for examples of the explanation of the figurescontained in this account. If you experience difficulty in doing this, go back tostudying the simple illustrative example, as the two accounts are prepared on exactlythe same basis.

The various accounts provide a useful source of data for studying the portfoliobehaviour of the various sectors of the economy. They are, however, subject to theproblems listed below:

The figures are derived from a number of sources so the total of financial transactionsmay not equal the financial surplus/deficit for the sector concerned. Details of thenecessary ‘balancing item’ are shown in table 1.14.

Figures are published on a ‘net’ basis.

Learning outcomes

By the end of this chapter and the relevant reading you should be able to:

• Describe at an introductory level the role of money in an economy.

• Explain the nature of financial claims and their differing features which appeal to

agents with differing circumstances.

• Explain the main functions of a financial system.

• Explain the nature and construction of the sectoral balance sheets.

• Explain the nature and construction of financial transactions accounts.

• Interpret the information provided by financial transactions accounts.

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Sample examination questions

1. Discuss the drawbacks of barter.

2. Discuss the role of a financial system in an economy.

3. Describe the characteristics of the following financial claims using the list of

attributes provided in this chapter: CD (certificate of deposit), treasury bill, gilt

edged security, index-linked gilt-edged securities, a bond issued by ICI.

4. Why in sectoral balance sheets does the Companies Sector generally show

negative net worth and the personal sector positive net wealth? Does this suggest

that companies are a drain on an economy?

5. Using table 1.13 in Buckle and Thompson (1998)

a. Interpret line 21.1 (i.e. identify what each sector is doing in terms of

transactions in sterling bank deposits).

b. From which sectors did life assurance and pension funds raise most of their

funds during the second quarter of 1997?

c. Interpret lines 21.2, 21.4 and 24.1 to obtain a picture of banks’ foreign

currency operations.

13

Chapter 2: Financial intermediation

Chapter 2

Financial intermediation

Essential reading



Further reading

Bain, A.D. The Economics of the Financial System. (Blackwell, 1992) second edition

[ISBN: 0-631-18197-0] Chapters 3 and 4.

Heffernan, S. Modern Banking in Theory and Practice. (Wiley, 1996)

[ISBN 0-471-96209-0] Chapter 1.


1998) second edition [ISBN 0-321-01465-0] Chapter 12.

IntroductionIn this chapter we introduce the process of financial intermediation. We consider itsnature and explain why most lending/borrowing takes place through intermediariesrather than lenders lending directly to borrowers. In considering this issue we are alsoconsidering the fundamental reasons for the existence of banks. We identify theadvantages that institutions such as banks have which enable them to undertakeintermediation. However we also argue that traditional intermediation servicesprovided by banks have declined in many countries in recent years and banks havesought to maintain profits by expansion into other areas of business. We will examinethese other areas in more detail in later chapters of this subject guide.

The nature of financial intermediationIn Chapter 1 of this guide we showed that in developed economies decisions to investare often taken separately from decisions to save. A company planning to invest in anew production line may not be able to finance all the investment from his/her ownresources and will have to borrow some or all of the required funds. An individualwith surplus funds out of his/her current income may want to lend these funds inorder to obtain a return. It would therefore seem logical for the firm wanting toborrow funds to seek out the individual wanting to lend funds, and vice versa. Inpractice direct lending, like this, does not generally happen and instead funds arechannelled through a financial intermediary such as a bank. To illustrate this, figure2.1 shows the sources of external funds raised by UK non-financial firms over theperiod 1970–96. Note that most funds raised by firms are internally generated (i.e.retained profits). What this figure illustrates is the share of different sources of fundsraised externally.

14


Figure 2.1: Sources of external funds for UK non-financial firms for the period 1970–96

(Note: definitions of the items of external sources of funds are given in Buckle andThompson (1998) page 35)

You will see from figure 2.1 that bank loans (i.e. intermediated finance) are the mostimportant source of external funding for firms. Mishkin and Eakins (1998) report asimilar finding for the US, France, Germany and Japan. It should also be noted thatshares and bonds have become more important sources of finance over recent years.We leave a discussion of why this might be the case until the end of this chapter.

To ask the question why does most lending/borrowing take place through a financialintermediary is to also ask the question of why financial intermediaries exist. Thereare three main reasons why financial intermediaries exist:

1. different requirements of lenders and borrowers

2. transaction costs

3. problems arising out of information asymmetries.

We now cover each of these reasons in turn.

Different requirements of lenders and borrowersFirms borrowing funds to finance investment will tend to want to repay the borrowingover the expected life of the investment. In addition the claims issued by firms will behave a relatively high default risk reflecting the nature of business investment. Incontrast, lenders will generally be looking to hold assets which are relatively liquidand low-risk. To reconcile the conflicting requirements of lenders and borrowers afinancial intermediary will hold the long-term, high-risk claims of borrowers andfinance this by issuing liabilities, called deposits, which are highly liquid and havelow default risk. Figure 2.2 illustrates the role of a financial intermediary.

Loans Shares Bonds Other Overseas

%50

30

10

15


Figure 2.2: Illustration of intermediated and direct financing

Activity

If you wanted to lend money (i.e. acquire a financial asset) what characteristics would

you look for in the financial asset you hold).

Transaction costsThe presence of transaction costs makes it very difficult for a potential lender to findan appropriate borrower. There are four main types of transaction costs:

1. Search costs: both lender and borrower will incur costs of searching for, andfinding information about, a suitable counterparty.

2. Verification costs: lenders must verify the accuracy of the information provided byborrowers.

3. Monitoring costs: once a loan is created, the lender must monitor the activities ofthe borrower, in particular to identify if a payment date is missed.

4. Enforcement costs: the lender will need to ensure enforcement of the terms of thecontract, or recovery of the debt in the event of default.

Activity

Identify which of the four categories of costs described above are incurred when a

physical good, such as a car, is purchased. Hence identify which costs are usually only

incurred with financial transactions.

Asymmetric informationThis is an important concept in finance and needs to be fully understood. Asymmetricinformation refers to the situation where one party to a transaction has moreinformation than the other party. This is a problem with most types of transactions,not just financial, and a classic example is provided by the sale/purchase of a secondhand car. In this case the seller has more information about the condition of the carthan the buyer. This is likely to make the buyer reluctant to purchase the car unlesshe/she can obtain more information, perhaps from a mechanic’s inspection. In thecase of a financial transaction, the borrower will have more information about thepotential returns and risks of the investment project for which funds are being

Households Firms

Funds lent

Financialintermediary (bank)

Funds lent

Financial claim

Financial claim(deposit)

Financial claim(loan)

Funds lent

16


borrowed compared to the lender. The existence of asymmetric information createsproblems for the lender, both before the loan is made, at the verification stage (seeabove), and after, at the monitoring/enforcement stages.

The first problem created by asymmetric information occurs when the lender isselecting a potential borrower. Adverse selection can occur (i.e. a borrower who islikely to default – often referred to as a ‘bad risk’ – is selected) because the potentialborrowers, who are the ones most likely to produce an adverse outcome, are the onesmost likely to be selected. To understand the nature of adverse selection please readthe case of Sally and Anna in section 2.2.1 of Buckle and Thompson (1998) and thendo the following activity.

Activity

Why does the existence of asymmetric information mean that ‘good risks’, like Sally,

may not get loans.

The second problem that arises out of asymmetric information is moral hazard. This isa problem that occurs after the loan is made and refers to the risk that the borrowermight engage in activities that are undesirable (immoral) from the lenders point ofview, because they make it less likely that the loan is repaid. A person is more likelyto behave differently when using borrowed funds compared to when using their ownfunds. In particular they may take more risks with the funds. To understand the natureof moral hazard please read the case of Joe in section 2.2.1 of Buckle and Thompson(1998) and then undertake the following activity.

Activity

If you know that Joe is putting some of his own savings into the investment project are

you more likely to lend to him ?

The existence of transaction costs and information asymmetries are importantimpediments to well functioning financial markets. Although the existence of organisedmarkets where tradeable debt and equity instruments can be issued and acquired (i.e.the bond and equity markets) overcome some of these obstacles, there are stillsubstantial transaction costs and high-risk for the lender and the problems associatedwith asymmetric information cannot be fully overcome in this way. The solution tothese problems has been the emergence of financial intermediaries such as banks. Thesuccess of banks is shown in figure 2.1 above. We now turn to examine how financialintermediaries are able to reduce or eliminate the problems discussed above.

The process of financial intermediationIntermediaries transform assets

We saw above that borrowers want to issue claims with characteristics that aredifferent from those sought by lenders. A financial intermediary is able to hold thelong-term, high-risk, claims issued by borrowers and finance this by issuing depositclaims with the characteristics of low-risk and short-term (often repayable ondemand). The financial intermediary therefore transforms the characteristics of thefunds that pass through it. A financial intermediary is said to mismatch the maturity ofthe assets it holds with the maturity of the liabilities it issues. In other words afinancial intermediary will borrow funds that are short-term (deposits) and lend fundswith a longer term to maturity (loans).1 As well as transforming the maturity orliquidity of funds the intermediary will also transform other characteristics of thefunds, in particular, default risk2 and size. The financial intermediary achieves thisasset transformation by managing the associated risks. The risks associated withmaturity transformation are reduced by diversifying funding sources.3 The risks

1The intermediary is said to becreating liquidity.

2The risk that the interestpayments or capital repayments

of the loan are not fulfilled bythe borrower.

3Management of maturitytransformation, or liquidity risk,is discussed further in Chapter 3

of this subject guide.

17


associated with the transformation of default risk can be reduced by a number oftechniques. The intermediary can obtain information on each potential borrower andselect only those borrowers who have, for example, good income/earnings or a goodrecord on repaying debt.4 A bank clearly has advantages over a direct lender here asthe payments services5 provided by the bank will provide it with useful informationon potential borrowers. Techniques that banks can use to manage default risk arediscussed in Chapter 3 of this guide and include holding many loans and diversifyingits portfolio of loans across different types of borrowers.

Intermediaries reduce transaction costsIf lenders incur lower transaction costs by lending to an intermediary, such as a bank,compared to lending directly to a borrower then lenders will choose to lend to(deposit money with) a bank. Similarly, borrowers will prefer to borrow from a bankif the information costs (mainly search costs) are lower than direct borrowing.Financial intermediaries are able to reduce transaction costs substantially because theyhave developed expertise and because their large size enables them to take advantageof economies of scale. For example, a bank will have a loan contract drawn up whichcan be used over and over again when making loans. The unit cost of each loancontract to the bank will be substantially lower than the cost to an individual ofhaving a loan contract drawn up when undertaking direct lending. Now read section2.3.1 of Buckle and Thompson (1998) to see, more formally, the effect anintermediary has on transaction costs.

Intermediaries reduce the problems arising out of asymmetric informationWe saw above that the two problems the lenders face are adverse selection and moralhazard. The problem of adverse selection can be solved by the production of moreinformation on the circumstances of the borrower. This can be done through privatecompanies collecting and publishing information on firms’ balance sheet positions andfinancial statements. In the US, firms such as Moody’s and Standard and Poor’s dothis. The information helps investors to select companies’ securities (bonds andequities). However, because of the free-rider problem, the problem of adverseselection is not completely removed. This occurs when people who do not pay forinformation take advantage of information acquired by other people. So, if one personpurchases information and then buys securities issued by a particular firm believingthem to be undervalued, other investors (who have not purchased the information)may observe this and purchase the same securities at the same time. This will bid upthe price of the securities to the true value thus negating the value of the information.If investors know there is a free-rider problem then they are unlikely to purchaseinformation and the adverse selection problem remains. Intermediaries are more ableto reduce the adverse selection problem because they develop expertise in informationproduction that enables them to select good risks. As described above banks have aparticular advantage here in that they have access to information from customerstransaction accounts held with the bank. A bank is able to avoid the free rider problembecause the loans it makes are private securities (i.e. not traded in a market). So otherinvestors are not able to observe the bank and bid up the price of the security to thepoint where little or no profit is made.

The problem of moral hazard can be reduced by banks by introducing restrictivecovenants into loan contracts. A restrictive covenant is a provision that restricts theborrower’s activity. One example is a mortgage loan that contains a provision thatrequires a borrower to purchase life assurance which pays off the loan in the event ofthe borrower dying. This restrictive covenant encourages the borrower to undertakedesirable behaviour, from the lender’s point of view, that makes the loan more likelyto be repaid. Now restrictive covenants can be (and are) written into bond contracts sowhy is an intermediary better at reducing moral hazard compared to traded bonds

4Banks often use credit scoringfor determining whether to lend

to individuals. See Buckle andThompson (1998), Chapter 3 for

further discussion.5The provision of

chequebook/deposit accounts.

18


containing restrictive covenants? The answer is again to do with the free-riderproblem discussed above. Restrictive covenants have to be monitored and enforced ifthey are to do the job of reducing moral hazard. In the bond market, investors canfree-ride on the monitoring and enforcement undertaken by other investors. If mostbond holders free-ride then insufficient resources will be devoted to monitoring andenforcement and moral hazard remains high. A bank does not face the free-riderproblem because, as described above, its loans are non-traded securities. The banktherefore gains the full benefits of its monitoring and enforcement and therefore hasan incentive to devote sufficient resources to the problem of reducing moral hazard.

Now read Buckle and Thompson (1998), section 2.3.2 and then do thefollowing activities:

Activities

1. Explain how asking the borrower to provide security (collateral) against the loan

reduces the problem of adverse selection?

2. Explain how the loan contracts created by banks are better at reducing the free-rider

problem than the bond contracts traded in capital markets?

The implications of financial intermediationWe will examine the implications of the existence of financial intermediaries fromtwo perspectives:

1. the utility of individual lenders and borrowers

2. the level of economic development.

The Hirschleifer modelThis model allows us to consider the effects of the creation of a financial system thatallows lending and borrowing to take place. The precise mechanism for the lendingand borrowing are not important and could come either from the development ofcapital markets or financial intermediaries. What is important is that there is amechanism that enables economic agents to lend and borrow.

The Hirschleifer model is a two period investment/consumption model and theassumptions of the model are stated in Buckle and Thompson (1998), section 2.4. Aneconomic agent has the choice in the first period between using resources (from aninitial endowment = Y

0) to produce goods and services for consumption in this period

(0), or for investment to provide consumption in the second period (1). For simplicity,it is assumed that there are no additional resources endowed to the agent in the secondperiod so any consumption in that period comes from investment in the first period.We also assume, at first, that there is no financial system. The outer line in figure 2.3running from Y

1to Y

0represents the physical investment opportunities line (PIL).

Point A represents a consumption of C0

in period 0 with (Y0-C

0) invested to produce

consumption goods of C1

in period 1. By consuming less in period 0 the economicagent can move to point B, where a higher level of consumption is provided for inperiod 1. The agent is therefore faced with the problem of allocating consumptionexpenditure over the two periods so as to maximise utility. The point where the agentmaximises utility is found by standard economic analysis and is the point of tangencybetween the PIL and the agent’s indifference curve. This is assumed to occur at point A.

19


Figure 2.3: Hirschleifer model: optimal allocation of consumption over periods 0 and 1

If we now introduce a financial system into the analysis then the economic agent isnow able to lend or borrow. The borrowing/lending opportunities are represented bythe financial investment opportunities line (FIL). It is assumed that lending andborrowing can be achieved at the same rate of interest, r. Utility is maximised wherethe agent’s indifference curve just touches the FIL. This can occur by borrowingagainst future production, by moving down the FIL (to say, point D), or by lendingto finance future consumption, moving up the FIL (to say, point E). This is shownin figure 2.4.

Figure 2.4: Hirschleifer model: borrowing or lending to increase utility

Utility has therefore been increased by the introduction of a financial intermediarysince the individual would have remained at point A without the intermediary.

The effects of financial intermediation on economic developmentA reduction in transaction costs and other frictions, such as asymmetric information,which result from the presence of financial intermediaries, are analysed in figure 2.5.The demand for credit is represented by the line D–D, with the normal downwardslope. The supply of credit is considered to respond positively to increases in interestrates and is represented by the line S–S. Note that two effects operate here: asubstitution effect, leading to a substitution of saving for consumption, and an incomeeffect, which could lower saving. We assume here that the substitution effectdominates, so that saving increases as interest rates increase. In the absence oftransaction costs and no other market frictions, equilibrium would occur at point A,

C0* Period 0

C1*

A

D

E

PIL

FIL

Co Y0

Period 0

Y1

C1

A

B

PIL

20


where both the quantity demanded and supplied are equal to OZ. Clearly transactioncosts do occur and in the absence of a financial intermediary, we assume thattransaction costs equal CD, so that the quantity of credit demanded and suppliedequals OY. The gap between the rates of interest paid by the borrower and lender istermed the spread. The introduction of a financial intermediary reduces these costs sothe spread narrows to EF (from CD) and the quantity of credit demanded andsupplied rises to OX. Provided the increased credit is used to finance investment thenit is reasonable to suppose that gross domestic product (GDP) will have increased. Inany case, if the increased credit had been used to finance consumption, it isreasonable to assume that utility will have risen.

Figure 2.5: The effects of the existence of financial intermediaries on the quantityof credit supplied and demanded

What is the future for financial intermediaries?

There is evidence that traditional banking (i.e. financial intermediation) has declined inrecent years in countries such as the US, Germany and the UK. The main reasons forthis decline are:

1. Low cost deposits from the public are not as readily available as a source of funds.Alternative liquid investments offering higher returns have taken funds away frombanks. In the US money market mutual funds (MMMF) have shown dramaticgrowth since they first appeared in the early 1980s. MMMFs are like mutual funds(unit trusts in the UK) in that they hold shares, but are also like banks in that theirliabilities are deposits against which cheques can be written. There are restrictionson the cheque-writing facility, but it is clear that these institutions have takenfunds away from banks.

2. Credit rating agencies now collect and sell financial information on a largenumber of companies.6 This makes it easier for firms with a good credit rating toborrow directly from markets by issuing securities such as commercial paper7 orbonds. The wider availability of information on borrowers has eroded, to someextent, the informational advantages that banks possess that enable them to carryout the intermediary function. This process whereby firms bypass banks andborrow directly from markets has been termed disintermediation.

How have banks responded to this decline? Mishkin and Eakins (1998) argue thatbanks have sought to maintain profit levels in two ways:

Quantity of creditO

A

D

D S

S

D

F

E

C

Y X Z

Rate ofInterest

6The main credit rating agenciesare the US based Standard and

Poor’s and Moody’s InvestorServices.

7A short-term financialinstrument with a maturity

typically between seven days andthree months.

1. Expanding into new riskier areas of lending, for example, lending to property (realestate) companies. One example of this comes from Japan where over the 1980sthe banking system was deregulated and as a consequence banks expanded theirlending rapidly. In particularly they lent aggressively to the property (real estate)sector. When property prices in Japan collapsed in the early 1990s most Japanesebanks were left with a large amount of ‘bad’ loans (i.e. loans that would not berepaid in full, if at all). In recent years a number of Japanese banks have failed asa consequence of these ‘bad’ loans including Hokkaido Takushoku, the tenthlargest commercial bank in Japan, in late 1997.

2. Pursuing new off-balance-sheet activities. These are non-traditional bankingactivities that earn the bank fee income rather than interest income.8 One area ofconcern here is the expansion of derivatives business, for example, banks acting asdealers in over-the-counter derivatives.9 A classic example here is the case ofBarings Bank which, in 1995, failed (and was taken over by ING group) as aresult of losses arising out of ‘betting’ with derivatives by a ‘rogue trader’ NickLeeson. For more information on the case of Barings failure see Buckle andThompson (1998), Chapter 14 and 18.

Please read Mishkin and Eakins (1998) at this point for further discussion of thedecline of traditional banking. This section is designed to introduce you to some ofthe issues relating to the future of banking. Many of the issues touched on here willbe taken up in the rest of this subject guide so it is a good idea to return to this sectionwhen you have completed the subject guide in order to gain a better understanding.

Learning outcomes


• Explain why most lending/borrowing takes place through financial intermediaries

rather than directly.

• Describe the main costs involved in lending/borrowing.

• Explain how asymmetric information can cause problems for the lender.

• Explain how financial intermediaries can reduce transaction costs for lenders

and borrowers.

• Explain how financial intermediaries are able to transform the characteristics of

funds as they pass from lender to borrower.

• Explain how financial intermediaries can reduce the problems associated with

asymmetric information.


1. Discuss the main reasons for the existence of financial intermediaries.

2. Describe the process of financial intermediation and explain how intermediaries

are able to manage this process.

3. Describe the problems caused by asymmetric information in the

lending/borrowing transaction and explain how financial intermediaries are able

to reduce these problems.

4. How does the free rider problem aggravate adverse selection and moral hazard

problems in financial markets?

5. What are the likely consequences of the existence of financial intermediaries for

the utility of individuals?

6. What benefits do financial intermediaries bring to the development of an economy?

21


8Off-balance-sheet activities arecovered in more detail in

Chapter 4 of this subject guide.9Financial derivatives are

contracts that are ‘derived’ froma financial instrument (e.g. a

share option is an optioncontract derived from a share

financial instrument.) Thesecontracts can be very risky. SeeChapter 8 of this subject guidefor a discussion of derivatives.

22


Suggested plan for question 1

1. Introduction

2. A description of the process of direct lending between lenders and borrowers.

3. Explain why lenders and borrowers, in general, do not lend directly – that is to

say, discuss the problems of:

a. conflicting requirements

b. transaction costs

c. asymmetric information.

4. Explain how financial intermediaries are able to reduce these problems for

lenders and borrowers.

5. Discuss the future of financial intermediation – in particular the evidence that

financial intermediation is in decline at the wholesale end of banks’ business.

6. Conclusion.

23

Chapter 3: Retail banking

Chapter 3

Retail banking

Essential reading



Further reading

Bain, A.D The economics of the financial system. (Blackwell, 1992) second edition

[ISBN: 0-631-18197-0] Chapter 3.

Gosling, P. Financial Services in the Digital Age: The future of banking, finance and

insurance. (Bowerdean Publishing Company Ltd, 1996) [ISBN: 0-906097-54-1].

Lewis, M.K. and K.T. Davis Domestic and international banking. (Philip Allan,

1987) [ISBN: 0-86003-144-6] Chapter 3 and Chapter 6.

Mester, L. ‘What’s the point of credit scoring?’ Business Review, (Federal Reserve

Bank of Philadelphia) September/October 1997.

IntroductionRetail banks have traditionally provided intermediation and payments services toindividuals and small businesses with all the components of those services suppliedby the bank. However it is becoming increasingly difficult to identify the nature of aretail bank. Firstly because many banks now combine both retail and wholesaleactivities. Secondly because technological developments have enabled banks tosupply a wide range of retail financial services to its customers but not supply all thesub-components of those services.

In this chapter we begin by examining the nature of traditional retail banking. Inparticular we investigate the provision of intermediation services and how banksmanage the risks involved in that provision. We also examine the nature of paymentsservices provided by retail banks and discuss why banks have traditionally combinedprovision of intermediation and payments services. Finally we investigate recentdevelopments in retail banking and discuss the impact of these on the futureorganisation of retail banks. We focus in particular on how it is now possible toseparate the components of a financial service/product and the trend towardsoutsourcing or sub-contracting the supply of components of a financialservice/product.

What is retail banking?It is becoming more and more difficult to define a retail bank. Traditionally, retailbanks provided banking services to individuals and small businesses dealing in largevolumes of low value transactions. This is in contrast to wholesale banking whichdeals with large value transactions, generally in small volumes. We deal withwholesale banking in the next chapter of this guide. In practice it is difficult toidentify purely retail banks that fund themselves from retail deposits and lend in theretail loan markets. In the UK, Australia, US and many other developed countries thelarge banks combine retail and wholesale activities. Technological developments arealso changing the nature of retail banking. Traditionally a retail bank would need a

24


substantial branch network to collect the deposits of the public, facilitate repayment ofdeposits and other account payments and make loans. The widespread use ofautomated teller machines and the growth in telephone banking, postal accounts andmore recently internet banks has allowed new types of retail bank to emerge that donot require extensive investment in branches. To make sense of the manydevelopments in retail banking it is helpful to see retail banking as a set of processesrather than institutions. We leave this analysis until the end of this chapter.

It is helpful to begin our analysis of retail banking by examining the aggregatebalance sheet for retail banks in the UK for the year ending December 1996. Thistable is taken from Buckle and Thompson (1998), Chapter 3.

Table 3.1 The combined balance sheet of UK retail banks at 31 December 1996(£ billion)

Liabilities Assets

Notes outstanding 2.7 Notes and coins 4.8

Total sterling deposits 467.8 Balances with the Bank of England 1.7

(of which, sight deposits 210.1) Market loans 102.1

Total bills 12.2

Foreign currency deposits 148.6 Investments 50.7

Items in suspense and transmission Advances 338.5

plus capital and other funds 100.0

Other currency and

miscellaneous assets 186.5

Total liabilities 711.0 Total assets 711.0

Table 3.1 shows us that retail banks main liabilities are deposits (approximately 88per cent of total liabilities. Of these deposits, 76 per cent are sterling and 24 per centare foreign currency, and of the sterling deposits 45 per cent are sight deposits. Sightdeposits are deposits that are repayable on demand. The other main items of liabilitiesare items in suspense and transmission which refer, for example, to cheques drawnand in the course of collection and capital which is made up principally of the bank’sissued share capital and reserves (reserves are mainly profits retained by the bank andnot distributed to shareholders). These capital funds represent the bank’s shareholdersinterest in the bank.

On the assets side of the balance sheet, the main item is advances which make up 65per cent of sterling assets. There will also be foreign currency advances in the itemother currency asset. Liquidity is provided by a small amount of cash accounting forapproximately 0.7 per cent of total assets. This is a very small cash base. However,additional liquidity is provided by market loans which refer mainly to short-termloans made through the inter-bank market. A bank that is short of funds can borrowfunds from other banks for a short period through the inter-bank market. Likewise, abank that has a surplus of funds can lend short-term through the inter-bank market.Short-term can be as short as overnight or one day. Further liquidity is provided bythe item of bills (these are debt instruments issued by firms and the government withan original maturity of less than one year – typically one month or three months) Abank can sell these bills quickly if it needs additional liquid funds. Finally, a bankholds investments, which are mainly government bonds. These provide an alternativesource of return for a bank when there are no good lending propositions. Also,because government bonds can be sold in a market before maturity they can beclassed as another source of liquidity.

25


The main feature that emerges from a study of the balance sheet in table 3.1 is thatbanks’ liabilities are mainly short-term deposits but their main assets are advanceswhich have a much longer term. The other main assets held by banks are assets thatcan be turned into cash at short notice, known as liquid assets. We examine the risksthat mismatching of the term to maturity of liabilities and assets creates, and thereasons why banks hold a large amount and variety of liquid assets in the next section.

What services and products do retail banksprovide?

Retail banks provide various products and services to individuals and smallbusinesses. Traditionally a retail bank provided:

1. intermediation services and

2. payments services.

Increasingly retail banks are providing a much wider range of products/servicesincluding insurance products, pension schemes, stockbroking services etc. In short,retail banks are becoming financial supermarkets. We examine some of the reasonsfor this later in this chapter.

Intermediation servicesActivity

Read Chapter 2 of this guide and identify the main features of asset transformation

undertaken by a financial intermediary.

In Chapter 2 of this guide we examined the nature of the process of financialintermediation undertaken by banks. In particular we saw that in transforming thecharacteristics of funds a bank is exposed to two main risks:

1. Liquidity risk – a consequence of issuing liabilities (deposits) which are largelyrepayable on demand or at very short notice whilst holding assets (mainlyadvances) which have a much longer term to maturity.

2. Default risk – the main asset held by banks are advances and default risk refers tothe risk of the interest and/or capital on these advances not being repaid.

Banks must manage these risks to prevent failure of the bank. In Chapter 9 of thisguide we will investigate how banks are supervised and regulated so as to minimisethe risk of failure of the bank. Here we focus on the strategies that banks can use tomanage these risks.

Managing liquidity riskLiquidity risk refers to the risk of the bank having insufficient funds to meet its cashoutflow commitments. A bank is particularly vulnerable to this risk because of thestructure of its balance sheet. We can see from figure 3.1, if a bank is required torepay a substantial amount of deposits then it will soon find itself in a situation whereit has insufficient funds as most of its assets are committed in long-term advances.There are two main strategies a bank can adopt to manage this problem:

Reserve asset managementThis requires a bank to hold a stock of liquid assets to protect the illiquid advancesportfolio from an unexpectedly large outflow of funds, This is illustrated in figure 3.1.

26


Figure 3.1: Illustration of reserve asset management

Cash inflows (from new deposits and loan repayments) would normally fund cashoutflows (deposit withdrawals and new loans). However, the stock of liquid assets heldby the bank acts as a buffer which can be drawn on when there is an imbalance ofoutflows over inflows. Normally liquid assets are held according to a maturity ladderwith assets running from cash to overnight deposits to bills and short-term deposits etc.The bank will obtain some return on its liquid asset holdings (other than cash) but thiswill be lower than on its main earning asset of advances. Therefore banks will belooking to hold just enough liquid assets to meet unexpected cash outflows.

Liability managementIn the last 30 years banks in most developed countries have moved away from reserveasset management towards liability management. Liability management involves abank managing its liabilities to meet loan commitments or replenish lost liquidity.One form that this could take is simply to adjust interest rates on its deposits.However if a bank is reliant solely on retail deposits then increasing deposit rates iscostly because it has to be done for existing deposits as well as new deposits attracted.However, the development of wholesale deposit markets (market loans in table 3.1),in particular an overnight interbank market, has allowed banks to use such markets asa marginal source and use of funds. For example, if a bank at the end of a workingday has made more loan commitments than it can meet from current funding then itcan borrow funds from another bank in the overnight market. Conversely, if a bankhas a surplus of funds at the end of a working day then it can lend these overnight.1

The existence of the interbank markets allows banks to exploit profitable lendingopportunities as they arise without being too concerned about raising the funding tomeet the loan.

Managing asset riskMany of the assets held by a retail bank are subject to the risk of a fall in value belowthat recorded in the balance sheet. The main asset held by a retail bank is advancesand these are subject to the risk of default (or credit risk). Credit risk is exacerbatedby the problems of adverse selection and moral hazard.2 Credit risk is influenced bythe stage of the economic cycle. Clearly when the economy is growing then creditrisk will be low for banks. If the economy goes into recession then credit riskincreases. The influence of the economic cycle represents the systematic (or macro-economic) component of the credit risk facing banks. In addition, banks face aborrower-specific component of credit risk. This is the risk that derives from theindividual decisions of the borrower. Banks are able to manage specific risk by usingthe techniques outlined below.

Liquid assetsDeposit withdrawals New loans

Loan repaymentsNew deposits

1See Buckle and Thompson(1998), section 10.3 for a

discussion of the interbankmarkets in the UK.

2See Chapter 2 of this guide.

27


Banks can manage default risk in a number of ways.3

ScreeningBanks can minimise the risk of default for each individual loan by considering thepurpose of the loan and the financial circumstance of the borrower. The bank shouldbe aiming to select good risks only. Credit scoring is increasingly being used by banksin this process of risk analysis and the advantage of credit scoring is that it can belargely automated.4 Credit scoring is a method of evaluating the credit risk of loanapplications using a scoring model. The scoring model is developed using historicaldata to identify which borrower characteristics provide a good prediction of whether aloan performed well or badly. Each characteristic will be weighted in the modelaccording to its importance in predicting default. Characteristics which might be usedin a credit scoring model for personal loans include the length of time the applicanthas been in the same job, monthly income, outstanding debt etc. Fair, Isaac andCompany in the US were the pioneers of credit scoring models. In the past, banksused credit reports, personal histories and the bank manager’s judgement to determinewhether to grant a loan. Credit scoring is now widely used in personal lending,especially credit card lending and is increasingly being used in mortgage lending. Theuse of credit scoring has enabled banks to make lending decisions over the telephoneand so has helped facilitate the establishment of telephone-based banks, discussedlater in this chapter.

PoolingBanks can undertake a large number of small loans rather than a small number oflarge loans. This is an application of the law of large numbers to the loan portfolio,which reduces the variability of loan loss, so increasing the predictability of lossthrough default.5

DiversificationBanks can diversify the loan portfolio by lending to a wide range of different types ofborrowers. For example a bank should lend to both individuals and businesses andwithin lending to businesses should lend to businesses in different industries. This hasthe effect of offsetting the firm specific-risks within the portfolio. A simple exampleillustrates the principle of diversification. A bank may lend to a number of firmsproducing ice cream and a number of firms producing raincoats and umbrellas. If aparticular summer is mainly rainy then not much ice cream will be sold and some icecream producing firms may default on their loans to the bank. However, the firmsproducing raincoats and umbrellas will prosper during a rainy summer and theincidence of loan default amongst these firms will be low. If the summer is mainly hotthen the reverse will occur with ice cream firms prospering and raincoat and umbrellafirms doing badly and the incidence of loan default will be the reverse. So byspreading its loans, the bank will not suffer high default risk across its whole portfolioof loans in the event of either an extremely hot or extremely rainy summer. Bydiversifying its loan portfolio a bank makes its borrower-specific loan risks moreindependent. It should be noted that banks that specialise in lending to one particularsector, region or industry, will be limited in their ability to diversify. Examplesinclude banks that specialise in mortgage lending or lending to a particular region orindustry (e.g. agricultural banks).

CollateralA bank may ask for collateral (or security) to be provided by the borrower. If theloan then goes to default then the bank is able to sell the collateral and so recoversome or all of the loan. Collateral also has the effect of reducing moral hazard6 asthe threat of loss has the effect of reducing the incentive of the borrower to engage inundesirable activities.

3Read Buckle and Thompson(1998), section 3.5.2 for further

detail.

4See Buckle and Thompson(1998), section 3.4 for further

discussion of this. Also seeMester (1997).

5See Bain (1992), pp.54–56 formore discussion.

6See Chapter 2 of this guide fordiscussion of moral hazard.

28


CapitalFinally, a bank should hold capital. This provides a cushion against loss in the eventof default losses which protects depositors from its effects. Regulators imposerequirements on banks regarding the amount of capital a bank should hold in relationto the riskiness of its assets. See Chapter 9 of this guide.

Activity

How does the use of credit scoring reduce the adverse selection problem and reduce

entry costs into the banking industry?

Payments servicesMost retail banks also provide payments services. A payments service is defined inBuckle and Thompson (1998), section 3.3 as:

an accounting procedure whereby transfer of ownership of certain assets are carried out

in settlement of debts incurred.

A payments service can be separated into three components:

1. a medium of exchange enabling customers to acquire goods

2. a medium of payment to effect payment for the goods acquired

3. a temporary store of purchasing power since income and expenditure are generallynot synchronised.

Paper money, issued by governments fulfils these three functions. A bank chequeaccount, that is the liabilities of a bank, also provides these three functions. It iswidely accepted as a medium of exchange and a medium of payment. Funds can alsobe stored in the account until purchases are made.

Recent developmentsRecent developments in payments services technology are reducing the use of papercheques. The new methods of payments7 are as follows.

Debit cardThis allows a customer to make a payment directly from a bank account. However thetransfer of funds between customer and retailer takes place electronically and thetransfer could take place immediately or could be delayed with the informationtransmitted to the bank by the retailer in batches. The debit card can therefore be seenas a form of electronic cheque.

Automated clearing house (ACH) debitAllows for direct crediting of pay or for direct debiting of customer’s accounts forregular payments such as mortgage repayment or utility bills. Transfers are normallyeffected electronically.

Credit cardA credit card also allows a customer to pay for a purchase however a credit card onlyperforms the function of medium of exchange as, from the customers point of view,payment is only made in the future when he/she settles the credit card account.

Future developmentsDevelopments in payments services in the near future will include the following.

Smart cards (stored value cards)Smart cards are effectively prepaid cards the size of a debit or credit card. Anelectronic chip embedded into the card allows a customer to transfer value to the cardfrom a bank account, possibly from an Automate Teller Machine or speciallyequipped telephone or personal computer. The smart card can then be used forpayment at a shop point of sale terminal. Funds are directed directly from the card to

7Read Lewis and Davis (1987),pp.158–169 for further

information of non-cash methodsof payments.

29


the retailer’s terminal. The retailer may then transfer the accumulated balances to theirown accounts. It is predicted that the smart card will reduce the amount of cash in usealthough its take up will depend on to what extent shop and other service providers(e.g. taxis, train operators) will introduce appropriate terminals.

Internet cashInternet cash is a development further into the future. It will be an account held on theinternet that can be instantly debited or credited following an internet transaction. Forexample, a customer may purchase a book over the internet and pay for it using hisinternet cash account. To realise the value of this internet cash it will need to beconverted into traditional money. In this form then internet cash simply represents amedium of exchange and payment but one which is separate from the actual transferof money.

Payments riskYou also need to be aware of the risks that banks (and their customers face) inproviding a payments service.8 A payments system provides for the transfer of fundsbetween accounts at two institutions. There are essentially two types of systems formaking settlement payments between two banks:

1. end of day net settlement

2. real time gross settlement

With the first of these, at the end of each working day, final debit and credit balancesare calculated for each member bank in the settlement system and net settlementtransfers are made through settlement accounts, normally held at the central bank.This gives rise to receiver risk whereby a bank may provide funds to a customerhaving received payment instructions from another bank. The receiving bank then hasan exposure to the bank that sent the instructions, until final settlement occurs at theend of the day. Those customers that have received payments may initiate furtherpayments and this can be repeated throughout the day, building up large exposures inthe banking system. If one of the settlement banks fail then this could lead tosettlement failures at other banks. This is an example of the systemic risk problem.9

One solution to this problem is to move to real time gross settlement wherebypayment instructions and settlement are more closely aligned. Such a system has beendeveloped in many of the major banking systems including the US and UK.

Joint provision of intermediation and paymentsservices

Finally in this section you need to understand why traditionally a bank provides bothintermediation services and payments services. In fact there are two main advantagesin combining these two services:

• The funds held in transaction accounts can be profitably on-lent by the bankbefore they are used by customers.

• Transaction accounts provide a bank with useful information which can helpthem in assessing credit risk and monitoring repayment of a loan. In other words,this information is useful to a bank in overcoming both adverse selection andmoral hazard.

Competition in retail bankingThe retail banking sector in many countries has experienced increased competition inrecent years as a result of new entrants into the industry. In the UK, these newentrants have come from a variety of sources:

8Please read Buckle andThompson, section 3.5.3.

9The systemic risk problem as ajustification for regulating banksis discussed in Chapter 9 of this

guide.

30


1. Savings and mortgage institutions:10 the 1986 Building Societies Act in the UKpermitted building societies to offer current accounts and make unsecured loans topersons, to a limited extent. The Act also allowed larger building societies toconvert into banks. Most of the larger Societies have since taken up this option.

2. Insurance companies: a number of insurance companies in the UK haveestablished banking subsidiaries. These include Legal and General, Prudential andStandard Life.

3. Retailing organisations: in the UK a number of supermarkets now offer selectedbanking products alongside groceries.

The majority of new entrants under categories 2 and 3 have so far chosen to offeronly a subset of retail banking products, namely credit cards, savings accounts,personal loans and mortgages. The main retail banking product missing from this listis the current (or cheque) account. In addition, many of the new entrants from theinsurance industry have chosen to offer retail banking services/products through newdelivery channels. In most cases the establishment of these new banks has only comeabout as a consequence of the ability to offer banking services through non-traditionalchannels. Retail banks have traditionally operated through branch networks. These arecostly to establish and to maintain. The introduction of automated teller machines(ATMs) was the first development that allowed delivery of certain elements of retailbanking services outside the branch. ATMs were first located inside or on the outsidewall of the branch. They are now located in shopping malls, workplaces, universities,petrol stations etc. Telephone banking was the next innovation in delivery channelsand many of the recent entrants into the banking industry are based completely ontelephone transactions. The pioneer in the UK was First Direct, a subsidiary of HongKong and Shanghai Banking Corporation (HSBC). The most recent innovation indelivery channels is the internet. Many retail banks in the UK have introduced onlinebanking allowing customers access to account information, to make payments and totransfer money between accounts. As more households gain access to the internet andgain confidence in using it to conduct banking transactions, then new banks are likelyto emerge basing their delivery of banking services solely on the internet.Developments in interactive digital television also offer a new means of deliveringretail banking services.

All these developments do not imply an early demise for branch networks. First,many customers will resist using the new technology. Second, branches allow banksto cross-sell other financial products to customers who go into the branch to undertakea banking transaction. In addition, a danger with telephone or internet based bankingis that it is likely to encourage customers to trade more on price so becoming morefickle. This has implications for banks’ ability to manage liquidity risk.

Activity

What are the implications of the growth in internet banking for a bank’s ability to

manage liquidity risk?

Future developments in retail bankingCompetition in retail banking from non-banks has led banks to diversify into otherfinancial services. Most retail banks now provide a wide variety of financialproducts/services in addition to the traditional services of intermediation andpayments. These include:

• Long-term savings products such as life assurance policies and pension plans

• General insurance

10Institutions in the UK, knownas building societies, that

specialise in providing mortgageloans for house purchase.

31


• Portfolio management

• Stockbroking

• Foreign exchange services.

Activity

Identify the main products/services provided by a retail bank in your country

Banks have increasingly used sophisticated marketing techniques to help target theseother financial products at certain types of customer. In particular, banks havesegmented personal customers according to wealth, income and a host of other socialand demographic factors.

In the future, banks may have to consider diversifying into non-financial business.Banks have developed certain core competencies or comparative advantages fromtheir traditional business that could be applied elsewhere. Thesecompetencies/advantages include:

• information advantages (banks have access to financial information on customers)

• risk analysis expertise

• expertise in the monitoring and enforcement of contracts

• delivery capacity.

Activity

What kinds of non-financial business are the competencies/advantages of banks ideally

suited to?

Banks have traditionally been fully vertically integrated firms, that is they supply allof the components of a product or service within the organisation. Howeverdevelopments in new technology are changing the nature of the financial firm. Youneed to read Buckle and Thompson (1998), section 3.4. The important points tounderstand are:

1. It is now possible to separate (or deconstruct) a financial product or service into itscomponent parts which can then be supplied separately.

An example of this is a mortgage loan. This can be separated into the followingcomponent processes:

a. origination – the mortgage is brokered to a customer

b. administration – paperwork processed

c. risk analysis – assessment of the credit worthiness of the borrower

d. funding – finance raised and asset held on the balance sheet and capital allocated to the risk.

2. A firm may have a comparative advantage in certain parts of the whole processbut not every part. For example, a bank with a branch network may have acomparative advantage in origination of mortgage loans but may not be the mostefficient in terms of funding the loan, perhaps because of a capital constraint.11 Itis becoming increasingly common in the US for banks to securitise their mortgageloans and issue the subsequent securities into the capital market.12 When an assetis securitised it is effectively packaged into a security and sold to investors.Securitisation allows a bank to turn an illiquid asset (like a mortgage loan - which,we saw in Chapter 2 of this guide is a non-traded loan) into a liquid securitywhich the bank can sell.

11In Chapter 9 of this guide weshow that banks must set a

certain amount of capital againstloans.

12In Chapter 4 of this guide weintroduce the concept of asset

backed securities which aresecuritised loans which allow the

bank to take the loan off thebalance sheet.

32


3. A new entrant to banking can sub-contract (outsource) some part of the processinvolved in delivering a financial product. This allows them to obtain theeconomies of scale for that process without having to invest. This makes it easierfor new firms to enter into banking. New entrants can therefore offer a wide rangeof financial products/services to customers but not be involved in everycomponent of the delivery of the product/service.

4. The organisation of a retail bank will probably become more like the organisationof firms in other industries where the degree of vertical integration is lower. Forexample a car manufacturer like Toyota supplies finished Toyota cars to itscustomers but many of the components of Toyota cars are supplied by other firms.

Activity

Read Buckle and Thompson (1998) section 3.3, and describe the organisation of a

virtual bank.

Learning outcomes


• Describe the main features of the balance sheet of a retail bank.

• Describe the main services provided by retail banks.

• Contrast the two main strategies retail banks can adopt to manage liquidity risk.

• Describe the main techniques that a retail bank can use to manage credit risk.

• Discuss the main developments in payments services provided by banks.

• Identify why retail banks have traditionally combined intermediation and

payments services.

• Explain why the retail banking sector is experiencing a growth in the number of

new entrants and hence increased competition.

• Discuss the implications of new technology for the organisation of a retail bank,

especially in terms of deconstruction of the delivery of financial products into its

component parts.


1. Compare and contrast two strategies that banks can adopt to manage liquidity risk.

2. Why have retail banks traditionally combined the supply of intermediation and

payments services?

3. What strategies can a bank use to manage default risk relating to its loan portfolio?

4. Distinguish between debit cards, credit cards and smart cards.

5. Discuss how developments in new technology are affecting the nature and

organisation of retail banking.

6. Identify and discuss the main forces that are leading to change in the retail

banking industry. What is the likely impact of these forces on the future structure

of the industry?

33

Chapter 4: Wholesale and international banking

Chapter 4

Wholesale and internationalbanking

Essential reading



Further reading


Longman, 1998) [ISBN 0-582-27800-7] Chapter 23.

Lewis, M.K. and K.T. Davis Domestic and international banking. (Philip Allan, 1987)

[ISBN 0-86003-144-6] Chapters 4, 8, 9 and 10.

IntroductionIn Chapter 3 of this guide we discussed the nature and role of retail banking. Thesubject for this chapter is wholesale and international banking. The differencebetween retail and wholesale banking is essentially one of size. Retail banks deal witha large number of small value transactions whereas wholesale banks deal with asmaller number of larger value transactions. International banks are wholesale banksthat also deal with international customers involving different currencies. In practice aparticular banking firm may be involved with all three activities but with separatesubsidiaries dealing with the various aspects. Thus, while it is useful to distinguishbetween retail, wholesale and international banking, it should be remembered that thisdistinction refers to different functions rather than different firms.

In this chapter we investigate the nature of wholesale banking, focusing in particularon the strategies adopted by wholesale banks for managing liquidity risk. We alsoexamine the nature of off-balance-sheet business and the reasons for its growth inrecent years. The business of international banking, and eurocurrency banking inparticular, is then investigated. One form of eurocurrency banking is sovereignlending which refers to lending directly to sovereign countries. This type of lendingproved to be disastrous for international banks. We therefore finish this chapter byexamining the reasons for the growth of this type of lending by banks over the 1970sand the subsequent international debt crisis of the 1980s.

Wholesale bankingYou should note that the wholesale banks are a heterogeneous group of financialinstitutions consisting in the UK of British merchant banks and foreign banks.1 Theassets held by wholesale banks operating in the UK, in aggregate, at the end of 1996are shown in table 4.1 below, which reproduces table 4.2 in Buckle and Thompson(1998). Note, the figures in parenthesis represent the percentage of total assets.

1In the US wholesale banksconsist of mainly US investment

banks and foreign banks.

34


Table 4.1 Assets of wholesale banks operating in the UK at end December 1996(£million)

Wholesale banks

SterlingNotes and coins & balancesat the Bank of England 714 (0.1)Market loans 118,899 (10.2)Bills 1,430 (0.1)Advances 141,287 (12.1)Investments 29,138 (2.5)Total sterling assets 291,468 (25.0)

Foreign CurrencyMarket loans 500,266 (42.9)Advances 219,266 (18.8)Bills, investments etc. 154,959 (13.3)Total foreign currency assets 874,491 (75.0)

Total Assets 973,780 (100.0)

This table is discussed in detail in Buckle and Thompson (1998), Chapter 4. Thedefinitions of the items in the table are provided there and in Chapter 3 of this subjectguide in relation to the balance sheet of retail banks.

The main features, which distinguish wholesale from retail banks, are:

1. The smaller proportion of sight deposits (deposits are deposits that are withdrawnon demand) for wholesale banks. Most deposits with wholesale banks are inter-bank or sourced from other money markets.

2. The larger size of individual transactions, a minimum £250,000 for a deposit and£500,000 for a loan. In practice much larger transactions are undertaken.

3. The high proportion of assets and liabilities denominated in foreign currency. Intable 4.1 we can see that 75 per cent of assets of wholesale banks are denominatedin a foreign currency. This is because most banks located in the UK are foreignbased (mainly Japanese, US and European) and the main reason they have locatedin London is to gain access to the eurocurrency markets. As we will see in thesection on international banking, later in this chapter, a eurocurrency transaction(borrowing or lending) in London would be in a currency other than sterling.

4. The extent of their dealing in the inter-bank market. Table 4.1 shows us thatapproximately 50 per cent of assets (sterling plus foreign currency) are marketloans, which are mainly inter-bank.

5. The extent of their off-balance-sheet business (see next section for more discussion).

6. They do not involve themselves in the payments mechanism to any great extent sothat cash holdings are minimal.

Features 1. and 2. above are even more pronounced for foreign as opposed todomestic wholesale banks such as merchant banks in the UK.

The developments in wholesale banking largely originated with the development ofeurocurrency banking in London (see later in this chapter). The US investment bankslocated in London were the main innovators in this area and the practices developedspread to other financial centres as eurocurrency markets developed in othercountries. Lewis and Davis (1987) identify three practices in particular that form thebasis of wholesale banking, namely:

35


• the development and use of interbank markets (in both domestic andinternational currencies)

• the issuing of domestic and foreign currency certificates of deposit (CDs)

• lending by means of term loans at variable rates of interest (rollover credits).

We consider the nature of interbank markets and their use in liquidity managementbelow. Before this we will examine the nature of the market in CDs and rollover credits.

Certificates of deposits2

Certificates of deposits are bearer securities issued by a bank (or building society inthe UK) as evidence of an interest-bearing time deposit. They are negotiableinstruments and since they are bearer securities, their ownership can be transferredprior to maturity. The original maturity of CDs is normally under 12 months, with themost common issue being three months. However, maturities up to five years areobtainable. Secondary markets exist in such instruments which allow the holder tosell the CD before maturity and thus improve the liquidity of such instruments.

Rollover creditsAs a large proportion of wholesale banks funding is relatively short-term, the banksinterest costs rise and fall in line with market interest rates generally. As aconsequence of this banks developed rollover credits which are loans that are repricedperiodically in line with market rates of interest. The ‘price’ of the loan is set as apredetermined spread or margin over an agreed reference rate. In the UK thisreference rate is LIBOR (the London Interbank Offered Rate). LIBOR is the rate ofinterest at which banks lend to each other corresponding to the interest rateadjustment period of the loan. Where the rollover credit is adjusted every threemonths then three-month LIBOR would be used as the reference rate. The spreadcovers the costs and risks of the intermediation to the bank and will vary fromcustomer to customer mainly according to the perceived risk. Note that the spread isnot adjusted after the loan is made. In the UK, all wholesale loans are linked toLIBOR whereas small and medium-sized loans are linked to the base rate.

Matching and liquidity in wholesale bankingBecause of the fewer number of their customers, it used to be thought that wholesalebanks would manage their liquidity position by matching the maturity dates andcurrency denominations of their assets and liabilities. Thus if a wholesale bankaccepted a large sterling deposit maturing in six months time, it would match thiswith a sterling loan maturing in six months’ time so as to lower risk.

Activity

What is meant by liquidity risk, as it affects banks?

The evidence discussed in section 4.2 of Buckle and Thompson (1998) suggests thatwholesale banks do not completely match their assets with their liabilities and thattherefore they do engage in maturity transformation by borrowing for a shorter periodthan that for which the loans are made.

This raises the question as to how wholesale banks manage their liquidity position.They do this by:

1. Using the inter-bank market – this market involves banks lending andborrowing from each other. If a wholesale bank receives a deposit and has noimmediate outlet for a loan, it can deposit the funds in the inter-bank market forperiods varying from overnight to up to three months. Conversely if the bank has

2See Buckle and Thompson(1998) sections, 10.2 and 10.3.

36


a request for a loan from a customer, and has no spare funds available, it canborrow in the inter-bank market. In a similar manner, certificates of deposit (CDs)could be purchased or sold to raise funds. For a discussion of the inter-bankmarket see section 10.3 of Buckle and Thompson.

2. Sale of ‘asset-backed securities’ (ABS). An ABS is a tradeable financialinstrument, which is supported (backed) by a pool of loans. The sale removesassets from the balance sheet of the bank and provides funds for alternative uses.Hence the sale of an ABS assists the bank in the management of its liquidityposition. This is an example of the process of securitisation.3 An example of thecreation of an ABS is where a bank makes (originates) mortgage loans but thencreates an ABS based on those loans. The ABS is then sold to investors effectivelychanging what was an illiquid asset into a liquid (marketable) asset.4

3. The process of securitisation has developed furthest in the US where there is ahighly developed market for mortgage-backed securities.5 The origins ofsecuritisation in the US goes back to the 1930s when the Federal governmentbegan offering insurance for mortgages made to certain disadvantaged groups.This provided a guarantee which made the mortgages attractive to other investors.It wasn’t until the 1970s that an active secondary market in mortgage-backedsecurities developed. At this time the Federal government reorganised the FederalNational Mortgage Association (FNMA or ‘Fannie Mae’) and established two newagencies; the Government National Mortgage Association (GNMA or ‘GinnieMae’) and the Federal Home Loan Corporation (FHMLC or ‘Freddie Mac’). Thepurpose of these two agencies was to issue securities backed by both insured anduninsured mortgages. In the US the basic security is known as the ‘passthrough’.Figure 4.1 illustrates the steps in the securitisation process.

Figure 4.1: The securitisation process

A financial intermediary originates a number of mortgage loans . These are thentransferred to a trust administered by a trustee.6 This trust acts independently of theoriginating bank. The trust issues securities that are passed to an underwriter fordistribution to investors. The proceeds of the sale of securities are passed back to theoriginator of the loans. Often, an originating bank will purchase a guarantee for theloans which enhances the attractiveness of the securities to investors. The borrowers ofthe securitised mortgages will continue making payments to the originator who passesthe income to the trustee. The trustee will ‘pass through’ the income to investors.

Source/Originator

Trust

Underwriter

Investors

Borrower

Trustee

Transfersmortgages

Issues securities

Distributessecurities

Loan

Forwards interest and principal

Passes throughpayments of interest

and principal

Functions

Cash flows

3Read Buckle and Thompson

(1998), section 4.2.4In Chapter 3 of this guide we

noted that securitisation allowsbanks to separate the various

sub-components of the provisionof a loan so that a bank can

provide those sub-componentswhere it can do so efficiently and

out-source (sub-contract) thosesub-components where it is less

efficient.5Read Howells and Bain (1998),

Chapter 28 for furtherdiscussion of the process of

securitisation.

6Sometimes referred to as aSpecial Purpose Vehicle (SPV).

37


A wider range of loans other than mortgage loans have been securitised in recentyears. These include credit card loans, car loans and student loans.

Activity

What do you think are the advantages to a bank, other than providing liquidity, of

securitising part of its loan portfolio?

The management of the liquidity position discussed above differs from the traditionalstrategy adopted by retail banks discussed in Chapter 3 of this guide.

You should now read section 4.2 of Buckle and Thompson noting as backgroundinformation the details given of their asset holdings given in Table 4.2. We now turnto a discussion of their off-balance-sheet business.

Off-balance-sheet businessOff-balance-sheet business can be defined as any activity that does not lead to anentry on the institution’s balance sheet. Off-balance-sheet business includes bothcontingent claims and other fee generating financial services. Contingent claims areclaims that are not captured on the balance sheet under normal accountingconventions but which involve the bank in an obligation should a particularcontingency occur. Some examples of contingent claims are:

• Loan commitments: advance commitment for provision of a loan, which willonly appear on the balance sheet when the loan is made. Otherwise it remains as acommitment to provide credit when the firm’s need arises.

• Guarantees: provision of commitment to guarantee the obligation of customer’sliability to a third party. Liability only occurs if the customer defaults so that noentry occurs on the balance sheet unless the default occurs.

• Underwriting security issues. When a company makes a share (or bond) issue, abank may guarantee to buy any shares (bonds) which are not purchased byinvestors. This is similar to b above as the obligation only arises if the securitiesare not purchased by other parties.

• Swap and Hedging transactions: these are discussed in Chapter 8 of this guide.

The other off-balance-sheet items are financial services provided by banks.These include:

• Loan related services: loan origination and acting as an agent for syndicatedloans.

• Trust and advisory services: portfolio management, arranging mergers andacquisitions, trust and estate management, safekeeping of securities.

• Brokerage and agency services: share and bond brokerage, unit trust (mutualfund) brokerage, life insurance brokerage, travel agency.

• Payments services: clearing house services, credit/debit cards, home banking.

In all these transactions the bank obtains a payment for the services it provides. Thisincome is called fee income and is an alternative source of income from a bank’straditional income, interest income, which comes from the difference between theinterest the bank receives from loans and the interest it pays on deposits. Fee incomehas grown relative to interest income in recent years – for details see table 4.4 inBuckle and Thompson (1998). This trend reflects the decline in traditional bankingactivities discussed in Chapter 2 of this guide.

Off-balance-sheet business has seen a large growth in recent years due mainly to thefollowing factors.

38


1. Since 1972, asset prices have been more volatile. The early 1970s saw thebreakdown of the Bretton Woods agreement which fixed exchange rates for mostdeveloped countries. The breakdown led to a general move to floating exchangerates, except for some countries in Europe which have fixed the exchange ratesbetween each other’s currency (although not against currencies outside thearrangement) for much of the time since the 1970s. In addition, the policy changeto targeting monetary aggregates and later inflation using the instrument of interestrates has resulted in greater fluctuations in interest rates. The greater volatility inexchange rates and interest rates is illustrated in figures 14.1 and 14.2 in Buckleand Thompson (1998). The resulting uncertainty has led to a greater demand forthe hedging instruments such as swaps, futures and options.

2. In some cases banks’ credit ratings have fallen making it difficult for them to raisedeposits at rates of interest, which permit a satisfactory margin over the rate theypay on deposits. In fact some large firms have better credit ratings than somebanks thus enabling the firm to obtain long-term finance at a more favourable ratethan through a loan from a bank. This phenomenon is referred to asdisintermediation and is discussed in Chapter 7 of this guide.

3. Arbitrage potential in capital markets. Although barriers between differentfinancial markets have been slowly breaking down as markets have become moreglobal (i.e. banks, other institutions and companies operating in markets other thanjust their own domestic market), the process of globalisation is not yet complete.This has allowed banks and others to exploit arbitrage possibilities. For example aUK company may have comparative advantage in borrowing (i.e. obtain a betterrate of interest) in the UK bond market, but wants to raise dollars. A banktherefore can arrange a swap to take place with the UK company swapping its UKissued bond with a US company that has a comparative advantage in the issue ofdollar bonds but which wants to raise sterling. In some cases the bank may takethe position of the US company and become the counterparty to the swap.

4. The imposition of higher capital requirements on banks by regulators (see Chapter9) since the late 1980s has led banks to attempt to escape such requirements. Thishas led banks to develop and pursue off-balance-sheet activities, although many ofthese activities (as described below) are now captured in capital ratios imposed.Another consequence of increased capital pressures has been the growth ofsecuritisation (discussed above) whereby banks package assets and sell them offas securities. In most cases the assets released from the balance sheet do notrequire capital backing.

You will need to understand how contingent commitment banking is analogous totraditional banking. For example, where a bank accepts a bill (i.e. enters into acontingent commitment) it is providing a guarantee that the bill will be honoured ifthe issuer defaults. The bank gains a fee for accepting the bill and the issuer benefitsas the acceptance means the bill can be issued with a lower rate of interest than wouldotherwise be the case. From the bill holder’s point of view the bank’s acceptance haslowered the risk of the instrument but at the expense of a lower rate of interest. This isanalogous to a deposit contract issued by a bank. From the depositor’s point of view,the bank is able to reduce the risk of the security compared to holding a primarysecurity, but this risk reduction is in return for a lower rate of interest earned. So abank is performing a similar role both on and off the balance sheet, transforming riskby using its skills in information collecting and risk analysis.

39


This growth of off-balance-sheet business has led to fears by the regulatory authoritiesthat the banks may be undertaking excessive risks. Off-balance-sheet businessinvolves new instruments about which knowledge of their riskiness may beincomplete. As you will see in Chapter 9 of this guide, the regulatory authorities havetried to overcome this danger in determining how much capital a bank should hold by:

1. converting off-balance-sheet business into on-balance sheet equivalents and then

2. applying standard risk weights.

Please now carefully read section 4.3 of Buckle and Thompson (1998).

Activity

What are the essential differences between the traditional on-balance sheet activities of

banks and their off-balance-sheet activities?

International bankingInternational banking involves cross-border business. Thus, for example, a US banklocated in London may accept a dollar deposit from a French institution and make aloan in dollars to a German firm. The bank may also switch currency by accepting adeposit denominated in one currency and making a loan in another currency. Londonis a major centre for international banking.7

Much of the business is in what is called a eurocurrency. As distinct from the newEuropean currency the ‘Euro’, a eurocurrency is a deposit or loan denominated ina currency other than that of the host country.8 Hence a dollar deposit in London isa eurocurrency whereas a sterling deposit is not. Similarly a sterling deposit inNew York is a eurocurrency but a dollar deposit there is not. The main currency inthe eurocurrency market is the dollar with the Deutsche Mark as the second mostused currency.

Activity

Which of the following are eurocurrency transactions?

1. a dollar deposit made by a UK resident in New York

2. a Deutschemark loan made by a US bank in London to a French company.

The market for eurocurrencies is essentially a short-term market with the maturity ofdeposits averaging less than three months. Lending is mainly for longer periods. Theshort-term international loans are generally connected with short-term trade financing.The main non-bank depositors and borrowers are governments and multinationalcorporations. The size of longer term loans is generally large so that in many casesloans are ‘syndicated’ (i.e. spread among many banks). The maturities of themedium/long-term loans range from three to 15 years. Normally loans are made atfloating rates of interest using a key interest rate, such as LIBOR, as a reference point.The interest rate will be adjusted at regular intervals as the reference rate changes.US$ syndicated loans are the most popular currency type. Syndication of loanspermits the risk of default to be spread among many banks. This in turn lowers therisk premium that would be charged to the interest rate thereby benefiting theborrower. There are a number of participants in the syndicate:

• lead manager: the bank that negotiates with the borrower and organsises thesyndication

• managers: along with the lead manager, a number of banks will organise thesyndicate participants and underwrite the loan

• participants: the other banks that participate in the making of the loan

7Read Buckle and Thompson(1998), section 7.2 for further

discussion of this.

8The term ‘eurocurrency’ is usedbecause the first deposits of this

type were placed in bankslocated in Europe, mainly

London, in the late 1950s andearly 1960’s. Further discussion

of the origins of theeurocurrency markets is provided

in Chapter 7 of this guide.

40


• agent: the bank that carries out the mechanical tasks of collecting funds fromsyndicate members and collects interest and repayment of principal from theborrower. This could be the same as the lead manager.

The analysis in Buckle and Thompson (1998), section 4.4 is carried out in terms ofeurodollars but can easily be extended to any other eurocurrency. You shouldunderstand the method of creation of eurodollar deposits and loans and the procedureis demonstrated in tables 4.5, 4.6 and 4.7. Read the associated narrative carefully.

The market has grown rapidly in recent years and a number of reasons have been putforward for this growth:

• Originally (before the end of the cold war), the desire of the Eastern Bloccountries to hold dollars for the purposes of international trade but away from thecontrol of the US.

• Lower costs of the eurocurrency market due to lower regulatory requirements.

• The growth in world trade which necessitated a growth of international banking.

• Greater balance of payments imbalances which increased the availability of fundsfor international investment.

Activity

Why do you think the dollar is the main currency of the eurocurrency markets?

You should now read section 4.4 of Buckle and Thompson (1998).

Sovereign lendingYou should have a basic understanding of the nature of sovereign lending and thereasons for, and consequences of, the international debt crisis that emerged in the1980s. The main points are summarised here.9

Sovereign lending refers to lending to sovereign governments, either directly to thegovernment or government agency or to a company within the country where the loanis guaranteed by the government. This form of lending by banks grew rapidlyfollowing major oil price rises in 1973 and 1974. Oil producing countries placed theirreceipts on deposit in the eurocurrency markets and these funds were on-lent bybanks, mainly to developing countries. The loans were mainly made with a floatingrate of interest in US dollars. When US interest rates were increased sharply at theend of the 1970s and at the same time, a worldwide recession lead to a reduction inexport receipts for developing countries, most developing countries with sovereigndebt exposure found it increasingly difficult to continue repaying the loans. ManyWestern banks had large exposures to developing countries debt and the effect ofseveral large debtor countries defaulting on debt repayments would have caused anumber of banks to become insolvent. Faced with a potential threat to the Worldbanking system a number of solutions to the sovereign debt problem were tried overthe 1980s:

• 1982–1985 IMF management of the problem

• 1985–1989 The Baker plan

• 1989– The Brady plan.

Alongside the ‘official solutions’ a number of market based solution to the debt crisisemerged over the 1980s. These were:

9Read Buckle and Thompson

(1998), section 4.5 for furtherdiscussion of these points.

41


• Selling the debt, facilitated by a secondary market in developing country debt. Thedebt would trade at a discount to face value. The price of the debt in the secondarymarket would reflect the markets view of the likelihood of the debt being servicedby the borrower.

• Debt–equity swap, whereby a bank would swap the developing countries debt forlocal currency (at a discount). This local currency would then be invested in anindustry in the developing country.

• Debt–debt swap, whereby the loans held by banks would be swapped for bondsissued by the developing country government. The bonds would be issued at adiscount to par or paying an interest rate below the market rate.

The Brady plan essentially gave official approval to the market solutions describedabove. In particular, the Brady deals that have since been negotiated with developingcountries have mainly utilised debt-debt swaps.

The threat to the international banking system has receded over the 1990smainly because:

• The Brady plan has been successful in reducing the debt owed bydeveloping countries.

• Banks have made provisions against the debt10 (set aside funds to protectthemselves from the effects of default).

Learning outcomes


• Identify the main features of wholesale banks that distinguish them from retail banks.

• Describe the main products and services provided by wholesale banks.

• Describe the two main ways in which wholesale banks manage liquidity risk.

• Describe the main types of off-balance-sheet business of banks.

• Identify the main features of eurocurrency deposits and loans.

• Discuss the reasons for the growth of the eurocurrency markets.

• Discuss the reasons for the sovereign lending crisis and the main solutions

adopted to solve the problem.


1. Discuss the essential differences and similarities between wholesale and retail banks.

2. Describe the nature of off-balance-sheet business of banks, giving examples, and

discuss the consequences of the growth of this type of activity.

3. Discuss the causes and consequences of sovereign lending by banks in the 1970s

4. Describe the nature of a wholesale bank and discuss the changes taking place in

the activities of wholesale banks.

10Referred to as loan lossprovisions in the US.

principle of banking

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