WH A T A R E B A N K S A N DWH A T A R E B A N K S A N D

WH A T D O T H E Y D OWH A T D O T H E Y D O??

The Meaning of BankingThe Meaning of Banking

The provision of deposit and loan products The provision of deposit and loan products normally differentiate banks from other normally differentiate banks from other types oftypes of

financial firmsfinancial firms . .

Deposits are Deposits are liabilities liabilities for banksfor banks,,

The banks manage the The banks manage the assets assets created created by by lendinglending..

the core activity is to act as the core activity is to act as intermediaries intermediaries between depositors and borrowersbetween depositors and borrowers..

Intermediation costs will also include the Intermediation costs will also include the cost of administration and other cost of administration and other transactions costs related to the savings transactions costs related to the savings and loans products offered by the bankand loans products offered by the bank..

The second core activity of banks is to offer The second core activity of banks is to offer liquidity liquidity to their customersto their customers..

Depositors, borrowers and lenders have Depositors, borrowers and lenders have different liquidity preferencesdifferent liquidity preferences..

the liquidity preferences may the liquidity preferences may change over change over time time because of unexpected events. If because of unexpected events. If customers make term deposits with a customers make term deposits with a fixed term of maturityfixed term of maturity

Liquidity Liquidity is therefore an important service is therefore an important service that a bank offers its customersthat a bank offers its customers..

By pooling assets and liabilities, banks are By pooling assets and liabilities, banks are said to be engaging in said to be engaging in asset asset transformationtransformation, i.e., transforming the , i.e., transforming the value of the assets and liabilitiesvalue of the assets and liabilities..

Many banking services have non-price Many banking services have non-price features associated with themfeatures associated with them..

•Organizational StructuresOrganizational Structures

why a bank exhibits the organizational why a bank exhibits the organizational structure it doesstructure it does..

Profit-maximizing banks have the same Profit-maximizing banks have the same objective as any other firmobjective as any other firm;;

The existence of the The existence of the ‘‘‘‘traditionaltraditional’’’’ bank, bank, which intermediates between borrower which intermediates between borrower and lender, and offers a payments and lender, and offers a payments service to its customers, fits in well with service to its customers, fits in well with the Coase theorythe Coase theory..

The core functions of a bank are more efficiently carried out by a command organizational structure, because loans and deposits are internal to a bank.

. .Banks and the Principal Agent ProblemBanks and the Principal Agent Problem--the shareholders of a bank (principal) and its the shareholders of a bank (principal) and its

management (agent)management (agent);;--the bank (principal) and its officers (agent)the bank (principal) and its officers (agent);;--the bank (principal) and its debtors (agent); the bank (principal) and its debtors (agent);

andand--the depositors (principal) and the bank the depositors (principal) and the bank

(agent)(agent)..

Asymmetric informationAsymmetric information, or differences in , or differences in information held by principal and agent, is information held by principal and agent, is the reason why banks face the problem of the reason why banks face the problem of adverse selectionadverse selection because the bank, the because the bank, the principal, normally has less information principal, normally has less information about the probability of default on a loan about the probability of default on a loan than the firm or individual, the agentthan the firm or individual, the agent..

Moral hazard Moral hazard is another problem if the is another problem if the principalprincipal,,

Moral hazard arises whenever, as a result Moral hazard arises whenever, as a result of entering into a contract, the incentives of entering into a contract, the incentives of the two parties change, such that the of the two parties change, such that the riskiness of the contract is alteredriskiness of the contract is altered..

Depositors may not monitor bank activities Depositors may not monitor bank activities closely enough for several reasonsclosely enough for several reasons..

Shareholders do have an incentive to Shareholders do have an incentive to monitor the bankmonitor the bank’’s behaviour, to ensure s behaviour, to ensure an acceptable rate of return on the an acceptable rate of return on the investment. Depositors may benefit from investment. Depositors may benefit from this monitoringthis monitoring..

shareholders face agency problems if shareholders face agency problems if managers maximize their own utility managers maximize their own utility functions, causing managerial behavior to be functions, causing managerial behavior to be at odds with shareholder interestat odds with shareholder interest..

Relationship BankingRelationship BankingRelationship banking Relationship banking can help to minimize can help to minimize principal agent and adverse selection principal agent and adverse selection problemsproblems..Lender and borrower are said to have a Lender and borrower are said to have a relational contract relational contract if there is an if there is an understandingunderstandingbetween both parties that it is likely to be some between both parties that it is likely to be some time before certain characteristics relatedtime before certain characteristics relatedto the contract can be observedto the contract can be observed..

Payment Systems: A Byproduct of Payment Systems: A Byproduct of the Intermediary Processthe Intermediary Process

Banks require a system for processing Banks require a system for processing the debits and credits arising from the debits and credits arising from these banking transactions. The these banking transactions. The payment system is a byproduct of payment system is a byproduct of intermediation, and facilitates the intermediation, and facilitates the transfer of ownership claims in the transfer of ownership claims in the financial sectorfinancial sector..

Credits and debits are transferred Credits and debits are transferred between the relevant partiesbetween the relevant parties..

there are there are two key riskstwo key risks associated with any associated with any payment. Banks must manage the payment. Banks must manage the followingfollowing..

11 - -Liquidity riskLiquidity risk: The settlement is not made : The settlement is not made at the expected time so that at the expected time so that assets/liabilities cannot be transferred assets/liabilities cannot be transferred from one agent to another via the systemfrom one agent to another via the system..

22 - -Operational riskOperational risk: Arising from the threat : Arising from the threat of operational breakdowns, preventing of operational breakdowns, preventing timely settlement. For example, the timely settlement. For example, the hardware or software supporting the hardware or software supporting the system may fail. System breakdowns can system may fail. System breakdowns can create liquidity risk. Given the open-ended create liquidity risk. Given the open-ended nature of the term, it is difficult to provide nature of the term, it is difficult to provide a precise definition, which makes a precise definition, which makes measurement problematicmeasurement problematic..

Definitions of Types of BankingDefinitions of Types of Banking

Universal bankingUniversal banking

Universal banks offer the full range of Universal banks offer the full range of banking services, together with non-banking services, together with non-banking financialbanking financial

services, under one legal entity. In addition, services, under one legal entity. In addition, the banks have direct links between the banks have direct links between banking and commerce through cross-banking and commerce through cross-shareholdings and shared directorships. shareholdings and shared directorships. Financial activities normally include the Financial activities normally include the followingfollowing..

11 - -Intermediation and liquidity via deposits Intermediation and liquidity via deposits and loans; a byproduct is the payments and loans; a byproduct is the payments systemsystem..

22 - -Trading of financial instruments (e.g., bond, Trading of financial instruments (e.g., bond, equity, currency) and associated derivativesequity, currency) and associated derivatives..

33 - -Proprietary trading, that is, trading on behalf of Proprietary trading, that is, trading on behalf of the bank itself, using its own trading bookthe bank itself, using its own trading book..

44 - -StockbrokingStockbroking..55 - -Corporate advisory services, including mergers Corporate advisory services, including mergers

and acquisitionsand acquisitions..66 - -Investment managementInvestment management..

77 - -InsuranceInsurance..Germany Germany is the home of universal bankingis the home of universal banking..the sum of a bankthe sum of a bank’’s equity investments (in excess s equity investments (in excess of 10% of the commercial firmof 10% of the commercial firm’’s capital) plus s capital) plus other fixed investments may not exceed the other fixed investments may not exceed the bankbank’’s total capital. In addition to a German s total capital. In addition to a German bank lending to commercial firms, it will also bank lending to commercial firms, it will also exert influence through the Supervisory Boardexert influence through the Supervisory Board..

Commercial and Investment banksCommercial and Investment banks

commercial banks were not allowed to commercial banks were not allowed to underwrite securities with the underwrite securities with the exception of municipal bondsexception of municipal bonds,,

investment banks were not provide and offering commercial banking services.

The objectives of the Act were twofold, to discourage collusion among firms in the banking sector, and to prevent another financial crisis of the sort witnessed between 1930 and 1933.

The early US investment banks: (a) raised capital for large corporations and government,

by acting as underwriters for corporate and government securities and (b) for a fee, arrangedmergers and acquisitions

Modern investment banks engage in an Modern investment banks engage in an expanded set of activitiesexpanded set of activities::

underwriting1 -mergers and acquisitions

2 -trading – equities, fixed income (bonds), proprietary3 fund management

4 -consultancy5 -global custody

Merchant banks