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BANKING AND ECONOMICS
Traditional banking----taking deposits and making loans
Modern bank is a complex financial institution staffed by
multi-skilled individuals conducting multi-task operations
Focus of the talk in next few days is on studying bank
behaviour (optimisation subject to constraints) and bank
management practices
Understanding the behaviour of banks using basic tools
of economic analysis
Question to Answer Why banks exists?
How to check bank financial health?
Is the merger of banks beneficial to society and
banks?
Size: Bigger banks are better for the society?
How to measure degree of competition in banking
Why banks need more regulations compare to NBFI’s ?
Are the banking regulations laws same in different
countries ?
What are the managerial issues in banking ?
Risk management and prudential regulation
Question to Answer Is the banking industry structure same across globe ? Why banks go abroad or merge? Has the globalisation changed the way banks operate now? Why some countries banks are more dominant
internationally ? Can a bank fail, if yes, then why? Is the bank failure new phenomenon or historical ? Are there some qualitative and quantitative techniques
developed to know beforehand a bank failure ? Yes, you will be able to answer all these questions in next
10 days?
Aims and Outcome of Course
AIM How economics can explain the existence, nature and
operation of retail, wholesale and international banking
OUTCOME demonstrate a historical development of banking evaluate of public policy argument for prudential
regulation identify risks and explain how banks can manage
these risks describe and interpret trend and innovations in
banking efficiency and competition relate the importance of banking to the national
and international economy
Teaching and Learning Activities and Strategies
Lectures 11 Seminars 11 Assessment
coursework assignment40%
end of unit examination60%
Approach First main text book:
Modern Banking by Shelagh HeffernanJohn Wiley & Sons, Ltd ISBN: 0-470-09500-82005 (new edition) Abbreviation: MB
Second main text book:Microeconomics of Banking by Freixas & Rochet MIT Press
Abbreviation: MOB Third main text book:
Commercial Bank Management: International Edition by Peter S. Rose Mcgraw-Hill
Abbreviation: CBM
Approach
Supplementary Text Books and Magazine The Economics of Money Banking and Financial
Markets F. Mishkin, AWL 5th edition, 1996 Financial Markets and Institutions F. Mishkin, AWL 3rd edition, 2000 Global Financial Institutions and Markets H. Johnson, Blackwell, 2000 Commercial Banks Financial Management
Sinkey, Prentice Hall, 5th edition, 1998 Internet, magazines and journals (i.e. Journal of
Banking and Finance). Weekly reading of “The Economist” and “Banker” is desirable for all students
The Modern Banking Firm
A review of financial markets and reasons for banks existence
Modern banking in the context of traditional model Types of banks and their operations Moral Hazard and asymmetric information in banking Modern activities in banking:
Off-balance sheet and securitisationReading
1. MB ch.1, ch.2 2. MOB ch.1 pp 1-8, ch.2 pp 15-203. CBM ch.1 pp 4-234. F. Allen and A.M. Santomero (February 2001) What do
financial intermediaries do? Journal of Banking and Finance Volume 25, Issue 2, Pages 271- 294
Banking Structure Around the World Main features of the banking systems in the
following countries: UK USA Germany
Reading MB ch.1,ch.2,ch.6 International Banking: text and cases Financial
Times EditionISBN: 0-201-75666-8ch.3
Some journal articles
Managing Risks in Banking
Types of risk a modern day bank faces: Credit risk Liquidity and funding risk Interest rate risk Market or price risk Foreign exchange risk Sovereign or political risk
Approaches to the management of risks: Gap analysis Duration analysis Duration gap analysis Securitisation, derivatives and options
Conclusion (summary)
Managing Risks in Banking
Reading MB ch.3 International Banking: text and cases Financial
Times EditionISBN: 0-201-75666-8ch.11
CBM ch.6,7,8,9,10 MOB ch.8
Banking Laws: Prudential Control in Banking
Introduction: Why banking regulation? Types of risks envisaged in banking and its
relations to banking regulation Arguments for prudential control/regulation Problems with external prudential regulations and
a case for free banking Prudential control and regulations in the UK Prudential control and regulations in the USA Reading MB ch.4,ch.5 CBM ch.2 pp 33-58 MOB ch.9
Empirical Work on Efficiency and Competition Issues in
Banking Why we study competitive issues in banking? Are
competitive banks good for us? Measuring bank output How to estimate productivity and efficiency in banking? Empirical test of economies of scale and scope in banking Empirically testing how banks price their products Empirical test of price discrimination in banking Empirical models of test of competition in banking marketReading MB ch.9 CBM ch.5 pp 149-175 MOB ch.3
Banking Failures Why banks fail? Case studies of bank failure The determinants of bank failure
Management incompetence Fraud Regulatory tolerance Global recession
Solutions of bank failureReading MB ch.7,ch.9 International Banking: text and cases Financial Times
Edition, Ch.9 MOB ch.7
The modern banking firm
Outline A review of financial markets and reasons for banks
existence Modern banking activities in the context of traditional
model Types of banks and their operations Asymmetric information, moral hazard and adverse
selection in banking 4 Major developments in banking Industry
Deregulation Globalisation Financial innovations Strengthening in the degree of competition
Banks: what and why?
Operational definition used by regulators “A bank is an institution whose current
operation consists in granting loans and receiving deposits from the public”
“Banks act as intermediaries b/w depositors and borrowers”
Banks are different from other financial firms in that they provide deposit and loan products
The deposit products pay out money on demand or after some notice
Thus banks manage liabilities and creates assets by lending money
Financial Markets
Funds Financial intermediaries
Funds
Borrower-SpendersBusiness firmsGovernmentHouseholdsForeigners
Lender-SaversHousehold
Business firmsGovernmentForeigners
Financial Markets
FundsFunds
Direct Finance
Indirect Finance
Funds
Why do banks exist? The traditional theory of banking Answer: Due to liquidity and payment services Money evolved from commodity money (e.g. gold coin) Now Money lubrication of trade frees us from
bother exchange the goods we want Efficient medium of exchange and payment Paper Money not SUFFICIENT BANKS came into actions –bank drafts, LOC, etc There are different type of banks. But role of banks is
same“perform intermediary role by accepting deposits and
making loans” “Bank receives interest margin in term of compensation
for this service”
Banks: what and why?
Why not borrowers and lenders come together w/o an intermediary?
Answer: 1. presence of information cost and2. borrowers and lenders have different liquidity
preferences Four types of information costs may incur to lender w/o
intermediationi. Search cost contact of two partiesii. Verification cost verification of information
provided by borroweriii. Monitoring costs monitoring of activities of
borrowervi. Enforcement cost in case of default
Information costs
Lenders will go to bank for intermediation if intermediary cost is less than the four costs components.
Bank may also enjoy “informational economies of scope” Economies of scope are said to be exist when two or more
products can be jointly produced at a lower cost than if the same products are produced individually
Informational economies of scope in lending mean banks can pool a portfolio of assets which have a lower default risk but the same expected return on investment
Banks can pool funds from different lenders (depositors) and can give liquidity at cheaper prices. This makes intermediation cost for the banks even less
In additions, firm may take loan from the banks to send the signal to others that firm is likely to be staying in the business and thus encouraging customers and suppliers to enter into long term relationship largely due to creditworthiness
Modern Banks
Modern Day Banks
Broadly speaking modern day banking consists of two types of banks
1. Specialist investment /wholesale banks focus on investment market
2. Generalist (retail and universal) banks offer wide range of products such as:
1. Deposit account2. Loan product3. Real estate services4. Stock broking5. Life insurance
Wholesale Banking
Wholesale banking may be described as “small number of very large customers” i.e. corporate and governments
These banks are firms, which act as “private bankers” accepting deposits from high net worth individuals and investing in broad range of financial assets
These banks with small deposit base have an access of a wide range of funds from the equity, bond and syndicated loan markets
Wholesale banking is largely interbank Example
ABN AMRO, MORGAN STANLAY
Wholesale Banking Modern wholesale (particularly USA investment banks) banks are
engaged in:i. Finance wholesalerii. Underwritingiii. Market makingiv. Consultancyv. Mergers and acquisitionvi. Fund management
Merchant banks in UK traditional functions also include the same as that of their cousins in USA
There had been a rapid growth in wholesale banking for the last two decades-Reason
i. Relationship banking had reduced cost of contractingii. Delegation of tasks of evaluation and monitoring of
borrower to a credit rating firms to avoid the cost of each time evaluating borrower profile
Retail Banking
Retail banking may be described as “large number of very small customers” i.e. households
Such system of banking is usually characterised with small number of banks with extensive branches network (with exception of USA)
Retail banking is largely intrabank (the bank itself makes many small loans)
NATWEST, BARCLAY, HSBC Services provided are:
Safe store Payment mechanism (money transmission system) Financial intermediation (savings and lending) Other wide services such as financial advice,
FOREX, share dealing and insurance etc.
Retail Banking
Retail banking has witnessed a rapid “process innovation” for the last two decades specifically:
i. Replacement of cashier with machine- cost reduced to 25% of cashier
ii. ATM facility domestically as well as worldwide
iii. Telephone bankingiv. Video linked financial servicesv. Electronic cash e-cashvi. Debit and credit cards Visa and mastervii. Virtual banking by internet
Universal Banking Universal banking refers to the provision of most or all
financial services under a single, largely unified banking structure-Very common in Germany
Walter (1994) identified four types of universal banks: Fully integrated universal banks- supplying all financial
services from one entity Partially integrated financial conglomerates and able to
supply all services but some like mortgage, leasing and insurance are provided through subsidiaries
Bank subsidiary structure -bank concentrates on retail banking and remaining activities like investment banking and insurance through legally separate subsidiary of the bank
Bank holding company structure - financial holding company owns both banking and non-banking subsidiaries. Holding company may be non-financial firm or holding company itself may be an industrial concern
Universal Banking
Universal banking may include: Intermediation Trading of financial instruments, foreign
exchange and their derivative Underwriting new debts and equity Brokerage Corporate advisory services(mergers and
acquisition advice) Investment, management, insurance
Banks all around the world are trying to become universal
Natwest, Barclays and HSBC are offering a broad range of services, ranging from deposit taking and loan making to investment advices
Why banks are like a firm or why they exhibit organisational structure?
Banks are like firms. Coase (1937) explained that a firm need an organisational structure because some procedures are more efficiently performed by “command” i.e. assigning tasks to workers and coordinating the work than reliance on market prices.
A traditional bank with intermediary and liquidity function fits in well with Coase theory.
Loans and deposits are internal to bank and they need command and control (CC) system.
This intermediary role of banks and CC system will lead to principal and agent structure.
Principal-agent problem in banking
Bank activities are usually collection of contracts b/w principal and agents.
Whenever these contracts are not honoured properly, principal-agent problem will arise.
This principal-agent problem may exists b/w shareholders of a bank (principal) and its management (agent), the bank (principal) and its officers (agents) and the bank (principal) and its debtors (agents), depositor (principal ) and bank (agent) due to different priorities and incentives.
Principal agent problem may arise due to the fact that agent has more information about his/her characteristics than the principal.
Moral hazard problem in banking
Bank activities are usually collection of contracts b/w principal and agents. Moral hazard is another problem in case of depositors (principal) and bank (agent)
Moral hazard occurs when incentive changes for any party, which are core of the contract
Example Depositors do not monitor bank activities and bank
may go to risky ventures/businesses. Investors may take loans and intentionally default. Deposit insurance scheme may be exploited by
banks
Adverse selection problem in banking
Moral hazard problem can lead to incentives problems because the principal cannot observe the agent action (i.e. bank shareholders and management) or the principal has inferior information compared to agent (i.e. managers and borrowers)
Differences in information held by principal and agent can give rise to adverse selection
Examples: Banks giving wrong and/or incomplete advice Rip-off of customers in UK See the “Economist” article
Relationship banking Relationship banking can help to minimise the
principal-agent, adverse selection and moral hazard problem arising b/w a bank and borrowers and bank and depositors.
Under relational banking lenders and borrowers have a relational contract
Bank and borrower and bank and depositors will try to give full information to each others (better flows of information).
Further an understanding b/w both parties that in future there may be need of some monitoring
Relationship banking Example
A good example in this regard is bringing of new product in the market. If an investor goes to bank for loan, the bank will see her/his record, no financial difficulty, no default, loan granted and a clause may be introduced for monitoring or altering the clauses of contract.
Relationship banking is very common in Japan and Germany
However, some time relationship banking may go wrong.
Example: Jurgen Schneider/Duetche Bank
Arms’ length banking An extreme opposite is an arms’ length
transactional or classical contract where many banks compete for the costumers business and customers shop around several banks.
Both parties will try to disclose bear minimum information and stick to the contract clauses.
UK and USA banking system is working under this system
4 Major Developments in Banking Industry1. Deregulation of financial institutions i.e. banks in regard to
their pricing decisions i.e. variable interest rate lending
2. Financial innovations
New processes (new markets i.e. Eurocurrency Market,
securitisation) New financial instruments (i.e. Certificate of
Deposits (CD’s), Floating Rate Notes (FRN) and Asset Backed
Securities (ABS))
3. Globalisation (most banks operate throughout the world now)
4. Strengthening in the degree of competition Forcing banks to:Re-structureDiversifyImprove efficiencyAbsorb greater risk
4 Major Developments in Banking IndustryDeregulation A major change in term of how modern day banks are
behaving is the direct result of deregulation Deregulation has come in three phases
Phase 1: lifting of quantitative controls on bank assets and ceiling on interest rate on deposits
Phase 2: Relaxation of the specialisation of business between banks and other financial intermediaries allowing both to compete in each other’s markets (i.e. investment banking, mortgage and insurance products)
Phase 3: Allowing competition from new entrants as well as increasing competition from incumbent and other financial intermediaries
4 Major Developments in Banking Industry
Financial Innovation Deregulation in turn has brought in financial innovation Financial innovations are the direct result of
technological advancement and ever rising demand and expectation of customers
3 major structural changes as a result of innovations Shift of focus on liability management rather than asset
management Shift to variable rate lending (from fixed) Introduction of cash management techniques (helping
banks to reduce average transaction cost)
4 Major Developments in Banking Industry
Post WWII focus on asset management due to: Heavy public sector debt to carry out reconstruction and
control on lending Asset management subject to constraints in term of Duration Now the focus is on liability management
Ability to create liability ---borrowing in inter bank market (USA banks have been borrowing from offshore centres)
1970s volatile inflation and interest rate led to culture of variable interest rate lending linked to LIBOR (London Inter Bank Offer Rate)
Variable rate determined by LIBOR, riskiness of customer, competitive pressure and marginal cost of lending
4 Major Developments in Banking Industry
Hence stock of bank loans = f(demand for bank credit) Modern day banking involves liability management by altering
interest rate on deposits and borrowing from Inter Bank Market Technological innovation has seen the development of new
financial products such as: Credit card Electronic Fund Transfer (EFT) Automated Teller Machines (ATM) Point of Sale (POS)
All this has led to better cash management on the part of consumer and significant cost reduction for the provider of these products-banks
4 Major Developments in Banking IndustryGlobalisation Globalisation of financial system generally and banking system
particularly is on the rise In post WWII however banks getting more global due to:
Push factors- interstate banking regulation in USA Pull factors- following prime customer---creation of branch
network in foreign countries by City Bank and Bank of America Few other factors helping banks to go global include:
Mergers,takeover and relaxation of capital control Increasing trend in securitisation Harmonisation of banking laws (European banking laws by
ECB)
Banking Structure Around the World
Main features of the banking systems in the
following countries:
UK
USA
Germany
UK Banking Sector
Overall Retail banking-dominates. Investment banking and overseas expansion- Poor
record. Concentration is high. Switch of status by the building societies. High profit-poor management.
Bank of England The Bank of England is the central bank Responsible for:
Monetary stability. Management of national debt. Banker to government and monetary sector. Assist to FSA.
Banking structure
Financial Services Authority (FSA) Replaced 9 regulatory authorities Main responsibilities are:
Maintaining market confidence Promoting public understanding of FI Protection of consumers Fighting of financial crime
Retail banking (app. 20) Small number of banks with extensive branches network Large number of accounts. Cash ratios above minimum High degree of leverage/ credit creation. Bulk of business in £ sterling.
Retail Banking (app. 20)
Retail bankingServices provided Safe store Payment mechanism (money transmission system) Financial intermediation (savings and lending) Other wide services such as financial advice, FOREX,
share dealing and insurance etc.Wholesale banking (app. 480)Services provided and main features Large accounts and small number of minimum deposits i.e.
£250k, £500k. Large foreign currency business-most of them are foreign. Advice on privatisation-portfolio management-services to
corporate sector. Not involved in payment mechanism.
Building Societies (75)Building Societies (75) Very significant, but share declined after 1986 Products offered:
Mortgage Life Insurance Pensions Investment products
International Banks in UK Government encourages foreign banks operations London is the most famous banking centre with New York
and Tokyo. Very significant share 375 foreign banks, 200 representative offices and 100
foreign securities houses
USA Banking System
Important Features US banking system has over 27,000 deposits
taking institutions compared to 500 banks and 83 building societies in UK
Banking system is concentrated as 76% total assets are held by commercial banks
Over the time US banking sector has lost its dominance
US banks weaknesses include developing country debt problems and decline in agriculture commodity and real estate prices
Structure and regulations of the US commercial banking industry
There are around 2800 commercial banks in the USA, for more than in any other country in the world
In Canada or UK usually five or six major banks dominates the industry but in USA ten largest banks hold only 36% of the assets in their industry
Restrictions and regulations on branches had resulted in more banks
Two-third deposits are held by commercial banks, and remaining by thrift institutions
In the past, it had been a case that an American bank could open a branch in foreign country easily than domestically
The McFadden Act 1927, had effectively prohibited larger banks to open branches across states
Structure and regulations of the US commercial banking industry The McFadden Act and state branching regulates
constituted strong anticompetitive forces in the commercial banking industry
But from late 1990s, situation has changed Regulation on branches particularly are being
eased The restriction on branches had resulted in three
developments:
Bank holding companies
Nonbank banks
Automated Teller Machines (ATM)
Bank holding companies
A holding company is a corporation that owns several
different companies
The growth of holding companies over the time had been
dramatic to avoid the branching restrictions
B/c the holding company can own a controlling
interest in several banks
These holding companies had been and can involve in
investment banking activities
can purchase a failed bank in even other states and
thus effectively avoid the branching restriction
Nonbank banks
Another way banks can avoid branching restrictions was
due to loopholes in the bank holding Act of 1956, which
defined a bank as a financial institution that accepts
deposits and makes loans
Once bank holding companies had recognized this
loophole, they opened branches with one function only
(means offering loan facility or taking deposits only)
However, the Competitive Act passed in 1981 had
effectively filled this loophole
ATM
The modern day facility of ATM was originally invented to avoid branching restrictions in USA
Banks recognized that even if they don’t had ATM machines by their own but could use rented machines, they can easily avoid branching restrictions
A number of these shared facilities such as Cirrus and NYCE have been established nationwide
States also had encouraged these ATM machines rather than “brick and mortar branches”
These ATM machines had got popularity with the advent of cheap computers
USA- Commercial banks consolidation
Banks failures in late 1980s and early 1990s had provided the base for banks consolidation
Mergers and consolidations had been an important part of bank failure strategy
Banks consolidation was further stimulated by the passage of Riegle-Neal Interstate Banking and Branching Efficiency Act
This legislation expands the regional compacts to the entire nation and overturn the McFadden Act of prohibited interstate banking
This Act had almost ensured the interstate banking roughly in all 50 states
USA- Commercial banks consolidation
It is anticipated that after consolidation there will be roughly 4000 commercial banks rather than present 8500
Another important feature of the USA commercial banking industry had been the separation of commercial banking from investment banking such as securities, insurance and real estate business
Glass-Steagall Act 1933 had prohibited them from underwriting corporate securities or from engaging in brokerage activities. In turn, this Act had also prohibited investment banks and insurance companies from engaging in commercial banking activities
In 1997, however, the Federal Reserve allowed holding companied to underwrite securities and stocks
Initially it was insured that the revenue from these activities should be 10%, raised to 25% later on
USA- Commercial banks consolidation
Restrictions on commercial banks securities and
insurance activities put American banks at a comparative
disadvantage relative to foreign banks
In 1999, the Congress had passed a bill, which effectively
abolished the Glass-Steagall Act
This legislation, which is called Gramm-Leach-Bliley
Financial Services Modernisation Act of 1999, had allowed
securities firms and insurance companies to purchase
banks and allowed banks to underwrite insurance and
securities and engage in real estate activities
Thrift industry in USA
Savings and loans association (S&Ls) Just as there is dual banking for commercial banks, savings
and loan association can be charted by the Federal government or by the states
Most of the S &Ls whether state or federally charted or member of Federal Home Loan Bank System (FHLBS)
The Savings Association Insurance Fund (SAIF), a subsidiary of FDIC, provides Federal Deposit Insurance (up to $100,000 per account) for S &Ls
The branching regulations for S&Ls were more liberal than for commercial banks:
From 1980s federally charted S&Ls were allowed to branch state-wide in all states
Thrift industry in USA
These S&Ls usually provides loans for mortgages, FHLBS makes loans on soft terms (low interest rates and longer repayment period). In late 1980s, these S&Ls started involving in commercial banking activities
Mutual saving banks Of the around 400 mutual banks around half are chartered by the
states Their deposits are ensured by the FDIC up to a limit of $100,000
per account The branching regulations for mutual saving banks are determined
by the states in which they operate B/c restrictions on branching are not severe there are fewer mutual
saving banks with vast branching structure
Credit unions
Credit unions Credit unions are small cooperative lending
institutions They are the only financial institutions which are tax
exempted and can be chartered either by the state or the federal government
The National Credit Union Share Insurance Fund (NCUSIF) provides insurance for deposits
Since the majority of the credit union lending is for consumer loans with fairly short term of maturity, they do not suffer the financial difficulties of S&Ls and mutual saving banks
These unions are permitted to do branching in all states w/o any problem
International banking in USA
In 1960s eight US banks operated branches in foreign countries and their total assets were less than $4 billion. Currently there are more than 100 American banks working abroad with assets totalling over $500 billion
US banks had most of their branches in Latin America, the Far East, the Caribbean and London
Due to trade expansion, foreign banks had been encouraged to do the business in USA . These foreign banks had been overall very successful
These foreign banking are roughly lending the same amount of money to corporations as the US banks
These foreign banks are operating by using the agency offices, subsidiary banks and branches. Before 1978, foreign banks were under fewer regulations with no reserve requirements. However, 1978 International Banking Act put foreign and domestic banks on equal footing
German Banking System
Features German banks are typically universal ones
A universal bank is one, which provides a complete range of commercial and investment banking services
The German Banking Act implicitly provides a legal definition of a universal bank
in the wider sense- a bank, which offers the whole range of commercial, and investment banking services. Enterprise type-offering banking business
Banking Act: banking business comprises of: acceptance of funds w/wo interest paid (deposit business) granting of loans and acceptance credits (lending business)
German Banking System
Banking Act: banking business comprises of: purchase of bills of exchange and cheques (discount
business) purchase and sale of securities for others (securities
business) safe custody/admin. of securities for (safe custody
business) guarantees and warrantees of others (guarantee
business) performing of cashless payment/clearing (giro
business) Wide definition and consequently; some activities
considered non-banks in UK, are banking activities in Germany. Generally speaking, German financial system is characterised as ‘bank based’ due to broad legal definition of banking business
German Banking System
The group of universal banks in Germany can be divided into three categories on the basis of ownership and legal form. These categories are:
commercial banking sector; saving bank sector; and credit cooperative sector
Building and loans associations are treated separate from the banking system
Three categories of universal banks together accounted for roughly 80% of the volume of business in Germany
This confirms the fact that German banks are really universal banks. All the banks are able in principle to conduct the whole range of banking business as specified in the banking Act.
Commercial banks in Germany
Commercial banks in Germany as a whole, account for roughly 25% share in the total volume of banking business
There are four different classes of banks under commercial banks category:
The big banks Regional and other commercial banks Foreign banks Private banks
Duetsche Bank, Dresdner Bank, Commerzbank and their Berlin subsidiaries operate nationally through network of local branch offices
Although these banks are major banks in term of their balance sheet volume, however, their share is not as significant in overall banking business
Regional/commercial/foreign banks
These banks concentrate on providing universal banking services in their particular regions, but some maintain their system of branches which had allowed them to operate on interregional or national basis.
Two such banks with an extensive branch network are the Bayerische Vereinsbank and the Hypo-Bank.
These two large banks are even permitted to engage in mortgage business.
Foreign banks in the German banking system had not been significant
Foreign banks are permitted to engage in those sorts of businesses, which are allowed to domestic banks
Private banks consists of limited partnership private bankers specialize in export finance, securities
trading, industrial finance, and housing finance etc.
Saving bank sector
Savings bank sector had the largest share in the domestic volume of business
Saving banks were originally conceived non-profit making concerns: to serve relatively less well-off members of the community; to give credit on favourable terms to public authorities; to finance local investment in the region
These banks do follow these obligations but now they have become universal banks which compete with the commercial banks for most forms of banking business
There are three tiers within the saving bank sector. These are:
Local savings banks State saving banks Central saving banks
Local saving banks
These are municipal or district institutions incorporated under public law as independent legal entities
Each state had its own Savings Bank Act, which specifies the structure and organisation of the saving banks in that state
A local saving bank is usually permitted to operate only in its own region and its investment in securities and other assets are subject to restrictions.
State savings banks (Central Giro Institutions)
Each state saving bank is incorporated under public law and is owned by its respective state government and state saving bank association
Works as clearing houses for their member local savings banks.
They are state bankers in their respective states and can conduct their business on interregional and international basis.
The largest state saving bank is the Westduetsche Landesbank girozentrale, which is roughly comparable to Commerzbank in terms of balance sheet assets
Central savings banks
Deutsche Girozentrale (DGZ) serves as the central clearing bank for the saving bank system and holds the liquidity reserves for the state saving banks
This is similar to state saving banks in term of business it conducts, but it is smaller in size than many of them.
Although, both local saving banks and state savings banks are universal banks, some activities such as securities trading underwriting and international business are more important for state saving banks.
Credit cooperative sector
The credit cooperative originated simply as cooperative banks
Provides credit to their members, but now have developed to universal banks
The organisation of the credit cooperative sector is similar to that of the saving bank sector
There are large numbers of local credit cooperatives and a system of larger regional banks headed by a central clearing- house institution
There are three tiers within the credit cooperative sector. These are: Local cooperative banks,regional central cooperative banks and federal clearing house institutions
Local and regional cooperative banks
Local cooperative banks The first tier of this sector comprises local banks organised
as cooperatives, whose members are local individuals and businesses.
Members of the local credit cooperatives contribute capital.
Regional central cooperative banks The local credit cooperative are headed by a second tier
consisting of regional central cooperative banks, which are either stock corporations or registered cooperatives owned by the local credit cooperatives.
Federal clearing house institutions
Third tier consists of federal clearing-house institution, which is a stock corporation owned by the regional credit cooperatives
This is the most important category of credit cooperative banks in terms of volume of business (among top 10)
The relationship between the local credit cooperatives and the regional institutions of the credit cooperative is similar to that between the local savings banks and the regional giro institutions.
The local credit cooperatives raise relatively large amount of funds in the form of personal saving deposits, while regional institutions of the credit cooperatives do relatively little deposit banking and raise the funds by borrowing from other banks
Mortgage banks
Among those banks in Germany, which provides a specialised range of banking services rather than universal services, the most important group consists of the mortgage banks.
These banks are owned by public or private sectors and the law in Germany generally limits mortgage banks to make long term mortgage loans and loans to municipalities and other public authorities.
These banks finance through bonds and long term deposits.
Most private mortgage banks are usually owned by commercial banks, which are interested to enter into this market
Banks with specialised functions
The group of banks offering specialised banking
services comprises various public and private
institutions
Their share in total volume of banking business in
Germany has been in the range of 10-12%.
These banks provides loans finance such as:
export finance;
finance of projects in less developed countries;
environmental programmes; and small and
medium sized German firms
Management of Risk in Banking
All profit maximising firms face two types of risks: Microeconomic risk (new competitive threat);
Macroeconomic risk (the effect of recession) Additional potential risks include:
Breakdown in technology; Commercial failure of a supplier or customer; Political interference;National disaster
Banker on the other side face some additional risks bankers job is to manage these risks. Risk
management is the primary responsibility of bank management.
Some risk are easy to think, calculate and manage, but some are difficult to even calculate.
Additionally, banks manage the risk arising from on and off-balance sheet business.
Management of Risk in Banking
Types of risk a modern day bank face Credit Liquidity and funding Settlement and payment Interest rate Foreign exchange Gearing or leverage Market or price
Approaches to the management of risks Credit risk
Credit risk analysis/credit evaluation
Management of Risk in Banking
Approaches to the management of risks Interest rate risk (through assets liability management
(ALM)) Gap analysis Duration analysis Duration gap analysis
Liquidity and funding Gap analysis
Foreign exchange Hedging
Market or price VaR and Stress Testing
Asset securitisation and derivatives
Definition of risks a bank face
Credit risk probability of default on a loan agreement.
risk that an asset or a loan will become irrecoverable due to outright default.
Liquidity and funding risk Liquidity risk
of insufficient liquidity for normal operating requirements
financing wage bills etc. the ability of the bank to meet its liabilities
when they fall due. It simply means shortage of liquid assets
Funding risk bank is unable to finance its day-to-day
operations smoothly.This is called maturity mismatching
Definition of risks a bank face
Interest rate risk Interest rate risk arises from interest rate
mismatches in both the value and maturity of interest sensitive assets, liabilities and off-balance sheet items.
Asset-Liability Management (ALM) manages interest rate risk.
If banks have excess fixed rate assets they are vulnerable to rising interest rate and
if excess fixed rate liabilities they are vulnerable to falling rates.
Typically banks are asset sensitive meaning a fall in interest rates will reduce net interest income by increasing the banks’ cost of funds relative to its yield on assets.
Definition of risks a bank face
Market or Price risk Banks face market (or price) risk on instruments
traded in well-defined markets. equities, bonds holding by bank (price
incr./decr.) Two types- General (systematic) and unsystematic A bank can be exposed to market risk (general
and specific) in relation to debt and service fixed and floating rate debt instruments such
as: bonds, debt derivatives, futures and
options on debt instruments, interest rate and cross country swaps and forward foreign exchange positions, equities and equity derivatives (equity swaps), futures and options on equity indices, options and futures warrants.
Definition of risks a bank face
Foreign exchange or currency risk Under flexible exchange rates a bank with global
operation face such type of risk and it arises usually due to adverse exchange rate
fluctuation which effects the bank foreign exchange position taken on its own account or on the behalf of its customers.
Banks engage in spot, forward, and swap dealing faces this risk. Banks have large positions, which changes dramatically within minutes.
Gearing or leverage risk Banks are highly geared (leveraged) than other
businesses. Suppose banks confirm to a risk asset ratio of 8%.
An 8% capital ratio translates into a 1250% ratio of “debt” (liabilities) to equity in contrast to 60-70% debt-equity ratio for commercial firms.
Credit Risk Management Credit risk techniques are probably among the best –
developed tools available to bankers and they have long experience of assessing and managing this risk. Essentially, following are the widely used techniques to manage credit risk.
Screening Monitoring Long-term customer relationships Loan commitments Collateral Compensating balances
The credit risk analysis departments usually use two types of methods.
Qualitative & Quantitative
Approaches to the management of credit risks
Qualitative Banks usually use four ways to minimise credit risk.
Accurate pricing of loans---more risky loans may be priced higher than the less risky loans.
Credit limits----credit limit may be imposed on the borrower according to their wealth or potential income in near future.
Collateral or security----loans should be properly secured against the wealth or assets of the borrower (houses or shares etc.)
Diversification---risky loans can be backed up through new capital injection or diversification through finding new loans markets.
Approaches to the management of credit risks
For firms or big borrowers banks can assess annual report of the company or debt-credit record.
judgement is made on the basis of past credit history (through credit rating agencies), the borrower gearing (leverage) ratio, wealth of borrower, volatility of the borrowers’ income, and whether or not collateral is a part of the loan agreement.
Sometime credit rating team will look on the forecasted macroeconomic indicators such as: inflation, interest rates and future economic growth.
Approaches to the management of credit risks
Quantitative method of credit risk analysis requires the use of financial data to predict the probability of default by the borrower.
The methods, which are usually commonly used, are Discriminant Analysis and Logit and Probit models
These methods are statistical techniques and involve regression
The probability of defaults is calculated on the basis of some important predetermined variables i.e age, marital status, residence and qualification etc.
Approaches to the management of interest rate risks
Interest rate risk managed through asset liability management. Two types of method are very common in analysing and minimising the interest rate risk. These are
gap analysis and duration analysis
Gap analysis Gap analysis is the most well known ALM technique
used to manage the interest rate risk. The gap is the difference between interest
sensitive assets and liabilities for a given time interval say six months. In gap analysis each of the bank assets and
liabilities is classified according to the date the asset or liability is going to be re-priced, and the “time buckets”
Approaches to the management of interest rate risks
normally overnight-3 months, 3-6 months 6-12 months, 12 months and more and so son.
Analyst will compute incremental and cumulative gaps results.
An incremental gap is defined as earning assets-funding sources in each time buckets, while cumulative gaps are the cumulative subtotals of the incremental gaps.
By definition incremental and cumulative gaps should be zero for complete interest risk aversion scenario.
A negative gap means sensitive liabilities are > sensitive assets.
A positive gap means sensitive assets are > sensitive liabilities.
GAP Analysis-Example
Gap analysis for interest rate risk
Overnight-3 months
> 3-6 months
> 6-12 months
> 1-2 years
> 2-5 years
> 5 years or not stated
Earning assets notes and coins £100 3-month bills £20 interbank loans £20 5 years bonds overdrafts £20 5-years loans £20 property £30 Funding sources (Liabilities) retail deposits £100 £50 £45 3-months wholesale deposits £5 Capital £10 Net mismatch gap £35 £20 -£50 -£55 £20 £30 Cumulative mismatch gap £35 £55 £5 -£50 -£30 £0
More on Interest-Sensitive Gap Measurements
Dollar Interest-Sensitive Gap
Interest-Sensitive Assets – Interest Sensitive Liabilities
=
Relative Interest-
Sensitive Gap SizeBank
Gap ISDollar
Interest Sensitivity
RatiosLiabilitie SensitiveInterest
Assets SensitiveInterest
Interest-Sensitive Assets-Liabilities
Assets Short-term securities issued by the government and
private borrowers Short-term loans made by the bank to borrowing
customers Variable-rate loans made by the bank to borrowing
customers
Liabilities Borrowings from money markets Short-term savings accounts Money-market deposits Variable-rate deposits
Gap Positions and the Effect of Interest Rate Changes on the Bank
Asset-Sensitive Bank Interest rates rise
NIM rises Interest rates fall
NIM falls Liability-Sensitive Bank
Interest rates rise NIM falls
Interest rates fall NIM rises
Important Decision Regarding IS Gap
Management must choose the time period over which NIM is to be managed
Management must choose a target NIM To increase NIM management must either:
Develop correct interest rate forecast Reallocate assets and liabilities to increase spread
Management must choose dollar volume of interest-sensitive assets and liabilities
NIM Influenced By: Changes in interest rates up or down Changes in the spread between assets and liabilities Changes in the volume of interest-sensitive assets and liabilities Changes in the mix of assets and liabilities
Problems with Interest-Sensitive Gap Management
Interest paid on liabilities tend to move faster than interest
rates earned on assets
Interest rate attached to bank assets and liabilities do not
move at the same speed as market interest rates
Point at which some assets and liabilities are repriced is not
easy to identify
Interest-sensitive gap does not consider the impact of
changing interest rates on equity position
Approaches to the management of interest rate risks
Duration analysis Duration analysis allows for the possibility that the
average life (duration) of an asset or liability differs from their respective maturities which makes matching of sensitive assets with sensitive liabilities quite difficult. Suppose the maturity of a loan is six months and
the bank opts to match this asset with a six months certificate of deposit (CD). If part of the loan is repaid each month, then the duration of the loan will differ from its maturity.
The formula for duration is as: Duration= Time to redemption {1-[coupon
size//MPV*r)]}+(1+r)/[1-(DPV of redemption/MPV)]---(1)
Where: r: market or nominal interest rate; MPV: market present value; DPV: discounted present value;
Present value is calculated as: Sum of cash flows/(1+r)n ……..(2)
Approaches to the management of risks- Example
Bond life: 10 years, Value: £100, Coupon rate: £5 annually, Redemption value: £100, Market interest
rate: 10%. Present value is calculated as: DF CF PV0.91 5 4.550.83 5 4.130.75 5 3.760.68 5 3.420.62 5 3.100.56 5 2.820.51 5 2.570.47 5 2.330.42 5 2.120.39 105 40.48
69.27
Approaches to the management of risks- Example
Duration is calculated:D= 10[1-5/6.9277)]+(1.1/0.1) {1-[100(1.1) -
10/69.277]}. D= 7.6 years rather than 10 years. Similarly duration of equity can be calculated as:
DE= {(MPVA*DA)-(MPVL*DL)] (MPVA-MPVL)---------(3)
The computed duration of equity is used to analyse the effect of a change in interest rate on the value of bank
More on Duration Duration of an Asset/Liability portfolio
n
1 iAiA i
D *w D
Where:wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio
n
1iLiL i
D * w D
Duration of a Liability Portfolio
Where:
wi = the dollar amount of the ith liability divided by total liabilities; DLi = the duration of the ith liability in the portfolio
Duration Gap
TA
TL * D - D D LA
Change in the Value of a Bank’s Net Worth:
L * i) (1
i * D- - A *
i) (1
i * D- NW LA
Overall Duration Gap is:
Impact of Changing Interest Rates on a Bank’s Net Worth
Positive Rise Decrease
Gap Fall Increase
Negative
Rise Increase
Gap Fall Decrease
Zero Rise No Change
Gap Fall No Change
Approaches to the management of liquidity risk
Triggered when majority of the customers are
interested to get their money back due to bad
management or perception of bank failure
All the times the bank must be able to meet
the cash flow obligation arising from deposit
withdrawals (normal case as well as in stress)
The best way to deal with this type of risk in
modern banking is to use the gap analysis.
Approaches to the management of liquidity risk
To control this risk, banks usually plan cash flows (in and out) over a short interval (e.g. one week)Assets Liabilities Loans 300 Deposits 400 Bonds 250 Interbank 100 Equity 50 Total 550 550 Liquidity Profile One week Two week interest income 1.0 1.0 interest expenses -0.7 -0.7 operating expenses -0.1 -0.1 tax 0.0 0.0 reimbursement of principal Loans and bonds 30 30 estimated new lending -25 -35 reimbursement of deposits -40 -10 estimated new deposits 10 10 new cash flow -24.8 -4.8 cumulative net cash flow -24.8 -29.6
Market Risk Management Banks participate in buying and selling of
financial instruments in various and diverse markets around the globe. Adverse changes in the price of these instruments can expose the banks significantly and effect the value of their portfolio. This is called market risk.
Two widely methods to calculate the exposure of market risk are:
Value at Risk (VaR): calculates market risk faced by a bank in everyday normal market condition.
Stress testing: calculates market risk in abnormal market condition.
In the following discussion we discuss each approach in detail.
Market Risk ManagementValue at Risk (VAR) Approach
Relatively new approach for measuring the market risk. VaR calculates the worst possible loss that a bank could
expect to suffer over a time interval, under normal market conditions, on the basis of some specific confidence level.
E.g., a bank might calculate that the daily VaR of its trading portfolio is $35 million at a 99% confidence interval. This means that there is only 1 chance in 100 that a loss > $35 million would occur on any given day.
VaR can be calculated for any portfolio of assets or liabilities whose market values are available on a periodic basis and price volatilities () can also be estimated.
JP Morgan’s VaR JP Morgan general definition for VaR is the
maximum estimated losses in the market value of a given position that may be incurred before the position is neutralized or reassessed.
VaRx = Vx * dV/dP * Dpi
Vx = market value of position x
dV/dP = sensitivity to price move per $ market value
Dpi = adverse price movement over time i; e.g, if the time horizon is one day, then VaR becomes daily earnings at risk DEAR = Vx x dV/dP x DPday
Portfolio Stress Testing
Relatively new technique that relies on computer modeling of different worst case scenarios and computation of effects of those scenarios on a bank’s portfolio position (Sept. 11 bombing).
The advantage of this technique is that it can allow risk managers to evaluate possible scenarios that may be completely absent from historical data.
For example Sept. 11 bombing of WTC: All assets in portfolio are revalued using changed
environment and a modified estimate for the return on the portfolio is created.
Many such scenarios can lead to many exercises and a range of values for return on the portfolio is derived.
By specifying the probability for each scenario, mangers can then generate a distribution of portfolio returns, from which VaR can be measured.
Financial Futures Contract An agreement between a buyer and a seller which calls for
the delivery of a particular financial asset at a set price at some future date
The Purpose of Financial Futures To shift the risk of interest rate fluctuations from risk-
averse investors to speculators
Most Common Financial Futures Contracts U.S. Treasury Bond Futures Contracts U.S. Treasury Bill Futures Contracts Three-Month Eurodollar Time Deposit Futures Contract 30-Day Federal Funds Futures Contracts One Month LIBOR Futures Contracts
The World’s Leading Futures and Option Exchanges
Chicago Board of Trade (CBOT)
Financial Exchange (FINEX)
New York Futures Exchange (NYFE)
Marche a Terme International De France (MATIF)
Singapore Exchange LTD. (SGX)
Chicago Mercantile Exchange (CME)
London International Financial Futures Exchange (LIFFE)
Sydney Futures Exchange
Toronto Futures Exchange (TFE)
Hedging with Futures Contracts
Avoiding higher borrowing costs and declining asset values
Use a short hedge: sell
futures contracts and then purchase
similar contracts later
Avoiding lower than expected
yields from loans and securities
Use a long hedge: buy
futures contracts and
then sell similar contracts later
Interest Rate Option It grants the holder of the option the right but not the
obligation to buy or sell specific financial instruments at an agreed upon price.
Types of Options Put Option - Gives the holder of the option the right to sell
the financial instrument at a set price Call Option - Gives the holder of the option the right to
purchase the financial instrument at a set pricePrincipal Uses of Option Contracts Protection of the bond portfolio Hedging against positive or negative gap positionsMost Common Option Contracts Used By Banks U.S. Treasury bill futures options; Eurodollar futures option;
U.S. Treasury bond option; LIBOR futures option
Using Swaps and Other Asset-Liability Management
Techniques
Using Swaps and Other Asset-Liability Management
Techniques• Swap contracts and selected other asset-liability management techniques can be used to eliminate or at least reduce a bank’s potential exposure to the risk of loss as market conditions change. • Swap contracts and other hedging tools can also generate additional revenues for banks by providing risk-hedging services to their customers.Interest Rate SwapA contract between two parties to exchange interest payments in an effort to save money and hedge against interest-rate riskCurrency SwapAn agreement between two parties, each owing funds to other contractors denominated in different currencies, to exchange the needed currencies with each other and honor their respective contracts.
Other Instruments (OTC)
Interest Rate CapProtects the holder from rising interest rates. For an
up front fee borrowers are assured their loan rate will not rise above the cap rate
Interest Rate Floor A contract setting the lowest interest rate a
borrower is allowed to pay on a flexible-rate loanInterest Rate Collar A contract setting the maximum and minimum
interest rates that may be assessed on a flexible-rate loan. It combines an interest rate cap and floor into one contract.
Off-Balance Sheet Financing in Banking and Credit Derivatives
Securitization of Assets The pooling of a group of similar loans and issuing securities
against the pool whose return depends on the stream of interest and principal payments generated by the loans
Advantages/Problem of Securitization Diversifies a bank’s credit risk exposure Creates liquid assets out of illiquid assets Allows the bank to better manage interest rate risk Allows the bank to generate fee incomeProblems with Securitization May not reduce a bank’s capital requirements Not available for all banks May increase competition for the best quality loans May increase competition for deposits
Types of Securitized Assets
Residential mortgages Home equity loans Automobile loans Commercial mortgages Small business administration loans Mobile home loans Credit card receivables Truck leases Computer leases
Loan Sales Marketing loan contracts held by an institution in
order to raise new cash Types of Loan Sales Participation loans
Where an outside party purchases a loan. They generally have no influence over the loan terms
Assignments Ownership of the loan is transferred to the buyer
of the loan. The buyer has a direct claim against the borrower.
Reasons/Risk Behind Loan Sales
Way to rid the bank of low yield securities Way to increase liquidity of assets Way to eliminate credit and interest rate risk Way to generate fee income Purchasing bank can diversify loan portfolio and reduce riskRisks In Loan Sales Best quality loans are the easiest to sell which may increase
volatility of earnings for the bank which sells the loans Loan purchased from another bank can turn bad just as easily as
one from their own bank Loan sales are cyclical
Standby Letters of Credit (SLCs) A financial instrument that guarantees performance or insures
against default in return for payment of a fee. It is a contingent obligation
Reasons for Growth of SLCs Rapid growth of direct financing worldwide Perception among banks and their customers that the risk of
economic fluctuations has increased Opportunity SLCs offer banks to use their credit evaluation skills
to earn fee income and the relatively low cost of issuing SLCsSources of Risk with SLCs Default risk of issuing bank Beneficiary must meet all conditions of letter to receive
payment Bankruptcy laws can cause problems for slcs Issuer faces substantial interest rate and liquidity risks
Credit Derivatives
Financial contracts offering protection to a designated beneficiary in case of loan default
Types of Credit Derivatives Credit swaps Credit options Credit default swaps Credit linked notes
Prudential control in banking
Risks in Banking Systematic risk------bank runs/contagion Default risk---------credit risk Price risk---------asset prices can change Fraud or incompetence risk--------operation risk Unwise diversification of assets Competition and excess risk taking
OutlineArguments for prudential control/regulation Arguments against prudential control/regulation Case studies
UK USA
Prudential control in banking
All firms have to ensure for capital adequacy (keep capital reserves (money) to offset any losses)
In addition, banks have to ensure sufficient liquidity.
Prudential control is more important for banking. due to two conflicting objectives on asset side of balance
sheet. Profit---------high to keep shareholders happy Liquidity-----low/high to earn profit/serve better and
insure depositors Bank has also self-interest in term of long-term survival But then question arises
Should prudential controls/regulation be compulsory set by state bank?
or bank management themselves
FINANCIAL REGULATION OF BANKSWHY REGULATE?
All Markets Financial Markets1. Protect consumer 1. The investor
2. Monopoly power 2. Conc. of fin.firms
3. Externalities 3. Threat of systemic collapse
4. Illegal Activity 4. M- laundering, tax evasion.
Benefits/Costs of prudential control/regulation
Benefits1. Protection of the public’s savings2. Control of the money supply3. Adequate and fair supply of loans4. Maintain public confidence5. Curb monopoly powers6. Support of government activities7. Help for special segments of the economy/societyCosts
1. Hampers competition and innovation. Cost of regulation high-compliance cost
2. Complexity of activities------innovation of modern finance --Competence of supervisor
3. Modern ALM makes it redundant. Deposit insurance alone has ended risk of systematic bank failure. Capital adequacy has ended credit risk.
Who Bears the Cost: Cost of Higher Capital Ratio on SpreadLet take the competitive model. The balance sheet of the banks is given by:
L+R=D+E (1) where L= loans; R= reserves; D= deposits and E=equity Let the capital asset ratio defined as: e= (E/L) and the reserves to deposits ratio k= (R/D) The balance sheet constraints can be expressed in an alternative way as:
L(1-e)= D(1-k) (2) The bank wants to maximize profit (objective function) in term of maximum rate of returns on equity rE. Profit function can be explained as:
Π= rLL-rEE-rDD (3) Now substituting (2) into 3, we get
Π= rLL-rEeL-rD(1-e/1-k)L (4) Differentiating Π with respect to L and setting to zero gives:
d Π/dL=rL-rEe-rD(1-e/1-k)=0 rL(1-k)-rEe(1-k)-rD(1-e)=0
rL-rD=rEe(1-k)+krL-rDe Now let define the spread as: s= rL-rD, then we can see that:
∂S/∂e=r E(1-k)-rD >0
SUM: Prudential Regulation of Banks The Challenge: strike the right balance:
Minimise the social costs of bank failure/financial crisisAND
Minimise MORAL HAZARD problems
Evidence of MH: Managers assume extra risks because of:(1) Deposit Insurance - if provided
(2) Looting hypothesis (Akerlof & Romer, 1993): Management: undertake riskier activities to boost short-term profits - then cash in on dividends/ shareholdings,etc. Gambles likely to be sizeable.
(3) Bank deemed "too big to fail”:
UK Financial Structure - Key Regulations
The Evolution of UK regulation is best assessed by looking at 6 Acts:
The UK Banking Act, 1979; Amended 1987 Financial Services Act, 1986 The Building Societies Act, 1986,1996 (no. of BS:
131 in ‘89 ; 63 in ’03) 1998 Banking Act Financial Services & Markets Act, 2000
Prudential control and regulations in the UK
Bank of England creation in 1694 Overall BoE is the regulatory authority (now combined with
FSA) Role of BoE is
Monetary control Prudential control Government debt through reserve ratio
Often role contradictory with each otherMajor Banking Regulation Pre-1979
No specific banking law in the UK Private banks treated like other commercial concerns Individual agents or firms could accept deposits without
any formal licence
Prudential control and regulations in the UK
1979 Act Identified two classes of institutions-recognised
banks and licensed deposit takers Act created a Deposit Protection Fund, to which all
recognised banks to contribute. Funds to compensate 75% of any deposit upto £10,000
Collapse of Johnson Matthey Bank (JMB) paved the way for amendment in the Act
1987 Banking Act Basically an amendment in 1979 Act Created supervisory board headed by the
Governor of BOE and members outside of the bank
Prudential control and regulations in the UK
1987 Banking Act Eliminated the distinction between deposit takers and banks Act clarified that a firm seeking as a recognised bank status
from BOE must offer a broad range of services including current (checking) deposit accounts, overdraft and loan facilities, atleast one of the foreign exchange facilities, foreign trade documentation (in the form of bills of exchange), investment management services, or alternatively very specialised services
Private auditors were given greater access to BOE information Any exposure to a single borrower, which exceeds 10% of
banks’ capital should be reported to BOE and supervisor should be consulted beforehand of any lending which exceeds 25% of bank capital to a single borrower
Act specified BOE control over foreign banks entry Act increased the deposit insurance limit to £20,000
Prudential control and regulations in the UK
Under Act BOE acts as a regulator. The asset side of a bank balance sheet is regulated
through measure of capital adequacy and liability side through liquidity adequacy
BOE Capital Adequacy How much capital is there to pay back liabilities
Two measures are used: Gearing or leverage ratio and Risk assets ratio
BOE Liquidity Adequacy Funding risk through liquidity gap analysis Interest rate risk through gap analysis Foreign exchange rate risk through a look on dealing
and structural positions Counter party risk through Euromarket monitoring
Capital Adequacy and the BOE
1. Gearing ratio:Deposits+ Ext. LiabilitiesCapital + Reserve
Lower the GR, lower the risk that a bank will lose its capital and fails
Example1: Suppose a bank balance sheet is as:Bank deposits + ext. liabilities = £1 mil.Bank’s capital + reserve = £1 mil.
GR= 1/1=1Implications: if bank lends £2 mil. and 50% of
borrowers default, bank loses all its capital but depositors get back their money.
Capital Adequacy and the BOE
Example 2: Suppose a bank balance sheet is as:Bank deposits + ext. liabilities = £2 mil.Bank’s capital + reserve = £1 mil.
GR= 2/1=2 Implications: if bank lends £3 mil. And 50% of
borrowers default, bank loses 1.5 mil (more than its capital) and all depositors not get back their money.
Usually ratio is set by the bilateral agreement between the bank and the BoE.The precise gearing ratio considered acceptable to both parties varies according to the nature of bank business and its assets. Some qualitative factors are also given some consideration.
Capital Adequacy and the BOE
2. Risk asset ratio Weighting is used for different assets It allows heterogeneous set of assets to be valued Now called Basle risk assets ratio It is calculated by taking into account tier one or core
capital (equity capital plus reserves) and tier two capital or supplementary capital (subordinated long-term debt)
Weights are pre-determined
Ratio is defined as: Tier one capital+ tier two capitalRisk adjusted assets
Capital Adequacy and the BOEExample: Suppose a hypothetical bank assets, and weights prescribed by
BOE and Basle. Cash £500 (0%)T. bills £2000 (0%)Mortgage £15000 (50%)Commercial loans £10000 (100%)
Unadjusted value of assets £27000Adjusted value of assets=
500*(.0)+2000*(.0)+15000*(.5)+10000*(1.0)=17500Risk assets ratio= (tier1 capital+tier2 capital)
17500 If tier1 and tier2=1500,Then risk assets ratio= 1500/17500= 8.6%
Capital Adequacy and the BOE-extended example
Risk Asset ratio -an illustrative calculationAssets £ m Weight fraction Weighted assets(£m)Cash 25 - -Treasury bills 5 0.1 0.50Other eligible bills 70 0.1 7.00Secured loans to discount market 100 0.1 10.00UK government stocks 50 0.2 10.00Other investment -government 25 0.2 5.00 -companies 25 1 25.00Commercial loans 400 1 400.00Personal loans 200 1 200.00Mortgage loans 100 0.5 50.00Total assets 1000 707.50Off-balance sheet risksGuarantess of commercial loans 20 1 20.00Standby letters of credits 50 0.5 25.00
752.50Total risk weighted assetsCapital ratio (8%)Capital required to satisfyregulation 0.08*752.50=£60.2m
Source: Bank of England
Financial Services & Markets Act- June 2000
Required a merger of numerous regulators: banking supervision division of BE, Friendly Societies regulators, Insurance Directorate (DTI), UK Listing Authority, Credit Unions
Statutory Requirements of FSA: Ensure Confidence in the UK financial system (fin.stability). Educate the public- risks of investing. Protect consumers - but encourage greater responsibility. Reduce financial crime. ALSO: Be cost effective: C/B analysis on all new regs. Major Initiative: a “risk based” approach to regulation. ALL firms
assigned impact score, RTO: “risk to our objectives”: IMPACT SCORE = [Impact of the problem] X [prob of problem arising] Score ranges from A (very high risk) to D (low risk). High Risk: major
banks, large insurance firms, stock exchanges, big broker-dealers. Signals a move away from rules for each type of institution.
Emphasis: effect of a firm’s actions ON the FSA’ ability to meet statutory objectives, NOT financial/systemic risk per se.
USA - Bank Structure & Regulation
Emphasis on protecting small depositors. Concern about potential collusion as important as issues related to financial stability – reflected in their legislation.
Major Banking Laws National Bank Act (1863/64) Banks must opt for a state or national charter (OCC) 1913: Federal Reserve Act: FED to provide an
“elastic” currency: FRS – 12 regional FR banks FDIC: created in 1933; administers deposit insurance
($100,000) Glass Steagall section of the Banking Act: 1933 Riegle Neal Interstate Banking & Branching Efficiency
Act: 1994 Gramm Leach Bliley Financial Markets Act: 1999
US Regulation: Multiple Regulators
Regulators Financial FirmsOCC (1863) National commercial banksFED (1913) FHCs/BHCs, FDIC (1933) Any bank (nat/ state) covered by FDIC
insuranceOTS (1989) Savings & loans (national or state)NCUA (1970) Credit unions- national or stateState Regs State chartered banks licensed by the state
FTC Uninsured state banks or savings & loans, credit unions, foreign branches of US or foreign banks
SEC (1934) Securities firms/investment banks, investment advisors, brokers
NAIC, DTI Insurance firms
USA banking regulation
Overall Evolved through time Different to UK banking regulation by:
Seeking help from legislation whenever crises Protection of small depositors more important Concern about potential collusion
National bank act passed in 1863 and amended in 1864
Federal Reserve Act 1913 created central bank regional Federal Reserve Banks and a Board of Governors
Banks must get license either by the Comptroller of the Currency or by a state official
USA banking regulation
Banks performance is monitored on a scale bases ranging from 1 to 5.
1-2 are considered good score for a bank, while 5 is bad which signals bank failure is just around the corner
Since 1991, Federal Deposit Insurance Corporation (FDIC) regulates capitalisation of the banks
Fed normally examines the state member banks, the Comptroller of the currency examines the national member banks and FDIC examines the non-member (of the FRS) insured banks
Member banks of FRS must comply a tier one capital asset or leverage ratio of at least 5%.
Major USA banking regulation
National Banking Act (1863,1864) Passed during the civil war to help fund the war Created the treasury and the comptroller of the
currency Created national banks with a federal charter
Federal Reserve Act of 1913 Passed after a series of financial panics at the
beginning of the century Created the federal reserve system. Gave the fed the
authority to act as the lender of last resort Created to provide a number of services to member
banks. Today the fed controls the money supply
Major USA banking regulation
McFadden-Pepper Act 1927 Prevented banks from expanding across state lines Made national banks subject to the branching laws
of their stateGlass-Steagall Act 1933
Passed during the great depression Separated investment and commercial banking Created the FDIC Fed given the power to set margin requirements Prohibited interest to be paid on checking accounts
Major USA banking regulation
FDIC Act 1935 Addressed the issues left out of the glass-steagall act Gave the FDIC the power to examine banks and take
necessary actionBank Holding Company Acts
Federal reserve given the power to regulate bank holding companies - 1956
Amendment reduced the tax burden of bank holding companies - 1966
Amended the definition of bank holding companies to include one-bank holding companies - 1970
Major USA banking regulation
Bank Merger Acts All mergers must be approved by the appropriate regulating
body Mergers must be evaluated in three areas
Effect on competition Effect on the convenience and needs of the community Effect on the financial condition of the banks
Social Responsibility Acts 1968 – full information on terms of loans must be given 1974 – cannot be denied a loan based on age, sex, race,
national origin or religion 1977 – cannot discriminate based on the neighborhood in
which borrower resides 1987 and 1991 – banks must disclose full terms on deposit
and savings accounts
Major USA banking regulation
Gramm-Leach-Bliley Act 1999 Permits banking-insurance-securities affiliations Consumer protections for consumers purchasing
insurance through a bank Must disclose policies regarding the sharing of
customers’ private information Customers are allowed to ‘opt out’ of private
information sharing Fees for ATM use must be clearly disclosed It is a federal crime to use fraud or deception to
steal someone’s account or personal information
DebateSingle vs Multiple Regulators: The Debate
(Based on UK/US experience)
(1) Growth of financial conglomerates - functional supervision is costly; may leave gaps
FSA: has a Major Financial Groups Division for the 50 most complex firms operate in UK, even if HQed elsewhere (eg: big 5 UK bks). Each conglomerate has a micro regulator: coordinates supervision in the FSA
FED: has control over FHCs that own banks: Since 1989: US Fed has led supervision of Large Complex Banking Corporations (LCBOs): 2-12 supervisors monitor each of the 50 leading organisations.
THUS: not part of debate - both systems have developed ways of dealing with FCs.
Single regulation eliminates functional regulation, which can raise compliance costs. But does it?
US: common to answer to more than one regulator
DebateSingle vs Multiple Regulators: The Debate
(Based on UK/US experience)
(3) Product boundaries less well defined: e.g. derivatives & securitisationAlternative to single regulator: assign a lead regulator (solo consolidation)?- UK - has caused problems in the past
(3) FSA: Single regulation creates Scale and Scope Economies :- Single system of reporting (?)- Better communication - firms report to single regulator- Single point of contact: firms and consumers (?)- Common methodology -e.g. RTO (?)- Pool resources/efficient resource allocation(?)- Single system for authorisation (?), supervision, discipline, training,etc.- Easier to recruit from pool of expertsUS authorities: - Are scale/scope economies achieved? - Competition between regulators encourages comp/inn. (Greenspan) - Monopoly power gives single regulator too much power, leading to reg.
forbearance and inefficiency.
DebateSingle vs Multiple Regulators: The Debate
(Based on UK/US experience)
(4) Cost of regulation - Early study (2002): cost of FSA 10% of US reg; (5) Cost of Compliance: firms under both systems complain but
may be more difficult to measure under multiple regs. (6) Overlap between organisations. Likely to be more of a
problem in the US –e.g. Citigroup case. Could raise compliance costs.
(7) Accountability: FSM Act makes FSA highly accountable- annual reports to Parliament, etc. Also true of the FED chair. Other US regulators do not have such a high profile.
(8) FSA’s 4 statutory duties - could aggravate conflicts of interest by scarce resources. Not the case in the US where each regulator (except the FED) has a single set of related duties.
(9) Moral hazard: a problem under both regimes.(10) Split between supervision (FSA) and monetary control (BE):
Raises question of responsibility for financial stability.
Bank Failure Case Studies
Why Banks Fail?
Why Banks Fail?
Banks are more Vulnerable, fragile and open to contagion Compared to other commercial firms- Why? Low capital to assets ratio (high leverage)-leaves little room for
losses Low cash to assets ratio- may require sale of earning assets to meet
deposit obligation High demand debt and short term debt to total debt (deposits)
ratios-that brings high potential for a run- may require hurried assets sale at cheap prices
Banking crises starts with run (mob of depositors appear at the bank and its branches, demanding their money)
To fulfil their demand, banks may call loans, may refuse to lend new credit or sell assets
Having said all banks do not fail- then why some banks fail?
Introduction Some modern best known cases are:
Bankhaus HerstattFranklin National BankBanco AmbrosianoContinental Illinois and Pen SquareJohnson Matthey BankersUS Thrift Bank of New EnglandBaringBank of Credit and Commerce International (BCCI)
Banks Failures
If not all banks are prone to failure then why study bank failure and bother about that?
Bank failure or crashes are important to understand b/c crises spread (contagion disease)
Indonesia, Thailand and Korea- Failure spread through out the banking system as sick institutions infected the healthy and dragged them down into insolvency.
Banking crises not new- Italian, Dutch English, Scots, French, Austrians, Germans, Japanese and American—all faced the banking crises/failure.
Cost of Bank Failures
The cost of bank failure in OECD as well as in developing countries is enormous. And sometime difficult to estimate
Few examples are given below:
Country Years loss % of GDP Norway 1987-90 4% USA 1984-91 3% Japan 1990-Cont. Huge Venezuela 1980-00 14% Bulgaria 1980-00 14% Mexico 1980-00 14% Hungary 1980-00 10%
Barings (1995)
Background A well known British bank, very good in mergers and
acquisition and quite powerful in emerging Far East market.
About 1/3 employees based in Asia and more than half outside UK.
The banking and market making arm of the bank (Baring Securities was a leading equity broker in Asia and Latin America)
The fund management operation had a reputation for its expertise in Eastern Europe.
Barings (1995)
Reasons of Downfall Exposure in Far East was the main reason for Baring downfall (unlimited
exposure in the derivative market). Mr Leeson was the culprit. He was head of the department, leading a team of 15
employees. Smart and manipulative person. He was an arbitrageur whose job was to spot differences in the prices of future
contracts and profits from buying futures on one market and simultaneously selling them on another.
Mr Leeson was suppose to earn benefit out of this business for subsidiary of Baring Securities.
Margins in these types of contracts are small but volume traded large. Mr Leeson was supposed to have been trying to profit by spotting differences in the prices of Nikkei-255 future contracts listed on Osaka securities Exchange (OSE) and the Singapore Monetary Exchange (SIMEX). SIMEX attracts stock markets futures b/c Osaka exchange is subject to more regulation and hence is more costly.
Barings (1995)
Rather than hedging his position Lessons seems to have decided to bet on the future direction of the Nikkei index.
The move proved costly for Mr Leeson. Mr Leeson used a secret error account 88888 to hide trading
losses and exaggerated his earnings to get maximum bonus. Baring London was deceived into thinking that Mr Leeson
made profits from arbitrage. But losses were accumulating in the 88888 account. It was reported that more than ¾ profits was earned through
this Mr Leeson business. All the time auditors failed to detect any wrongdoing. During the process of selling and buying Mr Lesson’s action
brought £827m losses.
Barings (1995)-Responsibles Low internal control in the area of risk management. Regulatory authorities share the blame. The SIMEX and Osaka
exchange failed to act despite the rapid growth of contracts at Baring.
BOE was also deficient in its supervision of Baring. BOE granted Baring solo status (mean Baring bank and Baring
securities required to meet a single set of capital and exposure standard). It means BOE was supposed to supervise trading business of Baring (not a good idea, given the fact that it had no expertise in this area), hence depositors were exposed to trading losses.
European rule of not taking more than 25% maximum equity capital exposure into single investment was ignored and BOE had not spotted this.
Coopers and Lybrand (external auditors of Baring) failed to conduct comprehensive tests that would have detected large funding requests from Singapore.
Franklin national bank (1974)
Background 20th largest bank in USA.Reasons of Downfall Large foreign exchange losses. Quick expansion. Unsound loans as a part of expansion strategy.Story Refused by FR to take over another bank. Large depositor’s withdrawal. Refused by other bank to lend. Borrowed $1.75 billion from FR. Taken over by a consortium of seven European banks Did not fail completely due to deposit insurance.
Banco Ambrosiano(1982)Background Italian bank based in Milan. Quoted on the Milan stock exchange. Subsidiary companies overseas. Luxembourg subsidiary called Banco Ambrosiano
Holding (BAH) 60% of this subsidiary owned by BA Milan.
BAH active on the interbank market. Taking Euro currency deposits from international
banks. Money from Euro currency was lent to non Italian
companies in BA group.
Banco Ambrosiano(1982)
Reasons of Downfall Massive fraud by chairman of the bank. Chairman departed Milan for London after receiving a letter from
BOI to reduce and explain overseas exposure. Deposit withdrawal after confidence lost due to chairman death in
London after hanging on the bridge. Former Italian PM was also involved in fraud.
Bank of Italy launched life boat operation. Seven banks provided money.
Later declared bankrupt by Italian court and taken over by another bank. BAH also suffered from losses of deposits , but refused by bank of Italy to launch life boat operation. BAH defaulted on loans and deposits.Weak relation b/w senior management and Bank of Italy are considered the root cause of this bank failure.
Significant supervisory changed after this failure.
Continental Illinois and Pen Square (1982)
Background Two American investment banks. Penn square energy loans passed to CI . Involved in heavy lending in real estate and energy
sector. CI relying on overseas market to fund its loans portfolio
60% of them were short term foreign deposits.Reasons of Downfall Lack of procedures to vet new loans. Poor quality loans to US corporate sector and CI failed to
classify bad loans as nonperforming. Rumours spread of difficulty faced by bank and bank run
started, made it difficult to raise funds.
Continental Illinois and Pen Square (1982)
US Comptroller of Currency intervened but it made
the matter worse and bank borrowed money from
Chicago Reserve Bank (CRB).
Private life boat was organized, but not sufficient
Run got worse and $6b disappeared within few
days.
FDIC and Comptroller announced assistance.
All CI directors were asked to resign in return.
Johnson Matthey Bankers (JMB) (1984)
Background An arm of Johnson Matthey, dealer in gold bullion. JM was the fifth largest gold dealer in London. Involved in lending to third world countries.Reasons of Downfall Significant Loans exposure to a single country (Nigeria). Auditors did not show responsibility. They agreed with
director presentation of accounts. Bank of England showed soft approach. Private auditors not given full authority to check. No
communication between auditors and BOE. Return submitted by management not subject to independent audit.
Johnson Matthey Bankers (JMB) (1984)
Lifeboat operation launched by BOE with the help of private banks. Use of “Too Big to Fail”. Lifeboat operation launched by BOE suggests regulator will be willing to accept too big to fail if the bank failure poses a real danger in term of widespread bankruptcies.
JMB affair prompted the establishment of committee.
The committee involved the Treasury, BOE, and external experts.
Amendment of Banking Act (1987).
Bank of Credit and Commerce International (BCCI)
Background Founded by the Pakistani financier and incorporated in
Luxembourg with small amount of capital $2.5m (less than BOE $5m requirements).
Initially given the status of deposit taker but later on after amendment in banking act became full bank with authority to open branches across UK.
When closed negative net worth of about $7b. Customers included Manuel Noriega (Panamian dictator) and
international terrorist Abu Nidal.Reasons of Downfall Fraud and illegal dealings. BCCI bought a Colombian bank with branches in Medellin and
Cali (centre for the cocaine trade and money laundering). International repute for capital flight, tax fraud and money
laundering.
Bank of Credit and Commerce International (BCCI)
Indicated in Florida, raided by British customs and executive imprisoned in Florida for money laundering.
BOE and pricewaterhouse failed to communicate with American regulatory authorities.
Bingham report criticised BOE and pricewaterhouse. BOE set up a special investigation unit to look into
suspected cases of fraud or financial malpractice as well as setting up a special legal unit.
Amendment of Act (closing UK branches of an international bank if deemed necessary).
Cross border supervision very important.
SummaryBank Name Derivative
market exposure
Foreign exchange market exposure
Lack of internal control
Weak asset management
Overseas exposure
Lack of regulatory control
External auditor role
Unsound policies (bad loans, aggressive expansion etc.)
Management fraud
Baring X X X X X X X
Franklin National Bank X X X X
Banco Ambrosiano X X X
CI and Pen Square X X X X
JMB X X X X
BCCI X X X
Common Lessons from Bank Failure Case Studies
A number of qualitative conclusions can be drawn from the individual bank failure case studies.
Bank may fail due to:1. Weak asset management
a. Low quality loans with inappropriate collateral arrangement.b. Excessive exposure to one sector or single firm/country. This
exposure overlooked by regulatory authorities. 2. Inexperience with new products (FNB, Bankhaus Herstatt).3. Managerial inefficiency in term of herd instinct (Barings).4. Bank fraud and dishonesty (BA, FNB, BCCI)5. Supervisors, bank inspectors and auditors missed important signal of
problem banks (JMB, BA, BCCI, Barings).6. Too big to fail may lead to moral hazard and resultant bank failure
(JMB)
Competitive Issues in Banking
Outline Competitive issues in banking
Productivity measurement Efficiency measurement Economies of scale and scope Test of competition in banking market Contestable banking markets Interest equivalence for non-price features Qualitative tests for price discrimination and
firms survival
Notes: For this topic, chapter 4 from the text book “Modern Banking in Theory and Practice” by Shelagh Heffernan John Wiley and Sons is a must reading.
Measuring of bank output
Measurement of output of services produced by financial institutions has special difficulties b/c they are not physical quantities.
Difficult to account for quality in a banking service.
i.e. ATM may improve the quality of payment services as well reduce the costs of transactions considerably but benefits are difficult to measure. Increase in frequency of transactions by a customer may increase the costs per customer. Hence difficult to measure the net benefits per customers.
Two common approaches to measure banks outputs:
The production approach The intermediation approach
Measuring of bank output
The production approach Banks are treated as firms for measuring output.
Banks use capital and labour to produce deposits and loan accounts and output is measured as: Number of accounts/number of transaction per account.
Uses bank output as flows.
Problem How to weight each bank service in the computation of
output. The method ignores interest costs. Difficult to compare data from different banks, thus
making accurate measure of efficiency difficult.
Measuring of bank output
The intermediation approach This approach recognises intermediation as the core
activity. Output is measured by the value of loans and
investment. Cost is measured as operating costs (the cost of
factor inputs such as labour and capital) plus interest costs.
Bank output is treated as a stock. Neither the intermediation nor the production
approach takes account of the multi-product nature of banking.
Most bank productivity studies used intermediation approach.
because this has fewer data problems than with the production approach.
Next Step:Productivity and Efficiency
Measures
Two types of productivity measures are used. Partial and Total
Partial measures are based on financial ratios. They show partial picture.
Assets per employee Loans per employee Profit per employee Cost per employee Admin. Cost as a % of total cost
Whereas, total measures take into account multiple nature of outputs and inputs in banking i.e.
Total Factor Productivity (TFP)
Productivity and Efficiency Measurement
Efficiency Estimation Empirical research is based on two methods of
efficiency estimation1. Stochastic Frontier Analysis (SFA)2. Data Envelopment Analysis (DEA)
DEA employs a efficiency ratio by using multiple inputs and outputs.
DEA compares the observe output (yjp) and inputs (xip) of several banks.
It then identifies the relatively more efficient bank with the relatively less efficient bank.
p = ipijpj Xv/Yu subject to p 1 for all p and weights vi,uj >0, p represents several banks
Productivity and Efficiency Measurement
Efficiency Estimation
The model is run repetitively with each bank appearing in the objective function once to derive individual efficiency rating.
The decision about efficiency or inefficiency is based on the following:
E=1 relative efficient, E<1 relative inefficient However, efficient does not mean top of the level
efficient in absolute terms but efficient compared to other banks in the data set.
p = ipijpj Xv/Yu subject to p 1 for all p and weights vi,uj >0, p represents several banks
Productivity and Efficiency Measurement
Productivity Estimation Malmquist productivity index is a popular method to estimate
TFP TFP is computed by taking into account efficiency change and
technical change The Malmquist index will be able to determine levels of change
in technical efficiency and change between time periods The Malmquist index is calculated as follows (as outlined in
Fare et al, 1994).
This formula can be further decomposed into efficiency and technical change as follows
2/1
10
111
0
0
11011 ),(
),(
),(
),(),,,(
ttt
ttt
ttt
ttt
tttt xud
xud
xud
xudxuxum
Productivity and Efficiency Measurement
Where the first part of the equation (that which lies outside of the parenthesis) represents efficiency change and the second part (contained within the parenthesis) represents technical change.
The Malmquist index provides a measure of changes in total factor productivity (TFP) from year to year.
The values are concentrated around 1, which implies no change.
A TFP index value which is greater than 1 implies an improvement, while a value less than 1 implies a decrease in productivity.
The efficiency change relates to how the firms performed relative to the production frontier.
2/1
10
0
111
0
110
0
111
011 ),(
),(
),(
),(
),(
),(),,,(
tt
ttt
t
ttt
ttt
ttt
ttt
tttt xud
xud
xud
xud
xud
xudxuxum
Productivity and Efficiency Measurement
An efficiency change index value which is greater than 1 implies that the firms are operating closer to the frontier than in the previous time period, while if the index figure is less than 1, the bank in question is operating further below from the frontier. The other component, technical change (TC), indicates a shift in the frontier.
This can be affected by technology or also changes in the economic or regulatory environment. A technical change index value which is less than 1 means the frontier has shifted inwards, while a TC index value which is greater than 1 implies that the frontier has shifted outwards.
Again, this index is a relative measure intended to indicate any movement in the frontier. A TC value of 1 indicates a static frontier in the relevant time period.
Productivity and Efficiency Measurement
The Malmquist index can be estimated as a function of a set of distance functions, which, in turn, can be estimated using DEA. This is a methodology proposed, again, by Fare et al (1997).
SFA is also used to estimate efficiency and productivity!
The index requires 4 DEA models to be estimated, which respectively spe cify
efficiency in the current time period, ),(0 ttt xud ; efficiency in the next time
period, ),( 111
0
ttt xud ; efficiency of a firm operating in this time period relative to
firms operating in the next time period, ),(10 ttt xud ; and the efficiency of firms
operating in the next time period relative to the frontier in this time period,
),( 110 ttt xud . The TFP index is then calculated using Equation (1), above.
Empirical Studies on Productivity and Efficiency
Numerous studies used DEA method to measure the efficiency of banks.
Some selection of studies is given below: Rangan et.al. (1988,90) used this approach by using
the data on 215 US banks.They break down the efficiency score into technical inefficiency (wasted resources) and scale inefficiency (non-constant return to scale). Bank output was measured with intermediation approach. The study showed the efficiency score of 0.7 implying 30% wastage, all due to technical inefficiency.
Field (1990) applied DEA to a cross section of 71 UK building societies in 1981. The results were that 80% were found to be inefficient due to scale inefficiencies. Unlike Rangan ((1988,90) bank size was positive with TE.
Empirical Studies on Productivity and Efficiency
Some selection of studies is given below: Drake et.al. (1991) used DEA to building
societies in 1988 after deregulation in 1987. 37% of these societies showed increase in their overall efficiency.
Humphrey (1992) measured productivity and scale economies using flow and stock measures of banking output. He applied both non-parametric growth accounting procedure and an econometric estimation of cost function. A structural model of bank production was used which incorporated both the production of intermediate deposit outputs as well as final loan outputs. He obtained two measures of total factor productivity by using 202 US banks.
Empirical Studies on Productivity and Efficiency
Some selection of studies is given below: Humphrey key findings were as follows:
Banking productivity had been flat (only 0.4% p.a. GR)
Real value of total assets: declined (the average TFP GR was –1.4% p.a)
The author identifies a number of possible reasons for decline in TFP.Some of these are:
Banks lost low cost deposit accounts, as corporate and retail customers switched to corporate cash management accounts and interest earning check accounts.
Economies of Scale and Scope
There is an extensive literature on the degree to which scale economies exist in banking.
The term economies of scale or scope are a long run concept when all the factor inputs, which contribute to a bank production process, can be varied.
Assuming all factor inputs are variable, bank is suitable to exhibit scale economies mean equi-proportionate increase in factor inputs yields a greater than equiproportionate increase in output or the banks are operating on the falling portion of their average cost curve.
Consider a bank with three factors of inputs capital (deposits), labour (the bank employee) and property in the form of branch network and 3 outputs like loans, investment and off balance sheet business .
Economies of Scale and Scope The economies of scale are said to exist if, as a
result of doubling each of three inputs, the bank is able to more than double its outputs.
Even this simple example is problematic in case of banks b/c all factor inputs are not variable. In short run it is really difficult to double inputs such as deposits.
Even if inputs are doubled and loans are doubled, then risk portfolio is bound to change, a critical important consideration for a bank wanted to maximize shareholder value added.
All this implies that it is really difficult to apply the concept of economies of scale in financial sector.
Hence it negates the underlying concept of mergers and acquisition on the basis of hope of economies of scale and scope.
Economies of Scale and Scope
Economies of scope exist if the joint production cost of producing two or more outputs is lower than if the products are produced separately.
For example a bank offers three services to customers (deposits, loans and payment services). Then, if a bank can supply these services more cheaply through a joint production process than producing and supplying them independently, it is said to be enjoying economies of scope.
From the strategic standpoint the question of whether or not economies of scale and scope are present in the banking is important.
Evidence of economies of scale will mean large banks have cost advantage over small one.
If cost complementries are present, multiproduct banks will be more efficient than the financial boutiques.
Economies of Scale and Scope
In term of empirical work, most of researcher uses cost function approach to measure SCALE and SCOPE economies i.e.
This more general model specification of cost function, which focuses upon scale economies and technological change, is specified as C(yit,wit,t):
mTm
3
1m
iTi
3
1i
2TTTmiim
3
1m
3
1i
nmmn
3
1n
3
1mmm
3
1m
jiij
3
1j
3
1iii
3
1ii
w~lnT
y~lnTT2/1Tw~lny~ln2/1
w~lnw~ln2/1w~ln
y~lny~ln2/1y~lnconst)Cln(
Economies of Scale and Scope Overall economies of scale are derived from
differentiating the translog cost function with respect to output.
Where MCi is the marginal cost with respect to the ith output and is the cost elasticity of the ith output. If OES >1, bank experiences diseconomies of scale, and increasing returns are apparent if OES<1. If OES=1 then, there is evidence of constant returns to scale.
Scope economies are said to be exist if: C(yit,wit,t)<[c(y1t,wit,t)+c(y2t,wit,t)+c(y3t,wit,t)]
iti
ititiiti
yln/Cln)t,w,y(C/MCyOES
Empirical Studies on Scale and Scope Economies in Banking
Empirical studies of economies of scale and scope in financial institutions showed mixed results.
USA studies Shaffer and David (1991) examined the question of
economies of scale for very large US multinational banks.
Traditional translog cost function with two and three factors was used with and without hedonic terms (qualitative factors). In the absence of hedonic terms they found evidence of scale economies.
In the translog equation with the hedonic terms included, scale was reduced from the level of without hedonic terms.
Empirical Studies on Scale and Scope Economies in Banking Humphrey (1992) obtained estimates of scale economies
for US banks. The author used flow measure of output. His study results suggested diseconomies of scale. However, when alternatives measures of output were
used, Humphrey found significant economies of scale for small banks, constant costs for medium sized banks and scale diseconomies in large banks.
This study however raised an important question. which measure of output should be used? The author suggested that stock measure was
more accurate than flow measure of output. The study overall results suggest there are slight
economies of scale for small banks, but slight diseconomies for large US banks.
Empirical Studies on Scale and Scope Economies in Banking
Numerous US studies have tested for economies of scope in banking with mixed results.
Gilligan and Smirlock (1984) study supported the hypothesis of economies of scope.
Mester (1987) concluded there was no strong evidence to either support or refute the presence of economies of scope.
Lawrence (1989) found cost complementarities (economies of scope) to be present.
Hunter, Timme and Yang (1990) found no evidence to support the presence of cost complementarities.
Empirical Studies on Scale and Scope Economies in BankingBritish studies
Hardwick (1990) tested for scale and scope economies using UK building societies data.
The author employed multi-product statistical cost analysis.
He tested for overall and product specific economies of scale by using a marginal cost approach.
Overall economies of scale were found except for very large building societies. Significant diseconomies were found in the use of capital in large building societies. For small banks cost saving was attributable in the use of labour compared to capital.
Hardwick did not find evidence either for or against economies of scope for large building societies.
Empirical Studies on Scale and Scope Economies in Banking
However, he found significant diseconomies of scope for building societies with assets worth £1.5 billion.
The results of the study virtually showed no case for diversification of building societies into broader banking market.
Drake (1992) using a multi-product translog cost function found evidence for economies of scale for medium sized banks.
He found no evidence to support the earlier Hardwick study of diseconomies of scale for building societies with assets in excess of £1.5 billion.
Nor did Drake find economies or diseconomies of scope for the building society industry except for the group with assets in the range of £500m-5 billion which showed significant diseconomies of scope.
Empirical Studies on Scale and Scope Economies in BankingEuropean studies Altunbas and Molyneux (1993) examined the cost structure in
four European countries (France, Germany, Italy and Spain). They found overall scale economies to exist in all four countries. Italy showed significant scale economies over all levels of
output. In Spain they were present only for smallest banks. France showed significant scale economies over a range of bank sizes. In Germany diseconomies of scale were found at all assets levels.
The presence of economies of scope results were mixed. In Spain significant economies of scope were evident for banks with assets of < $1.5 billion. In France it is middle sized banks which showed economies of scope. Diseconomies of scope were found for all Italian banks. In Germany, largest banks showed scope economies, smaller banks showed scale diseconomies.
Empirical Model of Competition in Banking
The Structure Conduct Performance (SCP) model
Since the Second World War, SCP model has been
popular in industrial economies.
Applied to the financial sector SCP says, “a change
in the market structure or concentration of banks
effects the way banks behave and performs”. There
is a well-developed link b/w structure, conduct and
performance.
Market structure is determined by the interaction of
cost (supply) and demand.
Empirical Model of Competition in Banking
The Structure Conduct Performance (SCP) model
Conduct is a function of number of sellers and
buyers, barrier to entry and cost structure.
Conduct in a market is determined by market
structure that is number or size distribution
of banks in the market and the condition of
entry. The conduct in term, result in bank
taking decisions about prices, advertising etc.
The outcome is market performance
(profitability).
Empirical Model of Competition in Banking
The Structure Conduct Performance (SCP)
model
In simple words less number of firms
(structure: high concentration), higher prices
(conduct) and higher profit (performance)
Thus conduct links market structure and
performance as:
Structure Conduct
Performance
Empirical model of competition in banking
The Efficient Market or Relative Efficiency model This model challenges the SCP approach. Some banks earn supernormal profit b/c they are more
efficient than others. This bank specific efficiency is exogenous and reflected in higher market share.
Therefore it is market share than concentration correlated with profit.
The relative efficiency model predicts the same positive profit concentration relationship as the SCP model.
However, the positive relationship is not explained by collusive behaviour in SCP case but greater efficiency and higher market share (and concentration).
Empirical Model of Competition in Banking
According to SCP, concentration is exogenous,
resulting in higher prices for consumers and
higher bank profitability.
In the relative efficiency model however, ,
exogenous bank specific efficiencies results in
more concentrated markets b/c of market
dominance of these relatively efficient banks.
If the relative efficiency model is found to hold,
it would suggest markets are best left alone.
Empirical tests of SCP and Relative Efficiency in Banking
Berger and Hannan (1989) conducted the direct tests of SCP and relative efficiency models using the equation
rjit : the interest paid at time t on one category of retail deposits by bank i located in the local banking market, ji. CONSjt: a measure of concentration in local market j at time t. xijt: vector of control variables that may differ across banks, market or time periods; :error term.
If SCP hypothesis hold, < 0 (negative relation between concentration and deposit rate “the price of bank services”). If relative efficiency model is hold, then >0.
The results show that SCP hypothesis hold for their data.
ij tijj tij t txCONCr
ijt
Empirical Results of SCP and Relative Efficiency in Banking
Jackson (1992) key finding was that price is non-linear U shape over the relevant range and support the relative efficiency type model, where high level of market concentration signal the gaining of market share by the most efficient firm.
They found a negative for low concentration group and positive for high concentration.
In response to Jackson study Berger and Hannan concluded the price concentration relationship is negative for some range of concentration.
Molyneux Forbes (1993) tested the SCP and relative efficiency hypothesis using European data.
Their main finding was a significant positive concentration price relationship, but the market share variable was negative.
The authors concluded that the SCP hypothesis is supported by this European sample.
Contestable Banking Markets
Some empirical studies have considered the question of whether banking markets are contestable.
A contestable market is one in which existing firms are “vulnerable to hit and run” entry.
For this type of market to exist sunk costs should be largely absent.
Sunk costs is an economic term which means that cost which cannot be recovered if firms stop producing and leaves industry. Sunk cost is different to fixed cost.
Lot of banking experts believe that bank markets are contestable.
It implies new firms can enter the banking market, hit and then run (offering lower prices).
Empirical Studies on Contestable Banking Markets This has very important policy implication because it
implies that banks due to fear of hit and run feature of the market, will set the price according to marginal cost and consumer surplus will be maximised.
Shaffer (1982) used the Rosse-Panzer Statistics (RPS) to test for contestability in US banking. He concluded that banks in the sample behave neither as monopolists nor as perfect competitors in the long run.
In Nathan and Neave (1989), a similar methodology was applied for Canadian banking market.
Authors derived a positive but significantly different from both zero and unity RPS confirming the absence of monopoly power among Canadian banks and trust companies.
Empirical Studies on Contestable Banking Markets
Nathan and Neave concluded that their results were consistent with a banking structure exhibiting some features of monopolistic, contestable competition.
Molyneux, Lloyd, Williams and Thornton (1994) tested for contestability in German, British, French, Italian and Spanish markets
The authors found the RPS for Germany, the UK, France and Spain, to be positive and significantly different from zero and unity.
Their conclusion was that in these markets, commercial bank revenues behaved as if they were earned under monopolistic competition. For Italy, the authors could not reject a hypothesis of monopoly.
Pricing Non-Price Characteristics in Banking
Non-price characteristics are an important feature of modern day banking
Some of these characteristics are: Number of ATM machine Number of branches Interest paid monthly, quarterly, biannually or
annually Maximum withdrawal limits Minimum investment limits Insurance on loans Security on loans Checking accounts facility and guarantees
Pricing Non-Price Characteristics in Banking
Some characteristics are positive and some are negative Nominal interest rate paid by/to customers may be low or high
compared with actual interest rate Questions is how banks price these characteristics and is it
possible to measure it and further how interest on deposits and loans are adjusted by banks
To do this type of analysis, one needs series on interest rate on deposits and loans and non-price characteristics attached to these deposits and loans
To compute interest equivalence of the non-price features of bank products, product interest rate is regressed on market interest rate (usually LIBOR: £ London Interbank Offer Rate). LIBOR is used in levels as well as with lagged. Non price features comes as a regressors in the equation
Statistically significantly variables are identified through such regression
Pricing Non-Price Characteristics in Banking
Hefferenan (1992) used the following equation to estimate the interest equivalence of banks non-price characteristics of major British retail banks and building societies.
r = + ixi + coLIBOR + ciLIBOR-i + eTT+Ui
r= rate of interest offered/levied on deposits/loansxi: banks non-price characteristics LIBOR: 3 months £ London Interbank Offer RateLIBOR-i: LIBOR lagged by i, i=0,1,2…TT: Time trendUi: error term
Pricing Non-Price Characteristics in Banking
For deposits products, negative and significant coefficients on non price characteristics is an indication of less interest is being paid in presence of these characteristics
For loans positive and statistically significant coefficients means customers are being charged more compared to competitive rate due to other non-price characteristics
Case Study: See British Retail Banking
Testing price discrimination in Banking
When a bank practice price discrimination, it offers same product at different prices to different customers
Price discrimination is possible when bank is able to separate customers to their different price elasticities of demand
But precondition of price discrimination in banking is that customers are being offered same product at different prices
Testing of price discrimination is done through adjusting for non-price features of the product.
Once done, then it becomes possible to compare the difference between ordinary products prices and the products where price discrimination is thought to be happening
In banking jargon, in the absence of price discrimination, price paid on ordinary accounts should be equal to special accounts
Testing Price Discrimination in Banking
Hefferan (1992) used the following relationship to calculate the magnitude of price discrimination in new products in British retail banking (High interest deposits and High interest checking accounts compare to traditional 7 Day Accounts).
The author used the following relationshipPDj= ADJINTj-7DAY/BASIC ACCOUNTS
Where, PDj= Price discrimination by bank j; ADJINTj= net interest paid by a bank on deposits adjusted for non price features; 7DAY/BASIC ACCOUNTS- the traditional 7-DAY or basic accounts interest paid
If PDJ > 0: New products customers are being discriminated positively. IF PDj < 0: New products customers are being discriminated negatively
Case Study: British Retail Banking
Measurement of Degree of Imperfect Competition in Banking If one knows from H-statistics that banking market in the
country is subject to imperfect competition, next step is to find how much retails banking in the country deviate from a perfectively competitive market
How much is the influence of individual banks on price setting
In simple words finding which bank is not giving a good deal to customers for deposits and loans and how much is rip-off (bad deal: loss).
To answer these questions a generalized linear pricing model is used
Heffernan (1992) used the following model to find out the degree of imperfect competition in British retail banking
INTi= a0+ajDj+bk[LIBOR-k]+cFIRMS+dMOS+eTT+Ui
Measurement of Degree of Imperfect Competition in Banking
INTi= a0+ajDj+bk[LIBOR-k]+cFIRMS+dMOS+eTT+Ui1. INTi: interest paid/received on deposits/loans2. LIBOR: 3 months £ London Interbank Offer Rate3. LIBOR-k: 3 months £ London Interbank Offer Rate
lagged by say 0,1,2 months4. FIRMS: Number of firms in sample (industry)5. MOS: Number of months since product was introduced6. TT: Time trend
Sum of LIBOR coefficients will give an indication of deviation from perfect competition
It can also give the value of rip-off/ bargain to customers Case Study: British Retail Banking
BANKING STRUCTURES- BY COUNTRY
Stylised Facts
• Table 1-2: Top 10 bks (by assets and/or tier 1 K)
• Top position has gone to Japan or the US since ‘69.
• Major differences in US/UK structures
• UK bks (’02): £2.5 tn in assets (with foreign: £4.7 tn);
• US bks (’04): $9.7 tn - note differences in distribution.
Table 1-2: Top 10 Banks, 1999-05(2005 Added)
1969Assets
1994Assets
1997Assets
1997Tier 1 capital
2002Tier 1 capital
2002Assets
2004 Tier 1 capital
2004Assets
2005Tier 1 K
2005Assets
USA 7 1 0 3 3 2 3 1 3 3
Japan 0 6 6 3 3 3 3 3 2 2
UK 1 1 1 1 1 1 2 2 3 3
France 1 1 1 1 1 1 2 2 2 2
Germany 0 0 1 1 1 0 0 1 0 0
Netherlands
0 0 0 1 0 2 0 0 0 0
Switzerland
1 0 0 0 0 1 0 1 0 0
China 0 1 1 0 1 0 0 0 0 0
BANKING STRUCTURES- Types of Banking
Universal Banking - the German hausbank One legal entity (though it can have subsidiaries)
Investment, wholesale, retail banking services.
Non-banking fin. services (e.g. insurance, consultancy).
Links between banking & commerce. E.G. Deutsche Bank, DresdnerRestricted Universal: different variations E.G. each part legally separate and individually capitalised; no significant cross-shareholdings
Structure-Commercial & Investment Banks
Terms originated in US due to regulation.
Commercial bks: 1933-99: restricted to wholesale&retail banking
• Wholesale banking: core services for large customers, e.g.: big corporations and governments. Most US commercial banks also have retail customers.
• Retail banking: core banking services to numerous personal customers and SMEs. High volume, small accts. Largely intra-bank and domestic.
BUT• In 1987, allowed “section 20 subsidiaries” to underwrite corporate debt and equities
Banking Structure (continued)US Investment bks: for a fee: (a) Underwrite bond/equity issues to raise capital for large
corporations and government (b) arrange mergers and acquisitions.
Modern US Inv. Bks: as above plus: trading: equities, fixed income (bonds), proprietary fund management consultancy global custody
UK Merchant bks: now very similar to investment banks
Q: Is an investment bank a “bank”?
Banking Structure (continued)US Investment Bks and Conflict of Interest
Issue: bk analysts: not a profit centre. •IBDs: inv. bk divisions: underwrite primary/secondary issues; provide other services – is profit centre Accusation: analysts talk up the share prices of IBD’s clients.• Investigation: initiated in 11/02 by NY AG- Spitzer - began at ML; widened to include others. • Settlement: 4/03 - 10 Inv bks to pay $1.4 bn: penalties, investor compensation, independent research body, firewalls, etc.
Banking Structure (continued)
UK Investment Bks and Conflict of Interest (FSA)• No specific accusations of bias.
• Inst. Investors play a more dominant role in the UK.
• BUT: the UK market has the same firms; also: corporate finance or equity brokerage parts of an IB generate revenue: underwriting/advisory/brokerage fees.• US: “prescriptive”/ UK: “principles”.
Banking Structure (continued)
UK Investment Bks - Sources of Conflict of Interest:(1) If analysts involved/influence other functions in the IBDE.G.- Analysts’ reports “altered” to improve IPO outcome- Analysts pressured to issue more buy/sell rather than hold recommendations to increase trading in shares of a particular firm.
FSA (2002) study: Proportion of buy recommendations made by IBs providing both analysts reports on a company AND acting as corporate brokers/advisors to that company (FTSE 100) was double that of independent corporate brokers.
Banking Structure (continued)
UK Investment Bks - Sources of Conflict of Interest:
(2) Remuneration of analystsE.G. Analysts salaries are dependent on generating IBD revenues
(3) Analysts or IBD hold shares themselves: temptation to issue reports to boost the share price; the opposite if planning to buy a stock. Covered by FSA’s code of conduct and conduct of business rules.
Banking Structure (continued)
UK Investment Bks - Sources of Conflict of Interest:
(4) Relations between IB and companies: E.G. firm threatens to take CF business elsewhere, OR Vice-Versa: IB will withdraw research coverage of a firm unless they get the business.
(5) If “Chinese walls” ineffective: analyst may use info from CF or trading & sales not yet in public domain. Covered by insider trading laws, Conduct of Business, and Code of Market Conduct.
Central Banking
The term 'central bank' normally refers to a state institution with responsibility for
(1) Monetary control, and possibly:
(2) Prudential control, and/or
(3) Government Debt Placement
This part of the banking lectures considers these 3 functions.
(1) Monetary Control
Monetary control: the stabilisation of the price level, or controlling inflation. Money supply: currency in circulation + deposits held at bks.
Simple monetary model
P = MS - y, where: P: rate of inflation: rate of change in p level over time MS: the rate of growth in the money supply y : the rate of growth of real output (e.g. real GNP)
TRADITIONAL methods include:
• Control of the MS/monetary targets: see inflation equation
• Reserve ratios: require banks to hold deposits (that may/may not earn interest) as reserves at central bank. Increasing the reserve ratio takes money out of circulation - MS
• Open Money Market Operations
CURRENT METHOD of Monetary Control
Central bank: - Raises or lowers interest rates used to lend to banks, which, in turn, raises or lowers aggregate demand, and through it the rate of inflation.
-Some (developed) countries also use monetary targets: more the exception than the rule.
(2) Prudential Control
To protect the economy from the effects of a financial crisis: periods of excessive volatility in the financial markets, resulting in problems of illiquidity/insolvency among financial firms - especially banks.
Why worry?:
1. A widespread banking collapse - rapid decline/withdrawal of bank core services- inefficient allocation of resources.
2. Falling MS: macro effects
Suppose customers are concerned about the ability of a bank to meet their liquidity demands: as a result of a rumour a bank becomes, increasingly illiquid:
• The bank soon runs out of cash (due to fractional reserve lending)
• Contagion sets in:
(1) asymmetric info means clients/investors unable to judge which bks are healthy
(2) runs on bks reduce their value: agents will want to liquidate before this happens.
All deposit taking bks : subject to runs - face illiquidity.
• As a core service, a problem of illiquidity soon becomes one of insolvency (liabilities>assets)
Financial System Collapse?
• Yes, if enough banks fail, because the core banking services: intermediation, liquidity, payments system - no longer available.
Systemic risk: risk of a collapse in the financial system
Thus, governments treat banks as special: The central bank can:
• Act as Lender of Last Resort: central bank supplies liquidity to solvent but illiquid banks.
OR
• Launch a Lifeboat Rescue
Problem: Moral Hazard
Inevitable if private banks know they will be bailed out. Response: take higher risks, especially if the bank encounters difficulties - “goes for broke”
Moral hazard (and bks’ contributory role to systemic collapse) result in close regulation: prudential regulation.
Increasingly, the regulatory function is being removed from central banks. E.G. UK: The Financial Services Authority (FSA): regulates/supervises ALL financial institutions.
(3) Government Debt Placement
(does not normally apply to central bks: developed world)
Central bk: expected to place govt debt on favourable terms.
Raises seigniorage income through:• A reserve ratio: bks deposit reserves at central bank - an implicit bk tax if no interest is paid.
• Issuing new currency at a rate of exchange that effectively lowers the value of old notes.
• Liberal monetary policy: inflation reduces the real value of debt
Issue 1: Potential Conflict of Interest - (1) and (2)
Issue: Supervision/Lender of Last Resort: MAY conflict with goal of price stabilisation/monetary control.
Many countries assign function (2) to another government body - UK, Australia, Canada, China, the EU, Japan (?). NOT the US.
Goodhart & Schoenmaker (1995): Sample: 26 countries. No evidence to support separation or combination of 3 functions.
Issue 2: Independence of Central Bk from Government
• Politicians have a short time horizon AND
• Govts: conflicting objectives: unemployment, commitment to a fixed/managed exchange rate regime.
BUT
• Many years to build a credible reputation for price stability.
• UK, Japan: granted some “independence” to their central banks E.G. UK:. Treasury appoints/approves all the members of the Monetary Policy Committee.
SUMMARY:LINK BETWEEN BANKS & CENTRAL BANK
• Central banks: responsible for price (and financial) stability.
• The MS is linked with inflation: banks (via deposits) hold the MS
• MS affected by fractional reserve lending: if banks lend more, the MS increases
• Central banks can reduce bank activity through, for e.g, reserve ratios (a potential tax on banks)
• Runs on banks can quickly reduce liquidity and add to instability unless the central bank intervenes.