Handout for Lecture 5.

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18 Νοε 2013 (πριν από 4 χρόνια και 7 μήνες)

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Handout for Lecture 5.


Note
: Lecture will begin with concluding slides from last
lecture.



Core / ‘traditional’ principles of bank management derive
profit from
asset transformation
, i.e.


Draw in funds at lower cost on the liability side.


Put them to more profitable use on the asset side.

i.e. This bank profit is from items ‘
on

the balance sheet
’.

Changes in banks’ balance sheets



review
:

Rise of
liability management
:

Money markets / non
-
transactions deposits to
acquire funds > customers’ deposits.

Same for
liquidity management

> high excess reserves.

Also
:

Interest rate risk
: hedging instruments

> adjustments to balance of interest
-
sensitive and
interest
-
insensitive assets items on BS.

Balance sheet of all US commercial banks (%), December 2004.

Com
bining this with the breakdown of assets shown previously, we thus now have
:


Balance sheet of all US commercial banks (%), Decembe
r 2004.


Assets

Liabilities

Reserves and cash items

4

Checkable deposits

9

Securities

25

Non
-
transa
c
tion
deposits

63

Loans

63

Borrowings

21

Other assets

8

Bank capital

7


100


100


Off
-
balance
-
sheet activities.


Deregulation
, etc.,

banks now
also → further
activities:

Not

defined with respect to BS

i.e.
Not appearing on the balance sheet.

Merging of activities of banks and non
-
bank financial institutions
(
nbfis
).

Boundaries less distinct.


Extent of Off
-
Balance
-
Sheet activity

1979

1984

1989

1994

1999

2001

41.3

40.0

37.6

35.9

28.7

28.1


Non
-
interest income as %age of gross income, UK large
banks:

Note
:

Actually now a
declining

proportion.

Due to increased competition from nbfis.

Examples of OBS activities.


Fee income

from specialized services, e.g.


Investment services, as seen.


Other investment bank services, e.g.issue of securities.


Foreign exchange trades for customers.


Fund management.


Credit cards.

Examples of OBS activities ,
contd
.


Trading activities and risk management
on own behalf
, e.g.

Foreign exchange
dealings.

Dealing in
derivatives
:

Financial futures, interest rate and exchange rate
hedging, etc.


Note
: Original purpose of derivatives, etc.:

Mitigate

risk
.

But in fact → massive
speculation
, including by banks.

→ whole new range of management problems.


The ‘
principal
-
agent
’ problem:


Agent / employee of bank:

Earns profits → gets bonus.

Makes losses → bank has to cover for him/her.

e.g. Barings employee Leeson 1992
-
5:

Lost bank $1.3 billion → bank failed.


Strategies

to counter PA problem:

Separate trading from book
-
keeping (‘back room’)
activities.

‘Chinese Wall’ between departments of same firm /
separate capital accounts, etc.


Disintermediation
’.



i.e. Intermediaries less dominant in credit market.



Affects

both sides of intermediation process:


Banks

increasingly turn to other activities apart from
intermediation, as seen.

e.g. May provide investment services to companies to obtain
best rate.

> Competing by lowering own ROA (i.e. competing ‘on
-
BS’).

i.e. Switch to
Off
-
Balance
-
Sheet

/ fee income.


Companies

may turn away from banks:

May get better loan rate from
capital market.

i.e.
direct

finance >
indirect

/ ‘
mediated
’ through bank.

Banks and ‘nbfis’: boundaries less distinct.

BUT:
particular significance

for the economy:

Payments system.

Sheer scale.

Money creation process, etc.




Heavy regulation
.

Equivalently,


further (interconnected) ‘basic’ principles of
bank management:

Find ways to
evade regulations

(‘loophole mining’).


Keep up with
innovations
.


Effects of:

1. Deregulation.

2. Innovation.

3. Globalisation.

ECON7003 Money and Banking. Hugh Goodacre


Lecture 5.


THE CHANGING CHARACTER OF

BANK MANAGEMENT

Conventional / traditional / ‘
mono
-
tasking
’:

Deposits in, loans out.

Remains basic.

BUT

no longer the only or even main source of profit.


Now ‘
multi
-
tasking
’ / evolution in face of:

Increased competition
, both from within banking sector
and from nbfis.

→ Restructuring of sector:


Diversification

of activities.


Increased
efficiency

(or ingenuity??).


Absorption (??) of
greater risk
.


Three interconnected trends in particular:

Deregulation.

Innovation.

Globalisation.

1. Deregulation.


Contradictory situation:


Concern for stability of financial sector:

‘Prudential’ controls.

Countering ‘loophole mining’, etc.

→ Trend to
tighten

regulation
.


Competition issues :

→ aim to allow banks greater freedom.

→ Trend to
de
regulation
!

Two strands of deregulation:


Removal of
government

restrictions.


Removal of
self
-
regulatory

restrictions.

i.e. Established from within banking / financial sector
itself:

e.g. Agreements among building societies on
interest rates, etc.

Three phases of deregulation.


Note
:
Not same timing or even sequence in different countries:


(i)

Decisive blow to traditional framework.


(ii)

Ending sharp distinction between banks and nbfis.


(iii) Allowing increased competition within financial sector
and from outside it.

Deregulation Phase (i)
Decisive blow to traditional framework.


Ending ‘traditional’ / ‘mono
-
tasking’ structure of sector.


Asset side:


Lifting quantitative
controls

on



banks’
assets
.


Liabilities side:

Lifting ceilings on
interest rates




on
deposits
.


UK
:



Began early:


‘Competition and Credit Control’, 1971.


Lifted credit restrictions.


Associated with very loose monetary policy /
‘Barber boom’.


Subsequent backsliding


‘corset’


deposits at BoE
to restrain growth of MS.


But by early 1980s all exchange and credit controls
ended.

US
:



Regulation Q
’ (imposed in 1933):

Limited interest rate payable on deposits.

Not lifted till 1982.


Note
: Traumatic effects of 1930s US bank failures.


→ Deregulation
came later than in UK
.

Very significant effects on international finance.

Variable rate lending
.


1970s
:

Volatile interest rates.

Inflation.


→ Banks increasingly allowed to issue variable rate loans.

e.g. Linked to LIBOR (London Inter
-
Bank Offer Rate).

> ‘Stuck’ with unprofitable loan rate.


Variable rate lending:

→ Stock of loans could become determined by demand.

Near
-
horizontal credit supply curve!



Banks could now liability
-
manage.


→ Great
expansion of
banks’ balance sheets
.

Also:

Reduction in Capital:Asset ratios.

Exposure to greater risk.

From asset management to liability management.


Asset management of

post
-
war decades
:

Large public sector (war) debt.

Readily tradable.


Quantitative controls

→ ‘traditional’ situation maintained:

Liabilities

side: Largely
passive

supply / customers’ deposits.

Assets

side:
Active

adjustment of balance sheets.

From asset management to liability management,
contd


From 1970s:

Banks
actively

create

liabilities

/ borrow from other banks /

money markets
’, as seen.


Preview of globalisation
:
UK CCC but US maintained Q:

→ impelled move of US banks into Eurodollar market.

Deregulation Phase (ii) Ending sharp distinction between
banks and nbfis.


UK
:


Banks and
building societies
:

1980s: banks allowed to compete in mortgage market.

1986: building societies allowed to compete in market
for consumer credit.

i.e. both allowed to
compete in each others’ markets
.


US
:


Once again,
much restrictive legislation

of 1930s


remained

in force till late, but:

1980s: some competition with ‘thrifts’ allowed.

1999: banks allowed more freedom to compete in
investment banking, insurance, etc.

Deregulation Phase (iii) Allowing increased competition within
financial sector and from outside it.


Within financial sector
:

nbfis → new kinds of financial services.


e.g. online banking


Egg, etc.

→ new kinds of nbfis competing with traditional banking.


Firms from
outside financial sector

enter financial services market:

UK
:
Tesco, Marks and Spencer, Virgin, etc.

US
:
Not only retail firms but also industrial:

e.g. General Motors.

General Electric’s financial arm → 1/3 of its revenue!