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Lecture 7

Commercial and Investment banking

Financial Markets and Institutions

Dr. George Alexandrou

Office: R.744 – Office Hours: Mon. 5:30-6:00p.m. and 9:00-9:30p.m.
E-mail: or

Learning outcomes

• Understand the nature of commercial banking and its

contribution in the business and economic life.

• Understand the basics of the operations of commercial

banking industry.

• Understand the basic characteristics and activities of the

investment banking.

• Understand the nature of the major noncommercial banks and

their international role.

Noncommercial banks

• Noncommercial international banks are the banks that focus

on the development and economic coordination of a number of

• The major noncommercial international banks are:

1. The bank for International Settlements

2. The International Monetary Fund

3. The World Bank

The Bank for International Settlements (BIS)

• Based in Basle, Switzerland (1930)

• BIS is the central bank of central banks.

– BIS was set up following the ‘Young Plan’ (1929).

• Depositors are the central banker who meet 10 times a year

(once a month for 10 months) to discuss policy and monetary

• Committee on Banking Regulation and Supervisory Practices

(Basle I, II & III since 1993).

BIS - Structure

• BIS established as a commercial bank.

• Original shareholders:
– The central banks of: Belgium, France, Germany, the UK, Italy
(holding jointly more than 50%), Japan, a financial group from the US
(J.P. Morgan, First National Bank of the city of NY, First National
Bank of Chicago).
• The US allocation of shares was sold to the public but
Citibank exercises their voting rights.
• Federal Reserve System is not a shareholder but participate in
BIS committees.
• BIS performs almost any financial service for central banks.
• However, BIS must not create money like a conventional bank
• BIS is not permitted to finance directly government operations.
BIS - Operations
• BIS dealings with the German government during the 2nd ww.

• Gold from occupied countries 3,740kgr ($4.2 - $50m).

• BIS is used by Treasuries of western governments and their

central banks as the forum to resolve issues on
– International money supply; currency values and interest rates.

• In their monthly meetings in Basle, the central bankers discuss

local and international problems.
– The meetings are informal and undocumented.
– ‘Gentlemen’s agreements’ are reached.
• Central banks’ deposits are pooled and invested anonymously.

International Monetary Fund (IMF)
• IMF is an organisation established by the Treasuries of the US
and the UK during the 2nd ww.

• Objectives:
– To assure free convertibility of currencies in trade.
– To avoid currency devaluations and make exports more competitive.
– To prevent international monetary crises.
• A pool of funds (gold and currencies) are available to countries
that experience deficits of their balance of payments.
• Initial agreement in Bretton Woods (1944) – 44 countries.
• Now membership is 150 country-members.

IMF – Structure and quotas
• IMF has two main departments:
– The General department (GD)
– The Special Drawing Rights (SDR) department.

• The SDR is the first reserve assets (money) to be created by

international decision.

• Within the GD each member has a General Resource Account


• Each member deposits in its GRA its quota.

• Quota (IMF) is the minimum subscription (contribution) of a
country in order to become a member of the IMF.

IMF – Structure and quotas 2
• A country satisfies its quota subscription by depositing:
– Freely usable currencies (at least 25% of the total quota) – reserve
tranche on which interest is paid and
– Its own currency.
• The total quota subscriptions is available to all members.
• A country can freely use its reserve tranche to satisfy its
balance of payment deficit.
• There is no need to reverse this transaction (buy its own
• If the reserve tranche in insufficient credit tranches can be
• Subsequent tranches are called upper credit tranches and are
available subject to scrutiny and payment of interest.
World Bank Group
• The World Bank Group is comprised of four affiliates:
1. The International Bank for Reconstruction and Development (IBRD)
2. The International Development Association (IDA)
3. The International Finance Corporation (IFC)
4. The Multilateral Investment Guarantee Agency (MIGA).

• The IBRD (or WB) was created during the Bretton Woods
conference (1944).
• WB concentrates on long-term development.
• WB and IMF hold their annual meetings jointly and
membership in the IMF is a prerequisite for WB membership
• WB must lend for productive purposes and stimulate
economic growth in developing countries.
The International Development Association (IDA)

• A WB affiliate that gives loans to the governments of the

poorest members countries that are not qualified for IBRD

• Contributions from the wealthiest members.

• Loans are interest-free and up to 35 to 40 years.

• 5-8% of the total financing to the less developed countries

comes from IBRD and IDA.

The International Finance Corporation (IFC)
• The IFC was established in 1956 and makes private sector
• It has 170 countries members.

• IFC advises governments on the fiscal, legal and regulatory


• IFC attracts international investors to the host country

security markets.

• IFC relies on capital markets for its funding and is an active

participant in privatizations.

The Multilateral Investment guarantee agency (MIGA)
• MIGA is the newest member of the WB group (1988).
• Formed by 42 WB member countries (now 160+ members).

• MIGA provides insurance protection for foreign investors

against noncommercial risk in developing countries:
– Currency transfer risk: risk that conditions for converting and
repatriating currency will deteriorate.
– Expropriation risk: the risk of being unwillingly deprived thi
investment or the benefits from the investment.
– Risk of war, revolution and civil disturbance.
• MIGA may insure:
– For equity investments, up to 90% (+up to 450% of investm for earn)
– For loans and loan guarantees 90% principal + 135% of principal for
accrued interest.
The nature of the retail Banking in the UK
The distinction between Retail and Wholesale banking has recently become less
clear, since retail banks undertake wholesale activities.

Retail banking is more relevant term that retail banks, since also non-banks offer
retail banking services.

Banking involves taking deposits and repackage the funds and on-lent as loans.

Retail banking: Large-volume, low-value end of the industry.

Deposits from individuals and small business (and loans to the same group).

Wholesale banking: Low-volume, large-value end of the industry.

Typical clients are the medium/large companies and large organisations.

To operate as a bank in the UK a business need authorisation by the FSA (’98).

The Balance Sheet of a bank
Liability refers to the money an individual or legal person has borrowed or has to
pay for a delivery of a good or service.
A borrower is liable to repay the loan in an agreed fashion at an agreed time or
over an agreed period.

The liabilities represent claims against the bank.

The liabilities part of a bank’s balance sheet has three main sources of money
coming in:

• Deposits (the largest part)

• Borrowings and

• Shareholders’ equity and retained profits.

The Balance Sheet of a bank (2)
The assets represent claims by the bank against others.

The assets part represents the uses of money and includes:

• Lending (the largest part)

• Notes and coins

• Money market funds

• Securities

• Fixed assets (property).

The Balance Sheet of a bank (3)

Table 1. A bank’s summary balance sheet

Where the money comes from How liabilities (money) has been used
Deposits Cash
Borrowings Money market funds
Shareholders’ funds Other securities

The Balance Sheet of a bank (4)

Table 2. A bank’s extended balance sheet

Ordinary share capital Cash
Other share capital Balances at the Bank of England
Reserves Money at call and short notice
Retained profits Bank and trade Bills of Exchange
Provisions against losses Treasury bills
Bond issues Securities
Customers’ deposits Advances to customers
Other borrowing Premises and equipment
Trade creditors

The UK Retail banks
• English banks:
- Barclays
- Lloyds-TSB
- Abbey National

• Scottish banks:
- Royal Bank of Scotland
- Bank of Scotland (HBOS)
- Clydesdale

• Northern Ireland banks:

- Bank of Ireland
- Ulster Bank
- Northern Bank.
The Balance Sheet of a Retail Bank
Table 3.1 The combined balance sheet of the UK retail banks at 31 Dec 1996.
Liabilities £ bn Assets £bn
Notes outstanding 2.7 Notes and coins 4.8
Total sterling deposits 467.8 Balances with the Bank of
(of which, sight deposits) (210.1) England 1.7
Foreign currency deposits 148.6 Market loans 102.1
Items in suspense and transmission Total bills 12.2
plus capital and other funds 92.0
Repo bills 13.6
Investments 50.7
Advances 338.5
Other currency and miscellaneous
assets 186.5
Banking Department lending to 0.9
central government

Total liabilities 711.0 Total assets 711.0

Source: Bank of England Statistical Abstracts, 1997, table 3.4.

The Balance Sheet of a Retail Bank (2)
In the liabilities side of the balance sheet we can see:

1. The small item ‘notes outstanding’ which refers to private bank notes.

2. The sterling deposits that constitute the majority of a bank’s liabilities.

This mainly comes from individuals and firms.
Around 45% of those deposits are sight deposits, i.e. payable in demand.

3. A fifth of a bank’s deposits are foreign currency deposits.

4. Finally, the other major part of bank liabilities is the items in suspense or
transmission (such as cheques drawn and in the course of collection) and
capital and other funds (such as issued share capital, long-term debt and

The Balance Sheet of a Retail Bank (3)
In the asset side of the retail banks balance sheet we have:
1. Cash in form of notes and coins is a relatively small fraction of a bank’s
assets (around 0.7%).
2. Another small item is the cash balances with the BoE. This is mainly the
0.15%, non-interest-bearing, compulsory ‘cash ratio’ required on all liabilities
exceeding £400m.
3. Market loans provide additional liquidity.
These are mainly short-term loans made in money markets.
4. The bills are mainly Treasury bills or bank bills.
5. The repo bills are claims refer to sale and repurchase agreements, where
banks acquire balances through the operation of a new system of monetary
6. The investments of a retail bank are mainly in holding marketable securities.
These are mainly government bonds or government guaranteed stocks and
therefore have the characteristics of low default risk and marketability.

The Balance Sheet of a Retail Bank (4)
7. Sterling advances are the main asset of a retail bank, which is her around
50% of the total assets. Major parts of these advances are:
•Overdraft facilities to corporate clients
•Term loans to business (increasingly since mid 70s)
•Personal lending (increasingly since 80s):
- Mortgages
- Unsecured lending.
8. Other currency and miscellaneous assets include
Advances in other currencies (20%)
Market loans and investments in other currencies (80%)
Miscellaneous assets include the bank’s physical assets (premises
and equipment)
9. The final item, Banking Department lending to Central Government, refers to
the Banking Department of the BoE, which is included in the retail banks
classification owing to its involvement in the clearing system.

Recent changes in Retail Banking

• ATMs

• Telephone banking
– First Direct (1989, Midland Bank)

• Non-banking firms supplying retail banking services

– Supermarkets (Tesco, Sainsburys, etc)
– Insurance companies (Prudential)

• Internet banking

Deconstruction of banking services

• Separate provision of each component, via subcontracting.

• For example mortgage loans can be deconstructed to:

– Origination
• Mortgage broker to customer.

– Administration
• processing paperwork.

– Risk analysis
• assess creditworthiness of client.

– Funding
• Finance is raised - Assets held on balance sheet - capital allocated to the risk.

Payment services

• Transfer of ownership of certain assets are carried out in settlement of debt


• Need for an instrument that serves as:

– Medium of exchange
– Means of payment.
– Temporary store of purchasing power (since payments and receipts are not
Original commodity satisfying these conditions was money.

• Now financial innovation has permitted unbundling the functions of money:

– credit card cervices as medium of exchange.
– Direct debit effects means of payment.
– current accounts now pay interest.
Risks in Retail Banking

Retail banks like all financial intermediaries have to manage the following risks:

1. Liquidity risk
Issued liabilities have shorter maturity (payable on demand) than the
assets’ term to maturity.

2. Asset risk
The risk that the realisable (redeemable) asset value is less than their
book value, due to default risk, price risk or fire sale discount.

Two additional sources of instability:

1. From the nature of the payments system (committing funds before payment).
2. From undertaking contingent commitments (more related to wholesale
Liquidity risk
Results from mismatching of maturity of assets and liabilities.
• Liabilities (deposits) can be withdrawn at call or very short notice, whereas
assets (advances) that make up to 70% of assets are relatively illiquid.
To deal with that banks should manage the inflow and outflow of their
• Overdraft commitments (on the asset side) are also uncertain, introducing
another element of liquidity risk.
Two aspects of bank operations ameliorate this risk:
1. The large scale of operations. Large number of net inflows from deposits
via small accounts makes the overall net inflow more
2. Through a diversified deposit basis.
Two main strategies of managing liquidity risk:
1. Reserve asset management and
2. Liability management

Liquidity risk - Reserve asset management

New deposits Loan repayments

Deposit withdrawals Liquid

assets New loans

Figure 3.1 The reverse asset management approach to liquidity risk

(Liquid Assets) + (New deposits) + (Loan Repayments)

used to finance:
(Deposit Withdrawals) + (New Loans)

Loan Repayments are the most predictable element of cash inflows.

Liquid assets provide a buffer stock against unexpectedly large outflows.

Liquid assets’ maturity is layered between: Cash - Overnight Deposits - Bills -
Certificates of Deposit (CDs), with increasing interest rates.
Liquidity risk - Liability management
The bank determines first the desired quantity of assets and then adjusts the
interest rates to attract the necessary amount of deposits (liabilities) to fund
this level of activity.

In Reserve Asset Management it is the opposite.

The interest rates are constant and the amount of assets is adjusted in line with
the quantity of the deposits attracted by these rates.

The marginal cost of raising additional retail deposit is high because the higher
rate has to be offered to all deposits.

The marginal cost of raising short-term (overnight) funds in the inter-bank

market is much lower since the bank is price-taker in this market.
That motivated the banks to move away from the Reserve Asset Management
and towards the Liability Management for managing Liquidity Risk.

Asset Risk
The Bank of England identifies three types of Asset Risk (possibility that the
value of assets will fall below their ‘book value’:

1. Risk of Default. …ways to deal with this are:

- Assessment of borrower’s circumstances:
Use of funds
Credit scoring
Security offered
Means of repayment (income, assets)

- Selecting a portfolio of large number of borrowers (pooling of risks)

increases the predictability of default

- Diversifying the loans portfolio over different types of borrowers.

Asset Risk - cont.
2. Investment Risk.
This relates to capital-uncertain assets. A fall in price will reduce the value of
these assets.

Example: The value of government securities held by a bank will fall if interest
rates increase (even with no default risk)

This risk can be hedged by selling band futures contracts or buying bond put

3. Fire sale Risk (or Forced-sale Risk).

The realisable value of an asset might be lower than its book value if it has to
be sold at short notice.

Payments Risk

The payment system provides for the transfer of funds between accounts at
different financial institutions.

In the UK every day: 16,000,000 transactions of Total value £160,000,000,000.

Two types of payment systems:

1. The Wholesale payments system, involves large-value, same-day, sterling
transfers. The main system is the CHAPS (Clearing House Automated
Payment System). In ’94: 16 member banks >£100bn daily.

2. The Retail payments systems:

- The cheques clearing systems (deals with cheques and paper items).
- The credit clearing systems
Additionally, the Bankers’ Automated Clearing Services (BACS),
is an electronic clearing house for items like standing orders and direct debits.
Payments Risk - cont.
CHAPS allows a bank to make a credit to other banks in the system (either on
its own account or on behalf of a customer).
The final settlement is made at the end of the day for the final overall debit and
credit balances (through settlement accounts held at the Bank of England).

Receiver Risk: The problem arises when a member bank, following an

instruction from another member, provides the funds to its customer before
the final settlement. If the receiving customer initiate further transaction
during the day (involving more bank members) and one bank fails before
final settlement, many banks will be left exposed.

Solution to this problem: The Real-time Gross Settlement (RTGS).

For this, all the bank transactions are recorded in the accounts of the BoE as
they occur, and the settlement bank receives an instruction only after the
payment has been settled by the BoE.

The nature of Wholesale banking
The non-retail banks are a heterogeneous group subdivided into:
• UK merchant banks (30)
– members of the British Merchant Bankers and Security Houses Association.
– Originally they financed trade and commerce by ‘accepting’ bills.
– Now they have expanded their activities to direct lending, underwriting, new
issues, portfolio management, M&A advice, etc.

• Other UK banks
– Regional banks
– finance houses
– leasing companies

• US banks

• Japanese and Other overseas banks

The nature of Wholesale banking (2)

Table 4.1 Sterling and foreign currency deposits (liabilities) of the non-retail
UK banks 31 December 1996 (in £million) [BT, p71].

Sterling Foreign % of sight sterling

currency to total sterling
UK merchant banks 23,440 13,317 21
Other UK banks 42,592 8,832 14
Japanese banks 29,728 149,465 7
US banks 26,234 121,450 26
Other overseas banks 159,623 533,958 14

Source: Bank of England Statistical Abstract, 1997.

The nature of Wholesale banking (3)
Liabilities (deposits) of the wholesale banking:

• The wholesale market is market for large-sized deposits (min £250,000)

and loans (min £500,000) with low proportion of sight deposits (7-26%,
which is much less than the 45% for the retail banks).

• Around 22% of sterling wholesale deposits are inter-bank.

• The remaining 78% is time deposits of UK and overseas companies.

• Almost 90% of foreign currency business originates from overseas

customers and banks (only the remaining 10% from other UK banks).

• 70% of foreign currency deposits is interbank - 30% is company time-


• Overseas banks are more heavily engaged in foreign currency business.

The nature of Wholesale banking (4)

Table 4.2 Assets of non-retail banks operating in the UK at 31 December 1996

(in £million) [BT, p72].
Merchant Other Japanese US Overseas
banks UK banks banks banks
Notes and coins and balance at 57 114 78 96 369
the BoE
Market loans 8,194 9,561 11,758 8,819 64,646
Bills 35 160 46 6 1,183
Claims under repo agreements 5,079 230 2 1,333 9,277
Advances 7,988 38,702 15,932 12,478 66,187
Investments 4,672 3,437 1,871 1,739 17,419
Total sterling assets 26,025 52,204 29,687 24,471 159,081

Market loans 5,811 6,778 105,210 70,567 311,900
Advances 4,706 1,789 34,237 41,884 136,650
Bills, investments etc. 5,142 3,645 12,311 17,487 116,650
Total Foreign currency 15,659 12,212 151,758 129,938 564,924

The nature of Wholesale banking (5)

Assets (loans and advances) of the wholesale banking:

• There is little need for cash balances.

• The main sterling assets are inter-bank loans (counterpart to inter-bank

deposits) and large-scale sterling loans to private sector (e.g. Channel

The nature of Wholesale banking (6)
Maturity analysis of sterling and foreign currency activities with non-banking
customers of retail and wholesale banks in the UK at 31 Jan 1987:

• Considerable maturity mismatching of assets and liabilities. The bulk of

deposits is for less than 3 months to maturity and the assets greater than a year.
• Similarity of mismatching between sterling and foreign currency assets and
• The mismatch is less for the wholesale banks than for the retail banks.
• The UK banks have greater mismatching than the overseas banks.
• The wholesale banks, like the retail banks are not just liquidity distributors but
act to transform maturities.
• Solution of the resulting liquidity risk:
– Liability management via access to inter-bank borrowing as immediate source of
funds to replace withdrawn deposits.
– Securitisation of assets (packaging liquid assets into marketable instruments that
can be sold on to investor).
Asset-backed securities (ABS)
Asset-backed security (ABS) is a tradable instrument supported by a pool of
• A banks removes some of its loans (assets) from its balance sheet and places
them in a Special-purpose Vehicle (SPV), which finances its holdings by
selling ABSs to investors. This process is also known as securitisation and
adds marketability to assets that have very little liquidity.
The first issue of ABS in the US (1970s). In the UK 1985.
• UK is the second largest market in the world (Total issues in 1996: £23bn)
almost 4% of the total bank and building societies’ lending (£580bn).
• In 1997, NatWest converted into bonds £1bn of housing loans and £3bn of
corporate loans.

Benefits from ABSs:

• The lender (bank) removes assets from its balance sheet (given that the
relevant risks are transferred to investors) and frees up capital for other uses.
• Additionally, reduces the overexposure of the lender to a particular sector.
Off-balance-sheet business
Off-balance-sheet is business that generates a contingent commitment and
income to the bank without it appearing on the balance sheet under
conventional accounting procedures.
• Loan commitments (advance commitment by a bank to provide a credit)
– Revolving lines of credit (credit line commitment over several years)
– Overdraft (a facility for customer borrowing but can be withdrawn)
– Note issuance facilities (facility to issue commercial paper over a number of
years, which transforms short-term funds to long-term funds)
All these generate fee income for the bank.
• Guarantees (a bank underwrites the obligations of a client, relieving the
counterparty from having to assess the creditworthiness of the client).
– Acceptances (the bank guarantees payment of client’s liability)
– performance bonds (the bank support the good name of the client and its
ability to perform under a particular contract).
All these also generate a fee for the bank.
Off-balance-sheet business (2)
• Swap and hedging transactions (A number of financial
instruments/products can be used to hedge transaction risks, I.e. intsrument
that neutralise risk exposure)
– Swaps (interest rates and currency)
– Interest rate caps, floors and collars (options)
– Forward rate agreements (forwards)
A transaction can be hedged (to neutralise risk) or unhedged (left open to
• Securities underwriting (a commercial of investment bank can guarantee
that the whole new issue of shares or bonds is taken up, by agreeing to buy
up to a set amount of securities).
For this the bank receives a fee.
Other financial services the provide by a bank generate fee but not recorded as
a balance sheet entry:
Loan origination - Trust and advice services - Brokerage and agency
services - payment services (credit card and cash management).
Off-balance-sheet business (3)

Table 4.4 Fee or commission income as a percentage of net interest income

for Barclays Bank Group, 1980-96.

1980 1982 1984 1986 1988 1990 1994 1996

29 34 41 45 52 64 84 84

Source: Barclays Bank annual report and accounts.

The data in Table 4.4 above show the increasing importance of fee and
commission income over the interest income during the recent period (the
latter represents the difference between the borrowing and lending rates).

Off-balance-sheet business (4)
• Factors determining the growth of the off-balance sheet business:
• 1) From the bank’s point of view:
• desire for fee income
• diversify operations
• expand into new business areas

– Changes in the financial environment.

• 2) Greater volatility of interest rates and exchange rates since 1970s has
led to increased demand for hedging instruments (some - like options and
futures - traded in exchanges and some provided by banks over the

• 3) Greater perception of credit risk by banks has led to shift away from
bank intermediation (deposits and lending) to capital market instruments
as source of financing (generates underwriting and securitisation fees).

Off-balance-sheet business (5)
• 4) Arbitrage opportunities in capital markets as result of barriers such as
exchange rate controls, interest rate controls, reserve ratios, e.g. swaps
allow borrower to raise money in market with comparative advantage and
swap into currency in which he wants to borrow.

• 5) Changes in regulations and technology

• 6) Regulatory pressures have increased levels of capital in banking.

• 7) This led to banks pursuing off-balance-sheet business, which is not

subject to capital adequacy controls and hence increases returns on capital

• 8) Advances in computing, information processing and

telecommunications technology have enabled more complex instruments
to be designed and priced (financial engineering)
Off-balance-sheet business (6)
Implications of the growth in off-balance-sheet business:
• 1) Banks have taken on risks which are not explicitly related to bank’s
• 2) Liquidity risk (insufficient funding to meet obligations immediately)
• 3) Credit risk (risk of default by the counter party).
• 4) Position risk (results from adverse movements in interest rates and
exchange rates)
• 5) Price risk (risk that market value of asset may be lower than book value).

As a result of these risks:

• Banks may be underpricing new securities.
• Regulators have responded to these risks by introducing new risk assets ratio
(bank has to have capital related to risk-adjusted value of its assets).
• Off-balance-sheet instruments are converted to a credit equivalent and then
risk-weighted along with on-balance sheet instruments.