Lecture 1 Theories of - Abank = financial intermediary that offers loans, deposits and payment services. = Insurance comps also = fin intermediaries. - Monetary policy = central bank — determines size and rate of growth of money supply, which in turn affects int rates. i.e. modifying int rates/buying or selling gov bonds, and changing amount of money that banks keep as reserves. - UK banking structure ~ 2003-2012 — total number of all types of banks in Western world has been decreasing, decline in number of financial institutions. = US banking structure: 2004 v 2013, total number of all types of banks has been decreasing. - Whyare banks special? © Act as intermediaries between borrowers and lenders - unique form of asset transformation, ‘© Provide liquidity to customers ~ payment systems. © Important role in macro economy- lending process creates credit. The nature of financial interme tion: - _ Fland fin markets (FM), provide a mechanism by which funds are transferred and allocated to their most productive opps. - Banks = Fl—core activity = provide loans to borrowers, and collect deposits from savers. Act as intermediaries between borrowers and savers. = Banks collect surplus funds from individuals (savers), and allocate them to firms (dis-savers or borrowers), with deficit funds. This increases ec efficiency, by promoting a better allocation of resources. - A financial claim = claim to the payment of a future sum of money/or a periodic payment of money. Obligation on issuer to pay interest periodically, and to redeem the claim at a stated value in one of three ways: * Ondemand = After giving a stated period of notice "Ona definite date, or within a range of dates. © Whenever borrowing takes place - when an economic unit's (indiv, households, comp, gov ete) total expenditure > total receipts. © Can take form of any financial asset ~ money, bank deposit accounts, bonds, shares, loans ete. © Lender of funds holds borrower's financial claim = holds fin asset. (© Issuer of claim (borrower), holds financial lability. - Direct finance: ‘© Nointermediary— borrowers obtain funds directly from lenders in fin markets. ©. Barriers: = Difficulty and expense of matching the complex needs of individual borrowers and lenders. = Incompatibility of financial needs of borrowers and lenders. * Lenders look for safety and liquidity, which borrowers may find difficult to promise. - Lenders’ requirements Scanned with CamScanner© Minimisation of risk minimising risk of borrower not meeting repayment obligations, and risk of assets dropping in value. © Minimisation of cost (© Liquidity ~ lenders prefer holding assets that can be more easily converted into cash — because of lack of knowledge of future events = lenders prefer ST to LT lending. - Borrower's requirements: (© Funds at particular specified date. © Funds for specific period of time — pref LT. e.g. comp borrowing to purchase capital equipment, which will only have positive returns in LT! © Funds at lowest poss cost. - Role of F © Bridge between borrowers and lenders ~ settle their incompatible needs and obj. © Offer suppliers of funds safety and liquidity, by using funds deposited for loans and investments. © Minimise transaction costs and information asymmetries - from direct lending. © Transaction costs = costs of searching for a counterparty to a financial transaction, costs of obtaining info about them, negotiating the contract, the costs of monitoring the borrowers, and the eventual enforcements if the borrower doesn’t fulfil its commitments. © Asymmetric info ~ one party has better info than counterparty. E.g. borrower has better info about risks and returns of investment, than lender. © Roles of banks: * Brokerage services (buying and selling stocks and bonds for clients) * Leasing and factoring * Before 2007 — securitisation — pooling and repackaging illiquid fin assets into marketable securities. © Shadow banking—in the decade before financial crisis of 2007— credit intermediation involving entities and activities outside the regular banking system. Functions of Fi/Role of banks: small-size, low-risk and highly liquid. larger size, higher risk an - The Brokerage Function: © Ficanact asa broker, and provide info to individuals about quality of security issues. Only one entity - the Fi broker, incurs costs to screen the quality of firm’s securities = resolves adverse selectian problem. © Eg. firm wants to issue initial public offering (IPO) of securities. Firm's quality is unknown to potential individual investors, so a reputable investment bank underwriter, researches firm, and organises a ‘road show’, to inform potential investors of firm’s quality = now willing to purchase at fair offering price © Broker ‘matches’ savers to quality firms that need funding. - The Asset transformation function: © Fis hold LT, high risk and large denomination (a classification for the face value of fin instruments) claims, and issue ST, low risk and small denomination deposit claims. Some have capacity to issue large loans. Scanned with CamScanner© Fis process risk = change nature of the assets — can invest time/energy to ascertain risk in the firm they wish to lend. © Asset diversifica © Transformation of large-denomination FA, into smaller units. E.g. insurance comp pools together the risks of accidents or life faced by many individuals. In return for contributing an insurance premium (cash), each individual obtains a claim on the insurance comp, that pays off when an accident occurs. Kind like portf theory — pools risks and diversifies. * Asset Evaluation: © Banks act as evaluators of credit risk for the depositor. Banks exploit asymmetric info between agents, for profit. * Bank can profit from the info it produces, by making private loans (i.e. avoiding free-rider problems) ~ need to monitor firms, but assumes there's one person who'll do something right = means there isn’t proper monitoring going on- if you put Fl between investors and firm, ‘they monitor efficiently over time = eliminates free-rider problem. © Fis can provide maturity intermediation: * The maturities of banks’ assets, may be diff from maturities of it liab = creates liquidity. * Eg. a bank makes LT loans using ST funding (demandable) deposits ~ more liquid than underlying loans, as they can be withdrawn for cash at depositor’s discretion. © Liquidity Creation and Monetary Policy: © The liquid (demandable) nature of bank deposits, makes them close substitutes for cash. * Outside money = created by gov, consists of currency held by public, or banks as reserves at central banks. * Inside money = created by Fis, substitute for currency in making transactions (includes bank deposits and even credit cards). * Variation in demand for inside money, can affect demand for outside money. As prices are denominated in (outside money) currency units, changes in inside money can affect monetary p * Demand for some inside money, e.g. bank deposits, can be unstable. * Eg. early 1930s US ~ depositors feared loses if their banks failed. Withdrew deposits (demand for inside money fell), for currency (demand for outside money increased). Federal Reserve failed to increase supply of outside money to offset this increased demand = led to severely contra policy deflation, and widespread unemployment. = Transformation function: © Size transformati * Banks collect funds from savers in small-size deposits, and repackage them into larger-size loans. Scanned with CamScanner«Exploit econs of scale associated with lending/borrowing, as they have access to large number of depositors, than any individual borrowers © Maturity transformation: Transform funds lent for short period of time, into medium and UT loans] "Eg. convert demand deposits (can be withdrawn on demand), into 25-year residential mortgages. = Banks’ liabilities (i.e. funds collected from savers), are mainly repayable on demand, or at relatively short notice. = Banks’ assets (funds lend to borrowers), are repayable in the medium to LT. = ‘Borrow short and lend long’ ~ mismatch their assets and liab — liquidity risk problems (not having enough liquid funds to meet liab). isk transformati * Individual borrowers = default (credit risk) - may not be able to repay amount of money borrowed. Information economies: ~ Transaction cost: ‘© Bankliab (I.e. deposits), are accepted as a means of exchange, and banks are the only intermediaries that can vary the level of deposits and can create and destroy credit. ‘© Banks transform primary securities issued by firms (deficit units) into secondary securities ~ more attractive to surplus units. © They reduce transaction costs ~ secondary securities will be less risky, more convenient and more liquid than primary securities (because banks benefit from econs of scale in transaction tech, and can diversify risks) = can offer lower loan rates compared to direct financing. - Economies of scale and economies of scope: (© Flexploit econs of scale ~ increasing vol of transactions = decreases cost per unit of transactions. ‘© Train high-quality staff in process of finding and monitoring suitable deficit units (borrowers) - would be time-consuming and costly for individual to do it! ‘© Fireduce risk by pooling or aggregating individual risks, so that surplus units will be depositing money, as deficit units make withdrawals = banks can collect relatively liquid deposits, and invest most of them in LT assets. ‘© Econs of scope = joint costs of producing two complementary outputs < combined costs of producing the two outputs separately e.g. selling both mortgages and life insurance policies production processes of both outputs might have the same inputs, e.g. capital (the building that the bank occupies), and labour (bank management). > Asymmetric info: ‘© Not everyone has same info. ‘© Everyone has less than perfect info. © Some parties to a transaction have inside info, that isn’t av. transaction = difficult for two parties to do business together in order to reduce mismatches in info. ble to both sides of the ‘egulators introduced Scanned with CamScannerEg. a gov selling a bond doesn’t know what buyers are prepared to pay, a bank doesn’t know how likely a borrower is to repay, an investor buying equity in Apple doesn’t know full details of comp’s operations and prospects. Info asymmetry can distort firm and users’ incentives = significant inefficiencies. Full and complete info isn’t uniformly available to all interested parties, and not all parties have same ability to utilise the info available to them, Parties have more info about themselves (e.g. intentions and abilities), than others do. These problems occur because info isn’t a free good, and the acquisition of info isn’t costless. Problems when Fl are absent Things that can be assisted with by introducing a bank. ‘These are the problems when there is no bank or Fl. Adverse selection: © Before buying a firm's debt/equity, individual incurs costs to investigate its quality. The poorest (adverse) quality firms, have the most incentive to issue securities to unwary investors investors who don’t know things. ‘© The better informed economic agent has incentive to exploit his informational adv. ‘+ Aproblem at the search/verification stage of the transaction - only buyer, not seller, knows quality of commodity being exchanged—they know they’re the only one who know the true characteristics of the commodity, so they exaggerate the quality. ‘* Buyer can only form an opinion on the commodity after buying it. If there are lots of bad commodities in the market, it will function poorly. ‘+ Exg.second hand car market ~seller knowsif caris bad, but buyer can only make judgement after running it. All cars of same type, will sell at same price, regardless of whether or not they are bad. Risk of purchasing a ‘lemon’, will lower the price that buyers are prepared to pay for the car, and because second-hand prices are low, people with non-lemon cars will have little incentive to put them on the market. ‘© Signalling = the actions of the informed party. E.g. offering a warranty signal of quality. ‘* Screening = action by less informed party to determine the info which the informed party possesses ~ e.g, action by insurance company to gather info about healthy history of potential customers. ‘* Those who take out bank loans, have better idea of risks they face, than bank. ‘= Adverse selection in FM results in firms attracting the wrong type of clients = pushes up insurance premiums and loan rates to the detriment of lower-risk customers. Scanned with CamScanner* Financial firms, i.e. banks/insurers, screen out/monitor customers by assessing risk profile, and adjust insurance premiums and loan rates to reflect the risks of individual clients. © Inbanking, adverse selection can occur as a result of loan pricing Moral hazar * After buying a firm’s securities, individual must monitor the firm’s managers. When they have control of other people's money = incentive to spend on excessively risky projects/perquisite consumption, resulting in agency costs. * Once you've engaged in transaction with firm (lent them money), ‘must monitor then, or they may become reckless with your money! * Hidden action * Arises when contract of fin arrangement, creates incentives for parties to behave against interest of others. Risk that borrowers may engage in activities that are undesirable — make loan repayment less likely, and harm interest of lender. * Eg. funds originally borrowed for ‘safe’ investment project e.g. car purchase/home improvement, but are then gambled in high-risk projects- e.g. invested in ‘get rich quick’ schemes. For banks, moral hazard occurs after loan has been granted, and is associated with monitoring and enforcement changes. © Those who get insurance, might take greater risks than they would without it, as they know that they're protected, so insurer might get larger claims than expected. ‘Bank loans — lenders screen out excessively high risks, and regularly monitor performance of borrowers, by obtaining various types of fin info. E.g. comps submit periodic reports on performance of their bus. * For loans to large comps ~credit rating agencies provide info on their performance and credit ratings — est of amount of credit that can be extended to a comp/person, without undue risk. ‘© Banks send inspectors to firms to monitor their progress. isk and liquidity: * Firm’s debt/equity may have risk characteristics, maturities and liquidity that may not be attractive to particular individuals. i.e. desired maturities may be diff- firm might want to borrow for LT, you might want to lend for $1 match! © Principal-agent problems: ‘Agent has superior info/expertise, and can choose how to behave after contract has been established, and is able to hide its outcome. ‘Agent can't be efficiently/costlessly monitored. Agency costs = serious deterrent to financial contracting, can lead to losses. Challenge is to create fin contracts/arrangements that align the interests of principal and agent. Principal can’t completely control the agent's behaviour. Scanned with CamScanner© The free-rider problem: ‘When people who don’t pay for info, take adv of the info that other people have paid for. E.g. you buy info that tells you which firms are good, and which are bad. You believe the purchase is worthwhile, cos you can buy securities of good firms that are undervalued, so you'll gain extra profits, but free-rider investors see that you're buying certain securities, so they do the same. By encouraging bank lending, a bank can profit from the info it produces, by making private loans (i.e. avoiding free-rider problems). ~ Relationship and transaction banking: ‘© Incredit markets, to overcome agency and adverse selection problems, parties can enter a relational contract = informal agreements between bank and borrowers, sustained by value of future relationships. ‘© Role of banks as relationship lenders = banks invest in developing close and LT relationships with customers = improves info flow between bank and borrow = benefits both parties. ‘© If customers has ‘history’- e.g. have borrowed previously from bank over long period of time, then bank's screening and monitoring costs will be much lower compared with those for new customers, and borrowers get future loans at lower rates of interest, © Relationship banking: Helps minimise principal agent and adverse selection problems. Relationship evolves over time between borrower and lender. e.g. Hausbak relationship in Germany ~ customer obtains variety of services from bank (current account, loans, credit cards etc). Relationship banking improves upon information flow= gets rid of info asymmetries, and allows for flexibility. Relationship banking can be sustained even with significant competitive pressures. The informational savings from relationship lending is a primary compet adv for existing banks over new market participants — because by drawing relational contracts, banks can ‘isolate’ themselves from competition from other banks and non-bank fin intermediaries. ‘© Transaction banking: Why do banks exist? Theories of financial intermediatior Characterised by arms-length relationship between bank and customers. Banks compete for customers on ‘hard facts’ and customers ‘shop around’ Counterparties bargain over terms and conditions, transactional banking limits the exchange of info. Involves a pure funding transaction, where bank acts as a ‘broker’, E.g. mortgage loan made bya bank, and then sold on to an investor in the form of a security = securitisation, No relationship between parties, and no flexi ity in contract terms. - Financial intermediation and delegated monitoring: 0 Role of banks as ‘monitors’ of borrowing. Scanned with CamScanner° Info production Because monitoring credit risk (likelihood that borrowers default) is costly, more efficient for surplus units (depositors), to delegate task of monitoring, to specialised agents — banks. They have expertise, and econs of scale in processing info on risks of borrowers. Diamond's study: "Theoretical model, in which a Fi (bank or insurance comp), has net cost savings, relative to direct lending and borrowing. Developed around two interconnected factors: * Diversification among diff investment projects — crucial in explaining why there is a benefit from delegating monitoring to an intermediary that isn’t monitored by its depositors. * The size of the delegated intermediary that can finance a large number of borrowers. Diversification increases with the number of bank loans = larger delegated intermediaries will generate higher econs of scale in monitoring = greater portfolio diversification than any lender could achieve. But who is monitoring the monitor? Fis as Delegated Monitors: = By acting as an asset transformer, a Fl acts as delegated monitor = efficiently produces info on the activities of a borrowing firm = reduces moral hazard. + _Eg.instead of each individual buying the firm’s debt and incurring monitoring costs, the indiv give their funds to a bank, which issues deposits to them. Bank manager (loan officer) also contributes their own funds (bank equity), and makes a loan to (purchase debt of) firm. Bank manager ~ residual claimant = incentive to be a delegated monitor of the borrowing firm's activities. Therefore, only manager incurs the cost of monitoring. * Delegated monitor = delegates responsibility of Fl to act on your behalf ~ comparative adv of delegating to firms—assumes they're better at dingit than you would be! "Where there is asymmetric info, monitoring is a way to improve efficiency. * Monitoring = screening projects, preventing opportunistic behaviour of borrower, punishing borrowers who fail to meet contractual obligations- acting like a policeman enforcing contractual obligations. Banks (under this theory), have comparative adv in these monitoring activities ~ banks’ ability to issue loans is better than ours! = Bassumptions for delegated monitoring theory to hold: * Scale economies in monitoring ~ a bank will finance many projects. © Capacity of investors must be small, compared to size of investment projects — if one investor is a big investor, could just meet up and do the deal, so wouldn't need the bank as a large depositor, so all Investors must be small, and projects must be big. © Low cost of delegation — cost of monitoring/controlling Fl, must be < surplus gained from scale economies in monitoring or controlling Investment projects — i.e. cost benefit analysis ~ cost of monitoring must be < doing it individually. Scanned with CamScanner‘© Surplus units could incur substantial search costs, if they seek out borrowers directly. ‘© Without banks, there would be duplication of info production costs, as surplus units would individually incur huge expenses in seeking out the relevant info, before committing funds to a borrower. © Banks have econs of scale and other expertise in processing info relating to deficit units — obtained on first contact with borrowers, but learned over time through repeated dealings. ‘© Asbanks build up this info (e.g. knowledge of credit risk associated with diff types of borrowers ~‘customer relationships’) = become experts in processing this info = have info adv, and depositors are willing to place funds with a bank, as they know that they will be directed to appropriate borrowers, without them incurring info costs. - Liguidity transformat © Banks provide fin claims to surplus units (depositors), that often have superior liquidity features compared with direct claims (e.g. equity or bonds). © Bank's deposits = contracts with high liquidity and low risk ~ held on liab side of B/S. These are financed by illiquid and higher-risk assets (e.g. loans), on asset side, ‘© Banks can hold liab/assets of diff liquidity on both sides of B/S through diversification of their portfolios, whereas depositors hold relatively undiversified portfolios (e.g. deposits have the same liquidity and risk features). © The better banks are at diversifying their B/S, the less likely it is that they will default on meeting deposit obligations. - Consumption smoothing ‘© Banks are institutions that enable economic agents to smooth consumption, by offering insurance against shocks to a consumer's consumption path. © Ecagents have uncertain prefs about their expenditure = creates a demand for liquid assets. © Fi provide these assets vie lending = smooths consumption patterns for individuals. Benefits of financial intermediation: Fl : to ultimate lenders (surplus units © Greater liquidity is achieved by lending to Fl, rather than directly to an ultimate borrower. © Less risk involved ~ due to pooling of risks by Fl, the improved risk assessment that intermediaries are able to undertake, and the portfolio diversification that can be frequently achieved. This reduction in risk may be reflected in guaranteed intrates on deposits with a Fl. © Reduced transaction costs associated with lending process. ‘© Lending decision is simplified, as there are fewer lending opps to Fl, than there are ultimate borrowers, © Assessing opps for lending to intermediaries = simpler than assessing lending to ultimate borrowers. - Benefits to ultimate borrowers (deficit units): ‘© Loans available for longer time period from Fi, than from ultimate lenders. © Fi prepared to offer larger loans than ultimate lenders. Scanned with CamScanner© Lower transaction costs than approaching ultimate lenders directly. ‘© Lower int rate ~ Fl minimise info costs and diversification of risk, can actually reduce the cost of intermediation. © More likely that loans will be available when req. - Benefits to society as a who! © More efficient u 7 of funds in econ, as evaluation of lending opps is improved. ‘© Causes higher level of borrowing and lending to be undertaken, due to lower risks and costs associated with lending to Fl. ‘© Improves availability of funds to higher-risk ventures, as Fl are able to absorb such risks = important for future prosperity of econ. ‘Types of banks (a taxonomy): > Universal ban © Offer full range of services, in conjunction with non-traditional banking activities, under one legal entity. Activities include: * Intermediation and liquidity, via deposits and loans * Trading of fin instruments (bonds, equities...) = Proprietary trading (trading on behalf of bank itself) * Stockbroking — this was highly favoured, as banks could earn a fee "Corporate advisory services (e.g. M&A) = Investment management = Insurance - offer life insurance and assurance = Wealth management services - Commercial banks: ‘© Historically focused on bus lending, IT now allows large firms to issue publicly traded securities, so commercial lending is not as important. © Their activities have broadened - real estate and consumer lending, has grown. © Rely on fee-generating off B/S activities, and increasingly move into non-traditional banking activities. © Prevented from underwriting securities (with some exceptions), so are like universal banks. © 1930s onwards ~ law separating commercial banks and investment banks, to stop commercial banks from taking excessive risks. © The major Fl in any economy. © The main providers of credit to households/corporate sectors. ‘© Typically joint stock companies, may be publicly listed on stock exchange, or privately owned. © Have well-diversified deposit and lending books, ad offer full range of fin services. © Eg. Citibank, HSBC, Deutsche Bank, Barclays — household names. ‘© Also do investment banking, insurance and other fin services. to commercial banks, but have diff ownership features — mutual ownership — ‘owned by their ‘members’ or ‘S/H’, who are the depositors/borrowers. © InUS~ savings and loan associations (S&Ls or thrifts) (UK- building societies), mainly financed by household deposits and lent retail mortgages. They were primarily Scanned with CamScannerestablished, by offering short-maturity savings deposits, and using these funds to make residential mortgage loans. © Now more diversified, offer wider range of small firm corporate loans, credit cards and other facilities. They were mainly mutual ownership, but many have become listed now. © Many thrifts started off as mutual orgs, which were legally owned by their depo: Their net worth/equity capital was derived from accumulated retained earnings. © However, recently, they've converted to stock-issuing institutions = can raise equity capital more easily from public investors. © Unlike commercial banks, they have strategic obj, other than maximising S/H wealth/profits. Their bus focuses on retail customers and small businesses, but as some have become v large (esp in Germany and Spain), they closely resemble commercial banks in their service and product offerings. - Co-operative bank ‘© Similar to savings banks. © Originally had mutual ownership and typically offered retail and small bus banking services. © Trend = large numbers of small co-op banks to group to form a much larger Institutions — now listed with publicly traded stock. © E.g. Britain— co-operative bank. © After fin crisis, various commentators are calling for more diversity in types of banks, with diff banking models suiting diff types of customers = supporting the real ‘economy, contributing to systemic stability and promoting inclusion. - Building societie: ©. Similar to savings and co-operative banks — mutual ownership, and focus primarily on retail deposit taking and mortgage lending. = Credit union: ‘© Mutually-organised, non-profit depository institutions. © Deposits = referred to as ‘shares’, as depositors are members of the credit union, and legally ‘own’ © Membership is restricted to individuals that have a ‘common boni employee of the same firm, member of same union or trade association, or resident of same community. © Non-profit status exempts them from corporate income taxes (according to bankers). © Eg. collapse of Streetcred credit union in UK: = Based in Rochdale, closed doors on 16" Oct 2007. * Members were unable to access savings, wages and benefits. * Not-for-profit agency, with 3,000 customers. + Collapsed- est debts of £450,000. = Financial Services Compensation Scheme (FSCS), said savings were protected, and it would work with the comp to discuss customer payouts. Mutual deposit institution, growing in importance in many countries. 0 Non-profit co-operative institutions that are owned by members, who pool their savings and lend to each other. infair advantage Scanned with CamScanner© Regulated differently from banks. © Parttime staff. © 2005-2010, growth in number of credit unions worldwide = 24%, ~ Investment banks: © Were prohibited from doing commercial banking acti take deposits from general public. E.g. Lehman Brothers. © Activities include: "Underwriting, trading (also proprietary trading activities), M&A, fund management, consultancy and global custody. © Deal mainly with comps and large institutions, and don’t traditionally deal with retail ‘customers — apart from provision of upmarket private banking services. © Help comps and gov raise funds in capital market, by issuing stock (equity or shares), or debt (bonds), © They issue new debt and equity that they arrange on behalf of clients, as well as providing corporate advisory services on M&A, and other corporate restructuring. © Asset management — managing wholesale investments (e.g. pension funds for corporate clients), as well as investment advisory services to wealthy people (private banking) and institutions. ‘© Other security services- brokerage, financing services and securities lending. © Important trading intermediary — help raise funds on capital markets, manage investment portfolios and carry out strategic planning. © Produce research, develop opinions on markets and secu © Trade and invest in securities (ie. issue, buy, sell) with their own capital (proprietary trading), or for their clients - wide range of fin instruments - bonds, equities, derivative products. ‘© Didn't used to hold retail deposits, and liab were mainly securities and ST wholesale financing but this has changed. s. They weren't allowed to ~ Central banks: © Gov institutions that don’t compete with banks that operate in private sector: © Roles: * Monetary control and price stability, open market operations, reserve ratios and discount rate. = Prudential control shielding the fin system from a crisis (bank runs, syster risk). = Gov debt placement — i.e. issuing gov debt (gilts etc) = Buying corporate debt and gov debt (QE). Govs can prevent adverse effects of bank runs by: = Acting as lender of last resort (discount window lending), or engaging in open market operations to increase supply of outside money. = Providing deposit insurance to reduce incentive for depositors to withdraw. = Investors have incentive to convert inside money to outside money. Central bank can provide emergency loans ta banks ~ e.g. pay everyone out = panic decreases. = Deposit insurance: © Acts to calm people down, and some panicking, Politicians hate it~demonstrates that they're not in control! Scanned with CamScanner© Was established by Banking Act of 1993 (Glass-Steagall Act). Created the Federal Deposit Insurance Corporation (FDIC). Compulsory for EU countries to provide deposit insurance for depositors (the scope and scale varies among member states). © Gov (taxpayers) must cover losses incurred by depositors when bank fails. © Therefore, must regulate ‘safety and soundness’ of depository institutions to prevent them from taking excessive risks (moral hazard). This can be done by: * Capital (bank equity-to-debt) ratio regulation - need to have capital regulation (put capital controls on the bank). "Restrictions on high-risk bank activities. * Risk-related deposit insurance premiums- how do you assess riskiness of bank? Recent trends affecting Fis: intermediation- where large, good quality firms shit Di ‘toward public security financing, and away from bank loans. i.e. able to go straight to fin markets for loans, whereas before, they would have to go to banks. Loan selling (asset securitisation) ~ mortgages = LT assets- banks have to wait years and years for them to be repaid. Growth in mutual fund investing. These are all results of improvements in IT = reduced need for banks to screen quality and monitor activities of many large firms. More info is available to individual investors = the securities and loans that banks previously held, can now be sold directly to the public, or to mutual funds that provide pooling and portfolio diversification, Other issues affecting Fis: Consolidation of fin services firms — due to liberalised branching laws, and to new technologies that allow econs of scale and scope in providing Fl services. Conflicts of interest that occur when Fis provide multiple services- e.g. an analyst provides favourable recommendations for stocks that have been underwritten by the analyst's investment bank. Proprietary trading and M&A advisory work = can result in possible insider trading. Reform of bank capital regulation (Basil II) and deposit Scanned with CamScanner