Banking Theory Law and Pratice: Prepared by Ganesh.P Assistant Professor Department of Commerce

Banking Theory Law and
Pratice
Prepared By
Ganesh.P
Assistant Professor
Department of Commerce
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 assignment 40%
 end of unit examination 60%
Approach
 First main text book:
 Modern Banking by Shelagh Heffernan
John Wiley & Sons, Ltd
ISBN: 0-470-09500-8
2005 (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 securitisation
Reading
1. MB ch.1, ch.2
2. MOB ch.1 pp 1-8, ch.2 pp 15-20
3. CBM ch.1 pp 4-23
4. 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
Edition
ISBN: 0-201-75666-8
ch.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
Edition
ISBN: 0-201-75666-8
ch.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 market
Reading
 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 failure
Reading
 MB ch.7,ch.9

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
Indirect Finance
Funds Financial Funds

intermediaries
Funds
Borrower-Spenders
Lender-Savers Business firms
Household Government
Business firms Funds Financial Funds
Households
Government Markets
Foreigners
Foreigners
Direct Finance
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 and
2. borrowers and lenders have different liquidity
preferences
 Four types of information costs may incur to lender w/o
intermediation
i. Search cost contact of two parties
ii. Verification cost verification of information
provided by borrower
iii. Monitoring costs monitoring of activities of
borrower
vi. 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 account
2. Loan product
3. Real estate services
4. Stock broking
5. 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 wholesaler
ii. Underwriting
iii. Market making
iv. Consultancy
v. Mergers and acquisition
vi. 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 contracting
ii. 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 banking
iv. Video linked financial services
v. Electronic cash e-cash
vi. Debit and credit cards Visa and master
vii. 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
Industry
1. 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-structure
Diversify
Improve efficiency
Absorb greater risk
Industry
Deregulation
 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
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)
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
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
Industry
Globalisation
 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 banking
Services 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
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
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)
 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
 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.
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

 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

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.
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.
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.
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.
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”
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 > 3-6 > 6-12 > 1-2 > 2-5 > 5 years or
-3 months months months years years 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- Interest-Sensitive Assets –
=
Sensitive Gap Interest Sensitive Liabilities
Relative
Dollar IS Gap
Interest- 
Sensitive Gap Bank Size
Interest Interest Sensitive Assets

Sensitivity 
Interest Sensitive Liabilities
Ratio
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
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 PV
0.91 5 4.55
0.83 5 4.13
0.75 5 3.76
0.68 5 3.42
0.62 5 3.10
0.56 5 2.82
0.51 5 2.57
0.47 5 2.33
0.42 5 2.12
0.39 105 40.48
69.27
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
DA  w
i 1
i * D Ai
Where:
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio
Duration of a Liability Portfolio

n
D L   w i * D Li
Where: i 1
wi = the dollar amount of the ith liability divided by total

liabilities; DLi = the duration of the ith liability in the portfolio
Duration Gap
Overall Duration Gap is:
TL
D  DA - DL *
TA
Change in the Value of a Bank’s Net Worth:
 i   i 
NW  - D A * * A  - - D L * * L
 (1  i)   (1  i) 
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
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.
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 Management
Value 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  Chicago Mercantile

(CBOT) Exchange (CME)
 Financial Exchange  London International
(FINEX) Financial Futures
 New York Futures Exchange (LIFFE)
Exchange (NYFE)  Sydney Futures
 Marche a Terme Exchange
International De France  Toronto Futures
(MATIF) Exchange (TFE)
 Singapore Exchange
LTD. (SGX)
Hedging with Futures Contracts
Avoiding higher
borrowing costs
 Use a short
hedge: sell futures
and declining asset contracts and then
values purchase similar
contracts later
Avoiding lower
than expected
yields from loans
 Use a long hedge:
buy futures
contracts and then
and securities 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 price
Principal Uses of Option Contracts
 Protection of the bond portfolio
 Hedging against positive or negative gap positions
Most 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
• 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 Swap
A contract between two parties to exchange interest payments in
an effort to save money and hedge against interest-rate risk
Currency Swap
An 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 Cap
Protects 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 loan
Interest 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 income
Problems 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

risk
Risks 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 SLCs
Sources 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
Outline
Arguments 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 BANKS
WHY REGULATE?
All Markets Financial Markets

1. 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
Benefits
1. Protection of the public’s savings
2. Control of the money supply
3. Adequate and fair supply of loans
4. Maintain public confidence
5. Curb monopoly powers
6. Support of government activities
7. Help for special segments of the economy/society
Costs
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 Spread
Let 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=rE(1-k)-rD >0
SUM: Prudential Regulation of Banks
The Challenge: strike the right balance:
 Minimise the social costs of bank failure/financial crisis

AND
 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 other
Major 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. Liabilities
Capital + 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=1
Implications: if bank lends £2 mil. and 50% of
borrowers default, bank loses all its capital but
depositors get back their money.
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.
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 capital

Risk adjusted assets
Example:
 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 £27000
Adjusted value of assets=
500*(.0)+2000*(.0)+15000*(.5)+10000*(1.0)=17500
Risk 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 calculation
Assets £ m Weight fraction Weighted assets(£m)
Cash 25 - -
Treasury bills 5 0.1 0.50
Other eligible bills 70 0.1 7.00
Secured loans to discount market 100 0.1 10.00
UK government stocks 50 0.2 10.00
Other investment -government 25 0.2 5.00
-companies 25 1 25.00
Commercial loans 400 1 400.00
Personal loans 200 1 200.00
Mortgage loans 100 0.5 50.00
Total assets 1000 707.50
Off-balance sheet risks
Guarantess of commercial loans 20 1 20.00
Standby letters of credits 50 0.5 25.00
752.50
Total risk weighted assets
Capital 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 Firms
OCC (1863) National commercial banks
FED (1913) FHCs/BHCs,
FDIC (1933) Any bank (nat/ state) covered by FDIC insurance
OTS (1989) Savings & loans (national or state)
NCUA (1970) Credit unions- national or state
State 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

McFadden-Pepper Act 1927
 Prevented banks from expanding across state lines
 Made national banks subject to the branching laws of
their state
Glass-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

FDIC Act 1935

 Addressed the issues left out of the glass-steagall act
 Gave the FDIC the power to examine banks and take
necessary action
Bank 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

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
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

Debate
Single 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
Debate
(3) Product boundaries less well defined: e.g. derivatives &

securitisation
Alternative 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 experts
US 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.
Debate
(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 Herstatt
Franklin National Bank
Banco Ambrosiano
Continental Illinois and Pen Square
Johnson Matthey Bankers
US Thrift Bank of New England
Baring
Bank 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.
Summary
Bank Name Derivative Foreign Lack of Weak asset Overseas Lack of External Unsound Management
market exchange internal management exposure regulatory auditor policies fraud
exposure market control control role (bad
exposure loans,
aggressive
expansion
etc.)
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

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.
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)
Measurement
Efficiency Estimation
 Empirical research is based on two methods of efficiency
estimation
1. 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 =  ujYjp /  viXip
subject to p  1 for all p and
weights
vi,uj >0, p represents several banks
Measurement
Efficiency Estimation
p =  ujYjp /  viXip
subject to p  1 for all p and
weights
vi,uj >0, p represents several banks
 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.
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). 1/ 2
 d 0 (u t 1 , xt 1 ) d 0 (u t 1 , xt 1 ) 
t t 1
m(u t , xt , u t 1 , xt 1 )   t  t 1 
 0 t t
d ( u , x ) d 0 (u t , x t ) 
This formula can be further decomposed into efficiency and technical

change as follows
Measurement
1/ 2
d 0t 1 (u t 1 , xt 1 )  d 0t (u t 1 , xt 1 ) d 0t (u t , xt ) 
m(u t , xt , u t 1 , xt 1 )    
d 0t (u t , xt )  d 0t 1 (u t 1 , xt 1 ) d 0t 1 (u t , xt ) 
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.
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.
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).
The index requires 4 DEA models to be estimated, which respectively specify

efficiency in the current time period, d 0t (u t , xt ) ; efficiency in the next time
period, d 0t 1 (u t 1 , xt 1 ) ; efficiency of a firm operating in this time period relative to
firms operating in the next time period, d 0t 1 (u t , xt ) ; and the efficiency of firms
operating in the next time period relative to the frontier in this time period,
d 0t (u t 1 , xt 1 ) . The TFP index is then calculated using Equation (1), above.
 SFA is also used to estimate efficiency and productivity!

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.
and Efficiency
 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.
and Efficiency

 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 .
 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 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.
 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):
3 3 3
ln( C i )  const    i ln ~
y i  1/ 2    ij ln ~
y i ln ~
yj 
i 1 i 1 j1
3 3 3
  m ln ~
w m  1/ 2    mn ln ~
w m ln ~
wn
m 1 m 1 n 1
3 3 3
 1/ 2    im ln ~
y i ln ~
w m  T T  1/ 2TT T 2   Ti T ln ~
yi
i 1 m 1 i 1
3
  Tm T ln ~
wm
m 1
 Overall economies of scale are derived from differentiating
the translog cost function with respect to output.
OES   y it MCi / C( y it , w it , t )    ln C /  ln y it
i i
 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)]
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.
 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.
 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.

British 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.
 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.
European 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.
Banking

 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).
Banking
 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).
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
rijt     CONC jt  xijt  ijt
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
ijt 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.
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

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
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 =  + ixi + coLIBOR + ciLIBOR-i + eTT+Ui
r= rate of interest offered/levied on deposits/loans
xi: banks non-price characteristics
LIBOR: 3 months £ London Interbank Offer Rate
LIBOR-i: LIBOR lagged by i, i=0,1,2…
TT: Time trend
Ui: error term
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 relationship
PDj= 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+Ui
1. INTi: interest paid/received on deposits/loans
2. LIBOR: 3 months £ London Interbank Offer Rate
3. LIBOR-k: 3 months £ London Interbank Offer Rate
lagged by say 0,1,2 months
4. FIRMS: Number of firms in sample (industry)
5. MOS: Number of months since product was
introduced
6. 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)
1969 1994 1997 1997 2002 2002 2004 2004 2005 2005
Assets Assets Assets Tier 1 Tier 1 Assets Tier 1 Assets Tier 1 Assets
capital capital capital K
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
Netherlan 0 0 0 1 0 2 0 0 0 0
ds
Switzerlan 1 0 0 0 0 1 0 1 0 0
d
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, Dresdner

Restricted 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”?
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.
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”.
UK Investment Bks - Sources of Conflict of Interest:

(1) If analysts involved/influence other functions in the IBD
E.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.
(2) Remuneration of analysts

E.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.
(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.

Banking Theory Law and Pratice: Prepared by Ganesh.P Assistant Professor Department of Commerce

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Banking Theory Law and Pratice: Prepared by Ganesh.P Assistant Professor Department of Commerce

Uploaded by

Copyright:

Available Formats

Banking Theory Law and

 evaluate of public policy argument for prudential

 Third main text book:

F. Mishkin, AWL 5th edition, 1996

F. Mishkin, AWL 3rd edition, 2000

H. Johnson, Blackwell, 2000

Sinkey, Prentice Hall, 5th edition, 1998

and Finance). Weekly reading of “The Economist” and

 Types of risk a modern day bank faces:

 Liquidity and funding risk

 Interest rate risk

 Market or price risk

 Foreign exchange risk

 Sovereign or political risk

 Approaches to the management of risks:

 Duration gap analysis

 Securitisation, derivatives and options

 International Banking: text and cases Financial Times

 Problems with external prudential regulations and a case

 Prudential control and regulations in the USA

 CBM ch.2 pp 33-58

 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 market

 CBM ch.5 pp 149-175

 International Banking: text and cases Financial Times

 Operational definition used by regulators

Funds Financial Funds

 Now Money lubrication of trade frees us from

 Paper Money not SUFFICIENT

 BANKS came into actions –bank drafts, LOC, etc

 There are different type of banks. But role of banks is

 Why not borrowers and lenders come together w/o an

 Lenders will go to bank for intermediation if intermediary cost

 Broadly speaking modern day banking consists of two

 Retail banking has witnessed a rapid “process innovation” for the

agent has more information about his/her characteristics

may go to risky ventures/businesses.

 Deposit insurance scheme may be exploited by banks

 See the “Economist” article

give full information to each others (better flows of

future there may be need of some monitoring

 Main features of the banking systems in the following

 Management of national debt.

 Banker to government and monetary sector.

Financial Services Authority (FSA)

 Promoting public understanding of FI

 Fighting of financial crime

Retail banking (app. 20)

 A holding company is a corporation that owns several

 The modern day facility of ATM was originally invented to avoid

Savings and loans association (S&Ls)

 These S&Ls usually provides loans for mortgages, FHLBS

 In 1960s eight US banks operated branches in foreign countries

 A universal bank is one, which provides a complete range

 acceptance of funds w/wo interest paid (deposit business)

 granting of loans and acceptance credits (lending

 Banking Act: banking business comprises of:

 performing of cashless payment/clearing (giro business)

 Wide definition and consequently; some activities

 The group of universal banks in Germany can be divided