Financial Intermediation

Juta will insert the book

Theory
cover here CHAPTER 1
Prof J Coetzee
 Financial Intermediation Theory
• Loans have consistently been
the preferred source of
financing (see the shaded
cells), especially when
compared to raising debt in
the bond market
• What is also noticeable is how
the relative contribution of
loans has decreased
substantially since 2009,
amidst the GFC and the
subsequent squeeze on bank
lending
• Question: Are banks special/
unique?
Financial Intermediation Theory
• At the heart of a bank’s purpose is its role to act as an
intermediary
• This function eliminates the so-called double coincidence of
wants problem by bringing together different market
participants and allocating resources more efficiently between
them
• This is especially effective because it reduces the search and
time costs associated with two parties finding each other
under a bartering system
 Financial Intermediation Theory
• Banks have the ability to
gather, store and
disseminate proprietary
information that reduces
information asymmetry
between the client and
the bank
• In doing so, they are able
to make more informed
decisions and allocate
resources more efficiently
by reducing information
and search costs
 The 3 generations of Financial Intermediation
Theory
• Reasons for the emergence of FI theory
– Failure of the general equilibrium theory to explain the role of banks
– Emergence of the information asymmetry paradigm
• Adverse selection
• Moral hazard
• A bank in its ability to collect, store and disseminate proprietary client information is, by its very nature, able
to overcome, at least partially, the market imperfections of adverse selection and moral hazard
• For example, credit screening is used to identify and categorise economic agents according to their risks and
characteristics, thereby reducing the likelihood of selecting a client who is likely to default
• Given that a bank is privy to proprietary and confidential client information and that it monitors the behaviour
of its clients, it is in an ideal position to identify situations where moral hazard may arise
• Of course, this is assumed to be true if the bank has all the information at its disposal
• It is clear, therefore, that adverse selection and moral hazard cause markets to perform sub-optimally and thus
fail
• This market failure, more specifically information asymmetry, implies that the general equilibrium theory of
perfect markets does not provide an adequate framework to justify the existence of banks
• It was with this in mind that the foundation was laid for theorists to establish explanations as to why FIs, and
in particular banks, exist
 The 3 generations of Financial Intermediation
Theory
• Generation 1
– The first generation focused on the role of a bank and asked the
question: are banks special?
– This generation was characterised by scholars questioning the rationale
for the existence of banks, especially with regards to establishing
whether or not they had features that made them special
 The 3 generations of Financial Intermediation
Theory
• Generation 2
– As financial markets became more competitive and global, particularly in the
latter part of the 1990s and early 2000s, the existence of banks was
increasingly under pressure
– Non-traditional competitors were entering the banking domain and
threatening bank survival and clients were exposed to new ways of doing
business that did not necessarily require the services of a bank
– Managing the risk associated with bank-client relationships became
increasingly challenging
– As a result, the second generation of FI theory emerged focusing on the
relevance of banks
– The central question at this time was: are banks still relevant?
 The 3 generations of Financial Intermediation
Theory
• Generation 3
– More recently, as a result of global events such as the terrorist attacks in the
US in September 2001 and also the GFC, the literature has focused more on
identifying the risks faced by banks and in particular how to manage them in
an increasingly complex and interconnected financial system
– The systemic risk associated with bank failure, especially in the global
banking context, has raised awareness of the systemic importance of banks,
resulting in renewed focus being placed on regulation
– The third, and current, generation has therefore been characterised by risks
emanating from sources that have either been non-traditional, or have not
been known to the bank
– Consequently, banks, and how we understand them, have been
questioned,with the central question thus being: are banks still banks?
 The 3 generations of Financial Intermediation
Theory
• Generation 3
– Five main focus areas will reflect the evolution of FI theory in generation 3:
1. The link between the monetary (especially where banks are involved) and real economy
2. The systemic importance of banks and the interconnected nature of both national and international
markets
3. The safety net of bailout provided by central banks to big banks – that is, moral hazard and the ‘too
big to fail’ issue
4. The complexity and innovation associated with financial markets and financial instruments
5. Regulatory and supervisory reforms that incorporate the above four areas

• At the heart of these five focus areas are the proposals of the so-called Basel III
capital requirements discussed in Chapter 15
43

• The management of risk as well as the actual identification, quantification and

mitigation of the risk from both a systemic and organisational perspective will be
a central feature of FI theory going forward
 The 3 generations of Financial Intermediation
Theory
• The 3 phases of the Great Recession
– The first phase of the GFC was the lead-up to the SPC
– The second phase was the policy response to the initial SPC
– The third phase of the Great Recession has been characterised by the
worldwide exposure to excessive sovereign debt levels
The functions of a bank
• The intermediation (asset transformation) function
• The credit (wealth creation) function
• The liquidity function
• The payments function
• The risk diversification function
• The provision of financial services and lower transaction costs
• The agency function
• The monetary policy function
• The trust and fiduciary function
• The guarantor function
• The advisory function
• The intergenerational savings function
The types of banks
• Universal banking
– Given the pressure on banks to compete with both traditional and
non-traditional competitors, mergers and acquisitions have resulted
in banks offering a broader range of financial products and services
– This approach is commonly referred to as the universal banking
approach and is evidenced by banks expanding their distribution
channels, through both virtual and branch infrastructures, as well as
by adopting the bancassurance model
The types of banks
• Corporate, investment and merchant banking
– Corporate, investment and merchant banks typically provide wholesale
funding from capital markets to corporate clients
– This enables large corporate clients to raise capital through the
underwriting function provided by these types of bank

• Commercial and business banking

– Commercial banking usually includes clients that have businesses
– These businesses can typically be classified as small, medium and large
businesses (including agricultural clients), although small businesses,
especially sole proprietorships, are often included in the retail banking
segment
The types of banks
• Mutual banking
– Mutual banks usually offer simple transaction accounts and minimal loan
facilities, along with attractive incentives for depositors to save with them, for
the right to vote as a shareholder
– Mutual banks are also known for their conservative approach to risk-taking,
hence offering few products and services
• Islamic banking
– Islamic banking focuses on providing banking products and services, based on
the principles of sharia law, to predominantly Muslim clients
– With the central premise being that usury is not permissible, Islamic banking
challenges the conventional norm that religion and commerce must be separated
and argues that modern commercial methods are not always ethical, especially
with regards to conventional banking activities
The types of banks
• Consumer banking
– Wealth management
• Wealth management focuses on the wealthiest clients segmented according to net
worth and usually includes professional and extremely high net worth individuals
• The wealth management business unit provides a comprehensive financial services
solution to these clients including investment management, structured lending and
international wealth management
– Private banking
• The private banking segment typically includes the same criteria as for wealth clients
except at a slightly lower level
• Banks also target professional high net worth clients and offer services similar to
those offered to wealth management with the same support staff structure
The types of banks
• Consumer banking
– Personal and retail banking
• Personal and retail banking deals with the banking needs of middle to lower
income clients
• This is typically the largest consumer segment on the books of a bank and
although relationship bankers are assigned to individual clients, the extent of
the attention given to any one client is much less when compared to the
wealth and private segments
• The underlying strategy in this market is to address client needs through the
branch network and to do so on a reactive or transactional basis
The types of banks
• Consumer banking
• Mass-market banking
– Since the implementation of the Financial Sector Charter in 2004, South African banks
have increased their focus on the so-called previously unbanked mass market
– As a result, and given the ensuing uptake of banking products, banks have established
mass-market business units that focus on the lowest end of the retail banking spectrum
– These clients are often previously unbanked and have low if not zero levels of net worth
and income
– Predominantly black African, these clients tend to reside in remote rural areas and
require, or can only afford, limited functionality on their banking products
– They are also characterised by having a lower level of education and financial literacy
 How do South African banks compare
internationally?
• In terms of assets, ICBC is
approximately 20 times larger than the
Standard Bank Group, 18 times larger
in terms of total equity and employs 9.4
times more employees
• In comparison to Nedbank, ICBC is
approximately 47 times larger in terms
of total assets, 41 times in terms of total
assets and employs over 15 times more
staff
• The South African Big Four banks are
therefore substantially smaller than the
largest banks in the world
THE FUTURE OUTLOOK FOR BANKS
• Risk versus uncertainty
• Global policy co-ordination
• Non-traditional sources of competition
• Consumerism and the client of tomorrow
• Regulation and risk management