MSc Financial Markets, Financial

Institutions and Banking

– Lecture 2 –

Juliane Thamm
Curran R. 4.06, Ext.: 3889
juliane.thamm@strath.ac.uk

Office hours: Thursdays 11am-12:30pm and by appointment

 Retail and
Wholesale Banks
Bank of England

UK’s central bank

founded in 1694, nationalised on 1 March 1946, and gained

independence in 1997

monopoly on the issue of banknotes in England and Wales

since the early 20th century

statutory responsibility for setting the UK's official interest rate

since 1997; interest rates decisions are taken by the Bank's
Monetary Policy Committee (MPC)
Bank of England

two core purposes — monetary stability and financial stability

Bank of England Act 1998 sets out responsibilities for

monetary stability

Responsibility for financial stability is shared between HM

Treasury (HMT), the Financial Services Authority (FSA) and
the Bank of England according to a Memorandum of
Understanding (MoU).
Financial Stability Functions

Risk assessment – monitoring current developments both in the

UK and abroad

Risk reduction – reducing vulnerabilities and increasing the

financial system’s ability to absorb unexpected events

Oversight of Payment Systems

Crisis Management

Lender of last resort- as part of its central bank functions, the Bank
may act as ‘lender of last resort’ to financial
institutions in difficulty, in order to prevent a loss
of confidence spreading through the financial
system as a whole
Retail Banking

What does a bank do?

– Takes deposits
– Makes loans

Retail banks focus on individuals and smaller businesses

This is high volume / low value business

How does a retail bank make money?

Financial Intermediation

Remember what we said about financial intermediaries

‘transforming’ financial claims

Maturity
– Banks borrow short term, but lend long

Risk
– Banks diversify loans, so deposits are safer

Size
– Banks pool small savings to make large loans
Risks in Banking

Liquidity risk
– The bank issues liabilities (deposits) that are payable on
demand, while holding assets (loans) with longer terms to
maturity

Asset risk
– The bank may not be able to recover all of the funds it has
lent to a borrower, e.g. when the borrower becomes
bankrupt
Managing Liquidity Risk

If all depositors asked for their money back on one day, the
bank would not be able to pay

In practice, with a diversified base of depositors the cash

required to meet withdrawals each day will be quite predictable

However, the bank will still need to hold reserves - a margin of

error
Reserve & Liability Management

New Deposits New Loans

RESERVES
(Liquid Assets)
Withdrawals Loan Repayments
Managing Asset Risk

How can a bank reduce default risk?

1) Credit scoring can help the bank to avoid lending to ‘bad risks’

2) The bank can require some form of security from the borrower,
e.g. a charge on assets

3) Diversification across different borrowers can reduce the impact

of any default
Building Societies
offer a wide range of financial services

required to dedicate 75% of their total operations towards

residential mortgage loans and associated home loan products

most operate as mutual institutions

Buildings Societies Act 1986 gives power to seek incorporation

(demutualisation)
Retail Banking Trends

Online and telephone banking

Entry into the retail banking market:

– by former building societies
– by supermarkets and other retailers
– by other types of financial institutions
e.g. insurance companies

Banks selling other financial products:

– mortgages
– pensions and insurance contracts
– investment products
Internet Banking

Cross- Core Core All

Banks border intern Onlin Onlin Internet three
surve servic et e e banking types
yed es banki tradin credi & online of
ng g t trading service
UK 48 2.08 75% 31.2 45.8 31.25% 23%
% 5% %
Franc 50 12% 84% 64% 18 62% 8%
e %
Germ 50(2006), p.23,
Source: Gkoutzinis 2% 86% 72% 30
Tab. 1.2 70% 24%
any %
Wholesale / Investment Banks

Wholesale banking is simply the provision of traditional

banking services (deposits / loans) to large companies

However, in recent years most wholesale banks have become

involved in capital market activities

We call this ‘investment banking’

One key trend is for banks to remove lending risks from their
balance sheets, selling them on to other types of investors
Wholesale Banking
Retail banks diversify across a large number of small customers

Wholesale banks will have a smaller number of large customers

What impact should this difference have on the way a wholesale bank
manages its reserves / liabilities compared to a retail bank?
Wholesale Banking
Liability management – a bank that becomes short of liquidity
can borrow from other banks with a surplus

Wholesale banks have also sought to manage risk through

“securitisation”

This involves taking assets that would be on the bank’s

balance sheet, parcelling them up as tradable securities and
selling them on to other investors such as insurance
companies
Securitisation Loan

BANK BORROWER
Interest
Capital Interest

Note: SPV is Special

SPV Purpose Vehicle

Capital Interest
Question: How does the
bank make money on
INVESTOR this?
Investment Banking

Key investment banking activities include:

– Managing equity and debt issues for companies
– Advising on corporate transactions such as mergers and
acquisitions

Most banks also engage in other capital market activities such

as market making, brokerage and asset management
Banks earn fees for most of these activities
Many banks also trade stocks and bonds on their own account,
looking to earn profits
Investment Banking

The best way to understand the scope of investment banking is

to look at a couple of examples:

Goldman Sachs
http://www.gs.com/our_firm/corporate_information/business_overview/index.ht
ml

Morgan Stanley
http://www.morganstanley.com/institutional/invest_bank/index.html?
page=inv_bank
The ‘Euromarkets’
A eurocurrency is a deposit or loan denominated in a currency
other than that of the country where the bank is physically
located, e.g.
– a dollar loan in London
– a yen deposit in New York

Why would you want to do this?

The eurocurrency markets are large and highly active. They

are often used to finance large loans and transactions
Non-bank Financial
Institutions
Non-bank Financial Institutions

The main types we will discuss are:

– Mutual funds and other investment funds
– Pension Funds
– Insurance Companies
– Hedge Funds

We have to ask:
– Why these different institutions exist?
– What the benefits of them are?
– What the potential costs are?
Investment Funds
Mutual funds allow individuals to invest in the stock or bond
market on a more efficient basis than they could achieve
themselves

Small individual savings are aggregated into larger

investment funds
– lower dealing costs
– greater diversification
– professional management

But, investors pay a fee for this service

– annual management charge, perhaps 1.0% per year
– spread between buying and selling prices
Investment Funds
Open-ended funds (OEICs; Unit Trusts)
– units created/cancelled to meet demand
– investors buy/sell units with the manager
– typically trade at Net Asset Value (NAV)

Closed-end funds (Investment Trusts)

– fixed amount of shares in issue
– after launch, investors buy/sell with each other
– may trade at a “discount” or “premium” to NAV
– discounts are most common
Unit Trusts and OEICs
Funds are categorised into sectors:
– UK Equity Growth / UK Equity Income / Overseas etc

Actively-managed funds attempt to beat an index or sector

average

Passive funds attempt to match the index

Most evidence suggests the average active manager fails to

beat the benchmark

Some studies find persistence in individual fund returns, but

this may not be due to manager skill (Carhart, JoF, 1997)
Hedge Funds
Hedge funds are investment funds that attempt to generate positive
investment returns based on the the skill of their manager rather than
general market returns

They employ a number of strategies not normally used in mutual funds:

– Leverage – they borrow to invest
– Short-selling – selling shares they don’t own
– Use of derivatives

Most funds are based ‘off-shore’ in countries where financial regulation

is relatively light (e.g. Cayman)

Hedge fund managers are paid fees based on their success, for
example 2% per year + 20% of returns on the fund
Short Selling
Short selling is a way of profiting from share prices going down. It is
a common strategy in hedge funds

You identify a stock you think is overpriced

Monday AB plc shares trade at 100p each

You borrow 1000 shares and sell them at 100p

Friday Bad news emerges and the price falls to 50p

You buy 1000 shares in the market for 50p
When the trade settles you return these shares
to the person you borrowed them from

Your profit is 1000 x (100p-50p) minus whatever it cost you to

borrow the shares for a week (likely quite small)
Hedge Fund Strategies
Equity Hedge – buys stocks the manager likes and sells short
stocks the manager thinks will fall in price

Fixed Income Arbitrage – buys underpriced bonds while short

selling similar (overpriced) issues

Merger Arbitrage – buys shares in takeover targets while shorting

shares of the acquirer

Macro – takes large directional bets on markets, often using

leverage to increase returns

Emerging Markets – takes positions in emerging market securities

(where shorting is often not possible)
Pension Funds
Three sources of pension income:
– State pension
– Occupational pensions
– Personal pensions

Pensions can be funded or pay-as-you go

– the UK state pension is PAYG
– most occupational pensions are funded
– all personal pensions are funded
Type of Occupational Pension
Defined Benefit (DB)
– employer promises set % of pay as pension
– 1/60th or 1/80th of final pay per year worked
– employee may contribute, but employer bears balance of cost
required to pay the promise

Defined Contribution (DC)

– employer and employee pay into fund
– employee chooses how to invest the fund
– on retirement the fund is available to the employee to buy a
retirement income (annuity)
Pensions Crisis?
The UK state pension has been declining as a % of average
earnings. People are living longer meaning pension provision has
become more costly (for a given retirement age).

DB schemes were invested in equities when the stock market went

down from 2000-2003. Interest rates fell. Most schemes moved into
deficit – their assets were less than the present value of their
liabilities. New accounting standards (FRS17/IAS19) put these
deficits on the balance sheet of the company.

DB schemes are being closed; replaced by DC.

Many individuals with DC schemes struggle to know how much to
save and how to invest their funds.
Have a look at www.pensionscommission.org.uk
Life Assurance
You pay regular ‘premiums’. In return the Life Company will pay a
lump sum to your dependants when you die.

The amount of the liability is fixed, but the date of payment is not
(for obvious reasons!).

Actuaries predict when, on average, customers will die, and the

rate of return that will be earned on the premiums in the meantime.

The fund will be invested in assets that are expected to match the
liability.

How does this investment approach compare to pension funds?

How does the liability differ?
Next Week (#3)
Lecture: Equity Capital Markets

Reading: HB chp 6 / BT chp 8, Ritter (1998)

Tutorial Questions:
– Compare and contrast the functions of banks
and building societies.
– What is an investment bank? What do they do?
– Provide some recent examples of activity by
investment banks, e.g. from the FT
– Should a bank be allowed to be both a retail and
an investment bank?