What are banks?

Prof. B.P.Mishra
XIMB
XUB

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 Lenders Requirement

The minimization of Risk

The Minimization of Cost
Liquidity-
Ease of converting a financial claim in to cash
without loss of Capital value
Borrowers Requirement

Funds on Time- a particular date

Funds for a specific period of time-
preferably long-term
Lowest possible cost
 The convergence

The majority of lenders want to lend short and

with highest possible return.

The majority of borrower demand liabilities

that are cheap and for long periods.

Intermediation through organized financial Market

And Intermediaries- Indirect Finance
Banks are intermediary , between willing Sa
Risk taking Investors.
The provision of accepting deposit ( Liability
And manage the assets created by lending.

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 Intermediation

COSTs: POOLING

Transaction
Information (Economies of Scale/ Scope)
Search
Enforcement
Transaction cost is subject to scale economies
Implying with larger the product users, the cost comes down.

Banks also enjoy the

information economies of scope in lending decisions.

Access to privileged information on

current and potential borrowers with the account with the bank.

Thus compared to depositors trying to lend directly,

Banks can pool a portfolio of assets with less risk of default
For a given expected return.

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 The Banking firm
Intermediary
I* = I AT NO INTERMEDIATION COST
D

i
SL = Supply of loan curves

SD =Supply of Deposit
IL

I*
ID
DL = Demand for loan

O T B

Volume of loan & Deposits

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 Commercial Bank.. Intermediaries perform six
basic functions
1.Denomination Intermediation
- Small amount of savings from individuals and others are pooled so
as to give loans of varying size
2. Default Risk intermediation
- Willingness to give loans to risky borrowers without hurting the
returns to savers
3. Maturity intermediation
- Ability to create loans whose maturities may mismatch with the
deposit
maturity profile
4. Liquidity intermediation
- Claims from savers that are highly liquid while loans to borrowers
are relatively less liquid
5. Information intermediation
- Ability to gather and process information from the financial
marketplace far more effectively than the individual saver
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6. Currency intermediation
- Ability to lend cross-currency
 Basic Principles of Banking
Principles of Intermediation
Principles of Liquidity
Principles Profitability
Principles Solvency
Principle of Trust

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The Core functions of the bank-
Provision of Intermediation & liquidity.
Indirectly a payment service.
Asset transformation.

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 Banking Service As a
Product
Price
Supply of Services

P1

Demand For services

Q1
Quantity of Services Provided

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Cost of intermediation-
Search
Verification
Monitoring
Enforcement
Other transaction cost

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The interest margin is equal to the net of lending &
deposit rate
Includes
Intermediation cost
Cost of capital
The risk premium charge on loans
Tax payment
The institutions profit

The more is the market competition,

the more narrow the interest margin.

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Provided the bank can act as an intermediary with
lowest cost,there will be demand for its services.

But Corporate (some) who can borrow at low cost

in relation to bank in the market, still borrow from banks
As it signals to financial markets and
to supplier its credit worthiness.

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Banks offer liquidity to their customers- depositors & borrowers.
This separates from others near bank/
Non-bank financial products.

It also explains why banks are subject to Prudential Regulation.

The claim on banks functions as money, hence there is
Public good element to the services bank offer.

The acquisition of information is not a costless activity.

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Banks engage in ASSET TRANSFORMATION-
Transferring the value of assets and liabilities.

POOLING of asset is also done by

Pension & Insurance companies.
But matching short term liability (deposit) with
long term assets ( loans) is done by banks.

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Banks also offer services with having non-price features
Associated with them.
The bank can charge for all services offered-
Savings account / ATM card/ Internet banking/ check
book facility etc.
But it pays a lower interest on deposits.

It also offers Other services for a fee

and off-balance sheet services.

Payment services are exclusive to the banks alone.

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 Payment Services

Two major Risks:

Liquidity Risk-
Settlement is not made at expected time
So that Asset/ Liabilities are not transferred from one agent
To another via the system.

Operational Risk-
Arising from the threat of operational Breakdowns,
Preventing timely settlement

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System Function
APACS: Association of Payment Umbrella organizaion-
Clearing Service 1984
Made up of
BACS,CCCL,CHAPS
BACS: Bankers Association Clearing NON-paper based bulk
System clearing
CCCL: Cheques and Credit Clearing Paper based Clearing
company Ltd
CHAPS: Clearing House Automated Real time Gross
System settlement
FEDWIRE, USA Inter State Clearing
CHIPS: Clearing House Interbank New-York Based Gross
payment System settlement
Real time system
TARGET: Trans European automatic Real Time Gross
Real-time Gross settlement transfer Settlement/ transfer
system
SWIFT :Society for worldwide Forex transfer 21
 Information Asymmetry
No information
Un-equal information
Less than perfect information
Insider information

Full and complete information is not uniformly

Available to all interested parties.

Not all parties have the same ability to utilize

The information available to them.

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Banks have to face agency problem of
Adverse selection & moral hazard.
The nature of contracts banks enter into are-

The shareholders of a bank( Principal) & its management ( Agent).

The bank (Principal) and its Officers (Agent)
The bank ( Principal) and its Debtors (Agent)
The Depositors ( Principal) and the bank (Agent)

Incentive problems arise because principal can not

monitor agent behavior.
Bank management can plead bad luck
When outcomes are poor.

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Bank has less information on probability of default,
Hence adverse selection because of information asymmetry.

Banks are reluctant to lend with high interest rate, as riskier

Borrowers tend to seek loan.

The problem of adverse incentives

( higher interest encouraging borrowers to undertake riskier activities )
Is another reason why banks will reduce the size of a loan
Or refuse loan to some individual & firms.

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 Moral Hazard

It arises when a contract or a financial arrangement

Create incentive for parties to behave against the
Interest of the other.

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Moral hazards is another problem.

Depositors may not be in a position for close monitoring of bank action.

A depositor cost of monitoring becomes small ,the larger
& the more diversified is the portfolio of loans.

Though there will be a loan losses, the pooling of loans

will mean that the variability of losses approaches zero.
The deposit insurance reduces the incentive for monitoring
of the bank by depositors.

Shareholders monitoring for value, may benefit the depositors.

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 Shadow Banking

First used in 2007 in Jackson Hole symposium

convened by FED Reserve, Kansass city USA.

The Financial Stability Board (2011) defines

Shadow Banking Broadly as:

Credit Intermediation involving entities and activities

outside the Regular banking system
 Universal banking-

Germany is the home of UNIVERSAL BANKING,

where
DUETSCHE bank has major holdings in
Daimler Benz Automobiles
Allianz Largest Insurance company
Metallgesellshaft Oil Industry
Philip Holzman Construction
Munich-re Reinsurance agency
To name a few

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Financial activities under Universal banking are-

Intermediation and liquidity via deposits & loans,

by product is the payment system.
Trading of financial instruments-
bonds, equity, derivatives , currency.
Proprietary trading- in own books
Stock broking
Corporate advisory services- M&A
Investment Management
Insurance.

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Commercial & Investment bank-
Originated In USA- Glass Steagall section of banking Act, 1933
Commercial banks are not allowed to Underwrite securities
Investment banks are not to offer banking services.

Modern Investment banks engage in-

Underwriting
M&A
Trading of financial instruments-
( bonds, equity, derivatives , Proprietary)
Fund management
Consultancy
Global Custody

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Merchant Banks:-

Francis Barrings in 1762 started financing

export & import of goods through bill of exchange.
Small traders were given much needed liquidity.
These banks were called acceptance houses till 1980s.
They expanded to loan underwriting, M&A advisory
Financial services Act(FSA )1986, permitted stock broking
And merchant banks became akin to US Investment banks.

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 Is investment bank a
bank?
Investment banks act as intermediary,
but do not accept deposit and facilitate payment systems.
But they contribute to increased liquidity to the system
by arranging new form of finance for a corporation.
This is different from meeting liquid demands of depositors.

Hence they are not banks in true sense.

Goldman Sachs accept core /traditional deposit from HNIs
Merrill Lynch, in 2000, approved to mobilize FDIC
Insured deposits by FED.

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Commercial Banking:-

Commercial Banks offer wholesale & Retail banking services.

Wholesale banking typically involves offering

Intermediary, liquidity & payment services to large customers
Corporation & Govt.

Retail banking offers the same services to a large number

Personal banking Customer & small business.

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 Bank Holding Companies
BHCs can own banking and in some countries Non- banking
Financial subsidiaries, which are legally separate
And individually capitalized.
BHCs were used to circumvent laws in USA
which placed restrictions on interstate branching,
(branches in more than one state)

Subsidiaries allowed to do investment banking subsequently.

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 Finance Holding Companies

Restricted Universal Banking under

Gramm Leach Bliley Financial Modernization (GLB) Act- 1999
Super ceding Glass Steagall act.

Bank Holding companies converted to Finance holding companies.

They can engage in commercial & investment banking,
But restricted, as subsidiaries ,
they will have to separately capitalized.
It is costly than they are part of same legal entity.
The cross share ownership of non-financial firm is largely prohibited .

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Financial Conglomerate
Briault (2000) defined a financial conglomerate
as a firm that undertakes at least two of the five
Financial activities:-

Intermediary / payments
Securities
Corporate Finance
Fund management
Advising & Selling investment product to retail customer.

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Advantage :-

A.The efficacy of the financial system is improved

If the conglomerates can achieve the Economies
of scale & scope.

B. In emerging economies, they can provide

expertise to deepen the
Financial market.

C. They diversify their functions on Products &

regions, Making them less vulnerable to downturns
in one economy or region.

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Disadvantages:-
A) Diversified financial firm encounter difficulties may go
broke Adopting high risk /return strategy- Too big to Fail.
Hence, the systemic threat to the global financial system is
increased.

B) Functional supervision is difficult with multiple regulators.

C) Compliance cost is too high, as each regulator

require them to allocate capital ( dedicated Capital).

D) Conflict of interest & Fire walls creation. Insider Trading

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 Traditional Vs Modern
Banking
Traditional Banking Modern Banking
Product & Services : Product & Services:
Limited Universal
Loans Loans
Deposits Deposits
Insurance
Securities?
Investment
Pensions
Other Financial
services
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 Traditional Vs Modern
Banking
Income Sources: Income Sources:
Net Interest Net Interest
Income Income
Fee & Commission
Income
Competitive Competitive
Environment: Environment:

Restricted High Competition

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 Traditional Vs Modern
Banking
STRATEGIC FOCUS: STRATEGIC FOCUS:
Asset Size & Returns to
Growth Shareholders
Creating
Shareholder Value
(Generating ROE >
COC)
CUSTOMER FOCUS: CUSTOMER FOCUS:
Supply Led Demand Led
Creating Value For
Customer
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THANKS

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