Lecture 3: Banking business

1. Banks vs other financial institutions

 Banks surplus units are the savers/depositors, the deficit units are the borrowers.
 Deposits will move from depositors to the bank and then the bank will use the
deposits to create loans for borrowers.
 You make a deposit for you it is an asset on your balance sheet, but for the bank a
deposit is a liability.
 Loans will be an asset for the bank, and for the borrower it is a liability as it is debt
and pay an interest rate.
 Deposits are a financial asset for Surplus Units (i.e., households) and a financial
liability for Depositary Institutions.
 Loans are a financial asset for Depositary Institutions and a financial liability for
Deficits Units (i.e., corporations)

What is special about banks?

 Deposits are accepted as a means of exchange (i.e., money)

o They are special because they are money.
 By varying the level of deposits, banks affect the supply of credit to the economy.
o Banks can influence the amount of money in the economy.
o Banks can control the supply of money.

Depositing-taking Institutions

 Deposit-taking institutions (or monetary institutions) offer (discretionary) deposits

that can accommodate the amount and liquidity desired by surplus units.
 repackage funds received from deposits to provide loans of the size and maturity
desired by deficit units.
 accept the risk on the loans provided.
 have more expertise than individual surplus units in evaluating the creditworthiness
of deficit units.
 diversify their loans among numerous deficit units and therefore can absorb
defaulted loans better than individual surplus units could.

The transformation function of Banks

  Size transformation:
o Exploiting economies of scale, banks transform a large number of small
deposits in larger-size loans.
o Take small deposits and make a large loan.
 Maturity transformation
o Creating a maturity mismatch on their balance sheet, banks convert demand
deposits in long-term financing for borrowers. Banks are said to be
“Borrowing short and lending long”.
o No maturity to a deposit because you can withdraw whenever.
o On the loans side, mortgages have maturity of many years, which builds the
problem of liquidity.
 Risk transformation
o Thanks to their ability to manage risks, banks minimise the risks associated
with financing a single borrower by diversifying their portfolios of assets,
pooling the risks, screening and monitoring the borrowers as well as holding
capital against unexpected losses.
o When risk leads to loss, we use capital to make for the losses.

Banks’ Deposits are special

 Banks as deposit-taking institutions play a fundamental role in the economy as their

deposit liabilities form a major part of the money supply of a country.

 The monetary function of banks is often seen as one of the main reasons for a more
stringent regulation on the banking system than on other non-deposit-taking
institutions.

 The so called “Credit Multiplier” shows how an expansion of bank deposits results in
an increase in the stock of money circulating in an economy.

Deposits and the Credit Multiplier

 When a deposit is made at a bank, a fraction is kept as a reserve to face requests of

withdrawals. This proportion is called the required reserve ratio.
o When a new deposit is made, we can assume that only a part is lend out. So,
if we lend everything and the depositor asks for money there is a problem.
 The bank uses the remaining portion of the deposit to lend to individuals or firms
who will then deposit the money in other bank accounts.

 Banks will hold part of the deposit as reserve and use the rest for lending.
o If the bank keeps 10% of reserve, there won’t be any problems when the
depositor comes at any time to withdraw money.
  Theoretically, this process will repeat until there are no excess reserves left.

 The total amount of money created with a new bank deposit can be found using the
credit multiplier, which is the reciprocal of the required reserve ratio.
 Multiplying the credit multiplier by the amount of the new deposit gives the total
amount of money that may be created.

Credit Multiplier

2. Traditional Banking vs Model Banking

Banks uses and sources of funds

 Bank assets
 Any item that the bank owns, or is owed, is an asset. These include cash held,
deposits held with other banks, financial assets such as stocks and bonds and
physical assets such as its branches. A loan made to a customer is a bank’s asset.
Loans are the largest asset class by value for most commercial banks.
 Bank liabilities
 Any item that the bank owes is treated as a liability. Customers deposits are the
largest liability class.

Banks’ Objective

 “Traditional” business: banks strategically focus on lending and deposit gathering as

their main objectives.
 Profits derive primarily from the difference between interest revenues from lending
(assets) minus the interest cost (liabilities) on deposits (net interest income).
 Banks aim to maximise profits by controlling operating costs.
 Banks can operate with a lower level of capital (and higher leverage) than non-
financial firms.
 o In a non-financial firm investment will be made by capital, for the bank most
of the liability side will be composed by dept.

Bank capital

 The difference between total assets and total liabilities is the bank capital (equity).
Banks can issue equity and save from past profits (retained earnings).
 Regulation assigns a special role to bank capital:
o Bank capital is intended to act as a cushion against losses in order to protect
depositors. It also creates an incentive for bank owners to refrain from
excessive risk taking (see Topic 1).
o When the bank’ assets are below the bank’s liabilities, the bank is insolvent.

The evolution of the banking business

 There are more products in the modern banking system so there are more income
sources in more businesses.
 There is high competition, so prices of services go down.

Universal Banking

 Under the universal banking model, the banking business is broadly defined to
include all aspects of financial service activity – including security operations,
insurance, pensions, leasing and so on

 Universal bank: An institution which combines its strictly commercial activities with
operations in market segments traditionally covered by investment banks, securities
 houses and insurance firms and this includes such business as portfolio management,
brokerage of securities, underwriting, mergers and acquisitions. A universal bank
undertakes the whole range of banking activities.

What is the scop for Ring-Fencing?

 Ring-fencing requires the separation of retail/small business and deposit activity

from the riskier activities undertaken by banks.
 Ring-fencing relies on two pillars:
o Resilience: protecting the retail banking activity from risks unrelated to it;
o Resolution: allowing banking groups to fail in an orderly manner in case of
trouble.

Core banking services

What are the “vital” or “core” banking service?

 facilities for accepting of deposits or other payments into an account.
 facilities for withdrawing money or making payments from such an account.
 overdraft facilities in connection with such accounts.

3. Banks’ range of activities

Payment services

Banks play a pivotal role in the payment system.

 The payment system is a network of arrangements that allow for the exchange of
goods and services, as well as assets. Hence the payment system is the network that
transfers funds from the account of one person or business to the account of
another.

Deposits and lending

Current or checking accounts:

 Mainly used for payments. Large range offered to accommodate different needs of
the customers, typically a base for offering other products. Pay no or low interest.

Time or saving deposits:

 Used as a saving product, it allows customers to deposit funds for a specified period
and at a fixed or variable interest rate. Time deposits’ facilities may allow the
depositor to withdraw their funds instantly or at a short notice.

Consumer loans and mortgages:

  Mainly for retail customers. Many types: unsecured (small amounts and short time to
repay), secured on property (long term and variable interest); variable or fixed rate
rate mortgage; Adjustable-rate mortgage (ARM)…

Other products

Investment products:
 Banks offer many securities-related products to retail customers such as mutual
funds (unit trusts in UK).
Pension and Insurance services:
 Pension services provide retirement income, while insurance services provide a
protection from adverse events (i.e. life insurance and non-life insurance, such as for
property and casualty, travel, mortgage repayment, income).
Payment protection insurance (PPI):
 Add-on products sold by banks that gives protection against an event (i.e. accident)
that reduce the ability of the borrower to meet its obligations.

Conduct of Business

 Conduct of business refers to how financial institutions conduct businesses with their
(retail) –customers/consumers and how they behave in the market.
 Many households accumulated risks that they were not aware of or did not
understand in the run up to the GFC crisis. Increased levels of household
indebtedness are a policy concern.
 The risk of incurring in “failures” in the conduct of business by banks is defined as
conduct risk.
 Misconduct by banks imposes costs on society at large.
 For example, mis-selling of financial products leads to a suboptimal allocation of
investments and risks (as witnessed in the years preceding the financial crisis).