1 Banks and Financial Intermediation BPF_BANK Banking Oleg Deev 2 Contents 1. Functions of banks. 2. Why banks exist? 3. Types of bank operations. 4. Bank business models. 5. Current trends in banking. 3 What is a Bank? ̶ Banking operations may be varied and complex, but a simple operational definition of a bank is available (usually used by regulators): A bank is an institution whose current operations consist in granting loans and receiving deposits from the public. ̶ combination of lending and borrowing, ̶ a public good? Main functions of banks: ̶ Offering liquidity and payment services ̶ Transforming assets ̶ Managing risks ̶ Processing information and monitoring borrowers 4 Liquidity and Payment Services ̶ Management of fiat money: ̶ money change (exchange between different currencies issued by distinct institutions) ̶ provision of payment services – management of clients’ accounts – the finality of payments - the guarantee by the bank that the debt of the payer (who has received the goods or services involved in the transaction) has been settled to the payee through a transfer of money Checking accounts, credit cards, electronic banking or wire transfers (CHIPS or Clearing House Interbank Payments System, TARGET or Trans-European Automated Real-Time Gross Settlement Express Transfer), international payments (SWIFT or Society for Worldwide Interbank Financial Tele-communication), etc. 5 Asset Transformation 1. Convenience of denomination - bank chooses the unit size (denomination) of its products (deposits and loans) in a way that is convenient for its clients. 2. Quality transformation - occurs when bank deposits offer better risk-return characteristics than direct investments (due to impossibility of diversification or asymmetric information situation). 3. Maturity transformation - banks transforms securities with short maturities, offered to depositors, into securities with long maturities, desired by borrowers. → liquidity risk 6 Risk Management ̶ Credit risk ̶ Historically achieved by loan security through collateral, assignment of rights or endorsement (guarantee) ̶ Risk appraisal of a loan ̶ Interest rate and Liquidity risks ̶ Bank transforms maturities or issues liquid deposits guaranteed by illiquid loans ̶ The cost of funds may rise above the interest income ̶ Bank may face unexpected withdrawals → Bank is forced to seek more expensive sources of funds ̶ Market risk ̶ Off-Balance-Sheet Operations ̶ loan commitments, credit lines, and guarantees ̶ swaps, hedging contracts, and securities underwriting ̶ Operational risk 7 Monitoring and Information Processing ̶ Imperfect information on borrowers ̶ Banks invest in the technologies that allow them to screen loan applicants and to monitor their projects. → Firms and financial intermediaries develop long-term relationships, thus mitigating the effects of moral hazard. ̶ Compared to security investments, the value of a bank loan results from this long-term relationship and is a priori unknown, both to the market and to the regulator. 8 Types of banking operations 1. Retail banking 2. Wholesale banking 3. Universal banking 4. Islamic banking 5. International banking. 9 Wholesale banking ̶ Large value, low volume part of banking business ̶ Mix of domestic and foreign currency business ̶ Large size of deposits and loans ̶ Tailor made loans ̶ Dependence on inter-bank market ̶ Greater importance of off-balance-sheet facilities ̶ Small proportion of demand deposits 10 Universal banking ̶ Keeps customers in one stop shop ̶ Economies of scale exhausted quickly and constant returns to scale ̶ Economies of scope ̶ Size allows for risks to be spread and internally diversified ̶ Size also creates danger of Too Big to Fail 11 Islamic banking ̶ Risk sharing – each participant must share in the same risk-return distribution (removes asymmetric information problem) ̶ Materiality – all financial transactions must be backed by a tangible asset (no options). ̶ Non-exploitation – neither party can be exploited ̶ No sinful activity – alcohol, gambling, etc ̶ Widely practiced model is 2-tier Mudaraba ̶ Depositors enter into a contract with the bank to share profit ̶ Bank enters into a contract with the borrower to split the profit ̶ Islamic banking assets only constitute up to 2% of global banking assets 12 Shadow banking ̶ Financial Stability Board definition – ‘credit intermediation involving entities and activities outside the regular banking system’ ̶ Hedge Funds – more aggressive investment strategies than life assurance & pension funds. ̶ Special Purpose Vehicles – vehicle for securitisation ̶ Money Market Funds – short term high quality securities ̶ Private Equity – investment in private companies Process takes between 3 and 7 steps: 1. Loan originated by Bank or other FI 2. Loan warehousing financed by ABCP 3. Pooling & structuring loans by broker/dealers 4. ABS warehousing via trading book financed by REPOs 5. Pooling & structuring of ABS into CDOs done by broker dealers. 6. ABS intermediation is carried out by SIVs & hedge funds 7. All steps funded in the wholesale market 13 International banking ̶ Home Country Characteristics ̶ Home country regulations ̶ Resource costs ̶ Host Country Characteristics ̶ Absence or lack of regulation ̶ Monopolistic characteristics ̶ Information exploitation 14 Bank Business Models Cluster analysis for European banks Ayadi and de Groen (2016) define BBMs distinguishes primarily between the key banking activities and the funding strategy, which broadly builds on assetliability approach. Analysis covers 147 banking groups in Europe (80% of EU bank assets) in years 2006-2013. Financial crisis affected BBMs – banks received state aid have reoriented towards focused retail. 91 -2 -1 0 1 2 Bank loans* Bank liabilities* Customer deposits* Customer loans Debt liabilities* Trading assets* Derivative exposures* Tangible common equity Fig. 4.4 Comparison of clusters, standardized scores Notes: Indicators marked with an asterisk (*) were used as instruments in the cluster analysis. The figures represent the number of standard deviations from the sample mean. Customer loans and customer deposits represent the balance sheet share of deposits from and loans to non-bank customers, respectively. Bank liabilities and bank loans identify the share of liabilities of and loans to other banks, including bank deposits, issued debt, interbank transactions, and received funding from central banks. Debt liabilities are calculated by netting customer deposits, bank liabilities, total equity and negative fair values of all derivative transactions from total liabilities. Derivative exposures captures all negative carrying values of derivative exposures. Trading assets are defined as total assets minus liquid assets (cash & deposits at central bank) minus total loans and intangible assets. (Tangible) com- 4 Banks’ Business Models in Europe 15 Financial Innovation Principal forms of structural change (Goodhart 1984): 1. The switch from asset management to liability management. 2. The development of variable rate lending. 3. The introduction of cash management technology. 16 Profitability of banks 17 Profitability of banks Price-to-book (P/B) ratios, by market type and industry 18 19 Bank branches per million inhabitants (EU15) Bank employees per million inhabitants (EU15) Source: ECB Statistical Data Warehouse 20 Recent shock affecting banks ̶ Macroeconomic shock – inflation, likelihood of recession, change in monetary policy ̶ Asset value shock – devaluation of cryptoassets, decline in property markets ̶ Energy and food supply shock – related to war in Ukraine ̶ Supply chain shock – during and after the pandemic ̶ Talent shock – shift in work habits and employment (including population aging) 21 Core business area IT systems used Lending IS from external vendors (i.e., SAP ‘‘Commercial Banking Operations’’ Module) Taking/managing deposits Branch and ATM network In-house-developed IS (online and mobile banking) SAP software modules Payments processing and infrastructure ATM networks In-house-developed IS (online and mobile banking) Card and digital payment networks SEPA Compliance with regulations Manual labour RegTech systems Marketing and sales CRM technology Salesforce automation technology 22 AI in Banking ̶ More accurate default predictions can be made with previously unused data types ̶ A greater variety of algorithms in credit risk estimation ̶ Safer payment networks (detection of fraud and money laundering) ̶ Managing the scale of the business infrastructure (predicting the amount of cash withdrawals, payments, etc.) ̶ Detection of non-compliance with regulations (analysis of phone conversations between employees and clients and between employees in real-time, natural language processing to read and interpret regulatory documents) ̶ Prediction of financial product purchases ̶ Churn prediction 23 Literature ̶ Matthews and Thompson (2015). The Economics of Banking. – Chapters 1, 3-5. ̶ McKinsey’s Global Banking Annual Review. December 2022. Report.