Introduction to Banking Chapter 1 &2

• A Financial Claim is: A. A claim to the payment of a future sum of money and/or a period payment of money. It carries obligations to the issuer to pay interest periodically B. A claim to the payment of a present sum of money and/or a period payment of money. It carries obligations to the issuer to pay interest periodically C. A claim to the payment of a future sum of money and/or a period payment of money. It carries an option to the issuer to pay interest periodically

Answer: A

• The ___ diversified a bank balance sheets are, the ___ likely it is that they will ___ its deposit obligations. A. More, less, default B. Less, more, meet C. More, less, meet

Answer: A

• The actions by the less informed party to determine the information possessed by informed party is called: A. Screening B. Signaling C. Monitoring

Answer: A

• Deposits are held on the ___ side of the bank balance sheet: A. Assets B. Liabilities C. Equities

Answer: B

• Banks bridge the gap between the need of borrowers and lenders by performing: A. Size transformation, Maturity transformation and Preferences transformation B. Preferences transformation, Maturity transformation and Risk transformation C. Size transformation, Maturity transformation and Risk transformation

Answer: C

Who do banks collect and allocate funds from?

Banks collect surplus funds from savers and allocate them to those with deficit funds (borrowers).

What are the requirements of borrowers?

Borrower's requirements • Funds at a particular date • Funds for a specific period of time, preferably long term • Funds at the lowest cost possible.

Deposits multiplier?

Deposits multiplier equals the reciprocal of the required reserve ratio

What are the requirements of lenders?

Lender's requirements: • Minimization of risk • Minimization of cost • Liquidity

Chapter 2 BANKING ACTIVITIES & CURRENT ISSUES IN BANKING

Liabilities: Assets: Customer Deposits Cash Equity Liquid Assets Loans Other investments Fixed Assets

What is deregulation?

Removing control and rules that in the past protected financial institutions. • Deregulation is undertaken to improve performance of the industry.

Credit Multiplier?

We assume that modern banks keep only a franction of the money that is deposited by the public. The fraction is kept as reserves and allows the bank to face possible withdrawal requests Credit Multiplier: is the ratio of change in the deposits to the change in the level of reserves

What is a central issue in re regulation?

• Capital adequacy is a central issue. • Basle agreements are concerned with capital adequacy.

Payment: • Smart Money or chip cards

• Cards that incorporate microprocessor or memory chip. • Microprocessor can delete, add and manipulate the information stored in the card. • e.g. prepaid phone cards.

Responses to the forces of change: Mergers & Acquisitions

• Combining two or more entities into one new one entity. • Explained by the equation that one plus one equals more than two because common motive increase the value of the new entity. • Both terms can be used interchangeably but: • A merger is when two similarly sized companies agree to go forward as a single bank. • An acquisition is when a bank takes over another one and clearly becomes the new owner. Also known as takeovers.

Explain conglomeration trend?

• Conglomeration (accumulation) is a major trend in financial markets • Driven by technological advances and deregulation • Banks are now allowed to act as "Universal Banks"

Payment: • Plastic Cards

• Credit cards, debit cards, travel and entertainment cards, shop cards etc. • Credit cards provide holders with pre-arranged credit limit to use for purchases at retail stores. • The retailer pays the credit card company a commission on every sale made via credit cards. • Consumer can obtains free credit if bill is paid on time. • If bill is not paid then interest is charged.

Deposit & Loan : Accounts (current)

• Current (checking) accounts pay no interest rates and are used mainly for payment. • Banks provide broad range of current accounts tailored to different customers period of time at a pre-determined or variable interest rate. • Banks offer a range of such products

On basis of what information are decisions made beforehand?

• Decisions are made beforehand (in advance) on the basis of less than complete information.

Can the deposit holder withdraw at any time?

• Deposit holdings are discretionary (unrestricted) Yes • Depositors are free to decide the frequency and amount of their transactions • For other institutions there is usually a contract which specifies the amount and frequency of the flow of funds. (such as insurance)

What are the characteristics of deposits?

• Deposits typically have the characteristics of being: • Small size • Low risk • High liquidity

Supervisory Re-regulation

• Deregulation increased perceived riskiness of banking business. • Even strongly market-oriented systems need to strengthen supervision. • Important to maintain safety and soundness of the financial system. • Re-regulation is the process of implementing new rules, restrictions and controls in response to market participants efforts to circumvent these regulations. • Effort to minimize adverse effects of excessive competition brought through deregulation.

What is direct finance?

• Direct Finance is when borrowers obtain their funds directly from savers.

E -Banking

• E-money includes reloadable electronic money instruments in the form of electronic tokens stored in computer memory. • Remote payments are instruments that allow remote access to a customer ' s account. • Major banks offer traditional remote banking services • ATMs and phone banking, as well as internet banking • Some smaller banks operate without branches exclusively through remote banking channels, some are subsidiaries of existing banking groups.

How do banks reduce costs by exploiting economies of scope?

• Economies of scope refers to a situation where the joint costs of producing two complementary outputs are less than the combined cost of producing the two outputs separately. • This arises when the production process of both outputs share common inputs such as capital(e.g. the actual building the bank occupies), labor (e.g. bank's management). A bank might sell both mortgages and life insurance policies that go with them. • However, economies of scope are difficult to quantify and measure.

What are the Benefits of Benefits of Intermediation:To Society?

• Efficient utilization of funds. • Higher level of borrowing and lending, due to lower costs. • Improvements in the availability of funds to higher risk ventures due to capabilities of banks to absorb such risks.

What is Consumption Smoothing?

• Enable economic agents to smooth consumption by offering insurance against shocks to consumers consumption path. • Economic agents have uncertain preferences about their expenditure and this creates a demand on liquid assets. • Banks provide these assets via lending.

• A bank is a financial intermediary whose core activity is to provide loans to savers and collect deposits from borrowers.

• F

• Direct Finance is when borrowers obtain their funds directly from banks.

• F

• The issuer of the claim has a financial asset.

• F

When are financial claims generated?

• Financial claims are generated whenever borrowing takes place.

In what form are financial claims?

• Financial claims can be in the form of any financial asset, e.g. money, bank deposit accounts, bonds, shares, loans.

Financial Innovation

• Financial innovation is an ongoing process whereby private parties try to experiment to differentiate their products • It is the act of creating and popularizing new financial instruments as well as new financial technologies • It can be related to the system or the business structure, or related to supervisory framework. • Process innovation is the introduction of new business processes to increase efficiency. • Product innovation can introduce new credit, deposit, insurance , leasing or any other product to respond to changes in the market.

What is the main role of Financial intermediaries and Markets?

• Financial intermediaries and financial markets main role is to provide a mechanism by which funds are transferred and allocated to their most productive opportunities. - A bank is a financial intermediary whose core activity is to provide loans to borrowers and collect deposits from savers

Who do financial intermediaries create extra costs for?

• Financial intermediaries can create extra costs for borrowers and lenders.

how do financial intermediaries reduce risk?

• Financial intermediaries reduce risk by pooling (aggregating) individual risks, so that surplus units will be depositing money as deficit units make withdrawals.

How does financial intermediation help borrowers?

• Financial intermediation bridges the gap and reconciles the need of borrowers and lenders. • It minimizes the costs of direct lending and minimizes transaction cost.

What are the Benefits of Intermediation To Lenders?

• Greater Liquidity • Less Risk Involved • Marketable securities may be issued as the counterpart to deposits with banks • CDs can be sold in the secondary market when the owner needs cash. • Reduction in transaction cost. • Lending decision is simplified.

What happens if efficiency due to deregulation is raised?

• If efficiency is raised, improvement in resource allocation will benefit the society and may lead to price reductions. • Can increase the competitiveness of the industry. • Loosening laws coupled with technology advances caused consolidation where the number of banks shrunk everywhere.

Whats is the meaning of information Asymmetry?

• Information Asymmetry : one party has better information than the other counterparty.

• Free-rider problems occur when people who do not pay for information take advantage of the information other people have paid for .

• T

• Information Asymmetry: one party has better information than the other counterparty

• T

Where does the bulk of a banks money come from?

• The Bulk of their money comes from deposits.

What is screening?

• The actions by the less informed party to determine the information possessed by informed party is called "screening".

Explain Adverse Selection?

• The better informed economic agent (party) has a natural incentive to exploit the information advantage. • Those who are un-informed should anticipate their informational handicap and behave accordingly. • The "Lemon" or bad car in a second hand car market is a good example of adverse selection Problem. .

What is the difference between total assets and liabilities?

• The difference between total assets and total liabilities is the bank's equity .

What does the issuer of financial claims record it as?

• The issuer of the claim has a financial liability.

How can banks prevent defaulting on meeting deposit obligations?

• The more diversified a bank balance sheets are, the less likely it is that they will default on meeting deposit obligations.

Deposit and Loan: Consumer Loans and Mortgages

Offered by banks to retail customers Can be "unsecured" without collateral, usually for a short to medium time periods and up to a certain amount Can be "secured on property" for longer periods. Interest can be variable relative to a benchmark or fixed over the term of the loan "Capped" loans have variable rates but a cap is placed on maximum interest "Discounted Mortgages" have variable rates that are discounted a few percentages below the benchmark.

Investment, Pension & Insurance: • Pension & Insurance

Pension funds provide retirement income Contributions are paid to the fund and invested long term They are considered "private" pension schemes (vs. public ones offered by the state). Insurance protect policyholders from adverse events Policyholders pay regular premiums and insurer promises compensation if the adverse event occurs.

Banks can engage in:

1.Taking deposits 2. Issuing money (digital money or electronic money) used on the internet 3 Carrying out insurance contracts 4.Dealing in investments 5.Managing investments 6. Advising on investments 7.Safeguarding or administering investments 8. Mortgage activities 9. Establishing & managing mutual funds and investment funds 10.Pension Schemes

What are the problems with Asymmetric (private) Information?

Three problems are relevant: • Not everyone has the same information • Everyone has less than perfect information • Some parties to a transaction have "inside" information which is not made available to both sides of the transaction.

• What is so special about banks?

additional services, but it is these functions that constitute banks' distinguishing features. • Banks play an important role in channeling funds from savers to borrowers.

Solve problems on worksheet

as per worksheet

What is a Financial Claim?

• A Financial Claim is a claim to the payment of a future sum of money and/or a period payment of money. It carries obligations to the issuer to pay interest periodically.

• What is a bank?

• A bank is a financial intermediary that offers

Payment: Travel and Entertainment Cards

• Allow repayment to be deferred until the end of month • Do not provide interest free credit • Unlike credit cards, all bills have to be paid by end of month. • Unpaid balances charged higher interest rates. • e.g. Diner' s Club and American Express

Banking Services: 1. Payment?

• Any organized arrangement for transferring value between participants • Is a by-product of financial intermediation • Facilitates the transfer of ownership of claims in the financial sector • Can be for goods and services as well as financial assets. • Can be for high value transfers between financial institutions. • If payment fails large parts of the economy would be affected.

Banks and other financial Institutions

• Banks are Deposit Taking Institutions (DTIs). • Also known as monetary financial institutions (MFIs). • They play a major role in the economy as their deposit liabilities form a major part of a country's money supply. .• Expansion in bank deposits result in an increase in money

Banks bridge the gap between the need of borrowers and lenders by performing what?

• Banks bridge the gap between the need of borrowers and lenders by performing: • Size transformation • Maturity transformation • Risk transformation

how can banks raise funds?

• Banks can raise funds by issuing bonds and equity ,and save from past profit (retained earning).

What is Liquidity Transformation?

• Banks deposits can be viewed as contracts that offer high liquidity and low risk. • Held on the liabilities side of the balance sheet. • Banks can hold assets and liabilities of different liquidity features through diversified portfolios.

Explain Commitment Mechanism?

• Banks deposits have evolved as a necessary device to discipline (control, restraint) bankers. • To control the risk propensity (tendency) of banks, demand deposits have evolved because changes in the supply and demand of these instruments will be reflected in financing costs. • This disciplines banks to behave prudently.

How do banks reduce cost by exploiting economies of scale?

• Banks reduce cost by exploiting scale and scope economies. • Financial intermediaries reduce transaction, information and search costs by exploiting economies of scale. • By increasing the volume of transactions, the cost per unit of transaction decreases. • Banks can standardize contracts and monitor customers. • They train high quality staff to find and monitor borrowers.

How do banks perform Maturity Transformation?

• Banks transform funds lent for a short period of time into medium and long term loans. • They convert demand deposits (funds deposited that can be withdrawn on demand) to mortgages. • Banks liabilities are short term (payable on a short notice) while their assets are repayable in a long or medium term. • This process is said to 'mismatch' their assets and liabilities. • This creates a liquidity risk for banks.

What do barriers to direct finance include?

• Barriers to direct financing include: • Difficulty and expense of matching the complex needs of borrowers and lenders • Incompatibility of the financial needs of borrowers and lenders.

Competition

• Before deregulation, banking was characterized by high level of government control and restrictions. • The purpose of these restrictions was to ensure stability and prevent banking crises, • Glass-Stegall act forbade banks for underwriting securities and insurance contracts. • Competitive pressure increased as a result of deregulation.

What are borrowers and lenders referred to as?

• Borrowers are referred to as deficit units, lenders are surplus units.

Risk Transformation

• Borrowers carry the risk of default (risk that they may not repay the amount they borrowed). • Savers wish to minimize their risk and prefer their money to be safe. • Banks are able to minimize the risk of individual loans by diversifying their investments, pooling risks, screening and monitoring borrowers and holding capital reserves.

Who has more information about risk adn return borrowers or lenders?

• Borrowers have better information about the investment in terms of risk and return than lenders.

Explain Information Production?

• Information about possible investment opportunities is not free. • Savers could incur substantial search costs if they were to seek out borrowers directly. • If there are no banks, there would be duplication of information. • Banks have economies of scale and expertise. • Banks build up this information and become experts in processing this information. • They have an information advantage and depositors are willing to place funds with a bank knowing these will be directed to appropriate borrowers.

What can information asymmetries generate?

• Information asymmetries, or the imperfect distribution of information among parties, can generate adverse selection and moral hazard problems.

What does Information asymmetry create obstacles for?

• Information asymmetry are obstacles for direct finance, and are examples of market failures.

What is the centre of all financial transactions and contracts?

• Information is at the centre of all financial transactions and contracts.

Payment: • Standing orders?

• Instructions from the customer (account holder) to the bank to pay a fixed amount at regular intervals into the account of someone else (individual or company). • Only the account holder can change the instructions.

Investment, Pension & Insurance: Investment Product

• Investment Product Mutual funds Investment in company stocks and other securities

Payment: • Debit Cards

• Issued by banks allow customers to withdraw money from their accounts. • Can be used to obtain cash and other information when used through ATMs

What are the characteristics of loans?

• Loans are: • Larger size • Higher risk • Illiquid

What are the Benefits of Intermediation:To Borrowers?

• Loans for a longer period of time .• Obtaining loans with larger amounts • Lower transaction cost • Lower interest rate, through the minimization of transaction cost and risk. • Greater likelihood for availability of loans when required.

What is the main source of funding for banks?

• Main source of funding is customer deposits

Banks & Other Financial Institutions

• Monetary function of banks is the main reason why they are subjected to heavier regulatory supervision than non deposit-taking counterparts • Insurance companies, pension funds, investment companies

What is the solution for adverse selection?

• One possible solution to adverse selection is to offer a warranty , as it would be viewed as a signal of quality. Hence "signaling" refers to the actions of the informed party in an adverse selection problem)

What is the solution for Information Asymmetry?

• One solution is the creation of organized financial markets, where information asymmetry and transaction costs are reduced .

Explain Relationship & Transaction Banking?

• One way to overcome agency and adverse selection problems is to enter a relationship contract. • Banks invest in developing close and long-term relationships between the bank and the borrower and thus are beneficial to both parties. • If a customer has a 'history', then the bank' s screening and monitoring costs will be lower . • Borrowers might find it easier to get future loans. • Relationships can be a competitive advantage. • Some banks hold equity in businesses they lend and have members on the board of directors of these companies.

Payment: Direct Debit?

• Originated by the supplier of goods and services • Customer has to sign the direct debit • Variable in amount and time can also be varied. • Utility bills are often paid this way.

Payment: Checks

• Payment services can be paper-based or • Checks • "A" buys goods/services and gives a check to "B" • "B" can pay it to their own account. B' s bank then initiates the request to debit A ' s account. • A ' s bank then authorizes "clears" the check and the settlement takes place. • Widely used • Debit transfers because they are written requests to debit the payee' s

Payment: Credit Transfers (Giro Credit)?

• Payment where the customer instructs their bank to transfer funds directly to the other party' s bank account.

What is the Principal Agent Problem?

• Principal agent problem is related to the problem of incentive structures. • How a principal is able to rely on the agent acting in the interests of the principal employing him rather than his own selfish interest and against those of the principal. • The agent can choose his/her behavior after the contract is established, hence the agent is able to conceal the outcome of the contract • Agency problems arise because an agent cannot be efficiently or costlessly monitored. • The challenge is to align the interests of the agent to those of the principal. • Example: managers and shareholders.

Payment • Check guarantee cards

• Retailers are reluctant to accept checks • When paying by checks further identification is provided by the payer by presenting this card • Details from the card written on the check to guarantee payment.

How do banks perform Size Transformation?

• Savers are willing to lend smaller amounts than required by borrowers. • Banks collect funds from savers in the form of small size deposits and repackage them into larger loans. • They have access to a larger number of depositors than an individual borrower.

What costs does Transaction cost include?

• Searching for a counterparty • Obtaining information about the counterparty • Negotiating the contract • Monitoring the borrower • Enforcement should the borrower not fulfill the commitment.

What is structural deregulation?

• Structural Deregulation refers to the liberalization of financial markets to allow institutions to compete freely.

Explain Moral Hazard?

• Superior information may enable one party to work against the interests of another • Moral hazard arises when a contract or a financial arrangement creates incentives for parties to behave against the interests of others. • Monitoring is required whenever there are problems of moral hazard and adverse selection. • Example: Rating agencies

What is Financial Intermediation and Delegated Monitoring

• The role of banks as monitors of borrowers. • Monitoring credit risk is costly. • It is efficient for savers to delegate the task of monitoring to specialized agents such as bank. • Banks have expertise and economies of scale processing information on the risks. • An intermediary has net cost savings relative to direct lending and borrowing • Diversification amongst investment projects • The size of the intermediary (economies of scale).

Classification of Banks

• There is no unique, universally accepted classification of financial intermediaries. • It can differ by country • All countries have regulations to define what banking business is.

How do banks promote economic efficiency?

• They channel funds from savers to borrowers, thereby increasing economic efficiency by promoting better allocation of resources.

What distinguishes banks from other financial institutions?

• This ability to collect deposits distinguishes banks from other financial institutions.

How do banks invest their deposits?

• This funding is invested in loans and other investment assets.

What is the Free Rider Problem?

• Those involved in financial transactions should invest in information. • However, this is not costless and free rider's might emerge. • Free-rider problems occur when people who do not pay for information take advantage of the information other people have paid for. • The government could produce information to help investors distinguish bad from good firms. • This is politically difficult.

What must we first understand to understand how banks work?

• We must understand financial intermediation to understand how banks work • This helps us understand the role of banks in the economy.