Tutorial 3
Explain the difference between consolidation and convergence. Are these trends in banking and financial services related? Do they influence each other? How?
Consolidation refers to increase in the size of financial institutions. The number of small, independently owned financial institutions is declining and the average size of individual banks, as well as securities firms, credit unions, finance companies, and insurance firms, has risen significantly. Convergence is the bringing together of firms from different industries to create conglomerate firms offering multiple services. Clearly, these two trends are related. In their effort to compete with each other, banks and their closest competitors have acquired other firms in their industry as well as across industries to provide multiple financial services in multiple markets.
Can you explain why many of the forces you named in the answer to the previous question have led to significant problems for the management of banks and other financial firms and for their stockholders?
The net result of recent changes in banking and the financial services market has been to put greater pressure upon their earnings, resulting in more volatile returns to stockholders and an increased bank failure in providing those rates. .Increased competition has led to a fluctuation in the bank's share of the financial service market place. Technological advances have significantly lowered the per-unit costs associated with high-volume transactions, but they have also depersonalized financial services. Due to consolidation of financial institutions, there has been a decline in employment in the financial-service sector as a whole. Due to the powerful trend of convergence, weaker firms fail or get merged into companies that are larger with more services. Institutions have also become more innovative in their service offerings and in finding new sources of funding, such as off-balance-sheet transactions. The increased risk faced by institutions today, therefore, has forced managers to more aggressively utilize a wide array of tools and techniques to improve and stabilize their earnings streams and manage the various risks they face. Also larger institutions with more services and that go across many countries are harder to manage as they are more complex.
Why do banks and other financial intermediaries exist in modern society, according to the banking theory?
The traditional view of banks as financial intermediaries sees them as simultaneously fulfilling the financial-service needs of savers (surplus-spending units) and borrowers (deficit-spending units), providing both a supply of credit and a supply of liquid assets. A newer view sees banks as delegated monitors who assess and evaluate borrowers on behalf of their depositors and earn fees for supplying monitoring services. Banks also provide a service of dividing up financial instruments into smaller units which would be readily affordable to millions of people. Banks accept risky loans from borrowers while issuing low risk securities to their depositors. Banks have been viewed in recent theory as suppliers of liquidity and transactions services that reduce costs for their customers and, through diversification, reduce risk. Banks are also critical in the payment system for goods and services and have played an increasingly important role as a guarantor and a risk management role for customers.
Of what benefit is agency theory in helping us understand financial-services firms? According to Allen (2001) how can it help us understand financial crises and speculative bubbles?
Agency theory analyzes the relationship between a firm's owner (shareholder) and its managers (agents). It explores whether there is a mechanism to compel managers to act in the best interest and maximize the welfare of the firm's owners. Owners do not have access to all the information and cannot fully evaluate the performance of a manager. One way to reduce costs from agency problems is, to develop better systems for monitoring the behavior of managers and to put in place stronger incentives for managers to follow the wishes of owners. Another way to accomplish this is by tying management salaries more closely to the firm's performance or giving management access to valuable benefits (such as stock options). However, recent events suggest these steps may also encourage managers to take on greater risk. Allen (2001 - see page1170) suggest that agents (employees of financial intermediaries) benefit from the upside of taking risks with other people's money through large bonuses etc but only have a limited downside (losing their job rather than covering all their losses). In this context risky assets become attractive and their prices are bid up leading to their a speculative bubble (their value becoming disconnected from fundamentals).
Which businesses are banking's closest and toughest competitors?
Among a bank's closest competitors are savings associations, credit unions, fringe banks, money market funds, mutual funds, hedge funds, security brokers and dealers, investment banks, finance companies, financial holding companies, and life and property/casualty insurance companies. All of these financial service providers are converging and embracing each other's innovations. The Financial Services Modernization Act has allowed many of these financial service providers to offer the public one-stop shopping for financial services.
How have banking and the financial-services market changed in recent years? What powerful forces are shaping financial markets and institutions today?
Banking is becoming a more volatile industry due, in part, to deregulation which has opened up individual banks to the full force of the financial marketplace (competitions). However, under the new regulatory trend-reregulation, the government tightened the financial-services sector due to crises and market collapse in the previous few years. At the same time, the number and variety of banking services has increased greatly due to the pressure of intensifying competition from nonbank financial-service providers and changing public demand for more conveniently and reliably provided services and increase in returns on their money invested. Adding to the intensity of competition, foreign banks have enjoyed success in their efforts to enter countries overseas (internationalization) and attract away profitable domestic business and household accounts. There has been service proliferation and greater competitive rivalry among financial firms that has led to a powerful trend— convergence. Convergence refers to the movement of businesses across industry lines so that a firm formerly offering perhaps one or two product line ventures into other product lines to broaden its sales base. Apart from these changes, there has also been a considerable improvement in the technological automation leading banking and financial services to comprise of a more capital-intensive, fixed-cost industry and a less labor-intensive, variable-cost industry than in the past. The trends of convergence, consolidation, geographic expansion, and technological change will continue to proliferate in the future years.
What relationship appears to exist between bank size, efficiency, and operating costs per unit of service produced and delivered?
For banks and nonbank financial service providers alike, economies of scale and economies of scope if achieved can lead to significant savings in operating costs with increases in service output. Economies of scale mean that costs per unit decrease as more units of the same service are produced because of greater efficiencies in using the firm's resources to produce multiple units of the same service or service package. Economies of scope imply that as more different services are provided, the operating cost reduces. This is because some resources are more efficiently used in jointly producing multiple services than turning out one service.
Why are some banks reaching out to become one-stop financial-service conglomerates?
This trend has been facilitated by de-regulation and technology. Banks seek to gain from economies of scale and scope. Banks and various financial institutions are converging in terms of the services they offer and embracing each other's innovations. There are two reasons that banks are increasingly becoming one-stop financial service conglomerates. The first reason is the increased competition from other types of financial institutions and the second reason is the erosion of the bank's market share for providing traditional services (both are facilitated by de-regulation and technology). Due to these reasons, the banks demanded for a relief from traditional rules and lobbying for an expanded authority to reach new markets around globe. This has led the United States Congress to pass the Financial Services Modernization Act which has allowed banks to expand their role to be full service providers. It is a beneficial step as it has led the U.S. banks to stay in the competition and increase the market share by entering into various new industries like the securities and insurance industries.