Handout for Lecture 5.

Note: Lecture will begin with concluding slides from last lecture.

Core / ‘traditional’ principles of bank management derive profit from asset transformation, i.e.

•Draw in funds at lower cost on the liability side.

•Put them to more profitable use on the asset side.

i.e. This bank profit is from items ‘on the balance sheet’.

Changes in banks’ balance sheets – review:

Rise of liability management:

Money markets / non-transactions deposits to acquire funds > customers’ deposits.

Same for liquidity management > high excess reserves.

Also: Interest rate risk: hedging instruments

> adjustments to balance of interest-sensitive and interest-insensitive assets items on BS.

Balance sheet of all US commercial banks (%), December 2004.

Combining this with the breakdown of assets shown previously, we thus now have: Balance sheet of all US commercial banks (%), December 2004.

Assets Liabilities

Reserves and cash items 4 Checkable deposits 9 Securities 25 Non-transaction deposits 63 Loans 63 Borrowings 21 Other assets 8 Bank capital 7 100 100

Off-balance-sheet activities.

Deregulation, etc., → banks now also → further activities:

Not defined with respect to BS

i.e. Not appearing on the balance sheet.

Merging of activities of banks and non-bank financial institutions (nbfis).

Boundaries less distinct.

Extent of Off-Balance-Sheet activity

Non-interest income as %age of gross income, UK large banks:

Note: Actually now a declining proportion.

Due to increased competition from nbfis.

Examples of OBS activities.

Fee income from specialized services, e.g.Investment services, as seen.•Other investment bank services, e.g.issue of

securities.•Foreign exchange trades for customers.•Fund management.•Credit cards.

Examples of OBS activities , contd.

Trading activities and risk management on own behalf, e.g.

Foreign exchange dealings.

Dealing in derivatives:

Financial futures, interest rate and exchange rate hedging, etc.

Note: Original purpose of derivatives, etc.:

Mitigate risk.

But in fact → massive speculation, including by banks.

→ whole new range of management problems.

The ‘principal-agent’ problem:

Agent / employee of bank:

Earns profits → gets bonus.

Makes losses → bank has to cover for him/her.

e.g. Barings employee Leeson 1992-5:

Lost bank $1.3 billion → bank failed.

Strategies to counter PA problem:

Separate trading from book-keeping (‘back room’) activities.

‘Chinese Wall’ between departments of same firm / separate capital accounts, etc.

‘Disintermediation’.

• i.e. Intermediaries less dominant in credit market.

• Affects both sides of intermediation process:

Banks increasingly turn to other activities apart from intermediation, as seen.

e.g. May provide investment services to companies to obtain best rate.

> Competing by lowering own ROA (i.e. competing ‘on-BS’).

i.e. Switch to Off-Balance-Sheet / fee income.

Companies may turn away from banks:

May get better loan rate from capital market.

i.e. direct finance > indirect / ‘mediated’ through bank.

Banks and ‘nbfis’: boundaries less distinct.

BUT: particular significance for the economy:

Payments system.

Sheer scale.

Money creation process, etc.

→ Heavy regulation.

Equivalently, → further (interconnected) ‘basic’ principles of bank management:

Find ways to evade regulations (‘loophole mining’).

→ Keep up with innovations.

Effects of:

1. Deregulation.

2. Innovation.

3. Globalisation.

ECON7003 Money and Banking. Hugh Goodacre

Lecture 5.

THE CHANGING CHARACTER OFBANK MANAGEMENT

Conventional / traditional / ‘mono-tasking’:

Deposits in, loans out.

Remains basic.

BUT no longer the only or even main source of profit.

Now ‘multi-tasking’ / evolution in face of:

Increased competition, both from within banking sector and from nbfis.

→ Restructuring of sector:

Diversification of activities.

Increased efficiency (or ingenuity??).

Absorption (??) of greater risk.

Three interconnected trends in particular:

Deregulation.

Innovation.

Globalisation.

1. Deregulation.

Contradictory situation:

Concern for stability of financial sector:

‘Prudential’ controls.

Countering ‘loophole mining’, etc.

→ Trend to tighten regulation.

Competition issues :

→ aim to allow banks greater freedom.

→ Trend to deregulation!

Two strands of deregulation:

Removal of government restrictions.

Removal of self-regulatory restrictions.

i.e. Established from within banking / financial sector itself:

e.g. Agreements among building societies on interest rates, etc.

Three phases of deregulation.

Note: Not same timing or even sequence in different countries:

(i) Decisive blow to traditional framework.

(ii) Ending sharp distinction between banks and nbfis.

(iii) Allowing increased competition within financial sector and from outside it.

Deregulation Phase (i) Decisive blow to traditional framework.

Ending ‘traditional’ / ‘mono-tasking’ structure of sector.

Asset side: Lifting quantitative controls on banks’ assets.

Liabilities side: Lifting ceilings on interest rates on deposits.

UK:

Began early:

• ‘Competition and Credit Control’, 1971.

• Lifted credit restrictions.

• Associated with very loose monetary policy / ‘Barber boom’.

• Subsequent backsliding – ‘corset’ – deposits at BoE to restrain growth of MS.

• But by early 1980s all exchange and credit controls ended.

US:

‘Regulation Q’ (imposed in 1933):

Limited interest rate payable on deposits.

Not lifted till 1982.

Note: Traumatic effects of 1930s US bank failures.

→ Deregulation came later than in UK.

Very significant effects on international finance.

Variable rate lending.

1970s:

Volatile interest rates.

Inflation.

→ Banks increasingly allowed to issue variable rate loans.

e.g. Linked to LIBOR (London Inter-Bank Offer Rate).

> ‘Stuck’ with unprofitable loan rate.

Variable rate lending:

→ Stock of loans could become determined by demand.

Near-horizontal credit supply curve!

→ Banks could now liability-manage.

→ Great expansion of banks’ balance sheets.

Also: Reduction in Capital:Asset ratios.

Exposure to greater risk.

From asset management to liability management.

Asset management of post-war decades:

Large public sector (war) debt.

Readily tradable.

Quantitative controls → ‘traditional’ situation maintained:

Liabilities side: Largely passive supply / customers’ deposits.

Assets side: Active adjustment of balance sheets.

From asset management to liability management, contd

From 1970s:

Banks actively create liabilities / borrow from other banks / ‘money markets’, as seen.

Preview of globalisation: UK CCC but US maintained Q:

→ impelled move of US banks into Eurodollar market.

Deregulation Phase (ii) Ending sharp distinction between banks and nbfis.

UK: Banks and building societies:

1980s: banks allowed to compete in mortgage market.

1986: building societies allowed to compete in market for consumer credit.

i.e. both allowed to compete in each others’ markets.

US: Once again, much restrictive legislation of 1930s remained in force till late, but:

1980s: some competition with ‘thrifts’ allowed.

1999: banks allowed more freedom to compete in investment banking, insurance, etc.

Deregulation Phase (iii) Allowing increased competition within financial sector and from outside it.

Within financial sector:

nbfis → new kinds of financial services.

e.g. online banking – Egg, etc.

→ new kinds of nbfis competing with traditional banking.

Firms from outside financial sector enter financial services market:

UK: Tesco, Marks and Spencer, Virgin, etc.

US: Not only retail firms but also industrial:

e.g. General Motors.

General Electric’s financial arm → 1/3 of its revenue!