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What are banks?

What do they do?


B.p.mishra
XIMB

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Banks are intermediary , between willing Savers and


Risk taking Investors.
The provision of accepting deposit ( Liability)
And manage the assets created by lending.

The Banking firm


Intermediary
I* = I
AT NO INTERMEDIATION COST
D

SL = Supply of loan curves

SD =Supply of Deposit

IL
I*
ID

DL = Demand for loan

Volume of loan & Deposits


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Basic Principles of Banking

Principles of Intermediation
Principles of Liquidity
Principles Profitability
Principles Solvency
Principle of Trust

Commercial Bank.. Intermediaries perform six


basic functions

1.Denomination Intermediation
- Small amount of savings from individuals and others are pooled so
as to give loans of varying size
2. Default Risk intermediation
- Willingness to give loans to risky borrowers without hurting the
returns to savers
3. Maturity intermediation
- Ability to create loans whose maturities may mismatch with the
deposit
maturity profile
4. Liquidity intermediation
- Claims from savers that are highly liquid while loans to borrowers
are relatively less liquid
5. Information intermediation
- Ability to gather and process information from the financial
marketplace far more effectively than the individual saver
6. Currency intermediation
- Ability to lend cross-currency

The Core functions of the bankProvision of Intermediation & liquidity.


Indirectly a payment service.
Asset transformation.

Banking Service As a
Product
Price

Supply of Services

P1

Demand For services


Q1
Quantity of Services Provided

Cost of intermediationSearch
Verification
Monitoring
Enforcement
Other transaction cost

The interest margin is equal to the net of lending &


deposit rate
Includes
Intermediation cost
Cost of capital
The risk premium charge on loans
Tax payment
The institutions profit
The more is the market competition,
the more narrow the interest margin.

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Transaction cost is subject to scale economies


Implying with larger the product users, the cost comes down.
Banks also enjoy the
information economies of scope in lending decisions.
Access to privileged information on
current and potential borrowers with the account with the bank.
Thus compared to depositors trying to lend directly,
Banks can pool a portfolio of assets with less risk of default
For a given expected return.
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Provided the bank can act as an intermediary with


lowest cost,there will be demand for its services.
But Corporate (some) who can borrow at low cost
in relation to bank in the market, still borrow from banks
As it signals to financial markets and
to supplier its credit worthiness.

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Banks offer liquidity to their customers- depositors & borrowers.


This separates from others near bank/
Non-bank financial products.
It also explains why banks are subject to Prudential Regulation.
The claim on banks functions as money, hence there is
Public good element to the services bank offer.

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Banks engage in ASSET TRANSFORMATIONTransferring the value of assets and liabilities.


POOLING of asset is also done by
Pension & Insurance companies.
But matching short term liability (deposit) with
long term assets ( loans) is done by banks.

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Banks also offer services with having non-price features


Associated with them.
The bank can charge for all services offeredSavings account / ATM card/ Internet banking/ check
book facility etc.
But it pays a lower interest on deposits.
It also offers Other services for a fee
and off-balance sheet services.
Payment services are exclusive to the banks alone.

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Payment Services
Two major Risks:
Liquidity RiskSettlement is not made at expected time
So that Asset/ Liabilities are not transferred from one agent
To another via the system.
Operational RiskArising from the threat of operational Breakdowns,
Preventing timely settlement
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System

Function

APACS: Association of Payment


Clearing Service

Umbrella organizaion1984
Made up of
BACS,CCCL,CHAPS

BACS: Bankers Association Clearing


System

NON-paper based bulk


clearing

CCCL: Cheques and Credit Clearing


company Ltd

Paper based Clearing

CHAPS: Clearing House Automated


System

Real time Gross


settlement

FEDWIRE, USA

Inter State Clearing

CHIPS: Clearing House Interbank


payment System

New-York Based Gross


settlement
Real time system

TARGET: Trans European automatic


Real-time Gross settlement transfer
system

Real Time Gross


Settlement/ transfer

SWIFT :Society for worldwide

Forex transfer

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Banks have to face agency problem of


Adverse selection & moral hazard.
The nature of contracts banks enter into areThe shareholders of a bank( Principal) & its management ( Agent).
The bank (Principal) and its Officers (Agent)
The bank ( Principal) and its Debtors (Agent)
The Depositors ( Principal) and the bank (Agent)

Incentive problems arise because principal can not


monitor agent behavior.
Bank management can plead bad luck
When outcomes are poor.
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Bank has less information on probability of default,


Hence adverse selection because of information asymmetry.
Banks are reluctant to lend with high interest rate, as riskier
Borrowers tend to seek loan.
The problem of adverse incentives
( higher interest encouraging borrowers to undertake riskier activities )

Is another reason why banks will reduce the size of a loan


Or refuse loan to some individual & firms.

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Moral hazards is another problem.


Depositors may not be in a position for close monitoring of bank action.
A depositor cost of monitoring becomes small ,the larger
& the more diversified is the portfolio of loans.

Though there will be a loan losses, the pooling of loans


will mean that the variability of losses approaches zero.
The deposit insurance reduces the incentive for monitoring
of the bank by depositors.
Shareholders monitoring for value, may benefit the depositors.

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Universal bankingGermany is the home of UNIVERSAL BANKING,


where
DUETSCHE bank has major holdings in
Daimler Benz Automobiles
Allianz Largest Insurance company
Metallgesellshaft Oil Industry
Philip Holzman Construction
Munich-re Reinsurance agency
To name a few

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Financial activities under Universal banking areIntermediation and liquidity via deposits & loans,
by product is the payment system.
Trading of financial instrumentsbonds, equity, derivatives , currency.
Proprietary trading- in own books
Stock broking
Corporate advisory services- M&A
Investment Management
Insurance.

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Commercial & Investment bankOriginated In USA- Glass Steagall section of banking Act, 1933
Commercial banks are not allowed to Underwrite securities
Investment banks are not to offer banking services.
Modern Investment banks engage inUnderwriting
M&A
Trading of financial instruments( bonds, equity, derivatives , Proprietary)
Fund management
Consultancy
Global Custody

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Merchant Banks:Francis Barrings in 1762 started financing


export & import of goods through bill of exchange.
Small traders were given much needed liquidity.
These banks were called acceptance houses till 1980s.
They expanded to loan underwriting, M&A advisory
Financial services Act(FSA )1986, permitted stock broking
And merchant banks became akin to US Investment banks.

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Is investment bank a
bank?
Investment banks act as intermediary,
but do not accept deposit and facilitate payment systems.
But they contribute to increased liquidity to the system
by arranging new form of finance for a corporation.
This is different from meeting liquid demands of depositors.
Hence they are not banks in true sense.
Goldman Sachs accept core /traditional deposit from HNIs
Merrill Lynch, in 2000, approved to mobilize FDIC
Insured deposits by FED.

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Commercial Banking:Commercial Banks offer wholesale & Retail banking services.


Wholesale banking typically involves offering
Intermediary, liquidity & payment services to large customers
Corporation & Govt.
Retail banking offers the same services to a large number
Personal banking Customer & small business.

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Bank Holding Companies


BHCs can own banking and in some countries Non- banking
Financial subsidiaries, which are legally separate
And individually capitalized.
BHCs were used to circumvent laws in USA
which placed restrictions on interstate branching,
(branches in more than one state)
Subsidiaries allowed to do investment banking subsequently.

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Finance Holding Companies


Restricted Universal Banking under
Gramm Leach Bliley Financial Modernization (GLB) Act- 1999
Super ceding Glass Steagall act.
Bank Holding companies converted to Finance holding companies.
They can engage in commercial & investment banking,
But restricted, as subsidiaries ,
they will have to separately capitalized.
It is costly than they are part of same legal entity.
The cross share ownership of non-financial firm is largely prohibited .

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Financial Conglomerate
Briault (2000) defined a financial conglomerate
as a firm that undertakes at least two of the five
Financial activities:Intermediary / payments
Securities
Corporate Finance
Fund management
Advising & Selling investment product to retail customer.

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Advantage :A.The efficacy of the financial system is improved


If the conglomerates can achieve the Economies of scale & scope.
B. In emerging economies, they can provide expertise to deepen the
Financial market.
C. They diversify their functions on Products & regions,
Making them less vulnerable to downturns
in one economy or region.

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Disadvantages:A) Diversified financial firm encounter difficulties may go broke


Adopting high risk /return strategy- Too big to Fail.
Hence, the systemic threat to the global financial system is increased.
B) Functional supervision is difficult with multiple regulators.
C) Compliance cost is too high, as each regulator
require them to allocate capital ( dedicated Capital).
D)

Conflict of interest & Fire walls creation. Insider Trading

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THANKS

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