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International Banking

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Types of Banking

Central BanksCommercial Banking

Retail Banking Wholesale Banking Private Banking

Investment BankingMortgage BanksIslamic Banks

3

Money – Over 2000 years ago

Banking: 13th-15th CenturiesLombardy and Florence 1463: First Bill of Exchange

Medici Bank

Banknotes: London Goldsmiths17th Century

New World: Gold and Silver Ports become important centres

Merchant Banking: 18th CenturyBaring Brothers

Joint Stock Banks:19th Century

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5

Role of Banks

Major role in financial system, Keynes (1930).

Central intermediary between savers and borrowers: Fractional reserve banking

Balance Sheet Assets. Liabilities. Net Worth (profitability).

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Economic functions of banks

Medium of Exchange

Maturity transformation

Risk transformation

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Commercial BankingSummary Bank Balance Sheet

Assets Liabilities

Cash

Money market funds

Other securities

Lending

Shareholders funds

Deposits

Borrowing

See HBOS Balance Sheet

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Bank Balance Sheet

Security

Liquidity

Profitability

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Risk Management

Liquidity Risk

Credit Risk

Market Risk

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Reserve Requirements

UK: No stipulated reserve requirements

USA: Monetary Control Act (1980) Federal Reserve can impose reserve requirements

If a deficit occurs, bank’s borrow from Central Bank

Interbank Market

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Liquidity Risk

Liquidity Ratios Ratio of liquid assets to total deposits

Banks should have internal risk management systems:

Percentage of deposits covered by: Cash Money at call Short-term securities Long-term investments

‘Run on a bank’

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Credit Rationing

Credit market: “thin”. Borrowers offered a price-quantity package on

a “take it or leave it” basis. Excess demand exists at the prevailing price. Conventional response is to raise price. Banks don’t. Conduct Credit Rationing.

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Pure Debt Contracts

All returns beyond a certain point accrues to borrowers.

Downside losses are shared.Thus, optimal risk for borrowers > bank.Banks don’t have perfect information

about borrower’s investment / attitude to risk.

Classic asymmetric information.

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Asymmetric Information

Adverse Selection: Increasing interest rates will deter safe

borrowers. Leave banks with risky ones.

Moral Hazard One party changes behaviour contrary to the

interests of the other. With limited liability, pure debt contracts may

encourage borrowers to take more risks than if they were using their own money.

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Forms of Credit Rationing (Keeton; 1979)

1) Bank lends out a proportion of the requirements.

2) Loan is refused completely.May also be supplementary conditions:

security. Limit on use to which funds are put.

Solution of credit rationing due to nature of pure debt contract.

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Implications

Economics of information argue that banks exist because they are better at acquiring and processing information.

Solution to the pure debt contract: play a repeated game. If a borrower is going to borrow more than

once. There is an incentive to be honest.

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Credit Risk

Capital Ratios Ratio of capital to lending Basel Committee (BIS)

Exposure Rules

Risk management Portfolio Diversification Risk Assessment

Increasing capital ratios Increased capital Reduced assets (lending)

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‘Capital’

Tier 1

Shareholders’ equity Retained profits Tier 2

Revaluation reserves

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Risk-weighted example

Assets Value (£mn)

Risk Weighting (%)

Risk weighted value (£mn)

Cash 100 0 -

Gilts 200 10 20

Mortgages 1000 50 500

Loans 2000 100 2000

Total 3300 2520

Tier 1 Capital 151.20

Total Capital 226.8

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Capital Ratios

Tier 1 =

Total =

%6100*2520

2.151

%9100*2520

8.226

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Deregulation / Liberalisation

NYSE- May Day (1975)LSE – ‘Big Bang’ (1986)Bank and Building Society Act (1986)Single European Market (1992)Japan – ‘Big Bang’ (1990 onwards)USA- Gramm-Leach-Billey (GLB) Act

(1999)

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‘Off-Balance Sheet’ Transactions

Traditional Banking activities became very competitive Narrow profit margins

Looked for alternative sources of profitTransactions are not included on current

balance sheet. Avoid regulatory costs Greater risks

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Balance Sheets

Off-balance sheet assetsOff-balance sheet liabilities

Securitisation Collateralised Debt Obligations (CDOs)

Credit Default Swap (CDSs) Insure against credit risk

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Implications

Risky investmentsFinancial Institutions

Insufficient capital to cover assets

Wider EconomyLack of Credit

Low investment Eventual decline in output and employment

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Issues

Risk-management issues

Poor risk management Credit ratios too low