Mrs.Shefa El Sagga F&BMP110/2/2010. Chapter 2 Mrs.Shefa El Sagga F&BMP2 Diversification of Banking...

Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 1110/2/201010/2/2010

Chapter 2

Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 22

Diversification of Banking Activities

The Expansion of Banks into Non-banking Financial Services

The Effect of Non-interest Income on Banks’ Total Income

Global Markets and Centers

International Banking

Banking Issues in the 21st Century 10/2/201010/2/2010

2.12.1 . .IntroductionIntroduction In the 21st century, banks remain a central component of

well-developed financial markets. The banking sector normally consists of specialist banks

operating in niche markets, and generalist banks offering a wide range of banking and other financial products, such as deposit accounts, loan products, real estate services, stock broking and life insurance.

For example, ‘‘private bankers’’ accept deposits from high net worth individuals and invest in a broad range of financial assets.

Modern investment banks have a relatively small deposit base but deal in the equity, bond and syndicated loan markets.


2.2. The Expansion of Banks into Non-2.2. The Expansion of Banks into Non-banking Financial Servicesbanking Financial Services

This section looks at the growing diversification of banks. where traditional wholesale and retail banking are important divisions, but a wide range of financial services.

For example, universal banks, even if in the restricted form, offer virtually every other financial service, from core banking to insurance.

Non-bank financial services include, among others, unit trusts/mutual funds, stock broking, insurance, pension fund or asset management, and real estate services.

Buying a basket of financial services from banks helps customers overcome information asymmetries that make it difficult to judge quality.

A bank with a good reputation be able to establish a competitive advantage and profit from offering those services. Non-banking Financial Services as: Derivatives, and Securitizationn


2.2.12.2.1 . .DerivativesDerivatives A derivative is a contract that gives one party a contingent claim

on an underlying asset (e.g., a bond, equity or commodity), or on the cash value of that asset, at some future date. The other party is bound to meet the corresponding liability.

Over the counter (OTC) are tailor-made for particular clients. Derivatives can be used to hedge against financial risks and are an

important part of banks’ risk management techniques, thereby:1. Enhancing profitability.

2. Shareholder value-added.

3. Meet capital standards.

4. And avoid regulatory taxes, which stem from reserve requirements and deposit insurance levies.


2.2.2. Securitization2.2.2. SecuritizationThe growth of securitization has also been very

rapid. The term includes the issue of bonds, commercial paper and the sale of asset backed securities, as: 1.Bonds and commercial paper.

2.Foreign bonds.

3.Asset Backed Securities.

4.Mortgage Backed Securities.

5.Collateralized Mortgage Obligations.Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 6610/2/201010/2/2010

1.1. Bonds and commercial paperBonds and commercial paper

A bond is an agreement to pay back a specified sum by a certain date. A. Short-term bonds have a maturity of up to 5 years,

B. A medium-term bond matures in 5–15 years,

C. While long bonds mature after 15 years or even longer.

The banks underwrite the placement of the bond on the market.

Government bonds are often sold by auction.Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 7710/2/201010/2/2010

Continue:Continue:2. Foreign bonds are issued by non-residents. 3. Asset Backed Securities The issue of asset backed securities is the process whereby

traditional bank assets (example, mortgages). Effectively, asset backed securitization means a large number

of homogeneous loans (income streams, maturity, credit and interest rate risks) are bundled together and sold as securities on a formal market. The process involves the following steps:A. Origination.B. Credit analysis.C. Loan servicing.D. Credit support.E. FundingF. Warehousing. Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 8810/2/201010/2/2010

ContinueContinue::4. Mortgage Backed Securities The Federal National Mortgage Association

encouraged financial institutions to securities as:A.commercial mortgages,

B. mobile home loans,

C. credit card receivables,

D.car loans,

E. computer and truck leases,

F. and trade receivablesMrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 9910/2/201010/2/2010

Continue:Continue:5. Collateralized Mortgage Obligations Mortgage Loan Corporation include collateralized

bond obligations (CBOs), offer a number of benefits:A. Release of core capital.B. Illiquid loans become liquid, C. Tradable securities.D. Investors are attracted to the bank.

In subsequent chapters, We will be observed that as banks continue to find new ways of transferring their credit risk to non-banking financial institutions..


2.3. The Effect of Non-interest Income on 2.3. The Effect of Non-interest Income on Banks’ Total IncomeBanks’ Total IncomeThe rapid expansion of new forms of off-balance sheet

activity means many banks are diversifying, and as a result, non-interest income is an increasingly important source of revenue because:

At least two-thirds of banks’ gross income comes from net interest income.

The source of the non-interest income varies, when it is divided into fees and commissions, profit and loss from financial operations.

Mrs. Shefa El Sagga F&BMPMrs. Shefa El Sagga F&BMP 111110/2/201010/2/2010

Discussion

Whether the diversification implied by the growth of noninterest?.?.

(Answer possibilities: Banks have already achieved a more stable revenue from these two types of negative sources income. 1. Net interest income2. Non-interest income).

10/2/201010/2/2010 Mrs. Shefa El Sagga F&BMPMrs. Shefa El Sagga F&BMP 1212

ContinueContinue:: Composition of non-interest income to be

heterogeneous, consisting of the following.1. Traditional fee income.2. Credit card fees. 3. Trust and fund management, 4. Global custody services.5. Newer sources of fee income.6. Fee income from off-balance sheet business. 7. Management consulting.8. Data processing.9. Securitization.10.Proprietary trading.


2.42.4 . .Global Markets and CentersGlobal Markets and CentersInternational banking is a logical extension of

domestic banking, and will include diversification away from the traditional core activities. The international banking as:

2.4.1. International Financial Markets.2.4.2. Key Financial Centers: London, New York

and Tokyo.


2.4.12.4.1 . .International Financial MarketsInternational Financial Markets In economics, a market is defined as: a set of arrangements

whereby buyers and sellers come together and enter into contracts to exchange goods or services.

An international financial market works on exactly the same principles. Financial markets are classified by several different criteria as follows:

1. The markets are global if instruments and services are traded across national frontiers and/or financial firms set up subsidiaries or branches in different national markets.

2. The maturity of the instruments being traded. 3. Maturity refers to the date when a financial transaction is completed.4. Whether the instruments are primary or secondary. 5. A primary market is a market for new issues by governments or

corporations, such as bonds and equities.


Discussion:Discussion:Q1: How the instrument is traded?.

Q2: What are the factors under consideration when analyzing the application for a loan?.

Q3: What are the different types of loans that commercial banks have refused practices?.


Continue:: Key international financial marketsIn the new millennium, nearly all financial markets in the main industrialized economies are international. Hence, global markets bring about a more efficient distribution of capital at the lowest possible price. Market imperfections are caused by the following factors.1.Differences in tax regimes. 2.Barriers to free trade including tariffs. 3.Barriers to factor mobility, such as capital controls, or restrictions on the employment of foreign nationals.4.Asymmetric information.


Continue: Stocks purchased on these markets help diversify investor

portfolios. The euro equities market has grown quite rapidly in recent

years, and caters to firms issuing stocks for sale in foreign markets. Firms issue equity on foreign stock markets for several reasons.

1. To increase their access to funds without oversupplying the home market.

2. To enhance the global reputation of the firm.3. To take advantage of regulatory differences.4. To widen share ownership and so reduce the possibility

of hostile takeovers.Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 181810/2/201010/2/2010

Continue: 5. To ensure that their shares can be traded almost

continuously, on a 24-hour basis.

6. Funds raised in foreign currencies can be used to fund foreign branches. However, foreign equity issues are not without potentially costly problems:

First, foreign equity investments may expose some investors to currency risk,

Second, to list on a foreign exchange.


2.4.2. Key Financial Centers: London, New 2.4.2. Key Financial Centers: London, New York and TokyoYork and Tokyo London, New York and Tokyo are the major international financial centers. One of the three exchanges can be used to trade equity on what is nearly a 24-hour market, there is a great deal of expansion in markets for instruments such as euro equities, euro commercial paper and derivatives, the most important factors of success following.

A. Competitiveness: Key FactorsB. ClusteringC. Offshore centers


A. Competitiveness: Key FactorsA. Competitiveness: Key FactorsAn important question is: what are the factors that make a centre competitive? A survey.

1. Skilled labor.2. Competent regulator.3. Favorable tax regime.4. Responsive government.5. A ‘‘light’’ regulatory touch6. Attractive living/working environment. where 1 is least competitive and 5 is most competitive. The scores

were as follows: New York London Paris Frankfurt London


B. ClusteringB. Clustering Clustering is the main explanation for the competitive success of a financial centre. A cluster as geographical concentrations of interconnected firms, specialist suppliers of goods and services, and firms in related industries. Clustering is made possible and sustained by the availability of factor inputs, such as capital, labor and information technology, the demand for the financial instrument/service.


Continue: Financial firms want to locate with other related financial institutions for a number of reasons. These include the following.

1. Thick labor markets.2. Information is an important component of

competitive advantage.3. Defensive strategy.4. Some services require face-to-face contact. 5. Joint services.6. Political stability and enhance a centre’s reputation

for quality.Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 232310/2/201010/2/2010

C. Offshore centersC. Offshore centers Offshore financial centers are primarily concerned with global financial transactions for on-residents; nationals are usually prohibited from using these services. Recently there has been pressure for these centers to come into regulatory line by eliminating exemptions. It is attract very high net worth to private clients and the large multinationals.


2.52.5 . .International BankingInternational Banking International banking has been special attention because:

there was a rapid increase in the scale of international banking.

The main banks from key western countries established an extensive network of global operations. To gain a full understanding of the determinants of international banking, it is important to address two questions:

1. Why do banks engage in the trade of international banking

services?.

2. What are the economic determinants of the multinational bank?.Mrs.Shefa El Sagga F&BMPMrs.Shefa El Sagga F&BMP 252510/2/201010/2/2010

2.5. International Banking2.5. International Banking2.5.1. International Trade in Banking Services.

2.5.2. Portfolio Diversification.

2.5.3. The Multinational Bank.


2.5.12.5.1 . .International Trade in Banking International Trade in Banking ServicesServicesComparative advantage is the basic principle

behind the international trade of goods and services.

Global systems/markets that facilitate trade in international banking services are discussed below as following:A. The International Payments System.B. The Euromarkets.C. The Interbank Market.


A. The International Payments SystemA. The International Payments SystemA payments system is the system of instruments

and rules which permits agents to meet payment obligations and to receive payments owed to them.

It becomes a global concern if the payments system extends across national boundaries.

The payments systems of New York and London take on global importance because they are key international financial centers.


B. The EuromarketsB. The EuromarketsEurobond and euro equity markets, However,

their contribution to the flow of global capital is worth stressing.

Development, foreign direct investment was the predominant source of global capital transfers between countries.

Euromarkets enhanced the direct flow of international funds.


C. The Interbank MarketC. The Interbank Market.. Used by over 1000 banks in over 50 different countries, the growth

of interbank claims has-been very rapid. Interbank trading in the Euromarkets accounts for two-thirds of all

the business transacted in these markets. The interbank market performs six basic functions:

1. Liquidity smoothing.

2. Global liquidity distribution.

3. Global capital distribution.

4. Hedging of risks.

5. Regulatory avoidance.

6. Central banks use the interbank markets to impose their interest rate policies.


2.5.2. Portfolio Diversification2.5.2. Portfolio DiversificationAnother reason why firms engage in international

banking is to further diversify their portfolios. Canadian banks are a case in point. The major

Canadian banks increased the foreign currency assets from the end of World War II on, for one of two reasons:

First, to increase external returns And second, to diversify portfolios and reduce risk.

Making international loans meant the banks could reduce the systematic risk arising from operating in a purely domestic market.


2.5.3. The Multinational Bank2.5.3. The Multinational BankA multinational enterprise (MNE) is defined as any firm

with plants extending across national boundaries.

Multinational bank (MNB) is a bank with cross-border representative offices, cross-border branches (legally dependent) and subsidiaries (legally independent).

Commercial banks, their primary function was to finance trade between the branches and the mother country. Branches were normally subject to tight control by head office.


2.6. Banking Issues in the 21st Century.2.6. Banking Issues in the 21st Century.A recent, popular opinion is that the contribution

of banks to the economy will diminish significantly or that banks will even disappear, as the traditional intermediary and liquidity functions of the bank decline in the face of new financial instruments and technology.

Financial systems evolve through time, passing through three phases.


Continue: Financial systems evolve through time, passing through three

phases.

1. Phase one is bank oriented, where most external finance is raised through bank loans, which in turn is funded through savings. and interest income is the main source of revenue.

2. Phase two is market oriented. begin to hold more securities and equity, and non-bank financial institutions may offer near-bank products, such as:

A. money market accounts.

B. Banks themselves reduce their dependence on the traditional intermediary function.

C. Increasing their off-balance sheet activities. Mrs. Shefa El Sagga F&BMPMrs. Shefa El Sagga F&BMP 343410/2/201010/2/2010

Continue:Third phase, trading, underwriting, advising and

asset management activities become more important for banks than the traditional core banking functions.

Web will offer banks great opportunities – It will be interesting to see which banks step up to this opportunity. . . (and have) turned potential threats into opportunities.

Comment After that:Mrs. Shefa El Sagga F&BMPMrs. Shefa El Sagga F&BMP 353510/2/201010/2/2010

2.6.1. Turning Threats into Opportunities2.6.1. Turning Threats into Opportunities

The figures on the performance of banks are mixed. While profitability was fairly static, it appears banks are looking for other sources of income by expanding into non-interest income areas as:

A. New technology and innovation.

B. E-banking and other remote delivery channels.

C. The growth of non-banks Consolidation.


A. New technology and innovationA. New technology and innovationEmergence of electronic (e-cash) or digital cash and

assume, for the moment, that it has replaced currency in circulation – a cashless society.

Development of technology to date, e-cash can consist of stored value cards, network money and e-wallets, It is characterized the following:

1. Stored value cards store prepaid funds electronically on a chip in the card.

2. Visa Cash is good examples.

3. The ‘‘smart card’’ stored value card, used widely in some parts of Continental Europe.


Continue:Customers can download cash from their

accounts into the card, but are more secure than cash because:

A. Personal information is stored in the chip, so only the owner can use the card.

B.The reduced chance of fraud (compared to a debit or credit card).

C.Attractive to customers and shop owners alike.


Discussion: Why the central bank concern to protection the balance of banks?.

With the most advanced technology, Banks are required studies to perform the core function to receive deposits and grant loans?.


B. E-banking and other remote delivery B. E-banking and other remote delivery channelschannelsIt is important to draw a distinction between the

question of whether digital cash will replace banks and the presence of electronic products which change the way intermediary banking services are delivered. They are two quite separate issues:

A.The main attraction of IT-based remote delivery.

B.Distribution of banking services is lower costs. Mrs. Shefa El Sagga F&BMPMrs. Shefa El Sagga F&BMP 404010/2/201010/2/2010

C. The growth of non-banksC. The growth of non-banksThe threat posed to traditional banks by the growth of non-

banks. Non-banks by definition, are firms which do not offer a complete core banking service but are very similar to banks. For example, personal loan or mortgage corporations specialize in loans or mortgages that are funded through:

A. Bond issues.

B. And/or by turning a bundle of assets into asset backed, or mortgage backed securities and selling them to raise liquidity.

Though they offer a ‘‘banking’’ product, loans/mortgages, they are not banks because They are not funded by deposits.


C. ConsolidationC. ConsolidationAnother important trend is increased

consolidation of the national banking sector through mergers and acquisitions.

Mergers of securities firms followed a similar trend. because of difficulties related and hidden in their balance sheets.


Chapter ReviewChapter ReviewQ1: How the instrument is traded?.Answer possibilities: There is room for circulation, and geographic location,

Instruments and bonds are traded through the open investment portfolios of shares, Instruments and bonds provide protection to investors by giving them the ability to diversify risk by providing investment tools with less risk and safe return periodically).

Q2: What are the factors under consideration when analyzing the application for a loan?.

(Answer possibilities: Ability to pay, Good reputation, Initial capital, Mortgage, Economic conditions).

Q3: What are the different types of loans that commercial banks have refused practices?.

(Answer possibilities: to change the ownership of the organization, to finance Fictitious companies, Loans Backed Mortgage for the second degree, Loans Backed Securities of the second degree, or not listed on the market, to finance new organizations if there are no adequate safeguards ).


Chapter ReviewChapter ReviewQ4: Why the central bank concern to protection the balance of banks?.(Answer possibilities: It issues the currency. Therefore cannot fail. And it also acts as lender of last resort).

Q5: With the most advanced technology, Banks are required studies to perform the core function to receive deposits and grant loans?. (Answer possibilities: The time and cost of collecting the information required to locate the optimal place for a deposit, Pool risks with other depositors or to locate the most suitable borrower(s)).


Home work:1. Why do banks engage in the trade of international banking

services?.

2. What are the economic determinants of the multinational bank?.

3. How funding the growth of non-banks?.

4. What are the definition of instruments?.

5. What is securitization?. Web will offer banks great opportunities – It will be

interesting to see which banks step up to this opportunity. . . (and have) turned potential threats into opportunities. Comment After that.


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Mrs.Shefa El Sagga F&BMP110/2/2010. Chapter 2 Mrs.Shefa El Sagga F&BMP2 Diversification of Banking...

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