4. Banking Business

What are the two types of financial intermediaries

Deposit Taking Institutions (DTIs)

Non Deposit Taking Institutions (NDTIs)

What are the flow of funds referred to as in deposit taking institutions

Discretionary - The depositor is free to add/remove the funds at any point in time and they can decide how much to add/remove

What are the flow of funds referred to as in non deposit taking institutions

Contractual - You will not get the money at any time. What you receive depends on the contract

What are the features of deposit taking institutions (DTIs)

Offer (discretionary) deposits that can accommodate the amount and liquidity desired by surplus units

Repackage funds received from deposits to provide loans of the size and maturity desired by deficit units

Accept the risk on the loans provided

Have more expertise than individual surplus units in evaluating the credit-worthiness of deficit units

Diversify their loans among numerous deficit units and therefore can absorb defaulted loans better than individual surplus units could

What are the three transformation functions of banks

Size Transformation

Maturity Transformation

Risk Transformation

What is the size transformation function of banks

Banks collect many small deposits from savers and combine them into larger loans for borrowers

What is the maturity transformation function of banks

Banks convert short term deposits into long term loans creating a maturity mismatch on their balance sheet

Banks are said to be “Borrowing short and lending long”

What is the risk transformation function of banks

Banks minimise the risks associated with financing a single borrower by diversifying their portfolios of assets, pooling the risks, screening and monitoring the borrowers as well as holding capital against unexpected losses

Why are banks’ deposits special

Banks’ deposit liabilities play an important role in creating and managing money in the economy as is also often seen as one of the main reasons for more strict regulation on the banking system rather than other non deposit taking institutions

Explain the credit multiplier model

Initial deposit (of e.g. £50) is made at a bank

Bank keeps a fraction of the deposit as reserves (required reserve ratio) (assuming a 10% reserve ratio the bank keeps £5)

The bank will then lend out the rest of the money (£45) to a borrower who spends it

That money is deposited into a different bank which creates a new £45 bank deposit

This process repeats and further deposits and loans are created

The money supply increases

What is the formula for the credit multiplier

Either:

∆ Deposits / ∆ Reserves

Or

1 / Required Reserve Ratio

What is the formula for the money supply

Money Supply = Initial Deposit x Credit Multiplier

What are the drawbacks of the credit multiplier model

Banks/depositors could not deposit the rest of the money instead they could hold it in cash or they could invest it in financial instruments

Banks could decide to hold more than the required reserve ratio leading to a smaller expansion than the model predicts

There are leakages from the system - money flows abroad, people hold money as cash or buy government bonds rather than bank deposits

What are bank assets

Any item that the bank owns, or is owed, is an asset. These include cash held, deposits held with other banks, financial assets such as stocks and bonds, physical assets such as its branches and loans made to a customer

Loans are the largest asset class by value for the vast majority of commercial banks

What are bank liabilities

Any item that the bank owes to others is treated as a liability

Customers deposits are the largest liability class

What are bank objectives

Traditional banks strategically focus on lending and deposit gathering as their main objectives

Profits derive from net interest income (interest revenues from lending - interest cost on deposits)

Banks aim to maximise profits by controlling operating costs

Banks can operate with a lower level of capital (and higher leverage) than non-financial firms

What is bank capital

The difference between total assets and total liabilities is the bank capital (equity)

Banks can issue equity and save from past profits (retained earnings)

How does regulation assign a special role to bank capital

Bank capital is intended to act as a cushion against losses in order to protect depositors

It also creates an incentive for bank owners to refrain from excessive risk taking

Insolvency occurs when the bank’s assets are below the bank’s liabilities

What is the difference between traditional and modern banking in terms of product and services

Traditional - Loans, deposits

Modern - Loans, deposits, insurance, securities/investment banking, pensions, other financial services

What is the difference between traditional and modern banking in terms of income sources

Traditional - Net Interest Income

Modern - Net Interest Income, Fees and Commissions Income

What is the difference between traditional and modern banking in terms of competitive environment

Traditional - Restricted

Modern - High Competition

What is the difference between traditional and modern banking in terms of strategic focus

Traditional - Assets size and growth

Modern - Returns to shareholders, creating shareholder value

What is the difference between traditional and modern banking in terms of customer focus

Traditional - Supply led

Modern - Demand led, creating value for customers

What is a universal bank/universal banking

Universal Bank - An institution which combines its strictly commercial activities with operations in market segments traditionally covered by investment banks, securities houses and insurance firms

Universal Banking - The banking business is broadly defined to include all aspects of financial service activity – including security operations, insurance, pensions, leasing and so on

What is ring fencing

A regulation that requires banks to separate their everyday retail banking activities from their riskier investment banking activities

What are the two pillars that ring fencing relies on

Resilience - Protecting the retail banking activity from risks unrelated to it

Resolution - Allowing banking groups to fail in an orderly manner in case of trouble

What is the scope of ring fencing

To avoid the spread of problems across the financial system e.g. systemic risk

What are the core banking services

Facilities for accepting of deposits or other payments into an account

Facilities for withdrawing money or making payments from such an account

Overdraft facilities in connection with such accounts

What is the payment system

The network of financial institutions and processes that allow the transfer of funds/assets between individuals, businesses and financial institutions

What is at the heart of the payment system

Cheques

Debit and Credit Cards

Giro or Credit Transfer

Direct Debits

Standing Orders

What are the types of deposits and lending that banks offer

Current or Checking Accounts

Time or Saving Deposits

Consumer Loans and Mortgages

What are other products that banks offer

Investment Products

Pension and Insurance Services

Payment Protection Insurance

What is conduct of business

How financial institutions treat their retail customers and how they behave in the market

What is conduct risk

The risk that a bank’s behaviour leads to poor outcomes for customers or damages market integrity

Why is conduct of business important

Misconduct costs society, not just the bank: customers lose money, firms pay fines and compensation, and public trust in banking falls.

Manipulation of financial markets distorts the proper functioning of these markets, allowing banks to profit from undue rents

Moreover, when misconduct is finally revealed, banks can be faced with severe penalties (financial and other) and this may have consequences for financial stability

What are litigation costs

The expenses involved in taking a legal dispute to court or defending yourself against someone else's legal claim

Banks are required to set aside reserves for their coverage

This also helps to restore confidence of the investors