Banks

What are the functions of commercial banks?

1. Accept deposits

2. Provide loans

3. Overdraft

4. Investment of funds

5. Agency functions

Types of deposits

Demand: can be made or withdrawn immediately

Fixed: Store money for a long period of time, with higher rates of interest

Savings: lower rates than fixed, can withdraw money more often.

Agency functions - explained

They represent their consumers, collect cheques and dividends, pay/accept bills, deposit interest, and income tax, buy/sell securities and arrange the transfer of money for consumers.

Examples of commercial banks

Natwest, Barclays, HSBC, Lloyds

Liability - definition

Something which must be paid/ the bank owes. 

A claim on assets 

How do banks use liabilities?

To buy assets, and income can be earned from these assets

What are examples of liabilities?

Share capital, deposits, borrowing

Assets - definition 

Something that can be sold for value, it is owned by banks or owed to them.

Whats owner’s equity or bank capital?

Whats left over when assets have been sold and liabilities have been paid

Examples of assets

Cash, securities and bills, loans and investments

What are the objectives of commercial banks

• Liquidity

• Profitability

• Security

How do these objectives conflict?

Liquidity vs profitability - more liquid assets like cash/ deposits make less money

Security vs profitability - riskier assets are more profitable

How are investment banks different?

Provide financial services to corporations and high net worth individuals rather than regular individuals or firms. 

What services do investment banks offer?

Underwriting securities, mergers and acquisitions advisory, trading, research, and asset management.

How do banks create credit?

Banks make loans, and creates a deposit in the customer’s account.

The customer becomes a debtor of the bank.

The loan is an asset for the bank (owed to it)

The deposit is a liability (they owe it)

What are the limits to credit creation 

• Reserve ratio: banks must keep a fraction of deposits as reserves

• Low demand for loans

• Outflows of cash

• Low confidence on either side

• High rates

• If these loans become unprofitable

What systemic risk

Built in risk in the system. It can mean that the failure of an individual bank may cascade into system wide collapse, e.g. 2008 crisis

Examples of investment banks

JP Morgan, Morgan Stanley, Goldman Sachs

Examples of both commercial and investment banks

HSBC, Barclays, Societe Generale

Other financial institutions

Pension funds - collect pension savings and invest them in securities

Insurance firms - charge customers fees to provide protection against risk

Hedge funds - invest pooled funds in the hopes of high returns. They take high risk

Private equity firms - invest in businesses to maximise returns. they often asset-strip and cut jobs when businesses are failing.

Why do banks fail (6)

1. Poor management

2. Lack of diversification

3. Insufficient reserves

4. Run on the bank

5. Economic downturns

6. Regulatory failures

Poor management - explained

Taking on too much risk, making bad loans

Lack of diversification - explained

Loan portfolio isn’t diverse, overexposed to failure of one asset/ sector

Insufficient reserves

May be due to illiquidity, can’t cover bad loans

Run on the bank

If too many depositors withdraw money at the same time due to a loss in confidence in the bank

Economic downturns

Recessions and higher interest rates can lead to an increase in loan defaults and a fall in the value of the banks assets

Regulatory failure

Inadequate oversight can lead to risky bank practices, fraud and corruption and ultimately commercial bank failure

Examples of bank failures

Northern Rock: failed in 2007 and was subsequently sold to virgin money

RBS: exposure to bad loans and toxic assets, required bailout and govt took a majority stake

Lloyds TSB: required bailout due to its acquisition of RBS, eventually bought by Sabadell

Silicon Valley Bank: 2023, disproportionately invested in long dated US bonds, when higher interest rates caused a fall in their value. Not enough cash to cover the deposits of their savers. Confidence collapsed, run on the bank

Central bank: two main functions

1. Maintain financial stability - the lender or last resort, commercial banks can borrow in short term when facing shortfall of cash. This minimises systemic risk and ensures depositors are protected

2. Help the govt maintain macroeconomic stability - delivery price stability, 2% +-1%.

Other functions of central bank

1. Issuance of notes and coins

2. The bankers bank

3. The governments bank

Buy and sell currency to influence exchange rate

New roles of central banks since 2008

1. Promote the safety and soundness of financial firms

2. Regulations to enhance the resilience of the financial system

What changed in financial regulation in. 1985-7?

Deregulation of the London stock exchange led to the big bang.

Reduction of currency exchange controls

Financial market liberalisation

1997 financial regulation

Bank of England no longer supervise banks, instead an independent financial services authority set up as a single unified regulator

What happened in 2013 to financial regulation?

Financial services authority split into an indecent financial conduct authority and the Bank of England’s prudential regulation authority

Difference between prudential and conduct authorities?

Prudential - supervises the safety of the industry

Conduct - regulates conduct and competition in the sector

What’s the financial policy committee ?

part of the bofe, it identifies and monitors and takes action to reduce systemic risk

Moral hazard - definition

Lack of incentive to guard against risk where one is protected from it’s consequences

Liquidity ratio - definition

The ratio of liquid assets held by a bank to their overall assets, need enough to cover expected demands from depositors

Capital ratio - definition

Measures the funds it has in response against the riskier assets it holds that could be vulnerable in the event of a crisis.

What’s a potentially risky strategy for a commercial bank?

Long term lending and short term borrowing. As if this investments go bad, cannot provide depositors with money when demanded

Key examples of bank failures that regulation may have prevented

The LIBOR scandal, the Enron Scandal, the 2010 Wall Street Flash Crash, the 2008 sub-prime mortgage crisis