Banking and Financial Intermediation

Introduction to Banking

  • BKF 1243 Foundations of Banking, Finance and Investments - Lecture 3
  • Dr Robert Suban, Department of Banking, Finance, Investments, University of Malta

Lecture Outline

  • Introduction & Definitions
  • The nature of financial intermediation
  • The Role of Banks
  • Information economies
  • What distinguishes banks from other financial institutions?
  • What are services typically offered by banks
  • What are the different types of banks
  • How do banks make money?

Introduction: Core Questions

  • What do banks do?
  • What makes banks so special?
  • As a business, why are banks different than any other business?
  • What functions do banks fulfill in the economy?

Hypothetical Scenario: A World Without Banks

  • Payments would be restricted to cash only.
  • Storing value would primarily be in the form of cash.
  • Large projects like buying a car or house, or developing businesses would be nearly impossible.
  • Economic development would be significantly hindered.

Malta's Private Sector Debt (2020)

  • Chart showing private sector's debt as % of GDP (Consolidated).
  • Includes debt of households, consolidated debt of NFC, and EA-Consolidated private sector debt.

Malta's Total Debt (2020)

  • Chart showing NFC Debt by creditor sector in EUR millions.
  • Breakdown includes financial corporations, NFCS, Households, General government, and Rest of the world.

Malta's Households' Debt (2020)

  • Chart showing households' debt in EUR millions.
  • Debt distribution among Banks, Non-bank financial institutions, NFCs and General government.

Definitions: Economic Units

  • Surplus Unit: An economic unit (company, government, household) whose income exceeds its expenditure. They have a surplus of funds which can be lent (lenders).
  • Deficit Units: An economic unit (company, government, household) whose expenditure exceeds its income. They have a deficit of funds and need to borrow to make up for the deficit (borrowers).
  • Financial Claim: A financial claim is generated whenever an act of borrowing takes place.
  • Financial claims can take several forms, such as money, bank deposit account, bonds, shares, loans, etc.
  • The lender holds a financial asset.
  • The borrower holds a financial liability.

Money Flow: Savers to Borrowers

  • Money flows from savers to borrowers through either direct or Indirect finance.

Definitions (cont.)

  • Indirect Finance: Borrowers obtain funds from a financial intermediary, such as a bank, and lenders deposit money into a financial intermediary.
    • Example: Getting a Loan from a bank
  • Direct Finance: Borrowers (deficit units) obtain funds directly from lenders (surplus units) without the need of intermediation.
    • Example: A Bond issue via financial markets (stock exchange)

Direct and Indirect Finance: Key Differences

  • Indirect Finance: Savers/depositors do not know who the borrowers are and vice versa; only the financial intermediary knows.
    • Example: A deposits money in Bank BOV which lends money to B
  • Direct Finance: Savers/depositors are purchasing the financial assets issued by the borrowers (ex: bond issue).
    • Example: A saver buys the bond of Coca Cola
  • Diagram showing the flow in both direct and indirect finance.

The Financial Intermediation Process

  • Diagram illustrating the intermediaries liability and borrowers liability.
    • The intermediary pays interest to atract funds.

Problems Associated with Direct Finance

  • Discussing the problems associated with direct finance.

Definitions (cont.): Problems with Direct Finance

  • Transaction costs: costs of searching for counterparty, obtaining information, negotiating contracts, monitoring borrowers, and enforcement costs in case of default. These create information asymmetries i.e. market failures.

Overcoming Problems: Indirect Finance

  • Resorting to indirect finance, i.e. banks to overcome the problems of direct finance.

Lenders’/Borrowers’ Requirements

  • Lenders’ Requirements
    • Minimisation of risk
    • Minimisation of costs
    • Liquidity
  • Borrowers’ Requirements
    • Funds to be available at a specific date
    • Funds to be available for a specific period (usually long-term)
    • Funds to be available at the lowest possible cost
  • Conclusion: There is a mismatch between borrowers and lenders requirements.

The Nature of Financial Intermediation

  • Financial intermediaries can bridge the gap between borrowers and lenders by satisfying the often incompatible needs and preferences of these two groups.
  • Financial intermediaries help to lower transaction costs:
    • Search costs
    • Costs of obtaining information about them
    • Costs of negotiating the contract
    • Costs of monitoring the borrowers
    • Enforcement costs (in case of default)
  • Financial intermediaries also help to overcome information asymmetries
  • Which one to choose? direct or indirect finance?

The Role of Banks

  • Understanding why indirect finance has advantages over direct finance requires understanding the role that banks fulfill.

The Role of Banks: Core Functions

  • Banks fulfill three main functions
    • Size transformation: By pooling small depositors funds into large loans
    • Maturity transformation: By transforming short-term deposits into long-term loans
    • Risk transformation: By minimising risks through diversification, screening, monitoring, and holding capital and reserves in case of losses

Theories of Financial Intermediation

  • Banks as delegated monitors (Diamond 1984): The monitoring of loan contracts is delegated to banks by small depositors
  • Banks as producers and processers of information: comparative advantage
  • Banks as transformers of liquidity
  • Banks as enabling consumption smoothing

Banks vs. Other Financial Institutions

  • Banks have unique characteristics that differentiate them.

Banks/Other Financial Institutions: Differences

  • Banks
    • Allowed to take Deposits from customers
    • Customers can access their money at any time
    • Customer deposits are guaranteed
  • Other Financial Institutions
    • Examples: insurance companies, pension funds, investment companies, Money broking
    • Not allowed to take deposits from customers
    • Customers can get access to their money when contract expires
    • Limited/no guarantee on customer deposits

Typical Services Offered by Banks

  • Range of activities that banks typically offer.

Range of Activities that banks typically offer

  • Accepting Deposits
  • Payment Services (cheques, money transfers, credit cards, etc.)
  • Loans (all types: home, car, personal, business)
  • Foreign exchange services
  • Advising and Managing investments
  • Stockbroking (buying/selling shares/bonds)
  • Bancassurance (selling insurance contracts like home/life insurance)
  • Assisting businesses to raise finance in financial markets (bonds or shares)
  • Providing bank guarantees
  • Internet and Mobile banking

Types of Banks: Central Banks

  • There is only one central bank per country.
  • Examples: Central Bank of Malta, Bank of England, Federal Reserve, Deutsche Bundesbank

Central Banks: Typical Functions

  • To manage monetary policy with the aim of achieving price stability
  • To prevent liquidity crises (Banks) = financial stability
  • Prevent situations of money market disorders and financial crises
  • To ensure the smooth functioning of the payment system (TARGET2 (Trans-European Automated Real-time Gross settlement Express Transfer system))

Retail/Personal/Commercial Banking

  • Retail or personal banking relates to financial services provided to consumers/SMEs and are usually small-scale in nature. Also referred to as High-Street Banks (the bank of mom and pop)
  • Personal Banking Services Typically Include:
    • Payment Services (Cheque, credit transfer, Standing orders, direct debits, plastic money)
    • Savings
    • Loans
    • Mortgages
    • Insurance
    • Pensions
    • Other Services

Personal/Commercial Banks: Examples

  • Logos of HSBC, BOV (Bank of Valletta), APS, BNP PARIBAS, Deutsche Bank, UniCredit.

Private Banking

  • Consists of providing financial and related services to wealthy clients (High-Net- Worth)
    • Retail-banking products (payment and account facilities)
    • Up-market investment-related services
  • The Major components of private banking services:
    • Tailoring services to individual client requirements
    • Anticipation of client needs
    • Long-term relationship orientation (Different generations of same family)
    • Personal contact
    • Discretion
  • The market for private banking is segmented according to the amount of investable assets
    • Low-end start from $250,000 up to top-end which have over $100 million of investable assets
  • High net worth individuals (HNWIs)

Private Banks: Examples

  • Logos of LOMBARD ODIER, PICTET, CREDIT SUISSE, UBS, JULIUS BAER.

Investment Banking

  • The main role of investment banks is to help companies and governments raise funds in the capital market either through the issue of bonds or equity (eg. Goldman Sachs, Merrill Lynch, Morgan Stanley)
  • Investment banks also offer advisory services on corporate restructuring or mergers and acquisitions (M&A)
  • Their services typically include:
    • Financial advisory– Mergers and Acquisitions (M&A advice)
    • Underwriting of security issues (guaranteeing a price at which new equity or bonds will sell for)
    • Trading and investing in securities on behalf of clients or own trading
    • Asset management (for corporations or institutional investors) or wealthy private individuals (private banking)
    • Other securities services (brokerage, financing services and securities lending)
  • Note: Investment banks do not take deposits from customers

Investment Banks: Examples

  • Goldman Sachs, Morgan Stanley, Bank of America, J.P. Morgan, citibank, Deutsche Bank.

Universal Banking

  • These are banks that do everything:
    1. Personal/Commercial Banking
    2. Private Banking
    3. Investment Banking
  • Examples: HSBC, BNP Paribas, Deutsche Bank, UBS and Credit Suisse Bank of America, JP Morgan, Citigroup

Islamic Banking

  • Western-based or conventional banking business is interest-based
  • Islamic banking business is now developing in various parts of the world and is non-interest based - Therefore, the products of such banks cannot charge or pay interest
  • Islamic Shariah law prohibits the payment of riba or interest but encourage entrepreneurial activity - Instead they offer products and services that involves profit-sharing (Liability is unlimited and partners contribute both capital and management)
  • There are currently more than 100 Islamic banks and most are based in Middle-East - But.. Western banks have introduced such type of banking for Muslim customers in the western world.

100 % Online Banks

  • This is an example of Fintech
  • They are like traditional banks but without branches/branch network
  • Customers do everything online or via telephone
  • Normally they do not offer the full range of products/services (tend to specialise on most profitable and/or easiest)

100% Online Banks: Examples

  • Starling Bank, monzo, N26, SoFi, chime, Revolut.

How Banks Make Money

  • For Commercial Banks
    1. By Lending Money (Net interest margin)
    2. Fee and Commission income (on other services)
  • For Investment Banks
    1. By assisting companies to issue securities
    2. By assisting companies in M &A activities
    3. Own Trading (not all banks)

Simplified Bank Balance Sheet

  • Assets
    • Cash (available for depositors to withdraw money)
    • Liquid Assets
    • Loans (to clients who are borrowers)
    • Other investments
    • Fixed Assets (buildings of the bank’s branch network)
  • Liabilities and Equity
    • Customer Deposits
    • Equity/Capital (Difference between total assets and total liabilities)

BNP Results 2024

  • Revenues in 4Q24 driven by solid commercial performances in each operating division.
  • Includes: Corporate & Institutional Banking, Commercial, Personal Banking & Services, Investment & Protection Services
  • Discusses the increase in revenues.

Goldman Sachs Results 2024

  • Financial Results
  • Global Banking & Markets, Asset & Wealth Management, Platform Solutions
  • Discusses the Pre-tax earnings Net earnings Net earnings to common Diluted EPS, ROE, ROTE, Efficiency Ratio

Key Takeaways

  • How banks are an essential factor in economic growth
  • The essential role that banks play in modern economies
  • The role that banks play in facilitating financial intermediation
  • The different types of banks and how they make money