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Topic 1: The Modern Bank

Topic 1: The Modern Bank. The Modern Bank. Lecture Outline Defining banks Differentiating banks Types of Modern banks Investment Banks Retail and Universal Banks Issues Facing the Modern Bank. Banks: What and Why?. Operational definition used by regulators

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Topic 1: The Modern Bank

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  1. Topic 1: The Modern Bank

  2. The Modern Bank Lecture Outline • Defining banks • Differentiating banks • Types of Modern banks • Investment Banks • Retail and Universal Banks • Issues Facing the Modern Bank

  3. Banks: What and Why? • Operational definition used by regulators • A bank is an institution whose current operation consists in granting loans and receiving deposits from the public. • Banks act as intermediaries b/w depositors and borrowers.

  4. Banks: What and Why? • Why do borrowers and lenders not come together w/o an intermediary? • Answer: • Borrowers and lenders have different liquidity preferences. • The presence of information costs.

  5. Information Costs • Four types of information costs may incur to lender w/o intermediation i.  Search cost contact of two parties ii. Verification cost verification of information provided by borrower iii. Monitoring costs monitoring of activities of borrower vi. Enforcement cost in case of default  

  6. Information Costs • Lenders will go to a bank for intermediation if the intermediary cost is less than the four cost components. • Bank may also enjoy “informational economies of scope.” • Economies of scope are said to exist when two or more products can be jointly produced at a lower cost than if the same products are produced individually.

  7. Information Costs • Banks can pool funds from different lenders (depositors) and can give liquidity at cheaper prices. • This makes intermediation cost for the banks even less. • In addition, firms may take loan from the banks to send the signal to others that firm is likely to be stay in business and thus encouraging customers and suppliers to enter into long term relationship largely due to creditworthiness.

  8. Differentiating Banks • Banks are different from other financial firms in that they deal in (provide) both deposit and loan products. • The deposit/loan products pay out/in money. • Thus banks manage liabilities (deposits) and create assets by lending.

  9. Modern Day Banks • Broadly speaking modern day banking consists of two types of banks. • Wholesale banks focus on investment market and large clients. • Generalist (retail and universal) banks offer wide range of products such as: • Deposit accounts • Loan products • Real estate services • Stock broking • Life insurance

  10. Wholesale Banking- Defined • Wholesale banking may be described as a “small number of very large customers” i.e. corporations and governments. • These banks are firms, which act as “private bankers” - accepting deposits from high net worth individuals and investing in broad range of financial assets. • These banks with small deposit base have an access of a wide range of funds from the equity, bond and syndicated loan markets. • Wholesale banking is largely interbank • Examples • ABN AMRO, MORGAN STANLEY

  11. Wholesale Banking - Services Provided • Modern wholesale (particularly USA investment banks) banks are engaged in: • Finance wholesaling • Underwriting • Market making • Consultancy • Mergers and acquisition • Fund management

  12. Wholesale Banking - Services Provided • The traditional functions of UK Merchant Banks also include the same as that of their cousins in USA specifically: • Finance trade by charging a fee to guarantee merchant bills of exchange • Underwriting • Initiating or arranging financial transactions • Market making • Mergers and acquisition • Dealing in securities on behalf of investors

  13. Wholesale banking-where we are? • There had been a rapid growth in wholesale banking for the last two decades • Reason • Relationship banking has reduced the cost of contracting • Enhanced profit due to; • delegation of evaluation of borrower to credit rating firms • growth of MNCs

  14. Retail banking- defined • Retail banking may be described as “large number of very small customers” i.e. households. • Such a system of banking is usually characterised by small number of banks with extensive branch networks (with the exception of the USA) • Retail banking is largely intrabank (the bank itself makes many small loans) • Example • NATWEST, BARCLAYS, HSBC

  15. Retail Banking - Services Provided • Services provided are: • Safe store of wealth • Payment mechanisms (money transmission system) • Financial intermediation (savings and lending) • Other wide services such as financial advice, FOREX, share dealing, insurance etc.

  16. Retail banking-where we are? • Retail banking has witnessed rapid “process innovation” for the last two decades specifically: • Replacement of cashier with machine cost reduced to 25% of cashier • ATM facility domestically as well as worldwide • Telephone banking • Video linked financial services • Electronic cash e-cash • Debit and credit cards Visa and MasterCard • Virtual banking by internet

  17. Universal Banking - Defined • Universal banking refers to the provision of most or all financial services under a single, largely unified banking structure. • Very common in Germany. • Walter (1994) identified four types of universal banks: • Fully integrated universal banks- supplying all financial services from one entity • Partially integrated financial conglomerates able to supply all services but some like mortgage, leasing and insurance are provided through subsidiaries

  18. Universal Banking-defined iii. Bank subsidiary structure bank concentrates on retail banking and remaining activities like investment banking and insurance through legally separate subsidiary of the bank vi. Bank holding company structure financial holding company owns both banking and non-banking subsidiaries. - Holding company may be non-financial firm or holding company itself may be an industrial concern

  19. Universal Banking-services provided • Universal banking may include: • Intermediation • Trading of financial instruments, foreign exchange and their derivative • Underwriting new debts and equity • Brokerage • Corporate advisory services(mergers and acquisition advice) • Investment, management, insurance • Holding equity of non-financial firms

  20. Universal Banking-where we are? • Banks all around the world are trying to become universal • Natwest, Barclays and HSBC are offering a broad range of services, ranging from deposit taking and loan making to investment advice.

  21. Issues Facing Modern Banks • Various factors that affect banks include market, social, legal and regulatory constraints. Some of these are given below: • Inflation and volatile interest rates: • Also, as rates rise, the market value of a bank’s assets decline and borrowers default on loans with greater frequency than normal. • Technological advances: • Telecommunications and computers are increasing economies of scale and scope for banks.

  22. Issues Facing Modern Banks • Consumers have become more sophisticated. • Global integration of financial markets is increasing competition from foreign financial service firms. • Problems in Banking: • Principal agent problem • Moral Hazard problem • Adverse selection problem • We will outline these problems further in the next lecture, as well as discuss methods of resolution.

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