AMERICAN COLLEGE S K O P J E ”PRINCIPLES OF BANKING” Chapter 5

1. AMERICAN COLLEGE S K O P J E   ”PRINCIPLES OF BANKING” Chapter 5  Instructror: Tome Nenovski, Ph. D.

2. 5. BANK INDUSTRY INNOVATIONS - Bank innovation – factor for keeping or even, increasing bank wealth; - Because of many reasons, traditional banking is not as profitable as it used to be: - Some traditional bank products have stopped being sold; - Fund resources have become narrow; - Strong bank regulation: Liabilities interest rates limitation; - Needs for new profitable bank products;

3. 5. BANK INDUSTRY INNOVATIONS - Developing new balance and off balance products; - Appearance of bank innovations; - Innovations = Systemic bank changes process;

4. 5. BANK INDUSTRY INNOVATIONS Innovation forms: - new products and services; - new organizational forms; - new systems for realizing bank clients orders; - finding new markets for securing liquidity; - changes in financial instruments etc.

5. 5. BANK INNOVATIONS - Computer and information technology as innovation source; - Introducing and developing financial engineering: inbounding some financial instruments to their consisted parts and their rebounding (new packing) in new instruments; - Introducing financial derivatives (futures, options, swaps); - New possibilities for transfer risk to other subjects; - Final result of introducing innovations: Bank profitability increase.

6. 5.1. Factors that create innovations - Instigators of huge banking changes in particular country are: Tax laws changes; technology progress; inflation rate changes; interest rates changes; foreign exchange rate changes; economic activity changes; regulation framework changes etc.

7. 5.1. Factors that create innovations - On global level there are couple of factors that induced innovations which are spread to the banks all round the world: a) deregulation; b) information technology; c) globalization; d) economy of scale; e) economy of scope (diversification).

8. 5.1.1. Deregulation - Banks are most regulated institutions within the economy; - Bank regulator determines what products and services bank can sell, who can govern bank, on which market bank can act etc.; - Big alternation: Bank deregulation = No limits for interest rates, directing bank credits and narrow bank specialization; possibility for usage new flexible financial instruments (financial derivatives, new off-balance sheet products etc.); Notice: Deregulation is not same as reregulation!

9. 5.1.2. Competition - Deregulation derived bigger bank (and financial market) competition and rivality; - Two types of competition: a) Price (interest rates) competititon; b) Product competition.

10. 5.1.3. Information technology - Info-technological revolution; - Transfering money and data at the same moment; - Need for changing classic bank organization (narrowing the number of branches); - Internet development (banking on line); - Virtual bank appearance.

11. 5.1.4. Globalization - Internationalization and globalization of bank activities; - Global or planet banks; - Big banks buy majority of shares of a certain bank they are interested in; - Universal banks are mostly represented in this process.

12. 5.1.5. Economies of scale - Bank deregulation – smaller bank profits margins; - Creating new bank products for compensating profit decrease; - Developing cost-benefit and trade-off bank functions and activities; - Two ways for introducing and developing economies of scale: a) Internal (bank own total development); b) External (bank merger and acquisition). - Goal: Decreasing bank costs.

13. 5.1.6. Economies of scope - Bank activities diversification; - Broadening bank activities in insurance, brokerage, investment funds; - Additional bank activities, lower costs and higher bank income; - Cross-selling services; - One-stop- banking; - Banks as financial supermarkets.

14. 5.2. More important bank innovation - Banks use new instruments for financing their activities, lowering costs and reducing risks; - Most important instruments are: a) Financial derivatives; b) Securitization; c) Selling credits; d) Stand by guarantees; e) Credit derivatives; f) Electronic banking; g) Bank innovations in dealing with securities.

15. 5.2.1. Financial derivatives - Instruments for hedging bank risks; - Appeared in 80’s and 90’s of XX century; - Types: forwards, futures, options and swaps; - More elaboration about these bank innovation in Chapter 7.

16. 5.2.2. Securitization - Definition: Conversion of part of the bank assets with lowered market value in securities that are acceptable for investors on secondary market; - Transforming part of bank credits into securities, usually bonds – Asset backed securities; - Goals: Regulating bank liquidity, hedging interest rate risk, finding income resource, accomplishing capital adequacy obligation etc.; - Securitization process (to be explained);

17. 5.2.2. Securitization/2 Participants in securitization process:

18. 5.2.2. Securitization/3 - Bank benefits from securitization: a) Securing liquidity; b) Hedging interest risk; c) Decreasing credit risk; d) Increasing bank profit; e) Accomplishing capital adequacy;

19. 5.2.2. Securitization/3 - Usage of securitization for collecting funds on lower price rather than costs for collecting deposits: - Bonds are part of the bank balance sheet; - Bonds obligation are paid by the bank; - Bonds price is lower than deposit price; - The term of bond maturity, usually, is longer than deposit term of maturity – The average Liabilities term of maturity becomes longer; - Weaknesses of that kind of securitization: -Need for additional increase the capital amount (Problem with accomplishing capital adequacy level); - Reserve requirement accomplishing problems.

20. 5.2.3. Selling credits - Banks sell new credits or credits with term to maturity up to 3 months; - Reasons why banks sell credits: - changing lower yield with higher yield credits; - lowering credit and interest rate risk; - lowering credit exposure; - getting liquid funds needed for investing in higher yield projects etc.

21. 5.2.3. Selling credits/2 - Credits buyers are: other banks, insurance companies, pension funds, mutual funds, big investment banks etc.; - Usually bank-credit seller keeps the right to take care for that credit on behalf of the credit-buyer; - Types of selling credits; - Participative credits; - Reproaching (transfering) credit to its buyer; - Selling credits on parts. - Selling credits weaknesses.

22. 5.2.4. Stand by guarantee - Definition: Financial instrument through which the bank guarantees that a particular client will fulfill his credit, securities or project obligation; - Stand by guarantee could be: a) Performance guarantee; b) Repayment guarantee. - Stand by guarantee is bank potential obligation; - Advantages: low issuing costs; low risk; profitability; big help for bank client; - Weaknesses: liquidity risk and interest rate risk.

23. 5.2.5. Credit derivatives - Bank security in a case of inability of a credit pay off; - Credit swaps: Two banks agree to change repaid parts of credits they have extended to their clients; - Advantages of credit swap: - Each bank can disperse its credit portfolio risk; - Spreading bank presence on other markets.

24. 5.2.5. Credit derivatives/2 - Full return swap; - Credit options: - Bank protection from extended credit value loss; - Setting off higher borrowing costs because of bank credit rating changes.

25. 5.2.6. Electronic banking - Modern technology revolution; - Electronic funds transfer; - Automatic teller machines – ATM introduction; - Point of sale – POS or Electronic funds transfer at the point of sale – EFTPOS; - Home banking; - Internet; - Intranet;

26. 5.2.6. Electronic banking/2 - Virtual banks; - Advantages for banks that have accepted new information technology: 1) Bank competition increase; 2) Economies of scale and economies of scope development (Bank productivity increase and bank costs decrease); 3) Bank organization changes (merger and acquisition); 4) Bank credit rating increases.

27. 5.2.7. Bank innovations in dealing with securities a) Mutual funds (A way for deposit disintermediation protection); b) Note Issuance Facilities – NIF - Revolving underwriting facility; c) Trade banking (temporarily company’s shareholder); d) Securities consulting.

28. KEY WORDS/TERMS Bank innovation Financial derivatives Forwards Futures Options Swaps Deregulation Information technology Globalization Economies of scale Economies of scope Competition

29. KEY WORDS/TERMS/2 Cross-selling services One-stop banking Securitization Selling credits Participative credits Reproach credits Stand by guarantee Performance guarantee Repayment guarantee Credit derivatives Electronic banking Risk hedging Automate teller machine Post of sale – POS

30. KEY WORDS/TERMS/3 Electronic funds transfer at the point of sale – EFTPOS Home banking Mutual funds Note issuance facilities – NIF Trade banking

31. CHECKING QUESTIONS What are the main reasons for bank innovation appearence? In which forms do innovations appear? What is the final result of introducing bank innovations? What are the main factors that create innovations? What does deregulation consist of? Explain price and product competition. What is hideen behind information technology? Define bank globalization. Define economies of scale. Explain what cross-selling services means.

32. CHECKING QUESTIONS/2 11.Define securitization. 12. What are bank benefits from securitization? 13. Why banks sell credits? 14. Enumerate types of selling credits. 15. Explain the meaning of performance and repayment guarantee. 16. How does credit swap function? 17. How does credit option function? 18. What are the main characteristics of electronic banking? 19. What are mutual funds?