Transcript banking-and-financial-institutions-acf-104-haut-2016

ACF-104
Guy Hargreaves
Wechat: Guyhargreaves
Course goals
 To gain a fundamental understanding of banking
systems in developed economies
 To understand the different types of banks, particularly
commercial banks
 To understand the financial logic and concepts behind
the banking system
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Course Coverage
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Review financial system and financial intermediation principles
Review structure of banking systems in developed economies
Review typical commercial bank structures and departments
Discuss “good banking” principles; importance to commercial
bank management, regulators and the economy
Understand commercial bank products, risk management and
impact on bank financial structure
Appreciate the business of commercial banking
Review commercial bank regulation in the context of Basel
Review international banking systems
Study how an actual commercial bank – ANZ Bank – operates in
a developed economy
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About.me
 27-years of experience in Investment and Corporate
Banking in Asia Pacific region
 New Zealander living in Hong Kong with wife and
three children
 My goal: deliver academic based course from the
perspective of a highly experienced practitioner
=> please feel free to ask questions at any time
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Structure and assessment
 Text:
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Financial Markets and Institutions;
Frederic Mishkin, Stanley Eakins
3 x 50 min lectures Mon-Fri 8.30-11.30am
1 x 60 min tutorial Mon-Thur 2.30-3.30pm (Chinese) 4239
1 x 60 min tutorial Mon-Thur 2.30-3.30pm (English) 6144
1 x 60 min tutorial Mon-Thur 3.40-4.40pm (English) 4239 if
requested by any students before 11.20am each day
 Exam: 2 hours on Friday, 18th November
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multiple choice questions + short questions + short essay
100% of final mark
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Financial system
 The typical components of any Financial System:
1.
2.
3.
4.
Financial Assets
Borrowers and Savers of financial assets
Financial Intermediaries
Central Banks and regulators (set and manage the rules of
the financial system)
 Financial systems exist within individual countries
which have their own currency
 Currency blocks (eg EUR) can have common
components (eg European Central Bank)
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Banking system
 A Banking System is that part of a financial system in
which regulated banks operate
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Does not include Capital Markets which are part of the
Financial Markets
Includes payments, Central Bank operations, bank loans/
deposits – any activity which involves a regulated bank
 Whether the activity is regulated (or not) is important
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Unregulated activity is conducted outside of the support
provided by Central Bank regulated commercial banks
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Financial asset
 An asset is any “property” of value held or owned by an
individual or company
 A Financial Asset can be thought of as financial
property eg:
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Cash (money) in your wallet
Deposit with a bank
Corporate bond
Common share of a company
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Financial claim
 A Financial Claim is a contract created when a
Borrower accepts money from a Saver (or Lender)
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Borrower must pay that money back some time in the future
Borrower must pay interest or a return on that money
Can be Secured or Unsecured with the borrower’s assets
 Holder of financial claim has a Financial Asset
 Grantor of financial claim has a Financial Liability
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Financial intermediation
 Two fundamental parties to any financial system:
1. Borrowers (deficit units)
2. Savers (surplus units)
 Financial Intermediation is conducted by third
parties who take deposits from Savers and make
loans with those deposits to Borrowers
 Financial intermediation increases economic
efficiency by offering valuable transformative
services to both Borrowers and Savers
11
Direct versus indirect finance
Retail / Wholesale
Commercial Banking
Investment
Banking
12
Types of financial intermediaries
 Intermediaries are usually either:
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Regulated commercial banks (mostly)
Non bank financial institutions (NBFIs) eg Investment Banks
 Regulated banks are typically:
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Retail Commercial Banks
Wholesale Commercial Banks
 “Deposit-Taking Institutions” – eg banks
 “Non-Deposit-Taking Institutions – eg insurance
companies
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Financial markets
 “Places or platforms” where financial assets are bought
and sold
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Electronic or “over-the-counter” (OTC)
Open outcry exchanges are almost things of the past (eg
futures pits)
 Most significant financial markets conduct trade in:
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Securities (shares and bonds eg NYSE, Nasdaq)
Futures and derivatives (eg Chicago Mercantile Exchange /
Chicago Board of Trade)
Foreign exchange (largest cash market of them all ~USD5
trillion turnover per day)
Commodities (much of the physical trade is OTC)
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Financial market liquidity
 Market liquidity impacts a participant’s ability to:
1. Transact in a market at their time of choosing
2. Transact volume of choosing
3. Minimise transaction costs
 Increasing market liquidity grows volumes while
lowering per unit transactions costs
=> Increased economic efficiency
15
The theory of banking
 Commercial banks perform three basic functions:
1. Size transformation
2. Maturity transformation
3. Risk transformation
 Commercial banks provide products and services at
the time of their customer’s choosing
 Because of the position of commercial banks within
the financial system, they also improve system
liquidity, reduce system cost and lower system risk
16
Size transformation
 It is unlikely a saver will deposit the exact amount of
funds into a retail bank that another customer would
like to borrow
 Banks have multiple sources of liquidity to cover
mismatches in financial transaction size:
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Central bank liquidity windows
Interbank markets
Public money market or bond markets
 Banks take a “portfolio management” approach to size
transformation as they have a broad base of saver and
borrower customers
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Maturity transformation
 It is unlikely a saver will deposit funds into a
commercial bank that mature on the exact date that a
borrower would like
 Banks manage “asset-liability” maturity mismatch risk
as part of their capital and liquidity management
 Banks also take a “portfolio management” approach to
maturity transformation as with size
18
Risk transformation
 It is unlikely a saver will want to deposit all its savings
with a single borrower – savers like to diversify their
credit risk across a broad range of borrowers
 Banks lend to a broad range of borrowers, offering
savers a diversified credit risk profile
 In addition, banks have a regulated capital structure
meaning borrowers have protection against expected
and unexpected losses in the portfolio
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Information asymmetry
 Financial market participants often have varying levels
of information –>Information Asymmetry
1.
2.
3.
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Some participants have Differing Information
Some participants have Inside Information
All participants have Imperfect Information
Inside Information is usually gained from private
sources and is illegal to use to trade (insider trading)
A key regulatory task is to prevent insider trading
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Moral hazard
 Moral hazard occurs in a contract when one of the
parties has an economic incentive to behave against
the interests of the other
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Classical example is a homeowner buying fire insurance just
before their home burns down
Insurance industry is large target of this behaviour
Commercial banks have a poor record of managing moral
hazard given large incentives to behave poorly
 Often arises in the Principal-Agent relationship where
the agent may act in its own interests rather than the
interests of its customer
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Adverse selection
 Adverse selection occurs when one party misuses an
information advantage when dealing with another
party
 Adverse selection can become a big problem in
commercial banking due to this information
asymmetry
 Better informed banks can tend to “exploit” less well
informed customers
 Compliance and Risk Management functions are being
heavily increased in banks today to prevent outcomes
like this
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Financial arbitrage
 Arbitrage is the act of profiting by taking two equal
but opposing positions in the “same product” at the
same time
 Find a buyer at $10 at the same time find a seller at $9
 Buy at $9 and sell at $10 to realise $1 profit
 Assume no market risk in doing so
 Financial instruments are priced in markets to be
“arbitrage free”
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Market efficiency
 While arbitrage in markets is now low, market prices
move daily in reaction to updated information that
impacts on risk premia
 Efficient markets hypothesis: the application of
rational expectations to financial markets so that the
equilibrium price of a security is always equal to its
fundamental value
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Most applicable to corporate securities – bonds/shares
Many players believe share prices are driven more by “Random
Walk”
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Shadow banking
 Shadow Banking is a banking-like system of financial
intermediation conducted by NBFIs
 As a result it is largely unregulated and is considered to
have contributed significantly to the 2007-9 global
financial crisis
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The history of money
 Before “money”, market participants used the Barter
System:
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Participants exchange goods and services directly for other goods
and services
Very inefficient because of high transactions costs, lack of price
transparency, minimal standardisation and costly/difficult to store
wealth
 “Commodity Money”, a fixed weight of grain, was used by
the Mesopotamians some 3,000 BC
 Commodity money was replaced by gold and silver, and
eventually by banknotes (first used in China during the
Song Dynasty circa 1,000 AD)
 Today we may be standing at the dawn of Cryptocurrency
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The uses of money
 Medium of exchange – widely accepted as payment for
goods and services
 Medium of valuation – widely accepted as method of
“relative” valuation of goods and services
 Store of value – confidence that participants can hold
money into the future to pay for goods and services in
a predictable way
 Standard of Deferred Payment - goods and services
consumed now can be paid for in the future with
money
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The properties of money
 To be a viable medium of exchange a monetary asset
needs various qualities:
1.
2.
3.
4.
5.
Acceptable to participants
Standardized quality
Durable
Valuable relative to its weight ie efficient to use
Divisible to accommodate various prices of goods and
services
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Money of today
 Governments around the globe today issue banknotes
and coins which derive value by government order or
“Fiat”
 Governments decree by law that all public and private
financial liabilities can be repaid by this “Fiat” money
– designating it as “legal tender”
 The right to issue (or print) money comes with
responsibility. Printing excessive banknotes or
expanding the Money Supply can cause inflation and
lead to collapse in trust in that money
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Money supply
 Monetary aggregates are measures of the quantity of
money in circulation – typically broader than simply
banknotes and coins:
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M1 is defined as banknotes, coins and on-call deposits
M2 is defined as M1 + most term deposits
 M1 and M2 is carefully watched by many markets to
monitor government trustworthiness!
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Recap of last section
 Important concepts underlying finance
 Banking and financial intermediation
 The function and characteristics of money and
monetary bases
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Definition for this course
 This course focuses on Commercial Banking
 Commercial banking can be thought of as any
regulated banking activity operated as a business
 For this course we will define commercial banking as:
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Retail banking (including Private banking)
Wholesale (or Corporate) banking
 Investment banking
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Important to note investment banking activity is not usually
regulated by a Central Bank
It is regulated when conducted by a regulated bank
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Two basic economic sectors
 Private sector – not controlled by the State
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Individuals
Private / public companies
Non-profits / charities
 Public sector – controlled by the State
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Federal government
State governments
Local governments
State owned enterprises
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Where does commercial banking fit?
 Private sector
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Individuals – banking licenses not generally available
Private / public companies – most commercial banks
Non-profits / charities – some banks eg Microfinance
 Public sector
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Federal government – Central Banks
State governments - no
Local governments - no
State owned enterprises – few SOE commercial banks remain
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Who are the savers / borrowers?
 Private sector
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Individuals – both savers and borrowers
Private / public companies – both savers and borrowers
Non-profits / charities – goal usually to be neither
 Public sector
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Federal government – mostly borrowers
State governments – mostly borrowers
Local governments – mostly borrowers
State owned enterprises – mostly borrowers
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Are commercial banks savers?
 Like any for-profit entity, commercial banks can be
savers and borrowers themselves
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Lending out profits not paid to shareholders
Borrowing for capital expenditure
 If a commercial bank is a saver / borrower, it will
conduct this activity with its own capital
 This activity is considered “proprietary” ie not
performed in the course of its financial intermediation
activity
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Recall: financial system
Retail / Wholesale
Commercial Banks
Investment Banks
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What makes up a banking system?
 Banking systems are usually made up of:
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Central Banks
Regulated commercial banks
 Retail (including Private) banks
 Wholesale banks
Payments systems
 Regulated banks deal in financial markets but markets are
not usually considered as part of the banking system
 Investment banks deal in financial and capital markets but
if unregulated they are not considered part of the banking
system
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What else do commercial banks do?
 Conduct operations in financial markets, eg
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Hedging risks for customers
Risk management for their own balance sheet
 Operate payments systems
 Facilitate trade flows
 Help with the conduct of monetary policy
 Support economic growth
 Assist in executing government development policies
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Recall: payment systems
 A Payment System is any organised system established
to allow participants to transfer financial assets
between themselves
 Payments take place for many reasons:
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In exchange for goods and services
Creation or repayment of a financial liability/asset
 Commercial banks have historically played a key role
in payments systems
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Payment systems - RTGS
 “Interbank” payment systems use Real Time Gross
Settlement (RTGS) to transfer money between bank
participants
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Retail participants must hold some form of account with a
commercial bank in the payments system
To effect payment a participant will instruct its bank to
transfer money from that participant’s account to the proper
account of another participant at its own bank
The two banks “settle” the transaction through adjustment of
their own accounts held with the relevant Central Bank
Central Banks usually manage RTGS systems
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Payment systems - SWIFT
 International payment systems use Society for
Worldwide Interbank Financial Telecommunication
(SWIFT) to transfer money between participants
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SWIFT is does not alter the underlying mechanics of
individual domestic payment systems
SWIFT is simply a system that arranges domestic payments
between international participants
Unless the banks handling a SWIFT transaction are primary
deposit-taking institutions in the currency of the transaction,
instructions will be handled through a correspondent banking
arrangement
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Commercial bank payment products
 Commercial banks offer many ways for their clients to
instruct a payment:
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Cheques
Online transfers
Standing orders
Credit cards
Debit cards
ATMs
Smartphones
SMS
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Correspondent banking
 Commercial banks often hold accounts with other
domestic or international commercial banks
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Nostro account: “our money held by you”
Vostro account: “your money held by us”
 When a bank holds an account with another bank it is
said to have a Correspondent Banking Relationship
 If a bank does not maintain an account with its Central
Bank it needs to have a correspondent banking
relationship with one that does
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Commercial banking products
 Retail and wholesale commercial banks offer a wide
range of products and services – including:
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Current and chequing accounts
Term deposits
Consumer loans and mortgages
Credit and Debit Cards
Cash management services
Corporate and SME loans
Trade Finance
Financial market products and services
Online banking
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Investment banking products
 Investment banks offer a wide range of products and
services – including:
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Capital market product arranging and underwriting
Financial market products and services
Securitised or asset backed arranging
Merger and acquisition advisory
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Financial market products
 Commercial banks offer a range of financial market
products and services including:
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Foreign exchange and forwards
Money market products
Syndicated loans
Derivative risk management products
Repo products
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Corporate banking products
 Corporate banking customers range from SME to mid
market to large listed multinational companies
(MNCs)
 These customers have a range of commercial banking
needs including:
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Lease and hire purchase financing
Invoice and receivable discounting
Corporate loans and commercial paper (CP)
Project finance
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Commercial banking customers
 Traditional commercial banking customers broadly
fall into categories of:
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Household savers, or borrowers for purchases of property or
smaller ticket personal goods (eg cars)
Corporate borrowers entering into bilateral or club loans for
capital expenditure (capex), working capital or M&A
Governments funding infrastructure or deficits
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Modern banking customers
 Post deregulation in the 1980s, the number and type of
bank customer has grown strongly
 Retail customers now also include:
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Financial market traders and speculators
Margin loan borrowers
Advisory customers (Private Banking, estate planning etc)
“Sub-prime” customers
Traditional deposit and consumer loan customers
Etc..
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Modern banking customers
 Wholesale commercial banking customers now also
include:
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Private Equity funds
Pension and Mutual funds
Hedge Funds
Mortgage and other originators
NBFIs
Traditional corporate borrowers
Corporate risk managers
Syndicated loan borrowers
Etc…
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Recap of last section
 Understand banking systems within developed
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economies
Appreciate the structure of a typical commercial
banking system
Review payment systems and how they operate
Describe the main products and services offered by
commercial banks
Understand the commercial banking customer base
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Retail commercial banks
 Limited liability corporate organisations
 Focus at “retail level”
 Mortgage and savings products
 Mostly listed on the stock exchange
 Medium sized balance sheets
 Large number of smaller customers
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Wholesale commercial banks
 Limited liability corporate organisations
 Focus at “wholesale or corporate level”
 Offer corporate loans
 All listed on the stock exchange
 Large sized balance sheets
 Smaller number of larger customers
56
Investment banks
 Investment banks are not usually regulated
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commercial banks
Focus at “wholesale / corporate level”
Offer Capital Markets products
Listed and unlisted
Volatile balance sheets
Smaller number of large customers
57
Commercial bank departments
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Board of Directors
Management Office
Financial Control
Risk Management
Legal and Compliance
Operations
Human Resources
Information Technology
Financial Markets
Wholesale Banking
Retail Banking
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Board of Directors
 Approves strategy of the bank
 Appoints the Chief Executive Officer
 Approves financial statements, audit, compensation
etc
59
Management Office
 Usually made up of:
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CEO – heads up and runs the bank
CFO – heads up finance function
CRO – heads up risk function
CTO – heads up IT function
COO – heads up operations function
Head of Financial Markets
Heads of Retail/Wholesale banking
 Develops bank strategy
 After Board approval it executes this strategy
60
Financial Control
 Management reporting
 Financial accounts (quarterly / semi / annual)
 Regulatory reporting
 Tax and transfer pricing
 Daily P&L
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Risk Management
 Credit risk
 Market risk
 Liquidity risk
 Country risk
 Operational risk
 Reputational risk
 Special Asset Management
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Legal and Compliance
 Group legal
 Front Office legal
 Compliance
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Ensures bank staff follow policy and procedures
Protects the bank against money laundering and other
criminal activity
Prevents insider trading and other crimes
63
Operations
 Cash settlements
 Securities settlements
 “Middle Office”
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Financial Markets
Corporate loan management
 Property management
 General logistics
64
Human Resources
 Bank staff are commercial banking’s most valuable
asset
 Hiring, firing, training, team building
 Some commercial banks have aggressive firing policies
 Compensation policy critical for “good banking”
65
Information Technology
 Front Office, Middle Office, Back Office computer
systems
 Commercial banks traditionally have used technology
to support operations rather than a competitive
weapon
 Many banks in 2015 stuck with outdated systems – big
problem!
66
Financial Markets
 Salespeople
 Traders
 Structurers
 Quants (so-called “rocket scientists”)
 Treasury management
67
Wholesale Banking
 Corporate Banking
 Project Finance
 Trade Finance
 Leasing
 Relationship management
 Cash management
68
Retail Banking
 Deposit products
 Mortgage department
 Credit Cards and Debit Cards
 Consumer loans
 Branches and infrastructure
69
Recap of last section
 Overview of structure of different types of commercial
banking enterprises
 Understand the different departments and roles of
those departments within a typical commercial bank
71
The theory of banking
 Commercial banks perform three basic theoretical
functions:
Size transformation
2. Maturity transformation
3. Risk transformation
1.
 In addition, commercial banks provide products and
services at the time of their customer’s choosing
 Because of the positioning of commercial banks within
the financial system, they improve system liquidity,
reduce system cost and lower system risk
72
Size transformation
 Unlikely a saver will deposit the exact amount of funds
with a retail bank that its borrower customer demands
on any given day
 Banks have multiple sources of liquidity to cover
mismatches in financial transaction size:



Central bank liquidity windows
Interbank markets
Public money market or bond markets
 Banks can take a “portfolio management” approach to
size transformation as they have a broad base of saver
and borrower customers
73
Maturity transformation
 Unlikely a saver will deposit funds with a commercial
bank to mature on the exact date that a borrower
customer wants its loan to mature
 Banks manage “asset-liability” maturity mismatch risk
as part of their capital and liquidity management
framework
 Banks also take a “portfolio management” approach to
maturity transformation as with size
74
Risk transformation
 Unlikely a saver will wish to deposit all its funds with a
single borrower, instead looking to diversify its credit
risk across a broad range of borrowers
 Banks lend to a broad range of borrowers, offering
savers a diversified credit risk profile
 In addition, banks have a regulated capital structure
ensuring borrowers have a cushion against expected
and unexpected losses in the portfolio
75
Credit creation
 Commercial banks have very privileged position in the
economy:
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
Usually the most leveraged sector in he economy (15-30x
leveraged!)
Often the beneficiary of government deposit insurance /
guarantee schemes
Guaranteed access to Central Bank pools of liquidity at all
times
76
Recall: credit creation
 When a bank accepts a deposit it is required to hold a
certain amount (eg say 10%) in approved reserves
(deposits with Central Bank or government securities)
 The balance (90%) can be lent to new borrowers who
purchase goods and services from another economic
entity, who then might deposit the proceeds in another
bank
 That other bank will then retain the reserve
requirement and further lend the funds to borrower
77
Theory of credit creation
Bank
$ Deposit
taken
$ Loan
made
$ Reserve
held
A
50.0000
45.0000
5.0000
B
45.0000
40.5000
4.5000
C
40.5000
36.4500
4.0500
D
36.4500
32.8050
3.6450
E
32.8050
29.5245
3.2805
…
…
…
…
500.000
450.000
50.000
Total
 Under a 10% Reserve Ratio for each $1 deposit taken the banking system can
create $10 in new deposits
 Credit Multiplier = Change in Deposits / Change in Reserves = 500 / 50 = 10
78
Theory, what about in practice?
 Retail banking
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Size transformation
 Who deposits the exact $355,450 you might need to buy your
apartment? – no-one!
Maturity transformation
 Who makes 30-year deposits? – no-one!
Risk transformation
 Who creates diversified portfolios backed by capital and
supported by Central Banks? – well actually there are alternative
investments which is why the deposit market is so competitive
Credit creation
 Who leverages the money supply so effectively to create plentiful
liquidity for retail borrowers? – no-one with any stability other
than commercial banks
79
Theory, what about in practice?
 Wholesale banking
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Size transformation
 Who deposits the exact $325.21m a company needs for its
acquisition? – no-one!
Maturity transformation
 Who makes 5-year deposits to fund corporate loans? – no-one!
Risk transformation
 As for Retail Banking
Credit creation
 As for Retail Banking
80
Improving economic efficiency
 Banks lend money and take deposits at the time their
customers demand


This reduces risk for borrowers that need certainty of funds on
a specific day
And reduces opportunity costs for savers who might otherwise
take time to find a borrower and while missing out on interest
payments
 Banks reduce transaction, information and search
costs by exploiting their large size and reach

Larger turnover, larger fund flows reduces unit costs and
increases economic efficiency
81
Credit creation boosts growth
 Central Bank policy impacts growth in an economy
through commercial banks
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Altering the money supply alters interest rates, which flows
through commercial banks to the real economy and impacts
demand
Altering the Central Bank Reserve Ratio impacts on the supply
of credit from the commercial banking system to the real
economy
Commercial banks can choose to raise capital, which through
the credit multiplier can lift the supply of credit to an
economy
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Capital allocation in an economy
 Commercial banks are amongst the most important
institutions in an economy when it comes to capital
allocation to different industries / sectors

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Lending reduced to twilight industries
Lending increased to new growing industries
Lending into increasing productivity, away from falling
productivity
Forced corporate restructurings
 Market based capital allocation drives developed
economies to become more efficient
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Commercial banks in financial markets
 Financial markets are not part of the banking system, but
are critical for commercial banks
 Commercial banks operate in a number of financial
markets and derivatives
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Money markets
FX markets
Commodity markets
Syndicated loan markets
 Commercial banks are mostly users of bond and equity
(capital) markets

Investment banking businesses are more focused on arranging deals
in the capital markets
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