Module 1

Financial Intermediation and BankingTheoretical Foundations
Prof. Santosh Sangem

XLRI, Finance Area
Banking Module 1, BM 2015-17.
Why Study Commercial Banks?

Most regulated of all financial entities
Bank deposits a widely used form for settling economic
obligations.
Also widely misunderstood
Banks are Dinosaurs .(Bill Gates, quoted in O Sullivan,
1996)
The banking industry is dead, and we ought to just bury it
(Dick Kovacevich (CEO, Norwest), quoted in Davis,1999)
The Banking Sector is becoming irrelevant economically and
its almost irrelevant politically (William Isaac, Former
Chairman, FDIC; quoted in Boyd and Gertler (1994))

Prominent role of banks in almost all major financial
crises during twentieth century
The U.S. Banking Panic of 1907

The Great Depression
Savings & Loan Crisis of the 1980s
Continental Illinois Bank Failure of 1984
Asian Financial Crisis of 1997-98
The Sub-Prime crisis/Credit crisis of 2007-

Costs of Banking Crises
Direct costs of restructuring banking sector

Lowered GDP growth
Estimates of impact from 5% of GDP to 300% of GDP
Banking crises accompanied by crises in other parts of
financial system and currency crises
A Paradox
Economic booms and claims of growing irrelevance of banks
in modern economies
Some Typical Issues

Are banks special or not???
Banks and external macro-environment
Regulation as the provider of incentives/disincentives
Deposit Insurance and Capital Maintenance requirements
Liquidity Maintenance & Management
Risk Management & Financial Innovation
Off- Balance Sheet Activities of Banks & Securitization
Excessive Risk Taking and Bank Failures
Banks are Financial Intermediaries

Banks and Non-Financial Firms

Both finance themselves through equity and borrowed funds
Both invest funds raised in income generating assets
Surplus over expenses paid to providers of capital
Too many similarities on the surface. But are they really similar?
A closer look at balance sheet composition

Assets
Manufacturing
Firms
Banks
(% of Total Assets)
Net Fixed Assets
Investments
50%-60%
10%-20%
3%-5%
25%-30%
20%-40%
(incl. in Current
Assets)
40%-60%
Reserve Balances with Central

Bank
3%-5%
Inter-Bank Balances
5%-10%
Current Assets
Loans & Advances

Liabilities
Net Worth
Long-Term Borrowed Funds
Short-Term Borrowed Funds &
Current Liabilities
Deposits from Customers
Contingent Liabilities
Manufacturing
Firms
Banks
(% of Total Assets)
40%-50%
5%-10%
30%-40%
10%-25%
-
0%-5%
0%-10%
75%-90%
15%-20%
200%-400%

Financial Assets as Major Component of Bank Assets
Loans as Primary Assets
High Financial Leverage
Low Net Worth
Deposits as Primary Source of Bank Funds
Typically interest cost of deposits is much lower than cost of
borrowed funds for manufacturing firms
Inter-Bank Balances and Reserve Balances

Much higher financial risks of banks relative to other firms
Business of Banking
Taking up a variety of financial risks to make profits
Reducing Financial Risks through reduction of leverage
Reduction of Profitability
Importance of Off-Balance Sheet Transactions for Banks
What is Financial Intermediation

Intermediaries as third parties
Financial intermediaries (FIs) intermediate between providers and
users of capital
Some FIs use their resources to borrow from the providers of
capital and lend to users of capital
FIs as providing valuable services to both providers and users of
capital
Which services do they provide?
Why are they able to provide these services?
Are these really useful for both providers and users of capital?
Direct Finance
Direct finance a transaction between provider and end-user of
capital
Both meet and exchange funds for financial assets
Flow of Funds
Borrowers
(deficit budget unit)
Lenders
(surplus budget unit)
Primary Security
Issues with Direct Finance

Direct finance an expensive means of transacting for savers and
borrowers
Total information collection and processing = 2N 2
Lesser extent of diversification for savers and borrowers

Liquidity risk for savers
An intermediary to collect, process, and match requirements (A
broker)
Total number of transactions = 2N
Savings equivalent to (2N2 2N) * cost per transaction
Additional cost to intermediary of screening borrowers
The screening function of financial intermediaries
Issues with Direct Finance

When would such brokers come ahead?
Private nature of information
Re-usability of information
Specialization and scale economies over time
Role of profitability and entry barriers
Asymmetric information and ex-post monitoring??
Liquidity risk for savers??
Portfolio diversification for savers??
Indirect Finance
ow
l
F
n
u
fF
Financial Intermediary
ds
y
ar
im
r
P
cu
e
S
Savers
(surplus budget unit)
y
rit
Pr
Flo
w
im
ar y
Se
cu
of
rit
Fu
nd
Borrowers
(deficit budget unit)
Indirect finance as risk-taking by Financial Intermediaries

Portfolio diversification benefits, liquidity creation, screening, and
ex-post monitoring
Qualitative Asset Transformation

Risk of default of borrower replaced with risk of default of
Financial Intermediary
Demand from savers for liquidity risk management services
Risk aversion of savers
Liquidity creation and provision
Maturity transformation and mismatched balance sheets
Business of managing liquidity and default risks
Interest spread as primary source of income
Issues in QAT
Characteristics of the Financial Intermediary
Capitalization
Ability to manage financial risks, especially liquidity risk
Resources for ex-ante screening and ex-post monitoring
Transaction costs for savers in monitoring the financial
intermediary ??
Reducing this element of transaction costs??
Total costs of screening and information collection = N
Make the liabilities of FIs risk-free for savers
Insured deposits
Characteristic of only banks
What else do Financial Intermediaries do?

Functions performed by FIs
The brokerage function
Adverse Selection, Screening, and Information Collection
Scale economies & reusability of information
Moral hazard and post-funding monitoring
Providing funds just one activity of financial intermediaries
Other services provided by FIs
Transaction services
Financial advisory
Issuances
Guarantees
and so on
Definitional Issues
Lack of clear and well-accepted definitions of bank
Definition by functions
Definition by services
Definition by legal basis
Definition by functions/services as inadequate

Changing nature of functions & services provided by banks
Definition by legal basis

Issue demand deposits and making business loans
Qualified for deposit insurance
Definitional Issues
Banks are financial institutions that are privileged by the laws of a
nation to have the power to issue deposits that are payable on
demand and which deposits are also generally accepted by
economic agents in final settlement of transactions between them
Emphasis on payments/transaction services
Regulations as laying down boundaries on activities of banks
But why do banks exist

Debate on rationale for existence of banks
Transaction cost & Asymmetric information based theories
Scale economies in information collection, monitoring, and
liquidity provision
Debt as a contract brings forth optimal behavior from users of
funds Agency Costs
Banks exist to deal with ex-ante & ex-post information
asymmetries
Industrial Organization based theories
Banks as portfolio managers for depositors
Arguments equally applicable to other financial
intermediaries

Incomplete Markets Theories
Typical providers of capital are risk averse

Need to manage liquidity risks across time
Bank deposits as a risk-free liquid asset
Banks (and other FIs) provide a variety of risk management services to
providers and users of capital
Understand banks in terms of their role in the functions of a

financial system
Providing a payments system for the exchange of goods and services
Pooling of funds for undertaking large-scale indivisible enterprise
Transfer economic resources across time, industries and geographical
locations
Managing uncertainty and controlling risk
Provide price information
Provide a way to deal with asymmetric information

Other rationales
Banks as providing a means of payment
Banks as the central players in transmission of monetary policy
actions
Banks as having ability to create liquidity for business through
provision of funds
Why the unique role of banks in payments and provision of risk
free liquid asset?
History of banks and bank regulation
A brief history of banking

The Medici Bank (1397) as the first formal bank
Early banks serving the needs of merchants Money changer
banks and merchant banks
Large number of failures in Continental Europe driven by bad
debts
Charters to deposit banks - primarily transaction services
Another objective of charters to finance the governments needs
Banks also as safe-keepers of money
Banks as universal banks
History & Regulation

The growth of fractional reserve banking
Logic of un-coordinated withdrawal requirements of depositors
Wider reach and accessibility
Large number of bank failures in 19th century and early 20th

century
Bank failures attributed to liquidity problems and undue risk
taking
US banking panic of 1907 and the creation of the federal reserve
Lender of last resort
The Great Depression

Deposit Insurance
Glass-Steagall Act
History & Regulation

Deposit insurance and risk-free deposits
Commercial banking under Glass-Steagall Act
Banks to provide only loans to business and governments
Banks as sole entities to issue deposits
Competition among banks as a destabilizing factor

Interest rate controls
Restrictions on geographical expansion
The introduction of reserve requirements

Payment of deposit insurance premium
Capital Maintenance The early forms
Lender of Last Resort

Objective of ensuring stability of banking sector
Liquidity problems as the primary cause of bank failures
Lack of liquidity when needed the most during crises
Essentially a government set-up agency
Provision of short-term loans to banks facing temporary liquidity
problems
Principles of LOLR function
Lend only against good collateral
Accept all good collateral
Penal rate of interest on loans
Policies as public knowledge
Deposit Insurance
Objective of Deposit Insurance
Protection of savings of depositors
Banking failures and bank runs primarily a result of liquidity

problems
Early private solutions like mutual agreements, own deposit
insurance schemes, etc.
The credibility problem breakdown of the pooling arrangements
Provision of liquidity post failure
The solution - governments to provide deposit insurance
Deregulation of banking
The US Scenario
Competition from foreign banks for customer deposits
Rise in interest rates since the late 1950s
The response financial innovation

Eurodollar deposits, inter-bank repos, commercial paper, etc
Financial innovation driven by demand of depositors and borrowers
Increasing competition from non-bank financial intermediaries

Declining profitability and viability of banks
Dangers of losing monopoly position in payments function
The regulatory response leveling the playing field

Deregulation
Deregulation of banking
Removal of administered interest rate regimes
Removal of portfolio restrictions on banks
Increasing scope and nature of activities allowed to banks
Setting up of financial markets and introducing a wider range of
financial instruments
Allowing a greater variety and number of non-bank financial
intermediaries to be setup
Allowing easier entry to foreign banks
Continental Bank & Thrifts

A common problem with all deposit insurance schemes
Moral Hazard
Continental Illinois Bank the first post-war failure of a large bank

Multiple failures in the S&L industry
Some common features
Excessive risk taking on the asset side
Short-term non-deposit funds and maturity mismatches
The regulatory response
Risk-based capital requirements (Basel-I)
Innovations in payments systems and short-term liquidity
markets
Moral Hazard and the Too-Big-To-Fail

Problem
Moral hazard as the taking on of more risk than warranted in the
absence of a safety net
Deposit insurance and moral hazard in banking
More acute moral hazard problem for large banks
Creditors of large bank with an implicit government guarantee as
to repayment in event of failure
Contagion effect of large bank failures
Better safe than sorry approach of regulators
Basel Norms
Basel-1 introduced in developed economies in early 1990s
Objective of ensuring sufficient capital maintenance
Leveling global playing field
Capital Requirements
Risk-Weighted Assets
Tier 1 and Tier 2 Capital Instruments
Basel-1 and Credit Risk
Standardized Risk Weights
Basel 1.5 and Market Risk
Growing importance of market traded securities
Tier 3 Capital Instruments
Basel Norms
Basel 2
Standardized risk weights not reflecting true risks
Portfolio diversification benefits not reflecting in lower capital
requirements
Pro-cyclical behavior of capital requirements
Basel 3 & 3.5
More of the same?
Liquidity Maintenance
Book Value of Leverage as well
Higher Capital Adequacy requirements
Counter-cyclical buffer
Seasonal variation requirement
Counter party Credit Risk (CVA)
Repeal of Glass Steagall Act

Growing size of investment banks and other non-bank financial
intermediaries
Scope for profitability and risk diversification for banks
Glass-Steagall Act as final set of restrictions on banks
Repealed in 1999
US Commercial banks free to provide all kinds of financial

services The universal bank model
Some reservations
Conflicts of interest
Higher risks with securities activities
Services offered by Modern Banks

Traditional Services
Safekeeping of assets
Currency exchange
Providing business loans
Discounting commercial bills
Demand deposit & Savings deposit accounts
Financing governments
Providing guarantees
Services offered by Modern Banks

Relatively recent trends
Consumer lending
Financial advisory
Equipment leasing
Cash management
Venture capital finance
Mutual funds & Portfolio management services
Selling insurance & Retirement policies
Securitization
Investment banking
Risk management
And so on
Banking Structures
Competition as a driver of change

Increasing activities of banks driven by competition
Search for higher profits
Exploiting economies of scale and scope
Asset-side competition
Investment (Merchant) banks, Venture capital funds, Financial markets,
Mutual funds, Pension funds, Hedge funds, etc
Liability-side competition
Money market mutual funds
Investment banks
Insurance companies
Other Financial Services

Securities Brokers
Investment banks
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Competition and Consolidation
Competition and Consolidation

M&A activity in banking on rise since the 1990s
Driven by competition and the exploitation of scale economies
Tendency of banks to grow larger (e.g. Number of German banks reduced
by 35% between 1997 and 2008 )
Dismantling of Glass-Steagall and the rise in Mega-Mergers
Providing greater product diversity to customers

Greater efficiency in risk management, liquidity and capital
management
Stability and bank size changing regulatory trends
Removal of geographical expansion restrictions
Sources of Scale Economies

Cost indivisibility
Higher share of fixed costs
Indivisibility of reputation
Financial economies of scale

Netting and liquidity requirements
Portfolio diversification and equity requirements
Claimed benefits of consolidation on banking sector efficiency

Lowered costs for customers
Competitive pricing of deposits and loans
Broader access to banking services
Sources of Scope Economies

The growth of Universal Banks since the 1990s
Provide a broad range of financial services and products
Dominant structure of banks in Continental Europe
Claimed Benefits
Cross-Selling of Products
Better resource utilization for common activities
Information re-use
From Bank Holding Companies (BHCs) to Financial Holding

Companies (FHCs)
BHCs restricted from carrying on most non-banking activities
Repeal of Glass Steagall Act & removal of restrictions on M&A
Difference in type of M&A transactions since 1999-00.
Financial Innovation
The financial innovation cycle
Development of a new product

Selling product to existing clientele
Duplication of product by other banks & FIs
Widespread use and active trading on financial markets
Key drivers of financial innovation
Search for profits by banks

Competition
Regulatory restrictions
Low and stable interest rate environment
Financial Innovation
Two post-war eras of financial innovation
1950-mid 1980s
Mid 1980s onwards
High Return/Low Cost vs. Risk Sharing Products

Demand driven financial innovation vs. Supply push financial
innovation
Rapid growth of non-bank financial intermediaries
A clientele for new financial products
Sophisticated clientele searching for better yields
Shift towards developing risk sharing financial products
Risk Sharing Innovations

Creating stable return distributions for clients
Demand Side Factors
Managerial Self-Interest
Bankruptcy Costs
Capital Market Imperfections
Participation Costs
Increased Cross-border Transactions
Supply Side Factors
Technology
Transaction Costs
Competition & First Mover Advantage
Off-Balance Sheet Activities of Banks

Rapid growth in off-balance sheet transactions of banks
Fee-based incomes
Trading profits
Increasing importance of derivative contracts

Nominal Amt of outstanding derivative contracts more than USD 1000
trillion
Banks and other FIs as dominant counterparties

Risk reducing transactions?
Clientele effect and Market segmentation

Risk appetites differ across different investor categories
Better risk sharing
Increased liquidity risks

Bank Regulation : Shifts in Thought

Frequent occurrence of banking crises and greater instability of
banking sectors
Liquidity problems as primary driving forces of bank failures
Increased concerns with bank solvency since the mid1980s
Belief of solvency problems as an outcome of undue risk taking
Adequate maintenance of capital by banks as a solution to limit undue risk
taking
Regulatory separation of liquidity problems and solvency risks
Shift of regulatory approaches from micro-management to

supervisory
Re-Recognition of Contagion post East Asian Crisis
Systemic Crises & Contagion

Systemic risk as the risk of multiple failures in a set of financial
markets/ financial intermediaries
Macroeconomic Factors & Systemic Risk
Asset Markets & Systemic Risk
Contagion as the spread of problems from one

intermediary/market to other intermediaries/markets
Bank Runs?
Banking sector most prone to systemic crises & contagion
Loss of depositor confidence
Inter-linkages between banks Inter-bank markets
Inter-linkages between banks Counterparties in financial markets
Bank Regulation : Some Rationales

Moral hazard effect of deposit insurance
Risk taking by banks needs to be monitored and restrained
Preventing disruptions in payments and settlement systems

Bank deposits as money
Banks as largest players in payments & settlement systems Systemic Risk
& Contagion
Opacity of risks taken up by banks

Depositor Safety
Monitoring the monitor

Banks as agencies monitoring behavior of borrowers
Enhanced efficiency of banks

Maintenance of competitive conditions
Consumer Protection
Bank Regulation- Prudential Regulation

Shift to prudential regulation principles
Safety and soundness of financial system as a whole

Depositor protection
Regulators as not micro-managers
Regulatory costs and financial system efficiency
Creation of an enabling operating environment
Reducing regulatory disparities
Some prudential regulation measures
Capital adequacy norms

Risk measurement practices
Sectoral credit limits
Disclosure & accounting practices
Shift towards self-regulatory organizations
Regulation and Social Benefits???

Traditional view of regulation as a solution to negative
externalities
Regulation as the outcome of a bargaining process between
regulators and interested entities
Pervasive regulation as an outcome of rational self-interest of
powerful interest groups
Regulation formulation as an optimal solution to the claims of all
interested parties
Doubts on the efficacy of regulation
Regulation as more of a satisfactory give and take solution

Module 1

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Financial Intermediation and BankingTheoretical Foundations

Prof. Santosh Sangem

Banking Module 1, BM 2015-17.

Why Study Commercial Banks?

Banking Module 1, BM 2015-17.

Why Study Commercial Banks?

The U.S. Banking Panic of 1907

Banking Module 1, BM 2015-17.

Why Study Commercial Banks?

Direct costs of restructuring banking sector

Banking Module 1, BM 2015-17.

Some Typical Issues

Banks are Financial Intermediaries

Banks and Non-Financial Firms

Banking Module 1, BM 2015-17.

Banks and Non-Financial Firms

Reserve Balances with Central

Banking Module 1, BM 2015-17.

Banks and Non-Financial Firms

Banking Module 1, BM 2015-17.

Banks and Non-Financial Firms

Banking Module 1, BM 2015-17.

Banks and Non-Financial Firms

Banking Module 1, BM 2015-17.

What is Financial Intermediation

Banking Module 1, BM 2015-17.

Issues with Direct Finance

Lesser extent of diversification for savers and borrowers

The screening function of financial intermediaries

Banking Module 1, BM 2015-17.

Issues with Direct Finance

Banking Module 1, BM 2015-17.

Indirect finance as risk-taking by Financial Intermediaries

Qualitative Asset Transformation

Banking Module 1, BM 2015-17.

What else do Financial Intermediaries do?

Definition by functions/services as inadequate

Definition by legal basis

Banking Module 1, BM 2015-17.

Banking Module 1, BM 2015-17.

But why do banks exist

But why do banks exist

Typical providers of capital are risk averse

Understand banks in terms of their role in the functions of a

But why do banks exist

Banking Module 1, BM 2015-17.

A brief history of banking

History & Regulation

Large number of bank failures in 19th century and early 20th

The Great Depression

History & Regulation

Competition among banks as a destabilizing factor

The introduction of reserve requirements

Lender of Last Resort

Banking failures and bank runs primarily a result of liquidity

Banking Module 1, BM 2015-17.

The response financial innovation

Increasing competition from non-bank financial intermediaries

The regulatory response leveling the playing field

Banking Module 1, BM 2015-17.

Banking Module 1, BM 2015-17.

Continental Bank & Thrifts

Continental Illinois Bank the first post-war failure of a large bank

Moral Hazard and the Too-Big-To-Fail