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Banking management

Banking Management is a financial institution that serves as a financial intermediary. Diploma in Banking Management course consists of various activities such as deposits, to provide credit, global financial markets, savings, etc.

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Banking management

  1. 1. | BANKING MANAGEMENT 1 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES BANKING MANAGEMENT CONTENT Chapter 1: AN INTRODUCTION TO BANKING MANAGEMENT A. What is Banking? B. History of Banking C. Types of Banking D. Global Banking Chapter 2: FINANCIAL SYSTEM A. The Role of the Financial System B. The Nature of Financial Claims C. The Structure of Financial Markets D. Financial System Accounting E. The Nature of Financial Intermediation F. The Process of Financial Intermediation Next Page >
  2. 2. | Chapter 3: RETAIL BANKING 2 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES G. The Implications of Financial Intermediation H. What is the Future for Financial Intermediaries? Chapter 3: RETAIL BANKING A. What is Retail Banking? B. What Services and Products do Retail Banks Provide? C. Competition in Retail Banking D. Future Developments in Retail Banking Chapter 4: WHOLESALE AND INTERNATIONAL BANKING A. Wholesale Banking B. Matching and Liquidity in Wholesale Banking C. Off-Balance-Sheet Business D. International Banking E. Laws and Regulations of International Banking < Previous Page Next Page >
  3. 3. | 3 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES F. Country Risk Management G. International Activities H. Funds Management I. Foreign Exchange J. Foreign Exchange Risk Chapter 5: MANAGING BANK LIABILITIES A. Understanding a Bank's Liabilities B. Funding Sources C. Deposit Management Program D. Safety and Soundness E. All Other Liabilities < Previous Page Next Page >
  4. 4. | 4 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES CHAPTER 1 AN INTRODUCTION TO BANKING MANAGEMENT What is Banking? A system of trading in money which involved safeguarding deposits and making funds available for borrowers, banking developed in the Middle Ages in response to the growing need for credit in commerce. The lending functions of banks were undertaken in England by money- lenders. Until their expulsion by Edward I in 1291, the most important money-lenders were Jews. They were replaced by Italian merchants who had papal dispensations to lend money at interest. In the13th cent. credit was essential to finance commerce and major projects. The most important was the wool trade but other examples included large buildings such as Edward's castles in north Wales. When Italians had their activities in England curtailed in the early 14th cent., they were replaced by English merchants and goldsmiths, whose rates of interest were sufficiently low to avoid the usury laws. Monarchs had borrowed from merchants and landowners for centuries. By the late 17th cent., the growth of parliamentary power over government expenditures required more regulation. The, founded in 1694, gave the government and other users of credit access to English funds. Similar developments occurred in Scotland and Ireland. These banks remained without serious competition until the later 18th cent., when expanding commercial activities gave scope to merchants, brewers, and landowners to establish banks based on their own cash reserves. Errors of judgement sometimes occurred and 'runs on the bank' took place when depositors, fearing for the security of their money, demanded its return. Fluctuations in the value of money because of the return to a gold-based currency after the end of the Napoleonic wars (1815) precipitated a series of crises. To stabilize the currency the government eventually introduced the 1844, which gave the Bank of England the functions of supervising the note issue and of monitoring the activities of the banking system. Regulatory powers < Previous Page Next Page >
  5. 5. | AN INTRODUCTION TO BANKING MANAGEMENT 5 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES were put in place in 1845 to control banking in Scotland and Ireland. In the 19th cent., overseas trade and the expanding British Empire reinforced the place of London as a centre of merchant banking. The skills of these specialist bankers attracted business from foreign firms and governments seeking loans. These arrangements made possible the rapid development of railways, heavy engineering, mines, and large commercial developments. Many of these merchant banks survive, including Rothschilds, Lazard Brothers, Kleinwort Benson, and Schroders. Internal trade was funded mainly by a larger number of local banks which, after the middle of the 19th cent., became consolidated into a much smaller number of banks. Numbers continued to diminish so that by 1980 banking was dominated by four companies: Barclays, Lloyds, Midland, and National Westminster Banking has been characterized, largely because of technological innovation, by an increasingly sophisticated provision of banking services and an expansion of consumer credit. The business of safeguarding and lending money is often arranged through machine-readable cards and continuous access by telephone. History of Banking Banking activities were sufficiently important in Babylonia in the second millennium B.C. that written standards of practice were considered necessary. These standards were part of the Code of Hammurabi? The earliest known formal laws. Obviously, these primitive banking transactions were very different in many ways to their modern-day counterparts. Deposits were not of money but of cattle, grain or other crops and eventually precious metals. Nevertheless, some of the basic concepts underlying toady‘s banking system were present in these ancient arrangements, however. A wide range of deposits was accepted, loans were made, and borrowers paid interest to lenders. Similar banking type arrangements could also be found in ancient Egypt. These arrangements stemmed from the requirement that grain harvests be stored in centralized state warehouses. Depositors could use written orders for the withdrawal of a certain quantity of grain as a means of payment. This system worked so well that it continued to exist even after private banks dealing in coinage and precious metals were established. We can trace modern-day banking to practices in the Medieval Italian cities of Florence, Venice and Genoa. The Italian bankers made loans to princes, to finance wars and their lavish lifestyles, and to merchants < Previous Page Next Page >
  6. 6. | AN INTRODUCTION TO BANKING MANAGEMENT 6 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES engaged in international trade. In fact, these early banks tended to be set up by trading families as a part of their more general business activities. The Bardi and Peruzzi families were dominant in Florence in the 14th century and established branches in other parts of Europe to facilitate their trading activities. Both these banks extended substantial loans to Edward III of England to finance the 100 years war against France. But Edward defaulted, and the banks failed. Perhaps the most famous of the medieval Italian banks was the Medici bank, set up by Giovanni Medici in 1397. The Medici had a long history as money changers, but it was Giovanni who moved the business from a green-covered table in the market place into the hall of a palace he had built for himself. He expanded the scope of the business and established branches of the bank as far north as London. While the Medici bank extended the usual loans to merchants and royals, it also enjoyed the distinction of being the main banker for the Pope. Papal business earned higher profits for the bank than any of its other activities and was the main driving force behind the establishment of branches in other Italian cities and across Europe. Much of the international business of the medieval banks was carried out through the use of bills of exchange. At the simplest level, this involved a creditor providing local currency to the debtor in return for a bill stating that a certain amount of another currency was payable at a future date often at the next big international fair. Because of the prohibition on directly charging interest, the connection between banking and trade was essential. The bankers would take deposits in one city, make a loan to someone transporting goods to another city, and then take repayment at the destination. The repayment was usually in a different currency, so it could easily incorporate what is essentially an interest payment, circumventing the church prohibitions. An example shows how it worked. A Florentine bank would lend 1000 florins in Florence requiring repayment of 40,000 pence in three months in the banks London office. In London, the bank would then loan out the 40,000 pence to be repaid in Florence at a rate of 36 pence per florin in three months. In six months, the bank makes 11.1 percent? That‘s an annual rate of 23.4 percent. It is also interesting to note that a double-entry bookkeeping system was used by these medieval bankers and that payments could be executed purely by book transfer. During the 17th and 18th centuries the Dutch and British improved upon Italian banking techniques. A key development often credited to the London goldsmiths around this time was the adoption of fractional reserve banking. By the middle of the 17th century, the civil war had resulted in the demise of the goldsmiths traditional business of making objects of gold and silver. Forced to find a way to make a living, and have the means to safely store precious metal, they turned to accepting deposits of precious metals for safekeeping. The goldsmith would then issue a receipt for the deposit. At first, these receipts circulated as form of money. But eventually, < Previous Page Next Page >
  7. 7. | AN INTRODUCTION TO BANKING MANAGEMENT 7 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES the goldsmiths realized that, since not all of the depositors would demand their gold and silver simultaneously, they could issue more receipts than they had metal in their vault. Banks became an integral part of the US economy from the beginning of the Republic. Five years after the Declaration of Independence, the first chartered bank was established in Philadelphia in 1781, and by 1794, there were seventeen more. At first, bank charters could only be obtained through an act of legislation. But, in 1838, New York adopted the Free Banking Act, which allowed anyone to engage in banking business as long as they met certain legal specifications. As free banking quickly spread to other states, problems associated with the system soon became apparent. For example, banks incorporated under these state laws had the right to issue their own bank notes. This led to a multiplicity of notes? Many of which proved to be worthless in the (all too common) event of a bank failure. With the civil war came legislation that provided for a federally chartered system of banks. This legislation allowed national banks to issue notes and placed a tax on state issued bank notes. These national bank notes came with a federal guarantee, which protected the note-holder if the bank failed. This new legislation also brought all banks under federal supervision. In essence, it laid the foundations of the present- day system. Types of Banking Online Banking Online banking (or Internet banking) allows customers to conduct financial transactions on a secure website operated by their retail or virtual bank, credit union or building society. Features: Online banking solutions have many features and capabilities in common, but traditionally also have some that are application specific. The common features fall broadly into several categories: 1) Transactional (e.g., performing a financial transaction such as an account to account transfer, paying a bill, wire transfer... and applications... apply for a loan, new account, etc.) < Previous Page Next Page >
  8. 8. | AN INTRODUCTION TO BANKING MANAGEMENT 8 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES  Electronic bill presentment and payment - EBPP  Funds transfer between a customer's own checking and savings accounts, or to another customer's account  Investment purchase or sale  Loan applications and transactions, such as repayments 2) Non-transactional (e.g., online statements, check links, cobrowsing, chat)  Bank statements 3) Financial Institution Administration - features allowing the financial institution to manage the online experience of their end users 4) ASP/Hosting Administration - features allowing the hosting company to administer the solution across financial institutions Features commonly unique to business banking include: 1) Support of multiple users having varying levels of authority 2) Transaction approval process 3) Wire transfer Features commonly unique to Internet banking include: Personal financial management support, such as importing data into personal accounting software. Some online banking platforms support account aggregation to allow the customers to monitor all of their accounts in one place whether they are with their main bank or with other institutions... Security: Protection through single password authentication, as is the case in most secure Internet shopping sites, is not considered secure enough for personal online banking applications in some countries. < Previous Page Next Page >
  9. 9. | AN INTRODUCTION TO BANKING MANAGEMENT 9 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES Basically there exist two different security methods for online banking. The PIN/TAN system where the PIN represents a password, used for the login and TANs representing one-time passwords to authenticate transactions. TANs can be distributed in different ways; the most popular one is to send a list of TANs to the online banking user by postal letter. The most secure way of using TANs is to generate them by need using a security token. These token generated TANs depend on the time and a unique secret, stored in the security token (this is called two-factor authentication or 2FA). Usually online banking with PIN/TAN is done via a web browser using SSL secured connections, so that there is no additional encryption needed. Signature based online banking where all transactions are signed and encrypted digitally. The Keys for the signature generation and encryption can be stored on smartcards or any memory medium, depending on the concrete implementation. Attacks: Most of the attacks on online banking used today are based on deceiving the user to steal login data and valid TANs. Two well known examples for those attacks are phishing and pharming. Cross-site scripting and keylogger/Trojan horses can also be used to steal login information. A method to attack signature based online banking methods is to manipulate the used software in a way, that correct transactions are shown on the screen and faked transactions are signed in the background. A recent FDIC Technology Incident Report, compiled from suspicious activity reports banks file quarterly, lists 536 cases of computer intrusion, with an average loss per incident of $30,000. That adds up to a nearly $16-million loss in the second quarter of 2007. Computer intrusions increased by 150 percent between the first quarter of 2007 and the second. In 80 percent of the cases, the source of the intrusion is unknown but it occurred during online banking, the report states. Countermeasures: There exist several countermeasures which try to avoid attacks. Digital certificates are used against phishing and pharming, the use of class-3 card readers is a measure to avoid manipulation of transactions by the software in signature based online banking variants. To protect their systems against Trojan horses, users should use virus scanners and be careful with downloaded software or e-mail attachments. In 2001 the FFIEC issued guidance for multifactor authentication (MFA) and then required to be in place < Previous Page Next Page >
  10. 10. | AN INTRODUCTION TO BANKING MANAGEMENT 10 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES by the end of 2006. Electronic Banking For many consumers, electronic banking means 24-hour access to cash through an automated teller machine (ATM) or Direct Deposit of paychecks into checking or savings accounts. But electronic banking now involves many different types of transactions. Electronic banking, also known as electronic fund transfer (EFT), uses computer and electronic technology as a substitute for checks and other paper transactions. EFTs are initiated through devices like cards or codes that let you, or those you authorize, access your account. Many financial institutions use ATM or debit cards and Personal Identification Numbers (PINs) for this purpose. Some use other forms of debit cards such as those that require, at the most, your signature or a scan. The federal Electronic Fund Transfer Act (EFT Act) covers some electronic consumer transactions. Electronic Fund Transfers: EFT offers several services that consumers may find practical:  Automated Teller Machines or 24-hour Tellers are electronic terminals that let you bank almost any time. To withdraw cash, make deposits, or transfer funds between accounts, you generally insert an ATM card and enter your PIN. Some financial institutions and ATM owners charge a fee, particularly to consumers who don‘t have accounts with them or on transactions at remote locations. Generally, ATMs must tell you they charge a fee and its amount on or at the terminal screen before you complete the transaction. Check the rules of your institution and ATMs you use to find out when or whether a fee is charged.  Direct Deposit lets you authorize specific deposits, such as paychecks and Social Security checks, to your account on a regular basis. You also may pre-authorize direct withdrawals so that recurring bills, such as insurance premiums, mortgages, and utility bills, are paid automatically. Be cautious before you pre-authorize direct withdrawals to pay sellers or companies with whom you are unfamiliar; funds from your bank account could be withdrawn fraudulently.  Pay-by-Phone Systems let you call your financial institution with instructions to pay certain bills or to transfer funds between accounts. You must have an agreement with the institution to make such < Previous Page Next Page >
  11. 11. | AN INTRODUCTION TO BANKING MANAGEMENT 11 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES transfers.  Personal Computer Banking lets you handle many banking transactions via your personal computer. For instance, you may use your computer to view your account balance, request transfers between accounts, and pay bills electronically.  Debit Card Purchase Transactions let you make purchases with a debit card, which also may be your ATM card. This could occur at a store or business, on the Internet or online, or by phone. The process is similar to using a credit card, with some important exceptions. While the process is fast and easy, a debit card purchase transfers money — fairly quickly — from your bank account to the company‘s account. So it‘s important that you have funds in your account to cover your purchase. This means you need to keep accurate records of the dates and amounts of your debit card purchases and ATM withdrawals in addition to any checks you write. Also be sure you know the store or business before you provide your debit card information, to avoid the possible loss of funds through fraud. Your liability for unauthorized use, and your rights for error resolution, may differ with a debit card.  Electronic Check Conversion converts a paper check into an electronic payment in a store or when a company receives your check in the mail. In a store, when you give your check to a cashier, the check is run through an electronic system that captures your banking information and the amount of the check. You‘re asked to sign a receipt and you get a copy for your records. When your check has been handed back to you, it should be voided or marked by the merchant so that it can‘t be used again. The merchant electronically sends information from the check (but not the check itself) to your bank or other financial institution, and the funds are transferred into the merchant‘s account. When you mail-in a check for payment to a merchant or other company, they may electronically send information from your check (but not the check itself) through the system, and the funds are transferred into their account. For a mailed check, you should still receive advance notice from a company that expects to send your check information through the system electronically. The merchant or other company might include the notice on your monthly statement or under its terms and conditions. The notice also should state if the merchant or company will electronically collect from your account a fee — like a ―bounced check‖ fee — if you have insufficient funds to cover the transaction. Be especially careful in Internet and telephone transactions that may involve use of your bank account information, rather than a check. A legitimate merchant that lets you use your bank account information to make < Previous Page Next Page >
  12. 12. | AN INTRODUCTION TO BANKING MANAGEMENT 12 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES a purchase or pay on an account should post information about the process on their website or explain the process over the telephone. The merchant also should ask for your permission to electronically debit your bank account for the item you‘re purchasing or paying on. However, because Internet and telephone electronic debits don‘t occur face-to-face, you should be cautious with whom you reveal your bank account information. Don‘t give this information to sellers with whom you have no prior experience or with whom you have not initiated the call, or to companies that seem reluctant to provide information or discuss the process with you. Not all electronic fund transfers are covered by the EFT Act. For example, some financial institutions and merchants issue cards with cash value stored electronically on the card itself. Examples include prepaid telephone cards, mass transit passes, and some gift cards. These ―stored-value‖ cards, as well as transactions using them, may not be covered by the EFT Act. This means you may not be covered for the loss or misuse of the card. Ask your financial institution or merchant about any protections offered for these cards. Disclosures: To understand your legal rights and responsibilities regarding your EFTs, read the documents you receive from the financial institution that issued your ―access device.‖ That is, a card, code or other means of accessing your account to initiate electronic fund transfers. Although the means varies by institution, it often involves a card and/or a PIN. No one should know your PIN except you and select employees of the financial institution. You also should read the documents you receive for your bank account, which may contain more information about EFTs. Before you contract for EFT services or make your first electronic transfer, the institution must tell you the following information in a form you can keep.  A summary of your liability for unauthorized transfers.  The telephone number and address of the person to be notified if you think an unauthorized transfer has been or may be made, a statement of the institution‘s ―business days‖ (which is, generally, the days the institution is open to the public for normal business), and the number of days you have to report suspected unauthorized transfers.  The type of transfers you can make, fees for transfers, and any limits on the frequency and dollar amount of transfers. < Previous Page Next Page >
  13. 13. | AN INTRODUCTION TO BANKING MANAGEMENT 13 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES  A summary of your right to receive documentation of transfers, to stop payment on a pre-authorized transfer, and the procedures to follow to stop payment.  A notice describing the procedures you must follow to report an error on a receipt for an EFT or your periodic statement, to request more information about a transfer listed on your statement, and how long you have to make your report.  A summary of the institution‘s liability to you if it fails to make or stop certain transactions.  Circumstances under which the institution will disclose information to third parties concerning your account.  A notice that you may be charged a fee by ATMs where you don‘t have an account. In addition to these disclosures, you will receive two other types of information for most transactions: terminal receipts and periodic statements. Separate rules apply to passbook accounts from which pre-authorized transfers are drawn. The best source of information about those rules is your contract with the financial institution for that account. You‘re entitled to a terminal receipt each time you initiate an electronic transfer, whether you use an ATM or make a point-of-sale electronic transfer. The receipt must show the amount and date of the transfer, and its type, such as ―from savings to checking.‖ When you make a point-of-sale transfer, you‘ll probably get your terminal receipt from the salesperson. You won‘t get a terminal receipt for regularly occurring electronic payments that you‘ve pre-authorized, like insurance premiums, mortgages, or utility bills. Instead, these transfers will appear on your periodic statement. If the pre-authorized payments vary, however, you should receive a notice of the amount that will be debited at least 10 days before the debit takes place. You‘re also entitled to a periodic statement for each statement cycle in which an electronic transfer is made. The statement must show the amount of any transfer, the date it was credited or debited to your account, the type of transfer and type of account(s) to or from which funds were transferred, and the address and telephone number for inquiries. You‘re entitled to a quarterly statement whether or not electronic transfers were made. < Previous Page Next Page >
  14. 14. | AN INTRODUCTION TO BANKING MANAGEMENT 14 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES Keep and compare your EFT receipts with your periodic statements the same way you compare your credit card receipts with your monthly credit card statement. This will help you make the best use of your rights under federal law to dispute errors and avoid liability for unauthorized transfers. Investment Banking Investment banking is a field of banking that aids companies in acquiring funds. In addition to the acquisition of new funds, investment banking also offers advice for a wide range of transactions a company might engage in. Traditionally, banks either engaged in commercial banking or investment banking. In commercial banking, the institution collects deposits from clients and gives direct loans to businesses and individuals. In the United States, it was illegal for a bank to have both commercial and investment banking until 1999, when the Gramm-Leach-Bliley Act legalized it. Through investment banking, an institution generates funds in two different ways. They may draw on public funds through the capital market by selling stock in their company, and they may also seek out venture capital or private equity in exchange for a stake in their company. An investment banking firm also does a large amount of consulting. Investment bankers give companies advice on mergers and acquisitions, for example. They also track the market in order to give advice on when to make public offerings and how best to manage the business' public assets. Some of the consultative activities investment banking firms engage in overlap with those of a private brokerage, as they will often give buy-and- sell advice to the companies they represent. The line between investment banking and other forms of banking has blurred in recent years, as deregulation allows banking institutions to take on more and more sectors. With the advent of mega-banks which operate at a number of levels, many of the services often associated with investment banking are being made available to clients who would otherwise be too small to make their business profitable. Careers in investment banking are lucrative and one of the most sought after positions in the money- market world. A career in investment banking involves extensive traveling, grueling hours and an often cut-throat lifestyle. While highly competitive and time intensive, investment banking also offers an exciting lifestyle with < Previous Page Next Page >
  15. 15. | AN INTRODUCTION TO BANKING MANAGEMENT 15 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES huge financial incentives that are a draw to many people An investment bank is a financial institution that raises capital, trades in securities and manages corporate mergers and acquisitions. Investment banks profit from companies and governments by raising money through issuing and selling securities in the capital markets (both equity, bond) and insuring bonds (selling credit default swaps), as well as providing advice on transactions such as mergers and acquisitions. To perform these services in the United States, an adviser must be a licensed broker-dealer, and is subject to SEC (FINRA) regulation. Until the late 1980s, the United States maintained a separation between investment banking and commercial banks. Other developed countries (including G7 countries) have not maintained this separation historically. A majority of investment banks offer strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, such as the trading of derivatives, fixed income, foreign exchange, commodity, and equity securities. Trading securities for cash or securities (i.e., facilitating transactions, market-making), or the promotion of securities (i.e., underwriting, research, etc.) was referred to as the "sell side". Dealing with the pension funds, mutual funds, hedge funds, and the investing public who consumed the products and services of the sell-side in order to maximize their return on investment constitutes the "buy side". Many firms have buy and sell side components. Functions of Investment Banking: Investment banks have multilateral functions to perform. Some of the most important functions of investment banking can be jot down as follows:  Investment banking help public and private corporations in issuing securities in the primary market, guarantee by standby underwriting or best efforts selling and foreign exchange management. Other services include acting as intermediaries in trading for clients.  Investment banking provides financial advice to investors and serves them by assisting in purchasing securities, managing financial assets and trading securities.  Investment banking differs from commercial banking in the sense that they don't accept deposits and grant retail loans. However the dividing lines between the two fraternal twins have become flimsy with < Previous Page Next Page >
  16. 16. | AN INTRODUCTION TO BANKING MANAGEMENT 16 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES loans and securities becoming almost substitutable ways of raising funds.  Small firms providing services of investment banking are called boutiques. These mainly specialize in bond trading, advising for mergers and acquisitions, providing technical analysis or program trading. Banking Day For exchange contracts it is the day on which the two contracting parties exchange the currencies which are being bought or sold.. For a spot transaction it is two business banking days forward in the country of the bank providing quotations which determine the spot value date. The only exception to this general rule is the spot day in the quoting centre coinciding with a banking holiday in the country(ies) of the foreign currency(ies). The value date then moves forward a day. The enquirer is the party who must make sure that his spot day coincides with the one applied by the respondent. The forward months maturity must fall on the corresponding date in the relevant calendar month. If the one month date falls on a non-banking day in one of the centers then the operative date would be the next business day that is common. The adjustment of the maturity for a particular month does not affect the other maturities that will continue to fall on the original corresponding date if they meet the open day requirement. If the last spot date falls on the last business day of a month, the forward dates will match this date by also falling due on the last business day. Also referred to as Maturity Date. Mobile Banking Mobile banking (also known as M-Banking, mbanking, SMS Banking etc.) is a term used for performing balance checks, account transactions, payments etc. via a mobile device such as a mobile phone. Mobile banking today (2007) is most often performed via SMS or the Mobile Internet but can also use special programs called clients downloaded to the mobile device. A mobile banking conceptual model: In one academic model, mobile banking is defined as: "Mobile Banking refers to provision and availment of banking- and financial services with the help of mobile telecommunication devices. The scope of offered services may include facilities to conduct bank and stock market transactions, to administer accounts and to access customised information." According to this model Mobile Banking can be said to consist of three inter-related < Previous Page Next Page >
  17. 17. | AN INTRODUCTION TO BANKING MANAGEMENT 17 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES concepts:  Mobile Accounting  Mobile Brokerage  Mobile Financial Information Services Most services in the categories designated Accounting and Brokerage are transaction-based. The non- transaction-based services of an informational nature are however essential for conducting transactions - for instance, balance inquiries might be needed before committing a money remittance. The accounting and brokerage services are therefore offered invariably in combination with information services. Information services, on the other hand, may be offered as an independent module. E Banking Internet banking (or E-banking) means any user with a personal computer and a browser can get connected to his bank -s website to perform any of the virtual banking functions. In internet banking system the bank has a centralized database that is web-enabled. All the services that the bank has permitted on the internet are displayed in menu. Any service can be selected and further interaction is dictated by the nature of service. The traditional branch model of bank is now giving place to an alternative delivery channels with ATM network. Once the branch offices of bank are interconnected through terrestrial or satellite links, there would be no physical identity for any branch. It would a borderless entity permitting anytime, anywhere and anyhow banking. The network which connects the various locations and gives connectivity to the central office within the organization is called intranet. These networks are limited to organizations for which they are set up. SWIFT is a live example of intranet application. Advantage of Internet banking As per the Internet and Mobile Association of India's report on online banking 2006, "There are many advantages of online banking. It is convenient, it isn't bound by operational timings, there are no geographical < Previous Page Next Page >
  18. 18. | AN INTRODUCTION TO BANKING MANAGEMENT 18 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES barriers and the services can be offered at a miniscule cost." Through Internet banking, you can check your transactions at any time of the day, and as many times as you want to. Where in a traditional method, you get quarterly statements from the bank. If the fund transfer has to be made outstation, where the bank does not have a branch, the bank would demand outstation charges. Whereas with the help of online banking, it will be absolutely free for you. Security Precautions: Customers should never share personal information like PIN numbers, passwords etc with anyone, including employees of the bank. It is important that documents that contain confidential information are safeguarded. PIN or password mailers should not be stored, the PIN and/or passwords should be changed immediately and memorised before destroying the mailers. Customers are advised not to provide sensitive account-related information over unsecured e-mails or over the phone. Take simple precautions like changing the ATM PIN and online login and transaction passwords on a regular basis. Also ensure that the logged in session is properly signed out. Private Banking Private banking is a term for banking, investment and other financial services provided by banks to private individuals investing sizable assets. The term "private" refers to the customer service being rendered on a more personal basis than in mass-market retail banking, usually via dedicated bank advisers. It should not be confused with a private bank, which is simply a non-incorporated banking institution. Historically private banking has been viewed as very exclusive, only catering for high net worth individuals with liquidity over $2 million, although it is now possible to open some private bank accounts with as little as $250,000 for private investors. An institution's private banking division will provide various services such as wealth management, savings, inheritance and tax planning for their clients. A high-level form of private banking (for the especially affluent) is often referred to as wealth management. The word "private" also alludes to bank secrecy and minimizing taxes via careful allocation of assets or by hiding assets from the taxing authorities. Swiss and certain offshore banks have been criticized for such cooperation with individuals practicing tax evasion. Although tax fraud is a criminal offense in Switzerland, tax evasion is only a civil offense, not requiring banks to notify taxing authorities. < Previous Page Next Page >
  19. 19. | AN INTRODUCTION TO BANKING MANAGEMENT 19 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES Global Banking In the 1970s, a number of smaller crashes tied to the policies put in place following the depression, resulted in deregulation and privatization of government-owned enterprises in the 1980s, indicating that governments of industrial countries around the world found private-sector solutions to problems of economic growth and development preferable to state-operated, semi-socialist programs. This spurred a trend that was already prevalent in the business sector, large companies becoming global and dealing with customers, suppliers, manufacturing, and information centres all over the world. Global banking and capital market services proliferated during the 1980s and 1990s as a result of a great increase in demand from companies, governments, and financial institutions, but also because financial market conditions were buoyant and, on the whole, bullish. Interest rates in the United States declined from about 15% for two-year U.S. Treasury notes to about 5% during the 20-year period, and financial assets grew then at a rate approximately twice the rate of the world economy. Such growth rate would have been lower, in the last twenty years, were it not for the profound effects of the internationalization of financial markets especially U.S. Foreign investments, particularly from Japan, who not only provided the funds to corporations in the U.S., but also helped finance the federal government; thus, transforming the U.S. stock market by far into the largest in the world. Nevertheless, in recent years, the dominance of U.S. financial markets has been disappearing and there has been an increasing interest in foreign stocks. The extraordinary growth of foreign financial markets results from both large increases in the pool of savings in foreign countries, such as Japan, and, especially, the deregulation of foreign financial markets, which has enabled them to expand their activities. Thus, American corporations and banks have started seeking investment opportunities abroad, prompting the development in the U.S. of mutual funds specializing in trading in foreign stock markets. Such growing internationalization and opportunity in financial services has entirely changed the competitive landscape, as now many banks have demonstrated a preference for the ―universal banking‖ model so prevalent in Europe. Universal banks are free to engage in all forms of financial services, make investments in client companies, and function as much as possible as a ―one-stop‖ supplier of both retail and wholesale financial services. < Previous Page Next Page >
  20. 20. | 20 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES Many such possible alignments could be accomplished only by large acquisitions, and there were many of them. By the end of 2000, a year in which a record level of financial services transactions with a market value of $10.5 trillion occurred, the top ten banks commanded a market share of more than 80% and the top five, 55%. Of the top ten banks ranked by market share, seven were large universal-type banks (three American and four European), and the remaining three were large U.S. investment banks who between them accounted for a 33% market share. This growth and opportunity also led to an unexpected outcome: entrance into the market of other financial intermediaries: nonbanks. Large corporate players were beginning to find their way into the financial service community, offering competition to established banks. The main services offered included insurances, pension, mutual, money market and hedge funds, loans and credits and securities. Indeed, by the end of 2001 the market capitalisation of the world‘s 15 largest financial services providers included four nonbanks. In recent years, the process of financial innovation has advanced enormously increasing the importance and profitability of nonbank finance. Such profitability priorly restricted to the nonbanking industry, has prompted the Office of the Comptroller of the Currency (OCC) to encourage banks to explore other financial instruments, diversifying banks' business as well as improving banking economic health. Hence, as the distinct financial instruments are being explored and adopted by the banking and nonbanking industries, the distinction between different financial institutions is gradually vanishing. < Previous Page Next Page >
  21. 21. | 21 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES CHAPTER 2 FINANCIAL SYSTEM The Role of the Financial System This chapter commences by examining the role of the financial system in acting as a lubricant to the real economy. The inner flows are real flows and in the absence of money, households would need to undertake barter to satisfy all their wants. Note the problem of ‗double coincidence of wants‘ in the practice of barter. In other words, a barter system is dependent on finding someone who has the goods you want and who wants the goods you are trying to exchange. To understand this point, consider how you would be paid your salary/grant if a system of barter existed in the activities in which you are involved. The middle flows represent the introduction of money into the economy. Note that the introduction of money means that the act of sale can now be separated from the act of purchase. Finally, the outer flows represent lending and borrowing transactions in the economy. The ability to borrow allows firms to invest in excess of their current income. This clearly encourages economic development. A financial system comprises financial institutions and financial markets. The main roles are:  to facilitate lending and borrowing (outer flows)  to enable wealth holders to adjust the composition of their wealth (through financial markets)  to provide a payments mechanism (middle flows) < Previous Page Next Page >
  22. 22. | FINANCIAL SYSTEM 22 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES  to provide specialist services such as insurance and pensions. The Nature of Financial Claims A financial claim is a claim to the payment of a sum of money at some future date or dates. Using Lancaster‘s approach to consumer demand, financial claims can be categorised according to the various attributes of that claim. The term attributes, or characteristics, refers to the various features you would look for when making an investment decision (i.e. when deciding whether to purchase a financial claim). The following features are some of the attributes most commonly used when describing a financial claim: Risk: This refers to the uncertain future outcome of a financial claim. For example, the future price of a share is not known with certainty. Another example of financial risk is default risk. This refers to the risk of debt instrument (e.g. a loan) not being repaid. Other examples of financial risk are interest rate risk and exchange rate risk. These risks refer to the unpredictability of future interest rates or exchange rates. As risk is a concept of fundamental importance in finance we will devote more attention to this characteristic. Risk, in general terms, is a measure of the variation around some average (expected) value. If an investor is considering whether to invest in an ordinary share s/he needs a measure of the expected return on the share as well as a measure of the variation around the expected return. This measure of variation is a measure of how far the actual return may differ from what we expect. If we believe the future will be like the past the best estimate of the expected return on corporate bonds next year is six per cent. This does not imply that the actual return next year will be six per cent. To provide a measure of the risk of the actual return being different from what we expect we normally use a measure of the dispersion of the distribution: the variance or standard deviation. The standard deviation of a distribution of historical returns is a statistical measure of how variable the returns have been around the average return. The higher the standard deviation the greater the variability and hence the greater the risk that the actual return in the future will be different from what we expect. This provides us with a quantitative measure of risk that we can use to compare the riskiness associated with different securities. Treasury bills had the lowest risk but earned the holder the lowest return. The positive relationship between risk and return exists because investors require compensation for bearing risk. The higher the risk < Previous Page Next Page >
  23. 23. | FINANCIAL SYSTEM 23 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES associated with a financial instrument, the higher the return they require to induce them to hold the asset.  Liquidity: Liquidity is the ease and speed with which a financial instrument can be turned into cash without loss. For example a bank deposit is easily and quickly turned into cash and so is seen as very liquid. However, a stock in a small company may not be easy to sell at short notice so is deemed to be illiquid.  Real value certainty: This means the susceptibility to loss in value of the claim due to a rise in the general level of prices.  Expected return: For many claims, such as a bank deposit, there is an explicit cash return to the holder. For claims where the return is not known with certainty in advance (i.e. there is an associated risk) then it is expected return that is used.  Term to maturity: This refers to the remaining time to maturity for a financial instrument. At maturity the instrument is repaid by the borrower. Term to maturity ranges from zero in the case of bank deposits that are withdrawable on demand to instruments such as shares which have no maturity date. Financial claims can be divided into two broad groups, debt and equity.  Debt: A debt instrument is a contractual arrangement whereby a borrower normally agrees to make regular payments (interest payments) of a fixed amount until a specified date when the debt matures. On maturity the amount borrowed is repaid. There are exceptions to this general definition. For example, a deposit contract may have no specified maturity date (it may be repayable on demand). Examples of debt instruments are deposits, loans, bills and bonds.  Deposit: This is a loan by an individual or company to a financial institution such as a bank.  Loan: A loan is a sum of money lent, normally by a financial institution such as a bank, to a company or individual.  Bill: A bill is a short-term paper claim issued by a company or government. The bill is bought by an investor at a discount to face value (i.e. at a price lower than face value). The issuer of the bill then pays < Previous Page Next Page >
  24. 24. | FINANCIAL SYSTEM 24 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES the investor the face value at the maturity date of the bill. The difference between the rate paid for the bill and its face value represents an interest payment or return to the investor.  Bond: A claim that normally pays a fixed rate of interest (known as coupon payments) until the maturity date and then at the maturity date the issuer pays the holder the par value (face value) of the bond. Bonds are issued by governments and companies and represent a long-term debt instrument compared to bills which are short-term. The common feature of debt is that the amount is fixed; (e.g. a deposit of £140 at a bank or the purchase of a £100 bond). This contrasts with equity (e.g. ordinary shares) where the value of the financial claim varies according to its market price.  Equity: This is a claim to a share in the net income and assets of a firm. Unlike with debt, firms are not contractually obliged to make regular payments to equity holders. In years when firms make sufficiently high profits then equity holders are paid a dividend. Equity holders will rank lower than debt holders in a firm in the event of liquidation. Equity holders are therefore regarded as the bearers of business risk. Finally, equity claims have no maturity date. The Structure of Financial Markets We have seen the distinction between debt and equity claims and therefore debt and equity markets, above. Other ways of classifying markets include separating them into:  primary and secondary markets  money and capital markets. Primary and secondary markets A primary market is one in which the new issues of a security, both debt and equity, are sold to initial buyers. A secondary market is a financial market in which securities that have been previously issued can be resold. Most trading in financial markets takes place on secondary markets (as wealth holders adjust their portfolios), yet it is the primary markets that facilitate the financing of investment projects by firms. Some < Previous Page Next Page >
  25. 25. | FINANCIAL SYSTEM 25 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES commentators on financial markets have argued that secondary market trading is largely irrelevant to the financing function of a financial system. However, the existence of a secondary market for a financial claim enhances the liquidity of that claim. The enhanced liquidity of these claims makes them more desirable to investors and therefore easier for the issuer to sell in the primary market. A secondary market also performs a role in setting the price of a primary market issue. That is, the price of the claims issued into the primary market (and hence the amount of capital raised by the issue) will be partly determined by the price of similar claims traded in the secondary market. Money and capital markets The categorisation of financial markets into money and capital markets is essentially based on the maturity of the claims traded in each. A money market is a market where short-term debt instruments (maturity of less than one year) are traded. Money markets are mainly wholesale markets (large size transactions) where firms and financial institutions manage their short-term liquidity needs. So a firm or bank with temporary surplus funds would purchase a money market instrument to earn interest. A capital market is a market for long-term financial instruments. These long-term instruments include company shares, government bonds and corporate bonds. Company shares, as noted above, have a theoretically infinite life. Corporate and government bonds are issued with initial maturities of between five and 30 years. Financial System Accounting In preparing accounts of the financial system it is useful to break down the total economy into a series of sectors (i.e. disaggregate). This makes it easier to highlight the salient features of the economy. Of course division of the economy into an excessive number of sectors would not be helpful since the salient features would be obscured by excessive detail. The UK follows conventional practice by dividing the economy into five broad categories; namely the public sector, the personal sector, the financial sector, industrial and commercial companies and the overseas sector. Two separate sets of accounts can be prepared. The first shows the stock of wealth existing at a particular point of time. The basis of this analysis is the ‗balance sheet‘. The second type records the flow of < Previous Page Next Page >
  26. 26. | FINANCIAL SYSTEM 26 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES funds between the various sectors over a period of time. Clearly the two sets of accounts are closely connected since the changes in a sector‘s stocks of wealth between two points of time represent the flow of funds to and from that sector over the time period between the two points. You should be aware of the general features of the sectors as revealed by these balance sheets. The key features are that:  The sector with the largest net wealth is the personal sector.  The industrial and commercial companies sector is a net debtor.  The public sector shows a small net wealth.  For the financial institutions sector, assets and liabilities balance each other, so net wealth is approximately zero. The second type of account shows the sector financial transactions. This is perhaps the more important of the two types of account examined in this section. Any sector‘s financial transactions results from the excess/deficit of expenditure over income. Thus if the sector spends less than its income, it is saving. A sector‘s saving can be used to invest in fixed assets (e.g. houses, factories) or to acquire financial assets. The difference between a sector‘s saving and investment is termed the financial balance. Where a sector saves more than it invests in a period then it has a financial surplus. The surplus can be used to acquire financial assets such as, for example, notes and coins, bank deposits, shares or to pay off previous debt (i.e. reducing its liabilities). Conversely if there is an excess of investment over saving in a period then the sector has a financial deficit which must be financed by selling assets or borrowing. The financial transactions accounts show the various financial transactions, which have been undertaken as a result of the financial surplus/deficit. The convention of financial accounts is:  A positive value implies an increase in financial assets or a decrease in financial liabilities (i.e. saving is greater than investment). < Previous Page Next Page >
  27. 27. | FINANCIAL SYSTEM 27 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES  A negative sign implies an increase in financial liabilities or a decrease in financial assets (i.e. investment is greater than saving). The accounting rules underlying the construction of all financial accounts are:  The sum of the financial surpluses and deficits equals zero, which reflects the fact that the financial assets of one sector are by definition the financial liabilities of another.  The net financial transactions of a sector will equal its financial balance.  The sum of transactions in a particular financial instrument will equal zero. This again follows from the fact that increased holdings of an asset of one sector will be balanced by increased liabilities of another.  The sum of saving across sectors, that is, for the economy, will equal the sum of investment across sectors. In other words all saving will find its way into investment. The Nature of Financial Intermediation A company planning to invest in a new production line may not be able to finance all the investment from his/her own resources and will have to borrow some or all of the required funds. An individual with surplus funds out of his/her current income may want to lend these funds in order to obtain a return. It would therefore seem logical for the firm wanting to borrow funds to seek out the individual wanting to lend funds, and vice versa. In practice direct lending, like this, does not generally happen and instead funds are channeled through a financial intermediary such as a bank. There are three main reasons why financial intermediaries exist:  different requirements of lenders and borrowers  transaction costs  Problems arising out of information asymmetries. Different requirements of lenders and borrowers < Previous Page Next Page >
  28. 28. | FINANCIAL SYSTEM 28 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES Firms borrowing funds to finance investment will tend to want to repay the borrowing over the expected life of the investment. In addition the claims issued by firms will be have a relatively high default risk reflecting the nature of business investment. In contrast, lenders will generally be looking to hold assets which are relatively liquid and low-risk. To reconcile the conflicting requirements of lenders and borrowers a financial intermediary will hold the long-term, high-risk claims of borrowers and finance this by issuing liabilities, called deposits, which are highly liquid and have low default risk. Transaction costs The presence of transaction costs makes it very difficult for a potential lender to find an appropriate borrower. There are four main types of transaction costs:  Search costs: both lender and borrower will incur costs of searching for, and finding information about, a suitable counterparty.  Verification costs: lenders must verify the accuracy of the information provided by borrowers.  Monitoring costs: once a loan is created, the lender must monitor the activities of the borrower, in particular to identify if a payment date is missed.  Enforcement costs: the lender will need to ensure enforcement of the terms of the contract, or recovery of the debt in the event of default. Asymmetric information This is an important concept in finance and needs to be fully understood. Asymmetric information refers to the situation where one party to a transaction has more information than the other party. This is a problem with most types of transactions, not just financial, and a classic example is provided by the sale/purchase of a second hand car. In this case the seller has more information about the condition of the car than the buyer. This is likely to make the buyer reluctant to purchase the car unless he/she can obtain more information, perhaps from a mechanic‘s inspection. In the case of a financial transaction, the borrower will have more information about the potential returns and risks of the investment project for which funds are being borrowed compared to the lender. The existence of asymmetric information creates problems for the lender, both before the loan is < Previous Page Next Page >
  29. 29. | FINANCIAL SYSTEM 29 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES made, at the verification stage, and after, at the monitoring/enforcement stages. The first problem created by asymmetric information occurs when the lender is selecting a potential borrower. Adverse selection can occur (i.e. a borrower who is likely to default – often referred to as a ‗bad risk‘ – is selected) because the potential borrowers, who are the ones most likely to produce an adverse outcome, are the ones most likely to be selected. The second problem that arises out of asymmetric information is moral hazard. This is a problem that occurs after the loan is made and refers to the risk that the borrower might engage in activities that are undesirable (immoral) from the lenders point of view, because they make it less likely that the loan is repaid. A person is more likely to behave differently when using borrowed funds compared to when using their own funds. In particular they may take more risks with the funds. The existence of transaction costs and information asymmetries are important impediments to well functioning financial markets. Although the existence of organized markets where tradeable debt and equity instruments can be issued and acquired (i.e. the bond and equity markets) overcome some of these obstacles, there are still substantial transaction costs and high-risk for the lender and the problems associated with asymmetric information cannot be fully overcome in this way. The solution to these problems has been the emergence of financial intermediaries such as banks. The Process of Financial Intermediation Intermediaries transform assets We saw above that borrowers want to issue claims with characteristics that are different from those sought by lenders. A financial intermediary is able to hold the long-term, high-risk, claims issued by borrowers and finance this by issuing deposit claims with the characteristics of low-risk and short-term (often repayable on demand). The financial intermediary therefore transforms the characteristics of the funds that pass through it. A financial intermediary is said to mismatch the maturity of the assets it holds with the maturity of the liabilities it issues. In other words a financial intermediary will borrow funds that are short-term (deposits) and lend funds with a longer term to maturity (loans). As well as transforming the maturity or liquidity of funds the intermediary will also transform other characteristics of the funds, in particular, default risk and size. The financial intermediary achieves this asset transformation by managing the associated risks. The risks associated with < Previous Page Next Page >
  30. 30. | FINANCIAL SYSTEM 30 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES maturity transformation are reduced by diversifying funding sources. The risks associated with the transformation of default risk can be reduced by a number of techniques. The intermediary can obtain information on each potential borrower and select only those borrowers who have, for example, good income/earnings or a good record on repaying debt. A bank clearly has advantages over a direct lender here as the payments services5 provided by the bank will provide it with useful information on potential borrowers. Intermediaries reduce transaction costs If lenders incur lower transaction costs by lending to an intermediary, such as a bank, compared to lending directly to a borrower then lenders will choose to lend to (deposit money with) a bank. Similarly, borrowers will prefer to borrow from a bank if the information costs (mainly search costs) are lower than direct borrowing. Financial intermediaries are able to reduce transaction costs substantially because they have developed expertise and because their large size enables them to take advantage of economies of scale. For example, a bank will have a loan contract drawn up which can be used over and over again when making loans. The unit cost of each loan contract to the bank will be substantially lower than the cost to an individual of having a loan contract drawn up when undertaking direct lending. Intermediaries reduce the problems arising out of asymmetric information We saw above that the two problems the lenders face are adverse selection and moral hazard. The problem of adverse selection can be solved by the production of more information on the circumstances of the borrower. This can be done through private companies collecting and publishing information on firms‘ balance sheet positions and financial statements. In the US, firms such as Moody‘s and Standard and Poor‘s do this. The information helps investors to select companies‘ securities (bonds and equities). However, because of the free- rider problem, the problem of adverse selection is not completely removed. This occurs when people who do not pay for information take advantage of information acquired by other people. So, if one person purchases information and then buys securities issued by a particular firm believing them to be undervalued, other investors (who have not purchased the information) may observe this and purchase the same securities at the same time. This will bid up the price of the securities to the true value thus negating the value of the information. < Previous Page Next Page >
  31. 31. | FINANCIAL SYSTEM 31 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES If investors know there is a free-rider problem then they are unlikely to purchase information and the adverse selection problem remains. Intermediaries are more able to reduce the adverse selection problem because they develop expertise in information production that enables them to select good risks. As described above banks have a particular advantage here in that they have access to information from customers transaction accounts held with the bank. A bank is able to avoid the free rider problem because the loans it makes are private securities (i.e. not traded in a market). So other investors are not able to observe the bank and bid up the price of the security to the point where little or no profit is made. The problem of moral hazard can be reduced by banks by introducing restrictive covenants into loan contracts. A restrictive covenant is a provision that restricts the borrower‘s activity. One example is a mortgage loan that contains a provision that requires a borrower to purchase life assurance which pays off the loan in the event of the borrower dying. This restrictive covenant encourages the borrower to undertake desirable behaviour, from the lender‘s point of view, that makes the loan more likely to be repaid. Now restrictive covenants can be (and are) written into bond contracts so why is an intermediary better at reducing moral hazard compared to traded bonds containing restrictive covenants? The answer is again to do with the free-rider problem discussed above. Restrictive covenants have to be monitored and enforced if they are to do the job of reducing moral hazard. In the bond market, investors can free-ride on the monitoring and enforcement undertaken by other investors. If most bond holders free-ride then insufficient resources will be devoted to monitoring and enforcement and moral hazard remains high. A bank does not face the free-rider problem because, as described above, its loans are non-traded securities. The bank therefore gains the full benefits of its monitoring and enforcement and therefore has an incentive to devote sufficient resources to the problem of reducing moral hazard. The Implications of Financial Intermediation We will examine the implications of the existence of financial intermediaries from two perspectives:  the utility of individual lenders and borrowers  the level of economic development. The Hirschleifer model < Previous Page Next Page >
  32. 32. | FINANCIAL SYSTEM 32 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES This model allows us to consider the effects of the creation of a financial system that allows lending and borrowing to take place. The precise mechanism for the lending and borrowing are not important and could come either from the development of capital markets or financial intermediaries. What is important is that there is a mechanism that enables economic agents to lend and borrow. The Hirschleifer model is a two period investment/consumption model and the assumptions of the model are stated in Buckle and Thompson (1998), section 2.4. An economic agent has the choice in the first period between using resources (from an initial endowment = Y0) to produce goods and services for consumption in this period (0), or for investment to provide consumption in the second period (1). For simplicity, it is assumed that there are no additional resources endowed to the agent in the second period so any consumption in that period comes from investment in the first period. If we now introduce a financial system into the analysis then the economic agent is now able to lend or borrow. The borrowing/lending opportunities are represented by the financial investment opportunities line (FIL). It is assumed that lending and borrowing can be achieved at the same rate of interest, r. Utility is maximised where the agent‘s indifference curve just touches the FIL. This can occur by borrowing against future production, by moving down the FIL (to say, point D), or by lending to finance future consumption, moving up the FIL (to say, point E). Utility has therefore been increased by the introduction of a financial intermediary since the individual would have remained at point A without the intermediary. The effects of financial intermediation on economic development A reduction in transaction costs and other frictions, such as asymmetric information, which result from the presence of financial intermediaries. The demand for credit is represented by the line D–D, with the normal downward slope. The supply of credit is considered to respond positively to increases in interest rates and is represented by the line S–S. Note that two effects operate here: a substitution effect, leading to a substitution of saving for consumption, and an income effect, which could lower saving. We assume here that the substitution effect dominates, so that saving increases as interest rates increase. Clearly transaction costs do occur and in the absence of a financial intermediary, we assume that transaction costs equal CD, so that the quantity of credit demanded and supplied equals OY. The gap between < Previous Page Next Page >
  33. 33. | FINANCIAL SYSTEM 33 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES the rates of interest paid by the borrower and lender is termed the spread. The introduction of a financial intermediary reduces these costs so the spread narrows to EF (from CD) and the quantity of credit demanded and supplied rises to OX. Provided the increased credit is used to finance investment then it is reasonable to suppose that gross domestic product (GDP) will have increased. In any case, if the increased credit had been used to finance consumption, it is reasonable to assume that utility will have risen. What is the Future for Financial Intermediaries? There is evidence that traditional banking (i.e. financial intermediation) has declined in recent years in countries such as the US, Germany and the UK. The main reasons for this decline are:  Low cost deposits from the public are not as readily available as a source of funds. Alternative liquid investments offering higher returns have taken funds away from banks. In the US money market mutual funds (MMMF) have shown dramatic growth since they first appeared in the early 1980s. MMMFs are like mutual funds (unit trusts in the UK) in that they hold shares, but are also like banks in that their liabilities are deposits against which cheques can be written. There are restrictions on the cheque- writing facility, but it is clear that these institutions have taken funds away from banks.  Credit rating agencies now collect and sell financial information on a large number of companies. This makes it easier for firms with a good credit rating to borrow directly from markets by issuing securities such as commercial paper or bonds. The wider availability of information on borrowers has eroded, to some extent, the informational advantages that banks possess that enable them to carry out the intermediary function. This process whereby firms bypass banks and borrow directly from markets has been termed disintermediation. How have banks responded to this decline? Mishkin and Eakins (1998) argue that banks have sought to maintain profit levels in two ways:  Expanding into new riskier areas of lending, for example, lending to property (real estate) companies. One example of this comes from Japan where over the 1980s the banking system was deregulated and as a consequence banks expanded their lending rapidly. In particularly they lent aggressively to the property (real estate) sector. When property prices in Japan collapsed in the early 1990s most Japanese banks were left with a large amount of ‗bad‘ loans (i.e. loans that would not be repaid in full, if at all). In < Previous Page Next Page >
  34. 34. | FINANCIAL SYSTEM 34 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES recent years a number of Japanese banks have failed as a consequence of these ‗bad‘ loans including Hokkaido Takushoku, the tenth largest commercial bank in Japan, in late 1997.  Pursuing new off-balance-sheet activities. These are non-traditional banking activities that earn the bank fee income rather than interest income. One area of concern here is the expansion of derivatives business, for example, banks acting as dealers in over-the-counter derivatives.9 A classic example here is the case of Barings Bank which, in 1995, failed (and was taken over by ING group) as a result of losses arising out of ‗betting‘ with derivatives by a ‗rogue trader‘ Nick Leeson. < Previous Page Next Page >
  35. 35. | 35 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES CHAPTER 3 RETAIL BANKING Retail banks have traditionally provided intermediation and payments services to individuals and small businesses with all the components of those services supplied by the bank. However it is becoming increasingly difficult to identify the nature of a retail bank. Firstly because many banks now combine both retail and wholesale activities. Secondly because technological developments have enabled banks to supply a wide range of retail financial services to its customers but not supply all the sub-components of those services. In this chapter we begin by examining the nature of traditional retail banking. In particular we investigate the provision of intermediation services and how banks manage the risks involved in that provision. We also examine the nature of payments services provided by retail banks and discuss why banks have traditionally combined provision of intermediation and payments services. Finally we investigate recent developments in retail banking and discuss the impact of these on the future organisation of retail banks. We focus in particular on how it is now possible to separate the components of a financial service/product and the trend towards outsourcing or sub-contracting the supply of components of a financial service/product. What is Retail Banking? It is becoming more and more difficult to define a retail bank. Traditionally, retail banks provided banking services to individuals and small businesses dealing in large volumes of low value transactions. This is in contrast to wholesale banking which deals with large value transactions, generally in small volumes. In practice it is difficult to identify purely retail banks that fund themselves from retail deposits and lend in the retail loan markets. In the UK, Australia, US and many other developed countries the large banks combine retail and wholesale activities. Technological developments are also changing the nature of retail banking. Traditionally a retail bank would need a substantial branch network to collect the deposits of the public, facilitate repayment of < Previous Page Next Page >
  36. 36. | RETAIL BANKING 36 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES deposits and other account payments and make loans. The widespread use of automated teller machines and the growth in telephone banking, postal accounts and more recently internet banks has allowed new types of retail bank to emerge that do not require extensive investment in branches. To make sense of the many developments in retail banking it is helpful to see retail banking as a set of processes rather than institutions. On the assets side of the balance sheet, the main item is advances which make up 65 per cent of sterling assets. There will also be foreign currency advances in the item other currency asset. Liquidity is provided by a small amount of cash accounting for approximately 0.7 per cent of total assets. This is a very small cash base. However, additional liquidity is provided by market loans which refer mainly to short-term loans made through the inter-bank market. A bank that is short of funds can borrow funds from other banks for a short period through the inter-bank market. Likewise, a bank that has a surplus of funds can lend short-term through the inter-bank market. Short-term can be as short as overnight or one day. Further liquidity is provided by the item of bills (these are debt instruments issued by firms and the government with an original maturity of less than one year – typically one month or three months) A bank can sell these bills quickly if it needs additional liquid funds. Finally, a bank holds investments, which are mainly government bonds. These provide an alternative source of return for a bank when there are no good lending propositions. Also, because government bonds can be sold in a market before maturity they can be classed as another source of liquidity. The other main assets held by banks are assets that can be turned into cash at short notice, known as liquid assets. We examine the risks that mismatching of the term to maturity of liabilities and assets creates, and the reasons why banks hold a large amount and variety of liquid assets in the next section. What Services and Products do Retail Banks Provide? Retail banks provide various products and services to individuals and small businesses. Traditionally a retail bank provided:  intermediation services and  payments services. < Previous Page Next Page >
  37. 37. | RETAIL BANKING 37 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES Increasingly retail banks are providing a much wider range of products/services including insurance products, pension schemes, stockbroking services etc. In short, retail banks are becoming financial supermarkets. In particular we saw that in transforming the characteristics of funds a bank is exposed to two main risks:  Liquidity risk – a consequence of issuing liabilities (deposits) which are largely repayable on demand or at very short notice whilst holding assets (mainly advances) which have a much longer term to maturity.  Default risk – the main asset held by banks are advances and default risk refers to the risk of the interest and/or capital on these advances not being repaid. Managing liquidity risk Liquidity risk refers to the risk of the bank having insufficient funds to meet its cash outflow commitments. A bank is particularly vulnerable to this risk because of the structure of its balance sheet. If a bank is required to repay a substantial amount of deposits then it will soon find itself in a situation where it has insufficient funds as most of its assets are committed in long-term advances. There are two main strategies a bank can adopt to manage this problem: Reserve Asset Management This requires a bank to hold a stock of liquid assets to protect the illiquid advances portfolio from an unexpectedly large outflow of funds. Cash inflows (from new deposits and loan repayments) would normally fund cash outflows (deposit withdrawals and new loans). However, the stock of liquid assets held by the bank acts as a buffer which can be drawn on when there is an imbalance of outflows over inflows. Normally liquid assets are held according to a maturity ladder with assets running from cash to overnight deposits to bills and short-term deposits etc. The bank will obtain some return on its liquid asset holdings (other than cash) but this will be lower than < Previous Page Next Page >
  38. 38. | RETAIL BANKING 38 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES on its main earning asset of advances. Therefore banks will be looking to hold just enough liquid assets to meet unexpected cash outflows. Liability management: In the last 30 years banks in most developed countries have moved away from reserve asset management towards liability management. Liability management involves a bank managing its liabilities to meet loan commitments or replenish lost liquidity. One form that this could take is simply to adjust interest rates on its deposits. However if a bank is reliant solely on retail deposits then increasing deposit rates is costly because it has to be done for existing deposits as well as new deposits attracted. However, the development of wholesale deposit markets in particular an overnight interbank market, has allowed banks to use such markets as a marginal source and use of funds. For example, if a bank at the end of a working day has made more loan commitments than it can meet from current funding then it can borrow funds from another bank in the overnight market. Conversely, if a bank has a surplus of funds at the end of a working day then it can lend these overnight. The existence of the interbank markets allows banks to exploit profitable lending opportunities as they arise without being too concerned about raising the funding to meet the loan. Managing asset risk Many of the assets held by a retail bank are subject to the risk of a fall in value below that recorded in the balance sheet. The main asset held by a retail bank is advances and these are subject to the risk of default (or credit risk). Credit risk is exacerbated by the problems of adverse selection and moral hazard. Credit risk is influenced by the stage of the economic cycle. Clearly when the economy is growing then credit risk will be low for banks. If the economy goes into recession then credit risk increases. The influence of the economic cycle represents the systematic (or macroeconomic) component of the credit risk facing banks. In addition, banks face a borrower-specific component of credit risk. This is the risk that derives from the individual decisions of the borrower. Banks are able to manage specific risk by using the techniques outlined below. Screening Banks can minimise the risk of default for each individual loan by considering the purpose of the loan and the financial circumstance of the borrower. The bank should be aiming to select good risks only. Credit scoring is increasingly being used by banks in this process of risk analysis and the advantage of credit scoring is that it can be largely automated. Credit scoring is a method of evaluating the credit risk of loan applications using a scoring model. The scoring model is developed using historical data to identify which borrower < Previous Page Next Page >
  39. 39. | RETAIL BANKING 39 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES characteristics provide a good prediction of whether a loan performed well or badly. Each characteristic will be weighted in the model according to its importance in predicting default. Characteristics which might be used in a credit scoring model for personal loans include the length of time the applicant has been in the same job, monthly income, outstanding debt etc. Fair, Isaac and Company in the US were the pioneers of credit scoring models. In the past, banks used credit reports, personal histories and the bank manager‘s judgement to determine whether to grant a loan. Credit scoring is now widely used in personal lending, especially credit card lending and is increasingly being used in mortgage lending. The use of credit scoring has enabled banks to make lending decisions over the telephone and so has helped facilitate the establishment of telephone-based banks. Pooling Banks can undertake a large number of small loans rather than a small number of large loans. This is an application of the law of large numbers to the loan portfolio, which reduces the variability of loan loss, so increasing the predictability of loss through default. Diversification Banks can diversify the loan portfolio by lending to a wide range of different types of borrowers. For example a bank should lend to both individuals and businesses and within lending to businesses should lend to businesses in different industries. This has the effect of offsetting the firm specific-risks within the portfolio. A simple example illustrates the principle of diversification. A bank may lend to a number of firms producing ice cream and a number of firms producing raincoats and umbrellas. If a particular summer is mainly rainy then not much ice cream will be sold and some ice cream producing firms may default on their loans to the bank. However, the firms producing raincoats and umbrellas will prosper during a rainy summer and the incidence of loan default amongst these firms will be low. If the summer is mainly hot then the reverse will occur with ice cream firms prospering and raincoat and umbrella firms doing badly and the incidence of loan default will be the reverse. So by spreading its loans, the bank will not suffer high default risk across its whole portfolio of loans in the event of either an extremely hot or extremely rainy summer. By diversifying its loan portfolio a bank makes its borrower-specific loan risks more independent. It should be noted that banks that specialise in lending to one particular sector, region or industry, will be limited in their ability to diversify. Examples include banks that specialise in mortgage lending or lending to a particular region or industry (e.g. agricultural banks). < Previous Page Next Page >
  40. 40. | RETAIL BANKING 40 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES Collateral A bank may ask for collateral (or security) to be provided by the borrower. If the loan then goes to default then the bank is able to sell the collateral and so recover some or all of the loan. Collateral also has the effect of reducing moral hazard as the threat of loss has the effect of reducing the incentive of the borrower to engage in undesirable activities. Capital Finally, a bank should hold capital. This provides a cushion against loss in the event of default losses which protects depositors from its effects. Regulators impose requirements on banks regarding the amount of capital a bank should hold in relation to the riskiness of its assets. Payments services Most retail banks also provide payments services. A payments service is defined in Buckle and Thompson (1998), section 3.3 as: an accounting procedure whereby transfer of ownership of certain assets are carried out in settlement of debts incurred. A payments service can be separated into three components:  a medium of exchange enabling customers to acquire goods  a medium of payment to effect payment for the goods acquired  a temporary store of purchasing power since income and expenditure are generally not synchronised. Paper money, issued by governments fulfils these three functions. A bank cheque account, that is the liabilities of a bank, also provides these three functions. It is widely accepted as a medium of exchange and a medium of payment. Funds can also be stored in the account until purchases are made. Recent developments Recent developments in payments services technology are reducing the use of paper cheques. The new methods of payments are as follows. < Previous Page Next Page >
  41. 41. | RETAIL BANKING 41 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES  Debit card: This allows a customer to make a payment directly from a bank account. However the transfer of funds between customer and retailer takes place electronically and the transfer could take place immediately or could be delayed with the information transmitted to the bank by the retailer in batches. The debit card can therefore be seen as a form of electronic cheque.  Automated clearing house (ACH) debit: Allows for direct crediting of pay or for direct debiting of customer‘s accounts for regular payments such as mortgage repayment or utility bills. Transfers are normally affected electronically.  Credit card: A credit card also allows a customer to pay for a purchase however a credit card only performs the function of medium of exchange as, from the customers point of view, payment is only made in the future when he/she settles the credit card account. Future Developments Developments in payments services in the near future will include the following. Smart cards (stored value cards) Smart cards are effectively prepaid cards the size of a debit or credit card. An electronic chip embedded into the card allows a customer to transfer value to the card from a bank account, possibly from an Automate Teller Machine or specially equipped telephone or personal computer. The smart card can then be used for payment at a shop point of sale terminal. Funds are directed directly from the card to the retailer‘s terminal. The retailer may then transfer the accumulated balances to their own accounts. It is predicted that the smart card will reduce the amount of cash in use although its take up will depend on to what extent shop and other service providers (e.g. taxis, train operators) will introduce appropriate terminals. Internet cash Internet cash is a development further into the future. It will be an account held on the internet that can be instantly debited or credited following an internet transaction. For example, a customer may purchase a book < Previous Page Next Page >
  42. 42. | RETAIL BANKING 42 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES over the internet and pay for it using his internet cash account. To realise the value of this internet cash it will need to be converted into traditional money. In this form then internet cash simply represents a medium of exchange and payment but one which is separate from the actual transfer of money. Payments risk You also need to be aware of the risks that banks (and their customers face) in providing a payments service. A payments system provides for the transfer of funds between accounts at two institutions. There are essentially two types of systems for making settlement payments between two banks:  end of day net settlement  real time gross settlement With the first of these, at the end of each working day, final debit and credit balances are calculated for each member bank in the settlement system and net settlement transfers are made through settlement accounts, normally held at the central bank. This gives rise to receiver risk whereby a bank may provide funds to a customer having received payment instructions from another bank. The receiving bank then has an exposure to the bank that sent the instructions, until final settlement occurs at the end of the day. Those customers that have received payments may initiate further payments and this can be repeated throughout the day, building up large exposures in the banking system. If one of the settlement banks fails then this could lead to settlement failures at other banks. This is an example of the systemic risk problem. One solution to this problem is to move to real time gross settlement whereby payment instructions and settlement are more closely aligned. Such a system has been developed in many of the major banking systems including the US and UK. Joint provision of intermediation and payments services Finally in this section you need to understand why traditionally a bank provides both intermediation services and payments services. In fact there are two main advantages in combining these two services: < Previous Page Next Page >
  43. 43. | RETAIL BANKING 43 1. Content Index 2. AN INTRODUCTION TO BANKING MANAGEMENT 3. FINANCIAL SYSTEM 4. RETAIL BANKING 5. WHOLESALE AND INTERNATIONAL BANKING 6. MANAGING BANK LIABILITIES  The funds held in transaction accounts can be profitably on-lent by the bank before they are used by customers.  Transaction accounts provide a bank with useful information which can help them in assessing credit risk and monitoring repayment of a loan. In other words, this information is useful to a bank in overcoming both adverse selection and moral hazard. Competition in Retail Banking The retail banking sector in many countries has experienced increased competition in recent years as a result of new entrants into the industry. In the UK, these new entrants have come from a variety of sources:  Savings and mortgage institutions: 10 the 1986 Building Societies Act in the UK permitted building societies to offer current accounts and make unsecured loans to persons, to a limited extent. The Act also allowed larger building societies to convert into banks. Most of the larger Societies have since taken up this option.  Insurance companies: a number of insurance companies in the UK have established banking subsidiaries. These include Legal and General, Prudential and Standard Life.  Retailing organisations: in the UK a number of supermarkets now offer selected banking products alongside groceries. The majority of new entrants under categories 2 and 3 have so far chosen to offer only a subset of retail banking products, namely credit cards, savings accounts, personal loans and mortgages. The main retail banking product missing from this list is the current (or cheque) account. In addition, many of the new entrants from the insurance industry have chosen to offer retail banking services/products through new delivery channels. In most cases the establishment of these new banks has only come about as a consequence of the ability to offer banking services through non-traditional channels. Retail banks have traditionally operated through branch networks. These are costly to establish and to maintain. The introduction of automated teller machines (ATMs) was the first development that allowed delivery of certain elements of retail banking services outside the branch. ATMs were first located inside or on the outside wall of the branch. They are now located in shopping malls, < Previous Page Next Page >