H05 Mngt concl and changes begin 080118a.ppt

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H05 Mngt concl and changes begin 080118a.ppt

  1. 1. <ul><li>Handout for Lecture 5. </li></ul><ul><li>Note : Lecture will begin with concluding slides from last lecture. </li></ul><ul><li>Core / ‘traditional’ principles of bank management derive profit from asset transformation , i.e. </li></ul><ul><ul><ul><li>Draw in funds at lower cost on the liability side. </li></ul></ul></ul><ul><ul><ul><li>Put them to more profitable use on the asset side. </li></ul></ul></ul><ul><ul><li>i.e. This bank profit is from items ‘ on the balance sheet ’. </li></ul></ul>
  2. 2. <ul><li>Changes in banks’ balance sheets – review : </li></ul><ul><ul><ul><li>Rise of liability management : </li></ul></ul></ul><ul><ul><ul><ul><li>Money markets / non-transactions deposits to acquire funds > customers’ deposits. </li></ul></ul></ul></ul><ul><ul><ul><li>Same for liquidity management > high excess reserves. </li></ul></ul></ul><ul><li>Also : Interest rate risk : hedging instruments </li></ul><ul><ul><ul><ul><li>> adjustments to balance of interest-sensitive and interest-insensitive assets items on BS. </li></ul></ul></ul></ul>Balance sheet of all US commercial banks (%), December 2004.
  3. 3. <ul><li>Off-balance-sheet activities. </li></ul><ul><li>Deregulation , etc., -> banks now also -> further activities: </li></ul><ul><ul><li>Not defined with respect to BS </li></ul></ul><ul><ul><li>i.e. Not appearing on the balance sheet. </li></ul></ul><ul><li>Merging of activities of banks and non-bank financial institutions ( nbfis ). </li></ul><ul><ul><li>Boundaries less distinct. </li></ul></ul>
  4. 4. Extent of Off-Balance-Sheet activity <ul><li>Note : Actually now a declining proportion. </li></ul><ul><ul><ul><li>Due to increased competition from nbfis. </li></ul></ul></ul>Non-interest income as %age of gross income, UK large banks:
  5. 5. <ul><li>Examples of OBS activities. </li></ul><ul><ul><li>Fee income from specialized services, e.g. </li></ul></ul><ul><ul><ul><ul><li>Investment services, as seen. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Other investment bank services, e.g.issue of securities. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Foreign exchange trades for customers. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Fund management. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Credit cards. </li></ul></ul></ul></ul>
  6. 6. <ul><li>Examples of OBS activities , contd . </li></ul><ul><li>Trading activities and risk management on own behalf , e.g. </li></ul><ul><ul><ul><li>Foreign exchange dealings. </li></ul></ul></ul><ul><ul><ul><li>Dealing in derivatives : </li></ul></ul></ul><ul><ul><ul><ul><li>Financial futures, interest rate and exchange rate hedging, etc. </li></ul></ul></ul></ul><ul><li>Note : Original purpose of derivatives, etc.: </li></ul><ul><ul><ul><li>Mitigate risk . </li></ul></ul></ul><ul><li>But in fact -> massive speculation , including by banks. </li></ul><ul><ul><li>-> whole new range of management problems. </li></ul></ul>
  7. 7. <ul><li>The ‘ principal-agent ’ problem: </li></ul><ul><li>Agent / employee of bank: </li></ul><ul><ul><ul><li>Earns profits -> gets bonus. </li></ul></ul></ul><ul><ul><ul><li>Makes losses -> bank has to cover for him/her. </li></ul></ul></ul><ul><li>e.g. Barings employee Leeson 1992-5: </li></ul><ul><ul><ul><li>Lost bank $1.3 billion -> bank failed. </li></ul></ul></ul><ul><li>Strategies to counter PA problem: </li></ul><ul><ul><ul><li>Separate trading from book-keeping (‘back room’) activities. </li></ul></ul></ul><ul><ul><ul><li>‘ Chinese Wall’ between departments of same firm / separate capital accounts, etc. </li></ul></ul></ul>
  8. 8. <ul><li>‘ Disintermediation ’. </li></ul><ul><ul><li>i.e. Intermediaries less dominant in credit market. </li></ul></ul><ul><ul><li>Affects both sides of intermediation process: </li></ul></ul><ul><li>Banks increasingly turn to other activities apart from intermediation, as seen. </li></ul><ul><ul><li>e.g. May provide investment services to companies to obtain best rate. </li></ul></ul><ul><ul><li>> Competing by lowering own ROA (i.e. competing ‘on-BS’). </li></ul></ul><ul><ul><li>i.e. Switch to Off-Balance-Sheet / fee income. </li></ul></ul><ul><li>Companies may turn away from banks: </li></ul><ul><ul><li>May get better loan rate from capital market. </li></ul></ul><ul><ul><li>i.e. direct finance > indirect / ‘ mediated ’ through bank. </li></ul></ul>
  9. 9. <ul><li>Banks and ‘nbfis’: boundaries less distinct. </li></ul><ul><ul><li>BUT: particular significance for the economy: </li></ul></ul><ul><ul><ul><li>Payments system. </li></ul></ul></ul><ul><ul><ul><li>Sheer scale. </li></ul></ul></ul><ul><ul><ul><li>Money creation process, etc. </li></ul></ul></ul><ul><li>-> Heavy regulation . </li></ul><ul><li>Equivalently, -> further (interconnected) ‘basic’ principles of bank management: </li></ul><ul><ul><li>Find ways to evade regulations (‘loophole mining’). </li></ul></ul><ul><ul><li>-> Keep up with innovations . </li></ul></ul>
  10. 10. <ul><li>Effects of: </li></ul><ul><ul><li>1. Deregulation. </li></ul></ul><ul><ul><li>2. Innovation. </li></ul></ul><ul><ul><li>3. Globalisation. </li></ul></ul>ECON7003 Money and Banking. Hugh Goodacre Lecture 5. THE CHANGING CHARACTER OF BANK MANAGEMENT
  11. 11. <ul><li>Conventional / traditional / ‘ mono-tasking ’: </li></ul><ul><ul><ul><li>Deposits in, loans out. </li></ul></ul></ul><ul><li>Remains basic. </li></ul><ul><li>BUT no longer the only or even main source of profit. </li></ul><ul><li>Now ‘ multi-tasking ’ / evolution in face of: </li></ul><ul><ul><ul><li>Increased competition , both from within banking sector and from nbfis. </li></ul></ul></ul><ul><ul><ul><ul><li>-> Restructuring of sector: </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Diversification of activities. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Increased efficiency (or ingenuity??). </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Absorption (??) of greater risk . </li></ul></ul></ul></ul></ul>
  12. 12. <ul><li>Three interconnected trends in particular: </li></ul><ul><ul><ul><ul><li>Deregulation. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Innovation. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Globalisation. </li></ul></ul></ul></ul>
  13. 13. <ul><li>1. Deregulation. </li></ul><ul><li>Contradictory situation: </li></ul><ul><ul><li>Concern for stability of financial sector: </li></ul></ul><ul><ul><ul><li>‘ Prudential’ controls. </li></ul></ul></ul><ul><ul><ul><li>Countering ‘loophole mining’, etc. </li></ul></ul></ul><ul><ul><li>-> Trend to tighten regulation . </li></ul></ul><ul><ul><li>Competition issues : </li></ul></ul><ul><ul><ul><li>-> aim to allow banks greater freedom. </li></ul></ul></ul><ul><ul><li>-> Trend to de regulation ! </li></ul></ul>
  14. 14. <ul><li>Two strands of deregulation: </li></ul><ul><ul><li>Removal of government restrictions. </li></ul></ul><ul><ul><li>Removal of self-regulatory restrictions. </li></ul></ul><ul><ul><ul><li>i.e. Established from within banking / financial sector itself: </li></ul></ul></ul><ul><ul><ul><ul><li>e.g. Agreements among building societies on interest rates, etc. </li></ul></ul></ul></ul>
  15. 15. <ul><li>Three phases of deregulation. </li></ul><ul><li>Note : Not same timing or even sequence in different countries: </li></ul><ul><ul><li>(i) Decisive blow to traditional framework. </li></ul></ul><ul><ul><li>(ii) Ending sharp distinction between banks and nbfis. </li></ul></ul><ul><ul><li>(iii) Allowing increased competition within financial sector and from outside it. </li></ul></ul>
  16. 16. <ul><li>Deregulation Phase (i) Decisive blow to traditional framework. </li></ul><ul><li>Ending ‘traditional’ / ‘mono-tasking’ structure of sector. </li></ul><ul><ul><ul><li>Asset side: Lifting quantitative controls on banks’ assets . </li></ul></ul></ul><ul><ul><ul><li>Liabilities side: Lifting ceilings on interest rates on deposits . </li></ul></ul></ul>
  17. 17. <ul><li>UK : </li></ul><ul><ul><li>Began early: </li></ul></ul><ul><ul><ul><li>‘ Competition and Credit Control’, 1971. </li></ul></ul></ul><ul><ul><ul><li>Lifted credit restrictions. </li></ul></ul></ul><ul><ul><ul><li>Associated with very loose monetary policy / ‘Barber boom’. </li></ul></ul></ul><ul><ul><ul><li>Subsequent backsliding – ‘corset’ – deposits at BoE to restrain growth of MS. </li></ul></ul></ul><ul><ul><ul><li>But by early 1980s all exchange and credit controls ended. </li></ul></ul></ul>
  18. 18. <ul><li>US : </li></ul><ul><li>‘ Regulation Q ’ (imposed in 1933): </li></ul><ul><ul><ul><li>Limited interest rate payable on deposits. </li></ul></ul></ul><ul><ul><ul><li>Not lifted till 1982. </li></ul></ul></ul><ul><li>Note : Traumatic effects of 1930s US bank failures. </li></ul><ul><ul><ul><li>-> Deregulation came later than in UK . </li></ul></ul></ul><ul><ul><ul><li>Very significant effects on international finance. </li></ul></ul></ul>
  19. 19. <ul><li>Variable rate lending . </li></ul><ul><li>1970s : </li></ul><ul><ul><li>Volatile interest rates. </li></ul></ul><ul><ul><li>Inflation. </li></ul></ul><ul><li>-> Banks increasingly allowed to issue variable rate loans. </li></ul><ul><ul><ul><ul><li>e.g. Linked to LIBOR (London Inter-Bank Offer Rate). </li></ul></ul></ul></ul><ul><ul><li>> ‘Stuck’ with unprofitable loan rate. </li></ul></ul>
  20. 20. <ul><ul><li>Variable rate lending: </li></ul></ul><ul><ul><ul><li>-> Stock of loans could become determined by demand. </li></ul></ul></ul><ul><ul><ul><li>Near-horizontal credit supply curve! </li></ul></ul></ul><ul><ul><ul><li>-> Banks could now liability-manage. </li></ul></ul></ul><ul><ul><li>-> Great expansion of banks’ balance sheets . </li></ul></ul><ul><ul><ul><li>Also: Reduction in Capital:Asset ratios. </li></ul></ul></ul><ul><ul><ul><ul><ul><li>Exposure to greater risk. </li></ul></ul></ul></ul></ul>
  21. 21. <ul><li>From asset management to liability management. </li></ul><ul><li>Asset management of post-war decades : </li></ul><ul><ul><li>Large public sector (war) debt. </li></ul></ul><ul><ul><li>Readily tradable. </li></ul></ul><ul><li>Quantitative controls -> ‘traditional’ situation maintained: </li></ul><ul><ul><li>Liabilities side: Largely passive supply / customers’ deposits. </li></ul></ul><ul><ul><li>Assets side: Active adjustment of balance sheets. </li></ul></ul>
  22. 22. <ul><li>From asset management to liability management, contd </li></ul><ul><li>From 1970s: </li></ul><ul><ul><li>Banks actively create liabilities / borrow from other banks / ‘ money markets ’, as seen. </li></ul></ul><ul><li>Preview of globalisation : UK CCC but US maintained Q: </li></ul><ul><ul><li>-> impelled move of US banks into Eurodollar market. </li></ul></ul>
  23. 23. <ul><li>Deregulation Phase (ii) Ending sharp distinction between banks and nbfis. </li></ul><ul><li>UK : Banks and building societies : </li></ul><ul><ul><ul><ul><li>1980s: banks allowed to compete in mortgage market. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>1986: building societies allowed to compete in market for consumer credit. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>i.e. both allowed to compete in each others’ markets . </li></ul></ul></ul></ul><ul><li>US : Once again, much restrictive legislation of 1930s remained in force till late, but: </li></ul><ul><ul><ul><ul><li>1980s: some competition with ‘thrifts’ allowed. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>1999: banks allowed more freedom to compete in investment banking, insurance, etc. </li></ul></ul></ul></ul>
  24. 24. <ul><li>Deregulation Phase (iii) Allowing increased competition within financial sector and from outside it. </li></ul><ul><li>Within financial sector : </li></ul><ul><ul><li>nbfis -> new kinds of financial services. </li></ul></ul><ul><ul><ul><ul><li>e.g. online banking – Egg, etc. </li></ul></ul></ul></ul><ul><ul><li>-> new kinds of nbfis competing with traditional banking. </li></ul></ul><ul><li>Firms from outside financial sector enter financial services market: </li></ul><ul><ul><li>UK : Tesco, Marks and Spencer, Virgin, etc. </li></ul></ul><ul><ul><li>US : Not only retail firms but also industrial: </li></ul></ul><ul><ul><ul><ul><li>e.g. General Motors. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>General Electric’s financial arm -> 1/3 of its revenue! </li></ul></ul></ul></ul>

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