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BEAM065: Bank Management
Dr Thaer Alhalabi
Week 1
Where do we currently stand?
• Week 1: The Global Banking Industry
• Week 2: Banking Regulation
• Week 3: Analysing Bank Performance and Risk
• Week 4: Managing Interest-Rate Risk
• Week 5: Managing Bank Funding Sources
• Week 7: Managing The Loan Portfolio
• Week 8: Coursework
• Week 9: International Banking
• Week 10: Governance and Stakeholder Monitoring
• Week 11: Revision for Final Assessment
Intended Learning Outcomes ILOs
This week we will discuss the main features of the banking industry. These slides are
related to the book ”The Global Banking Industry”, available on ELE. The ILOs of this
lecture are as follows:
• To understand why banks exist
• To explain the main functions performed by banks in an economic system
• To describe the main features of different bank business models
Agenda
• Why do banks exist?

• Banking institutions and activities

Bank As Financial Intermediaries
The flow of funds and financial intermediation
Bank As Financial Intermediaries
Savings into investment in an economy without financial intermediaries
Bank As Financial Intermediaries
• Financial Intermediation is the process of transferring money from economic
agents with a surplus of funds to economic agents with a deficit.

• Funds can be transferred either directly, on financial markets, or indirectly by using

financial intermediaries, such as banks.

• A system where intermediaries do not exist would rely solely on financial markets,
markets where financial securities are sold.
Bank As Financial Intermediaries
•Brokers
•Asset transformers
–Risk transformation
–Maturity (liquidity) transformation
–Volume transformation
•Intermediaries’ economies of scale
–(a) Efficiencies in gathering information (expert analysis)
–(b) Risk spreading across a large number of borrowers
–(c) Transaction costs (search, transaction and monitoring costs)
•Financial markets
Bank As Financial Intermediaries
Savings into investment in an economy with financial intermediaries and financial markets
Bank As Financial Intermediaries
• Financial Intermediation is the process of transferring money from economic
agents with a surplus of funds to economic agents with a deficit.

• Funds can be transferred either directly, on financial markets, or indirectly by using

financial intermediaries, such as banks.

• A system where intermediaries do not exist would rely solely on financial markets,
markets where financial securities are sold.
Direct vs Indirect Financing
Direct vs Indirect Financing
• Direct financing might not occur if the cost of finding a counterparty is too high

• Moreover, the needs of savers might be incompatible with those of borrowers

• For this reason, financial intermediaries, such as banks, might be needed

• Financial intermediaries can reduce transaction and information costs because of

their expertise and because they can exploit economies of scale and economies of
scope
The Role of Transaction Costs
• Transaction costs are costs related to searching for a counterparty and concluding the
transaction
• Financial intermediaries, such as banks, can reduce transaction costs and, thus, they can offer
lower interest rates relative to direct financing
• Banks can reduce transaction costs because they can achieve economies of scale by engaging
in numerous transactions, unlike individual borrowers and lenders – as the volume of
transactions increases, if there are economies of scale, the cost of producing one transaction
decreases
• Banks can also achieve economies of scope, that is, cost savings resulting from producing two
or more outputs at the same time
• If there are economies of scope, the joint cost of producing the two products (e.g., deposits and
loans) is less than the combined costs of producing the outputs separately
Economies of Scope: Example
• The annual cost of an IT software and a financial economist specialised in loan pricing is:
IT loan: £5,000
Loan pricing specialist: £35,000
• The same items for insurance contracts are as follows:
IT insurance: £4,000
Insurance pricing specialist: £30,000
• Now, imagine that the cost of an IT software to price both loans and insurance contracts is
£8,000, and the salary for a financial economist who can price both loans and insurance
contracts is £55,000
• Then, we will have economies of scope because:
(8,000+55,000) < (5,000+35,000+4,000+30,000)
£63,000 < £74,000
The Role of Information Costs
• In real financial markets, everyone has less than perfect information, and not everyone has the
same information (i.e., there are information asymmetries)
• In lending transactions, usually, the borrower has an advantage relative to the lender:
borrowers have more and/or better information than lenders about the project going to be
funded.
• Obtaining adequate information from borrowers (before the transaction) and monitoring them
(after the transaction) is costly
• If these information costs are too high, the transaction might not occur
• Banks can reduce information costs thanks to their expertise in gathering and processing
information and because of economies of scale – as the amount of borrowers increases, the
average cost of processing information for each borrower decreases.
Adverse Selection and Moral Hazard
Information costs can generate two problems: adverse selection (before the transaction
takes place), and moral hazard (after the transaction)
• Adverse selection: the worst (that is, riskier) potential borrowers are the ones that are
most likely to receive the loan – this phenomenon occurs because it is often very difficult
to assess the riskiness of each borrower correctly and the same interest rate is charged to
all borrowers and the riskier borrowers are more likely to accept the loan (since riskier
project usually carry a higher expected return)
• Moral hazard: once borrowers have received the loans, they might engage in activities
that will reduce the chances that the loans will be paid back – excessive risk-taking by the
borrowers may be optimal from the borrowers’ perspective (more risk = higher expected
return) but undesirable from the lenders’ perspective because the borrowers have to pay
back a fixed amount of money to the lender (in other words, for lenders there is only
downside risk, not upside risk) Enrico Onali (University of Exeter) The Global Banking
Industry BEAM065 Bank Ma
Adverse Selection and Moral Hazard
So, why are banks important to address adverse selection and moral hazard?
• Banks have better skills and technologies than individual investors in processing
information – they can obtain and analyse financial information presented by borrowers
more effectively
• As a result of these advantages, they can price loans better than individual lenders,
reducing adverse selection costs
• They can also exploit economies of scale when processing information and they can
acquire technology that might improve their ability to evaluate the risk of potential
borrowers before the transaction and monitor borrowers after the transaction
• In the next slide, we will explain better the role of banks as delegated monitors: they can
monitor the borrowers’ behaviour on behalf of depositors and other bank creditors
Banks as Delegated Monitors
• If there are many individual lenders, and each lender incurs costs to ensure that the
contract is enforced (monitoring costs), the cost of monitoring may be very high
• Also, there might be a free-rider problem: lenders know that they can avoid monitoring
costs if other lenders perform monitoring – But if all lenders try to free-ride on the others,
eventually we will have a situation where none of the lenders monitors!
• Thus, it might be more efficient for depositors to delegate the task of monitoring to
specialised agents such as banks
• Banks can act as delegated monitors because they can diversify among different
investment projects, and they have specialised expertise
• Banks can also address the free-rider problem because they do not share information
collected on borrowers with other parties, and they can monitor better the borrowers’
financial transactions
The “Transformation Function” of Banks
One of the reasons for banks to exist is their “transformation function”. In particular, banks
perform the following activities:
• Size transformation: banks can satisfy the needs of borrowers and savers by collecting
small amounts of money from many savers to fund borrowers’ needs – banks “transform”
many small deposits into large loans
• Maturity transformation: banks can satisfy the need of borrowers and savers whose
maturity preferences are mismatched: in particular, banks “transform” short-term deposits
into long-term loans
• Risk transformation: banks “transform” risky loans into many low-risk deposit accounts –
they can withstand the risk in their loan portfolio because lend money to many borrowers
and, since it is unlikely that all borrowers default at the same time, they can reduce their
overall business risk; moreover, banks can diversify their loans according to the type of
borrower (e.g., firms or households) and their geographical location, and they have better
risk-management technologies
Agenda
• Why do banks exist?

• Banking institutions and activities

Deposit Institutions
• There are different types of banking institutions, and the same bank can engage in
different types of banking activities

• Deposit institutions are important because they carry out the “traditional” banking activities
of collecting deposits to provide loans to households and businesses

• Moreover, since bank customers can use their deposit accounts for payments (via bank
cards, cheques, bank transfers and so on), deposit institutions are important channels of a
central bank’s monetary policy

• The main types of deposit institutions are: commercial banks, savings institutions, building
societies, and cooperative banks (note that we are not including investment banks)
Deposit Institutions
• The main driver of deposit institutions’ profits is the net interest income (NII): the
difference between interest income and interest expense

• For example, if a bank is paying an interest rate of 2% a year on depositors and charges
5% on loans, assuming that both loans and deposits are equal to £1bn, then the interest
income will be equal to 5% x £1bn = £50,000,000 and the interest expense will be equal
to 2% × £1bn = £20,000,000

• Thus, the NII will be equal to £30,000,000

• In the long run, the NII must be positive for a deposit institution to survive because it is a
major source of profitability
Deposit Institutions
• In the previous example, the net interest spread, NIS, is 3% (5% – 2%), which is also
equal to the net interest margin (NIM, net interest income divided by average earning
assets), in this particular example

• However, this does not need to be the case – for example, if loans are funded partly by
equity, the NIM might differ from the NIS

• For example, assume that loans are funded 20% by equity and 80% by deposits – in this
case, the interest expense will be equal to 2% x £1bn × 0.8 = £16,000,000, and the NII
will be £50,000,000 – £16,000,000 = £34,000,000

• The net interest margin, in this case, is £34,000,000/£1,000,000,000 = 3.4%, and thus it is
higher than the net interest spread (3%)
The Credit Multiplier
• Bank deposits are connected to the payment system and an expansion of bank deposits
increases the quantity of money circulating in the economy – vice versa, a contraction of
bank deposits leads to a reduction in the quantity of money circulating in the economy

• Many countries rely on a fractional reserve banking system – banks hold a fraction of
deposits in reserves

• Since most of the money collected from depositors is lent, banks can effectively “create”
money

• The credit multiplier (also known as “deposit multiplier”), equal to 1/[Reserve Ratio], can
be defined as the maximum amount of money that can be created by a bank for each
pound (or dollar) of reserves
The Credit Multiplier: Example
• Imagine that a bank (Bank A) receives an additional amount of deposits equal to £50,000.
The reserve ratio is 10%. What will happen to the total amount of money in the banking
system?
The Credit Multiplier: Example
• In the previous slide, an increase in deposits for Bank A by £50,000 results in a total
amount of additional deposits in the banking system equal to: 1/[Reserve Ratio] × Change
in deposits in Bank A

• This occurs because when Bank A lends 90% of its additional deposits (£45,000) to its
customers, we are assuming that they will deposit their money into Bank B – That’s why ∆
Deposits for Bank B is equal to ∆ Loans for Bank A

• Similarly, Bank B keeps 10% of the new deposits as reserve (£4,500) and the additional
amount of loans (£40,500) is deposited into Bank C, and so on
Adverse Selection and Moral Hazard
• Banking activities can be classified according to a variety of characteristics
• For example, retail banking refers to financial services provided to individuals,
households, and small firms, and they are characterised by small transaction sizes
• Retail banking is usually provided by deposit institutions such as commercial banks,
savings banks, cooperative banks, building societies, and credit unions
• These institutions are also involved in the provision of payment services to the public
because holding a bank account with these institutions allows customers to pay via
debit/credit cards, bank transfers, and cheques
• Nowadays, debit/credit card payments and bank transfers can be executed via online
banking
Main Bank Business Models
• Wholesale banking includes financial services provided to corporations, governments,
and other financial institutions The typical transaction size for this type of activities is
usually much larger than for retail banking

• Wholesale banking activities are often divided into business banking (for medium-size
firms) and corporate banking (large corporations)

• Investment banking activities comprise services provided to either rich individuals (e.g.,
wealth management) or corporations (e.g., underwriting, mergers, and acquisitions) – For
this reason, they fall between the two main categories of retail banking and wholesale
banking
Main Bank Business Models
• Universal banks can provide both retail banking and wholesale banking activities and
activities that were typically performed by other financial intermediaries (e.g., insurance
and pensions products)

• In the U.S., many institutions that we call “banks” are actually Bank Holding Companies
(BHCs)

• BHCs are corporations that control banking institutions because they own the majority of
their shares – or have a controlling interest even without owning the majority of their
shares – but are not necessarily involved in providing financial services to their customers

• In other countries, there might be similar institutions to BHCs – for example, in the
European Union the term Financial Holding Company is used
Example of BHCs (Data from Orbis)
• Using data from Orbis (available from the Library), you can find which banks in the US are
classified as BHCs, Commercial Banks, and so on
Example of BHCs (Data from Orbis)
• As you can see, many large institutions are BHCs
Example of BHCs (Data from Orbis)
• Using data from Orbis (available from the Library), you can find which banks in the US are
classified as BHCs, Commercial Banks, and so on
Example of BHCs (Data from Orbis)
• In some cases, investment banks and BHCs do not have any data about loans and
customer deposits (n.a. means “not available”) because they do not engage in retail-
banking activities
The Interbank Market
• Banks might provide a variety of services to other financial institutions
• The most important interbank market activity is, however, the interbank lending market,
which is characterised by large transactions with usually short maturities
• Thus the interbank lending market can be considered a subset of the money market (a
market where securities with maturities up to one year are traded)
• The interest paid is usually quite low because these transactions are typically low risk
• The interbank lending market helps banks manage their funding risk, which is the risk that
a bank might be unable to meet its short-term liabilities on time
• The interbank lending market can be used to borrow money to satisfy reserve
requirements imposed by the central bank
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