Part 1. Introduction to bank financial management in the financial – services industry.

This part of the book contains two chapters: Chapter 1 provides an introduction to banking in the financial-services industry (FSI). The major themes of the chapter are the functions of a financial system, the major players in the FSI, the fundamentals of financial intermediation, the risks of banking, and dimensions of bank competition and how regulation shapes them. The decline of banking, described as “The End of Banking as We Know It,” furnishes a starting point for distinguishing between the gathering of deposits to fund loans, the traditional business of banking, and modern banking. Which goes beyond the customary geographic and product markets of old-line commercial banking. Although traditional commercial banking has been in relative decline over the past quarter century, commercial banks still are the most important players in the U.S. financial system. Appendix A to chapter 1 provides a detailed list of sources of banking information and a few tips on researching on the Internet and writing reports as “executive summaries.” Appendix B contrasts and compares three alternative models of bank industry linkage: (1) the Japanese model, or keiretsu approach; (2) the German model, or universal-bank approach; and (3) the Anglo-American model, or capital-markets approach.

Chapter 2 presents three alternative ways of viewing a bank: (1) as a consolidated balance sheet or portfolio, (2) as an information processor with similarities to communications firms, and (3) as a regulated financial-services firm. The chapter mainly develops the portfolio concept by highlighting a bank’s souces and uses of funds and its risk management.

Chapter 1. Overview of banking and the financial-services industry.

Contens

Learning Objectives

Chapter Theme

Key Concepts, Ideas, and Terms

The Functions of a Financial System

Financial-Services Firms and Financial-Services Industry

• The “-ization” of the FSI

• The Role of Banks in the FSI

Types and Classes of Commercial Banks

Bank Holding Companies: The Dominant Organizational Form

• The Diversity and Capitalization of Large BHCs

Intermediation versus Disintermediation and Indirect Finance versus Direct

Finance

• The Creation and Characteristics of Financial Claims (Contracts)

• The Financial Cornerstones: Debt and Equity Claims

• The Pricing of Financial Assets

• The Role and Function of Financial Markets and Securitization

• Why Do Financial Intermediaries Exist?

The End of banking as We Know It?

The Role of Bank Regulation and Supervision

• The Principal-Agent Relations in a Regulated Financial System

• Techniques for Managing the Guarantee Business

• Entry and Exit Rules

The Regulatory Dialectic (Struggle Model)

The Risks of Banking

• Credit Risk

• Interest-Rate Risk and the Fisher Effect

• The Fisher Effect, Monetary Discipline, and Economic Growth and

Development

Liquidity Risk

External Conditions: The Risk of Price Level and Sectoral Instabilities

Problem Banks: Identification, Enforcement, and Closure

Recapitulation and Lessons

The Dimensions of Financial-Services Competition and the Role of Regulation in Shaping Them

• The Price Function

• The Convenience Function

• The Confidence Function

• Recapitulation and Lessons

Chapter Summary

List of Key Words, Concepts, and Acronyms

Review Questions

Problems

Appendix A: Sources of Banking Information

• Notes on Research, the Internet, and Writing Cases and Reports

Appendix B: Models of Bank-Industry Linkages

• The Japanese Model, or Keiretsu Approach

• The German Model, or Universal-Bank Approach

• The Anglo-American Model, or Capital-Markets Approach

Selected References

LEARNING OBJECTIVES

• To understand functions of a financial system

• To understand the role, importance, and risks of banking

• To distinguish between direct and indirect finance

• To understand the “decline” of banking

• To distinguish between traditional commercial banking and modern banking

• To understand the dimensions of bank competition and how regulation shapes them

CHAPTER THEME

This chapter presents an introduction and overview of banking and financial-services industry (FSI). The primary function of a financial system is resource allocation. Financial-services firms (FSFs) act as intermediaries in the allocation of financial resources. As financial markets become more complete, direct finance tends to reduce the importance of certain financial institutions and the process of indirect finance. This phenomenon, driven in part by deregulation, financial innovation, and technological change, has led to the decline of the business of funding loans with deposits – traditional commercial banking. To survive in the FSI, banks must adapt to this changing environment. A financial-management perspective emphasizes the importance of understanding the risks of banking and how to manage them. Both market and regulatory discipline monitor and restrict bank risk taking. Explicit price, user convenience, and public confidence are the primary dimensions of bank competition.

KEY CONCEPTS, IDEAS, AND TERMS

• Bank holding company (BHC)

• Credit risk

• Dimensions of bank competition (price, confidence, convenience)

• Direct finance versus indirect finance (intermediation)

• Discipline (market and regulatory)

• Financial markets

• Financial-services firm (FSF)

• Financial-services industry (FSI)

• Financial system (core functions)

• Globalization

• Institutionalization

• Internet-rate risk

• Intermediation versus disintermediation

• Liquidity risk

• Pass-through finance

• Regulatory dialectic (struggle model)

• Risk management

• Securitization

THE FUNCTIONS OF FINANCIAL SYSTEM

The primary function of a financial system is resource allocation. To accomplish this task, financial systems perform six basic, or core, functions:

1. They clear and settle payments (a payments system)

2. They aggregate (pool) and disaggregate wealth and flows of funds so that both large-scale and small-scale projects can be financed

3. They transfer economic resources over time, space, and industries

4. They accumulate, process, and disseminate information for decision-making purposes

5. They provide ways for managing uncertainty and controlling risk

6. They provide ways for dealing with incentive and asymmetric-information problems that arise in financial contracting

Although financial institutions come and go, these six core functions are relatively unchanging. Moreover, as financial innovation and competition among institutions generate greater efficiency in the performance of a financial system, institutional form tends to follow function.

To see the importance of commercial banks to a financial system, consider each of the six functions in the form of a question focusing on the importance of banks. For example, do banks clear and settle payments? Do they pool funds? For commercial banks, the answer to each of the six questions is : Yes! This is not to deny that other financial institutions perform some of these functions also. The important point, however, is that commercial banks perform all of these functions and that they have been adapting their institutional forms to follow the evolution of the individual functions.