Modern Banking

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M O D E R N B A N K I N G

The introduction of government-backed deposit insurance to discourage bank runs alters the incentives of banks, to the detriment of the taxpayer. In the presence of less than perfect information about loans and other assets acquired by banks, deposit insurance (and lender of last resort/lifeboat facilities) creates moral hazard problems and encourages banks to assume a riskier portfolio than they otherwise would. Risk is underpriced in a system backed by explicit or implicit guarantees; points argued by, among others, Benston et al. (1986) and Kane (1985). Hence the need for regulation, which the banking sector will accept, provided the benefits of mispricing outweigh the cost of compliance – see Buser et al. (1981).

In the 19th century, Thornton (1802) distinguished between credit and money, and Keynes (1930) highlighted their importance in a macroeconomy, showing the role of banks in relation to monetary policy. Gurley and Shaw (1956), Pesek and Saving (1969) and Tobin (1963) extended these themes. By the 1950s, the role of banks in the creation of money had become standard fare in introductory economic textbooks.

1.8. Conclusion

The main purpose of this chapter has been to review the traditional model of the bank. Banks are distinguished from other financial firms by the intermediary and payments functions they perform. The organisational structure of banks is consistent with Coase’s classic analysis of the firm, and extensions of these ideas by authors such as Alchian, Demsetz and Williamson. Information plays an important role in banking; the presence of information costs helps to explain why banks act as intermediaries. Asymmetry of information gives rise to adverse selection and moral hazard, and the classic principal – agent problem between depositors and shareholders and a bank, and the bank and its officers and debtors.

After a review of payments systems and related technology, section 1.3 identified the main organisational structures of banks, including universal and restricted universal banks, holding companies and the difference between commercial (wholesale and retail) and investment banking. The growth of financial conglomerates was also discussed. It was noted that the US banking system has a structure quite unique to the western world, and as will be shown in Chapter 5, is largely the product of the statutes passed by Congress to regulate the banking sector.

Section 1.6 introduced central banking, explaining the link between a country’s private banks and the central bank. The various functions of the central bank were reviewed. Concepts such as bank runs and contagion were introduced, in relation to the need for a central bank to provide liquidity when banking systems are threatened. These terms receive more detailed attention in Chapters 4 and 8. Also discussed were the important issues of central bank independence from government, and allocation of responsibility for the prudential regulation of banks to an agency that is separate from the central bank.

In this chapter different types of banking structure, such as universal, commercial and investment banking, were introduced, along with a discussion of the growth of financial conglomerates. These topics prepare the ground for Chapter 2, which looks at the diversification of banking activities. By the end of the 20th century, all but the smaller

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W H A T A R E B A N K S A N D W H A T D O T H E Y D O?

or specialised banks expanded into other financial activities, while continuing to offer the core banking functions. Chapter 2 also reviews aspects of international financial markets and the growth of international banking. The final section considers the thorny issue of whether the growth of information technology and other developments threaten the very nature of banking.

2.1. Introduction

In the 21st century, banks remain a central component of well-developed financial markets, though, as was noted in Chapter 1, some banks have expanded their activities beyond the traditional core functions. The banking sector normally consists of specialist banks operating in niche markets, and generalist banks offering a wide range of banking and other financial products, such as deposit accounts, loan products, real estate services, stockbroking and life insurance. For example, ‘‘private bankers’’ accept deposits from high net worth individuals and invest in a broad range of financial assets. Modern investment banks have a relatively small deposit base but deal in the equity, bond and syndicated loan markets. Universal banks, even the restricted form, offer virtually every financial service, from core banking to insurance. This chapter begins with a review of the diversification of banks into non-banking financial activities. There has also been a rapid growth of global banking activities, international extensions of the core banking functions discussed in Chapter 1. Section 2.4 reviews trends in the international trade of banking services and multinational banks. Section 2.5 looks at the performance of the banking sector and considers the key issues facing banks in the new century. Section 2.6 concludes.

2.2. The Expansion of Banks into Non-banking Financial Services

While Chapter 1 focused on the core banking functions, this section looks at the growing diversification of banks. Of course, many of the savings banks or small British building societies continue to focus mainly on the core banking activities. However, the norm is for the key 5 to 10 banks in any western country1 to be diversified financial institutions, where traditional wholesale and retail banking are important divisions, but a wide range of financial services are also on offer. For example, universal banks, even if in the restricted form, offer virtually every other financial service, from core banking to insurance.

Non-bank financial services include, among others, unit trusts/mutual funds, stockbroking, insurance, pension fund or asset management, and real estate services. Customers demand a bundle of services because it is more convenient to obtain them in this way. For example,

1 The US banking system is different; a point noted in chapter one. However, the top 20 or so US banks (in terms of tier one capital or assets) have also diversified.

a Includes outright forward and forex swaps, currency swaps and currency options. b Includes forward rate agreements, interest rate swaps and interest rate options.

c Includes equity-linked forwards, swaps and options.

d Includes gold and other commodities forwards, swaps and options.

Sources: http://www.bis.org/statistics/derstats.htm (table 23A); BIS (1996) 64th Annual Report p. 112; BIS (1999) 69th Annual Report p. 132; BIS (June 2001) Quarterly Review, p. 89; BIS (June 2003) Quarterly Review, p. 99.

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D I V E R S I F I C A T I O N O F B A N K I N G A C T I V I T I E S

credit rating of less than BBB. They were used to fund some hostile takeovers in the United States, but the market collapsed in 1990, and again after the Asian crises and Russian default (1997, 1998). They continue to be issued from time to time.

Commercial paper, as the Goldman Sachs case study shows, dates back to the 1800s. Corporations issue a promissory note, which agrees to repay the bearer at some specified date in the future. The USA has outstanding commercial paper issues of more than $1 trillion, but they have only been issued in European countries since the 1980s, and the size of the market is much smaller, amounting to about $17 billion in the UK.

Asset Backed Securities

The issue of asset backed securities is the process whereby traditional bank assets (for example, mortgages) are sold by a bank to a trust or corporation, which in turn sells the assets as securities. The bank could issue a bond with the pooled assets acting as collateral, but the credit rating of the bank is assigned to the new security, the proceeds of the bond are subject to reserve requirements, and the assets are included in any computation of the bank’s capital ratio.

The bank can avoid these constraints if a separate entity is established (special purpose vehicle, SPV, or trust). The bank sells the asset pool to the SPV, which pays for the assets from the proceeds of the sale of securities. Effectively, while the process commences in an informal market (the bank locates borrowers and makes the loans), asset backed securitisation means a large number of homogeneous loans (in terms of income streams, maturity, credit and interest rate risks) are bundled together and sold as securities on a formal market.

The process involves the following steps.

žOrigination: Locating the customer, usually via the bank.

žCredit analysis: Estimating the likelihood of the potential borrower paying off the loan.

žLoan servicing: Ensuring the debt and interest is paid off on time by the agreed schedule, i.e., enforcing the loan contract.

žCredit support: In the event of the debtor encountering difficulties, deciding whether the loan should be called or the debtor given a grace period until he/she can pay.

žFunding: Loans themselves must be financed, usually through reliance on retail/wholesale deposits, or in the case of finance companies, borrowing from banks.

žWarehousing: Ensuring loans with similar characteristics (e.g., risk, income streams) are in the same portfolio.

Many of the above functions continue to be performed by the bank. However, the portfolio of loans is sold to a special purpose vehicle (trust or corporation), which engages an investment banker (for a fee) to sell them as securities. Assets are moved off-balance sheet provided a third party assumes the credit risk. Also, manufacturing firms with their own finance companies (e.g., General Electric, General Motors and Ford) offer loans which they securitise. Some banks have dropped out of the auto loan market because they cannot obtain a large enough interest rate spread to stay in business.

Banks undertake asset backed securitisation for a number of reasons. First, they can reduce the number of assets on the balance sheet and so boost their risk assets ratio or

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Fannie Mae and Freddie Mac share the same charters and regulation but claim to compete with each other and to have separate business strategies. These government agencies are subject to a number of restrictions. Mortgages must be for residential property and may not exceed a limit of up to $332 700. Freddie and Fannie are prohibited from originating mortgages – they must buy them from banks and S&Ls.

After the 1970 issue, MBSs grew rapidly. Currently they hold or guarantee nearly half the US outstanding mortgages, and have close to $3 trillion in liabilities.8 Their success encouraged financial institutions to securitise commercial mortgages, mobile home loans, credit card receivables, car loans, computer and truck leases, and trade receivables.

Collateralised Mortgage Obligations

CMOs originated in the USA in 1983 after they were introduced by First Boston and The Federal Home Mortgage Loan Corporation. They go through the same stages as MBSs (e.g., origination, pooling, placement of the pooled mortgages with a SPV, etc.) until the security reaches the investment bank. Instead of selling the MBS/ABS to investors, the investment bank places the security as collateral in a trust, and, essentially, splits it, offering groups of investors a series of tranches (a portion of the payments) associated with the security – a CMO. Suppose the investment bank creates three tranches or investment classes. Each class has fixed coupon, which may be paid monthly, quarterly or semi-annually. In addition, the investor is holding a bond – they are owed a certain amount. Mortgagees in the pool pay their monthly principal and interest, but there will always be some who unexpectedly prepay (or default on) the full amount of the mortgage. The investment bank issuing the CMO will pay out the interest owed to the first group, plus all the principal paid by the mortgagees, including those who have prepaid. The second class of investors is also paid the fixed interest owed, but does not get any of the principal until the first class has been paid in full and the bond retired. Likewise for the third tranche – no principal is repaid until the second class has been paid off in full, and the associated bond retired. The number of tranches can vary from 3 to 30. There can also be a zero or Z-tranche, where the investor is not paid interest9 or principal until all the other classes are retired.

The CMO is an example of a pass through security: cash flows, interest and principal, from the underlying security (e.g., a mortgage) are passed through to the investor. There are other forms of security apart from mortgages – the generic term is collateralised debt obligation (CDO). A CDO is backed by a pool of debt obligations, such as corporate loans or structured finance obligations. Once pooled, like an MBO, they are split into a number of security tranches, and offered to different groups of investors. The performance of the underlying pool of debt obligations determines the payment of interest and principal, and when the security is actually retired. They are attractive because they offer investors a greater range of risk/return choices than the standard MBS/ABS. For example, with a MBO, the investor can choose to incur a high degree of prepayment risk (by opting for the first

8 Source: Wallison (2003).

9 As with the coupons in other classes, a fixed interest rate is quoted but no interest paid until all the other classes are retired.