Commercial Bank Operations (Notes)

Lewis, MK and Davis, KT, 1987, Domestic and International Banking, Hemel Hempstead: Plillip Allan, ch. 2, 

Chapter 2: Financial Intermediaries and Financial Assets

2.1 Intermediaries Services: An Introduction

• Essentially comes down to offering some financial product e.g. loans, and means to invest with deposits

• Intermediation services: require an act of joint consumption by the loan and deposits customers. It is contracts with the provision of services arising from differences in the characteristics of contracts entered into depositors and borrowers

• Two types of intermediation: (i) ‘distributive’ or ‘brokerage’ - facilitate the transfer of ownership of existing financial assets, while doing this they supply information/specialist advice yet do not alter the characteristic of the financial asset and (ii) More often however, what is done is that the primary securities (those offered by the borrowers) is altered to the secondary securities (offered by the financial intermediary) and the way this is done is by issuing different contracts.

 We can spilt the types of financial products offered in three categories:

1. Payment services - providing money to pay for goods/services
2. Consumption transfer - where firms can invest now and consumers can pay over time
3. Financial security - ensures the continuance of consumption and investment in the face of a change in economic circumstances, ill health, accidents etc.

2.2 Stages of Intermediation

• This section look at hypothetical states to illustrate the need for financial intermediaries.

1. Absence of Financial Assets - Initially we need money to overcome the inefficiencies and economic costs of barter exchange. It also allows people to invest as they have previously accumulated money balances.

1. Direct Financing - By allowing for borrowing and lending, the constraints upon savings and investment can be more comprehensively lifted. Lenders are encouraged to save as before they could save only in 2 ways: hold on to commodity, whose liquidity and value is not certain or clear or hold onto money which has a certain monetary value yet bares no interest, so financial assets offer a middle choice. For direct financing to occur, borrowers and lenders with common interest need to meet this can either happen by accident or there will be transition cost involved. So by paying an interest rate which is acceptable they eradicate the transaction cost. Two types of problems arise when there is a separation of savings from the accumulation of wealth (i) ex ante problem of imperfect information where the lender cannot get full information of the borrowers and adverse selection where asymmetric information costs arise because of the lender’s inability to observe the attributes of the borrowers and (ii) ex poste problem which is that there is a moral hazard that many borrowers flow because of the inability of lenders

1. Information Services of Intermediaries - Creating a pool of data on investors and borrowers and so providing information quite easily. They can offer specialist advice to customers based on the information they have accumulated.

1. Portfolio Transformation Services - Where the borrowers and investors do not match in size, duration or in any other respect, intermediaries match it by ‘debt substitution’ that is the substitution of the intermediaries own liabilities for those of the ultimate borrowers. Two levels of this are: (i) contract level  - the process of gathering information and monitoring teh investments is also centralized, but in addition to reducing transition costs, this substitution alters the pattern of claims and thus reduces the risk to lenders, if only by the means of the pooling process. (ii) issuing contracts to lenders which are fundamentally different to those issued to borrower, this closes the problem with the gap between lenders and borrowers and this can be done by attaining specialist information. Instead of distributing the liquidity as with the first level, here the ‘creation of liquidity’ happens and this means that where borrowers assets acquired by the intermediary are information and incentive sensitive, they are converted into liquid claims from the viewpoint of lenders.

1. Liquidity production: Intermediaries usually ‘impart liquidity’ and what this means is that the primary securities they attain are usually less liquid than the secondary securities they offer. Liquidity is based on the asset’s marketability, reversibility, divisibility and capital certainty. (1) Marketability realated to the ease and speed within which the value of the asset can be realised. (2) Reversibility refers to the discrpency in value between the contemporeous acquisition and realisation of an asset (3) Divisibility is reflected in the smallest unit in which transactions in the asset concerned can occur. And (4) Capital certainity is the extent to which an asset’s future value in terms of cash can be predicted at future dates. Liquidity is not real science, it is more subjective and it based on teh intermediaries perception of the asset can be defined as having high amounts of these four characteristics.

The Rationale for Intermediaries: A summary

The complete markets paradigm

• Arrow-Debreu general equilibrium model, basically that AD=AS
• There is basically a market failure in a situation where financial intemediaries do not exist, that is they reduce search, monitoring and transaction costs and provide savers with greater safety and financial security than they can obtain from their own portfolios without access to makrets for contingent claims. 
• Orginally it was understood that financial intemediaries represent the final stage in the evolution of the financial system and now the new view is that it should be seen no more than transitory phase in the evolution path to a full set of Arrow-Debreu markets. 

2.3 Pooled Investment Funds

• Both mutual funds, or open ended investment companies (US name), and unit trusts (UK name) are legal constructions which permit the ‘pooling of a large number of small unequal amounts of money belonging to different induviduals in a common fund to be invested by skilled managers’. 
• Open-ended and close-ended are both funds of pooled investment the difference is in how they both are managed. Open-ended fund issues and redeems shares on demand, whenever investors put money in or out the fund. The close-end fund is a different animal. Like a company, it issues a set number of shares in an initial public offering and they trade on an exchange.
• The point of these is to create a size sufficiently large for risk diversification to operate.
• The three functions of open-ended pools which allow induviduals to purchase a share of managed portfolio:

1. ‘Brokerage’ - information is processed and collected for resale
2. ‘Diversification’ - As the fund is large it allows risk to be diversified
3. ‘Liquidity’ - units can be readily encashed, and open-ended funds are more liquid than direct shareholdings.

2.4 Money Market Mutual Funds

• Whereas mutual funds had their origins in Britain in 19th C & were well estabilished in the US by the 1930s, money market mutual funds are of very recent origin.
• The pooled funds for Money markets is placed mainly on short-term ‘prime’ paper. This paper is only issued in large denominations e.g. $1 mil minimum and without pooling the investment would clearly be beyond the resource of most induviduals. Thus the funds untertake a size intermediation , enabling induviduals to aggregate their resources in order to take advantage of the higher interest rate avaliable on large job lots.
• Also very low risk and examples include: t-bills, CDs, Broker’s Call, Federal funds. Essentially what we have to remember is that money market securities are low risk and low return.
• http://www.investopedia.com/articles/mutualfund/04/081104.asp#axzz290qnaunV 

2.5 Savings Institutions 

• Common elements in savings instituitions: 

1. most liabilities take the form of deposits whereby gathering of funds is facilitated and the attractiveness of the liabilities enhanced, by the ability of customers to make small-scale deposits and withdrawals upon savings account with the intermediary.
2. No depositer has an account which could be regarded as of significant size relative to intemediary’s total deposit liability.
3. The asset portfolio is on average of longer maturity than the liability portfolio
4. The asset portfolio contains a reserve of highly liquid assets 
5. Thos earning assets mostly consist of a large number of small claims on different households or firms which in most cases are induvidually not marketable.

• They are different to mutual funds in two regards (i) the savings institutions may be able to get a spillover effect from their deposit business to their loan portfolio and (ii) in the course of monitoring the deposit business of customers, the instiutions build up a profile as to a customer’s ability to repay loans. 

2.6 Insurance Institutions 

• Insurance companies take in funds, called premiums, invest them in securities to generate investment income, and then pay out to policy-holders.

Life Insurance

• For term policies the insurer holds prepaid premiums on behalf of those insured. With whole-life policies the same principle applies, but on a larger scale. Endowment insurance policies require the insurer to manage an accumulating balance of the insured’s savings. Annuities require the insurer to manage a decumulating balance of the annuitants’ savings. 

General Insurance

• General insurers are in no sense savings institutions or providers of other forms of wealth accumulation. But the basis of almost all insurance is the accumulation of a fund of assets from which uncertain losses can be met.

Maturity Transformations

• This relates to the function of commercial banks above which is to create liquidity and take risks upon itself (which isn’t as irrational as it sounds given that they should have less risk as they have information and specialist knowledge).
• They buy assets which are long and small in size and they transform them into short-term larger securities.
• The issue is still how is it logical for banks to give liquidity guarantees which don’t exist and guarantees of deposit which as with the nature of any security they use the deposit for, cannot actually exist.

Four Major concerns for bankers while profit-maximizing

1. Liquidity Managements : Reserves in banks earn zero interest especially as the law says there are no reserve requirements in UK or USA. So the concern is how many liquid assets such as T-bills to keep in reserves for when there is an emergency yet profit maximize as much as possible.
2. Asset Management: Loans are asset and default risk is absolutely crucial as banks have to make that up elsewhere because it is depositors money not their own money they use to give out loans. So the issue is how can you essentially get that idea low risk high return which doesn’t necessarily exist.
3. Liability Management : Liabilities are deposits and bankers are searching low cost ways to increase liabilities. They do this by offering deposit insurance to a certain extent, but again they are constantly questing are there cheaper ways to attract funds.
4. Capital Adaquency Management : Similar to liquidity management, where that was focused on the nature of reserves that banks keep capital adaquency questions the size question, how much capital should exist in reserves.

Trends in the realms of Banking and Finance

1. Merger & Acquisition - The trend that investment banks are merging with commercial banks and the motivation behind this is that the nature of mergers reduce costs thus providing incentives for shareholders to vote for it.
2. Executive Pay - Incentives for board members to get bonuses by getting involved with risk strategy issues and mis calculating risk as a result.
3. Capital Adquency Management -Banks are not keeping enough capital, in some cases they are so blinded by the risk calculation they lend 167% of capital to just one borrower. There are new regulations coming now. 
4. Growing Competition - Competition and new ways of banking are changing the face of banking. For example the surge in internet banking and  the enormous cost incentives has resulted in the closure in many bank branches, leaving the few banks remaining with merely operational staff.