The Multinational Bank

A multinational enterprise (MNE) is defined as any firm with plants extending across national boundaries. A multinational bank (MNB) is a bank with cross-border representative offices, cross-border branches (legally dependent) and subsidiaries (legally independent). Multinational banks are not unique to the post-war period. From the 13th to the 16th centuries, the merchant banks of the Medici and Fugger families had branches located throughout Europe, to finance foreign trade. In the 19th...

China and financial repression

In 1979, China's banking system was financially repressed by any measure used. The banking system is undergoing reform as part of a bigger plan to move to a market based economy, while conforming to the political ideals of communism. To what degree have these reforms removed the characteristics of financial repression from the Chinese banking system One interesting figure is China's ratio of M2 to annual GDP, reported in Table 6.3. In 2002, it stood at 165 , higher than any country listed,...

Liquidity or funding risk

These terms are really synonyms - the risk of insufficient liquidity for normal operating requirements, that is, the ability of the bank to meet its liabilities when they fall due. A shortage of liquid assets is often the source of the problems, because the bank is unable to raise funds in the retail or wholesale markets. Funding risk usually refers to a bank's inability to fund its day-to-day operations. As was discussed in Chapter 1, liquidity is an important service offered by a bank, and...

Questions

Use the description of Bancomer as a nationalised bank to discuss the pros and cons of having a nationalised banking system. Is it a sound public policy objective 2. In the context of the case, explain the meaning of (f) market segmentation within a retail branch. 3. What did the Visa group expect to gain from the purchase of Bancomer, one of the newly privatised major banks in Mexico 4. Mexico is an emerging market economy. What factors are unique to banks in this type of economy Did the new...

Liquidity Risk and Asset Liability Management

The ALM group in a traditional bank is also responsible for the management of liquidity risk. As defined earlier, it is the risk that a bank is unable to meet its liabilities when they fall due. Liquidity risk is normally associated with the liabilities side of the balance sheet when depositors unexpectedly withdraw their financial claims. Assuming the liquidity preferences of a bank's customers are roughly constant, the problem usually arises if there is a run on the bank as depositors try to...

Zaitech and the Bubble Economy

As was the case in the west, by the mid-1980s, large Japanese corporations realised that issuing their own bonds could be a cheaper alternative to borrowing from Japanese banks. Also, an investment strategy known as zaitech was increasing in popularity it was more profitable for a Japanese corporation to invest in financial assets rather than Japanese manufacturing businesses. Early on, these firms borrowed money for simple financial speculation, but over time the process became more...

Islamic Banking in Malaysia Iran and Pakistan

Malaysia operates both a conventional and an Islamic banking system. The first Islamic bank was established in 1983, and dual banking, where a bank can offer both conventional and Islamic banking services, was introduced in 1993. Banks offering both types must have 76 Archer and Ahmed (2003) identify the areas of Islamic banking which require explicit attention with regard to prudential regulation, accounting and corporate governance. 77 Accounting and Audit Organisation for Islamic Financial...

Critique of Basel

There were numerous criticisms of Basel 2, but some were addressed during the consultative process (e.g. SMEs). The problems with the use of VaR were discussed earlier. Here, the more general problems related to the Basel 2 framework are reviewed. Perhaps the most serious is that it moves with the economic cycle, i.e. it is pro-cyclical. To the extent that the creditworthiness of financial and non-financial firms moves with the cycle, the method for calculating the amount of capital to be set...

A US National Banking Structure

US regulatory authorities have largely abandoned trying to regulate bank interest rates or bank products,45 accepting that it is not possible to do so in an environment of rapidly changing technology and financial innovation. Foreign banks can expect to be 43 For more detail, see the Federal Reserve Bulletin (1993). 44 Sumitomo bank purchased Daiwa's US operations in January 1996. At the time it was ranked the 14th largest Japanese bank by tier 1 capital Sumitomo was the 2nd largest. (Source...

The Japanese Financial System 1945Mid1990s

To understand how Japan ended up with a chronic, but serious, banking crisis, it is helpful to briefly review the growth of Japan's financial structure from the ruins of World War II. Japan faced a severe shortage of capital and weak financial infrastructure. The financial assets of the household sector were virtually wiped out. The priority of the US occupying force and the new Japanese government was to increase assets, which in turn could finance recovery of the real economy. The outcome was...

The Evolution of Bankers Trust

In the late 1970s, BT was a typical money centre bank,61 strapped with credit losses arising from recession and the Real Estate Investment Trust crisis. It continued to operate a progressive retail and commercial domestic banking business, with an international focus. But capital requirements, together with provisioning for bad debt, meant the bank would be constrained in any attempt to operate in all markets. BT emerged from the 1970s wounded but still viable, and this position had a profound...

Overview of Bancomer

Throughout its 60-year history, Bancomer's owners and management pursued a strategy which focused on growth in the retail and middle market sectors, with a strong marketing orientation, reflecting a willingness to respond to customer needs. It operated a decentralised management structure prior to nationalisation, which, it argued, made the bank highly responsive to community needs. Under nationalisation, decision-making became centralised and bureaucratic, in line with the objective of...

Stochastic frontier analysis and other parametric techniques

Over the last two decades, the use of parametric techniques to estimate bank efficiency has increased. The most common includes a stochastic frontier approach, which uses a translog cost function. Parametric approaches allow a more explicit breakdown of the constituents of X-efficiency, namely technical inefficiency, which arises from factor inputs being over-used (e.g. expansion of staff) and allocative inefficiency - resources are not allocated efficiently, due to lax management or expense...

From Partnership to Public Listing

In 1986, Mr John Weinberg, as senior partner, was responsible for informing those who were to be promoted from being vice-presidents to partners. The firm had grown so large that for the first time, partners did not know every candidate up for partnership. Also, many of the new partners came from trading, illustrating its importance in this traditional investment bank. These were signals that Goldmans had grown so large, it was time to look at alternative methods of corporate governance, to...

The Basic Principles and Key Products

The countries where Islamic banking plays a central role are classified as emerging economies, though they vary considerably in terms of living standards, income and level of development. It is estimated that there are roughly 250 Islamic financial institutions IFIs operating in more than 48 countries, with combined assets of somewhere between 200 and 250 billion, though some estimates are as high as 400 billion.66 To put this in perspective, the top 10 banks measured by tier 1 capital in 2003...

Consolidation and Systemic Risk

The subject of systemic risk was covered in Chapters 4 and 5. Mergers and acquisitions can affect systemic risk in a variety of ways. First, mergers and acquisitions generally result in a more diversified firm, which should reduce the risk. However, there is some research showing that the gains from diversification are offset by banks taking more risks, in search of greater expected returns. M amp As also increase the size of banks and if these larger firms fail, the systemic consequences are...

Advanced internal ratings based approach and credit risk

As Table 4.4 shows, if a bank's credit risk management system is approved for the advanced internal ratings based approach AIRB , the bank supplies its own estimates for PD, LGD, EAD and maturity. There are no rules on what factors should be used for the purposes of risk mitigation. Furthermore, all physical collateral is recognised, unlike the limited recognition of property and equity under IRB. Basel 2 proposals reward more sophisticated risk management systems by reducing the amount of...

Subordinated Debt

Another example of an incentive based approach is that all banks be required to have a certain percentage of their capital in subordinated debt uninsured, unsecured loans which are junior to all other types of lender, that is, the lenders would be the last to be paid off in the event of bankruptcy. However, a number of issues need to be dealt with if it is to be successful. A clear signal that these creditors will not be bailed out is necessary. Thus, only well-informed buyers, such as...

The Financial Services Act 1986

Financial Regulatory Structure

The main objective of this Act was the protection of investors in the ''Big Bang'' era. Self-regulation was introduced for all financial firms. A two-tier system, the lower tier consisted of SROs or self-regulatory organisations, which would regulate different functions. Originally, there were six SROs, each responsible for the regulation of futures dealers, securities dealers, investment managers, personal investment, life insurance and unit trusts. The number was later reduced to three the...

Failing US commercial banks

During 1980-94, more banks over 1600 than thrifts failed, but less than half the assets by value were involved. The key point is that the bank failures were concentrated in regions of the USA at different points in time, as Chart 7.1 illustrates. The crisis can be divided into three phases. Chart 7.1 US Bank Failures in the Northeast and Southwest, 1986-1995. copyright FDIC. Phase J The early 1980s. Between 1980 and 1984, there were 192 bank failures, about 12 of the total between 1980 and...

The South East Asian Financial Crisis 199799 831 An Overview of General Contributing Factors

What became known as the Asian financial crisis originated in Thailand, then spread quickly to South Korea, Indonesia, Malaysia, Thailand, other Asian economies and beyond.15 The onset, speed and seriousness of the crises took experts by surprise - there were no official forecasts of a sudden downturn, let alone crisis. Spreads on Asian bonds had substantially narrowed during 1996 and for most of 1997 likewise, credit ratings remained largely unchanged. Until the onset of problems, fiscal and...

The Secondary Banking Crisis 1973

The events of the early 1990s share some features with the UK's secondary banking crisis. In the early 1970s, several small banks were rescued by the Bank of England. A number of so-called ''secondary'' banks were established in the UK in the 1960s. Unlike the mainstream banks, which relied on relatively cheap, stable retail deposits, most of the funding for the new banks came from the growing wholesale money markets, which they 33 This account is from Hoggarth and Soussa 2001 and Logan 2000 ....

Bank structure France

The French financial system, including its banks, has developed at a relatively slow pace, due partly to the relatively high degree of state interference in this sector. France is characterised by numerous regulations, even though it has recently shed some of its more onerous rules. For example, before 1985, France had no money market to speak of, apart from an interbank market. The key banks in France are the 400 members of the AFB or Association Francaise des Banques. The system was highly...

Credit risk mitigation collateral guarantees and credit derivatives

Basel recognises collateral, guarantees and credit derivatives as ''credit risk mitigants'', because the presence of any three may mean that in the event of default, some assets are recovered, which reduces the size of a loss for the bank. However, certain restrictions apply, depending on the risk management approach adopted by a bank. Collateral backs a loan, and in the event of default, is used to recover some assets, Thus, collateral affects LGD - the higher the quality and amount of...

Market Risk and Value at Risk

The VaR model is used to measure a bank's market risk, and it therefore serves a different purpose from RAROC. It has since been adapted to measure credit risk, which is briefly reviewed in the next section. Though VaR was originally used as an internal measure by banks, it assumed even greater importance after the 1996 market risk amendment to the 1988 Basel agreement - regulators encouraged banks to use VaR. The Basel agreement was mentioned briefly in Chapter 2. Where appropriate, some...

Barings

The recovery in profitability has been amazing following the reorganization, leaving Barings to conclude that it was not actually terribly difficult to make money in the securities markets. A 1993 remark attributed to the Chairman of Barings plc, speaking to Mr Brian Quinn, Director of the Bank of England at the time People at the London end of Barings were all so know-all that nobody dared ask a stupid question in case they looked silly in front of everyone else. Nick Leeson, Rogue Trader,...

Failing thrifts

Thrifts are savings and loan S amp L banks, either mutuals or shareholder owned, though by the end of the crisis, the majority were stock owned. Until 1989, they were backed by deposit insurance provided by the Federal Savings and Loan Insurance Corporation FSLIC . The FSLIC was in turn regulated by the Federal Home Loan Bank Board. Both institutions were dissolved by statute in 1989. In 1932, Congress passed the Federal Home Loan Bank Act. The Act created 12 Federal Home Loan Banks, with the...

Foreign Bank Entry Does it Help or Hinder Emerging Financial Markets

The role foreign banks are allowed to play is an important differentiating characteristic of banking systems in emerging market economies. Branches and or subsidiaries of foreign commercial banks dominate the banking systems in a variety of countries, such as the Bahamas, Barbados, Fiji, the Maldives, New Zealand, St Lucia, Seychelles, the Solomon Islands and, in recent years, Hungary, Mexico and Kazakhstan. The new banking systems in some of the former Soviet bloc economies have strongly...

Separation of commercial and investment banking

The Glass Steagall sections 20, 32 of the Banking Act 1933 , which became known as the Glass Steagall Act, separated commercial and investment banking from 1933 Table 5.7 Key Regulators of Financial Firms Table 5.7 Key Regulators of Financial Firms National commercial banks - includes foreign branches, branches of foreign FHCs BHCs, national commercial banks includes foreign branches , foreign banks, state banks which are members of the Fed Any bank national state covered by FDIC insurance -...

Bankhaus Herstatt

This West German bank collapsed in June 1974 because of losses from foreign exchange trading, which were originally estimated at 83 million but rose to 200 million. At the time it was unclear how the bank had managed to run up such losses. The bank's failure is famous because it exposed a weakness in the system related to liquidity risk. Bankhaus Herstatt was due to settle the purchase of Deutsche marks DMs, in exchange for dollars on 26 June. On that day, the German correspondent banks, on...

Pillar 1 Operational Risk

Operational risk OR is a new controversial addition to the denominator of the risk assets ratio. Recall Basel's definition of operational risk from Chapter 3, which in more recent documents has changed very slightly Operational Risk is defined as the risk of losses resulting from inadequate or failed internal processes, people and systems, or external events. BIS, 2003a, p. 8 Based on the most recent Basel publications at the time of writing, a bank may adopt one of three approaches or a...

Deposit insurance

Deposit insurance has been an important part of the US system since the Federal Deposit Insurance Corporation FDIC was set up after the 1933 US Banking Act. The FDIC was created to protect small depositors from ever experiencing the losses which were a consequence of massive bank failures that occurred between 1929-33. All member banks of the Federal Reserve System are required to join the FDIC non-members may join if they meet the FDIC admission criteria. Membership is important for any bank...

The growth of nonbanks

There has been much discussion on the threat posed to traditional banks by the growth of non-banks. Non-banks,55 by definition, are firms which do not offer a complete core banking service but are very similar to banks. For example, personal loan or mortgage corporations specialise in loans or mortgages that are funded through bond issues and or by turning a bundle of assets into asset backed or mortgage backed securities and selling them to raise liquidity. Though they offer a ''banking''...

Bank Structure and Regulation in Japan 541 Background

In the post-war period, Japan faced a severe shortage of capital and weak financial infrastructure. World War II virtually wiped out the household sector's financial assets. The priority of the US occupying force and the new Japanese government was to increase assets, which in turn could finance recovery of the real economy. The outcome was a highly segmented financial system, with strong regulatory control exerted by the Ministry of Finance MoF , backed by the Bank of Japan. Domestic and...

Transactions contracts

El-Hawary et al. 2004 identify three categories of transactions based contract. Musharaka this is an equity agreement between the bank and one or more partners to share the risks of an investment project. The returns losses are determined by the percentage contribution each party makes. For example, if a bank puts up 60 of the capital and two investors provide 20 each, the bank will get 60 of the profits or bear 60 of the losses, and each of the other two parties will gain lose 20 of the...

Harmonisation of accounting standards

There are significant differences in the application of accounting standards, even among industrialised countries. In the United States, pre-Enron, the standards were used to ensure that those looking at a firm's accounts would get a ''true and fair view'' of the firm. The result was a proliferation of accounting rules which, in Europe, are regarded as too onerous. Also, many non-Anglo Saxon countries view firms' accounts as serving a different purpose, such as providing information to...

Why Banks Use Derivatives

It is important to be clear on the different uses of these instruments by the banking sector. Banks can advise their clients as to the most suitable instrument for hedging against a particular type of risk, and buy or sell the instrument on their clients' behalf. This may help the bank to build on relationships and open up cross-selling opportunities. Additionally, banks employ these instruments to hedge out their own positions, with a view to improving the quality of their risk management....

Canadian Bank Failures

During the autumn of 1985, five out of 14 Canadian domestic banks found themselves in difficulty. Two banks Canadian Commercial and Northland had to close. The problems of Canadian Commercial Bank CCB , based in Edmonton, originated with its loan portfolio, which was concentrated in the real estate and energy sectors. A formal inspection in early 1982 revealed two-thirds of uncollected interest was on property loans and another 16 on energy related loans. In the summer of 1985 after CCB had...

Market risk the internal model approach

Banks, subject to the approval of the national regulator, are allowed to use their own internal models to compute the amount of capital to be set aside for market risk, subject to a number of conditions. The market leader is JP Morgan's Riskmetrics . Value at risk was discussed at length in Chapter 3. This subsection shows what Basel requires of banks if they use a VaR model. Throughout, it will be assumed they are using the Riskmetrics model, so the key equation is Vx the market value of...

Aggregate Credit Risk Exposure and Management

Up to this point, the discussion has focused on loans to individuals or firms. All banks will want to manage their aggregate credit exposure. A heavy concentration of loans in one sector has the potential of threatening the survival of the bank. There are many examples of banks getting into problems precisely because of over-exposure in one sector. The case of the Texan banks has already been mentioned. Not only did the value of their collateral oil wells and real estate fall when the oil...

Capital or gearing risk

Banks are more highly geared leveraged than other businesses - individuals feel safe placing their deposits at a bank with a reputation for soundness. There are normally no sudden or random changes in the amount people wish to save or borrow, hence the banking system as a whole tends to be stable, unless depositors are given reason to believe the system is becoming unsound. Thus, for banks, the gearing or leverage limit is more critical because their relatively high gearing means the threshold...

Sovereign and Political Risk Analysis 651 A Review of Terminology

The final section of this chapter undertakes a brief review of sovereign and country risk. Again, whole books have been written on the subject. The purpose here is to explore the key ideas and findings in this area. The section provides the definitions of standard terms, reviews why emerging market economies tend to be net importers of external finance, and investigates models designed to identify the factors which increase the risk of sovereign defaults, The impact of political risk is also...

Financial Innovation and Risk Management

The financial products discussed above are examples of recent financial innovations. Like the manufacturing sector, financial innovation can take the form of process innovation, whereby an existing product or service can be offered more cheaply because of a technological innovation. Product innovation involves the introduction of a new good or service. The new financial instruments discussed above are examples of where technological changes resulted in product innovations. Silber 1975, 1983...

The Role of Regulators

Bank examiners, auditors and other regulators missed important signals and or were guilty of ''regulatory forbearance'', that is, putting the interests of the regulated bank ahead of the taxpayer. In many cases of failure, subsequent investigation shows stated exposure limits were exceeded, with the knowledge of the regulator. Examples include Johnson Matthey Bankers, Banco Ambrosiano, most of the US thrifts and Barings. Like all firms, banks pay for external private auditing of their accounts....

VaR Portfolios and Market Risk

It is possible to show simple applications of VaR for individual trading positions involving two currencies or equities. However, banks compute VaR for large portfolios of equities, bonds, currencies and commodities. Management will want an aggregate number showing the potential value at risk for the bank's entire trading position. This aggregate VaR is not just a simple sum of the individual positions because they can be positively or negatively correlated with each other, which will raise or...

Bank Structure and Regulation in the USA 531 Background

The central bank and bank supervisory functions in the USA have evolved to create a US banking and financial structure which, by the late 20th century, was notably different from those in other western countries. Several factors explain its unique structure. First, US regulators have been far more inclined to seek statutory remedies in the event of a new problem, resulting in a plethora of legislation. Second, the protection of small depositors has been considered an important objective since...

Stress Testing and Scenario Analysis to Complement VaR

Given the limitations of VaR, most banks apply scenario analysis and stress testing to complement estimates of market risk produced by VaR. Banks begin by identifying plausible unfavourable scenarios which cause extreme changes to the value of one or more of the four risk factors, i.e. interest, equity, currency or commodity prices. These might include an event which causes most financial agents to act in a similar manner, prompting severe illiquidity, as illustrated by the LTCM case, discussed...

Regulation of foreign banks

The International Banking Act 1978 eliminated some of the differences in the way domestic and foreign banks were regulated in the US market. For the first time, foreign banks were bound by the McFadden,42 Bank Holding Company and Glass Steagall Acts. Foreign bank branches and agencies were to be regulated by the Fed. Foreign subsidiaries could apply for a federal charter, which would give them access to federal services such as the discount window, cheque collection and clearing. 41 Marginal...

The Meaning of International Financial Architecture

Though the term ''international financial architecture'' is relatively new, institutions such as the Basel Committee have been working towards a common system of regulating global banks for over two decades. National bodies concerned with containing national crises, such as Sweden's central bank and the Bank of England, have been around for centuries. However, the agenda for international financial architecture is much broader, bringing together the various organisations dealing with...

Conclusion

This chapter reviewed the various aspects of bank risk management. It began by noting that banks differ from other firms in the range of financial risks they assume. The management of these risks will be a crucial determinant of their profitability and shareholder value-added. The traditional function of an asset-liability management group in banks which involves the management of credit, interest rate and liquidity risks was reviewed, together with the use of gap analysis, duration and...

Expansion into Global Markets

Some Islamic banks have attempted to expand into the global markets since the early 1980s, to capture a Muslim market overseas and diversify their portfolio, but have faced a number of challenges. There are difficulties with being recognised as banks, because they 79 Source ''Malaysia IBS deposits Hit 10 Market Share'', Islamic Banker, 90, July 2003, pp. 8-11. cannot hold interest-earning government securities, such as bonds.80 The profit loss-sharing nature of their deposit and lending...

Interest rate risk

The capital charge applies to all debt securities, interest rate derivatives e.g. futures, forwards, forward rate agreements, swaps and hybrid instruments. The maturity approach involves three steps. 1. Obtain a net overall weighted position for each of 16 time bands. Before they are summed, the net position in each time band is multiplied by a risk factor, which varies from 0 at the short end to 12.5 at the long end. 2. 10 of each net position in each time band is disallowed to take account of...

The Lamfalussy report February 2001

Though this report dealt with EU securities markets, the ratification of its key recommendations by the EU Parliament in February 2002 may have important implications for the future integration of banking and other financial markets. The report made a number of recommendations, most of which were eventually endorsed by Parliament. The key proposal was that rules for EU securities markets would be formulated by expert committees. They consist of a Committee of European Securities Regulators ESRC...

Johnson Matthey Bankers

Johnson Matthey Bankers JMB is the banking arm of Johnson Matthey, dealers in gold bullion and precious metals. JMB was rescued in October 1984, following an approach to the Bank of England by the directors of JM, who believed the problems with JMB might threaten the whole group. The original lifeboat rescue package consisted of the purchase of JMB and its subsidiaries by the Bank of England for a nominal sum 1.00 , and wrote off a large proportion of their assets. The bullion dealer, Johnson...

Equity risk

Determining the market risk arising from equities is a two-stage process, based on a charge for specific risk X and one for market risk Y . To obtain the specific risk the net an offset of the long and short of the spot and forward position for each stock is computed. The net exposure of each share position is multiplied by a risk sensitivity factor, which is 8 for specific and market risk, but if the national regulator judges the portfolio to be liquid and well diversified, the systematic risk...

Banco Ambrosiano

Banco Ambrosiano BA was a commercial bank based in Milan and quoted on the Milan Stock Exchange. It had a number of foreign subsidiaries and companies located overseas, in Luxembourg, Nassau, Nicaragua and Peru. The Luxembourg subsidiary was called Banco Ambrosiano Holdings BAH . The parent, Banco Ambrosiano, owned 69 of BAH. BAH was active on the interbank market, taking eurocurrency deposits from international banks which were on-lent to other non-Italian companies in the BA group. The parent...

Portfolio Diversification

Another reason why firms engage in international banking is to further diversify their portfolios. Canadian banks are a case in point. The major Canadian banks increased the foreign currency assets from the end of World War II on, so that by the early 1990s, international assets accounted for 32 of Canadian bank assets 80 of these assets are held by the big five.29 A bank undertakes international lending for one of two reasons. First, to increase external returns and second, to diversify...

The Precommitment Approach

This proposal would deal with private banks' criticism of Basel, that if a bank is allowed to use its own internal model, the minimum capital requirement is too high because it is 45 All the figures in this paragraph come from The Banker 2004 , pp. 154-165. The article is based on a survey of 200 global leading banks undertaken by FT Research for Accenture, Mercer Oliver Wyman and SAP. based on VaR multiplied by 3 or even 4. The larger banks claim this requirement creates a disincentive to use...

Pillar 2 Responsibilities of National Supervisors

This pillar identifies the role of the national supervisors under Basel 2. Basel has identified four principles of supervisory review 1. Supervisors are expected to ensure banks use appropriate methodology to determine Basel 2 ratios, and have a strategy to maintain capital requirements. 2. Supervisors should review banks' internal assessment procedures and strategies, taking appropriate action if these fall below standard. 3. Banks should be encouraged by supervisors to hold capital above the...

Global Regulation of Banks

No bank ever went bust for want of capital says one senior banker. They go bust because of bad management. Anonymous, quoted in The Economist, 16 8 03, p. 63 The principle objective of this chapter is to review attempts to regulate internationally active banks through global agreements. The chapter begins with a review of the reasons why governments regulate markets in general, and financial markets in particular. It continues with a discussion of why banks, which are part of the financial...

Bank Structure Italy

The banking structure in Italy underwent major changes in the 1990s, the result of financial reform in preparation for operating in a single market. By 2000, the number of banks in Italy had more than halved due to the 561 mergers and takeovers during the 1990s. The proliferation of large numbers of small, local branchless uncompetitive banks was the outcome of the 1936 Banking Act, which allowed commercial banks to take short-term 18-month deposits and loans, while investment banks were...

Cross Guarantee Contracts

Ely 2000 argues this is another market oriented method to encourage banks to be safe and sound. A cross-guarantee contract is a form of private insurance against insolvency. The guarantors provide unconditional guarantees of the financial firms' including banks liabilities. It would be negotiated on a firm by firm basis, and to operate in the financial sector, a firm would be required to find a guarantor. The guarantor would be paid a premium that would reflect how risky each bank's activities...

Basel 2 The Three Pillar Approach

New Capital Regulation Rules, known as Basel 2, will more closely align regulatory requirements with economic risk, and will have a profound effect on banking industry structures and practices. Citigroup Smith Barney, Basel II Strategic Implications, October 2003, p. 3 23 Recall from Chapter 3 that unlike the maturity approach, duration distinguishes between the average life of an asset or liability and their respective maturity. 24 Readers interested in a more detailed description of the...

Credit Risk Decisions Retail versus Corporate

If a bank is looking to minimise its aggregate credit risk, then good risk management of retail and corporate lending is essential. The approaches taken for retail and corporate loans differ considerably, mainly because a corporation is able to produce a variety of financial ratios, which are not available when the suitability of an individual or a small firm for a loan is being assessed. Most bankers concede that lack of information makes retail lending more difficult than corporate lending....

Improved disclosure

Improved disclosure by financial firms is an important component of effective international supervision because it can improve market discipline. The disclosure can be direct, provided by the firms themselves e.g. pillar 3 of Basel 2 or indirect, where the ratings published by independent rating agencies are used. A more radical suggestion is to use spreads on subordinated debt as an indicator of the health of a financial firm. The Federal Reserve Bank of Chicago has provided some evidence that...

Default Mode Approach

The default model approach draws on modern portfolio theory to measure a bank's aggregate credit exposure for non-traded assets, such as loans on the banking book. In PT, to obtain a measure of the risk-return trade-off between a portfolio of assets, there must be data on the expected return on the assets, the risk of the asset measured by the standard deviation , and the correlation between the risks of the assets. If these assets are loans, then this translates into the expected return on...

The 1988 Basel Accord Basel

The 1988 Basel Accord was a watershed because it established Basel's main raison d' tre to focus on the effective supervision of international banking operations through greater coordination among international bank supervisors and regulators. Improved international financial stability would be a key consequence of the Committee's actions. 10 Some countries, such as the UK, have representatives from both the Financial Services Authority and the Bank of England. The 1988 Basel Accord established...

Credit risk foundation and advanced internal ratings based approach

Subject to the approval of the national supervisor, these banks may use their own internal ratings and credit information to determine how much capital is to be set aside for credit Table 4.3 Foundation vs Advanced IRB Table 4.3 Foundation vs Advanced IRB EAD refers to loan commitments the amount of a loan or credit line that is likely to be drawn at the time of default, and equivalent to potential credit exposure PCE discussed in Chapter 3. In IRB, the average maturity is assumed to be 3...

N

1 1 1 1 1 1 1 1 1 t UK Fr Ge Lux Swi Sp Dk NL Belg Source OECD Paris 2000 Bank Profitability Statistical Supplement Average Staff Costs divided by Average Employees 1991-1999 . See note on all banks Figure 2.11 Number of employees per branch. Source OECD Paris 2000 Bank Profitability Statistical Supplement Average Number of Employees divided by the Average Number of Branches. See notes on all banks Figure 2.12 Financial sector share of total employment. Source OECD Economic Outlook 2000 amp IMF...

Risk Management by Major Global Bank

Barclays Bank plc very kindly agreed to provide information on how a major global bank actually manages its risk.54 Barclays is a long-established British bank, headquartered in London but with major global operations. By tier 1 capital, it is the fourth largest UK bank, and ranks 14th in the world, according to the July 2003 edition of The Banker. Chart 3.2 shows the way Barclays organises its risk management. Essentially, risk is managed along two lines, by type of risk and by different...

Financial Derivatives and Risk Management 341 Types of Financial Derivative

Before looking at how banks manage credit and market risk, this section considers the role of financial derivatives in risk management, because they are part of a bank's tool kit for managing risk. Derivatives were touched upon briefly in Chapter 2, which provided some basic definitions and noted the rapid growth in the derivatives market after 1980. Financial Derivatives or derivatives for short are instruments that allow financial risks to be traded directly because each derivative is linked...

Duration Analysis

Duration analysis expands on the gap analysis presented above by taking duration into account. Again, the objective is to consider the impact on shareholders' equity if a risk-free rate, for all maturities, rises or falls, but takes the procedure one step further. Duration analysis allows for the possibility that the average life duration of an asset or liability differs from their respective maturities. Suppose the maturity of a loan is six months and the bank opts to match this asset with a...

Key Financial Centres London New York and Tokyo

London, New York and Tokyo are the major international financial centres. Among these, London is pre-eminent, because most of the business conducted in the City of London is global. The London Stock Exchange has, since 1986, allowed investment houses based in 23 Source The Economist, 20 01 01, p. 90. 24 The creation of section 20 subsidiaries and the Gramm Leach Bliley Act 1999 have partly ended the separation between US investment and commercial banks. New York and Tokyo to trade in London,...

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...

Duration Gap Analysis

Duration gap analysis estimates a bank's overall interest rate exposure on the balance sheet, taking into account that duration gaps are present. The key question is, in the presence of a duration gap, how is the value of shareholders equity affected for a given change in interest rates The duration of the assets and liabilities are matched, instead of matching time until repricing, as in standard gap analysis. The on- and off-balance sheet interest sensitive positions of the bank are placed in...

The Interbank Market

Used by over 1000 banks in over 50 different countries, the growth of interbank claims has been very rapid. In 1983, total interbank claims stood at 1.5 trillion, rising to 6.5 trillion by 1998 and, early in the new century, 11.1 trillion, with interbank loans making up over half of this total. Among the developed economies, cross-border lending in the first quarter of 2001 reached an all time high of 387.6 billion, a 70 increase over the previous quarter.28 On the other hand, banks continued...

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...

Introduction

New risks to manage as a result of continued disintermediation, innovation and greater competition, especially in wholesale markets, where globalisation further eroded barriers. In Chapter 2 the movement of banks into new areas of off-balance sheet banking, such as the switch from interest income generating sources to non-interest income activities, was discussed.1 As a consequence, risk management has expanded to include not just ALM, but the management of risks arising from off-balance sheet...

Definitions of Types of Banking Universal banking

Universal banks offer the full range of banking services, together with non-banking financial services, under one legal entity. In addition, the banks have direct links between banking and commerce through cross-shareholdings and shared directorships. Financial activities normally include the following. Intermediation and liquidity via deposits and loans a byproduct is the payments system. Trading of financial instruments e.g., bond, equity, currency and associated derivatives. Proprietary...

Gap Analysis

Gap analysis is the most well known ALM technique, normally used to manage interest rate risk, though it can also be used in liquidity risk management. The ''gap'' is the difference between interest sensitive assets and liabilities for a given time interval, say six months. In gap analysis, each of the bank's asset and liability categories is classified according to the date the asset or liability is repriced, and ''time buckets'' groupings of assets or liabilities are placed in the buckets,...

Interest Rate Risk and Asset Liability Management

Traditionally, the ALM group within a bank has been concerned with control of interest rate risk on the balance sheet. For some banks it may be equally or even more important to manage interest rate risk arising from off-balance sheet business, but it is instructive to look at the traditional methods and progress to the relatively new procedures. To provide an example of the complexities of interest rate risk management, consider a highly simplified case where a bank, newly licensed by the...

Mortgage Backed Securities

The Federal National Mortgage Association Fannie Mae was set up in 1948 by the government to encourage home ownership in the United States. Fannie Mae supported saving and loans banks S amp Ls 7 in the USA, by buying mortgages which local but federally chartered S amp Ls could not fund through deposits. In 1968, the organisation was split into Fannie Mae and Ginnie Mae the Government National Mortgage Corporation . Ginnie Mae is a wholly owned corporation of US government departments. It claims...

Banking Issues in the 21st Century

A recent, popular opinion is that the contribution of banks to the economy will diminish significantly or that banks will even disappear, as the traditional intermediary and liquidity functions of the bank decline in the face of new financial instruments and technology. Rybczynski 1997 argued that financial systems evolve through time, passing through three phases. Phase one is bank oriented, where most external finance is raised through bank loans, which in turn is funded through savings....

An International Comparison of Payments Technology

Modern Technology Banking

Figures 1.3-1.6 illustrate how the pace and form of payments-related technological innovation has varied widely among the different industrialised countries. Figure 1.3 shows that ATMs are more plentiful in Japan and North America than in Western Europe. In Europe, Denmark has the fewest ATMs relative to population, followed by the UK and the Netherlands. The other European countries are roughly the same. The change in the UK is surprising because, in the 1980s, it was one of the leading ATM...

Government Debt Placement

If a central bank has this responsibility, it is expected to place government debt on the most favourable terms possible. Essentially, a government can instruct the central bank to raise seigniorage income43 through a variety of methods, which include a reserve ratio requiring banks to set aside a certain percentage of their deposits as non-interest-earning reserves held at the central bank - an implicit tax , interest ceilings, issuing new currency at a rate of exchange that effectively lowers...

Monetary Control or Price Stability

A country's money supply is defined as currency in circulation outside the banking system plus deposits held at banks.36 Banks play an important role in creating money, but so does the central bank. Banks create money by lending out deposits, hence their activities can affect the central bank. The traditional methods37 for controlling the money supply include the following. 1. Open market operations traditionally, this was done by buying and selling gilts UK government Treasury bills but since...

International Trade in Banking Services

Comparative advantage is the basic principle behind the international trade of goods and services. If a good service is produced in one country relatively more efficiently than elsewhere in the world, then free trade would imply that, in the absence of trade barriers, the home country exports the good service and the COUNTRY gains from trade. Firms engage in international trade because of competitive advantage. They exploit arbitrage opportunities. If a firm is the most efficient world producer...

Ebanking and other remote delivery channels

According to Good 1998 , electricity was invented in 1873 and took 46 years for mass adoption throughout the world. It took 35 years for telephones, 25 years for radio, and 16 years for PCs. For the World Wide web, it has taken only 6 years.46 It is important to draw a distinction between the question of whether digital cash will replace banks and the presence of electronic products which change the way intermediary banking services are delivered. They are two quite separate issues. The main...

The Effect of Noninterest Income on Banks Total Income

The rapid expansion of new forms of off-balance sheet activity means many banks are diversifying, and as a result, non-interest income is an increasingly important source of revenue. The ratios of net interest income and net non-interest income to gross income, for the period 1990-99, are shown in Figures 2.1 and 2.2. Looking at the averages for the Figure 2.1 Ratio of net interest income to gross income. Figure 2.1 Ratio of net interest income to gross income. Source-. OECD Paris 2000 Bank...

Summary Why are Banks Special

A key objective of the preceding sections of this chapter has been to identify the key features of banks, with an emphasis on the reasons why banks differ from other financial institutions. Before moving on to related topics, it is worth summarising the main reasons why banks are special. First and foremost, unlike other financial firms, they act as intermediaries between borrowers and lenders and, in so doing, offer a unique form of asset transformation. Second, liquidity is an important...

Bank Holding Companies

The term ''bank holding company'' originated in the United States. The Bank Holding Company Act 1956 defined a BHC as any firm which held at least 25 of the voting stock of a bank subsidiary in two or more banks. BHCs are commercial banks, regulated by the Federal Reserve Bank.30 Having been granted legal status, bank deposits under the control of BHCs grew from 15 in the 1960s to over 90 by the 1990s. Each BHC owns banking and in some countries, non-banking financial subsidiaries, which are...

New technology and innovation

Begin with the emergence of electronic e-cash or digital cash and assume, for the moment, that it has replaced currency in circulation - a cashless society the likelihood of the advent of a cashless society is discussed later in the section . Based on the development of technology to date, e-cash can consist of stored value cards, network money and e-wallets. Stored value cards store prepaid funds electronically on a chip in the card. Mondex39 and Visa Cash are good examples. The ''smart card''...

Competitiveness Key Factors

An important question is what are the factors that make a centre competitive A survey of experts undertaken by the CSFI 2003 25 identified six characteristics considered important to the competitiveness of a financial centre. The score beside each attribute is based on a scale of 1 unimportant to 5 very important . Favourable tax regime 3.88 Responsive government 3.84 A ''light'' regulatory touch 3.54 Attractive living working environment 3.5 Using the characteristics listed above, respondents...

Financial Holding Companies

The Gramm Leach Bliley Financial Modernisation GLB Act was passed in late 1999 and effectively repeals the Glass Steagall Act. The GLB Act allows US bank holding companies to convert into financial holding companies FHCs , which can own subsidiary commercial banks, investment banks and insurance firms. Likewise, investment banks and insurance firms may form FHCs, subject to the approval of the Federal Reserve. The GLB Act means, for the first time, that US banks can become restricted universal...

Payment Systems A Byproduct of the Intermediary Process

One theme of this chapter is that banks differ from other financial firms because they act as intermediaries and provide liquidity. Banks require a system for processing the debits and credits arising from these banking transactions. The payment system is a byproduct of intermediation, and facilitates the transfer of ownership claims in the financial sector. Credits and debits are transferred between the relevant parties. In the UK alone, there were over 28 billion cash payments in 2001, but...

Section 20 Subsidiaries

In 1981, the US Supreme Court ruled that section 20 of the Glass Steagall Act did not extend to subsidiaries of commercial banks. They could offer investment banking activities, provided they were not ''engaged principally'' in the said activities. Since 1987, BHC 29 Syndicated lending is when a lead bank persuades a number of other banks to contribute to a loan normally very large loans to finance massive projects such as upgrading a railway network, or sovereign loans to developing emerging...

Financial Conglomerates

Briault 2000 defined a financial conglomerate as a firm that undertakes at least two of five financial activities intermediary payments, insurance, securities corporate finance, fund management and advising on or selling investment products to retail customers. He reports that while in 1978 the vast majority of UK banks engaged in just one of these five activities, by 1998, 8 firms were authorised to offer all five functions, 13 were authorised to offer four, and more than 50 were authorised to...

International Financial Markets

In economics, a market is defined as a set of arrangements whereby buyers and sellers come together and enter into contracts to exchange goods or services. An international financial market works on exactly the same principles. Financial instruments and services, which include diverse items such as currencies, private banking services and corporate finance advice, are traded internationally, that is, across national frontiers. Below, the different types of global financial markets and key...

Relationship Banking

Relationship banking can help to minimise principal agent and adverse selection problems. Lender and borrower are said to have a relational contract if there is an understanding between both parties that it is likely to be some time before certain characteristics related to the contract can be observed. Over an extended period of time, the customer relies on the bank to supply financial services. The bank depends on long-standing borrowers to repay their loans and to purchase related financial...

Acknowledgements

Many individuals helped with this book. Anonymous referees made useful suggestions, which were incorporated into the book. Special thanks to Amelia Pais, who read and provided such helpful feedback on several chapters, and in record time Peter Sinclair was also generous with his time and comments on different parts of the book. I am also grateful to other academics who provided input at various stages some without knowing it Roy Batchelor, Alec Chrystal, Xiaoqing Fu, Ted Gardiner, Charles...