PART 2 : BANKING Chapter 1 : Banks Alain de Crombrugghe 25 April 2014 ECON M831 CORPORATE FINANCE AND FINANCIAL INTERMEDIATION What are the functions of banks ?

Outline Functions of banks Contracts Type of banks Risk management

1. The functions of banks 1. Liquidity of provision and creation 2. Intermediation : reduction of transaction costs Management of the payment system 3. Creation of information and delegated monitoring 4. Transformation – Of size – Of maturity – Of risk 5. Other services NB. Hubbard, R.G. (2005) Money, the financial system and the economy, Pearson 5th Ed. Part 4 : “Information-Risk-Liquidity” : triangle of functions, analysis of roles or shocks on triangle: intermediation, crises, interest ceiling, insurance, international…

2. Contracts 1. Loans (asset side) – 4 variables (3 determine the 4th) Capital – Payments – Interest rate - Maturity – Conditions : frequency (duration and monitoring effect) – Guarantees, collateral : Banks take no equity share. (only interbank loans used to be unsecured). – Penalties : early termination, « covenants », etc. 2. Deposits (liability side) – Rate (may change) – Capital – Maturity – change notice – Frequency (compounded interest) 3. Other contracts Note 1 : Income stream through interest margin (lending-deposit rate) and through fees. Note 2 : Problems for « small clients » : Small amounts tend to generate similar costs as large amounts + poor people lack assets to offer as collateral.

3. Type of banks Commercial banks – Deposit banks « Monetary financial institutions » MFI for ECB Universal banks Also hold shares in firms : Germany, Japan. Investment banks Savings banks Cooperative banks Banking and Insurance companies « micro banks », microfinance. The « separation » issue is back in 2010 from the 1930’s See Liikkanen report, Volker, Vickers … Competition authorities have entered the scene : state aid, dominant position, distorsions in prices….

Type of banks Business model Reference business models of banking : – Interest margin : between lending and deposit rate – Fee business : asset management, advice, … Business models in recent discussions : – « Originate and distribute » – « Bancassurance » dynamising the liquidities of insurance, increased leverage, commercial link (branches; leasing (finance) of insured (insurance) assets) – « Interbank market financing » « money market financing » : higher volatility. xx

Type of banks Liberalization Financial regulation and deregulation Liberalization : 4D (1980’s) : – Deregulation – Disintermediation – Despecialization – Diversification USA : financial firms : 5% of stock market in 1970’s, 25% in 2005 (The Economist, “A World Awash with Profits”, p And from 4 to 40% of profits). Also large on other stock markets.

Issues with 4 D : – Internal conflict of interest Commercial Bank issues credit to firm owned by Investment Bank or by investment funds, Private Bank advises clients to buy shares in firm to which Commercial Bank is heavily exposed and which it wants to recapitalize, or in which Investment bank or fund holds shares… LA PORTA, R., LOPEZ DE SALINAS, L. & ZAMARRIPA, G. (2002) « Related Lending » NBER Working Paper 8848, Mexican banks owned by non-financial firms seem to face more conflict and losses than German and Japanese banks owning non-financial firms (but not owned by them). Information economies of scale versus conflict of interest ? Life insurance (actually a savings contract) can subsidize risk insurance (a true casualty management), but should not. – Valuation by financial markets Trend is against conglomerates in developed financial markets, why doesn’t this apply to banking and insurance ? The issue is where is information and/or diversification best managed ? – Poor risk management and search for profits : Too high deposit rates (US savings and Loans , Iceland 2007, Cyprus 2012) Too risky assets, lack of experience (commercial properties and S&L USA 1980’s), lack of understanding (subprimes, repackaged in ABS), lack of diversification (Spanish Caixa and real estate, Cyprus banks buy Greek debt 2010)...

– Liberalization paradox from point of view of Government Belgian Gov 1980’s : get cheaper finance through competition between lenders instead of through guaranteed lending from bank cartel (low deposit rates, forced gov finance), BUT : eventually higher rates (and spreads within the euro) because of competition of B Gov (and all Gov) with other Gov’s and borrowers. (see e.g. Tijd 10 nov 2011 quoting Reinhart).

“Liberalization vs Financial repression” and other forced savings Show : No crises, strong capital controls, low deposit rates (regulation Q in USA, government sponsored bank cartels in Europe, etc.) : (graph in Reinhart Rogoff AER 2011) This contributed to post-war reconstruction and to a reduction of war debts (with limited use of inflation, but use of forced savings instead). After floating dollar (1971) and oil crisis (1973): huge capital movements, liberalization, return of crises (including Europe : e.g. UK in the 1970’s) crisis : some return of financial repression. Low central bank interest rates favour banks over savers. Indirect way to help banks recapitalize. Indirect way to help governments reduce their debt (even more so if inflation rises). See Rajan (2010) “Fault lines” chap.... and The Economist 25/02/2012 “Repressed Memories” p. 62. Transfer from savers to borrowers. See also de Crombrugghe and De Keuleneer on Greek bonds on VoxEU.

Source : American Economic Review 2011.

4. Risk management Risk factors (at bank level) : – 1. Credit risk – 2. Liquidity risk – 3. Market risk (prices, interest rate, echange rate) – 4. Operational, technical – 5. Legal - system Measuring risk (see HULL) – 1. VAR – 2. Tail risk – 3. Rating (related to probability of default).

Risk management Risk management instruments – 1. Collateral (against credit risk) – 2. Hedging (against market risk) « Duration » management « Forward » and « Futures » « Swaps » Options CDS and insurance (with countreparty risk, cfr KBC’s CDO’s and MBIA’s bankruptcy in June 2009) – 3. Diversification (of borrowers, of collateral, of industry or country) … but paradoxes in Europe ! – 4. Liquidity (with interbank market and lender of last resort? ) – 5. Equity (Basle norms) – 6. Scale economies ? x

Risk management Swaps See annex in Word.