Chapter 10 Banking Industry: Structure and Competition

Financial Innovation and the evolution of the banking industry Financial engineering –Option theory provides a unified framework for performance evaluation in banking industry The life and work of Fischer Black Mortgage backed securities Adjustable rate mortgages and interest rate swaps

Financial engineering Option theory provides a unified framework for performance evaluation in banking industry CitiBank +Traveler's Group = CItiGroup Travellor’s insurance + SmithBarneySalomon = Travellor’s group SmithBarney + Salomon Brothers = SmithBarneySalomon

The life and work of Fischer Black Fischer never took a course in either economics or finance, so he never learned the way you were supposed to do things. But that lack of training proved to be an advantage, Treynor suggested, since the traditional methods in those fields were better at producing academic careers than new knowledge. Fischer’s intellectual formation was instead in physics and mathematics, and his success in finance came from applying the methods of astrophysics. (To be continued)

Lacking the ability to run controlled experiments on the stars, the astrophysist relies on careful observation and then imagination to find the simplicity underlying apparent complexity. In Fischer’s hands, the same habits of research turned out to be effective for producing new knowledge in finance.

Production per se has thus become a central value in our society; our utopian image is the ever-expanding economy. Such an image, though it is held by some of the most prudent, realistic, and practical men in our society, is truly utopian for it rests on the false premise that the potentialities of the environment in which we live are infinite, that ‘science’ will always find a way to make any damage we do to nature unimportant and will enable us to go on forever milking the cow without feeding her.

Mortgage backed securities Selling mortgages to investors. Keep serving mortgage payment, charging a fee. By securitizing mortgages, banks unload assets from their balance sheets. They can do more businesses

Adjustable rate mortgages and interest rate swaps

Economy of scale and information technology Economies of scale have increased because large upfront investments are required to set up many information technology platforms for financial institutions. (p. 251) Achieving low costs in banking requires huge investments in information technology. In turn, such enormous investments require a business line of very large scale. (p. 252)

The necessity of bank regulation Indeed, it was often easier for a U.S. bank to open a branch in a foreign country than to open one in another state in the United states! (p. 249) The lack of regulatory control in many poor countries is the fundamental reason of recurring financial crisis. Discussing Asian financial crisis

In financial analysis, two problems become very prominent. One is the level of initial cost or initial asset. The other is the level of uncertainty. We will use the following example to illustrate them.

Suppose a project will be jointed undertaken by two firms. The earning of the project will be equally shared by two firms. The cost of first firm will be 10000, 2500, 2500, 2500, 2500 in year 0, 1, 2 3, 4 and the cost of the second firm will be 4450 from year 0 to 4. If the discount rate is 15% per year, what is the cost in present value for each firm? (To be continued)

If however, each firm can withdraw from their commitment to the project anytime, which firm is more likely to pay extra cost to finish the project? In raising children, mothers pay much higher initial cost than fathers. If the family contract is enforced over a long term, fathers can be required to contribute more over the years. However, if marriage contract can be terminated any time, who will be more likely to pay extra cost? Will the lack of enforcement of long term contract increase or decrease the number of projects? What caused the low fertility rates in most Western countries?

Why it is very difficult for poor countries to develop sophisticated financial systems?

Exercise Suppose the initial investment on IT technology to replace checking with online transaction is 10 million dollars and the maintenance cost of the IT system is 1 million dollar per year. The system will last 10 years. The cost of each check clearing is 1 dollar and the cost of each online transaction is negligible. Assume the number of transaction is the same every year. How many transactions each year are required for the new IT system to break even, assuming discount rate is 10% every year?

Exercise A company is seeking 10 million loan that will mature in 10 years. It has a choice between bank loan and public debt. A bank loan rate is 2% above LIBOR rate. Public debt is 1% above LIBOR rate plus a one time underwriting fee of 0.5 million dollar. Assume interest payment is annual. All cash flows are discounted at 6%. Calculate the cost differential between two methods and determine which fundraising method the company should adopt. If the bank loan rate is 1.5% above LIBOR rate and other conditions remain the same, which fundraising method the company should adopt?

Exercise A company needs to raise 3 million dollar fund for a project. The owners of the company have a choice of equity financing and debt financing. The duration of the project is expected to be 20 years and each year the project is expected to generate 2 million dollar revenue. When there is no stress in cash flow problems, the variable cost in 60% of the revenue. For an equity financing, the external investor will require a rate of return that is consistent with equity market return. Inferred from CAPM, the risk premium will be 6%. Current risk free rate is 5%. The external equity investors will take the share according to the project value calculated by discounting future earning streams with the discount rate determined by CAPM. The bank loan will be 2% above the risk free rate. However, the added financial strain from regular interest rate payment will increase the variable cost by 5% of the revenue. From the original owners’ perspective, which financing method should they adopt?