Guy Hargreaves ACF-104

Recap of yesterday The fundamental principles of financial intermediation “Financial claims” - marketable and non-marketable Identify various financial markets, and banking and non- banking financial intermediaries Deposit-taking and non-deposit-taking financial intermediaries Banking versus shadow banking markets The function and characteristics of money and monetary bases The importance of market liquidity to the operation of the global economy 2

Today’s goals Understand banking systems within developed economies Appreciate the structure of a typical commercial banking system Review payment systems and how they operate Describe the main products and services offered by commercial banks Understand the commercial banking customer base 4

Definition for this course This course focuses on Commercial Banking Commercial banking can be thought of as any regulated banking activity operated as a business For this course we will define commercial banking as: Retail banking (including Private banking) Wholesale (or Corporate) banking We will also look at investment banking Important to note investment banking activity is not usually regulated by a Central Bank It is regulated when conducted by a regulated bank 5

Two basic economic sectors Private sector – not controlled by the State Individuals Private / public companies Non-profits / charities Public sector – controlled by the State Federal government State governments Local governments State owned enterprises 6

Where does commercial banking fit? Private sector Individuals – banking licenses not generally available Private / public companies – most commercial banks Non-profits / charities – some banks eg Microfinance Public sector Federal government – Central Banks State governments - no Local governments - no State owned enterprises – few SOE commercial banks remain 7

Who are the savers / borrowers? Private sector Individuals – both savers and borrowers Private / public companies – both savers and borrowers Non-profits / charities – goal usually to be neither Public sector Federal government – mostly borrowers State governments – mostly borrowers Local governments – mostly borrowers State owned enterprises – mostly borrowers 8

Are commercial banks savers? 9 Like any for-profit entity, commercial banks can be savers and borrowers themselves Lending out profits not paid to shareholders Borrowing for capital expenditure If a commercial bank is a saver / borrower, it will conduct this activity with its own capital This activity is considered “proprietary” ie not performed in the course of its financial intermediation activity

The financial system 10 Retail / Wholesale Commercial Banks Investment Banks

What is a banking system? 11 The Banking System is that part of a financial system in which regulated banks operate Does not include Capital Markets which are part of the Financial Markets Includes payments, Central Bank operations, bank loans, deposits – any activity which involves a regulated bank Whether the activity is regulated is an important distinction Unregulated activity is conducted outside of the security and support provided by Central Bank regulated commercial banks

What is a banking system? 12 Banking systems are usually made up of: Central Banks Regulated commercial banks Retail (including Private) banks Wholesale banks Payments systems Regulated banks deal in financial markets but markets are not usually considered as part of the banking system Investment banks deal in financial and capital markets but if unregulated they are not considered part of the banking system

What else do commercial banks do? 13 Conduct operations in financial markets, eg Hedging risks for customers Risk management for their own balance sheet Operate payments systems Facilitate trade flows Help with the conduct of monetary policy Support economic growth Assist in executing development policies

Recall: payment systems A Payment System is any organised system established to allow participants to transfer financial assets between themselves Payments take place for many reasons: In exchange for goods and services Creation or repayment of a financial liability/asset Commercial banks have historically played a key role in payments systems 14

Payment systems - RTGS “Interbank” payment systems use Real Time Gross Settlement (RTGS) to transfer money between bank participants Retail participants must hold some form of account with a commercial bank in the payments system To effect payment a participant will instruct its bank to transfer money from that participant’s account to the proper account of another participant at its own bank The two banks “settle” the transaction through adjustment of their own accounts held with the relevant Central Bank Central Banks usually manage RTGS systems 15

Payment systems - SWIFT International payment systems use Society for Worldwide Interbank Financial Telecommunication (SWIFT) to transfer money between participants SWIFT is does not alter the underlying mechanics of individual domestic payment systems SWIFT is simply a system that arranges domestic payments between international participants Unless the banks handling a SWIFT transaction are primary deposit-taking institutions in the currency of the transaction, instructions will be handled through a correspondent banking arrangement 16

Commercial bank payment products Commercial banks offer many ways for their clients to instruct a payment: Cheques Online transfers Standing orders Credit cards Debit cards ATMs Smartphones SMS 17

Correspondent banking Commercial banks often hold accounts with other domestic or international commercial banks Nostro account: “our money held by you” Vostro account: “your money held by us” When a bank holds an account with another bank it is said to have a Correspondent Banking Relationship If a bank does not maintain an account with its Central Bank it needs to have a correspondent banking relationship with one that does 18

Commercial banking products Retail and wholesale commercial banks offer a wide range of products and services – including: Current and chequing accounts Term deposits Consumer loans and mortgages Credit and Debit Cards Cash management services Corporate and SME loans Trade Finance Financial market products and services Online banking 19

Investment banking products Investment banks offer a wide range of products and services – including: Capital market product arranging and underwriting Financial market products and services Securitised or asset backed arranging Merger and acquisition advisory 20

Mortgage products One of the most fundamental banking products A bank lends money to a borrower to purchase a house, apartment or other property Only a portion of the property purchase price is lent (eg 50%) – the balance is funded from savings of the borrower The borrower repays loan principal and interest over an agreed time frame (eg 30 years) The bank takes a “mortgage” over the property which entitles it to seize and sell the property to repay the loan if the borrower defaults Banks are at the heart of retail property financing across the globe 21

Credit and debit cards A group of banks were responsible for the development of widely used credit cards such as Visa and Mastercard Card products offer the great convenience of being cash-like and widely accepted Credit cards offer the holder an unsecured line of credit that can be drawn to pay for goods and services Debit cards are accounts that must have positive fund balances before they can be used to pay for goods and services 22

Cash management services Corporate customers have complex daily cash management requirements including: Multi currency cash accounts Account sweeping and reconciliation Lockbox facilities Subsidiary account management Foreign exchange Sophisticated online cash management solutions are now offered by many banks to help corporate customers manage their business flows 23

Trade finance Commercial banks are central to the financing of trade flows across the globe: Guaranteeing payments for exporters and importers through correspondent banking relationships Financing shipments of commodities around the globe Working capital finance for trading companies Inventory financing 24

Financial market products Commercial banks offer a range of financial market products and services including: Foreign exchange and forwards Money market products Syndicated loans Derivative risk management products Repo products 25

Corporate banking products Corporate banking customers range from SME to mid market to large listed multinational companies (MNCs) These customers have a range of commercial banking needs including: Lease and hire purchase financing Invoice and receivable discounting Corporate loans and commercial paper (CP) Project finance 26

Commercial banking customers Traditional commercial banking customers broadly fall into categories of: Household savers, or borrowers for purchases of property or smaller ticket personal goods (eg cars) Corporate borrowers entering into bilateral or club loans for capital expenditure (capex), working capital or M&A Governments funding infrastructure or deficits 27

Modern banking customers Post deregulation in the 1980s, the number and type of bank customer has grown strongly Retail customers now also include: Financial market traders and speculators Margin loan borrowers Advisory customers (Private Banking, estate planning etc) “Sub-prime” customers Traditional deposit and consumer loan customers Etc.. 28

Modern banking customers Wholesale commercial banking customers now also include: Private Equity funds Pension and Mutual funds Hedge Funds Mortgage and other originators NBFIs Traditional corporate borrowers Corporate risk managers Syndicated loan borrowers Etc… 29