2. Today’s goals Understand the role of maturity transformation, aggregation and risk transformation Understand the credit creation multiplier Understand the importance of the payment system and how it operates Describe the main products and services offered by banks Understand the structure and customer base of the global banking industry Position the banking industry within the global financial system 2

3. The theory of banking Banks, like other financial intermediaries, perform three basic high level functions: 1. Size transformation 2. Maturity transformation 3. Risk transformation In addition, banks provide intermediation products and services at the time of their customer’s choosing Because of the central positioning of banks in the financial system they can improve system liquidity, reduce system cost and lower system risk 3 Casu, Girardone & Molyneux: Chapter 1.3

4. Size transformation Unlikely a saver will deposit the exact amount of funds with a bank that a borrower demands on any given day Banks have multiple sources of liquidity to cover mismatches in financial transaction size: Central bank liquidity windows Interbank markets Public money market or bond markets Banks can take a “portfolio management” approach to the transformation of varying size requirements from their broad customer base of savers and borrowers 4 Casu, Girardone & Molyneux: Chapter 1.3

5. Maturity transformation Unlikely a saver will deposit funds with a bank to the to the exact maturity that a borrower demands on any given day Banks manage “asset-liability” maturity mismatch risk as part of their capital and liquidity management framework Banks also take a “portfolio management” approach to the transformation of maturity requirements – more heavily regulated as Basel III approaches 5 Casu, Girardone & Molyneux: Chapter 1.3

6. Risk transformation Unlikely a saver will wish to deposit all its funds with a single borrower, instead seeking to diversify its credit risk across a broad range of borrowers Banks lend to a broad range of borrowers, offering savers a diversified credit risk profile In addition, banks have a regulated capital structure ensuring borrowers have a cushion against expected and unexpected losses in the portfolio 6 Casu, Girardone & Molyneux: Chapter 1.3

7. Time and scale is money! Banks lend funds and take deposits at the time of choosing of borrowers and savers respectively Reduces risk for borrowers that need certainty of funds on a specific day Reduces opportunity costs for savers who might otherwise take additional time to find a borrower and thereby forfeit interest receipts Banks reduce transaction, information and search costs by exploiting economies of scale Larger turnover, larger fund flows reduces unit costs and increases economic efficiency 7 Casu, Girardone & Molyneux: Chapter 1.4

8. Credit creation Banks have very privileged position in the economy: Usually the most leveraged sector in he economy (15-30x leveraged!) Often the beneficiary of government deposit insurance / guarantee schemes Guaranteed access to regulatory pools of liquidity at all times All we ask is that as the sector responsible for creating credit growth (via credit multiplier) banks behave fairly, reasonably and professionally! 8 Casu, Girardone & Molyneux: Chapter 2.3

9. Credit creation When a bank accepts a deposit it is required to hold a certain amount (eg say 10%) in approved reserves (eg deposits with Central Bank, government securities) The balance can be lent to new borrowers who may deposit into other banks, or purchase goods and services from another economic entity who deposits the proceeds in another bank That bank will then retain the reserve requirement and further lend the funds to borrowers In practice things don’t work this smoothly but this is the theory behind credit creation 9 Casu, Girardone & Molyneux: Chapter 2.3

10. Theory of credit creation Bank$ Deposit taken $ Loan made $ Reserve held A 50.000045.00005.0000 B 45.000040.50004.5000 C 40.500036.45004.0500 D 36.450032.80503.6450 E 32.805029.52453.2805 … ……… Total 500.000450.00050.000 Under a 10% Reserve Ratio for each $1 deposit taken the banking system can create $10 in new deposits Credit Multiplier = Change in Deposits / Change in Reserves = 500 / 50 = 10 10 Casu, Girardone & Molyneux: Chapter 2.3

11. Payment systems A Payment System is any organised system established to arrange for participants to transfer money between themselves Payments take place for many reasons: In exchange for goods and services Creation or repayment of a financial liability/asset Banks historically have played a key role in global payments systems Many points of access for participants – not to be confused with the underlying money transfer mechanism 11 Casu, Girardone & Molyneux: Chapter 2.4

12. Payment systems Large domestic payment systems use Real Time Gross Settlement (RTGS) to transfer money between participants All participants must hold some form of account with a 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 12

13. Payment systems 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 currency payment systems SWIFT is simply a system that arranges domestic payments between participants in the same manner as previously described 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 13

14. Payment systems Banks often hold accounts with other domestic or international 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 14 Casu, Girardone & Molyneux: Chapter 2.4

15. Ways to pay There are many ways of instructing payment: Cheques Online transfers Standing orders Credit cards Debit cards ATMs Smartphones SMS 15 Casu, Girardone & Molyneux: Chapter 2.4

16. Banking products and services Retail and Corporate 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 Capital Market products and services Securitised or asset backed lending Investment products and services Insurance Advisory services Online banking 16 Casu, Girardone & Molyneux: Chapter 2.4

17. 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 17 Casu, Girardone & Molyneux: Chapter 2.4

18. 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 18 Casu, Girardone & Molyneux: Chapter 2.4

19. 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 19 Casu, Girardone & Molyneux: Chapter 2.4

20. Trade finance 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 as they flow around the globe Working capital finance for trading companies Inventory financing 20 Casu, Girardone & Molyneux: Chapter 3.5

21. Financial market products Banks offer a range of financial market products and services including: Foreign exchange and forwards Money market products Bond and share trading and underwriting Merger and acquisition advisory Syndicated loans Derivative risk management products Repo products 21 Casu, Girardone & Molyneux: Chapter 3.5

22. Investment products Banks have increasingly moved into many areas of investment products including: Pension and mutual fund management Trustee and custodial services Private banking and advisory 22

23. Corporate banking products Bank corporate customers range from SME to mid market to large listed multinational companies (MNCs) These customers have a range of banking needs including: Lease and hire purchase financing Invoice and receivable discounting Corporate loans and commercial paper (CP) Pre IPO finance Securities underwriting Project finance 23 Casu, Girardone & Molyneux: Chapter 3.5

24. Securitised lending Discussion of securitisation often focuses on products that help banks to manage there own balance sheets Much (probably most) of the assets that have been securitised since the industry was born in the 1980s have come from third party originators or corporates Banks structure, underwrite and distribute securitisation transactions for their customers 24

25. Traditional versus modern banking Traditionally banks focused on deposit and lending products In the 1980’s governments around the world embarked on a process of banking deregulation and liberalisation This resulted in a strong globalisation trend in the industry where many banks grew their international operations, applying for banking licenses across the globe At the same time many countries floated their currencies, and the derivatives market was born – creating an explosion in new financial market products The growth in new products and networks beyond traditional deposit and lending created what we know as modern banking today 25 Casu, Girardone & Molyneux: Chapter 3.2

26. Traditional banking customers Traditional banking customers broadly fell 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 26

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 Insurance customers Fund management investors Advisory customers (Private Banking, estate planning etc) “Sub-prime” customers Traditional deposit and consumer loan customers Etc.. 27

28. Modern banking customers Wholesale customers now also include: Private Equity funds Pension and Mutual funds Hedge Funds Mortgage and other originators NBFIs Traditional corporate borrowers Corporate risk managers Capital Market issuers Syndicated loan borrowers Etc… 28

29. Banking in context Banks have played a central role in the global financial system and its growth Growth of Capital Markets has seen a trend of “disintermediation” in recent years Banks and NBFIs still play a central role in the operation of Capital Markets, however their intermediation role has reduced in relative importance over the past few decades 29

30. Recall Savers Financial Intermediaries (Banks) Borrowers Savers Financial (Capital) Markets Borrowers..versus Direct Finance Intermediation 30

31. Bonds versus loans While some bankers focus on Capital Markets business, many others compete with Capital Markets for business In 2014 approx USD 4.5 trillion in bond issuance in USD and EUR alone - across Investment Grade, High Yield, Hybrid, Financials, ABS, Government In 2014 approx USD 4.0 trillion in Syndicated Loan issuance => Capital Market volumes likely overwhelm bank intermediation volumes in today’s financial markets 31