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NOTES
Financial Intermediaries
2 typesA
...
Indirect- Financial intermediary borrows funds from lender and then uses these
funds to make loans to borrowers
...
It arises
because:
• not everyone has the same information;
• everyone has less than perfect information, and
• some parties to a transaction have ‘inside’ information which is not made available to both
sides of the transaction
...

• Information asymmetries or the imperfect distribution of information among parties can
generate adverse selection and moral hazard
...
e
...
It is also called Lemon problem
...

Moral hazard- Usually takes place after the transaction where the borrower engages in
immoral activities and increases the chances of default
...


•
•

INTERMEDIARIES
Depository Financial Institution - This Includes all the banks that seeks public
deposits to lend others
...

Non-Depository Financial Institution - Any financial institution other than
Monetary Financial Institution, such as- Insurance companies, unit trusts,
pension funds etc
...

Fees and Commissions
✓
✓
✓
✓

Insurance
Advisory service
Contracts
Investment

✓
✓
✓
✓

Mutual Funds
Finance companies
Insurance companies
FIs providing pension
fund and other
retirement benefits

TYPES OF DFIs1
...

✓ Large number of customers
✓ Bank’s goal- cost efficiency
✓ Low profitability
✓ Standard financial services and products
It includes- Commercial banks, Saving banks, Co-operative Banks, Building societies, Credit
unions and financial house
It raises funds primarily by issuing current accounts, saving accounts and time deposits
which are used to lend in the form of commercial/mortgage or consumer loans
...


2
...
Corporate banks- Provides financial services and products to companies (usually large
companies)
• The companies are usually divided based on their turnover✓ < £1 million
✓ £1- 10 million
✓ > £10 million
The financial services and products increase and grows in complexity as large as the
company gets
...
Investment banks (Merchant banks)- Deal with companies and other large financial
institution to raise funds in the capital market either through issue of stocks or debts
...
Islamic Bank- Based on Islamic law which prohibits payment of interests but promotes
the entrepreneurial ideas
...


FORWARD CONTRACT and FUTURE CONTRACT

SWAPS

Basis

Investment bank

Commercial
banks

Meaning

FI that offers services like
brokerage, underwriting
securities etc

FIs that are into
lending and
borrowing

Services

Customer specific

Standardized

Customer base

Fewer

Very large

Type of customers

Large companies and institutions

All citizens

Source of earning

Commission and
Interest payments
Fee- It is earned in 2 ways:
and fee
Public offering- securities offered
to public
✓ Best efforts- offers
securities to an investor
and the investor pays a
fee to the bank
...


OPTIONS CONTRACT- The investor owns the right to buy or sell at a future date
...
It can be given to banks wherein banks pay premium for them
...
, Girardone, C
...
, (2015)
...


HUMPHREY- PAPER (COMPULSORY) REFER ON KEATS [ADVANCE]

SPAC-A special purpose acquisition company (SPAC) is a "blank check" shell corporation designed
to take companies public without going through the traditional IPO process
...

Production process of banks
Bank efficiency are mainly focused on the relationship between banks' input and output
...
Here, the inputs may
refer to the capital, labour and deposits which are used to produce outputs such as- loans, investing
in other assets etc
...

Production approach- The major difference here is that only 2 inputs are used, No
deposit is considered as input, to produce the same output
...
The data required is difficult to collect,
2
...


SCOPE ECONOMIES- Cost saving by joint production
...
TC(q1,q2) < TC(q1) + TC(q2)
X-Efficiencies- Differences in managerial ability to control costs or maximize revenues/profits
...
Some banks are better at spotting mispricing11 and thus have a higher return on their actively
managed portfolio
...

• DFA (DISTRIBUTION FREE APPROACH)
...

Non Parametric Methods to Estimate Efficiency:
• DEA (DATA ENVELOPMENT ANALYSIS)
...

Market must be measured in two aspects• Concentration- The assets and services owned by the banks in the market
• Competition- The competition can be measure in two wayso Structural
o Nonstructural
In case of Structural: S-C-P and efficiency hypothesis (ad hoc approach) models are
used to measure whether the highly concentrated market induces collusive
behaviour among the larger banks resulting in better performance or whether the
efficiency of larger banks results in superior performance leading to acquiring higher
shares in the market
...
These models
test the use of market power and competition and analyze the bank’s competitive
conduct in the absence of structural measures
...
concentration ratios) and firm performance
...

• Highly concentrated markets usually have low cost of collusion among the
largest banks in the industry (illegal cooperation)
...

Pij = a0 + a1 CRj + ΣakXki + ε
Where:
● Pij= performance measure of bank i market j
...

Plus a variety of variables also deemed important determinants of bank
performance (such as capital /assets ratio, asset size, ownership, LLPs etc
...
The hypothesis claims that if a bank achieves a higher degree of
efficiency than other banks in the market (i
...
its cost structure is comparatively
more effective), its profit maximising behaviour will allow it to gain market share by
reducing price
...

● And all the other variables are defined as before
...

Relative Market Power Hypothesis
It establishes that variability in performance is explained by efficiency as well as by the
residual influence of the market share, because market share captures the influence of
factors unrelated to efficiency, such as market power and/or product differentiation
Herfindhal-Hirschhman Index (HHI)
𝑘

𝐻𝐻𝐼 = ∑ 𝐴2𝑖
𝑖=1

It is the sum of the squared market share for all banks in the specific market area
Post merger HHI cases
• HHI < 1000 → Un-concentrated
• 1000 < HHI < 1800 → Moderately Concentrated (Change in HHI is less than 100)
• HHI > 1800 → Highly Concentrated (Change in HHI is more than 50)
Non structural approaches
Based on the idea that factors other than the market structure and concentration may
affect competitive behaviour, such as entry/exit barriers and the contestability of the
market
...

Panzar & Rosse – H static
H <= 0 → Monopoly or collusive oligopoly
H = 1 → Perfect Competition

0 < H < 1 → Monopolistic competition
Lerner Index
Determines the trend in competitive behavior over time
...
For a
perfectly competitive firm (where P=MC), L=0; such a firm has no market power
...

P= output price
MC= marginal cost

The Boone Indicator
New measure based on the Efficiency hypothesis, measuring the effect of Efficiency
(measured in terms of average costs) and performance (measured in terms of profitability)
...
Hence β should be negative
...

Asset management focuses on maximising return on loans and securities, minimising risk
and having adequate liquidity
...

Liquidity Management refers to the ability of a bank to meet its cash and collateral
obligation without incurring substantial losses
...

A bank’s reserves are an insurance against the costs associated with the deposits outflows
...


The higher the cost associated with deposit outflows, the more excess reserve a bank will
have to hold
...

Banks must take decisions about the amount of capital they hold, mainly for the three
following reasons:
•
•
•

Capital is a caution that helps prevent bank failure
...

The higher is the bank capital, the lower is the return on equity – trade-off between
safety (high capital) and ROE
...


How to manage Capital surplus•
•
•

by buying back some of the bank’s stocks that will reduce the amount of bank
capital
by paying out higher dividends and therefore reduce the bank’s retained earnings
by acquiring new funds (ie increase the EM and keep bank capital constant, they
can Increase the bank’s assets)
...


Off-balance sheet managementOff-Balance Sheet (OBS) items are now ‘big business’ and have grown substantially in both volume
and scope during the past two decades especially for wholesale banks
...


These OBS items generate fee income for banks and create a commitment for the bank,
which may or may not lead to balance sheet entry in the future
...
Loan commitment- Loan commitment is one of the areas of off-balance sheet
activities
...

Many business loans are made up under loan commitments
...
Over the set period the borrower
may decide to use only a part or even none of the loan commitment
...
Therefore, typically, loan commitments
involve large amounts, they generate relative low bank margins and banks are
compensated by the fee charges from making such a commitment, what we call the
fee income
...

Let's see the different types of loan commitment:
Revolving lines of credit: a bank gives a line of credit and commits for several
years ahead
...
The bank however can withdraw their great facility under certain
circumstances
...

• Note issuance facility: the bank arranges and guarantees the availability of funds
from issue of succession of short-term notes commonly, for three to six months
...

• Commission fee: it is the percentage of total commitment and pay upfront by the
borrower
...

• Servicing fee: to use the borrowed amount to cover the banks transaction cost
...

As mentioned, the bank receives fee such as the commitment fee, user's fee, commission
fee, service fee etc
...
35 per cent
...

•

2
...
For example, acceptances, in which the bank guarantees the payment of a
customer’s liability to the holder of the debt, and letters of credit (such
as commercial letter of credit) which is a document issued by a bank stating its
commitment to pay someone a stated amount of money on behalf of a buyer, as
long as the seller meets very specific terms and conditions
...


Therefore, the importer can arrange a letter of credit to be issued by its bank
guaranteed payment
...
Hedging and swaps transaction- Hedge, here, refers to the reduction of risk on
exposure to changes in market prices or rates, through taking an offsetting position
...
The derivative systems that we saw in
previous weeks involved the future contracts, forward contracts and option
contracts
...
Therefore, by using the derivatives contract, it is
possible to construct hedges, so that losses on the underlying assets are matched by
gains on the derivative contract
...

Exchange traded derivative:
It guarantees every contract, meaning that counterparty risk of default is reduced
...
Exchange traded
derivative constantly monitors players through a clearing house
...
Therefore,
terms are specific to that agreement
...

Obviously, there are risks in relation to mispricing, risk related to liquidity, and the default
risk, given that there are no guarantees from an exchange
...
Securities underwriting- Securities underwriting refers to the process by which
investment banks raise investment capital from investors on behalf of corporations
and governments that are issuing securities (both equity and debt capital)
...

•

•

BANK RISKS
Interest rate risk- The risk incurred by financial intermediaries when the maturity of
its assets and liabilities are mismatched
...
It can significantly affect a
bank’s portfolio and it is comprised by the systematic risk and the firm specific risk
...


•

•

•

•

•

•

o Firm specific risk- Firm specific risk is the risk of default of the borrowing firm
associated with the specific types of project risk taken by that firm
...
An off-balance sheet item does not
appear on the current balance sheet because it does not concern holding on asset or
the issuance of liability
...
That
means investing too much on technology where there are no more areas to
explore economies of scale or economies of scope
...

Sovereign or Country risk- The risk that the repayments from foreign borrowers may
be interrupted or limited because of interference from foreign government or for
political reason
...
That can be on a day-to-day withdrawal, which are usually
predictable
...


Others
o Macroeconomics- Inflation, unemployment etc
...


𝒕∗
𝑫=

𝑪𝑭
(𝟏 + 𝒓)𝒕
𝑷𝑽

The percentage change in the market price of an asset or a liability is equal to its duration
times the relative change in interest rates attached to that particular asset or liability:
𝑳

DURATION GAP (DG)= DA − 𝑨 DL
The greater the duration gap of assets (A) and liabilities (L), the greater the effect that a
change of interest rates (r) has on bank's capital Δ(E)
...

According to the Basel Committee, credit risk is defined as ‘the potential that a bank
borrower (or counterparty) will fail to meet its obligations in accordance with agreed terms’
...


Capacity

Capital

Collateral

Condition

•Capacity refers
to cash flow
and the ability
of that cash
flow to service
the debt
...


•Collateral
refers to the
security
backing up the
loan, whereas
the external
factors or
conditions
refer to the
borrower's
sensitivity to
external forces,
such as interest
rates and
business cycles
and
competitive
pressures
...


CREDIT RISK MODELS
1
...
All these factors have an important
role in credit decision
...
Credit scoring models- The other type of credit risk management is related to credit
scoring models
...
There are two categories of
credit scoring models:
o Linear probability and logit models- It uses the accounting information as inputs into a
model explaining repayment experience on old loans
...

𝒁𝒊 = 𝜮𝜷𝒋 𝑿𝒊𝑱 + 𝜺
o Linear discriminant model= Discriminant models, divides the borrowers into different
default classes, and their observed characteristics
...

The higher values of z, the lower the default risk classification for the borrower, with a
benchmark of 1
...

As you can see, in this formula, there are a number of elements, observed
characteristics such as retained earnings, working capital over total assets, savings over
total assets and several other factors
...
4X2 + 3
...
6X4 + 1
...
A loan is approved only if
RAROC is sufficient high relative to a benchmark cost of capital for the bank
...

However, the measurement of the denominator poses some difficulties in
applying the model
...


A capital requirement (also known as regulatory capital or capital adequacy) is the amount
of capital a bank or other financial institution must have as required by its financial
regulator
...

The financial regulations are defined under BASEL ACCORDS
...

This in turn can create a contagion risk
...
The possibility of a systemic crisis, induced by bank runs, bears two objectives for
capital adequacy regulation in banking
...

This will reduce the probability of
systemic crisis
...


Types of
Regulations

Statutory (external)

carried out by the government or
the government agency
...


Self Regulation
(Internal)

It is carried out by the firm itself
...


TYPES OF INTERNATIONAL BANKING REGULATIONS
➢ PRUDENTIAL REGULATION
▪ Prudential regulation is about the safety and soundness of financial institutions
with reference to ‘consumer protection’
...

➢ CONDUCT OF BUSINESS REGULATION
▪ Refers to how FIs conduct business with their customers
▪ Focuses on avoiding – fraudulent activities, bad advice to customers, employees/
FI acting incompetent etc
▪ It ensures disclosure, fair business, competence, integrity and honesty from FI
and its employees
➢ SYSTEMIC REGULATION
▪ It is about the safety and soundness of FIs for purely systemic reasons because
the social cost of failure of a financial institution exceeds the private costs

▪

▪
▪
▪
▪
▪
▪

Regulators have a concern about the liquidity, the solvency and the risk of
financial institutions and they want to monitor with the systemic regulation,
particularly, they want to alleviate problems related with a bankruptcy that may
lead to contagion risk
...

The 1988 Capital Accord – BASEL I
Besides the definition of bank capital - Tier 1 capital (eg equity capital and disclosed
reserves) and Tier 2 capital (deemed of lower quality, eg general loan losses reserves) - the
main emphasis lies on the structure of the risk weights and solvency
...

𝑇𝑖𝑒𝑟 1 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
𝑅𝑖𝑠𝑘 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
Total risk-based capital ratio- The ratio of total capital (tier 1+2) to total riskweighted assets of at least 8%
...

𝑇𝑖𝑒𝑟1 + 𝑇𝑖𝑒𝑟 2
𝑅𝑖𝑠𝑘 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

Calculating risk weightage
The assets are categorised in different risk classes according to the riskiness of each
...


For bilateral OTC derivatives and off-balance sheet commitments, first a credit equivalent
amount is calculated and then a risk weight is applied
...


Flexibility

Risk sensitivity

Includes only credit and
market rates—low
sensitivity

Flexibility, menu of
approaches, incentives for
better risk management
includes only credit, market
rates and capital
requirements for
operational risk---high
sensitivity

Pillars of
BASEL II
Market Discipline
Supervisory Review
Minimum capital
requirements
The new ratio is capital over
credit risk + market risk +
operational risk for a
minimum of 8 per cent
...
One of
the main goals is to
encourage banks to develop
internal assessment
methods
...
In
that way, Basel II can
produce significant benefits
in helping banks and
supervisors to manage risk
and improve stability, and
enable market participants
to make better risk
assessments
...

External rating system is used to identify risk classes, more US firms were rated
before, hence, it is beneficial for those firms rather than Asia or Europe
...

A series of measures are introduced to promote the build up of capital buffers in
good times that can be drawn upon in periods of stress: ‘Reducing procyclicality and
promoting countercyclical buffers’ (Basel Committee on Banking Supervision,
Consultative Document, Strengthening the resilience of the banking sector,
December 2009
A global minimum liquidity standard is introduced for internationally active banks
that includes a 30-day liquidity coverage ratio requirement underpinned by a longerterm structural liquidity ratio called the net stable funding ratio
The need for additional capital, liquidity or other supervisory measures to reduce the
externalities created by systemically important institutions is addressed
...
5 per cent to withstand
future periods of stress, bringing the total common equity requirements to 7 per cent
...
5 per cent, on top of Tier 1 capital, will be met with
common equity, after the application of deductions
...
625 per cent, 1
January 2017 = 1
...
875 per cent, 1 January 2019 = 2
...

The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital
that can be used to absorb losses during periods of financial and economic stress
...

Countercyclical Capital Buffer – 2
...

EARLY WARNING SYSTEM
Early Warning System is model designed to predict the variables that may cause financial
distress
...


CAMELS

Variables

Capital adequacy

Total risk-based capital ratio; Tier 1 ratio; charge offs to loan loss reserves

Asset quality

NPLs/total assets; noncurrent loan ratio; loans secured by commercial real estate/total assets; other loan
assets

Management quality

Non-interest expenses to revenue (net interest income plus non-interest income)

Earnings

Return on assets (ROA), NIM

Liquidity

Core deposits/total assets; volatile liabilities ratio (long term assets/short term liabilities)

Sensitivity to market
risk

Non-interest income/total assets (proxy returns on risky assets)

CAMELS RATING1- Bank is sound in every aspect
2- Fundamentally sound but have minor weaknesses that can be corrected in
normal course of business
3- Bank has a combination of financial, operational, or compliance weaknesses
ranging from moderately severe to unsatisfactory
...

5- means that the bank has an extremely high immediate or nearterm probability of failure

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