Boeksamenvatting: The Economics of Banking.
In this chapter we will discuss the major changes that have taken place in the banking sector. Some key ratios that will be used in this book:
Return on assets (ROA) = gross profit / total assets x 100%
Return on equity (ROE) = gross profit / equity x 100%
Net interest margin (NIM) = net interest income / interest-earnings assets x 100%
Operating expense (OE) ratio = operating expenses / total assets x 100%
Banks had to evolve because of the increased competition from within and outside the banking sector. The banks had to change their structure. There are three trends within the developed countries that made the activity and strategy of the banks change:
The deregulation of financial markets and banks in particular has played a significant role in explaining the development of the financial sector. Deregulation consists of the removal of impositions by government bodies and the removal of self-imposed restrictions. The process of deregulation has come in three faces across developed economies:
Lifting of quantitative controls on bank assets and the ceilings on interest rates on deposits.
The specialization of business between banks and other financial intermediaries slowed down which allowed both parties to compete in each other’s markets.
The increasing competition from new entrants and from incumbents and other financial intermediaries.
Financial innovation is any change in the scale, scope and delivery of financial services. It is not the extension or imitation of a financial product that already exists in another market.
In generally there are three forces that stimulated financial innovation:
Instability of the financial environment; unpredictable inflation, exchange rates and interest rates. This led to an increased demand to seek for instruments to reduce these risks.
Regulation; the regulation of the USA domestic banks led to the development of the Eurodollar market.
The development of technology in the financial sector; the application of computer technology and telecommunication.
Financial instability, regulation and technology put pressure on banks to innovate. Goodhart identified three principal forms of structural change due to financial innovation:
The switch from asset management to liability management. Asset management is that Banks manage their assets regarding duration and type of lending subject to the constraint provided by their holdings of reserve assets. Liability management is the ability to create liabilities by, for example, borrowing in the interbank market.
The development of variable-rate lending. This led to the rapid expansion of bank balance sheets.
The introduction of cash management technology. Cash management was improved by the innovation of new financial products like the credit card and electronic fund transfer (EFT).
The globalization of banking in particular has paralleled the globalization of the financial system and the growth in multinational corporations in general. The internationalization of banking after the wars resulted from the push factors of regulation in home country and the pull factors of following customers.
Canals (1997) divides the process of globalization into three strands:
Creation of branch network in foreign countries.
A merger or outright takeover.
An alliance supported by minority shareholding of each other’s equity.
What also increased the globalization process is the harmonization of regulation; For example the creation of the EU as a single market with a single passport for banking services. Also establishment of the General Agreement on Trade and Services (GATS) stimulated globalization.
The GATS include a removal of capital account restrictions, allowing market access, ensuring equivalent regulatory treatment for foreign banks as domestic banks and move towards a harmonizing regulatory practice with international best practice.
The pace of the globalization was even more increased by the increasing trend to securitization. Securitization is the process by which banks unload their marketable assets onto the securities market. It can also be seen as the process of disintermediation whereby the company sector obtains direct finance from the international capital market with the aid of its investment bank.
Financial innovation and globalization lead to the expanding of a bank’s balance sheets in both domestic and foreign assets. In most cases profits as percentage of assets decline. The increased interest rates accompanied with a rise in inflation increased margins because a significant proportion of deposits paid no interest, whereas all assets except the minimal deposits at the Bank of England earned interested linked to the official bank rate. This is known as the endowment effect.
Endowment effect = net interest margin – net interest spread
Net interest margin = net interest income / interest-earning assets
Net interest spread = rate received in interest-earning assets – rate paid on interest-earning deposits
The endowment effect was reduced during the early 1980s by the innovation of interest-bearing demand deposits. Also competition from within the banking system and from non-banking financial intermediaries (NBFIs) declined.
Banks face competition on both sides of the balance sheet:
Asset side; Competition from specialist consumer credit institutions, NBFIs and the forces of disintermediation.
Liability side; Competition from mutual funds and an array of liquid savings products offered by NBFIs.
The following figure shows the equilibrium for banking services.
Figuur 1. Zie bijlage.
When the demand (D) and the supply (S) intersect we are at the banking service equilibrium. As a response to the competition of NBFIs and the forces disintermediation the demand will fall. The banks have to lower their cost structure, which shifts the supply curve down, to reach an equilibrium with the same quantity. Although the quantity is the same, the price has changed. The price is lower as a result of the decreased cost structure. An individual bank can only restore profitability by reducing its costs.
When a merger takes place unit costs have been reduced as a result of economies of scale through consolidation, branch closures and labour shedding. The merged bank is able to close branches and concentrate branch business on surviving branches.
Usually competition is seen as a good thing. However, competitive pressure has driven banks to consolidate. A consolidation is the merger and acquisition of smaller companies into larger companies. A consolidation, however, differs from a merger in that the consolidated companies could also result in a new entity.
Technologies have lowered the barriers to entry. The treat of entry ensures that incumbent banks will behave in a competitive matter.
Across most of the developed economies there has been a decline in net interest margins, reduction in unit costs, restructuring through downsize and merger, and increase in diversification as banks have moved into traditionally non-banking financial services.
Banks are more and more opening up to sell new products but this does not go without the associated risks. Because of this risk management systems have been developed.
The bank in the future is very likely to be a financial institution like the current universal banks that provide all types of banking and financial service. Unlike the modern universal bank, the future bank may be a contract bank that will supply all financial services but source individual services form other financial institutions.
The twenty-first century bank might include the following features:
Deconstruction: The process of decomposing services into their component parts which can then be priced and provided separately.
Overcapitalization: many banks in the developed economies find themselves with excess capital, meaning too much capital necessary to support the existing or expected level of assets.
Cross-subsidization will be eroded as new entrants pick out the services that are most profitable.
Banks will separate core competencies from delivery.
Banks will gravitate towards delivery of financial services for which the capital market would be a greater source of funds than the traditional deposit (securitization).
A higher proportion of the bank’s income will come from off-balance sheet business.
The structure of the bank will change and will move in the direction of what Llewellyn (1996) calls contract banking. Contract baking means that the bank will have a contract to deliver financial services to its customer. It sources service from other banks, NBFIs and from the capital market.
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