The Economics of Banking by Kent Matthews and John Thompson

Chapter 1: Trends in domestic and international banking

Introduction

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:

• Deregulation
• Financial innovation
• Globalization

Deregulation

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

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).

Globalization

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.

Profitability

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.

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.

The future

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.

Chapter 2: The impact of the capital market

Introduction

We are now going to examine how the presence of the capital market improves the welfare of agents in the economy. The capital market is a market where firms and individuals borrow on a long-term basis. The opposite is a money market where funds are lent and borrowed on a short-term basis. There are two parties involved in the capital market:

• Deficit units who wish to spend more than their current income.

• Surplus units whose current income exceeds their current expenditures

We assume a world in which the individual agent accepts the interest rate, thus is a price taker. The welfare of the agent will be improved when saving and investment decisions are improved.

The role of the capital market

To examine the role of the capital market we use a two-period model. This model has the following assumptions:

• The market is a perfect capital market. This means that the individual can lent/borrow as much as he wishes at the current interest rate, the individual has perfect knowledge and access to the capital market is costless.

• No distortionary taxes.

• The agents maximize their utility.

• Investment opportunities are infinitely invisible.

• Investment is subject to diminishing returns.

The figure on the next page represents the equilibrium without a capital market. On the x-axis we see the consumption and income in period 1 and on the y-axis the consumption and income in period 2.

We first assume that Y1=Y2, but a person’s income in period 2 may be higher because of saving goods in period 1. The physical investment opportunities line (PIL) represents assumption 5 of the model. The individual’s utility function is represented by the line U. The steeper the slope of this curve, the greater is the time preference for consumption in period 1.

Point Z represents the initial endowment point. At this point, the individual’s initial endowments are equal to consumptions in period 1 and 2. The individual can move to point Q by saving Y1-C1 in period 1. A key point to note in this analysis is that we are in an autarky.

If we want to introduce the capital market into this model we have to add the financial investment opportunities line (FIL). Financial investment opportunities are defined for a given level of wealth, which is conditional on the initial endowment for this agent. The individual maximizes consumption in period 1 by saving all income in period 1, Y1=0. The slope of the FIL is – (1+r).

The optimum production plan will occur when the present value of output is maximized. This is at point T, where FIL and PIL intersect. The agent’s utility is maximized at point P, the tangency point of the agent’s best utility curve and the FIL. A saving of Y1-C1 in period 1 will increase consumption in period 2 with C2-Y2. The individual’s consumption possibilities are given by:

C2 = Y2 + (1+r) Y1 and C1 = Y1 + Y2/(1+r)

As a result of the introduction of the capital market the utility has increased. This is because the equilibrium point of the saver, P, lies above the PIL.

Market rate of interest

Through the capital market savers can channel their surplus resources to borrowers with deficit resources. We separate the investment-production decision from the savings-consumption decision to develop the classic loanable funds theory. This theory explains how the rate of interest is determined by the interaction of savers and investors.

The figure on the next page shows the equilibrium rate of interest determined by interaction of savings and investment decisions by agents. The higher the interest rate, the higher is the level of savings. The equilibrium rate of interest is where savings and investment intersect, S(r) = I(r). With S_r > 0 and I_r < 0.

This theory was criticized by Keynes, because the classical economists assumed that investment equals savings at all times. In the loanable funds theory the financial counterpart to savings and investment decision is the flow supply and demand for financial securities.

Savings represent the flow demand for securities, S = ΔB^d

Investment represent the flow supply of securities, I = B^s

Where Δ is the change of the level of stock and B is the stock of bonds as a proxy for all securities. When the rate of interest rises, the price of securities falls and the flow demand for securities increases. The demand and supply equations can be specified:

ΔB^d = f(r)

ΔB^s = g(r)

f ' > 0 ; g’ < 0

When a firm wants to attract funds for investment they will increase the flow supply for securities. This will shift the ΔB^s line to the right, to ΔB^{s 1} . This will lower the price of securities and raise the rate of interest from r0 to r1.

When there is an increased desire for households to save, then ΔB^d increase. This will shift this line to the left. Again a higher interest rate and a lower price are reached.

Chapter 3: Banks and financial intermediation

Now we will examine the role of financial intermediation in general and banks in particular. Financial intermediation is borrowing by deficit units from financial institutions rather than directly from surplus units themselves. The major external source of finance for individuals and firms comes from financial intermediaries. Financial intermediaries can be distinguished by four criteria:

• Their liabilities are specified for a fixed sum that is not related to the performance of their portfolio.

• Deposits are short-term and always much shorter than their assets.

• A high proportion of liabilities are chequeable.

• Neither their assets nor liabilities are in the main transferable.

We often make a distinction between financial intermediaries who accept deposits and make loans directly to borrowers (banks, building societies) and those who lend via the purchase of securities (insurance companies, pension funds). The latter do not fulfill criteria 1 and thus we will focus on the first group, the dominant institutions of which are banks.

Borrowers and lenders

The utility functions of borrowers and lenders differ from each other and therefore they have to be transformed.

• Borrowers require large quantities of funds whereas lenders generally will only have smaller amounts of funds. The bank will collect a number of smaller deposits, bundle them together and lent them out a larger sum. This is called size transformation.

• Lenders have a strong preference for loans with a short horizon. In contrast to the borrower who wants to have security of the funds over the life of the project or investment.

• Lenders prefer assets with low risk whereas borrowers prefer risky operations. Borrowers are willing to pay a higher price than necessary to remunerate lenders where risk is low. This is referred to as risk transformation. Two types of risks are:

  • Default risk: The possibility that the borrower will default an fail to repay either or both the interest due on the loan and the principal itself.

  • Price risk: Variation in the price of the financial claim

The price risk is mainly absent on the asset’s side of the balance sheet. The main risk for banks is the default of their borrowers. A method to reduce their risk is spreading their loans over different segments of the economy. The different segments can be based on geographical location, industry etc. In this way the bank reduces the loss of a failure in a segment. Banks also obtain collateral from their borrowers, which reduces the risk of an individual loan. Another thing a bank can do is hold sufficient capital to meet unexpected losses. Because of all these things a bank can offer relatively riskless deposits while making risky loans.

Transaction costs

There are different cots involved in transferring funds from surplus to deficit units. The main categories of costs are:

• Search costs: These costs involve transactors searching out agents willing to take an opposite position. Like a borrower seeking for lenders.

• Verification costs: Arise from the need of the lender to evaluate the proposal for which the funds are required.

• Monitoring costs: When the loan is made, the lender will like to monitor the progress of the borrower and ensure that the funds are used in accordance with the purpose agreed.

• Enforcement costs: Are incurred by the lender when the borrower violates any of the contract conditions.

When there is no bank then the cost/return structure of the saver and borrower, with R as the rate of interest and T as the costs incurred, is:

The return to the saver (R_S) = R – T_S

The cost to the borrower (R_B) = R + T_B

The spread = R_B – R_s = T_B + T_S

When we introduce a bank this cost/return structure will change because the bank has a transaction cost C. The costs incurred by the borrower and lender will change, due to the introduction of the bank, to T’_B and T’_S.

The return to the saver (R_S) = R – T’_S

The cost to the borrower (R_B) = R + T’_B + C

The spread = R_B – R_s = T’_B + T’_S + C

The introduction of the bank will lower the cost of the financial transaction because the borrower’s and saver’s cost fall by more than the amount of the costs, C, raised by the intermediary (the bank).

(T_B + T_S) - (T’_B + T’_S) > C

The existence of transaction costs changes the FIL.

• For a borrower with T_B, the slope of the FIL will change to – (1 + r + T_B).

• For a saver with T_S, the slope of the FIL will change to – (1 + r - T_S).

There exists a gap between the saving and borrowing rates so that the interest rate charge for borrowing would always be higher than that paid to savers.

Costs are also lowered for borrowers through size and maturity transformation. We consider here the scale of costs and the time at which the individual loans mature. In addition to economies of scale, also scope economies are also likely to be present. Scope economies arise from diversification of the business. With all this research it is fairly to say that the introduction of banks lowers the costs of transferring funds from deficit to surplus units.

Liquidity insurance

When there is no perfect information, consumers are unsure when they will require funds to finance consumption in case of unanticipated events. People need liquidity to offset the shocks that can occur to the economy. The existence of banks enables customers to change their consumption pattern in response to shocks. The value of this service permits a fee to be earned by the financial intermediary.

Diamond and Dybvig used a three-period model. The decisions for period 1 and 2 are made in period 0. There are two periods needed to be productive. The consumer are divided into early (begin period 1) and late consumers (end period 2). In this model the financial intermediary acts as an insurance agent.

Asymmetry of information

In general the borrower has more information about the loan than the lender. So the borrower should know more about the risk of the project. Asymmetric information raises two problems:

• Moral hazard: The risk that the borrower may engage in activities that reduce the profitability of the loan being repaid.

• Adverse selection: The lender may select projects that are wrong in the sense that they offer a lower change of meeting the outcomes specified by the borrower than loans for other more viable projects that are rejected.

Asymmetric information and the consequences moral hazard and adverse selection reduce the efficiency of the transfer of funds from surplus to deficit units. How can the introduction of a bank help us to overcome this problem?

The literature gives us three answers to this question:

1. Information-sharing coalitions.

Banks are subjected to scale economies in their borrowing and lending activities so that they can be considered as information-sharing coalitions. Leyland and Pyle have the most contribution to this argument. The lender must collect information but this is very costly to obtain.

It is also very difficult to determine the quality of information. According to Leyland and Pyle, the price of information will reflect the average quality, so that high-quality information seeking firms will lose money.

They also argue that a way to get information of a project a firm can offer collateral security, and so a coalition of borrowers can do better than an individual borrower.

2. Role of banks in delegated monitoring

Banks operate as delegated monitors for borrowers. Monitoring is referred to as the collection of information about a firm, its investment projects and its behavior before and after the loan application is made. Some examples of monitoring are; examining a firm’s creditworthiness, seeing if the borrower keeps the terms of the contract.

A bank has an advantage in the monitoring process because it has private information concerning the client’s flows of income and expenditures. This is a very important factor. Another fact is that banks are the main operators in the payment mechanism. Lenders have an incentive to delegate the monitoring to a third party.

Diamond considers three types of contracting arrangement between lenders and borrowers:

• No monitoring.

• Direct monitoring by investors.

• Delegated monitoring via an intermediary.

This is a so called ‘all or nothing’ approach, it is very expensive and inefficient.

3. A mechanism for commitment

The banks provide a mechanism for commitment to a long-term relationship. It is impossible to write a contract that specifies all possible outcomes; there is an absence of complete contracts. Mayer (1990) stated that if banks have close relationships with their clients, this may give them an alternative commitment. This relationship may help to overcome the problems of moral hazard and adverse selection.

Operation of the payments mechanism

It is always necessary for the public to keep money balances, i.e. bank deposits, to finance their transactions. This gives banks a great advantage over other financial institutions because they can use these funds held on deposit as a means to purchase interest-earning assets so as to earn profits. The operation of the payments mechanism by banks gives them a great advantage over rivals in the role of financial intermediaries.

Direct borrowing from the capital market

Banks play an important role with respect to direct borrowing by deficit units. This role takes the following forms of guarantee:

• Loan commitments

• Debt guarantees; like the guarantee of bills of exchange on behalf of its customers.

• Security underwriting; banks advice on the issue of new securities and will take up any quantity of the issue not taken up in the market.

For all these activities the bank receives fee income rather than interest receipt. This is called off-balance-sheet business because it does not appear on the balance sheet.

Chapter 4: Banking typology

Introduction

In this chapter we will examine different types of banking operation. The basic operation of all types of bank is the same; they accept deposits and make loans. We change the basic balance sheet to a simple stylized bank balance sheet:

The components of this balance sheet explained:

• Sight deposits are deposits that can be withdrawn without notice.

• Time deposits are deposits made with a bank for a fixed period of time.

• Capital represents a shareholder’s interest in the firm and comprises equity, reserves etc.

• Balances at the Central Bank: the cash required to finance interbank transactions and to meet required ratios.

• Other liquid assets: assets that can be converted into cash quickly and without loss.

• Investments consist of holdings of securities issued by the government and in some cases firms.

We can distinguish between four types of banking operation:

• Retail banking

• Wholesale banking

• Universal baking

• International banking

Main part of the banks provides only retail banking. Most banking firms are universal banks.

General features of banking

When a country has a high percentage of sight deposits this indicates a significant degree of maturity transformation by the banks in their role as financial intermediaries.

Most countries require their central banks to hold a specified balance as proportion of the level of their deposits. This proportion is called the reserve ratio. This ratio varies widely between countries.

Banks face a number of risks in their operations:

• Liquidity risk: Risk that the demand for repayment of deposits exceeds the liquid resourced of the bank.

• Asset risk: Risk that assets held by banks may not be redeemable at their book value.

• Foreign currency risk: Risk that exchange rates may move against the bank causing the net value of its foreign currency assets/liabilities to deteriorate.

• Payments risk: Risk that arises from operation of payments mechanism and the possibility of failure of a bank to be able to make the required settlements.

• Risk of settlement (Herstatt risk): Risk of loss in foreign exchange trading where one party delivers foreign exchange but the other party fails to meet its end of the bargain.

• Off-balance-sheet risk: Risk that business that is fee earning will lead to losses through the failure of the counterparties to carry out their obligations.

Retail banking

Retail banking is providing the services of accepting deposits and making loans to individuals and small businesses; the banks act as financial intermediaries. The transactions made are usually of small value but in large volume so the number of transactions in a year is very large.

Retail banking involves liquidity and asset risk but these risks are overcome by attracting large numbers of customers, both deposits and borrowers. With respect to the asset risk, the large number of borrowers can also act as an protection since it is unlikely that a small number of loan failures will cause the banks great financial distress.

Wholesale banking

Wholesale banking deals with a small number of customers but a large size of each account. This is in contrast to retail banking. For very large loans, groups of banks will operate as a syndicate with one bank being denoted as lead bank. This has two advantages for the bank in the aspect of risk management:

• Risk from exposure to an individual customer is reduced.

• Risk reduction through diversification can be achieved through extending the range of types of customer to whom loans are made.

The balance sheet of wholesale banking differs from the balance sheet of retail banking. Some important differences are:

• Wholesale banking does not operate in the payments mechanism and therefore their holdings of cash and balances at the central bank are lower.

• Off-balance-sheet assets are more important in wholesale banking.

• Greater use of foreign currency business.

• Smaller proportion of sight deposits and a greater volume of trading assets.

• Wholesale banks make greater use of the interbank market to obtain their funds. When they are short of funds they can raise money through borrowing in the interbank market. Surplus funds will be deposited in the interbank market, this is called liability management.

Universal banking

Universal banks are banks that operate the entire range of financial services ranging through the normal banking service of accepting deposits and making loans, insurance, security services, underwriting and owning shares in client companies. Saunders and Walter (1993) distinguished between four different types of universal bank organization:

• A fully integrated bank providing all service within a single firm.

• A partially integrated bank that undertakes commercial and investment banking under the same roof but that provides the other services through specialized subsidiaries.

• A bank whose core business is not only accepting deposits and making loans but also providing a wide range of financial services through subsidiaries.

• A holding company that controls spate subsidiaries set up to provide banking, investment banking and other financial services.

Because universal banks offer a wide range of financial services and therefore they are more able to attract and keep customers. However, greater specialization may also bring rewards. Universal banking provides scope for improved monitoring and control of the non-financial firms. Another advantage is that has the size and ability to obtain economies of scale and scope.

Chapter 6: The theory of the banking firm

Introduction

Banks are different from other commercial and industrial enterprises because the monetary mechanism enables them to attract deposits on onward investment. Therefore we need a specific theory for the banking firm. Banks also differ from ordinary firms in the case of leverage.

The textbook model

Textbooks of economics will usually portray the banking sector as a passive agent in the monetary transmission mechanism. This view comes from the money multiplier approach. The money multiplier is a non-behavioral relationship between changes in the stock of base money and the stock of broad money. We can derive two statements:

H = C + R

M = C + D

In these formulas H is base money, C is currency in circulation with the non-bank public, R is the bank reserves, M is the broad money and D is bank deposits. Then the money multiplier is m = M/H.

We first assume a primitive type of balance sheet with no physical capital and no equity on its liabilities.

If there is a reserve ratio k so that R = kD, then the balance sheet can be represented as;

L = (1 - k) D

If we divide this formula by base money we can derive the credit and deposit multiplier:

Credit multiplier: ΔL = ΔH

Deposit multiplier: ΔD = ΔH

The central bank can control supply of base money by using open-market operations to fund the government budget deficit, which is given by the financing constraint;

G – T = ΔH + ΔB

Where G is government spending, T is tax receipts and ΔB is the sales of government debt.

The supply base of money is not exogenous but usually supplied on demand of the central bank to the banking system. In developing a framework for the analysis of the banking firm, Baltensperger (1980) sets the objective of the bank as a profit function (π):

π = r_L L – r_D D – l – s – c

• r_L is the rate of interest charged on loans

• r_D is the interest paid on deposits

• l is the cost of illiquidity

• s is the cost due to the default

• c is the real resource cost

The perfectly competitive bank

We begin by adding T and r_T to the balance sheet to make it more realistic. T stands for government treasury bills and r_T is the rate of interest. In the competitive model of the banking firm, the individual bank is a price taker, so r_L and r_D are constant.

The bank’s objective is to maximize profit:  Max π = r_L L + r_T T – r_D D – l – s - c with L + T = (1-k) D

The equilibrium conditions are:

r_L = r_T + C’

r_D = r_T (1-k) – C’_D

Rearranging these formulas gives us the margin of intermediation:

r_L – r_D = C’_D + C’_L + kr_T

This result shows that the margin of intermediation is given by the product of the reserve ratio and the risk-free rate and the sum of the marginal costs of loan and deposit production by the bank.

The monopoly bank

A perfectly competitive model is an extreme model; another extreme is the monopoly model. The existence of monopolistic features is something characteristic of financial intermediaries. The information role of banks gives them some monopolistic discretion in the pricing of loans according to risk characteristics.

The balance sheet is given by: L + T + R = D

The monopoly bank represents the banking industry as a whole and will face downward-sloping demand for loans with respect to the loan rate and an upward-sloping demand for deposits with respect to the deposit rate, so

L^d = L(r_L)

D^d = L(r_D)

With the conditions L_r < 0 and D_r > 0

Some additional assumptions of this model:

• The bank faces a scale and allocation decision, and scale is identified by the volume of deposits.

• The market for bills is perfectly competitive and the bank is a price taker.

• The loan and deposit markets are perfectly competitive.

• Loans are imperfect substitutes for bills.

• Reserves earn no interest.

• The bank maximizes profits.

• The bank faces a fixed cost schedule.

The interest-setting equations by the monopoly bank are as follows: r_L = and r_D =

The figure on the next page shows the equilibrium of loans. It shows that the monopoly bank extends loans until the marginal revenue on loans, described by MR_L curve, equals the opportunity cost, the rate of interest on bills. Thus the monopoly bank produces L* loans.

The next figure shows the equilibrium for deposits. The bank sells deposits until the point where the marginal cost of deposits equals the marginal return from its investment. So the bank supplies D* deposits.

From these two figures we can conclude that when the bill rate rises, then the loan rate and the deposit rate will also rise. And a rise in the loan rate reduces the equilibrium quantity of loans and increases the equilibrium quantity of deposits. The bank substitutes loans for bills at the margin.

However this model also does have a number of weaknesses:

• Profit is earned exclusively from monopoly power.

• There is no analysis of the costs of supplying loans and deposits.

• The volumes of loans and deposits are determined independently of each other.

• The assumption of price maker in the loan and deposit market and price taker in the bill market is questionable.

The imperfect competition model

We will now look at Cournot competition. To enable aggregation, assume that there are n banks, all facing the same linear cost function of the type: C_i(D,L) = γ_D D_i + γ_L L_i

Each bank maximizes its profits taken the volume of deposits and loans of other banks as given. There is a unique equilibrium where each bank sets its deposits as D* = D/n and loans as L* = L/n. This leads to the equation: (r_T (1-k) - γ_D – r_D) / r_D = 1 / n e_D and (r_L – (r_T - γ_L)) / r_L = 1 / n e_L

An important thing to note about these expressions is that the response of the loan rate and the deposit rate to change in the bill rate will depend on the intensity of competition given by the number of banks.

The imperfections associated with banking are:

• Incomplete or imperfect information.

• Uncertainty.

• Transaction costs.

Chapter 7: Models of banking behavior

Introduction

In this chapter alternative approaches to the banking firm will be discussed. An attempt is made to incorporate uncertainty of yields on assets by appealing portfolio theory, developed as the Tobin-Markowitz model. It will show that the assumption of risk aversion produces a risk premium in the margin of intermediation and explains the role of diversification in the asset management of banks.

Asset and liability management

The core activity of a bank is all about taking in deposits and transforming them into loans; it is all about asset and liability management. The two fundamental risks a bank faces on its balance sheet are default risk and withdrawal risk. The purpose of holding cash reserves is to minimize withdrawal risk and for the bank not to face cash reserve deficiency.

Liquidity management

Liquidity management involves managing reserves to meet predictable outflows of deposits. The bank maintains some reserves and it can expect some loan repayment. The bank can also borrow funds from the interbank market. Asset management can be considered as a two-stage, decision-making process. First the bank decides the quantity of reserves to hold and then it decides how to allocate its earnings assets between low-risk, low-return bills and high-risk, high-return loans. The balance sheet equals:

L + R = D

The bank faces a continuous outflow of deposits over a specific period of time before new deposits or inflows replenish them at the beginning of the new period. If the withdrawal outflows are less than the stock reserves, the bank does not face a liquidity crisis.

A bank will choose the level of liquidity reserves such that the probability of a reserve deficiency is equal to the ratio of the rate of interest on earning assets (r) to the cost of meeting a reserve deficiency (p). The bank chooses a level of reserves such that the marginal benefits (not having to incur liquidation costs) equal marginal costs (interest income foregone).

The model states that when there are no reserve ratios, a bank will decide on the optimal level of reserves on the basis of the interest on earnings assets, the cost of meeting a reserve deficiency and the probability distribution of deposit withdrawals.

The major effect of imposing a reserve ratio is to reduce the critical value of the deposit withdrawals beyond which a deficiency occurs. An adjustment to the optimal level of reserves R* will only be profitable if the resulting gain more than offsets the costs of the adjustment itself, C.

C = v abs(R – R₀)

v stands for the marginal costs, R₀ the reserves before the adjustment and R the reserves after the adjustment.

Loan pricing

The rate of interest on loans depends on a variety of individual borrower characteristics. One common characteristic is an allowance for risk of default combined with the degree of risk aversion by the bank. Under what conditions would banks sell risky deposits in order to by risky loans? In other words under what conditions does intermediation take place?

Consider a bank that faces a choice of three assets; one riskless asset and two assets with uncertain yield. We can see deposits as a negative asset. The profit function of the bank is given by the equation:

π = r_LL + r_TT – r_D D

For intermediation to exist the following conditions must hold:

E(r_L) – r_T > 0  a positive risk premium on loans

E(r_D) – r_T < 0  a negative risk premium on deposits

These two conditions combined give us the condition that there must be a positive spread:

E(r_L) - E(r_D) > 0

When the yield on loans and the interest on deposits is zero, then the spread is given by:

E(r_L) - E(r_D) = β(σ²_rL L + σ²_rD D)

β is the coefficient of risk aversion.

Chapter 8: Credit rationing

Introduction

We now will focus on the role of securitization in banking and especially on the economics of the process rather than the precise administrative detail. First we have to distinguish between securitization and asset-backed securitization (ABS). Securitization is the process of matching up of borrowers and savers wholly or partly by way of financial markets. It includes:

• Issuing of financial securities by firms as opposed to raising loans from banks.

• Deposits with non-bank financial intermediaries who themselves hold financial securities.

• Asset-backed securities (sales of financial securities) which are themselves backed by other financial assets.

The process of ABS is discussed later in this chapter.

It is useful to consider intermediation as a bundle of separate services, namely:

• Loan origination: Location of creditworthy borrower.

• Loan funding: Funds secured through designing securities that are attractive to savers, in the case of bank deposits.

• Loan serving: Administering and enforcing loan conditions.

• Loan warehousing: Holding the loan in the lender’s portfolio of assets.

These services can also be unbundled into their separate components.

To understand the study of securitization it is useful to set up a simple model of bank lending describing the cost of holding loans (CHL) on the bank’s balance sheet and the cost to the borrower of the loan.

CHL = er_E + (r_D + g) + C_L + ρ

With:

• e is the cpaital-to-asset ratio

• k is the required reserve ratio

• r_E is the required rate of return on equity

• C_L is the marginal administrative and servicing costs

• p is the expected rate of loan default

• r_D is the deposit rate

• g is the regulatory costs including deposit insurance.

The price, the loan rate r_L, will equal the marginal cost of attracting funds, so:

r_L = er_E + (r_D + g) + C_L + ρ

Thus the spread between the loan rate and the deposit rate is given by:

S_L = er_E + (r_D + g) + C_L + ρ - r_D

Sales of securities through financial markets

One of the main reasons for securitization is that many large borrowers have had a higher credit rating than the lending banks themselves and can therefore raise finance by tapping financial markets at a lower cost than by borrowing from banks. Secondly, regulatory costs have arisen.

Securitization through financial markets can be considered in three categories:

1. Direct replacement

Direct replacement requires that bank loans are replaced with the sale of securities such as bonds or equity on the financial markets.

2. Underwritten replacement

Most issues of long term security, such as bonds and new issues of equity, are underwritten. This involves a financial institution agreeing to buy up any of the securities that are not taken up by the market. Both parties of the agreement benefit. The issuer is guaranteed that the whole issue is taken up and this increases the volume of funds because of the increase in certainty. This benefit can be seen as a fee to the financial institution.

Alternatives to bank loans exist. The commercial paper has partially replaced bank loans at the shore end of the market and NIFs have tended to replace bank lending. Nevertheless, banks have involved in view if underwriting of issuing securities so that securitization has only partially been replaced toe role of banks in financial intermediation.

The cost of raising funds in the capital market is given by the equation:

r_F = r_I + u

Where r_F is the cost of funds raised, r_I is the return to the investor and u is the issue costs including any credit rating fees expressed as a fee.

When the following condition holds, then firms will be indifferent to raising funds through the capital market and deposits;

r_F = r_L or r_I + u = r_D + S_L

3. Deposit replacement

Two characteristics of deposits are their nominal value certainty and a high degree of liquidity. Certificates of deposits (CDs) are a type of deposits although they do not really fulfill the characteristics of deposits. Savers tend to hold claims on banks in the form of deposits.

A characteristic of the non-banking firms is that they accept funds and then use these funds to purchase real and financial securities. In this way the public is indirectly holding securities, thus bypassing the intermediation role of the banks.

Asset-backed securitization (ABS)

Asset-backed securitization (ABS) is a process whereby liquid assets are pooled together and sold off to investors as a composite financial security that includes the future cash proceeds. You get a present payment in return for future streams of income. The purchaser of the composite financial security finances the purchase through the issue of other financial securities which are termed as asset –backed securities.

The process of ABS

The source bank groups together the ABS securities combination that is acceptable for the ultimate buyers. For this transaction a special entity is set up. This is called a special-purpose vehicle (SPV), a special-purpose entity (SPE) or in case of a company, a special-purpose company (SPC). The entity is completely separate from the bank and if the originator becomes bankrupt then no claims can be made against the SPV.

The securities receive credit in the form of a guarantee from the bank. In this way the securities can be rated by a credit agency and then sold on to the market. This part of the process is essential.

The gains from ABS

Banks gain from ABS.

• Firstly, a gain is that issuing ABS is equivalent to raising additional funds. The decision to engage in ABS will depend on the costs for the bank. The condition necessary for this is:

C_P + C_H + C_R < min(r_D, r_B)

Where C_p are cash proceeds from ABS, C_H are credit enhancement costs, C_R are credit rating agency fees.

• Secondly, they remove asset from their balance sheet, thus easing pressure from capital regulations.

• Third, ABSs generally contain high-grade loans that are subject to the same capital requirements as lower-grade loans that provide higher yields.

• Fourthly, securitization provides a means for a bank to manage its risk.

• Finally, securitization has changed the nature of bank lending.

Chapter 9: Banking efficiency and the structure of banking

Introduction

We will now take a look at the structure of banking and especially at the potential for economies of scale and scope together with related issue as to whether mergers have raised the level of the efficiency in banks.

Measurement of output

One problem that arises when we want to measure the performance of banking is that there is no clear measure of output for banks. Therefore it is also difficult to allow for quality improvements. The costs are clearly an input as far as the bank is concerned but the services produced can equally be regarded as an output by the customer.

Bank output can be measured in a number of ways:

• Number of accounts

• Number of transactions

• Average value of accounts

• Assets per employee

• Average employees per branch

• Assets per branch

• Total value of deposits and/or loans

• Value of income including interest and non-interest income

There are not only different ways to measure output but there are also two different approaches:

• Intermediation approach: Views banks as an intermediary so that its output is measured by the value of loans and investments together with the off-balance sheet income. Its input costs are measured by the payments made to factors of production, including interest payments.

• Production approach: Views banks as firms that use factors of production and produce different categories of loans and deposit accounts. The number of transactions is accounted as a flow.

Performance measures

We introduce some specific performance measures:

• Average earnings on assets (EOA) = (interest income + non-interest income – provisions) / total assets

• Cost-income ratio = operating expenses / operating income

Performance measures are frequently used to compare banks with each other. They are valid for the comparison of similar banks but they are not valid for international comparison. An alternative to using performance measures is to apply the neoclassical production theory of the firm to the bank. This theory shows how cost efficiency can be obtained. Efficiency is separated into technical efficiency (TE) and allocative efficiency (AE). The following formula, with CE is the cost efficiency, is used to calculate the AE:

AE = CE / TE

The method of data envelopment analysis (DEA) is a popular technology that has been used or measuring bank efficiency. This is a non-parametric approach that constructs an envelope of outputs with respect to inputs using a linear programming method. An advantage of this model is that it does not need a functional form for the production function.

Using the DEA analysis, then the efficiency for the jth firm can be defined as:

(U₁Y_1,j + U₂Y_2,j + L) / (V₁Y_1,j + V₂Y_2,j + L)

Where:

• U₁ is the weight given to output 1

• Y_1,j is the amount of output 1 from decision making unit DMU j

• V₁ is the weight given to input 1

• X_1,j is the amount of input 1 to DMU j

The DEA approach is a non-paramedic approach, but one can also use a parametric approach. Parametric approaches seem to overcome the problem of the error. For this approach hold the same critics as for the production function approach.

We will now discuss three separate types of non-parametric approaches:

1. Stochastic frontier analysis (SFA)

This approach specifies a function for cost, profit or production to determine the frontier. It treats the random error with symmetric distribution and it treats inefficiency with an asymmetric distribution.

2. Distribution-free approach (DFA)

A functional form that assumes that random errors are zero on average and the efficiency is stable over time.

Inefficiency = average residual of the individual – average residual for the firm on the frontier.

3. Thick-frontier approach (TFA)

This is a functional form that determines the frontier on performance of the best firms. All the firms are ranked according to their performances. This method provides efficiency rates for the industry as a whole rather than for individual firms.

In the parametric approach, the following cost formula is used to measure cost inefficiency:

Ln C_i = f(w_i, q_i, z_i, y) + ln u_i + ln ε_i

Where w stands for input prices, q for output, z for bank control variables, u for inefficiency and ε is a random error term.

Cost inefficiency = 1 – (u^min / u^b)

B stands for the bank for which the inefficiency is calculated. And u^min is the minimum of all the banks.

The elasticity of cost with respect to output indicates the existence of economies of scale. The following must hold for this:

• ϐ ln C / ϐ ln q_m > 1  when there are diseconomies of scale

• ϐ ln C / ϐ ln q_m < 1  when there are increasing returns to scale

• ϐ ln C / ϐ ln q_m = 1  when there are constant returns to scale

Reasons for the growth of mergers and acquisitions

In the last few years there has been a growth in mergers and acquisitions while the number of institutions declined. There are several reasons for this growth in M&A:

• Increased technical progress

• Improvements in financial conditions

• Excess capacity

• International consolidation of financial markets

• Deregulation

Motives for mergers

A merger is often described as the activity of a well-managed firm that takes over poorly managed firms and transforms the performance of these firms. There is enough evidence to prove that this is true.

The book mentions three motives for mergers:

• Technical efficiency makes the bank’s production of products the best. Because of this technical economies occur.

• The second motive comes from the separation of ownership and management of firms. In this way managers may engage is operations that do not maximize shareholder’s wealth.

• This motive arises from arrogance of managers who think that they can identify bargains, believing that the market got the valuation wrong.

Empirical evidence

The study of evaluation of mergers and acquisitions is based on five different studies which can be placed into two categories:

1. Static studies; studies that do not consider the behavior of the merger firms before and after the merger. Some static studies are”:

• Studies based on production functions

• Studies based on cost functions.

• Studies based on the efficient frontier approach.

2. Dynamic studies; studies that consider the behavior of the firms before and after the merger. Some dynamic studies are:

• Studies based on the use of accounting data.

• Studies based on event studies.

We will discuss some of these theories more briefly. But first we take a look at the price of acquisitions. The acquirer has the choice whether to do the action or not. In this case, the act of purchase can be seen as a call option. This if a real option when there is no underlying that can be traded, as opposed to a financial option where there is a tradable underlying asset. To value the call option several data is needed:

• Share price: Aggregate market value of target and acquirer prior to announcement.

• Exercise price: Hypothetical future market value of separate entities forecast by their beta value.

• Standard deviation: Annualized stander deviation of weekly returns after the merger.

• Dividend yield: Average dividend yield in the year after the merger.

• Risk-free rate

• Time to maturity

Then compare the calculated the real-option premium with the actual takeover premium defined as the gap between the share price and the price actually paid.

The production function approach

The production function that is most used is the function of Cobb-Douglas:

Y_t = A_tK_t^αL_t^β

Where Y is output, K is capital and L is labor. The parameters α and β are the fractions of labor and capital used in the production process, added up 1. When transforming this function in an logarithmic function you get a linear function. With this function values before and after a merger can be compared. With such a comparison usually dummy variables are introduced. Haynes and Thompson (1999) combined these dummy variables with the production function approach and got the following formula:

Ln Q = α + β₁ ln L + β₂ ln K1 + β₃ ln K2 + β₄ Time + ∑ β_j Merger

Where K represents the division between fixed and liquid assets at constant prices and Q is the book value of commercial assets also at constant prices. Merger refers to years 1 to 5 after the merger.

However, there is a problem with this approach. The estimate of the productivity gains depends critically on the specification of the production function.

The cost function approach

This approach estimates a cost function for the banks and examines how this function behaves over time. The most used cost function is the translog cost function:

Ln (TC) = α + β₁ ln Q + β2 0.5 (ln Q)² + β3 ln L + β4 0.5 (ln L)² + β5 ln K + β6 0.5 (ln K)² +

β7 ln L ln K

The curve of this function is U-shaped. This approach investigates whether there is economies of scale. Old research suggest that only small banks will gain economies of scale while more recent research suggests a greater potential for scale economies.

The accounting approach

This approach uses financial ratios for the evaluation of mergers. Some examples of the ratios used are ROA, ROE or overhead costs to total asset cash flows. There are many economists that used this approach in their studies. Some economists are Cornett and Tehranian (1992), Rhoades (1993) and Vander Vennet (1966).

The efficient frontier approach

The amount of studies that use this approach has grown significantly over recent years. The efficiency of a merger can be measure by assessing the changes in relative performance after the merger as compared with the pre-merger. One way to do this is to perform a sensitivity analysis.

Chapter 10: Banking competition

Introduction

We will discuss in this chapter the competitive structure of the banking market and relate it to the profit performance of banks. The structure-conduct-performance model will be introduced. In this model market structure is defined as the interaction of demand and supply factors. And conduct is influenced by factors such as the number of competing firms and customers and barriers to entry. The combination of these factors influences the performance of the firm.

Concentration in banking markets

The structure-conduct-performance (SCP) hypothesis is that fewer and larger firms (high concentration) are more likely to engage in anticompetitive behavior. Concentration is usually measured by the Herfindahl-Hirschman Index (HHI), which is the sum of the squared market shares of the banks in the market. The upper bound of this index is 10.000 which indicates a monopoly. The lower bound is zero in the case of an infinite number of banks (perfect competition). A general rule is that mergers that increase the HHI by more than 100 points in concentrated markets raise antitrust concerns.

Another rule for the measure of concentration is the n-bank concentration ratio (CR), which stands for the percentage of the market controlled by the top n banks in the market. The three-bank and the five-bank ratios are most common used in studies.

Although there are theories arguing that there is a link between concentration and market power, there are also studies that argue the contrary.

Structure-conduct-performance

This theory predicts that the degree of monopoly and scale of the banking industry will influence its performance. This model can be summarized as:

Structure  Conduct   Performance

The SCP hypothesis says that increased concentration along with barriers to entry will lower the cost of collusion between banks. This would result in above-normal profits for all the banks in the market. The profit of a bank is specified as:

Π_i = α₀ + α₁ CR_n + ∑ α_j Z_i,j + ε_i

The variable Z stands for a number of control variables for the bank.

The SCP hypothesis can be extended by the statement that individual banks may have informational advantages relating to their clients that give them localized market power independently of what could be obtained from collusion. This is known as the relative market power hypothesis (RMPH), or also called the EHS model, and was developed by Demsetz (1973). The new profit function for the bank will be:

Π_i = α₀ + α₁ CR_n + α₂ s_i + ∑ α_j Z_i,j + ε_i

The new element in this formula is α₂ s_i, which stands for the market share of each bank as an independent control variable.

It can be argued that market concentration is not an impediment to competition. In this way banking represents a contestable market. This is a market in which an entrant has access to all production techniques available to the incumbents, is not prohibited from wooing the incumbent’s customers and entry decisions can be reversed without costs.

Competition analysis

The SCP and EHS approaches have some shortcoming which have been addressed by the new empirical industrial organization (NEIO). The NEIO assesses the strength of market power by examining deviations between observed and marginal cost pricing, without using any market structure indicator.

The most popular method used for this is the Rosse-Panzar method. This method proposes the estimation of a bank’s specific revenue function in terms of the bank factor prices. In this method they use the H-statistic to reveal the effect of a rise in factor prices on revenue. The H-statistic is calculated as the sum of the elasticities of revenue with respect to factor prices.

H = ∑ (ϐR* w / ϐw R*)

• . H=1  perfect competition. Below you can see H in perfect competition. We see that an increase in unit costs, thus a vertical shift of AC, will increase the price.

• When H ˂ 0  monopoly equilibrium. Below you can see H in monopoly case. The equilibrium is where MR=MC, with p0, c0 and q0. An increase in all input prices pushes the A (AC) curve up and the MC curve to the left. Because the price elasticity of demand is greater than unity, total revenue declines and hence H<0.

• 0 < H < 1  monopolistic free entry. On the next page you can see the graph of monopolistic free entry. Competition takes place until the zero profit condition is satisfied and price equals average cost for each bank.

Many empirical studies using the Rosse-Panzar approach have been used to study the banking markets of various countries. Banking markets exhibit monopolistic competition. Research has shown that competition is tougher in the large bank market segment than in smaller, perhaps more specialized, banks.

There is some evidence of Cournot pricing behavior in the UK banking market. But the evidence is also inconsistent with strategic competition and bundled pricing. The most recent study of the UK banking market suggests that banking in the new century is as competitive as in the 1990s and 1980s in the business of intermediation. There is evidence of a worsening competitiveness in off-balance-sheet and fee-income-generating product markets.

Chapter 12: Bank regulation

Introduction

In recent years bank failures around the world have been common. It is natural to think that bank failure is something that happens in emerging economies with unsophisticated banking systems. But practice has shown some enormous bank failures in developed economies. The scale and frequency of these failures have raised doubts about the efficiency of bank regulation. We will discuss three issues; arguments for regulation, existing state of regulation and the regulatory system from the perspective of the free banking school.

The case for regulation

The strongest need for regulation is when physical danger is involved. Like fire alarms and road safety regulations. Financial regulations fall not into this category. Financial regulations would create social marginal costs that are greater than private marginal costs. These social marginal costs occur because bank failure has a far greater effect throughout the economy than failure of a manufacturing concern because of the widespread use of banks to make payments and as a store for savings.

One thing we should keep in mind is that regulation involves real resource costs, which arise from two sources:

• Direct regulatory costs. Can be derived from the Financial Services Authority (FSA) projected budget.

• Compliance costs borne by the firms regulated. Can be derived from a survey carried out by the Financial Services Practitioners panel.

The main reasons for why we need regulation are:

• Consumers lack market power and prone to exploitation from the monopolistic behavior banks.

• Depositors are uninformed and unable to monitor banks and therefore require protection.

• We need regulation to ensure the safety and stability of the banking system.

These arguments form the main reason for why we need regulation with reason 1 and 2 linked to each other. There is support for regulation and this support is based on three propositions:

• Uninsured depositors are unable to monitor banks.

• Even if depositors have the sophistication to monitor banks, the additional interest rates banks would pay on deposits to reflect risk would not deter bank behavior.

• Uninsured depositors are likely to run rather than monitor.

Research has shown that a deposit insurance scheme reduces the danger of banks runs and the consequences of these runs. This is not only supported by theory but also by history. The most common theory used for this is the analysis of Diamond and Dybvig (1983). This model consists of a large number of identical agents who live for three periods. Each agent has 1 unit of a good. Some agents are forced to consume in period one because of an unpredictable liquidity demand and they receive 1 unit of goods. These agents are called type-1 agents.

The rest of the agents consumes in period 2 and they receive R units of goods. These are called type-2 agents. They can make an insurance contract so that each agent can choose whether to withdraw their funds in period 1 or to hold the funds until period 2. When both types of agents withdraw their funds in period 1 then we are dealing with a bank run.

Bank owners have the incentive to take on much more risk than would be prudential since there is a change of a substantial gain in the owners net worth against the chance of zero loss. However, there are also economists that argue that bank owners are risk averse and would value their employment.

Regulation

The economists have different view on whether there must be regulation or not. Although these views differ regulation is necessary to mimic the control and monitoring that would exist if depositors were coordinated and well informed. Until 1979 there were no banking laws in the UK but in that year the Banking Act was set up.

Central banks and other regulatory agencies have typically used two measures of capital adequacy:

• The gearing ratio: It is the ratio of bank deposits plus external liabilities to bank capital and reserves.

• The risk capital-asset ratio: This ratio sets out a common minimum risk capital-asset ratio for international banks.

The Accord of 1988, while it was seen as a good attempt to provide transparent and common minimum regulatory standards in international banking, was criticized on a number of counts:

• Differences in taxes and accounting rules meant that measurement of capital varied widely across countries.

• The Accord concentrated on credit risk alone. Other types of risk, such as interest rate risk, liquidity risk, currency risk and operating risk, were ignored.

• There was no reward for banks that reduced portfolio risk because there was no acknowledgment of risk diversification in the calculations of capital requirements.

• The Accord did not recognize that, although different banks have different financial operations, they are all expected to conform to the same risk capital-asset ratio.

• It did not take into account the market value of bank assets, except in the case of foreign exchange and interest rate contracts. It created a problem of accounting lags because the information required to calculate the capital adequacy lagged behind the market values of assets.

The Federal De[posit Insurance Corporation Act 1991 introduced a scale of premia for deposit insurance according to capitalization. A well-capitalized bank is a bank that has a total risk capital-asset ratio greater than or equal to 10% with a tier-1 capital-asset ratio greater than or equal to 6%.

Because of financial innovation there were consistent changes in the Accord. In 1996 the Accord required banks to allocate capital to cover risk of losses from movements in market prices. The Basel Committee developed a new and revised set of proposals on capital standards for international banks. The new proposal was called Basel II.

The major innovation in comparison to Basel I is that now it allows banks to use internal risk assessments as inputs to capital calculations. Basel II consists of three pillars:

1. Minimum capital requirements > 8%.

• These requirements are used to cover credit risk. There are three approaches specified for credit risk:

  • Standardized approach. It assesses weights of specific assets with the addition of the risk weights being ordered according to external rating agencies.

  • Internal-rating-based approach. Some banks have permissions to use their own internal ratings.

  • Securitization approach.

• Operational risk: The risk of loss resulting from inadequate or failed internal process, people, systems or external events. There are three methods for calculating operational risk capital charges:

  • The base indicator approach. Calculates a percentage of a 3 year average of gross income.

  • The standardized approach. Divides bank activities into eight business lines and the capital charge is the 3 year average of gross income applied to specific percentages for each line of business.

  • The advanced measurement system. The risk measure obtained from the banks’ own internal risk measurement system.

• Trading book risk

2. Supervisory review process. This pillar gives regulatory discretion to national regulatory authorities to fine-tune regulatory capital levels.

     3.  Market discipline. This pillar compels the bank to make greater disclosure to financial markets to make market discipline and making risk management practices more                   transparent.

The case against regulation

Economists who are against regulation posed the question whether free banking would be worse than regulation banking when we see from practice that central bank supervision produces problems in banking. Central bank financing has led to devaluation of the currency trough inflation, something we can see from history.

Free banking is referred to as a situation in which banks are allowed to operate freely without external regulation and even to issue bank notes, subject to the normal restrictions of company law.

Even though there are economists against regulation, there is still high pressure for it. This pressure comes from the existence of deposit insurance. According to Benston and Kaufman (1996) the types of regulations that should be used, when deposit insurance is a political thing and is evil, are:

• Prohibition of activities that are considered excessively risky.

• Monitoring and controlling the risky activities of banks.

• Requiring banks to hold sufficient capital to absorb potential losses.

Number 1 and 2 are not operational in practice but number 3 is. Number 3 is the basis of Basel I and II.

Some economists have the view that the current regulation system should be revised and changed to allow market discipline to counteract moral hazard problems created by the deposit insurance. A suggestion for this is to use subordinated debt in bank and capital regulation.

An alternative proposal about deposit insurance is the narrow banking scheme put forward by Tobin (1985). This was strongly supported by some other economists. This proposal of Tobin was that deposit insurance and lender-of-last-resort facilities should be restricted to banks involved in the payments mechanism.

At the end there is still the choice between regulated banking and free banking. This choice can be made easier because of a cost-benefit type of calculation. We expect that individual bank reserves and capital ratios will be higher under free banking and the interest rate spreads will also be higher.

Chapter 13: Risk management

Introduction

The business of banks involves risk. The make profit by taking risk and managing risk. The focus of risk management lies on the making of loans and taking in deposits. The figure below describes a taxonomy of the potential risks the bank faces

Risk typology

There are three ways for a bank to minimize its credit risk:

• Price of loan has to reflect the riskiness.

• Some credit limit must be placed because the interest rate cannot bear all the risk.

• There are collateral and administrative conditions associated with the loan/.

Some definitions of different types of risk a bank can face:

• Liquidity risk: The possibility that a bank will be unable to meet its liquid because of unexpected withdrawals of deposits.

• Operational risk: Possibility of loss resulting from errors in structuring payments or settling transactions.

• Legal risk: Possibility of loss when a contract cannot be enforced because the customer had no authority to enter into the contract or the contract terms are unenforceable in a bankruptcy case.

• Market risk: Possibility of loss over a given period of time related to uncertain movements in market risk factors.

• Yield curve level risk: An equal change in rates across all maturities.

• Yield curve shape risk: Changes in the relative rates for instruments of different maturities.

Interest rate risk management

A bank will use gap analysis to evaluate the exposure of the banking book to interest changes. The gap is the difference between interest-rate-sensitive assets and liabilities over a given time interval:

Negative gap = Interest-sensitive liabilities > Interest-sensitive assets

Positive gap = Interest-sensitive liabilities < Interest-sensitive assets

Mismatches in the balance sheet are measure by this gap. The bank deals with interest rate risk by using various hedging operations. Some examples are:

• Duration-matching of assets and liabilities.

• Interest rate futures, options and forward rate agreements

• Interest rate swaps

Banks have long-term assets and short-term liabilities, a rise in the rate of interest will reduce the market value of their assets (PV_A) more than the market value of their liabilities (PV_L). The change in value of a portfolio is given by the initial value multiplied by the negative of its duration and the rate of change in the relevant rate of interest.

Solvent banks always have positive equity value so that PV_A > PV_L. The duration gap (DG) is defined by the following formula:

DG = D_A – (PV_L / PV_A) D_L

Where D stands for the duration of the asset and liability portfolio.

If we link the DG to the gap change in the value of the bank be obtain the next formula:

dV = -DG (dr / (1+r)) PV_A)

A future is a transaction where the price is agreed now but delivery takes place at a later date.

Basis = Cash price – future price

If a bank faces falling interest rates then it should purchase futures. The bank can use these futures to hedge individual transactions. If the bank faces rising interest rates then it should sell futures.

Effective return = initial cash rate – change in basis

In other words, the bank is exchanging interest rate risk for basic risk, of which they hope it will be smaller.

Another way to manage interest rate risk is to use forward rate agreements (FRAs). FRAs are due in the future. They are based on a notional principal, which serves as a reference for the calculation of the interest rate payments. The principal itself is not exchanged, just the interest rate at the end of the contract.

A basic swap exists when two parties agree to exchange cash flows based on notional principal. In a usual basic swap party A pays party B a fixes rate based on the notional principal, while party B pays party A a floating rate of interest. Swaps are often used to adjust the sensitivity of specified assets or liabilities or the portfolio as a whole. However, there is an advantage about swaps. When there is a large change in the level of the rate , a fixed-rate obligation will become very onerous.

An option refers the right to purchase a security (call option) or to sell a security (put option). We assume a strike price of 95 and a premium of 20 basis points. Call option will only be exercised when the price exceeds the strike price. A put option will only be exercised when the strike price exceeds the price.

Market risk

The model that is often used to deal with market risk on the trading book is the value-at-risk (VaR) model. It calculates the likely loss that a bank might experience on its whole trading book. It is the maximum loss that a bank would accept over a specific time period within a given confidence interval. VaR is an estimate of the value of losses (ΔP) with confidence α% over a time horizon:

Pr(ΔP Δt < VaR) = α

Returns are calculated as:

R_t = (P_t – P_t-1) / P_t-1 x 100

Where P is the value of the asset and t defines the time period in consideration. We assume that the asset returns are normally distributed. The advantage of VaR is that it provides a statistical measure of probable loss on not just a single asset but a whole portfolio of assets. For a two-asset portfolio, the return is:

R_p = α₁ R₁ + α₂ R₂

And the riskiness is defined by:

σ_p√( α₁² σ₁² + α₂² σ₂² + 2ρ_1,2 α₁ α₂ σ₁ σ₂)

Where ρ stands for the correlation coefficient between return of asset 1 and 2. Α is the share of the asset in the portfolio.

The value of a portfolio is the summation of the values of each asset:

V_p = ∑ V_i

Change in value of portfolio = sensitivity of the portfolio to a price change x change in price of the underlying asset)

There are some assumptions regarding the VaR:

• Returns are normally distributed.

• Serially uncorrelated returns.

• Standard deviation (volatility) is stable over time.

• Constant variance – covariance of returns.

Credit risk

The riskiness of a loan is reflected in the price of the loan. The general loan pricing formula is:

R_L = (1 + r_F) / (1-δ) - 1

In this formula δ is the default rate and calculated as 1 minus the repayment rate = 1- μ.

This expression does not only account the expected default on loans but also the return on capital required from the loan to compensate shareholders, the cost of funds including the cost of meeting regulatory requirements and deposit insurance and the administrative costs.

The recognition of risk and the potential of unexpected losses give rise to the concept of risk-adjusted capital (CAR). In turn, the allocation of CAR to specific bank activities given rise to the concept of risk-adjusted return on capital (RAROC).

RAROC = (R – C – E / CAR) + r_F

Where R is the revenue, C the costs and E the expected losses.

One simple way of assigning loans to different risk classes is through the method of credit scoring. Credit scoring is a technical method of assigning a score that classifies potential borrowers into risk classes, which determines whether a loan is made, rejected or lies in an area that requires additional scrutiny. The loans in history are divided into two groups; those who have defaulted (Z=1) and those who have repaid (Z=0). The Z-score is calculated as:

Z_i = ∑ α_i X_i

This formula is uses in the ZETA model which shows a linear relationship between the Z-score and seven factors:

• Return on assets

• Stability of earnings

• Debt service

• Cumulative profitability

• Liquidity

• Capitalization

• Size

This model has been successful in classifying borrowers into different categories. They used data from the past to do this. But the problem of the credit scoring framework is that there is not recent information.

An alternative model is the risk of ruin approach. It bears a resemblance to the option pricing models of Black and Scholes. The model states that a firm goes bankrupt when the market value of its assets falls below its debt obligations. The value of equity is seen as a call option on the value of the firm’s assets.

There is a link made between the observed volatility of the value of equity and unobserved volatility of the firm’s assets. In this model an expected default frequency (EDF) is calculated for each borrowing firm.

The formula for the calculation of distance of default (d) is:

d = ((A-D)/A) / σ_A = (A-D) / A σ_A

d is equivalent to a Z score in the standard normal distribution.

Each loan is assigned a credit rating. In total there are 8 credit ratings; AAA, AA, A, BBB, BB, B, CCC and default. A loan can have a constant credit rating over time but it can also be upgraded or downgraded. The expected value and standard deviation of a loan are given by:

Mean = μ = ∑ p₁ V_i

Standard deviation = σ = √ (∑ p_i(V_i – μ)²

The use of the value-at-risk method gives the impression that risk management in banks has reached the levels of technology associated with the natural sciences. Modern risk management methods should be seen as complements for good judgment and not as substitutes.

A credit default swap (CDS) is an insurance policy where the safety of a loan is guaranteed to counterpart risk. A CDS:

Contingent liability is:

• Failure to meet payment obligations.

• Bankruptcy or moratorium in the case of sovereign debt.

• Repudiation.

• Material adverse restructuring of the debt.

The process of CDS looks a lot like the securitization process. Though there are two important differences:

• The original borrower is not involved in the CD S, unlike the case of securitization.

• The debt is not removed from the balance sheet, so there are no reserve ratio benefits.

Operational risk

Operational risk is defined as the possibility of loss resulting from errors in structuring payments or settling transactions. It is the risk loss resulting from inadequate or failed internal processes, people and systems or from external events. Rachlin (1998) categories operational risk into different categories:

• Process risk

• People risk

• Systems risk

• Business strategy risk

• External environment risk

An advantage of operational risk is that it can be divided into high-frequency low-severity (HFLS) events, which occur regularly and for which data can be found, and low-frequency high-severity (LFHS) events, which are rare. When measuring operational risk we need to account for both types. To calculate expected operational loss (E(L)), the bank needs a probability (ρ) of the operational loss event and the cost of the operational loss event (θ).

E(L) = ρθ

Chapter 14: The macroeconomics of banking

Introduction

We will now take a look at a developed banking system for workings and controllability of the macro economy through the application of monetary policy. The central bank has the control of the monetary policy.

The economics of central banking

Central banks are something we especially see in the modern world. One of the oldest central banks is the bank of England.

Often is assumed the central bank controls the money supply through the money multiplier. However, this is in fact very different from reality. Central banks use the required reserve ratio to control bank lending and thereby the money supply. When the reserve ratio increases then the CB creates a shortage of reserves for the banking system. This forces banks to raise interest rates to reduce loan demand.

In reality, central banks use the discount rate to control the money supply. The discount rate is the rate of interest at which the central bank is willing to lend reserves to the commercial banks.

A next step for the central bank is to choose the rate of interest. How they do this depends on the relationship of the central bank and the government. Central banks are independent and this means two things:

• Goal independence means that the central bank sets the goals of the monetary policy

• Operational independence refers to a central bank that has freedom to achieve the ends which are themselves set by the government.

When a central bank is not politically independent of the government then it will tend to support government by financing its spending with little regard to the monetary consequences.

The central bank can have one or more goals. The theory of central banking suggests that the central bank should have policy aims that include output stabilization but give output stability a lower weight than the government would wish and inflation a higher weight than the government would wish.

The following type of loss function describes the government and society’s preferences:

L = 0.5E (π² + b (x-x)²)

This figure shows the Isoloss curves from the formula.

The Philips curve specifies inflation as a function of the output gap and expected inflation (π^e):

π = x + π^e + ε

We can rearrange the formula to obtain x:

x = (π – π^e) + ε

The profit functions are tangent to the Isoless curves.

Point B represents the zero-shock equilibrium for the government and highlights the inflation bias in its strategy.

Financial innovation and monetary policy

Goodhart (1984) identified a major structural change in the developed economies’ banking system. That was the switch from asset management to liability management. The most important development in this was that of interest-bearing sight deposits.

The conventional money demand function is:

M^d = f(P,γ,R_b) , f_p > 0, f_y > 0, f_r < 0

Where M is the stock of money, P is the price, γ is real income and R_b is the rate of interest on short-term bonds.

If we add the development of interest-bearing sigh deposits into this formula we get:

M^d = f(P,γ,R_b - R_d) , f_p > 0, f_y > 0, f_r < 0

The substitution between money and non-money liquid assets will depend on the margin between the interest on non-money liquid assets and deposits. When interest rates rise then banks will also raise their interest rates on deposits.

We will use the LM/IS model to explain the different policy responses to real and monetary shocks.

The real demand shock causes the IS curve to shift outwards, to the right. This increases both income and the rate of interest. Holding the money supply constant there would be an income of Y’. When the interest rate is held constant at R1 then income would rise even further to Y2.

When there is a monetary shock and the money supply is held constant then the equilibrium level of income will increase to Y2. If the rate of interest is held constant them the equilibrium income level will return to Y1.

An interest rate target can be described by a money supply response function in the form of:

M^s = M* + λ (R-Ṝ) + v.

Central banks allow the interest rate to look like a Taylor rule. This is an interest rate response function that reacts to inflation deviating from its target and real output deviating from some given capacity level of output:

R – π* = ϕ (π-π*) + γ (y-y*)

• π* is the target rate of inflation

• y* is the real output

• ϕ and γ are coefficients that show the power of reaction to the two determinants of government policy.

Bank credit and the transmission mechanism

The monetary transmission mechanism separates the effect of monetary policy on the economy into a direct and indirect route. It is summarized in the following table:

The indirect route works through the effect of interest rates and asset prices on the real economy. A decrease in the rate of interest or in asset prices results in a fall in the cost of capital and an increase in investment and consumer durables spending.

The credit channel works by amplifying the effects of the interest rate changes by endogenous changes in the external finance premium. The external finance premium is the gap between the cost of funds raised externally and the cost of funds raise internally.

The balance sheet channel is based on the notion that the external finance premium facing a borrower should depend on the borrower’s net worth. The supply of capital is sensitive to shocks that have persistence on output.

The bank lending channel recognizes that monetary policy also changes the supply of bank credit. When the credit supply of a bank is withdrawn, medium of small business incur costs in trying to find new lenders. Thus shutting off bank credit increases the external finance premium.

An aggregate banking system balance sheet looks like:

L + R = D + E

Where L is loans, R is reserves, D is deposits and E is equity.

The government financing constraint is:

G – T = ΔH + ΔB + ΔF

Where G is government spending, T is tax revenue, H is base money, B is government bonds and F is borrowing from foreigners.

Rearranging the expressions leads to the money supply to the flow of funds:

ΔM = ((G – T) – ΔB) + ΔL – ΔE – ΔF

The first part ((G – T) – ΔB) represents the public sector funding requirement.

List of important terms and definitions

Prudential control: Deregulation of financial markets and banks has been directed towards their competitive actions, but this has been accompanied with increased regulation over the soundness of their financial position.

Deregulation: Consists of the removal of impositions by government bodies and the removal of self-imposed restrictions.

Financial innovation: Any change in the scale, scope and delivery of financial services.

Asset management: Banks manage their assets regarding duration and type of lending subject to the constraint provided by their holdings of reserve assets.

Liability management: Ability to create liabilities by, for example, borrowing in the interbank market.

General Agreement on Trade and Services (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.

Securitization: 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.

Endowment effect: 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.

Consolidation: 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.

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.

Contract baking means that the bank will have a contract to deliver financial services to its customer.

Capital market: A market where firms and individuals borrow on a long-term basis.

Money market: The opposite of a capital market, a market where funds are lent and borrowed on a short-term basis.

Loanable funds theory: Explains how the rate of interest is determined by the interaction of savers and investors.

Financial intermediation is borrowing by deficit units from financial institutions rather than directly from surplus units themselves.

Size transformation: When the bank will collect a number of smaller deposits, bundles them together and lent them out a larger sum.

Risk transformation: Borrowers are willing to pay a higher price than necessary to remunerate lenders where risk is low.

Default risk: The possibility that the borrower will default an fail to repay either or both the interest due on the loan and the principal itself.

Price risk: Variation in the price of the financial claim

Search costs: These costs involve transactors searching out agents willing to take an opposite position. Like a borrower seeking for lenders.

Verification costs: Arise from the need of the lender to evaluate the proposal for which the funds are required.

Monitoring costs: When the loan is made, the lender will like to monitor the progress of the borrower and ensure that the funds are used in accordance with the purpose agreed.

Enforcement costs: Are incurred by the lender when the borrower violates any of the contract conditions.

Moral hazard: The risk that the borrower may engage in activities that reduce the profitability of the loan being repaid.

Adverse selection: The lender may select projects that are wrong in the sense that they offer a lower change of meeting the outcomes specified by the borrower than loans for other more viable projects that are rejected.

Monitoring: Refers to the collection of information about a firm, its investment projects and its behavior before and after the loan application is made.

Security underwriting: Banks advice on the issue of new securities and will take up any quantity of the issue not taken up in the market.

Off-balance-sheet business: When the bank receives fee income rather than interest receipt for its activities. This is called off-balance-sheet business because it does not appear on the balance sheet.

Sight deposits: Deposits that can be withdrawn without notice.

Time deposits: Deposits made with a bank for a fixed period of time.

Capital: represents a shareholder’s interest in the firm and comprises equity, reserves etc.

Balances at the Central Bank: The cash required to finance interbank transactions and to meet required ratios.

Other liquid assets: Assets that can be converted into cash quickly and without loss.

Investments: Consist of holdings of securities issued by the government and in some cases firms.

Reserve ratio: A specified balance as proportion of the level of deposits.

Liquidity risk: Risk that the demand for repayment of deposits exceeds the liquid resourced of the bank.

Asset risk: Risk that assets held by banks may not be redeemable at their book value.

Foreign currency risk: Risk that exchange rates may move against the bank causing the net value of its foreign currency assets/liabilities to deteriorate.

Payments risk: Risk that arises from operation of payments mechanism and the possibility of failure of a bank to be able to make the required settlements.

Risk of settlement (Herstatt risk): Risk of loss in foreign exchange trading where one party delivers foreign exchange but the other party fails to meet its end of the bargain.

Off-balance-sheet risk: Risk that business that is fee earning will lead to losses through the failure of the counterparties to carry out their obligations.

Retail banking: Providing the services of accepting deposits and making loans to individuals and small businesses; the banks act as financial intermediaries.

Wholesale banking deals with a small number of customers but a large size of each account.

Liability management: Surplus funds will be deposited in the interbank market.

Universal banks: Banks that operate the entire range of financial services ranging through the normal banking service of accepting deposits and making loans, insurance, security services, underwriting and owning shares in client companies.

Money multiplier: A non-behavioral relationship between changes in the stock of base money and the stock of broad money.

Liquidity management: Involves managing reserves to meet predictable outflows of deposits.

Availability doctrine: States that spending is always in excess of available funds. Not the price but the availability of credit is the important determinant of credit.

Credit rationing: The act of placing restrictions on the amount of credit.

Adverse incentives: When the contracted interest rate creates an incentive for the borrower to take on greater risk than he/she otherwise would, so that the higher interest rate can be paid.

Pooling contract: A common contract to the two types of borrowers, honest and dishonest borrowers.

Securitization: The process of matching up of borrowers and savers wholly or partly by way of financial markets.

Asset-backed securities: Sales of financial securities.

Loan origination: Location of creditworthy borrower.

Loan funding: Funds secured through designing securities that are attractive to savers, in the case of bank deposits.

Loan serving: Administering and enforcing loan conditions.

Loan warehousing: Holding the loan in the lender’s portfolio of assets.

Asset-backed securitization (ABS): is a process whereby liquid assets are pooled together and sold off to investors as a composite financial security that includes the future cash proceeds

Method of data envelopment analysis (DEA): This is a non-parametric approach that constructs an envelope of outputs with respect to inputs using a linear programming method.

Stochastic frontier analysis (SFA): This approach specifies a function for cost, profit or production to determine the frontier. It treats the random error with symmetric distribution and it treats inefficiency with an asymmetric distribution.

Distribution-free approach (DFA): A functional form that assumes that random errors are zero on average and the efficiency is stable over time.

Thick-frontier approach (TFA): This is a functional form that determines the frontier on performance of the best firms. All the firms are ranked according to their performances. This method provides efficiency rates for the industry as a whole rather than for individual firms.

Static studies: Studies that do not consider the behavior of the merger firms before and after the merger.

Dynamic studies: Studies that consider the behavior of the firms before and after the merger.

Share price: Aggregate market value of target and acquirer prior to announcement.

Exercise price: Hypothetical future market value of separate entities forecast by their beta value.

Standard deviation: Annualized stander deviation of weekly returns after the merger.

Dividend yield: Average dividend yield in the year after the merger.

Market structure: Is defined as the interaction of demand and supply factors.

The structure-conduct-performance (SCP): hypothesis that fewer and larger firms are more likely to engage in anticompetitive behavior.

Herfindahl-Hirschman Index (HHI): The sum of the squared market shares of the banks in the market.

N-bank concentration ratio (CR): The percentage of the market controlled by the top n banks in the market.

Relative market power hypothesis: Individual banks may have informational advantages relating to their clients that give them localized market power independently of what could be obtained from collusion.

Contestable market: This is a market in which an entrant has access to all production techniques available to the incumbents, is not prohibited from wooing the incumbent’s customers and entry decisions can be reversed without costs.

New empirical industrial organization ( NEIO): The NEIO assesses the strength of market power by examining deviations between observed and marginal cost pricing, without using any market structure indicator.

Rosse-Panzar method: A method that proposes the estimation of a bank’s specific revenue function in terms of the bank factor prices.

The H-statistic: The sum of the elasticities of revenue with respect to factor prices.

A bank run: When both types of agents withdraw their funds in period 1.

The gearing ratio: It is the ratio of bank deposits plus external liabilities to bank capital and reserves.

The risk capital-asset ratio: This ratio sets out a common minimum risk capital-asset ratio for international banks.

A well-capitalized bank: A bank that has a total risk capital-asset ratio greater than or equal to 10% with a tier-1 capital-asset ratio greater than or equal to 6%.

Standardized approach. It assesses weights of specific assets with the addition of the risk weights being ordered according to external rating agencies.

Operational risk: The risk of loss resulting from inadequate or failed internal process, people, systems or external events.

Free banking: A situation in which banks are allowed to operate freely without external regulation, subject to the normal restrictions of company law.

Liquidity risk: The possibility that a bank will be unable to meet its liquid because of unexpected withdrawals of deposits.

Operational risk: Possibility of loss resulting from errors in structuring payments or settling transactions.

Legal risk: Possibility of loss when a contract cannot be enforced because the customer had no authority to enter into the contract or the contract terms are unenforceable in a bankruptcy case.

Market risk: Possibility of loss over a given period of time related to uncertain movements in market risk factors.

Yield curve level risk: An equal change in rates across all maturities.

Yield curve shape risk: Changes in the relative rates for instruments of different maturities.

A future: A transaction where the price is agreed now but delivery takes place at a later date.

A basic swap: Exists when two parties agree to exchange cash flows based on notional principal.

Call option: An option refers the right to purchase a security.

Put option: Option to sell a security.

Value-at-risk (VaR) model: Used to deal with market risk on the trading book is the It calculates the likely loss that a bank might experience on its whole trading book.

Credit scoring: A technical method of assigning a score that classifies potential borrowers into risk classes, which determines whether a loan is made, rejected or lies n an area that requires additional scrutiny.

A credit default swap (CDS) is an insurance policy where the safety of a loan is guaranteed to counterpart risk

Contingent liability is: Failure to meet payment obligations, bankruptcy or moratorium in the case of sovereign debt, repudiation and material adverse restructuring of the debt.

The discount rate: The rate of interest at which the central bank is willing to lend reserves to the commercial banks.

Taylor rule: This is an interest rate response function that reacts to inflation deviating from its target and real output deviating from some given capacity level of output:

Credit channel: Works by amplifying the effects of the interest rate changes by endogenous changes in the external finance premium.

The external finance premium: The gap between the cost of funds raised externally and the cost of funds raise internally.