Basic banking (0)

Tallinna Tehnikaülikool - Majandus - Raha ja pangandus

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Financial Institutions and Services

Objectives and Outcomes

To give overview of main players.

Introduction

It is common to distinguish between monetary financial institutions ( MFIs ) and other financial intermediaries. The distinction is based on the functions of institutions – institutions in the first group (MFIs) play important role in the process of money creation in modern economies .
European Central Bank (ECB) describes Monetary financial institutions as including national central banks (and also ECB in the euro area), credit institutions and non-credit institutions which receive deposits from general public (individuals and non-MFI firms ) and grant credit and/or invest in securities. Major non-credit MFIs in Europe are money market funds.
Credit institutions are defined in the directive1 relating to the taking up and pursuit of the business of credit institutions as:
a) undertakings whose business is to receive deposits or other repayable funds from the public and to grant credits for its own account ; or
b) electronic money institutions within the meaning of Directive 2000/46/EC.
Later in this text we use data on monetary aggregates in different countries and regions . The consolidated MFI balance sheet is used to calculate some key monetary and credit variables, including monetary aggregates, which are regularly monitored by Central Banks.
Table ... Consolidated MFI balance sheet.
Schematic consolidated balance sheet of the MFI sector for the euro area( 1 )
Assets
Liabilities
1. Loans
1. Currency in circulation
2. Securities other than shares
2. Deposits of central government
3. Shares and other equities
3. Deposits of other general government and other euro area residents
4. External assets
4. Money market fund shares/ units
5. Fixed assets
5. Debt securities issued
6. Remaining assets
6. Capital and reserves
7. External liabilities
8. Remaining liabilities
( 1 ) A detailed description of the instrument categories is provided in Annex 4 of the ECB publication: "The single monetary policy in Stage Three: General documentation on ESCB monetary policy instruments and procedures".
Source: ECB, http://www.ecb.int/mopo/eaec/intermediaries/html/index.en.html
Figure … Composition of the consolidated balance sheet of the euro area MFIs (including the Eurosystem) at end-2012
Suorce: ECB, ( http://www.ecb.europa.eu/mopo/eaec/intermediaries/html/index.en.html )
Banking and other institutions (Molyneux, Altunbas et al. 1996), ( types of …, depository (savings), contractual savings, investment, retail, universal , …, management of financials,
Other financial institutions (OFIs) are for example insurance corporations, pension funds, financial auxiliaries, mutual funds, securities and derivatives dealers and financial corporations engaged in lending.
For statistical purposes the OFI sub-sector is defined in the ESA 20102 as a corporation or quasi -corporation other than an insurance corporation and pension fund that is engaged mainly in financial intermediation by incurring liabilities in forms other than currency, deposits and/or close substitutes for deposits from institutional entities other than MFIs, in particular those engaged primarily in long- term financing, such as corporations engaged in financial leasing, financial vehicle corporations created to be holders of securitised assets, financial holding corporations, dealers in securities and derivatives (when dealing for their own account), venture capital corporations and development capital companies ( http://www.ecb.int/home/glossary/html/glosso.en.html#94 ).

Overview of the Chapter

Intermediation and Institutions

Financial intermediation refers to the process of allocation and transformation of financial resources in economies according to the needs of economic agents3. The objective is fulfilled by banks, non-bank financial institutions, and capital markets .
Traditionally, the most important part of the intermediation has been considered channelling the funds form from ultimate creditors (surplus saving units) to the ultimate borrowers (deficit saving units) with the banks playing major role in the process. The simple intermediation description is given on the figure below . Traditionally the system has considered having two components that deal with short-term and long-term savings.
Banking is mainly engaged in maturity transformation of short-term savings to long-term loans. The intermediation of long-term savings is performed either directly (savers buying the securities) by the capital markets or indirectly by the placement of the ultimate creditor’s funds with asset managers (insurance companies and funds). The process is finalised by asset managers who invest the funds into long-term securities.
Figure ... Traditional banking based financial intermediation (Pozsar and Singh, 2011, p. 3).

Major Financial Services

Appendix 1 (p. L177/57) of above mentioned EU directive 2006/48/EC lists particularly the services of credit institutions that are subject of mutual recognition in the EU:
1. Acceptance of deposits and other repayable funds
2. Lending including, inter alia: consumer credit, mortgage credit, factoring, with or without recourse, financing of commercial transactions (including forfeiting)
3. Financial leasing
4. Money transmission services
5. Issuing and administering means of payment (e.g. credit cards, travellers' cheques and bankers' drafts)
6. Guarantees and commitments
7. Trading for own account or for account of customers in:
a) money market instruments (cheques, bills , certificates of deposit , etc.);
b) foreign exchange;
c) financial futures and options;
d) exchange and interest ‑rate instruments; or
e) transferable securities.
8. Participation in securities issues and the provision of services related to such issues
9. Advice to undertakings on capital structure, industrial strategy and related questions and advice as well as services relating to mergers and the purchase of undertakings
10. Money broking
11. Portfolio management and advice
12. Safekeeping and administration of securities
13. Credit reference services
14. Safe custody services.
Later more detailed description will be added ...

Summary

Everyone can write his or her own.

Basic Banking

To give overview of the movements in bank’s balance sheet due to the operations.

Establishing a Bank

First, a bank has to fulfil all requirements set for joint stock companies in the country of establishment . Second, special requirements are set for financial and credit institutions almost in all countries in the world. To begin operations the bank must have fully paid in capital in the amount of € 5 000 000 in Euro area (+ differences in EU countries belonging and not to belonging to Euro area + latest regulations).
The bank’s balance sheet immediately after establishment is described by Figure 1a.
Balance sheet 1a. Establishing the bank
Assets (€ ths.)
Liabilities (€ ths.)
Cash
5000
Bank Capital
5000
If the banks’ only task where to give their depositors a safe place to keep their money the balance sheet of the bank after acquiring the deposits in the amount of € 40000 ths. would look as described below.
Balance sheet 2. Deposits inflow.
Assets (€ ths.)
Liabilities (€ ths.)
Cash
45000
Deposits
40000
Bank Capital
5000
Neither owners nor the depositors would be happy with the situation in so called full - reserve banking or 100- percent -reserve banking. Someone should cover the costs of safe keeping of the money and the owners are certainly also expecting the opportunity cost of their invested capital to be covered. That would certainly lead to the fees to be paid by the depositors instead of getting interest from the bank on their money (lent to the bank!?). Many potential depositors would find the system unsatisfying and would keep their money in “pillows”.
Currently, there is no country which would practice full-reserve banking. Instead, fractional reserve banking is in use in all financial systems over the world. In this system banks lend part of the money deposited with them to borrowers. Deposits (cash) that a bank has acquired but has not loaned out are called reserves. Banks hold reserves both voluntarily and because of reserve requirements.
The main reason to hold reserves is to be ready for the case whereby the depositors withdraw unusually large quantities of deposits from the bank - banks usually hold excess reserves for the liquidity management. Central banks see the reserve requirement also as a tool to influence money supply (see chapter … Money).
Under the requirements of Eurosystem’s minimum reserve system the credit institutions are obliged to hold minimum reserves with the National Central Bank. The reserve base of an institution is defined in relation to elements of its balance sheet’s liability side. In United States the reserves may be in the form of deposit with the Federal Reserve Bank or in the form of the cash held in the credit institution.
Reserve requirements4 are set in Europe on the level of 2% of deposit-type liabilities (reacting to the economic conditions after the crisis the ECB has relaxed the minimum reserve requirement and it is currently on the level of 1%).
According to ECB, the Eurosystem’s minimum reserve system pursues the following monetary policy functions:

Stabilisation of money market interest rates. The averaging provision of the Eurosystem’s minimum reserve system aims to contribute to the stabilisation of money market interest rates by giving institutions an incentive to smooth the effects of temporary liquidity fluctuations.

Creation or enlargement of a structural liquidity shortage. The Eurosystem’s minimum reserve system contributes to creating or enlarging a structural liquidity shortage. This may be helpful in order to improve the ability of the Eurosystem to operate efficiently as a supplier of liquidity.

A tool for monetary policy.
At the beginning of its life, the bank does not have liabilities to its clients and therefore the cash paid in as the capital can be described as excess reserves.
Balance sheet 1b. Reserves at establishment.
Assets (€ ths.)
Liabilities (€ ths.)
Excess reserves
5000
Bank Capital
5000
To start operations, the bank has to acquire additional resources5. Major resources for credit institutions (and service to clients) are deposits that exceed in the fully operational banks the capital approximately ten times . Acquiring the deposits implies the need to deposit a portion of acquired resources with central bank (€ 800 000 in example of the bank described by Figure 2 that has acquired € 40 000 000 of deposits). The remaining part of non-invested reserves comprises excess reserves.
Balance sheet 2b. Deposits inflow.
Assets (€ ths.)
Liabilities (€ ths.)
Required reserves
800
Deposits
40000
Excess reserves (cash or …)
44200
Bank Capital
5000
The banks tend to hold ... The excess reserves form the bases of the bank’s operations. For example, our bank above is able to extend loans to its clients in maximum amount of € 44 200 000 as described in Figure 3.
Balance sheet 3. Bank making loans.
Assets (€ ths.)
Liabilities (€ ths.)
Required reserves
800
Deposits
40000
Max. Loans
44200
Bank Capital
5000

Bank Objectives and Financial Management

As in all private companies in market economies banks seek to maximize their profits or more precisely, they are supposed to maximize their value . This is of course not the only objective the bank managers have to keep in their minds. As always with almost all managerial tasks, there are multiple and usually contradicting to each other objectives to follow.
In the case of financial management such most fundamental objectives are, in addition to the value maximisation, the need to acquire liquid assets sufficient to meet the bank’s obligations when required and the need to minimize risks to the acceptable level.
Value
Trade-offs
Risk
Liquidity
Figure … Trade-offs in financial management.
Above objectives require number of activities in the practice of banking that would ensure the fulfilment of these objectives:

first, enough cash must be ready in the bank to pay its depositors when needed creating the need for liquidity management;

second, the bank should acquire funds at lowest possible cost engaging in liability management;

third, the risks should be minimised by diversifying the assets in the portfolio and by selecting the assets with low expected rate of default into it using proper asset management;

fourth , the financial structure of the institution should be chosen that simultaneously creates the biggest possible margin and minimizes overall risks by asset-liability management;

fifth, the proper level of capital should be determined and maintained by the means of capital adequacy management.

Liquidity Management

Based on the trade-off of objectives, the bank will most probably have some excess reserves to secure itself against possible liquidity problems and it will most probably have diverse asset portfolio at least over asset classes as described in Figure 4a, for example.
Balance sheet 4a. Assumed reality of making loans.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
9800
Deposits
40000
Loans
30200
Bank Capital
5000
Securities
5000
Because of different reasons, the depositors may withdraw their resources from the bank resulting with decrease of reserves.
Balance sheet 5a. Deposit outflow of € 5 milj.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
4800
Deposits
35000
Loans
30200
Bank Capital
5000
With high reserves the bank is protected even against unexpected outflows of deposits.
It could have been otherwise if the bank had lower initial reserves.
Balance sheet 4b. Assumed reality with lower excess reserves.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
5050
Deposits
40000
Loans
34950
Bank Capital
5000
Securities
5000
Deposit outflow of the same size would be followed by decrease of reserves below the required level.
Balance sheet 5b. Deposit outflow (€ 5 milj.) and low reserves.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
50
Deposits
35000
Loans
34950
Bank Capital
5000
Securities
5000
“Excess” reserves € - 0,65 milj.
But if outflow had been € 10 milj? The results may be even worse.
Balance sheet 5c. Deposit outflow (€ 10 milj.) and low reserves.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
-4950
Deposits
30000
Loans
34950
Bank Capital
5000
Securities
5000
In that case the bank will have serious liquidity problems. There are five possible remedies to react according to situation, all of them costly.
First, the bank can borrow from other banks or corporations to cover the shortage of funds.
Balance sheet 6. Borrowing from other banks or corporations.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
714
Deposits
35000
Loans
34950
Borrowing from banks
664
Securities
5000
Bank Capital
5000
Second, the banks sell securities it owns.
Balance sheet 7. Selling securities (€ 0,65 milj).
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
700
Deposits
35000
Loans
34950
Bank Capital
5000
Securities
4350
Third, the bank can borrow from Central Bank.
Balance sheet 8. Borrowing from Central Bank.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
714
Deposits
35000
Loans
34950
Borrowing from CB
664
Securities
5000
Bank Capital
5000
Fourth, the bank can decrease the existing loan portfolio.
Balance sheet 9. Reducing the loans (€ 0,65 milj).
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
700
Deposits
35000
Loans
34300
Bank Capital
5000
Securities
5000
Two possibilities:

Calling in by not renewing some loans;

Selling some loans to other banks.
Fifth, the bank can increase the capital if possible.
Balance sheet 10. Deposit outflow (€ 10 milj.) and low reserves, increasing capital.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
60
Deposits
30000
Loans
34950
Bank Capital
10010
Securities
5000
Increasing growth of costs from one to five above.
Reserves (or excess reserves) are insurance against the unexpected costs associated with possible outflows of deposits.

Capital Adequacy Management

There are three factors influencing the optimal size of the capital held by banks:

bank capital is securing the banks against failure to satisfy its obligations to its depositors or borrowers;

the amount of the capital affects the returns to the equity; and

minimum capital requirements that are set by the regulators.
As seen from the examples at the end of the last subchapter, the liquidity management and capital management serve at least partly the same purpose.
We use banks from Figures 9 and 10 as examples of two possible different initial situations, the first describing a bank with low capital and the second describing a bank with high capital. Suppose that both have invested in mortgage loans that became worthless during the last economic and financial crisis. The bad loans have to be written off and their value in balance sheet declines by € 4500000.
The resulting balance sheets will be as follows.
Balance sheet 9a. Loss of value of the loans, the bank with low initial capital level.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
700
Deposits
35000
Loans
29800
Bank Capital
500
Securities
5000
Balance sheet 10a. Loss of value of the loans, the bank with high initial capital level.
Assets (€ ths.)
Liabilities (€ ths.)
Reserves
60
Deposits
30000
Loans
30450
Bank Capital
5510
Securities
5000
The main reason to keep the bank capital on the certain level is to reduce the probability of becoming insolvent. The higher the capital is, the lower the probability of failure. The cost of this safety is carried by owners by lower returns on equity.

Asset Management

Liability and Asset-Liability Management

Summary

Basics of Financial Intermediaries

Financial intermediation AG, ch. 13 – 15), (structure ( direct and indirect , functions (Jevons, Friedman), instruments (money market instruments, capital market instruments),
A financial intermediary is a firm that substitutes its own liability for that of some ultimate borrower; it engages in financial asset transformation. Financial intermediaries are best described by the most important types of transactions they are engaged in. They purchase financial assets from borrowers (generally some kind of long-term, specific to the borrower, loan contract) and sell another financial asset or assets to savers (generally relatively liquid claim against the intermediary, for example a deposit account).
Differently from other agents in financial markets, financial intermediaries tend to hold financial assets to make profits as an investment portfolio and not as an inventory for resale. In addition, financial intermediaries charge higher interest rates from borrowers and pay lower interest rates to savers to ensure the profits.
Depository Institutions (commercial banks, savings and loan associations, mutual savings banks, credit unions);
Contractual Savings Institutions (life insurance companies, fire and casualty insurance companies, pension funds, government retirement funds);
Investment Intermediaries ( finance companies, stock and bond mutual funds, money market mutual funds).

Financial Services

Delivery channels in banking

There are five most important delivery channels in banking.
The bank branch .
The branch means usually a manned office in easily acessible premises but it includes also mobile banking vehicles ranging from travelling ATM-s to travelling mini-branch facilities. The visions of fully non-branch banking of the internet revolution have not realised and must probably the branch networks remain dominant channel for (retail?) banks also in foreseeable future.
The call center and phone bank.
Wide range of services starting from the help on banking issues to providing transfers and loans can be arranged through the call center that now usually operates within retail banking as part of a multi -channel mix.
Self-service.
Self-service equipment can be defined as any customer facing terminal that is provided by the bank and activated and used by the customer to intermediate the financial services. Wide range of equipment can be used for self-service purposes starting with the remotely located ATMs, automated depositories, and ending with the growing number of online banking terminals located within the bank’s premises. First, self-service can be seen as a part of a bank’s branch representation and it can be targeted solely at generating interchange income at third party locations under second strategy. The card payments are the example of the second strategy of self-service development.
The mobile banking.
The typical transaction set offered in mobile banking provides information about account activity and facilitates payments. Recent offerings also include such features as (lines of) credit, and contactless e-purses. The mobile banking service has established itself as a component of the standard retail banking package.
The internet.
The advent of the internet has provided facilities that enable customers to carry out certain monetary and non-monetary transactions and that give customers the ability to avoid the use of both branches and call centers. Arguably there has been two phases of development of the internet banking. First became the wave of enthusiasm with the ideas of internet-only banks that ran up to 2001. The second wave has recognized the internet bank as the complement to the branches that are still needed to develop the customer relationship.

References and readings

Cavell, David J. (2008). Retail financial services – The main delivery channels reviewed. London: VRL Publishing.
Gylfason, T., Holmström, B., Korkman, S., Söderström, H. T., and Vihriälä, V. (2010). Nordics in Global Crisis: Vulnerability and resilience. Helsinki: ETLA and Taloustieto Oy.
Howells, P., and Bain, K. 2008. The Economics of Money, Banking and Finance: A European Text, 4th ed. Prentice Hall, Financial Times, Harlow , England.
Molyneux, P., Altunbas, Y., and Gardener, E. (1996). Efficiency in European Banking. Chichester: John Wiley & Sons .
Pozsar, Z. and M. Singh. (2011). The Nonbank-Bank Nexus and the Shadow Banking System. IMF Working Paper, No. 28
1 Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions, http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32006L0048:EN:NOT
2 The European System of National and Regional Accounts (ESA 2010) is the newest internationally compatible EU accounting framework for a systematic and detailed description of an economy , http://epp.eurostat.ec.europa.eu/portal/page/portal/esa_2010/introduction
3 Refer to the text in chapter ...
4 THE SINGLE MONETARY POLICY IN STAGE THREE. General documentation on Eurosystem monetary policy instruments and procedures, European Central Bank, November 2000, http://www.ecb.int/pub/pdf/other/gendoc2000en.pdf
5 For simplicity we assume in examples of this chapter that there are no other regulations exept the initial capital requirement and reserve requirement based on the amount of the deposits kept with bank by its customers.
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