Banking and Financial Institutions

Guy HargreavesACF-104

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Recap of yesterdayThe fundamental principles of financial

intermediation“Financial claims” - marketable and non-marketableIdentify various financial markets, and banking and

non-banking financial intermediaries Deposit-taking and non-deposit-taking financial

intermediariesBanking versus shadow banking markets The function and characteristics of money and

monetary basesThe importance of market liquidity to the operation of

the global economy

Banking Systems and commercial banks within developed economies

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Today’s goalsUnderstand banking systems within

developed economiesAppreciate the structure of a typical

commercial banking system Review payment systems and how they

operateDescribe the main products and services

offered by commercial banks Understand the commercial banking

customer base

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Definition for this courseThis course focuses on Commercial BankingCommercial banking can be thought of as any

regulated banking activity operated as a businessFor this course we will define commercial

banking as: Retail banking (including Private banking) Wholesale (or Corporate) banking

We will also look at investment banking Important to note investment banking activity is not

usually regulated by a Central Bank It is regulated when conducted by a regulated bank

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Two basic economic sectorsPrivate sector – not controlled by the State

Individuals Private / public companies Non-profits / charities

Public sector – controlled by the State Federal government State governments Local governments State owned enterprises

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Where does commercial banking fit?Private sector

Individuals – banking licenses not generally available

Private / public companies – most commercial banks Non-profits / charities – some banks eg

Microfinance

Public sector Federal government – Central Banks State governments - no Local governments - no State owned enterprises – few SOE commercial

banks remain

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Who are the savers / borrowers?Private sector

Individuals – both savers and borrowers Private / public companies – both savers and

borrowers Non-profits / charities – goal usually to be neither

Public sector Federal government – mostly borrowers State governments – mostly borrowers Local governments – mostly borrowers State owned enterprises – mostly borrowers

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Are commercial banks savers?Like any for-profit entity, commercial banks

can be savers and borrowers themselves Lending out profits not paid to shareholders Borrowing for capital expenditure

If a commercial bank is a saver / borrower, it will conduct this activity with its own capital

This activity is considered “proprietary” ie not performed in the course of its financial intermediation activity

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The financial systemRetail / WholesaleCommercial Banks

Investment Banks

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What is a banking system?The Banking System is that part of a financial

system in which regulated banks operate Does not include Capital Markets which are part of

the Financial Markets Includes payments, Central Bank operations, bank

loans, deposits – any activity which involves a regulated bank

Whether the activity is regulated is an important distinction

Unregulated activity is conducted outside of the security and support provided by Central Bank regulated commercial banks

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What is a banking system?Banking systems are usually made up of:

Central Banks Regulated commercial banks

Retail (including Private) banks Wholesale banks

Payments systems

Regulated banks deal in financial markets but markets are not usually considered as part of the banking system

Investment banks deal in financial and capital markets but if unregulated they are not considered part of the banking system

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What else do commercial banks do?Conduct operations in financial markets, eg

Hedging risks for customers Risk management for their own balance sheet

Operate payments systemsFacilitate trade flowsHelp with the conduct of monetary policySupport economic growthAssist in executing development policies

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Recall: payment systemsA Payment System is any organised system

established to allow participants to transfer financial assets between themselves

Payments take place for many reasons: In exchange for goods and services Creation or repayment of a financial liability/asset

Commercial banks have historically played a key role in payments systems

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Payment systems - RTGS“Interbank” payment systems use Real Time

Gross Settlement (RTGS) to transfer money between bank participants

Retail participants must hold some form of account with a commercial bank in the payments system

To effect payment a participant will instruct its bank to transfer money from that participant’s account to the proper account of another participant at its own bank

The two banks “settle” the transaction through adjustment of their own accounts held with the relevant Central Bank

Central Banks usually manage RTGS systems

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Payment systems - SWIFTInternational payment systems use Society

for Worldwide Interbank Financial Telecommunication (SWIFT) to transfer money between participants

SWIFT is does not alter the underlying mechanics of individual domestic payment systems

SWIFT is simply a system that arranges domestic payments between international participants

Unless the banks handling a SWIFT transaction are primary deposit-taking institutions in the currency of the transaction, instructions will be handled through a correspondent banking arrangement

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Commercial bank payment productsCommercial banks offer many ways for their

clients to instruct a payment: Cheques Online transfers Standing orders Credit cards Debit cards ATMs Smartphones SMS

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Correspondent bankingCommercial banks often hold accounts with

other domestic or international commercial banks

Nostro account: “our money held by you” Vostro account: “your money held by us”

When a bank holds an account with another bank it is said to have a Correspondent Banking Relationship

If a bank does not maintain an account with its Central Bank it needs to have a correspondent banking relationship with one that does

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Commercial banking productsRetail and wholesale commercial banks offer a

wide range of products and services – including:

Current and chequing accounts Term deposits Consumer loans and mortgages Credit and Debit Cards Cash management services Corporate and SME loans Trade Finance Financial market products and services Online banking

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Investment banking productsInvestment banks offer a wide range of

products and services – including: Capital market product arranging and underwriting Financial market products and services Securitised or asset backed arranging Merger and acquisition advisory

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Mortgage productsOne of the most fundamental banking products

A bank lends money to a borrower to purchase a house, apartment or other property

Only a portion of the property purchase price is lent (eg 50%) – the balance is funded from savings of the borrower

The borrower repays loan principal and interest over an agreed time frame (eg 30 years)

The bank takes a “mortgage” over the property which entitles it to seize and sell the property to repay the loan if the borrower defaults

Banks are at the heart of retail property financing across the globe

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Credit and debit cardsA group of banks were responsible for the

development of widely used credit cards such as Visa and Mastercard

Card products offer the great convenience of being cash-like and widely accepted

Credit cards offer the holder an unsecured line of credit that can be drawn to pay for goods and services

Debit cards are accounts that must have positive fund balances before they can be used to pay for goods and services

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Cash management servicesCorporate customers have complex daily cash

management requirements including: Multi currency cash accounts Account sweeping and reconciliation Lockbox facilities Subsidiary account management Foreign exchange

Sophisticated online cash management solutions are now offered by many banks to help corporate customers manage their business flows

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Trade financeCommercial banks are central to the

financing of trade flows across the globe: Guaranteeing payments for exporters and importers

through correspondent banking relationships Financing shipments of commodities around the

globe Working capital finance for trading companies Inventory financing

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Financial market productsCommercial banks offer a range of financial

market products and services including: Foreign exchange and forwards Money market products Syndicated loans Derivative risk management products Repo products

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Corporate banking productsCorporate banking customers range from

SME to mid market to large listed multinational companies (MNCs)

These customers have a range of commercial banking needs including:

Lease and hire purchase financing Invoice and receivable discounting Corporate loans and commercial paper (CP) Project finance

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Commercial banking customersTraditional commercial banking customers

broadly fall into categories of: Household savers, or borrowers for purchases of

property or smaller ticket personal goods (eg cars) Corporate borrowers entering into bilateral or club

loans for capital expenditure (capex), working capital or M&A

Governments funding infrastructure or deficits

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Modern banking customersPost deregulation in the 1980s, the number

and type of bank customer has grown strongly

Retail customers now also include: Financial market traders and speculators Margin loan borrowers Advisory customers (Private Banking, estate

planning etc) “Sub-prime” customers Traditional deposit and consumer loan customers Etc..

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Modern banking customersWholesale commercial banking customers

now also include: Private Equity funds Pension and Mutual funds Hedge Funds Mortgage and other originators NBFIs Traditional corporate borrowers Corporate risk managers Syndicated loan borrowers Etc…