What Do Banks Do

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What Do Banks Do?

• Intermediation
• Transforming savings received primarily from
  households into credit for business firms and
  others in order to make investments
• Are there others who perform intermediation roles
  in the financial markets?

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Why Is Intermediation Important?

• Liquidity
• Intermediaries provide liquid financial
  instruments
• One of the oldest reasons for the existence of
  financial institutions
• Knights Templar
• Delegated Monitoring
• Individuals do not have the ability to make
  informed investment decisions
• Intermediaries act as agents

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Why Is Intermediation Important?

• Information asymmetries
• Financial intermediaries have unique abilities to
  select investment opportunities
• Work with clients one on one
• Transaction costs
• Intermediaries reduce transaction costs in
  markets
• Access to markets for individuals
• Allow for smaller transaction sizes for
  individuals

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Are Banks Unique In Their Intermediation Role

• Yes
• Bank loans contain information
• Markets respond positively to bank loan renewals
• Banks create relationships
• Relationship lending
• Able to exploit profitable opportunities that
  others would avoid
• Banks are in a unique position to provide
  liquidity and serve as the best alternative
• Deposit insurance

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Are Banks Unique In Their Intermediation Role

• No
• Any intermediary can provide liquidity
• Many non-bank firms create relationships that
  create unique opportunities
• Venture capital
• Banking system is a product of regulation and is
  not efficient
• Un-regulated markets would have developed an
  efficient system

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The Other Roles of Commercial Banks Today

• Payment Role
• Checkable deposits, clear checks, transfer funds
• Again, not unique
• Guarantor Role
• Provide standby letters of credit and other forms
  of guarantees
• Risk Management Role
• Essentially providing insurance services both
  traditional and non-traditional

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The Other Roles of Commercial Banks Today

• The Investment Banking Role
• Financial service diversification has allowed
  banks to take a more active role
• Underwriting Securities
• Big issuer of ABS
• Offering Mutual Funds and Annuities
• Offering Merchant Banking Services
• Venture capital role
• Offering Risk Management and Hedging Services
• Exchange rate risk
• Interest rate risk
• Essentially banks have become market makers for
  many financial products

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The Roles of Commercial Banks Today

• Savings/Investment Advisor Role
• One stop shop concept
• Again, financial service diversification has
  allowed this to happen
• Safekeeping/Certification of Value Role
• Safe deposit boxes, savings accounts, CDs
• Agency Role
• Trust services
• Policy Role
• Banks are used by government to control the
  economy
• Federal Reserve Bank

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Traditional Services Offered By Banks

• Carrying Out Currency Exchange
• Discounting Commercial Notes and Making Business
  Loans
• Offering Savings Deposits
• Safekeeping of Valuables
• Supporting Government Activities with Credit
• Offering Checking Accounts
• Offering Trust Services

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More Recent Services Offered by Banks

• Granting Consumer Loans
• Providing Financial Advice
• Managing Cash
• Offering Equipment Leasing
• Making Venture Capital Loans
• Selling Insurance Policies
• Selling Retirement Plans

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The Financial Service Competitors of Banks

• Savings Associations
• Savings Banks
• Credit Unions
• Money Market Funds
• Mutual Funds (Investment Companies)
• Hedge Funds
• Security Brokers and Dealers
• Investment Banks
• Finance Companies
• Financial Holding Companies
• Life and Property-Casualty Insurance Companies

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Some Leading Non-Bank Competitors

• Merrill-Lynch
• Traditionally think of them as a stock broker
• One of the first non-bank companies to form a
  holding company
• Deals in govt securities, asset management, and
  mutual funds (especially money market funds)
• Controls an industrial bank

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Some Leading Non-Bank Competitors

• American Express
• Credit cards
• Owns FDIC-insured industrial bank
• Provides mortgage, home equity, and consumer
  loans
• Offers savings and deposits, on-line bill paying
• Household International
• Largest finance company in the world
• Credit cards, auto loans, home loans, consumer
  loans
• Purchased HSCB of London in 2002

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Some Leading Non-Bank Competitors

• Countrywide
• Mortgages
• Set up branch-like offices
• Broker/dealer subsidiary and insurance subsidiary
• Bought Treasury Bank, NA
• GE Capital
• Originally set up as a captive finance company
  to provide financing to customers
• Today does a bunch of leasing, credit cards,
  insurance, etc.
• Would be 10th largest bank in the US

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Common Thread

• What do all of these competitors have in common
  with banks?
• They all own banks or have industrial banks
• Is this a potential problem?

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Bank Structure

• Unit Bank
• Offer All Services From One Office
• One of the Oldest Kinds of Banks
• New Banks are Generally Unit Banks

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Bank Structure

• Branch banking
• Offer Full Range of Services from Several
  Locations
• Senior Management at the Home Office
• Each Branch has its Own Management Team with
  Limited Decision Making Ability
• Some Functions are Highly Centralized, While
  Others are Decentralized

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Bank Structure

• Bank Holding Company
• A Corporation Chartered for the Purpose of
  Holding the Stock of One or More Banks
• Control of a bank is Assumed When 25 or More of
  the Stock is Owned
• Must Get Approval from Federal Reserve Board to
  Control a Bank

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Reasons for the Growth of BHCs

• A Way Around Regulatory Restrictions
• Geographic Diversification
• Product Line Diversification
• Tax Sheltering
• Double Leveraging

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Nonbank Businesses of BHCs

• Finance Companies
• Mortgage Companies
• Data Processing Companies
• Factoring Companies
• Security Brokerage Firms
• Financial Advising
• Credit Insurance Underwriters
• Merchant Banking

• Investment Banking Firms
• Trust Companies
• Credit Card Companies
• Leasing Companies
• Insurance Companies and Agencies
• Real Estate Services
• Savings Associations

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Bank Structure

• Financial Holding Company
• Special Type of Holding Company
• Offers the Broadest Range of Services
• List of Activities Offered May Expand as
  Regulators Decide What Services are Compatible
  with Banking
• Each Affiliated Financial Firm has its Own
  Capital and Management and its Own Profit or Loss

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Bank Structure

• Bank Subsidiaries
• Bank Controls One or More Subsidiaries
• Subsidiaries Offer Other Services Such as
  Insurance and Security Brokerage Services
• Profits and Losses of Each Subsidiary Impact
  Parent Bank

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Structure and Organization of Banks in Europe

• Germany Largest European Banking Industry
• Private Sector Banks
• Public Sector Banks
• France Second in Number of Banks
• Belgium Dominated by Five Large Banks
• Great Britain Dominated by a Half Dozen Banking
  Firms
• Switzerland Credit Suisse and UBS and Many
  Smaller Firms
• Italy Privatized Banking in the 1990s

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Structure and Organization of Banks in Asia

• China Large Dominating Government Sector,
  Although Private Banks are Expanding
• Japan Dominated by the Big Four Financial Group
  with More than One Hundred Smaller Domestic Banks
  and Seventy Foreign Banks

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Consolidation in Banking

• Decreased of banks
• Primarily smaller banks that have gone away
• Increased importance on asset size
• Larger banks have greater share of the market
• Will this trend continue?

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Bank Efficiency

• Economies of Scale
• As Output Doubles Economies of Scale Mean Less
  Than the Doubling of Production Costs
• Producing Multiple Units of the Same Package
  Costs Less Because of Efficiencies
• Economies of Scope
• A Financial Services Provider can Save Operating
  Costs When it Expands the Mix of Products it
  Offers
• Resources are Used More Efficiently in Jointly
  Producing Multiple Services

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Bank Efficiency

• Are the largest banks the most cost efficient?
• Probably so
• Are the largest banks the most profit efficient?
• Not necessarily, not all bank operations shown to
  be particularly profitable
• Asset specialization may play a role in overall
  profitability

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Community Banks

• Typical Size is 250 Million
• Organizational Chart is Not Complicated
• Significantly Affected by Health of Local Economy
• Generally Know their Customers Well

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Money Center or Wholesale Banks

• Generally Multi-Billion Dollar Company
• Organizational Chart is Much More Complex
• Serve Many Different Markets with Many Different
  Services
• Better Able to Withstand Risks of Fluctuating
  Economy
• Able to Raise Large Amounts of Capital at
  Relatively Low Costs