Birkbeck 2.13 FIR. Lecture 2. Financial Regulation.

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• Handout for Lecture 5.
• Note Lecture will begin with concluding slides
  from last lecture.
• Core / traditional principles of bank
  management derive profit from asset
  transformation, i.e.
• Draw in funds at lower cost on the liability
  side.
• Put them to more profitable use on the asset
  side.
• i.e. This bank profit is from items on the
  balance sheet.

2
Changes in banks balance sheets review Rise
of liability management Money markets /
non-transactions deposits to acquire funds gt
customers deposits. Same for liquidity
management gt high excess reserves. Also
Interest rate risk hedging instruments gt
adjustments to balance of interest-sensitive and
interest-insensitive assets items on BS.
3
Off-balance-sheet activities. Deregulation,
etc., ? banks now also ? further activities Not
defined with respect to BS i.e. Not appearing on
the balance sheet. Merging of activities of banks
and non-bank financial institutions
(nbfis). Boundaries less distinct.
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Extent of Off-Balance-Sheet activity
Note Actually now a declining proportion. Due
to increased competition from nbfis.
5

• Examples of OBS activities.
• Fee income from specialized services, e.g.
• Investment services, as seen.
• Other investment bank services, e.g.issue of
  securities.
• Foreign exchange trades for customers.
• Fund management.
• Credit cards.

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• Examples of OBS activities , contd.
• Trading activities and risk management on own
  behalf, e.g.
• Foreign exchange dealings.
• Dealing in derivatives
• Financial futures, interest rate and exchange
  rate hedging, etc.
• Note Original purpose of derivatives, etc.
• Mitigate risk.
• But in fact ? massive speculation, including by
  banks.
• ? whole new range of management problems.

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• The principal-agent problem
• Agent / employee of bank
• Earns profits ? gets bonus.
• Makes losses ? bank has to cover for him/her.
• e.g. Barings employee Leeson 1992-5
• Lost bank 1.3 billion ? bank failed.
• Strategies to counter PA problem
• Separate trading from book-keeping (back room)
  activities.
• Chinese Wall between departments of same firm /
  separate capital accounts, etc.

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• Disintermediation.
• i.e. Intermediaries less dominant in credit
  market.
• Affects both sides of intermediation process
• Banks increasingly turn to other activities apart
  from intermediation, as seen.
• e.g. May provide investment services to companies
  to obtain best rate.
• gt Competing by lowering own ROA (i.e. competing
  on-BS).
• i.e. Switch to Off-Balance-Sheet / fee income.
• Companies may turn away from banks
• May get better loan rate from capital market.
• i.e. direct finance gt indirect / mediated
  through bank.

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• Banks and nbfis boundaries less distinct.
• BUT particular significance for the economy
• Payments system.
• Sheer scale.
• Money creation process, etc.
• ? Heavy regulation.
• Equivalently, ? further (interconnected) basic
  principles of bank management
• Find ways to evade regulations (loophole
  mining).
• ? Keep up with innovations.

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ECON7003 Money and Banking. Hugh
GoodacreLecture 5.THE CHANGING CHARACTER
OFBANK MANAGEMENT
Effects of 1. Deregulation. 2. Innovation. 3.
Globalisation.
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Conventional / traditional / mono-tasking Depos
its in, loans out. Remains basic. BUT no longer
the only or even main source of profit. Now
multi-tasking / evolution in face of Increased
competition, both from within banking sector and
from nbfis. ? Restructuring of sector Diversific
ation of activities. Increased efficiency (or
ingenuity??). Absorption (??) of greater risk.
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Three interconnected trends in
particular Deregulation. Innovation. Globalisatio
n.
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• 1. Deregulation.
• Contradictory situation
• Concern for stability of financial sector
• Prudential controls.
• Countering loophole mining, etc.
• ? Trend to tighten regulation.
• Competition issues
• ? aim to allow banks greater freedom.
• ? Trend to deregulation!

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• Two strands of deregulation
• Removal of government restrictions.
• Removal of self-regulatory restrictions.
• i.e. Established from within banking / financial
  sector itself
• e.g. Agreements among building societies on
  interest rates, etc.

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Three phases of deregulation. Note Not same
timing or even sequence in different
countries (i) Decisive blow to traditional
framework. (ii) Ending sharp distinction
between banks and nbfis. (iii) Allowing
increased competition within financial sector and
from outside it.
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• Deregulation Phase (i) Decisive blow to
  traditional framework.
• Ending traditional / mono-tasking structure
  of sector.
• Asset side Lifting quantitative controls on
  banks assets.
• Liabilities side Lifting ceilings on interest
  rates on deposits.

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• UK
• Began early
• Competition and Credit Control, 1971.
• Lifted credit restrictions.
• Associated with very loose monetary policy /
  Barber boom.
• Subsequent backsliding corset deposits at
  BoE to restrain growth of MS.
• But by early 1980s all exchange and credit
  controls ended.

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US Regulation Q (imposed in 1933) Limited
interest rate payable on deposits. Not lifted
till 1982. Note Traumatic effects of 1930s US
bank failures. ? Deregulation came later than in
UK. Very significant effects on international
finance.
19
Variable rate lending. 1970s Volatile interest
rates. Inflation. ? Banks increasingly allowed
to issue variable rate loans. e.g. Linked to
LIBOR (London Inter-Bank Offer Rate). gt Stuck
with unprofitable loan rate.
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Variable rate lending ? Stock of loans could
become determined by demand. Near-horizontal
credit supply curve! ? Banks could now
liability-manage. ? Great expansion of banks
balance sheets. Also Reduction in CapitalAsset
ratios. Exposure to greater risk.
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• From asset management to liability management.
• Asset management of post-war decades
• Large public sector (war) debt.
• Readily tradable.
• Quantitative controls ? traditional situation
  maintained
• Liabilities side Largely passive supply /
  customers deposits.
• Assets side Active adjustment of balance
  sheets.

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From asset management to liability management,
contd From 1970s Banks actively create
liabilities / borrow from other banks / money
markets, as seen. Preview of globalisation UK
CCC but US maintained Q ? impelled move of US
banks into Eurodollar market.
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Deregulation Phase (ii) Ending sharp distinction
between banks and nbfis. UK Banks and building
societies 1980s banks allowed to compete in
mortgage market. 1986 building societies allowed
to compete in market for consumer credit. i.e.
both allowed to compete in each others
markets. US Once again, much restrictive
legislation of 1930s remained in force till
late, but 1980s some competition with thrifts
allowed. 1999 banks allowed more freedom to
compete in investment banking, insurance, etc.
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Deregulation Phase (iii) Allowing increased
competition within financial sector and from
outside it. Within financial sector nbfis ? new
kinds of financial services. e.g. online banking
Egg, etc. ? new kinds of nbfis competing with
traditional banking. Firms from outside
financial sector enter financial services
market UK Tesco, Marks and Spencer, Virgin,
etc. US Not only retail firms but also
industrial e.g. General Motors. General
Electrics financial arm ? 1/3 of its revenue!