Overview of Banking Intermediaries 2024-2025 PDF

Empirical Banking Overview of Banking Intermediaries Stefano Caiazza 2024-2025  Definitions A bank is an institution whose current operations consist of granting loans and receiving deposits from the public. Commercial banks...

Empirical Banking Overview of Banking Intermediaries Stefano Caiazza 2024-2025  Definitions A bank is an institution whose current operations consist of granting loans and receiving deposits from the public. Commercial banks Wholesale banking services (liquidity and payment services to a large customer, i.e., big corporations and Governments) Retail banking services offered to small business Investment banks Raise capital for large corporations and Governments by acting as underwriters for corporate and Government securities Arrange mergers and acquisitions (M&As) Trading Consultancy Global custody  Balance sheet ASSETS LIABILITIES Reserve and cash Transaction Deposits (checkable accounts) Required (legal) reserve Demand Deposits (non-interest-bearing) Negotiable Order of Withdrawal (NOW - interest bearing) Excess reserve Money Market Deposits (MMD – limited checks, interest, Securities no reserve requirements) Government and Agency Bonds State and local Government Bonds Non Transaction Deposits Corporate Bonds Saving Deposits Loans Time Deposits Commercial and Industrial Borrowings Real Estate (residential and commercial mortgages) Interbank loans (Federal Funds Market) Consumer (credit cards, automobile loans) Bonds Interbank loans Repurchase Agreements (Repo) Other Assets (physical capital) Capital  Unicredit Reclassified consolidated balance sheet (€ million)  Unicredit Reclassified consolidated Income Statement (€ million)  Basic Bank Suppose you open an account at First National Bank (FNB) Vault cash: Cash kept on hand in a depository institution's vault to meet day-to-day business needs, such as cashing checks for customers; Vault cash is one of two assets legally qualifying as bank reserves and used to back up deposits. The other is the Federal Reserve Deposit. Since vault cash is also part of the bank’s reserves: If you opened the account at the FNB with a check written on an account at another bank:  PAST Basic Bank If the required (legal) reserve is equal to 10% of deposits Interest rate on reserves (US) https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm In normal conditions, banks lend reserves to get higher interest rates  FED & ECB FED ECB requires banks to hold a minimum of 1% of specific liabilities, mainly customer deposits, at their national central bank. Until October 2022 the rate of interest paid was tied to the interest rate on the main refinancing operations. It was then reduced to reflect the deposit facility rate, before being set at 0% in July 2023. all funds on banks’ current accounts that exceed the minimum reserve requirements are remunerated at 0% when the deposit facility rate is above 0%, and at the deposit facility rate when it is below 0%. https://www.ecb.europa.eu/press/pr/date/2023/html/ecb.pr230727~7206e9aa48.en.html  Basic Bank – Liquidity Managements Suppose that the First National Bank’s initial balance sheet is as follows… If it suffers of $10 million deposit outflow Required reserves are now 10% of $90 million ($9 million), so its reserves still exceed this amount by $1 million. In short, if a bank has ample reserves, a deposit outflow does not necessitate changes in other parts of its balance sheet. Suppose that the First National Bank’s initial balance sheet is as follows… If it suffers of $10 million deposit outflow The bank has a problem: It has a reserve requirement of 10% of $90 million, or $9 million, but it has no reserves! To eliminate this shortfall, the bank has four basic options. 1) FNB borrows reserves from other banks in the Federal Funds market or from corporations (selling certificate of deposit) The cost of this activity is the interest rate on these borrowings, such as the Federal Funds rate. https://www.newyorkfed.org/markets/reference-rates/effr https://www.ecb.europa.eu/stats/financial_markets_and_interest_rates/euro_short-term_rate/html/index.en.html  Basic Bank – Liquidity Managements 2) FNB can increase required reserves by selling some of its securities The bank incurs transaction costs when it sells these securities. Government securities are very liquid, so the transaction costs of selling them are pretty modest. However, for other securities, the transaction cost can be appreciably higher. 3) FNB can borrow reserves from the Central Bank The cost associated with discount loans is the interest rate that must be paid to the Fed (the discount rate). https://www.frbdiscountwindow.org/ https://www.ecb.europa.eu/home/html/index.en.html 4) FNB can reduce its loan by the corresponding amount The costly way to «acquire» reserves Excess reserves are insurance against the costs associated with deposit outflows. The higher the costs, the more excess reserves banks want to hold.  9 August 2007 Collapse of Lehman Brothers Euro-zone: Bank deposits with ECB 15 September 2008  Functions of Bank Intermediaries Monetary function: Banks create money - Payment Systems (Target2 in the Euro area and Fedwire in the US). Credit function: Banks intermediate between surplus and deficit agents. Financial function: Banks operate in the financial markets on behalf of clients and their accounts. Service function: Banks offer services to customers (households and companies).  Monetary Function What is money? Money is what money does (sir John Hicks) What does money do? Money, whatever its form, has three different functions: Unit of account for pricing goods Medium of exchange for buying goods Store of value for saving The nature of money has evolved over time Commodity money is an object made of something that has a market value, such as a gold coin. Fiat money – that is declared legal tender and issued by a Central bank but has no intrinsic value and can not be converted into gold. Representative money – consisted of paper checks and other non-physical forms of currency representing the intent to pay. Present-day currency can also exist independently of a physical representation. Money can exist in a bank account in the form of a computer entry or stored in the form of a savings account. 1929-1963 1947-1953 1974-1982  Monetary aggregates Monetary aggregates are compiled by Central Banks based on surveys of monetary and financial institutions; they measure the amount of money circulating in an economy. ECB Definitions: M1 is the sum of currency in circulation and overnight deposits. M2 is the sum of M1, deposits with an agreed maturity of up to two years, and deposits redeemable at notice of up to three months. M3 is the sum of M2, repurchase agreements (REPO), money market fund shares, and debt securities with a maturity of up to two years. Monetary aggregates in the Euro area October 2024 – EUR billions https://www.ecb.europa.eu/pub/economic-bulletin/html/index.en.html  Banks and creation of money The most simple money multiplier described in textbooks links reservable deposits to bank reserves according to the following equation: 1 1) ∆D = ∆R β ∆R refers to changes in legal reserves, ∆D refers to changes in reservable deposits, β is the required reserves ratio, and 1/β is the deposit multiplier. We could think of equation 1) in terms of Monetary Base (MB). What is the monetary base? It is the sum of currencies and reserves. Is it possible to derive equation 1)?  Deposits multiplier Suppose a new bank receives 100 Euros in cash to open a new deposit and that legal reserve (LR) coefficient is 2% (β=2%). From the balance-sheet point of view, this operation increases deposit (liabilities) and vault cash (assets) that is a part of the bank’s reserves Numerical Procedure Formal procedure Time Deposits LR (2%) Loans (L) Deposits LR Loans (L) Loans (L) t1 100 2 98 MB B (1-B)MB (1-B)MB t2 98 1,96 96,04 (1-B)MB B[(1-B)MB] [(1-B)MB](1-B) (1-B)2MB t3 96,04 1,92 94,12 (1-B)2MB B(1-B)2MB [(1-B)2 MB ] (1-B) (1-B)3MB t4 94,12 1,88 92,24 (1-B)3MB B(1-B)3MB [(1-B)3 MB ] (1-B) (1-B)4MB …….. tn 5000 100 4900 (1-B)n-1MB B(1-B)n-1MB [(1-B)n-1 BM ](1-B) (1-B)n MB 1 1− β D= MB L= MB β β  Formal Demonstration of Deposits Multiplier 2) D = MB + MB (1 − β ) + MB (1 − β ) 2 +...... + MB (1 − β ) n −1 Multiply 2) by (1 − β ) 3) D(1 − β ) = MB(1 − β ) + MB(1 − β ) 2 +...... + MB(1 − β ) n Subtracting 2) from 3) 4) D − D(1 − β ) = MB − MB(1 − β ) n MB − MB (1 − β ) n 5) D = β Since for n→∞ the limit of MB (1 − β ) shrinks to zero n 1 6) D = MB β 20  Schumpeter’s contribution Schumpeter states that the nature of bank deposits is different from deposits whose object is tangible assets: The receipt issued by the holder of the baggage deposit entitles the owner to return the bag but does not replace the asset. The person who deposits the bag then renounces using the same until the return time. The receipt issued by the bank is a perfect substitute for the legal currency, i.e., it can be used as a means of payment just like the legal currency. The bank, therefore, creates money because the depositor (the creditor) does not give up using cash since he can make payments using the receipt obtained from the bank, i.e., transferring the credit towards the bank and, at the same time, also the borrower (financed by the bank) can spend money.  Payment System Banks require a system for processing debts and credits arising from these banking transactions. The payment system is a byproduct of intermediation and facilitates the transfer of ownership claims in the financial sector. The settlement system can be: Bilateral: each bank holds a deposit in each of the other banks. Multilateral: The deposits are collected at a single institution. The institution that manages the regulation becomes the “Bank of banks". The multilateral regulatory system can take place: Gross regulation: each transaction is processed individually Net regulation: transactions are regulated at the same moment (usually at the end of the day), and funds are transferred on a net basis. Liquidity service but multiple default risk.  Credit Function This is the typical and traditional function of banks: the core activity is to act as intermediaries between depositors and borrowers. Banks support asset allocations: Among agents: Banks transform the relationship between creditors and debtors from bilateral to multilateral. Spatial transformation: Links local financial needs to global financial circuits. Through time: maturity transformation facilitates short-term investments (families) with long-term needs (firms). Risk: Originate-to-distribute. Banks play a crucial role in Monetary Policy Transmission, the process through which monetary policy decisions affect the economy in general and the price level. The transmission mechanism is characterized by long, variable, and uncertain time lags. Transmission mechanism of monetary policy Source: ECB: https://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html  Interest Rate Channel iOFF = Official interest rate (CB) iINT.BNK = interbank interest rate iMKT = market interest rate iBNK = loans interest rate I = Investments 1) Selling Securities C = Consumption 2) Decreasing of Loans AD = Aggregate Demand 𝑃𝑃̇ = 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝐼𝐼 𝑣𝑣𝑣𝑣𝑃𝑃𝑃𝑃𝑣𝑣𝑣𝑣𝑃𝑃𝑣𝑣𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑣𝑣𝑣𝑣𝑃𝑃𝑣𝑣𝐼𝐼 𝑄𝑄̇ = 𝑅𝑅𝐼𝐼𝑣𝑣𝐼𝐼 𝑂𝑂𝑂𝑂𝑣𝑣𝑂𝑂𝑂𝑂𝑣𝑣 𝑣𝑣𝑣𝑣𝑃𝑃𝑃𝑃𝑣𝑣𝑣𝑣𝑃𝑃𝑣𝑣𝐼𝐼 > Liquidity Financial System. OFF INT.BNK i MKT ↑ I↓ P↓ i ↑→ i ↑→ → → AD ↓→ i BNK ↑ C ↓. Q↓  Interest Rate Channel Suppose the Central Bank implements a restrictive monetary policy to reduce inflation by raising official interest rates. The effects are as follows: 1) Interest rates on the interbank market increase. Since the price that each bank must pay to the Central Bank has increased to obtain liquidity (reserves), intermediaries will increase the interest rate applied to the loan of reserves offered to other banks in the interbank market. 2) The rise in interest rates on interbank loans encourages banks to call back liquid funds to avoid financing themselves on unfavorable terms. This can happen, for example, by selling part of the securities in their portfolio or by reducing loans to financial operators under repo operations. The sale of securities by banks tends, with equal demand for securities, to reduce their price and raise market interest rates (the reciprocal of the price of securities). At the same time, the slowdown in trade on the Stock Exchange, caused by the contraction in loans to financial operators and the fall in the value of securities that operators offer as collateral to banks against such loans, promotes the decrease in stock prices.  Interest Rate Channel 3) The rise in market rates has, as a further effect, encouraged banks to raise interest rates on loans to pass on to customers the higher cost of bank reserves and capital losses caused by the fall in the price of securities remaining in the banks' portfolio. 4) The rise in interest rates is driving firms to postpone investment decisions and households to postpone purchasing credit-based durable and leisure goods. In addition, households will find it convenient to postpone current consumption by investing in the financial market (neoclassical consumption theory: Fisher’s intertemporal consumption model). 5) The decrease in consumption and investment leads to a fall in aggregate demand. 6) The fall in aggregate demand, caused by lower investment and consumption expenditure, facilitates a slowdown in the inflation rate and real GDP growth. Which of the two effects will prevail over the other depends on the inclination of the aggregate and supply curve.  Bank Loan Channel Liq = Liquidity β = Coefficient of Legal Reserve LR = Legal Reserve ER = Excess Reserve D = Deposits Banking Sector L = Loans. I = Investments I↓ P↓ C = Consumption Liq ↓→ ER ↑→ D ↓→ L ↓→ → AD ↓→ AD = Aggregate Demand 𝑃𝑃̇ = 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝐼𝐼 𝑣𝑣𝑣𝑣𝑃𝑃𝑃𝑃𝑣𝑣𝑣𝑣𝑃𝑃𝑣𝑣𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝑣𝑣𝑣𝑣𝑃𝑃𝑣𝑣𝐼𝐼 C↓. 𝑄𝑄̇ = 𝑅𝑅𝐼𝐼𝑣𝑣𝐼𝐼 𝑂𝑂𝑂𝑂𝑣𝑣𝑂𝑂𝑂𝑂𝑣𝑣 𝑣𝑣𝑣𝑣𝑃𝑃𝑃𝑃𝑣𝑣𝑣𝑣𝑃𝑃𝑣𝑣𝐼𝐼 Q↓ Banking Sector. I↓ P↓ β ↑→ LR ↑→ D ↓→ L ↓→ → AD ↓→ C↓. Q↓  Bank Loan Channel Suppose the Central Bank implements a restrictive monetary policy to reduce the inflation rate by a decrease in the Monetary Base (reserves) or through an increase in the legal reserve ratio, β. The effects are as follows: 1) The decrease in reserves leads the bank to increase them (to reach the desired level) and reduces banks’ propensity to offer loans. The same result shall be achieved by an increase in the legal reserve ratio (β), leading to a rise in the minimum required reserve. 2) The reduced propensity to lend money to the economy implies a reduction in loans and a corresponding decrease in deposits. 3) Less lending means lower corporate investment expenditure and lower household credit-based consumption expenditure. 4) The reduction in consumption and investment leads to a fall in aggregate demand. 5) The decline in aggregate demand facilitates a slowdown in the inflation rate and real GDP growth. Which of the two effects will prevail over the other depends on the inclination of the aggregate and supply curve.  Credit Function This is the typical and traditional function of banks: the core activity is to act as intermediaries between depositors and borrowers. Banks support asset allocations: Among agents: Banks transform the relationship between creditors and debtors from bilateral to multilateral. Spatial transformation linking local financial needs to global financial circuits. Through time: maturity transformation allows to facilitate of short-term investments (families) with long- term needs (firms). Risk: Originate-to-distribute. Banks play a crucial role in Monetary Policy Transmission, the process through which monetary policy decisions affect the economy in general and the price level. The transmission mechanism is characterized by long, variable, and uncertain time lags.  From originate-to-hold to originate-to-distribute In traditional banking, banks originate credits and hold them on their balance sheet until maturity. It was costly because of the impossibility of selling loans and investing in other more profitable assets. Over time, however, banks began to replace the originate-to-hold model with the originate-to- distribute model, whereby they originate a credit and sell a portion of it at the time of origination or later. So, a non-marketable asset (loan) is transformed into a marketable asset with desired maturities, returns, and risk profiles. Pay attention: Banks transfer the cash flow of loans, i.e., return and risk. Originate-to- distribute transfers risk among banks.  Originate-to-distribute PROS: Originate-to-distribute model complete markets. New assets with different return-risk combinations are available in the financial market. More agents, excluded before, could receive loans. Less regulatory capital absorbing. For the individual bank, it reduces the risk and allows portfolio diversification. CONS: Incentives based on quantity rather than the quality of loans: revenues related to the number of operations. Few incentives to monitor the originator’s credit risk. Leverage multiplier effect. For the whole banking system, it increases risk because it concentrates it.  Advertising of a subprime mortgage NINJA People: No Income No Job Or Assets Many features of typical subprime loans, including prepayment penalties, balloon payments, low or no documentation, and variable interest rates, particularly in combination, have increased the risk of foreclosure. Financial Function - Structured Finance  Capital Share Capital: Funds raised by issuing common and preferred shares. Shareholder’s Equity: Total Assets – Total Debts. Market Value of Equity: Market value of all outstanding shares. It is a cushion against a drop in the value of assets, which could force the corporation into insolvency. From a financial point of view, it represents the source of internal financing (internal finance). Shareholders and management decide the level of shareholder’s equity and whether to increase its level (capital adequacy management). High level of capital Benefit: Prevents insolvency Cost: Rate of return A trade-off between safety and return  Capital and Returns Let’s consider two banks with identical balance sheets except that capital EM=10 (100/10) EM=25 (100/4) IF ROA=1% THEN ROE=10% IF ROA=1% THEN ROE=25% EM ≡ Equity multipliers Suppose that both banks deal with $5 million of Non Performing Loans (NPLs) Low Capital Bank is insolvent Given the Return on Assets, the lower the bank capital, the higher the return for the shareholders.  Regulatory Capital Two major international bank failures in 1974, Bankhaus Herstatt and Franklin National Bank. Bankhaus Herstatt was an average size West German bank with problems settling foreign currency transactions. Franklin National Bank was the twentieth US bank got default. A standing Committee of Bank Supervisory Authorities from the G-10 countries (Belgium, Canada, France, Germany, Italy, Japan, The Netherlands, Sweden, The UK, and The US) plus Luxembourg and Switzerland is set up. It has a permanent secretariat based at the Bank for International Settlements (BIS) in Basel. The 1988 Basel Accord established a single set of capital adequacy standards for international banks of participating countries in January 1993.  Basel I Basel 1 requires all international banks to set aside capital based on the (Basel) risk assets ratio: regulatory capital (Tier 1 + Tier 2) Basel risk assets ratio = ≥ 8% weighted risk assets Assets ( weighted by credit type) Tier 1 ≥ 4% weighted risk assets Tier 1 capital: common equity shares, disclosed reserves, non-cumulative preferred stock, retained earnings. Tier 2 or supplementary capital: consisting of all other capital such as cumulative perpetual preferred stock, revaluation reserves, general loan loss reserves, hybrid debt instruments (e.g., convertible bonds, cumulative preference shares), and subordinated debt (e.g., convertible bonds, cumulative preference shares).  Basel I Risk weights are assigned to assets by credit type. The more creditworthy the asset, the lower the risk weight. 0%: cash, gold, bonds issued by OECD governments. 20%: bonds issued by agencies of OECD governments, local (municipal) governments, and insured mortgages. 50%: uninsured mortgages. 100%: all corporate loans and claims by non-OECD banks or government debt, equity, and property.  Basel II In response to criticism of the 1988 Accord, several changes were made, culminating in the 2001 proposal. Three Pillars approach  Basel II Under Pillar 1, the new minimum capital requirements (CR) have to be worked out as follows: CR ≥ CR(mr)+ CR(or) +CR(cr) Summary of Approaches  Basel III Basel III is a comprehensive set of reform measures in banking prudential regulation developed by the Basel Committee on Banking Supervision to strengthen the banking sector's regulation, supervision, and risk management. These measures aim to: Improve the banking sector's ability to absorb financial and economic stress shocks, whatever the source. Improve risk management and governance. Strengthen banks' transparency and disclosures.  Capital 14 – Basel III https://www.fsb.org/wp-content/uploads/P271021.pdf#page=34 https://www.bis.org/bcbs/publ/d525.pdf  Global Systemically Important Banks (G-SIBs) During the financial crisis that started in 2007, the failure or impairment of several large, globally active financial institutions sent shocks through the financial system, which, in turn, harmed the real economy. Five indicators: Cross-jurisdictional activity Size Interconnectedness Substitutability Complexity G-SIBs are allocated into five equally sized buckets Each bucket is associated with a different additional Common Equity Tier 1 capital requirement, ranging from 3.5% to 1.0%. Scores and buckets G-SIBs as of November 2023 G-SIBs as of November 2022  Basel IV In contrast to Basel III, whose changes were predominantly aimed at increasing the quality and quantity of capital and liquidity and thus the numerator of the regulatory capital ratio, Basel IV focuses on the denominator of the capital ratio - the measurement of a bank's risk positions, especially in credit, market, counterparty and operational risk under Pillar 1. The new rules aim to limit the influence or use of internal models and to ensure more uniform and, thus, more comparable procedures through more standardization. European credit institutions have often used Internal Models to contain capital provisions to an extent that is not always consistent with the real risk profile. The main feature of the reform is the introduction of a parameter called output floor that limits the occurrence of excessive reductions in defining the capital requirements of banks. Therefore, the amount of the different RWA obtained with the application of the Internal Models cannot be less than 72.5% (output floor) of that calculated using the Standard approach. The prudential regulation provides for a gradual application of the output floor amount for a transitional period: 50% in 2025, 55% in 2026, 60% in 2027, 65% in 2028, and an output floor of 70% for the year 2028.  Basel IV A New Standard Model to measure credit risk to improve it in different contexts (i.e., firms without rating, …) Update the Internal Model for credit risk (i.e., the use of LGD, PD, EAD parameters must not be lower than specific pre-established minimum values ​(output floor), …). A new Standard Model has been designated as the only method for assessing operational risks, as the Basel Committee decided to eliminate all previous Standard and Advanced approaches. The new Standard Model defines that the amount of own funds to be set aside to deal with operational risks will be determined by multiplying the following two parameters: BIC, Business Indicator Component which represents the sum of the various banking revenues; ILC, Internal Loss Multiplier which takes into account the amount of operating losses recorded in the last ten years. Market Risk Models are revisited. Each bank will have to prepare periodic reports that evaluate the risks connected to the ESG context and those related to Crypto-assets. Only subsequently will specific provisions be issued to quantify the related funds.  Basel IV It is expected that: The set of 157 European banks analyzed by the EBA will have to strengthen their core capital level by approximately 600 million Euros at an aggregate level, corresponding to an estimated average increase for Tier 1 of 12.6%. The subset of 58 large international banks will have to implement Tier 1 by 13.3% on average. This impact is mainly conditioned by the application of the output floor and the adoption of the new standard approach for operational risk. The subset of the other 99 medium-sized banks is mainly influenced by the update of the RWA parameters of credit risk and the application of the output floor. Therefore, Tier 1 will have to be strengthened by 8.9% on average for this category. European banks in particular are strongly affected by these changes, as many make extensive use of internal models and their exposure is often heavily concentrated in areas with lower risk weightings. These positions are held on the banks' balance sheets.