Introduction to Banking Lecture Notes PDF

Introduction to Banking Script Version 1.5, October 2024 Prof. Dr. Gregor Weiss Faculty of Management and Economics Chair in Sustainable Banking Gregor Weiss (UL) Banking 1 /...

Introduction to Banking Script Version 1.5, October 2024 Prof. Dr. Gregor Weiss Faculty of Management and Economics Chair in Sustainable Banking Gregor Weiss (UL) Banking 1 / 678 Outline 0 Course organization 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 2 / 678 Outline 0 Course organization 0.1 General information 0.2 Erasmus students 0.3 E-learning 0.4 Textbook 0.5 Objectives of the lecture 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 3 / 678 General Information I Weekly hours: 3 hours (2 hours lecture + 1 Elearning content via Moodle). Optional/elective course in the B.Sc. Economics. Credits: 5 ECTS. Assessment: Electronic exam (60 min), ßingle choice”. Gregor Weiss (UL) Banking 4 / 678 General Information II Class information as well as the E-Learning course can be found in the Moodle-course. All lectures are recorded and uploaded on YouTube. If you have any questions about the course’s content, please contact lehre.banken - at - wifa.uni-leipzig.de Consultation Consultation hour: Tuedays, 13:30-14:30, by prior appointment! Ñ Contact Mrs. Schlothmann via banken - at - wifa.uni-leipzig.de for scheduling an appointment. Gregor Weiss (UL) Banking 5 / 678 Erasmus students / Exchange students Exchange students (Erasmus/non-E.U.) can register for the course and take the regular exam at the end of the semester to earn the 5 ECTS. Please make sure that you are properly enrolled in the course. If you are not, you may be refused entrance to the exam! The resit exam is at the end of the summer term, so if you fail the exam, you will only be able to earn the credits in the summer term. Important: There will be no Erasmus paper in this course. Your only chance is the re-sit exam in the summer term. Erasmus Contact at the Faculty For any further question in the context of Erasmus, please contact Dr. Maik Pradel (pradel - at - wifa.uni-leipzig.de). Gregor Weiss (UL) Banking 6 / 678 E-learning I Per week: E-learning component (1 SWS) of the course will be available via Moodle The E-learning component of the course is relevant for the exam Gregor Weiss (UL) Banking 7 / 678 E-learning II Recorded lectures (Videos will be uploaded throughout the semester) Gregor Weiss (UL) Banking 8 / 678 E-learning III @jobsbankfin (mailing list for job advertisements) Gregor Weiss (UL) Banking 9 / 678 Textbook Bankpolitik Paul, S., Horsch, A., Kaltofen, D., Uhde, A. & Weiss, G. 1. Auflage, 2024 Schaeffer-Poeschel Verlag ISBN: 978-3-7910-4633-4 Gregor Weiss (UL) Banking 10 / 678 Objectives of the lecture Introduction to the basics of banking and discussion of the German banking system. Presentation of different theories for the existence of banks and their functions in a country’s economy. Discussion of the basic laws for the regulation and accounting of private banks. Analysis of selected international banking systems (USA, UK and Japan). Gregor Weiss (UL) Banking 11 / 678 Introduction and characteristics of the German banking sector Outline I 1 Introduction and characteristics of the German banking sector Definition of the term “bank” Functions of banks Commercial banking vs. investment banking Banks, BigTech, and FinTechs Characteristics of the German banking system 2 Explanation of the existence and functions of banks 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 12 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Outline I 1 Introduction and characteristics of the German banking sector Definition of the term “bank” Functions of banks Commercial banking vs. investment banking Banks, BigTech, and FinTechs Characteristics of the German banking system 2 Explanation of the existence and functions of banks 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 13 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 14 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “bank” I We first go over the definitions of the term “bank”. In general, banks are companies that take on deposits and grant loans. Obviously, this only applies to a subset of banks so that banks, in addition to the mere lending business, also often offer additional banking services. Banks have similar functions as financial markets and compete with them in a number of ways. We therefore first define the objectives and functions of financial markets: Financial markets A financial market is a market on which financial contracts are traded. Financial contracts represent claims to present or future payments. Gregor Weiss (UL) Banking 15 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “bank” II In simple terms, financial markets are the place, where lenders and borrowers meet. Knowing this, it becomes clear that banks and financial markets fulfill similar functions. In contrast to a trading platform (a financial market such as a stock exchange), a bank itself appears as a market participant. Financial intermediaries in the strict/broader sense In a strict sense, a financial intermediary is an institution that receives capital from lenders and passes it on to borrowers (for example banks, insurers, VC-funds, etc.). In a broader sense, a financial intermediary only makes trading financial contracts possible or easier (e.g., a stock exchange). Gregor Weiss (UL) Banking 16 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “bank” III Tasks of a financial intermediary Capital providers Capital seekers Real assets Equity Fixed assets Equity Financial assets Current assets Debt Bank Loans to capital seekers Savings and me deposits Bonds Financial and real assets Equity Assets: use of funds Liabilies: source of funds Source: own illustration, based on Hartmann-Wendels/Pfingsten/Weber (2007, p. 13). Gregor Weiss (UL) Banking 17 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “bank” IV Legal definition of the term “bank” In accordance with §1 Abs. 1 Satz 1 of the German Banking Act (Kreditwesengesetz, KWG) credit institutions are company which conduct banking business commercially or on a scale which requires commercially organized business operations. §1 Abs. 1 KWG (banking business) (1) Deposit business: acceptance of funds from others as deposits or unconditionally repayable funds from public, unless the claim to repayment is securitized1 in the form of bearer or order bonds2 , irrespective of whether or not interest is paid. 1 securitization=issuing of tradable securities from book claims or property rights). 2 In contrast to bearer bonds, order bonds are made out to the name of a specific creditor. They can be transferred by endorsement. Gregor Weiss (UL) Banking 18 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “bank” V §1 Abs. 1 KWG (banking operations) (1a) Pfandbrief business3 : comprises the business specified in §1 Abs. 1 Satz 2 German Pfandbrief Act (PfandBG). (2) Lending business: granting of money loans and acceptance credits4. (3) Discount business: purchase of bills of exchange and cheques. (4) Financial commission business: purchase and sale of financial instruments in the credit institution’s own name for the account of others. (5) Safe custody business: safe custody and administration of securities for the account of others. (6) Central Securities Depository: The activity as a central securities depository as defined in subsection (6), 3 Pfandbrief=interest-bearing security issued by a mortgage bank, next to the solvency of the issuing bank in case of insolvency there are also additional collaterals (e.g., mortgages, claims against the state, ship mortgages, etc.) 4 Hereby, a bank accepts the bill of exchange of its customer (the beneficiary of the bill of exchange is a creditor). Gregor Weiss (UL) Banking 19 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “bank” VI §1 Abs. 1 KWG (banking operations) (7) Business of loan acquisition: comprises specific types of revolving loans, the entering into a commitment to repurchase previously sold claims in respect of loans prior to their maturity. (8) Guarantee business: the assumption of sureties, guarantees and other warranties on behalf of others, for example granting of guarantees. (9) Cheque collection business, bill collection business and travellers’ cheque business. (10) Underwriting business: purchase of financial instruments at the credit institution’s own risk for placing in the market. (11) E-money-business: repealed. (12) Counterparty business: acting in the capacity of a central counterparty5 within the meaning of subsection (31). 5 intermediary that is installed as a contracting party between sellers and buyers at stock exchanges or some OTC trading venues for derivatives. Gregor Weiss (UL) Banking 20 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “bank” VII The terms bank, banker, and savings bank are legally protected by § 39, 40 KWG (an authorization of the BaFin6 to conduct banking business is necessary). The term credit union or “Volksbank” in German and savings and loan bank (Spar- und Darlehenskasse) may only be used by credit institutions operating in the legal form of a registered cooperative society belonging to an audit association. The term “savings bank” (Sparkasse) may only be used by public savings banks (and the so-called free or independent savings banks7 ) with authorization (§ 40 KWG). Also protected are the terms building society (Bausparkasse) and investment company by § 3 InvG. 6 Bundesanstalt für Finanzdienstleistungsaufsicht/Federal Financial Supervisory Authority in Bonn 7 There are currently 6 independent savings banks organized as public limited companies (AG) such as Hamburger Sparkasse AG and Bordesholmer Sparkasse AG Gregor Weiss (UL) Banking 21 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “bank” VIII In addition to credit institutions, the KWG also mentions financial service institutions and financial companies. Financial service institutions (Finanzdienstleistungsunternehmen) are companies which provide financial services to others commercially or on a scale which requires commercially organized business operations and which are not credit institutions. Gregor Weiss (UL) Banking 22 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “financial service institution” I Legal definition of the term “Financial service institution” Financial service institution are company which provide financial services to others commercially or on a scale which requires commercially organised business operations, and which are not credit institutions (§ 1 Abs. 1a Satz 1 German Banking Act). §1 Abs. 1a (financial service operations) Investment Brokerage Brokerage of transactions involving financial instruments. Investment Advice Providing personalized investment recommendations based on client circumstances. Operating multilateral trading facilities for financial instruments. Placement business Placement of financial instruments without firm underwriting commitments. Gregor Weiss (UL) Banking 23 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “financial service institution” II §1 Abs. 1a (financial service operations) Contract brokerage: Purchase and sale of financial instruments on behalf of third parties. Financial Portfolio Management: Management of individual portfolios with discretionary powers. Proprietary Trading Activities Continuous offering of purchase and sale of financial instruments using own capital (proprietary trading). Systematic internalization: frequent organized trading on own account outside regulated markets. Acquiring or disposing of financial instruments for own account as a service for others. High-frequency trading using latency-minimizing infrastructure and algorithmic order execution without human intervention. Gregor Weiss (UL) Banking 24 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “financial service institution” III §1 Abs. 1a (financial service operations) Third-country deposit brokerage: Brokerage of deposit transactions with non-EEA companies. Crypto custody business: Custody and management of crypto assets and private cryptographic keys. Foreign currency business: Trading in foreign notes and coins. Crypto securities register maintenance: Maintenance of crypto securities registers. Factoring and finance leases: Purchase of receivables through factoring and conclusion of finance leases. Investment management: Acquisition and sale of financial instruments for investors with discretionary powers outside of investment funds. Restricted custody business: Safekeeping and management of securities exclusively for alternative investment funds (AIF). Gregor Weiss (UL) Banking 25 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “financial company” I §1 Abs. 3 (financial companies) Financial company (or financial companies) are companies which are not credit institutions, investment management companies, or externally managed investment companies and whose principal activity involves activities listed in §1 Abs. 3 KWG: acquiring and holding ownership interests, acquiring pecuniary claims against payment, leasing contracts, trading in financial instruments for own account, advising others on investing in financial instruments, advising companies on capital structure, industrial strategy and related questions and, in the event of corporate M&A, advising the companies and tendering services arranging loans between credit institutions. Gregor Weiss (UL) Banking 26 / 678 Introduction and characteristics of the German banking sector Definition of the term “bank” Definition of the term “financial company” II Other types of financial companies (not all explicitly mentioned in the KWG) groups of institutions (§10a, 12 Abs. 2, 13b, 14, 25 Abs.2 KWG), financial holding companies and groups, mixed companies, providers of ancillary services (§1 Abs. 3c KWG), Bank assurance / Allfinanz (= insurer+bank). Gregor Weiss (UL) Banking 27 / 678 Introduction and characteristics of the German banking sector Functions of banks Outline I 1 Introduction and characteristics of the German banking sector Definition of the term “bank” Functions of banks Commercial banking vs. investment banking Banks, BigTech, and FinTechs Characteristics of the German banking system 2 Explanation of the existence and functions of banks 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 28 / 678 Introduction and characteristics of the German banking sector Functions of banks Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 29 / 678 Introduction and characteristics of the German banking sector Functions of banks Functions of banks I One way to define the term “bank” is to show in which ways financial intermediaries exceed financial markets in fulfilling market functions. Therefore, we take a look at the most important market functions (in particular of a financial market). Market functions A financial market has several important functions: coordination, allocation, and selection, lot size transformation, maturity transformation, and risk transformation. Gregor Weiss (UL) Banking 30 / 678 Introduction and characteristics of the German banking sector Functions of banks Functions of banks II Coordination Financial markets help to match lenders with borrowers and provide them with an opportunity to trade. Allocation Financial markets allow for the efficient allocation of scarce resources: “capital”/“funds”. Selection In some cases, access to financial markets is limited by certain regulations (e.g., selection by credit risk, qualification, etc.). Gregor Weiss (UL) Banking 31 / 678 Introduction and characteristics of the German banking sector Functions of banks Functions of banks III In addition to these three general market functions, banks also fulfill a few other important functions: Lot size transformation Banks match investments of different sizes (small savings deposits vs. big business or mortgage loans). Maturity transformation Banks match investments of different maturities (e.g., short-term savings deposits vs. long-term business or mortgage loans). Gregor Weiss (UL) Banking 32 / 678 Introduction and characteristics of the German banking sector Functions of banks Functions of banks IV Risk transformation Financial markets, especially banks, match lenders’ accepted risk in a financial contract with the tolerated risk of a financial contract (e.g., by reducing or dividing risk). Gregor Weiss (UL) Banking 33 / 678 Introduction and characteristics of the German banking sector Functions of banks Functions of banks V In addition to these “abstract” services for their customers, banks also fulfill important functions for the economy: Facilitating Payment Services: Banks provide the infrastructure for secure and efficient payment systems, enabling cashless transactions and the transfer of funds within the economy. Intermediating between Savers and Borrowers: Banks collect deposits from savers and lend these funds to individuals, businesses, and governments, providing liquidity within the economy. Creating Money: By issuing loans, banks expand the money supply through the creation of commercial bank money, which supports economic activity and growth. Gregor Weiss (UL) Banking 34 / 678 Introduction and characteristics of the German banking sector Commercial banking vs. investment banking Outline I 1 Introduction and characteristics of the German banking sector Definition of the term “bank” Functions of banks Commercial banking vs. investment banking Banks, BigTech, and FinTechs Characteristics of the German banking system 2 Explanation of the existence and functions of banks 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 35 / 678 Introduction and characteristics of the German banking sector Commercial banking vs. investment banking Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 36 / 678 Introduction and characteristics of the German banking sector Commercial banking vs. investment banking Commercial banking vs. investment banking I In addition to the KWG classification of banking services, another classification can be derived by roughly separating banking services (and therefore banks themselves) into so called commercial banking and investment banking. Commercial banking Commercial banking includes deposit-taking and lending as well as other services such as payment services. Investment banking, on the other hand, mostly consists of services related to securities. Investment banking Investment banking includes all services concerning (commercial) asset management, trading activities, and raising capital. Gregor Weiss (UL) Banking 37 / 678 Introduction and characteristics of the German banking sector Commercial banking vs. investment banking Commercial banking vs. investment banking II Investment bank An investment bank is a financial institution that helps their clients with: wealth management raising capital (e.g., by issuing new securities), and trading securities. In contrast to commercials banks, they do not take deposits. Gregor Weiss (UL) Banking 38 / 678 Introduction and characteristics of the German banking sector Commercial banking vs. investment banking Commercial banking vs. investment banking III The activities of an investment bank are usually associated with the buy- or sell-side of a financial market. This separation is important to help investors manage conflicts of interest (e. g. sell-side’s research may influence buy-side’s decisions) This separation is also often required by regulation to ensure transparency and fairness. Buy-side related activities: Engages in purchasing and investing large portions of securities for fund management, advises companies on investments, and securitizes and sells financial products to clients (e. g. insurers, asset managers, banks). Sell-side related activities: Involves creating, promoting, and selling traded securities to the public, securities trading, market-making (providing bid and ask prices to maintain liquidity), underwriting and marketing during IPOs,... Gregor Weiss (UL) Banking 39 / 678 Introduction and characteristics of the German banking sector Commercial banking vs. investment banking Commercial banking vs. investment banking IV Ultimately, the definition of a bank, given in the KWG, is a description of a universal bank’s activities, combining commercial and investment bank services. Whether or not a bank participates in commercial banking and/or investment banking depends on a bank’s business strategy and also national regulations (in Germany!). Depending on national regulations, banks operate either in a universal banking system or in a specialized banking system. Gregor Weiss (UL) Banking 40 / 678 Introduction and characteristics of the German banking sector Commercial banking vs. investment banking Commercial banking vs. investment banking V Universal banking system vs. specialized banking system A universal banking system consists of both universal banks and specialized banks. In general, one entity could provide all kind of services.8 However, in a specialized banking system, banking activities are limited to only one field of business (usually: commercial banking OR investment banking). 8 In Germany: so called Vollbanklizenz, i.e., Einlagenkreditinstitut. Gregor Weiss (UL) Banking 41 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Outline I 1 Introduction and characteristics of the German banking sector Definition of the term “bank” Functions of banks Commercial banking vs. investment banking Banks, BigTech, and FinTechs Characteristics of the German banking system 2 Explanation of the existence and functions of banks 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 42 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 43 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Four types of FinTechs Gregor Weiss (UL) Banking 44 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Examples of FinTechs Gregor Weiss (UL) Banking 45 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Comprehensive financial services N26: raised $775m in venture capital in 2021 and thereby increased the company’s value to ¿8bn. It is the first German “unicorn”9 Bunq: second largest neobank in the EU, completed largest Series A financing round in 2021 and became a “unicorn” with ¿193m, with a current enterprise value of over ¿1.6bn Tomorrow Bank: over ¿120k turnover in 2022, strong growth with a completely sustainable corporate concept, describe themselves as “zebras”10. 9 A unicorn is a start-up that has a valuation of more than $1bn or ¿, but is not (yet) traded on the stock exchange. 10 The term comes from a counter-movement to “unicorn”. It refers to companies aiming for both profitability and the improvement of society: Link Gregor Weiss (UL) Banking 46 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs An excursion: blockchain technology Also known as “distributed ledger technology” Blockchains Blockchains are “forgery-proof, distributed data structures in which transactions are logged in time sequence, traceable, unchangeable and mapped without a central authority.” (BaFin 2017) Ownership structures can thus be efficiently secured and regulated directly, as seamless and unalterable data recording creates the basis. Data is stored and backed up on every computer in the associated network. This increases the reliability and verifiability of the data for all parties involved (private or public) and is thus decentralised. Ñ As a result, there is no longer a centralised instance that can be attacked and manipulated. Gregor Weiss (UL) Banking 47 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Big Data and Big Techs I Big Tech Big Techs are large technology companies from the USA and China that have the highest market capitalisation in the world. Examples are Amazon, Apple, Meta, Alphabet, Alibaba and Tencent. Their core business is not financial products, but cloud, search or communication services or e-commerce, but they are also taking over more and more financial services. Examples of Big Tech with Banking Licenses in Germany Trade Republic received a full banking license from the EZB in 2023. Paypal (Europe) S.à.r.l. received a full banking license from the CSSF (Luxembourg Banking Authority) in 2007. Amazon Payment Europe S.C.A received a full banking license from the CSSF in 2010. Gregor Weiss (UL) Banking 48 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Big Tech and Big Data II Big Techs have four initial advantages when they enter the financial sector: 1 already have high-volume technical infrastructure, which means they can include financial add-ons in their product range at very low marginal costs 2 already have a large customer base; established trust can be utilised for the additional offerings through a reputation transfer 3 already have a large amount of data on their customers (big data), which makes it possible to develop targeted banking services 4 already have sufficient equity and the corresponding market value; this financial strength means that necessary investments in the banking business can be made without delay and economies of scale can be utilised Gregor Weiss (UL) Banking 49 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Digital Finance in the European Union Gregor Weiss (UL) Banking 50 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Open Banking Definition Open Banking refers to the practice of enabling secure interoperability in the banking ecosystem, allowing third-party financial service providers access to consumer banking, transaction, and other financial data through the use of APIs (Application Programming Interfaces). Key Elements: APIs: Standardized interfaces for data sharing. Customer Consent: Data is shared only with explicit customer approval. Third-Party Providers (TPPs): Fintechs or other entities providing services using bank data. Goal: Promote competition, innovation, and a more customer-centric approach in the financial industry. Gregor Weiss (UL) Banking 51 / 678 Introduction and characteristics of the German banking sector Banks, BigTech, and FinTechs Benefits and Risks of Open Banking Benefits: Enhanced Financial Services: More personalized financial products (e.g., budgeting apps). Increased Competition: Reduced barriers for new entrants (Fintechs). Better Customer Experience: Easier switching between banks, consolidated financial view. Risks: Data Security and Privacy: Potential for data breaches. Operational Risks: Integration issues between banks and TPPs. Regulatory Challenges: Compliance with data protection regulations (e.g., GDPR in the EU). Gregor Weiss (UL) Banking 52 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Outline I 1 Introduction and characteristics of the German banking sector Definition of the term “bank” Functions of banks Commercial banking vs. investment banking Banks, BigTech, and FinTechs Characteristics of the German banking system 2 Explanation of the existence and functions of banks 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 53 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 54 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system I The German banking system consists of universal banks and specialized banks. Universal banks cover: credit banks (private universal banks), savings banks (Sparkassen) and co-operative banks / credit unions. Specialty banks include various specialized credit institutions such as mortgage banks, investment companies, etc. Apart from these two groups of banks, the German banking system also includes the European Central Bank, the Deutsche Bundesbank, and the Federal Financial Supervisory Authority (BaFin). Gregor Weiss (UL) Banking 55 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system II Side note! The German banking system is a universal banking system! In principle, every credit institution is allowed to conduct any banking business. When specialty banks focus on certain activities it is for historical or business rather than legal reasons. Gregor Weiss (UL) Banking 56 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system III Gregor Weiss (UL) Banking 57 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system IV The supervision of German banks ECB and Deutsche Bundesbank in the ESCB „Bank of the banks“ Abroad (= liquidity provider); controlling money supply in accordance with the guidelines of the Economic and Monetary Union Universal banks Specialized banks Credit banks Mortgage banks Acceptance coperaons Subsidiaries of German Savings banks Investment companies banks (including branches) Special purpose credit instuons Co-operave banks/ credit unions Building sociees Federal Financial Supervisory Authority (BaFin) Supervision of compliance with KWG Source: own illustration, cf. Eilenberger, 2012 p. 31. Gregor Weiss (UL) Banking 58 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Private banks I In the following, we are going to discuss the three pillars of the banking sector in more detail. Private banks One aspect of private banks is that they are privately-owned. Usually shareholder-value maximization is their sole business objective, they trade under the legal form of a AG or a KGaA and often have their focus mainly on securities business and on investment banking. Gregor Weiss (UL) Banking 59 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Private banks II In Germany the following banks are private banks: The four major branch banks: Deutsche Bank, Commerzbank, Hypovereinsbank/Unicredit, Postbank (part of Deutsche Bank). Regionally operating German branch banks: e.g., National-Bank, Südwestbank. Internet banks: z.B. ING-DiBa, ComDirect, DKB. Private bankers (also: “banking houses”): Trade under the legal form of a general partnership (OHG) or a limited partnership (KG) and therefore always have at least one personally liable shareholder. In accordance with § 32 KWG, the owners of a banking house need a written permission from the BaFin for offering banking services. Establishing banking houses with a sole trader as their legal form has not been possible since 1976. Examples: Joh. Berenberg, Gossler & Co. (1590), Hauck & Aufhäuser Privatbankiers (1796), M. M. Warburg & Co (1798). Often banking houses offer services in the field of private banking/wealth management and investment banking.11 11 Private banking covers financial services for wealthy clients (usually ¡ 1 mio. EURO). Gregor Weiss (UL) Banking 60 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Private banks III In Germany the following are private banks (cont.): Foreign banks: On the one hand, these cover subsidiaries of foreign banks that operate their own branch networks in Germany. Examples for this are Banco Santander/Santander Bank and the Targobank (until 2008 Citigroup, since then Crédit Mutuel). On the other hand, the branches of foreign banks that only serve the original customers of these banks in Germany (e.g., ABN AMRO) also belong to the group of foreign banks. Private mortgage banks12 : e.g., Hypo Real Estate. Private building societies: for example BHW Bausparkasse. 12 A mortgage is a loan on real estate that is secured by a land charge (mortgage or land charge) and whose lending limit is up to 60% of the loan value or up to 50% of the market value of a property. Gregor Weiss (UL) Banking 61 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Private banks IV The interests of the German private banks are represented by the Federal Association of German Banks (Bundesverband deutscher Banken e.V.). This lobby group organizes the deposit protection for private banks through the Compensation Fund of German Banks (Entschädigungseinrichtung Deutscher Banken GmbH (EdB)) and the Deposit Protection Fund of the Association of German Banks (Einlagensicherungsfonds des Bundesverbandes Deutscher Banken). At the end of 2023, they had 155 members in total from the private bank sector in Germany as well as 29 extraordinary members (such as FinTechs and seven state associations). Gregor Weiss (UL) Banking 62 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Private banks V Extract from the annual report 2022 of Deutsche Bank AG Source: Deutsche Bank AG, annual report 2022, p. 205. Gregor Weiss (UL) Banking 63 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Private banks VI Extract from the annual report 2022 of Deutsche Bank AG Source: Deutsche Bank AG, annual report 2014, p. 206. Gregor Weiss (UL) Banking 64 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Private banks VII Extract from the annual report 2022 of Deutsche Bank AG Source: Deutsche Bank AG, annual report 2014, p. 206. Gregor Weiss (UL) Banking 65 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Public-sector banks I The second pillar of the German banking sector consists of the public-sector credit institutions: Public-sector banks Public-sector banks are typically held completely or mainly by the state. Normally the federation, a federal state, a municipality, an administrative union, or another public agency is the owner/responsible body of the bank, they owe their existence to specific public interests (for example to supply the population with payment services and loans), they often (but not always) have the legal form of a public agency institution (AöR, Anstalt des öffentlichen Rechts) and they restrict themselves a) to specific banking products and b) to services in their region. Gregor Weiss (UL) Banking 66 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Public-sector banks II In Germany, the following are public-sector banks (in 2023): the Deutsche Bundesbank, those belonging to the savings banks sector DekaBank Deutsche Girozentrale Landesbanken (5, state-owned regional banks: Helaba, BayernLB, Nord-LB, LBBW, Saar-LB) savings banks within the DSGV, (353) and independent savings banks (5, e.g., Haspa), public law real estate credit agencies (Grundkreditanstalten, 3), banks with special tasks (11), banks with special tasks with part concession (2), among them the KfW banking group and Landesbausparkassen (state-owned regional building societies, 5). Gregor Weiss (UL) Banking 67 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Public-sector banks III In 2023, there were in total 353 member entities in the ”Deutsche Sparkassen- und Giroverband”(separated into different kinds of institutes such as “Stadtsparkassen”, “Landessparkassen” etc.) and total assets of around 2.5 billion EURO. The institutional liability (Anstaltslast) and guarantor liability (Gewährträgerhaftung) were important for the public banking sector until 2005: Institutional liability (”Anstaltslast”) The principle of institutional liability includes securing the economic basis of the institution for the entire duration of its existence by the responsible body (e.g., a county or city). Guarantor liability (”Gewährträgerhaftung ) Guarantor liability is the direct claim of the creditors to the guarantor (again, usually a county or city). Gregor Weiss (UL) Banking 68 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Public-sector banks IV The institutional liability had priority over the guarantor liability. Institutional liability as well as guarantor liability practically lead to the missing loan default risk for public-sector banks. Because both created a considerable competitive advantage for these banks, both guaranties were abolished on the initiative of the EU commission. Gregor Weiss (UL) Banking 69 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Public-sector banks V Example: Haspa Source: Haspa annual report 2022 Gregor Weiss (UL) Banking 70 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system Public-sector banks VI Example: Haspa Source: Haspa annual report 2022 Gregor Weiss (UL) Banking 71 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The cooperative sector I The third pillar of the German banking sector consists of the cooperative banks (mutual banks/ credit unions): Cooperative credit institutions The feature common to this group of banks is that by establishing themselves they have committed to the promotion of the acquisition and business of its members (see also § 1 Cooperative Act (Genossenschaftsgesetz)). Characteristics of these banks are that: the liable equity capital consists of the members’ cooperative deposits (between 50 and 100 e), they usually only do regional business, they primarily grant loans (similar to savings banks) and they are organized as a registered cooperative company (e.G.). Gregor Weiss (UL) Banking 72 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The cooperative sector II The following banks belong to the cooperative banks in Germany (in 2023): the central group institute: DZ Bank which carries out central bank functions for the cooperative banks, the 697 Volks- and Raiffeisenbanken (credit cooperatives), approx. 11 Sparda banks, 13 PSD banks (pure retail banks), the specialized institutions offering special services to all member cooperatives (e.g., Union Investment, R+V insurance) and other banks (church-owned banks, ApoBank (pharmacists’/physicians’ cooperative), etc.). Gregor Weiss (UL) Banking 73 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system V The 10 biggest banks in Germany Total Assets Institute Employees (Mio. ¿) Deutsche Bank AG 1.323.993 82.969 DZ Bank AG 627.273 32.271 KfW Bankengruppe 550.962 7.734 Commerzbank AG 473.044 46.218 Unicredit Bank AG 312.112 11.815 Landesbank Baden-Württemberg 282.344 9.893 J.P. Morgan AG 281.415 1.287 Bayerische Landesbank 266.554 8.481 Landesbank Hessen-Thüringen 212.341 6.297 ING Holding Deutschland GmbH 181.897 6.191 Source: die-bank.de, 08/2022 Gregor Weiss (UL) Banking 74 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system VI Number of banks in Germany Number of Number of Banking Group institutes offices Large Private banks 3 0,23% 3.719 16,35% Other Private banks 240 18,17% 4.825 21,21% Landesbanken 6 0,45% 144 0,63% Savings banks 354 26,80% 7.326 32,21% Credit unions 718 54,35% 6.731 29,59% Universal banks (total) 1.321 100,00% 22.745 100,00% Source: Deutsche Bundesbank, 08/2023 Gregor Weiss (UL) Banking 75 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system VII Balance Sheet of German Universal Banks’ - Assets Assets Mio. ¿ In % Cash in hand 19.730,00 0,2 Balances with central banks 50.567,00 0,5 Treasury bills and treasury discount paper 7.974,00 0,1 Bills 224,00 0,0 Unsecuritised lending to banks 2.804.433,00 25,0 Unsecuritised lending to non-baks 4.176.696,00 37,2 Debt securities and other fixed interest securities 908.370,00 8,1 Shares and other variable yield securities 210.526,00 1,9 Participating interests 102.132,00 0,9 and shares in affiliated enterprises Fiduciary assets 41.070,00 0,4 Tangible asets and others 2.906.556,00 25,9 Total assets 11.228.278,0 100,0 Source: Deutsche Bundesbank, 08/2023 Gregor Weiss (UL) Banking 76 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system VIII Balance Sheet of German Universal Banks - Liabilities Liabilities Mio. ¿ In % Liabilities to banks 2.149.561,00 19,1 Liabilities to non-banks 4.978.328,00 44,3 Securitised debts 548.647,00 4,9 Fiduciary liabilities 41.070,00 0,4 Value adjustments 4.828,00 0,0 Provisions for liabilities and charges 68.973,00 0,6 Subordinated liabilities 92.907,00 0,8 Capital 581.295,00 5,2 Other liabilities 2.762.669,00 24,6 Total liabilities 11.228.278,0 100,0 Source: Deutsche Bundesbank, 08/2023 Gregor Weiss (UL) Banking 77 / 678 Introduction and characteristics of the German banking sector Characteristics of the German banking system The German banking system IX Business Structure of German Universal Banks Explanation: Commercial banks is a different term for ”Private banks”; Big banks refers to the largest German private banks Source: Deutsche Bundesbank, 08/2023 Gregor Weiss (UL) Banking 78 / 678 Explanation of the existence and functions of banks Outline I 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks Introduction Explanatory approaches Financial intermediation Overview of the functions of banks Financial and Bank services 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 79 / 678 Explanation of the existence and functions of banks Introduction Outline I 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks Introduction Explanatory approaches Financial intermediation Overview of the functions of banks Financial and Bank services 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 80 / 678 Explanation of the existence and functions of banks Introduction Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 81 / 678 Explanation of the existence and functions of banks Introduction Why do banks exist? In perfect markets, i.e., without transaction costs and information asymmetries, depositors/investors could channel their savings efficiently to investment projects by themselves. Ñ Banks would not exist. However, 1 Transaction costs (e.g., fixed costs of financial contracts and project monitoring) exist. Ñ Neoclassical approach 2 Information is not equally distributed. Ñ Information economics approach 3 Banks provide certain services (e.g., risk and maturity transformation, broker services) Gregor Weiss (UL) Banking 82 / 678 Explanation of the existence and functions of banks Explanatory approaches Outline I 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks Introduction Explanatory approaches Financial intermediation Overview of the functions of banks Financial and Bank services 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 83 / 678 Explanation of the existence and functions of banks Explanatory approaches Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 84 / 678 Explanation of the existence and functions of banks Explanatory approaches The neoclassical explanation: transaction costs A risk-averse lender (L) can increase her/his utility by increasing the number of projects she/he is investing in (risk diversification). However, it might be too costly to invest in a large number of projects because each financial contract is associated with costs. Financial intermediaries (FI ) can lower those transaction costs by 1 decreasing the number of transactions, 2 lowering the cost of each transaction through standardisation of financial contracts and monitoring, 3 profiting from economics of scale, i.e., if financial contracts have fixed costs, transactions costs increase less than proportionally to the financing volume. Ñ FI can lower transaction costs without reducing diversification. Gregor Weiss (UL) Banking 85 / 678 Explanation of the existence and functions of banks Explanatory approaches FI as service providers Providing information: credit rating and assessment, project evalution and monitoring. Other services: security trading, brokerage, financial trading (e.g., foreign exchange) and financial auctioning (e.g., security issuing), and most importantly being a financial producer (produces financial securities/contracts). In addition, they offer risky, long-term loans and accept risk-free, short-term deposits. Gregor Weiss (UL) Banking 86 / 678 Explanation of the existence and functions of banks Explanatory approaches Financial contracts and asymmetric information Asymmetric information Asymmetric information is present when one party of a transaction/contract possesses more information than the other party. If the better informed party can take advantage of its knowledge it may lead to various difficulties in negotiations or even prevent a transaction/contract in the first place. Eliminating problems associated with asymmetric information causes costs (e.g., financial contracts, project evaluation, and monitoring) These are equal to the difference between the best solution at symmetric information (first best solution) and asymmetric information (second best solution). Asymmetric information and financial contracts play a central role in banking theory. Gregor Weiss (UL) Banking 87 / 678 Explanation of the existence and functions of banks Explanatory approaches Financial contracts and cooperation Service (e.g., lending) and compensation (e.g., loan repayment or profit participation) do not take place at the same time. The design of financial contracts depends on the certainty of compensation, the information distribution and the risk-tolerance of lenders. 1 Under certainty and symmetric information interest conditions can be calculated with the internal rate of return. 2 Under uncertainty and symmetric information, the individual risk tolerance (e.g., being risk neutral or risk-averse) is required to formulate a financial contract. 3 For either case asymmetric information require special measures such as incentive compatible financial contracts monitoring because verification of project returns is not possible. Gregor Weiss (UL) Banking 88 / 678 Explanation of the existence and functions of banks Explanatory approaches The information economics explanation: information asymmetries I Information asymmetries can discourage two parties from entering a contract. FIs can reduce or eliminate information asymmetries, by 1 evaluating and monitoring projects and 2 formulating incentive compatible contracts. E.g., between entrepreneurs (E ) and capital providers L information asymmetries about the success (probability and amount of returns) of business projects exist. The costs of reducing those information asymmetries might be prohibitively high for each individual L. ÝÑ FIs gather information and provide information to all L for a fee. Gregor Weiss (UL) Banking 89 / 678 Explanation of the existence and functions of banks Explanatory approaches The information economics explanation: information asymmetries II Existence of a FI Therefore, the existence of a FI is beneficial for every party. The FI can amortize the costs of acquiring the information by selling the information repetitively. Each L reduces his monitoring cost by buying the information at a cheaper price. E is able to acquire the necessary funds for his project because the costs to gather information for L become bearable. Gregor Weiss (UL) Banking 90 / 678 Explanation of the existence and functions of banks Explanatory approaches The information economics explanation: information asymmetries III However, the information provision of the FI does not eliminate the asymmetric information problems because in this case both E and FI have more information than L. FI would be better of by either 1 saving the monitoring costs and selling fictional information or 2 cooperating with E : providing false information and sharing the returns of the project. ñ L can neither rely on information provided by FI nor by E. ñ The monitoring activity is not sufficient to explain the existence of FIs because the problems associated with information asymmetries still exist. ñ So how else can you alleviate information asymmetries and justify the existence of FIs? Gregor Weiss (UL) Banking 91 / 678 Explanation of the existence and functions of banks Financial intermediation Outline I 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks Introduction Explanatory approaches Financial intermediation Overview of the functions of banks Financial and Bank services 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 92 / 678 Explanation of the existence and functions of banks Financial intermediation Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 93 / 678 Explanation of the existence and functions of banks Financial intermediation 13 Diamond model – without FIs Setting: An entrepreneur (E ) has an investment project with uncertain outcome (ỹ ) and investment volume of 1 MU. E has no liquid funds and thus needs to raise capital from multiple lenders (L). Assumption/ Problem: Only E can observe the outcome of the investment project without costs (ex post information asymmetry). Without monitoring E would always report investment outcome y 0 to maximize his income. But: L would anticipate that, thus not providing any funding. Solutions: 1 Contracts including non-monetary punishments that incentivise E to report the true investment outcome 2 Project monitoring by L 13 Douglas W. Diamond, (1984): Financial Intermediation and Delegated Monitoring. In: Review of Economic Studies. Band 51, S. 393–414 Gregor Weiss (UL) Banking 94 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – without FIs: Concept of non-monetary punishments Concept of non-monetary punishments E.g. imprisonment, poor reputation, or loss of manpower in case of insolvency Punishments without transfer of assets, i.e., they hurt E (ex-post) but don’t benefit L. Give E ex-ante an incentive to meet the repayment terms (punctually and truthfully).a a Why are non-monetary punishments part of this model? If E does not meet the repayment terms, he does not have any assets which could be liquidated by L. Gregor Weiss (UL) Banking 95 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – without FIs: Optimal financial contract with penalty function I In this model the non-monetary penalty for E depends only on the repayment amount z py q because it’s the only observable variable for both E and L. Penalty function: Φpz py qq How does the optimal penalty function look like? It should provide incentives for E to meet the agreed terms of repayment. Optimal contract : Φ pz py qq max ph z py q, 0q h is the agreed repayment. It is the smallest amount E has to pay to L to not receive any non-monetary punishment. This contractual form is considered as a normal debt contract. Gregor Weiss (UL) Banking 96 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – without FIs: Optimal financial contract with penalty function II Optimal contract Optimal contract : Φ pz py qq max ph z py q, 0q h is the agreed repayment. It is the smallest amount E has to pay to L to not receive any non-monetary punishment.a Φ pz py qq is incentive compatible because E has no incentive to settle for less than h. Φ pz py qq is minimal, i.e. the non-monetary punishment is always exactly as much as the difference between the agreed payment and the actual payment z py q.b a Why? Due to the max argument of the function the punishment will always depend on the greater value of either h z py q or 0. b If the punishment would be less, then E would not have an incentive to pay back anything. Gregor Weiss (UL) Banking 97 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – without FIs: Optimal financial contract with penalty function III Amount of repayment E offers a repayment, which makes L choose the investment project over the risk free investment. To maximize his own earnings the repayment will make L indifferent between choosing between both alternatives. Expected repayment is then: Epz py qq R. z py q minph, y q: (aggregate) repayment to (all) L14 Gregor Weiss (UL) Banking 98 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – without FIs: Optimal financial contract with penalty function IV Thus, it follows: P py hq Epy | y hq P py ¥ hq h R Epz py qq. The expected value of z includes: 1 Partial repayment with probability P py hq and conditional expectation Epy | y hq. 2 Full repayment h with probability P py ¥ hq. h R = risk premium. In case of poor project earnings E is punished without any benefits for the L. Because all L are risk neutral they only consider the expected value of the project earnings and not the probability distribution. Independent of the probability of the investment success the expected repayment is always R. Gregor Weiss (UL) Banking 99 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – without FIs: Costs of a debt contract with penalty function First vs. second best solution First best solution (symmetric information): Epy q R; E 1 s profit is Epy q R. Second best solution (due to the ex post information asymmetry): A debt contract with penalty function Φ and a suitable h. E 1 s profit is Epy q h. The costs of asymmetry is the difference between the first best solution and the second best solution: h R. Gregor Weiss (UL) Banking 100 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – without FIs: Advantage of project monitoring Note: Penalties always reduce welfare (because the Ls do not benefit from N 1 s penalty). Therefore, it can be advantageous for E to allow all L to observe the project’s earnings. ñ Information asymmetries are eliminated. E must pay the monitoring cost c to every lender Ñ m lenders. Costs for monitoring: m c Conclusion: Diamond model without FIs The choice of the contract type depends on the respective contract costs: welfare decreasing penalty costs (h R) vs. monitoring costs (m c) Gregor Weiss (UL) Banking 101 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – with FIs: Preliminary thoughts Problem: Risky projects and a high requirement of lenders result in high costs in both cases presented above. Solution: Monitoring costs can be reduced by delegation to a single third party – the financial intermediary (FI ). A FI can be beneficial for E and L if it decreases the costs associated with the cooperation problem. Benchmark is the direct E –L–relationship But: Delegation to FI shifts the cooperation problem from E –L to FI –L. How can the new cooperation problem be solved? Ñ Diamond model with delegated monitoring Gregor Weiss (UL) Banking 102 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – with FIs: Cost reduction by delegated monitoring I Diversification Company 1 Capital provider 1 Financial intermediary Company n Capital provider n x m Diversicaon through investment in several projects Source: own illustration, according to Hartmann-Wendels/Pfingsten/Weber (2007, S. 126). Gregor Weiss (UL) Banking 103 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – with FIs: Cost reduction by delegated monitoring II FI takes over monitoring: Monitoring costs are reduced from m c to 1 c. Problem: Information asymmetry between FI and Ls. Delegation costs = necessary costs to solve the cooperation problem between FI and Ls. To justify the usefulness of an FI one has to show that despite the additional delegation costs total costs decrease. Model assumption: FI is risk neutral and does not own capital. Procedure: FI receives payments from Ls, finances project of E , gets a repayment from E , which FI transfers to Ls. Gregor Weiss (UL) Banking 104 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – with FIs: Cost reduction by delegated monitoring III Total costs of a FI : monitoring costs (c) of E + delegation costs (d) of Ls FI creates information symmetry. Direct investment by Ls into E 1 s project is now replaced by investment into “project FI”: same success probabilities and share of earnings. Reduction of the delegation costs by diversification: the FI finances projects of several Es. FI invests funds from m n Ls in n projects. Every L agrees on a debt contract with a penalty function with the FI. The total amount of repayments depends on the outcome/earnings of all projects. Gregor Weiss (UL) Banking 105 / 678 Explanation of the existence and functions of banks Financial intermediation Diamond model – with FIs: Cost reduction by delegated monitoring IV Through diversification the probability of a negative outcome of the whole “project FI” is lower because the project earnings are independent. ñ The repayment amount h the Ls are willing to accept and the welfare loss decreases. Conclusion of the Diamond model After diversification (i.e., d gets negligible) the existence of a FI is justified if c EpΦ pz py qqq, which holds in most cases. Gregor Weiss (UL) Banking 106 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Outline I 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks Introduction Explanatory approaches Financial intermediation Overview of the functions of banks Financial and Bank services 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 107 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 108 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Overview of the functions of banks I Coordination: Financial markets help to match lenders with borrowers and provide them with an opportunity to trade. Allocation: Financial markets allow for the efficient allocation of the scarce resource: “funds/capital”. Selection: In some cases access to financial markets is limited by certain regulations (e.g., selection by credit risk, qualification, etc). Lot size transformation: Banks match investments of different sizes (e.g., small savings deposits vs. big business or mortgage loans). Maturity transformation: Banks match investments of different maturities (e.g., short-term savings deposits vs. long-term business or mortgage loans). Risk transformation: Financial markets, especially banks, match lenders’ accepted risk in a financial contract with the tolerated risk of a financial contract (e.g., by reducing or dividing risk). Gregor Weiss (UL) Banking 109 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Overview of the functions of banks II In addition to these “abstract” services for their customers, banks also fulfill important functions for the economy: Supply and creation of money: Banks do not only match borrowers with lenders in a zero-sum game, but are also able to create commercial bank money15 within the banking sector and therefore create “additional” loans. Providing liquidity by investment services and facilitating payment services. 15 A claim on cash or cash equivalents that are created by (cashless) account-to-account transactions. Commercial bank money is created by placing central bank money into deposit accounts, or by commercial banks making loans. Gregor Weiss (UL) Banking 110 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Credit multiplier I Banks “create” money. This process can be illustrated by the model of a credit multiplier. It is based on the assumption that modern banks retain only a portion of the money they receive from deposits. This portion is held back as a reserve, so that the bank remains liquid in the event of cash withdrawals. The remaining part will be offered as loans, for example. Assumption of the model: There is only one bank in the system. The required reserve is 10% of the total deposits. Gregor Weiss (UL) Banking 111 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Credit multiplier II To illustrate the adjustment of the required reserves, the following example is given: Balance Sheet Source: Casu/Girardone/Molyneux (2006, p. 22). Gregor Weiss (UL) Banking 112 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Credit multiplier III Period 0: Assume that the bank holds deposits with a value of 50 million euros. The required reserve is 10%. That means for every 10 euros that the bank receives, it retains 1 euro in cash and can grant 9 euros as loans. Ñ 5 million as reserve and 45 million for lending. In period 1 deposits are increased by 50.000 euros, which are retained as reserve at first. A bank does not make profit just by depositing cash. So the bank should stay with the required reserve of 10%. Gregor Weiss (UL) Banking 113 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Credit multiplier IV In period 2 the bank returns to a required reserve of 10%. Therefore, the bank is able to grant additional loans of 45.000 euros. Credit multiplier In this example, the credit multiplier is defined as the relation between the changes in deposits and the changes in reserves: 05 50 Credit multiplier 50, 10 ∆D ∆R 5, 005 5 ∆D = change in deposits ∆R = change in reserves The credit multiplier is always the reciprocal of the required reserve: 0,10 10. 1 Gregor Weiss (UL) Banking 114 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Credit multiplier V Extension of the model. Assumptions: There is more than only one bank. If bank A experiences an increase of deposits by 50.000 euros and retains 10% as reserve, the remaining 45.000 euros can be granted as loans and will eventually return to the banks. The money is lent to an individual, who reinvests it at bank B. The bank again retains 10% in cash (4.500 euros) and invests the rest (for example) into lending. This money again gets back to bank C. Gregor Weiss (UL) Banking 115 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Credit multiplier VI Every step leads to a growth of 90% compared to the original before. The sum of the additional deposits created with n banks therefore equals: 50 p50 0, 9q p50 0, 92q p50 0, 93q p50 0, 94q p50 0, 9n q The geometric series converges to 1500,9 500. Following the above formula, according to which the deposit 1 multiplier is equal to the reciprocal of the required reserve ( 0,1 ), the grant of 50.000 euros into the system leads to additional 500.000 euros in deposits. Gregor Weiss (UL) Banking 116 / 678 Explanation of the existence and functions of banks Overview of the functions of banks Credit multiplier VII Disadvantages of the model The assumptions of the simple model are not very realistic. The system has weaknesses, for example that money can go overseas. Individuals invest their capital in government bonds or keep it as cash rather than depositing it. Nevertheless the bank “creates” money! This monetary function of bank deposits is often considered as the main reason for the stronger regulation and stricter supervision of banks (in comparison to institutions without deposits, for example, insurance or investment companies). Gregor Weiss (UL) Banking 117 / 678 Explanation of the existence and functions of banks Financial and Bank services Outline I 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks Introduction Explanatory approaches Financial intermediation Overview of the functions of banks Financial and Bank services 3 Central banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation Gregor Weiss (UL) Banking 118 / 678 Explanation of the existence and functions of banks Financial and Bank services Outline II 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 119 / 678 Explanation of the existence and functions of banks Financial and Bank services Financial services Classification Source: Casu/Girardone/Molyneux (2006, S. 24). Gregor Weiss (UL) Banking 120 / 678 Explanation of the existence and functions of banks Financial and Bank services Bank Services I There is a wide range of services such as: payment services, deposits and loans, investments, insurance products, and online banking. Payment services Services include payment money transfer, checks, money transfer, standing orders, old-age provision, direct remittances, as well as payment cards like credit cards, debit cards, etc. Gregor Weiss (UL) Banking 121 / 678 Explanation of the existence and functions of banks Financial and Bank services Bank Services II Deposits and loans Deposits and loans include the current account on which the money is issued at a very low interest rate. However, there are fixed-term deposits and savings accounts, that have a fixed investment period and a fixed or varying interest rate. In addition, there are also loans for consumer goods and mortgages. They exist without collateral for smaller amounts and they exist with property as collateral. The bank also offers large loans with mortgages for their customers to purchase houses etc. Gregor Weiss (UL) Banking 122 / 678 Explanation of the existence and functions of banks Financial and Bank services Bank Services III Investments, old-age provision, insurance products Investments, old-age provision, and insurance products include access to funds. The bank advises and carries out the purchases of shares and similar products. Often savings and investment products overlap. For the retirement provision as well as for insurance products, the bank establishes a plan of periodical payments to pay the customer in the event of damage or old age. Online banking The banks have implemented the newest technologies into the business. Especially private customers can make electronic transactions and profit from other convenient ways of payment. In addition, they have access to different financial products like shares. The online services are also made accessible to business customers. Gregor Weiss (UL) Banking 123 / 678 Central banks Outline I 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks 3 Central banks Introduction Banking supervision and regulation The U.S.-American banking system Supranational banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 124 / 678 Central banks Introduction Outline I 1 Introduction and characteristics of the German banking sector 2 Explanation of the existence and functions of banks 3 Central banks Introduction Banking supervision and regulation The U.S.-American banking system Supranational banks 4 Business models and income sources of banks 5 Financial accounting for banks 6 Risk management in banks 7 Bank regulation 8 Special characteristics of international banking systems Gregor Weiss (UL) Banking 125 / 678 Central banks Introduction Central banks I The monetary policy of a country is usually conducted by the central bank of a country. Usually, modern central banks serve the main purpose to secure price stability and (subsequently) the support of general economic policy. Depending on their legal form, central banks differ from other state institutions in terms of their tools and their independence from other state institutions. The tasks of the central bank in Germany are carried out by the European Central bank (ECB) and Deutsche Bundesbank within the European System of Central banks (ESCB). Gregor Weiss (UL) Banking 126 / 678 Central banks Introduction Central banks II The tasks of a central bank can roughly be attributed to the assets and liabilities side of the central bank’s balance sheet: Central bank tasks - assets side Keeping a currency reserve (gold and foreign currencies). Refinancing of commercial banks (main and longer-term refinancing operations). Granting of loans to the state. Open market transactions (purchase of securities) to control the money supply. Gregor Weiss (UL) Banking 127 / 678 Central banks Introduction Central banks III Central bank tasks - liabilities side Issuance of bank notes (right of issuing bank notes). These represent claimss to the central bank in the balance sheet. Commercial banks’ deposits (e.g., within the so-called “deposit facility”). State deposits (Cash management / account management for the public sector). Gregor Weiss (UL) Banking 128 / 678 Central banks Introduction Central banks IV ECB balance sheet - Assets Assets Mio. ¿ in % Gold and gold receivables 27.689,00 3,96% Claims on non-euro area residents 55.603,00 7,96% denominated in foreign currency Claims on euro area residents 1.159,00 0,17% denominated in foreign currency Claims on non-euro area residents - 0,00% denominated in euro Other claims on euro area credit institutions 12,00 0,00% denominated in euro Securities of euro area 457.271,00 65,46% residents denominated in euro Intra-Eurosystem claims 125.763,00 18,00% Other assets 31.355,00 4,49% Total assets 698.853,00 100,00% Quelle: ECB, 2023 Gregor Weiss (UL) Banking 129 / 678 Central banks Introduction Central banks V ECB balance sheet - Liabilities Liabilities Mio. ¿ In % Banknotes in circulation 125.763,00 18,00% Other liabilities to euro area 17.734,00 2,54% credit institutions denominated in euro Liabilities to other euro area 63.863,00 9,14% residents denominated in euro Liabilities to non-euro area 78.108,00 11,18% residents denominated in euro Intra-Eurosystem liabilities 355.474,00 50,87% Other liabilities 5.908,00 0,85% Provisions 6.636,00 0,95% Revaluation accounts 36.487,00 5,22% Capital and reserves 8.880,00 1,27% Profit for the year - 0,00% Total liabilities 698.853,00 100,00% Quelle: ECB, 2023 Gregor Weiss (UL) Banking 130 / 678 Central banks Introduction Central banks VI ESCB The European System of Central banks (ESCB) (BEWARE: ESCB EUROSYSTEM) was introduced on 1 January 1999 and consists of the ECB and the national central banks. Its primary monetary objective is to secure price stability within the European Union. Its secondary objective is the support of the economic policy. The ESCB has the following specific tasks: Establishing and implementing a common monetary policy. Exchange rate policy. Management of foreign exchange reserves. Supervision of credit institutions in the EU and safeguarding financial stability. Ensuring the functioning of payment transactions (especially the provision of money). Gregor Weiss (UL) Banking 131 / 678 Central banks Introduction European Banking Union Gregor Weiss (UL) Banking 132 / 678 Central banks Introduction Rulesystem in the European Banking Union Gregor Weiss (UL) Banking 133 / 678 Central banks Introduction Competencies of the ECB Gregor Weiss (UL) Banking 134 / 678 Central banks Introduction Central banks VII European Central bank The ECB in Frankfurt is governed directly under EU law and has been the common monetary authority of the member states of the European Monetary Union as well as a component of the ESCB (together with other national central banks) since 1998. In addition to the above-mentioned objectives of the ESCB, it also performs other tasks (creation of the central bank balance sheet, collection of the necessary statistical data, etc.), including, in particular, the supervision of systemically important banks in the Eurosystem under the single banking supervisory mechanism (SSM) since November 2014.a The ECB is governed by the Executive Board, the Governing Council, the General Council, and the Supervisory Board. a SSM=Single Supervisory Mechanism. Within the framework of the SSM, the ECB has taken over the supervision of banks whose balance sheet total assets exceed 30 billion euros or account for 20 percent of a country’s GDP. Gregor Weiss (UL) Banking 135 / 678 Central banks Introduction Central banks VIII Instruments of the ECB The ECB has various instruments at its disposal to achieve its monetary policy objectives, in particular it can change interest rates in effect between it and commercial banks. Specifically, it can use the following instruments: open market operations standing facilities currency intervention reserve requirementss outright monetary transactions Gregor Weiss (UL) Banking 136 / 678 Central banks Introduction Central banks IX Open Market Operations The open market policy is the main instrument of the ECB (more general: monetary policy). The central bank uses it to control market interest rates and the creation of cash (by commercial banks). From a te

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