Week One:
This week we will discuss the types of banking models. In general, when talking about banks
there are three main models:
(1) Commercial banks → they take deposits, do payment services and lend money
(2) Investment banks → they operate on financial markets, this includes the underwriting of
securities
(3) Universal banks → they combine commercial and investment banking activities.
Universal banking is now available worldwide, however in the past it was not always
allowed.
Advantages and Disadvantages of Universal Banking:
Advantages: - Economies of scale: economizing on fixed costs of raising capital
and on other costs, such as ICT (Information and Communication
Technology) systems
- Economies of scope: efficient use of information gained from one
activity on other activities; for instance, information gained on
lending client can be used to price securities such as bonds
properly
- Risk diversification: returns to commercial and investment banking
are not perfectly correlated
Disadvantages: - Potential conflict of interest: a bank could sell securities of a firm
with low quality in order to avoid taking losses on its own loan
portfolio to this customer
- Complexity may make management more difficult resulting in a
worse risk-return trade-off
- Laeven and Levine (2007) present evidence on a stock market
discount for diversified banks: market value of a universal bank is
smaller than the sum of the market values of the commercial bank
and the investment bank
- Investment bank may use funding attracted by the commercial
bank that is protected by deposit insurance
- Universal bank may become “too-big-to fail” and the authorities
may have to undertake a costly bailout of a universal bank in
distress
- The purpose of the bailout may be to safeguard the payments
system that is facilitated by the commercial bank, but in practice
the authorities need to bail out the commercial bank as well as the
investment bank.
Universal banking in US:
- Before 1933 universal banking was allowed in the US
- Glass-Steagall Act of 1933: separation of commercial banking and investment banking
because of potential conflict of interest in case of issuance of securities for lending
customers
- One way to resolve potential conflict of interest: banks may build reputation for only
, issuing good securities
- Risk of losing reputation is check on conflict of interest because reputation is valuable to
bank
Empirical Evidence on Potential Conflict of Interest:
- Kroszner and Rajan (1994) find that before 1933:
- Bonds issued by universal banks had relatively low defaults
- Universal banks with smaller investment banking affiliates underwrote more
senior bonds that are relatively transparent
- Hence, in the 1990s, economic research suggested re-introduction of universal banking
in the US would not be a problem
Gramm-Leach-Bliley Act of 1999:
- In the 1990s an increase in the optimal scale of investment banking due to the need for
large amounts of capital and cost of computing
- Economies of scale can be realized by merging investment bank with commercial bank
- Regulatory response came with the Gramm-Leach_Bliley Act of 1999, which dismantled
barriers to universal banking in the US
Universal Banking & Risk-Return Options:
Expansion in a bank’s ability to produce a wider set of products or enter new markets
expands the opportunity set. If these activities are less than perfectly correlated with the existing
set, this ability to diversify risk allows lower risk without surrendering expected return. Shift of
the risk-return curve upwards (see figure 9.1 in chapter 9 of Oxford Handbook of Banking). This
upward shift of the risk-return curve need not lead to lower risk-taking because the actual
outcome will depend on the preferences of bank owners and managers. Bank owners that are
more risk averse, having a relatively steep indifference curve, may choose to increase expected
returns and reduce risk. Bank owners who are less risk averse may choose a combination of
higher risk and higher expected returns.
Endogeneity of risk taking:
- Risk taking is endogenous and diversification need not lead to lower observed levels of
risk.
- In empirical research it is difficult to find a clear and stable link between measures of
diversification and measures of risk.
- ySaunders and Walter (1994) reviewed 18 studies that examined whether non-bank
activities reduced the risk of Bank Holding Companies and found no consensus.
, Week Two:
This week looks at capital adequacy. Capital requirements impose a minimum amount of capital
or equity. The bank’s balance sheet also consists of the following: the left-hand side has the
assets (A) and the right-hand side has the debt or liabilities (L) and equity (E). There are a few
ratios:
𝐸
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 = 𝐴
𝐿 𝐿
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝐴
𝑜𝑟 𝐸
Purpose of capital requirements:
- Reduce risk-taking behavior by banks, i.e incentive to gamble by investing in risky
assets as banks have more to lose
- Reduce probability of bank failure and associated costs for:
- Bank liability holders
- Bank lending customers
- Public treasury as costs of bailout can be high
Capital Adequacy Standards: International Cooperation:
- Eliminate international competition in the area of capital regulation, in particular,
eliminate competitive reductions in standards to gain market share
- Reduce compliance costs for banks
- Reduce incentives to engage in international regulatory capital arbitrage by banks
- Banks may have incentives to locate activities in countries with lenient capital
regulation
- Make it easier to compare capital at banks internationally through higher transparency
Basel Accords:
- Under auspices of the basel committee on Banking Supervision representing G-10
countries (group of largest economies in the world)
- Basel Accords are not treaties and legally binding, but rely on moral suasion
- 1988: Basel I Accord
- 2004: Basel II Accord
- 2010: Basel III Accord
- 2017: Finalization of Basel III Accord
Risk-Based Capital Ratio”
- Basel I introduced a Risk-Based Capital Ratio
𝐶𝑟
- 𝑅𝐵𝐶𝑅 = Σ𝑤𝑖𝐴𝑖
≥ 0. 08
- The numerator is a measure of capital, and the denominator is a measure of
risk-weighted assets
- RBCR recognizes that not all assets are equally risky and hence require different
capital buffers
- 𝑤𝐼 is risk-weight of asset i with 0 ≤ 𝑤𝑖 ≤ 1
- Safer assets have lower risk weights
This week we will discuss the types of banking models. In general, when talking about banks
there are three main models:
(1) Commercial banks → they take deposits, do payment services and lend money
(2) Investment banks → they operate on financial markets, this includes the underwriting of
securities
(3) Universal banks → they combine commercial and investment banking activities.
Universal banking is now available worldwide, however in the past it was not always
allowed.
Advantages and Disadvantages of Universal Banking:
Advantages: - Economies of scale: economizing on fixed costs of raising capital
and on other costs, such as ICT (Information and Communication
Technology) systems
- Economies of scope: efficient use of information gained from one
activity on other activities; for instance, information gained on
lending client can be used to price securities such as bonds
properly
- Risk diversification: returns to commercial and investment banking
are not perfectly correlated
Disadvantages: - Potential conflict of interest: a bank could sell securities of a firm
with low quality in order to avoid taking losses on its own loan
portfolio to this customer
- Complexity may make management more difficult resulting in a
worse risk-return trade-off
- Laeven and Levine (2007) present evidence on a stock market
discount for diversified banks: market value of a universal bank is
smaller than the sum of the market values of the commercial bank
and the investment bank
- Investment bank may use funding attracted by the commercial
bank that is protected by deposit insurance
- Universal bank may become “too-big-to fail” and the authorities
may have to undertake a costly bailout of a universal bank in
distress
- The purpose of the bailout may be to safeguard the payments
system that is facilitated by the commercial bank, but in practice
the authorities need to bail out the commercial bank as well as the
investment bank.
Universal banking in US:
- Before 1933 universal banking was allowed in the US
- Glass-Steagall Act of 1933: separation of commercial banking and investment banking
because of potential conflict of interest in case of issuance of securities for lending
customers
- One way to resolve potential conflict of interest: banks may build reputation for only
, issuing good securities
- Risk of losing reputation is check on conflict of interest because reputation is valuable to
bank
Empirical Evidence on Potential Conflict of Interest:
- Kroszner and Rajan (1994) find that before 1933:
- Bonds issued by universal banks had relatively low defaults
- Universal banks with smaller investment banking affiliates underwrote more
senior bonds that are relatively transparent
- Hence, in the 1990s, economic research suggested re-introduction of universal banking
in the US would not be a problem
Gramm-Leach-Bliley Act of 1999:
- In the 1990s an increase in the optimal scale of investment banking due to the need for
large amounts of capital and cost of computing
- Economies of scale can be realized by merging investment bank with commercial bank
- Regulatory response came with the Gramm-Leach_Bliley Act of 1999, which dismantled
barriers to universal banking in the US
Universal Banking & Risk-Return Options:
Expansion in a bank’s ability to produce a wider set of products or enter new markets
expands the opportunity set. If these activities are less than perfectly correlated with the existing
set, this ability to diversify risk allows lower risk without surrendering expected return. Shift of
the risk-return curve upwards (see figure 9.1 in chapter 9 of Oxford Handbook of Banking). This
upward shift of the risk-return curve need not lead to lower risk-taking because the actual
outcome will depend on the preferences of bank owners and managers. Bank owners that are
more risk averse, having a relatively steep indifference curve, may choose to increase expected
returns and reduce risk. Bank owners who are less risk averse may choose a combination of
higher risk and higher expected returns.
Endogeneity of risk taking:
- Risk taking is endogenous and diversification need not lead to lower observed levels of
risk.
- In empirical research it is difficult to find a clear and stable link between measures of
diversification and measures of risk.
- ySaunders and Walter (1994) reviewed 18 studies that examined whether non-bank
activities reduced the risk of Bank Holding Companies and found no consensus.
, Week Two:
This week looks at capital adequacy. Capital requirements impose a minimum amount of capital
or equity. The bank’s balance sheet also consists of the following: the left-hand side has the
assets (A) and the right-hand side has the debt or liabilities (L) and equity (E). There are a few
ratios:
𝐸
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑎𝑡𝑖𝑜 = 𝐴
𝐿 𝐿
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑖𝑜 = 𝐴
𝑜𝑟 𝐸
Purpose of capital requirements:
- Reduce risk-taking behavior by banks, i.e incentive to gamble by investing in risky
assets as banks have more to lose
- Reduce probability of bank failure and associated costs for:
- Bank liability holders
- Bank lending customers
- Public treasury as costs of bailout can be high
Capital Adequacy Standards: International Cooperation:
- Eliminate international competition in the area of capital regulation, in particular,
eliminate competitive reductions in standards to gain market share
- Reduce compliance costs for banks
- Reduce incentives to engage in international regulatory capital arbitrage by banks
- Banks may have incentives to locate activities in countries with lenient capital
regulation
- Make it easier to compare capital at banks internationally through higher transparency
Basel Accords:
- Under auspices of the basel committee on Banking Supervision representing G-10
countries (group of largest economies in the world)
- Basel Accords are not treaties and legally binding, but rely on moral suasion
- 1988: Basel I Accord
- 2004: Basel II Accord
- 2010: Basel III Accord
- 2017: Finalization of Basel III Accord
Risk-Based Capital Ratio”
- Basel I introduced a Risk-Based Capital Ratio
𝐶𝑟
- 𝑅𝐵𝐶𝑅 = Σ𝑤𝑖𝐴𝑖
≥ 0. 08
- The numerator is a measure of capital, and the denominator is a measure of
risk-weighted assets
- RBCR recognizes that not all assets are equally risky and hence require different
capital buffers
- 𝑤𝐼 is risk-weight of asset i with 0 ≤ 𝑤𝑖 ≤ 1
- Safer assets have lower risk weights
