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Introduction To Banking Systems

Financial intermediaries like banks are the most important source of external financing for businesses. Banks provide rents to society by reducing transaction costs through economies of scale and expertise, reducing risk through risk pooling and access to borrowers and savers, and reducing information asymmetry. However, banks must also address problems like moral hazard and principal-agent conflicts between shareholders, managers, debt holders, and regulators. Banks solve these problems through tools like producing private information through monitoring, complying with regulations, engaging in financial intermediation, using restrictive debt contracts, and requiring adequate net worth. Banks manage risks to their balance sheets through liquidity management, asset management, liability management, and maintaining adequate capital ratios.

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46 views16 pages

Introduction To Banking Systems

Financial intermediaries like banks are the most important source of external financing for businesses. Banks provide rents to society by reducing transaction costs through economies of scale and expertise, reducing risk through risk pooling and access to borrowers and savers, and reducing information asymmetry. However, banks must also address problems like moral hazard and principal-agent conflicts between shareholders, managers, debt holders, and regulators. Banks solve these problems through tools like producing private information through monitoring, complying with regulations, engaging in financial intermediation, using restrictive debt contracts, and requiring adequate net worth. Banks manage risks to their balance sheets through liquidity management, asset management, liability management, and maintaining adequate capital ratios.

Uploaded by

Sagar Ansary
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Introduction to Banking

System

Prof. Sayantan Kundu

Indian Institute of Management Ranchi

1
How important are FIs and Banks?

Source: Mishkin 6E Pearson 2


Facts that show importance of Banks
1) Stocks are not the most important source of external financing for
businesses.
2) Issuing marketable debt and equity securities is not the primary way in
which businesses finance their operations.
3) Indirect finance, which involves the activities of financial
intermediaries, is many times more important than direct finance, in
which businesses raise funds directly from lenders in financial markets.
4) Financial intermediaries, particularly banks, are the most important
source of external funds used to finance businesses.
5) The financial system is among the most heavily regulated sectors of
economy.
6) Only large, well-established corporations have easy access to securities
markets to finance their activities.
7) Collateral is a prevalent feature of debt contracts for both households
and businesses.
8) Debt contracts are typically extremely complicated legal documents that
place substantial restrictions on the behaviour of the borrowers. 3
Why we give banks rents for its service?
Financial intermediaries make profits by asking for rent against
• Reducing transactions costs
➢ Economies of Scale
➢ Expertise (comparative advantage)
• Reducing risk by risk pooling
➢ Low transaction cost
➢ Charter and regulatory framework
➢ Access to large set of borrowers and savers
• Reducing information asymmetry (adverse selection)
➢ Private Production and Sale of Information
➢ Government Regulation to Increase Information
➢ Collateral and Mortgages
➢ Net Worth of Equity holders

But what about moral hazard? It is known only after loan is made?
4
Why is Equity Risky?
Moral Hazard in Equity Contracts: Principal-Agent Problem
• Result of separation of ownership by stockholders (principals)
from control by managers (agents)
• Managers act in own rather than stockholders' interest
• Majority shareholders act for their benefit rather than minority
shareholders
• Manage income – siphoning of funds
• Market timing (negative) vs Signalling (positive)

Majority shareholders run the company by representation in


board – they may indulge in risky investments. If that goes right
they receive major profit, otherwise they will deliver the company
to bondholders/creditors

5
The full spectrum of agency conflict
Promoter/
Manager / Minority
majority Debt holders Regulator
Agent Shareholder
shareholder
Promoter/
majority
shareholder

Manager/
Agent

Minority
Shareholder

Debt Holders

Regulator

6
How FIs make equity less risky
Tools to Help Solve the Principal-Agent Problem
• Production of Information: Monitoring
• Government Regulation to Increase Information
• Financial Intermediation (e.g.: venture capital)
• Debt Contracts (how?)

Tools to Help Solve Moral Hazard through Debt Contracts


• Net Worth Requirement
• Monitoring and Enforcement of Restrictive Covenants.
• discourage undesirable (investment) behaviour
• encourage desirable behaviour
• keep collateral valuable
• provide information

7
How FIs solve the problem?

Source: Mishkin 6E Pearson 8


Banks Balance Sheet
The Balance Sheet is a list of a bank’s assets (Usage of funds)
and liabilities (sources of funds)
TOTAL ASSETS
• Loans TOTAL LIABILITIES
• Cash • Checkable Deposits TOTAL CAPITAL
• Investments into = • Fixed Deposits
+ • Equity Capital
Govt Securities • Borrowings
• Physical Assets

• A bank’s balance sheet lists sources of bank funds (liabilities)


and uses to which they are put (assets)
• Banks invest these liabilities (sources) into assets (uses) in
order to create value for their capital providers (asset
transformation)
• Fractional Reserve Banking System [Read]

9
Banks Balance Sheet

Source: Mishkin 6E Pearson 10


Banks Income Statement
Banks Income and Expenses
• Interest Expense on deposits Interest rate margin
• Interest income on loans and mortgages
• Interest income on deposits with govt bond and central bank
• Interest Expense on borrowings from other banks and central
bank
• Expense on bank operation
• Provisions for bad loans
• NPA (non-performing asset write-off)

Read:
REPO
REVERSE REPO
INTER BANK OVERNIGHT BORROWING RATES: LIBOR & MIBOR

11
Banks Income Statement
Off-Balance-Sheet Activities
• Loan sales (secondary loan participation)
• Fee income from
• Banking Service
• Custodian, depository, liquidity, payments and transfer
• Read NEFT, RTGS and IMPS
• Foreign exchange trades for customers
• Servicing mortgage-backed securities
• Guarantees of debt
• Backup lines of credit
• Trading Activities and Risk Management Techniques
• Financial futures and options
• Foreign exchange trading
• Interest rate swaps
12
Banks Income Statement

Source: Mishkin 6E Pearson 13


Fractional Reserve Banking
What is Fractional Reserve Banking
• Fractional reserve banking is a banking system in which only a
fraction of bank deposits are backed by actual cash on hand and
are available for withdrawal. This is done to expand the
economy by freeing up capital that can be loaned out to other
parties.

Salient Features and factors


• Fractional Reserve Multiplier Effect (+)
• Bank Run (risk)
• Reserve requirements
• Deposit Insurance
• Value of Bank Charter
• Contagion effect - herd effect and effect on entire banking
industry
14
Bank Risk Management
• Liquidity Management
• Availability of enough cash in spite of Fractional Reserve Banking to
pay back depositors under normal circumstance
• Time and duration bucket mapping of assets and liabilities (Asset
Liability Management - READ)
• Having investment into statutory securities (SLR)
• Asset management
• Geographical, Income, Sectoral diversification
• Having a pool of quality assets, inspection and maintenance
• Provision for bad loans and write-offs
• Managing credit risk
• Managing interest-rate risk (IncGAP= RSA-RSL)
• Liability Management
• Having effective balance of deposits in both rate and time buckets
• Managing Capital Adequacy
• Having enough equity capital & leverage ratio
• Limitation in speculative & off-balance sheet activities
• (Read Global Case “Whither the Basel Accord?” in MISHKIN)
15
Thank You

Please Read Chapters 15, 17 and 18 of Mishkin

16

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