Principle of Banking Chapter 1 - Foreign Trade University PDF

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THE PRINCIPLES OF BANKING 2021 -NHA302-

Lecturer: Chu Mai Linh, Ms. Email: [email protected] Google Drive: https://bitly.com.vn/no9shr 1

Module Information • • • • •

Module Code Module Title Lecturer Credit Value Textbooks

NHA302 PRINCIPLES OF BANKING Chu Mai Linh, M.Sc. 3 Credit Hrs.

1.

Casu B., Girardone, C., Molyneux, P., 2015, Introduction to Banking, 2nd ed., Prentice Hall (C.G.M - Chapters 1,2,3,4,7,9,10,11,12)

2.

Rose S.P. , 2018, Bank Management and Financial Services, 8th ed., McGraw-Hill Education (Rose- Chapters 1,10,12, 16,17,18)

3.

Nguyễn Văn Tiến & Nguyễn Thu Thủy, Giáo trình nguyên lý & nghiệp vụ ngân hàng thương mại, Nhà xuất bản thống kê 2014. 2

LEARNING OBJECTIVES Outcomes

Understanding

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Memorizing

•

Implementation •

Analyzing

•

Judgement

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Students will be able to explain the business of financial institutions, the role of financial intermediaries, why financial institutions have liquidity concerns, concerns regulators have with financial institutions Students will be able to remember key terms to help them learn the language of banking and financial services. Besides, they need to know the lending process as well as investment activities of the bank. Students will be able to apply relevant theories to solve all the questions, case studies and problems. They could apply the concepts and theories to explain the real situations. In addition, the lending process can be applied in real circumstances when students have an internship in the banks. Students will be able to analyze the real situations in the banking and financial services. Students will be able to demonstrate their understandings of this course through ongoing evaluation methods such as in class exercises, group assignments, midterm examination and final examination.

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Syllabus Plan Session

Topics covered

1

Introduction to Banking

2

Bank Regulation and Supervision Banks balance sheet and income structure

References C.G.M - Chapters 1, 2, 3 Rose - Chapter 1 C.G.M - Chapters 7 & 9 Circular No. 22/2019/TT-NHNN Law on Credit Instituition 47/2010/QH12 Amendments to some articles of the law on credit institutions Law No. 17/2017/QH14

3

Banking risks and measurements

4

Managing and Pricing Deposit Services

5

Providing Loans to Businesses and Consumers

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Other banking services

C.G.M - Chapters 10, 11, 12 Rose – Chapter 12 Rose – Chapters 16, 17, 18 Circular No. 39/2016/TT-NHNN Rose - Chapter 10 C.G.M - Chapter 4 4

Assignments and Assessments Form of Assessment

Size of the assessment e.g. duration/length

Attendance

% Contribution

10% of the final mark

Midterm Exam

45 Mins.

20% of the final mark

Poster Presentation

Submission deadline: 11.59 pm on May, 4th 2021

10% of the final mark

Examination

60 Mins.

60% of the final mark

5

Chapter 1 Introduction to banking

• C.G.M - Chapters 1, 2, 3

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Learning Objectives • Introduction

• Types of banking

• Why are banks special?

• Global Trends

• The Changing Dynamics of Bank Industries

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Introduction

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Introduction A bank is a financial intermediary that offers loans and deposits, and payment services. • Commercial banks make up the largest group of depository institutions measured by asset size. They perform functions similar to those of savings institutions and credit unions. • However, they differ in their composition of assets and liabilities, which are much more varied. • Commercial bank liabilities usually include several types of non-deposit sources of funds, while their loans are broader in range, including consumer, commercial, and real estate loans.

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Legal Definition of Commercial Bank in Vietnam • In Vietnam, according to the Art.4 of Law on Credit Institution 2010, • 1. Credit institution means an enterprise conducting one. some or all banking operations. Credit institutions include banks, non-bank credit institutions, microfinance institutions and people's credit funds. • 2. Bank means a type of credit institution which may conduct all banking operations under this Law. Based on their characteristics and operation objectives, banks include commercial banks, policy banks and cooperative banks. • 3. Commercial bank means a type of bank which may conduct all banking operations and other business activities under this Law for profit. Source: http://itpc.hochiminhcity.gov.vn/investors/how_to_invest/law/Law_on_Credit_Institutions/mldocument_view/?set_language=en

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The Art.4 Law on Credit Institution 2010 12. Banking operations means the trading in and regular provision of one or some of the following services: a/ Deposit taking; b/ Credit extension: c/ Via-account payment.

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The Art.4 – Law on Credit Institution 2010 13. Deposit taking means receiving money from an organization or individual as demand or term deposit, savings deposit, issuing deposit certificates, bills or treasury bills, and other forms of receiving deposits on the principles of full payment of principals and interests to depositors under agreement. 14. Credit extension means an agreement allowing an organization or individual to use a sum of money or a commitment allowing the use of a sum of money on the repayment principle by such professional operations as lending, discount, financial leasing, factoring, bank guarantee and other credit extension operations. …. 22. Payment account means a client's demand deposit account opened by a client at a bank to use payment services provided by such bank. 12

What do banks do? • At the 21st century, banks no longer limit their service offerings to traditional services but have increasingly become general financial service providers. • Other financial institutions are trying to be as similar to banks as possible in the services they offer. • All countries have regulations that define what banking business is. For example, in all EU countries banks have been permitted to perform a broad array of financial services activity since the early 1990s and since 1999 both US and Japanese banks are also allowed to operate as full-service financial firms.

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What do banks do? • Nowadays banks offer a wide range of additional services, but it is these functions that constitute banks’ distinguishing features. • Modern banks offer a wide range of financial services, including: ● payment services; ● deposit and lending services; ● investment, pensions and insurance services; ● e-banking.

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What do banks do? • accepting deposits; • issuing e-money (or digital money), i.e. electronic money used on the internet; • implementing or carrying out contracts of insurance as principal; • dealing in investments (as principal or agent); • managing investments; • advising on investments; • safeguarding and administering investments; • arranging deals in investments and arranging regulated mortgage activities; • advising on regulated mortgage contracts; • entering into and administering a regulated mortgage contract; • establishing and managing collective investment schemes (for example, investment funds and mutual funds); • establishing and managing pension schemes. 15

Example • Bank as a financial services holding company. For example, J.P. Morgan Chase as the world’s 5th largest FI operating in 60 countries, has J.P. Morgan Chase Bank, J.P. Morgan Securities, J.P. Morgan Insurance Agency, Washington Mutual, and several investment banks, including Bear Stearns. Largest US. Commercial banks in 2015, ranked by total assets in billions of dollars

In 2015, U.S. FIs held assets totaling more than $30.45 trillion. In contrast, the U.S. motor vehicle and parts industry (e.g., General Motors and Ford Motor Corp.) held total assets of $0.55 trillion.

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What are the bank’s risks? 1) Banks hold some assets that are potentially subject to default or credit risk. 2) Banks tend to mismatch the maturities of their balance sheet assets and liabilities to a greater or lesser extent and are thus exposed to interest rate risk. 3) Banks are exposed to degree of liability withdrawal or liquidity risk. 4) Banks are exposed to operating risks because the production of financial services requires the use of real resources and back-office support systems. 5) Moreover, banks are exposed to some type of underwriting risk, whether through the sale of securities or the issue of various types of credit guarantees on or off the balance sheet.

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Why are banks special?

• Flows of funds in a world without banks

• Monitoring costs • Liquidity risk • Price risk

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Why are banks special? • In an economy without FIs: Monitoring costs: the level of fund flows is likely to be quite low Liquidity reasons: due to the relatively long-term nature of corporate equity and debt, and the lack of a secondary market, household investors don’t have incentive to hold financial claims (equity and debt securities) issued by corporations. Price risk: investors also face a price risk on sale of securities.

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Why are banks special? • Flows of funds in a world with FIs:

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Why are banks special? • FIs ad Brokers:  Due to the economies of scale, FI plays an extremely important role by reducing transaction and information costs or imperfections between households and corporations.  The FI encourages a higher rate of savings than would otherwise exist.

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Why are banks special? • FIs Function as Asset Transformers: An FI issues financial claims that are more attractive to household savers than the claims directly issued by corporations as a result of lower monitoring costs, lower liquidity costs, and lower price risk. FIs purchase the financial claims issued by corporations—equities, bonds, and other debt claims called primary securities—and finance these purchases by selling financial claims to household investors and other sectors in the form of deposits, insurance policies. • The financial claims of FIs may be considered secondary securities. Securities issued by FIs and backed by primary securities.

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Why are banks special? • Information Costs • Household savers must monitor the actions of firms in a timely and complete fashion after purchasing securities. Failure to monitor exposes investors to agency costs. • FI’s Role as Delegated Monitor In a sense, small savers have appointed the FI as a delegated monitor to act on their behalf. • FI’s Role as Information Producer

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Why are banks special? • Liquidity and Price Risk • Often, banks claims have superior liquidity attributes compared with those of primary securities such as corporate equity and bonds. • The banks transaction account deposit contracts which allow household savers to withdraw money immediately.  But how can FIs be confident enough to guarantee that they can provide liquidity services to investors and savers when they themselves invest in risky asset portfolios?

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Liquidity and Price Risk • The answers to these questions lie in the ability of FIs to diversify away some but not all of their portfolio risks. • As long as the returns on different investments arenot perfectly positively correlated, by exploiting the benefits of size, FIs diversify away significant amounts of portfolio risk—especially the risk specific to the individual firm issuing any given security.

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Liquidity and Price Risk • It means that the FIs is able to reduce risk by holding a number of securities in a portfolio. • This risk diversification allows an FI to predict more accurately its expected return on its asset portfolio. • As long as an FI is sufficiently large to gain from diversification and monitoring, its financial claims are likely to be viewed as liquid and attractive to small savers compared with direct investments in the capital market.

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Why are banks special? • Reduced Transaction Costs • Maturity Intermediation • FIs’ ability to reduce risk by diversification is that they can better bear the risk of mismatching the maturities of their assets and liabilities than can small household savers. • FIs can produce new types of contracts, such as long-term mortgage loans to households, while still raising funds with short-term liability contracts.

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Other Aspects of Specialness • The Transmission of Monetary Policy • Because the liabilities of depository institutions are a significant component of the money supply that impacts the rate of inflation, they play a key role in the transmission of monetary policy from the central bank to the rest of the economy. • Credit Allocation • FIs are often viewed as special is that they are the major and sometimes the only source of financing for a particular sector of the economy preidentified as being in special need of financing such as credit needs of residential real estate or farming sector. • Payment Services • Depository institutions such as banks and thrifts are special in that the efficiency with which they provide payment services directly benefits the economy. 28

Banks Regulation 1) safety and soundness regulation 2) monetary policy regulation 3) credit allocation regulation 4) consumer protection regulation 5) investor protection regulation 6) entry and chartering regulation.

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Safety and soundness regulation 1. Requirement for diversifications of banks assets. Thus, banks are required not to make loans exceeding more than 15 percent of their own equity capital funds to any one company or borrower. 2. Setting of the minimum level of capital or equity funds that the owners of an FI need to contribute to the funding of its operations. 3. The provision of guaranty funds such as the Deposit Insurance Fund (DIF) for depository institutions, the Security Investors Protection Corporation (SIPC) for securities firms, etc. 4. The fourth layer of regulation is monitoring and surveillance itself. 30

Example for Capital Requirement • J.P.Morgen Chase’s Report on Capital, March 2020

SLR - Supplementary leverage ratio Source: J.P.Morgen Chase Form 10-Q, March 2020, page 48 https://www.jpmorganchase.com/ir

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The Changing Dynamics of Specialness • Trends in the United States

• the share of commercial banks declined from 54.5 to 35.8 percent between 1948 and 2015, while the share of thrifts (savings banks, savings associations, and credit unions) fell from 12.0 to 6.7 percent over the same period. • the share of investment companies (mutual funds and money market mutual funds), has increased their share from 0.3 to 22.6 percent between 1948 and 2015. period. 32

The Changing Dynamics of Specialness • The Rise of Financial Services Holding Companies • The Shift Away of Risk Measurement and Management and the Financial Crisis  a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of “originate and hold” to “originate to distribute”

• Firmwide Risk Management While FIs have traditionally examined risk measurement and management by functional area (e.g., credit risk or liquidity risk), more recently, they have recognized the value of enterprise risk management. Enterprise risk management recognizes the importance of prioritizing and managing the full spectrum of risks as an interrelated risk portfolio.

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Changing dynamics of specialness • The Rise of Financial Services Holding Companies • The Financial Services Modernization Act of 1999 opened the door for the creation of full-service financial institutions in the United States, which allowed for the creation of “financial services holding companies” that could engage in banking activities, insurance activities, and securities activities. • As a result, assets of financial institutions by functional area, the financial services holding company (which combines these activities in a single financial institution) has become the dominant form of financial institution in terms of total assets.

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Changing dynamics of specialness • The Shift Away from Risk Measurement and Management and the Financial Crisis • a shift in the banking model from that of “originate and hold” to “originate to distribute”: banks have shifted to an underwriting model in which they originate or warehouse loans, and then quickly sell them. Increasing Bank Loan Secondary Market Trading, 1991–2015Q1

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Firmwide Risk Management

Source: J.P.Morgen Chase Form 10-Q, March 2020, page 47 https://www.jpmorganchase.com/ir 36

Global Trends • U.S. FIs must now compete not only with other domestic FIs but increasingly with foreign FIs that provide services (such as payment services and denomination intermediation) comparable to those of U.S. FIs. • The 10 largest banks in the world in 2020 by Tier 1 Capital: https://bitly.com.vn/dzc3dx

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Banks’ Financial Services • Products Sold by U.S Financial Services Industry,1950

• Products Sold by U.S Financial Services Industry, 2016

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Size, Structure and Composition of the US Banking Industry • Small Banks vs Large Banks  Small banks are defined as banks with assets less than $1 billion.  Large banks are defined as banks with assetsof $1 billion or more. • Breakdown of Loan Portfolios 2015 (source: FDIC, 2015)

Types of loan

Small Banks

Large Banks

Real estate C&l Comsumer loans Credit Card Others

73.53% 14.23% 4.23% 0.28% 7.73%

45.71% 22.83% 9.08% 8.63% 13.50%

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A Breakdown Of The Loan Portfolios Of The Largest U.S. Banks 2018 • Source: Forbes, 2018 – https://bitly.com.vn/t6rzw4

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Size, Structure and Composition of the Industry • Smaller or community banks—under $1 billion in asset size— tend to specialize in retail or consumer banking, such as providing residential mortgages and consumer loans and accessing the local deposit base. • The majority of banks are often either regional or superregional banks, having several hundred billion dollars in assets and engage wholesale commercial banking activities, encompassing consumer and residential lending as well as commercial and industrial lending (C&I loans), both regionally and nationally. • The very biggest banks often have the separate title money center banks. U.S.-based money center banks include: Bank of New York Mellon, Deutsche Bank (through its U.S. acquisition of Bankers Trust), Citigroup. They have fewer retail branches and heavily rely on nondeposit or borrowed sources of funds.

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A Comparison of Assets Concentration by US Bank size 1984 vs 2015

• Asset share of the smallest banks (under $1 billion)reduced from 36.6 percent in 1984 to 7.5 percent in 2015. • These smaller or community banks—under $1 billion in asset size— tend to specialize in retail or consumer banking, such as providing residential mortgages and consumer loans and accessing the local deposit base. • The relative asset share of the largest banks (more than $1 billion in assets), on the other hand, increased from 63.4 percent in 1984 to 92.5 42 percent in 2015.
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