—oV Banks ‘ge Sly wo enequres 1585 Boa & The basics Be sure you understand and know how to use the terms in bold in | the text below. | yending on a country’s regulations and customs, the range of activities and the F ms of ne will ay bank, however, can roughly be divided into two main | types of businesses, (1) taking deposits and making loans—retail and commercial banking—and (2) providing such services as ging companies access to funds through | equity capital and debt capital issues, trading, advising on mergers & acquisitions, ‘etc.— investment banking. Universal banks combine both activities. > Retail and commercial banks with individuals, while commercial banks deal with firms. In industrial- tacos ost adult individuals have a bank account and/or a savings account at a retail bank (although there is stil a relatively high percentage of unbanked | households among undocumented migrants and the underprivileged) where they | ‘can deposit and withdraw money. Some bank cients have overdra are allowed to have a negative balance on their bank accounts, in some countries, checking accounts are interest-bearing. the idea being Both retail and commercial banks use deposit money to make loans, that they make money on the spread between the interest they pay onthe deposits and the interest they charge on their loans. The standard model for these banks is ft facilities, ie. | |. “originate-to-hold”, in which they hold the loans through maturity. They depend on their core deposits, ‘the deposits regularly made by the bank's clients that. can be counted as a stable source of funds for lending. The “originate-to-hold” mode! has, however, gradually shifted to an “originate-to- Slistribute" model—less common in France than in the US. ofthe U.K-—in which the banks originate the loans, pool them, then sell them as a package toa third party that securitizes ‘them (see Chapter 4). The advantage is that the banks can use the extra liquidity to extend more loans and keep interest rates lower than they would if they kept ‘the loans until they matured. The ‘originate-to-distribute model was blamed for: ‘the: ‘subprime crisis: as lenders could offload the loans they originated instead of holding them, they were no longer so fussy about the creditworthiness of the borrowers and came up with systems—no down payments, adjustable rate mortgages (ARM), ‘Negative interest rates, et. —that encouraged subprime borrowers to purchase real estate, Asa result, securitization nosedived in 2008 to reemerge in 2011, Many high-street banks provide their clients with e-banking services, ie., the possibilty to manage their accounts online 24/7. Other banks are pure play internet/ online banks. The pure players, that have no high-street branches, save money on operating costs and allegedly can offer their cients lower fees and higher interest rates on their savings. > Corporate and investment banks Historically the headquarters of major American investment banks were located on | Wal treet. Even though a few of these institutions have moved north to Midtown ‘Manhattan, “Wall Street” has remained a metonym to refer to them. Unless they are very specialized boutiques, large investment banks offer a range of activities including advising on Initial Public Offerings (POs), private placements | or mergers & acquisitions (M&A), underwriting debt or equity, trading on behalf of institutions or trading on their own accounts—also known as proprietary trading/ Prop trading and Private wealth management. They employ analysts who stuc Histed study pubic ‘companies to issue buy, hold or sell recommendations to the The bank’s revenue is generated in its front and trading, as well as such functions as Office isgplit ito * the sell side: advising clients and selling them securities; * the buy side: buying securities on account of other ins institutions—including the Portfolio managers of mutual funds and pension funds that invest money on behalf of their cients—as well as the prop desk/propriets the institution itself 7 eee ‘office where research, sales, sales trading M&A advisory, are performed. The front~ The middle office is in charge of risk management, compliance and IT systems, and the back office is in charge of administrative jobs—back office operations (8PO)—that are sometimes outsourced, ‘The unraveling of insider trading scandals has pointed to the potential conflicts of interest within investment banks and given evidence that the Chinese wall that [Link] to separate divisions—e.g., the corporate advisory team is anned from ‘communicating with the front office—has often been breached. It has also been Suggested that some investment banks may have foisted toxic products on investors, Gf even worse, deliberately structured securities so they would turn sour, and sold them to other financial institutions while shorting them, ‘he leading investment banks are sometimes called “bulge bracket investment banks” because of ther wide range of activites. These banks, that operate worldwide, are ‘market makers and can underwrite sovereign bonds, 2008 was a tuming point for investment banks. * Two bulge bracket investment banks were written off the list. 85-year-old Bear Steams was acquired for $2 per share—or about $236 milion, considerably less than the sole value ofits building—by 1. Morgan. Lehman Brothers filed for Chapter 11 bankruptcy protection, and ts Asian and European operations were bought by Nomura, while Barclays acquired its North American ones. * Two banks, Morgan Stanley and Goldman Sachs, mutated into bank holding companies," which gave them access to the Fed's emergency lending facilities, but subjected them to more oversight and higher capital requirements. * Merrill Lynch was taken over by Bank of America, and Wachovia by Wells Fargo. Meanwhile in the U.K., the ABN Amro takeover by Royal Bank of Scotland had finally been completed in 2007, just before the beginning of the subprime crisis, > Banking regulations and regulatory authorities ‘As the bank sector consolidated, and a few financial institutions became even bigger ‘than they had been, the question of whether some banks were “too big to fail” was ‘moot. Did their size mean that there was an implicit guarantee that they would, if ‘needed, be bailed out by governments with the taxpayers’ money? If so, was there a Possibility that this might create a moral hazara, i, that the banks would not be as cautious as desired and might abuse the govemments’ protection? | American Expres, the last big independent cect card company, aso became a bank holding company in 2008, The Basel’ Committee on Banking Supervision of the Bank for International Settlements (BIS)? sought to address the systemic and moral hazard risks associsted with the potential failure of large banks. In November 2011, it identified 29 global systemically important banks (G-SIBs)3 The Basel Committee had already come up with new rules for capital requirements The 1988 minimum capital adequacy standards, also knowns the Cooke ratio, that required banks to set aside at least 8% of their risk-adjusted assets (RWAs) in pital, had to be reviewed, Such financial innovation as derivatives and securtiza tion—that made it difficult to assess the risk carried by banks—had made it obsolete in the late 1990s. In 2004 the Basel Committee had issued the McDonough ratio. Basel lI—that changed the weighting of risk depending on a borrower's credit rating. The McDonough ratio had not been fully implemented in the U.S. when the 2008 financial crisis led the Basel Committee to develop another new, more stringent capital framework, Basel Il Basel il introduces additional capital buffers, a minimum leverage ratio, as well as a liquidity coverage ratio (LCR)* and a net stable funding ratio (NSFR)° to reinforce the banks' ability to face liquidity risks. Both the United States and the European Union have endorsed the Base Il standards, but, as Basel Ill is not {egally-binding, it may be implemented in different ways. Grandfathering clauses have been included and the new capital requirements should be gradually phased in. Banks are in the process of deleveraging by selling assets in order to meet the new standards. Meanwhile, national regulators approached the issue from differert angles. nthe US., the Volcker rule required that depository institutions be prohibited from engaging in proprietary trading and being affiliated to a hedge fund or a private equity fund. The UK Vickers rule wanted to ring-fence retail activities to protect them from loss on the investment side. In the European Union, a review led by Erki Likanen—the governor of the Bank of Finland—suggested that the link between retail banking and Investment banking should be severed. That report also wanted banks to hold more capital against risky activities and to provide for debt to be automatically turned into 1. Spelt “Basle” in Bish English, The hoad office ofthe BIS isin Base, Switzedand. 2, “The mission ofthe Bank for Intemational Settlements (IS) i to serve cental banks in their pursuit ‘of monetary and financil stabil, to foster interational cooperation in these areas and to act 3s 2 ‘bank for central banks." http/wiww bis. org/about/ndex htm 3. The number was reduced to 28 in November 2012, as 3 banks were removed from the list and 2 added tot 4. “The liquidity coverage ratio (LCR) wil require banks to have suffclent high-quality liquid assets to withstand a 30-day stressed funding scenario that is specified by suneriso.” [Link]! ‘bcbs/base/o3summarytable pf. The deadline forthe fullimplementation of the LCR & 2019. 5. “The net stable funding ratio (SFR) i a longer-term structural ratio designed to address liquidity mismatches. t covers the ene balance sheet and provides incentives for barks to use stable sources of funding