BANKING, THE ORIGINS AND EVOLUTION OF FINANCE Nick Cortes, Manav Patel, Mariam Tehseen, & Jesse Panek CHAPTERS 2 AND 3 Banking Background and The Role of the Central Bank GOLDSMITHS In the past, the Trade and Barter system was used at all the ports and markets. Ex: Trading Livestock for Grain, Lumber for Textiles like Wool (The Fugger family of Augsburg for instance were originally wool merchants) Many of these merchants and markets turned to coinage for trading currency and gold was one of the most malleable (easy to shape or form) precious metals, which was also not subject to oxidation or corrosion. GOLDSMITHS In the 1600's, Goldsmiths in the United Kingdom (UK), invented banknotes. These merchants would hold money in vault for safe keeping and give receipts for deposits made out to the "bearer". The bearer could use these receipts, to purchase goods or lend out through trade. Italian merchants, however; took this idea one step further linking metallurgy to bank notes which then evolved into banking groups. States like Florence and Lombardy became dominant economic powers because these merchants traded across borders using their cash resources for banking and trade. HISTORY Just like the Goldsmiths of the past these banks could collect deposits and trade; but they also could lend money out. These formal benches of trade were known as bancos which is the Italian word for bench, and here began two forms of commercial banking. They allowed merchants to begin savings accounts and provided loans to the public. One thing to note; however, is that if there were only ten tons of gold (currency) deposited in a particular bank, yet that bank lent out 15 tons of gold and everyone for some adverse reason (distrust, natural calamity, or famine) returned to make a withdrawal the bank wouldn't have enough gold to pay out the merchants who originally entrusted these banks to secure their money. This would then be a bank run and this institution would go bankrupt. 5 HISTORY (CONTINUED) As you can imagine this would cause a great deal of chaos and distrust in the system; especially if in a time of need. Imagine if the money you earned, deposited, and then wanted to use was now nonexistent because the bank you dealt with couldn't back the "value it was creating". The first (1st) international banking crisis was in 1345. Edward III defaulted on a loan causing the families in Florence into liquidation. This made banks not only competitive but also reliant upon each other. If one bank was forced to liquidate all of its assets it could reach out to its competitor/business ally for additional currency or help. Why would they help? To ensure the entire system wouldn't collapse. 6 BANKING 7 Central Bank Florence Lombardi PRESENT DAY BANKS 8 What Role do Banks play in the Modern Economy? • We are now in an era where money is no longer tied to gold or silver. A bank can advance or create money, called the creation of a "credit line". • • Banks now play the vital role as "Financial Intermediaries" Without these institutions we would not have credit or options for small business which is the back-bone of community and governments alike. • The purpose of banking today is to allocate capital efficiently and loan money. Taking idol cash deposits and lending them out to other businesses which create and add value throughout our communities • This is the blood vein of our economies and the freedoms we are all privileged to bear. 9 TYPES OF BANKS CENTRAL Supervisors of banking system, Issuing bank notes, regulates the money in circulation, controls interest COMMERCIAL Classic-High Street banks taking deposits/len ds money, i.e., retail and wholesale banking MERCHANT/ INVESTMENT SAVINGS COOPERATIVE Gives advice on raising finance or with bonds & equities helps people price/sell them/or they'll purchase them for Mutually owned by its members, allowing small deposits for such a large type of bank/offer taxexempt accounts These Banks are not focused with maximum profit in mind. Instead, they aim to offer lowcost loans to their members 10 TYPES OF BANKS MORTGAGE Specializes in mortgages i.e., Nationwide GIRO AND NATIONAL SAVINGS CREDIT UNIONS Wheel/circle-two connections-money transfers to pay bills and Postal to pay bills Non-Profit Financial Institution member only low interest, lends money and offers tax privileges, Fee Free i.e., Navy Federal-PSECU do not pay federal taxes (CONTINUED) ISLAMIC Managing money according to Sharia (Islamic) law, paying or receiving interest is not allowed Non-usury CLEARING BANKS Clears cheques, commonly used in the UK OTHER TYPES OF BANKS STATE OR PUBLIC BANKS Owned by state that are not central banks but carryout some public sector activity SHADOW BANKING Lending by institutions other than banks i.e., investment companies, hedge funds, insur ance companies, pension funds 11 INTERNATIONAL BANKING Variety of activities, deposits/loans to nationals in foreign currencies, and non-nationals in domestic currency, i.e., trade finance, foreign exchange, international finance 12 CENTRAL BANK • OVERVIEW OF CENTRAL BANK • • • • • General autonomous organization National organization Serves government and commercial banking sector Manages government’s monetary policy Production and circulation of currency e.g. Central bank of Canada, Federal Reserves etc. 13 CENTRAL BANK OVERVIEW • To regulate the flow of currency in the market. • To supply and circulate money across a nation's market. • To stabilize a country's currency / and economy. • e.g. Interest rates, open market trading, reserve requirements, and liquidity management • To combat unemployment in a nation • To ensure alignment with country's long-term policy objectives. Ref: Image taken from https://www.wallstreetmojo.com/central-bank 14 FUNCTIONS OF THE CENTRAL BANK Ref: image taken from https://www.economicsdiscussion.net/banks/central-bank-and-its-functions/4165 15 TRADITIONAL FUNCTION • • • • • To print notes or money in the relevant nation Manages inflation and implements monetary policy. Taking care of deposits or reserves of commercial banks Allowing for easy access to foreign exchange in times of need. To assist commercial banks by providing them with loans. Ref: image taken from https://www.freepik.com/premium-vector/distribution-money-central-bank-commercial-banks-cash-circulation-concept_30284632.htm 16 DEVELOPMENT FUNCTION Ref: image taken from https://www.civilsdaily.com/central-banking-in-india-functions-of-rbi/ NEW APPROACH TO UK FINANCIAL SECTOR REGULATION THE FINANCIAL POLICY COMMITTEE (FPC) This committee oversees monitoring the broader financial system's stability. It will oversee developing macroprudential tools to assess systemic risks and periodically monitoring hazards. THE PRUDENTIAL REGULATORY AUTHORITY (PRA) This authority was founded as a division of the Bank of England to oversee the major, more complicated investment firms and firms that handle balance sheet risk. THE FINANCIAL CONDUCT AUTHORITY (FCA) This authority was set up to keep an eye on systemic corporations' business practices and consumer protection concerns. 17 18 CENTRAL BANK ACTIVITIES ● Supervising the banking system ● Advising the government on monetary policy ● Issuing banknotes ● Acting as banker to the other banks ● Acting as banker to the government ● Raising money for the government ● Controlling the nation’s currency reserves ● Acting as lender of last resort (LLR ● Liaison with international bodies 19 CHAPTER 4 COMMERCIAL BANKING 20 TYPES OF SERVICES: Deposits: Current accounts, deposit accounts, payments Decentralized banking technologies: Bitcoin, Ethereum Loans: Overdraft, Personal loan, Mortgage, Credit Card Other services: Securities purchases, securities custody, Mutual Funds, Advising, Mutual Funds, Safe deposits, Foreign Exchange, Insurance 21 FORMS OF DELIVERY • Branch delivery - infrastructure allowing customers to meet in person for services • Telephone Banking - utilizes passwords on account to allow customers to engage in negotiations, creating accounts, securing loans and mortgages, etc. • Internet Banking- allows a variety of services to be provided over the internet • Clearing Systems- allow banks to ensure settlement is fulfilled between banks, sufficient funds are provided • Cross-border clearing- Network allowing transactions to occur internationally quickly and securely 22 Key Retail Banking Issues (Valdez, Molyneux 84) • Across all the Western financial markets, commercial banks face a series of key challenges: • 1 Capital strength: Have they got enough to back their business? • 2 Liquidity: Can they meet predictable and unpredictable cash requirements? • 3 Risk management: Can they manage risk properly? • 4 Executive pay: Do they pay too much? • 5 Competition: Can they price competitively? • 6 Cost control: Can they be efficient? • 7 Sales of non-banking products: What products should they offer? • 8 Use of IT: How can IT help in reducing costs in front and back office operations? WHOLESALE BANKING 23 Uncommitted Facilities: Committed Facilities: • Overdrafts: allows clients to overdraw funds for a cost (bank interest rate + margin) • -Term loans: typically 5-7 years, amortized over period, floating interest rate tied to interbank rate • Lines of credit: allows client to borrow a sum of money for a certain amount of time at the cost of an interbank rate • • Banker’s acceptances: a form of short term loan allowing a business to pay expenses and complete a transaction by acting as a guarantor on the deal before being repaid once profit is generated from the deal -Standby credit: a contingency fund allowing a customer to repay debts in the case of an emergency that allows both the bank and the customer a form of security since the committed funds are only to be used in certain circumstances • -Revolving credit: allows customer freedom to withdraw funds within a certain limit • -Project Finance: Project being financed serves as collateral to prove to banks that the result of the financing will produce profit 24 SYNDICATED FACILITIES Allows banks to take on only part of loan, limits exposure to risk. -NIFs, RUFs, MOFs: financial products commonly used by businesses and organizations to manage their cash flow, access funding for short-term borrowing needs, and support their operations and growth -Relationship banking: allows bilateral agreements between bank branches to facilitate banking operations LOAN AGREEMENT SECTIONS (VALDEZ, MOLYNEUX 99) 1 Introduction: This will cover the amount of the loan and its purpose, conditions of drawdown and particulars of the participating banks. 2 Facilities: The loan may be drawn down in separate tranches with different terms on interest and repayment. The procedures for drawing down will be covered. 3 Payment: This covers the interest calculations, calculation of the interbank rate, repayment arrangements, fees, or any similar charges. 4 Provisions: To protect the bank, there will be covenants, events of default, procedures if basic circumstances change. 26 COVENANTS PROTECTING BANKS (VALDEZ, MOLYNEUX 99) ● Interest cover: This is the relationship between profit (before tax and interest) and interest. This is to ensure that there is a comfortable margin over the loan interest. If there is not, how can the borrower repay the principal? Sometimes cash flow may be used instead of profit. After all, profit is not cash. ● Net worth: Suppose all assets were sold and liabilities paid – what is left? Normally, this should be the figure of share capital and reserves ± current profit/loss, minus goodwill, tax and dividends to be paid. The agreement stipulates a minimum net worth. ● Total borrowing: This will be limited and must cover hire purchase, finance leases and ‘puttable’ capital instruments (see Chapter 7). ● Gearing: Long-term debt to capital as defined in net worth above – a maximum ratio will be stated. ● Current ratio: A minimum figure will be given for the ratio of current assets to current liabilities – a measure of liquidity. CHAPTER 5 INVESTMENT BANKING 28 WHAT IS INVESTMENT BANKING? - Advisory based transactions by banks for individuals, corporations, and governments Important in terms matching buyers and sellers Help liquidate markets Promote efficiency and economic growth Vital for a healthy economy 29 ORIGIN OF INVESTMENT BANKING IN THE UK - Investment banking originated in the UK using a Bill of Exchange Now more commonly used by commercial banks Medici banks helped a firm trade with another firm in London using a bill of exchange UK banks were then tasked in backing trades with bill of exchange 30 ORIGIN OF INVESTMENT BANKING IN THE UK - Many bill of exchanges are more complicated Sellers might not be able to wait the whole period to get their money Possibly get a loan from a bank Or sell the bill of exchange to a bank for a discount 31 ORIGIN OF INVESTMENT BANKING IN THE UK - Sometimes banks are unsure of the credit of a seller Require a merchant bank to sign off the bill Merchant banks would charge a fee 32 CORPORATE FINANCE Corporate Finance is a sub-division within investment banks, and they are tasked with duties such as: New Issues Right Issues Merger and Acquistions Research 33 NEW ISSUES - New issues of bond and shares need to be created They need to be priced, sold to investors, and underwrote Underwriting is the promise of buying securities that investors don't buy Fees are charged and merchant banks share risk by doing this Could lead to disasters such as the BP situation 34 RIGHT ISSUES - Right issues need to be prices and underwritten for when prices fall under the offer price An example of this would be during the BP situation Some shares were being created quoted and new ones were being made Many developing countries have investment banks do this for them 35 MERGERS AND ACQUISTIONS - Firms may want to acquire or merge with other firms and would want help from investment banks Investment banks will help pull trades together between firms Investment banks will value the other firm Give advice on when the best time to acquire them will be Multiple investment banks may be involved Investment banks usually charge around .125%-.5% on these deals These deals are worth hundreds of millions of dollars 36 MERGERS AND ACQUISTIONS Top M&A deals in 2012-2013 37 RESEARCH - Research is vital for investment banks to operate Good research capabilities help them be efficient and effective Good research helps investment banks give out the advice they do For any investment bank to be successful, they must invest in their research 38 INVESTMENT MANAGEMENT Investment managers use funds from banks or other people to invest. There are four main ways they get these funds: High net-worth individuals Corporates Pension Funds Mutual Funds 39 HIGH NET-WORTH INDIVIDUALS CORPORATES - - - People with high net-worth can approach banks to invest their money This is called private banking Banks will have a minimum threshold that individuals must meet - - Organizations may have a large amount of cash flow they'd want to invest This can help them gain a larger war chest for them to possibly takeover another firm Investment banks could be the ones who handle their investments 40 PENSION FUNDS MUTUAL FUNDS - - - Certain governments may feel that they lack skills to invest large amounts of capital effectively Investment banks can be outsourced to properly manage them - Mutual funds are the collection of investments such as market instruments, bonds, and equities Banks run their own mutual funds and advertise it towards smaller investors Fund managers will charge a small fee for handling the fund CHAPTER 6 REGULATION 42 PURPOSE OF REGULATION There are three big reasons for the purpose of regulation, to regulate monopolies, to safeguard welfare, and dealing with externalities Also helps to negate systemic risk: (VALDEZ, MOLYNEUX 99) "all events capable of imperilling the stability of the banking and financial system" Presentation title 43 THEORIES FOR BANKING CRISES - Random withdraws and its uncertainty for needs • Natural outgrowth of the business cycle which cause economic downgrowth, assets value reduced, depositors withdrawing money Presentation title BANKING CRISIS - There has been 124 banking crisis between 1970-2007 between countries - Policy maker concerns - Crisis have large fiscal costs 44 SYSTEMIC RISK - What is systemic risk? - Liquidity and solvency issues - Regulation don't make it safe but instead stable - Regulation for the entire system SYSTEMICALLY IMPORTANT FINANCIAL INSTITUTIONS (SIFI) - The rise of SIFIs are crucial to regulation - SIFIs size are an important consideration when regulating - They have a large amount of borrowers - International operations make it harder to regulate between institutions 46 47 TOP 30 SIFIS CONCERNS WITH BIG BANKS - Big banks play a crucial role in our financial systems - Main source for a lot of borrowers - Bank failure results to detrimental damage - Hazards and safety nets are more severe 49 PRIMARY REGULATING PARTIES/POLICIES BY LOCATION UK - the Independent Commission on Banking (Vickers Commission) US- Dodd-Frank Act (Volcker Rule), Consumer Protection Act, Federal Deposit Insurance Corporation(FDIC), Consumer Financial Protection Bureau, Government Accountability Office, Securities and Exchange Commision (SEC) Europe- European Parliament and Ecofin, European Systemic Risk Board (ESRB), European System of Financial Supervisors (ESFS) THANK YOU CITATION Valdez, S., Molyneux, P. (2016). An Introduction to Global Financial Markets. Palgrave.
