Principles of banking and finance
M. Buckle, E. Beccalli
FN1024, 2790024
2011
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a Level 1 course (also known as a ‘100 course’) offered as
part of the University of London International Programmes in Economics, Management,
Finance and the Social Sciences. This is equivalent to Level 4 within the Framework for
Higher Education Qualifications in England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk/current_students/programme_resources/lse/index.shtml
This guide was prepared for the University of London International Programmes by:
M. Buckle, MSc, PhD, Senior Lecturer in Finance, European Business Management School,
Department of Accounting, University of Wales, Swansea.
E. Beccalli, Visiting Senior Fellow in Accounting, London School of Economics and
Political Science.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide.
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Published by: University of London
© University of London 2008
Reprinted with minor revisions 2011
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Contents
Contents
Chapter 1: Introduction........................................................................................... 1
General introduction to the subject................................................................................. 1
Learning outcomes......................................................................................................... 1
Essential reading............................................................................................................ 2
Further reading............................................................................................................... 3
References..................................................................................................................... 4
Online study resources.................................................................................................... 6
The structure of the subject guide .................................................................................. 7
How to use this subject guide......................................................................................... 8
Structure of each chapter................................................................................................ 9
Examination................................................................................................................... 9
Syllabus........................................................................................................................ 11
Part I: Financial systems........................................................................................ 13
Overview...................................................................................................................... 13
Chapter 2: Introduction to financial systems........................................................ 15
Aims............................................................................................................................ 15
Learning outcomes....................................................................................................... 15
Essential reading.......................................................................................................... 15
Further reading ........................................................................................................... 15
Introduction................................................................................................................. 16
The structure of financial systems: financial markets, securities and financial
intermediaries.............................................................................................................. 17
Taxonomy of financial intermediaries............................................................................ 18
Nature of financial instruments (securities).................................................................... 26
Structure of financial markets ...................................................................................... 32
Summary...................................................................................................................... 36
Key terms .................................................................................................................... 37
A reminder of your learning outcomes........................................................................... 37
Sample examination questions...................................................................................... 38
Chapter 3: Comparative financial systems............................................................ 39
Aims ........................................................................................................................... 39
Learning outcomes....................................................................................................... 39
Essential reading.......................................................................................................... 39
Further reading............................................................................................................. 39
References .................................................................................................................. 39
Introduction ................................................................................................................ 40
The evolution of financial systems................................................................................. 43
The emergence of market-based and bank-based systems............................................. 45
Market-based versus bank-based financial systems: implications................................... 50
Financial crises............................................................................................................. 53
Financial bubbles.......................................................................................................... 59
Summary...................................................................................................................... 61
Key terms..................................................................................................................... 62
A reminder of your learning outcomes........................................................................... 62
Sample examination questions...................................................................................... 62
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24 Principles of banking and finance
Part II: Principles of banking................................................................................. 63
Overview...................................................................................................................... 63
Chapter 4: Role of financial intermediation . ....................................................... 65
Aims............................................................................................................................ 65
Learning outcomes....................................................................................................... 65
Essential reading.......................................................................................................... 65
Further reading............................................................................................................. 65
References .................................................................................................................. 65
Introduction................................................................................................................. 66
Some evidence on financial intermediation .................................................................. 67
Why do financial intermediaries exist?.......................................................................... 68
Asset transformation.................................................................................................... 69
Transaction costs.......................................................................................................... 71
Liquidity needs ........................................................................................................... 72
Asymmetric information: adverse selection and moral hazard........................................ 73
What is the future for financial intermediaries?............................................................. 82
Summary...................................................................................................................... 86
Key terms..................................................................................................................... 87
A reminder of your learning outcomes........................................................................... 87
Sample examination questions...................................................................................... 87
Chapter 5: Regulation of banks . .......................................................................... 89
Aims ........................................................................................................................... 89
Learning outcomes....................................................................................................... 89
Essential reading.......................................................................................................... 89
Further reading............................................................................................................. 89
References .................................................................................................................. 90
Introduction................................................................................................................. 90
Free banking................................................................................................................ 90
Why do banks need regulations?.................................................................................. 92
Arguments against regulation . .................................................................................... 95
Traditional regulation mechanisms ............................................................................... 96
Alternatives to traditional regulation: disclosure-based regulation of banking.............. 108
International banking regulation................................................................................. 110
Summary.................................................................................................................... 111
Key terms................................................................................................................... 112
A reminder of your learning outcomes......................................................................... 112
Sample examination questions.................................................................................... 112
Chapter 6: Risk management in banking............................................................ 115
Aims ......................................................................................................................... 115
Learning outcomes..................................................................................................... 115
Essential reading........................................................................................................ 115
Further reading........................................................................................................... 115
References ................................................................................................................ 115
Introduction............................................................................................................... 116
Taxonomy of risk........................................................................................................ 116
Policies to reduce risk................................................................................................. 120
Credit risk management............................................................................................. 120
Interest rate risk management.................................................................................... 125
Summary.................................................................................................................... 134
Key terms................................................................................................................... 134
ii
Contents
A reminder of your learning outcomes......................................................................... 135
Sample examination questions.................................................................................... 135
Part III: Principles of finance............................................................................... 137
Overview.................................................................................................................... 137
Chapter 7: Capital budgeting and valuation....................................................... 139
Aims.......................................................................................................................... 139
Learning outcomes..................................................................................................... 139
Essential reading........................................................................................................ 139
Further reading ......................................................................................................... 139
Introduction............................................................................................................... 140
The concept of present value...................................................................................... 140
Net present value (NPV) and the valuation of real assets............................................. 142
Other real asset appraisal techniques.......................................................................... 144
Valuation of financial assets (securities)...................................................................... 150
Common stocks (i.e. ordinary shares).......................................................................... 152
Summary.................................................................................................................... 155
Key terms................................................................................................................... 155
A reminder of your learning outcomes......................................................................... 155
Sample examination questions.................................................................................... 156
Chapter 8: Securities and portfolios – risk and return........................................ 159
Aims ......................................................................................................................... 159
Learning outcomes..................................................................................................... 159
Essential reading........................................................................................................ 159
Further reading ......................................................................................................... 159
References................................................................................................................. 160
Introduction............................................................................................................... 160
Risk and return of a single financial security................................................................ 160
Risk and return of a portfolio: portfolio analysis........................................................... 164
Benefits of diversification............................................................................................ 165
Mean-standard deviation portfolio theory................................................................... 166
Asset pricing models................................................................................................... 171
Arbitrage Pricing Theory (APT)..................................................................................... 177
Summary.................................................................................................................... 180
Key terms................................................................................................................... 181
A reminder of your learning outcomes......................................................................... 181
Sample examination questions.................................................................................... 181
Chapter 9: Financial markets – transmission of information.............................. 183
Aims ......................................................................................................................... 183
Learning outcomes..................................................................................................... 183
Essential reading........................................................................................................ 183
Further reading ......................................................................................................... 183
References................................................................................................................. 184
Introduction............................................................................................................... 184
Informational efficient markets................................................................................... 185
Concept of excess returns........................................................................................... 187
Levels of informational market efficiency: weak, semi-strong and strong forms............. 188
Empirical evidence on efficient markets....................................................................... 190
Summary.................................................................................................................... 197
Key terms................................................................................................................... 197
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24 Principles of banking and finance
A reminder of your learning outcomes......................................................................... 197
Sample examination questions.................................................................................... 198
Appendix 1: Solutions to numerical activities..................................................... 199
Answers to ‘Activities’ marked with an asterisk............................................................ 199
Chapter 5................................................................................................................... 199
Chapter 6................................................................................................................... 199
Chapter 7................................................................................................................... 200
Chapter 8................................................................................................................... 201
Chapter 9................................................................................................................... 202
Appendix 2: Sample examination paper............................................................. 203
iv
Chapter 1: Introduction
Chapter 1: Introduction
General introduction to the subject
This subject guide provides an introduction to the principles of banking
and finance. It covers a broad range of topics using an economic
perspective, and aims to give a general background to any student
interested in the subject of banking and finance.
The contents of the subject guide can be broken down into three main parts:
• In Part I, we investigate the structure and functions of financial
systems. We focus on each of the three main entities that compose
a financial system: financial intermediaries, securities and financial
markets. We then investigate the difference in the relative importance
of financial intermediaries and financial markets around the world,
and thus propose a historical and economic investigation of the reasons
behind the emergence of bank-based systems and market-based
systems in different countries.
• In Part II, we examine the issues that come under the broad heading
of principles of banking. Here we examine the key economic reasons
used to justify the existence of financial intermediaries (and specifically
banks). We then investigate the special nature of banking regulation.
Finally we outline the key risks in banking and the main methods
used for risk management. Thus the areas covered include the role
of financial intermediation, banking regulation and banking risk
management.
• In Part III, we move to the issues known as principles of finance. Here
we will examine the techniques used by firms to value real investment
projects, and the models used by investors to value bonds and stocks.
We then investigate the issues related to the formation of an optimal
portfolio by investors, and we derive the main equilibrium asset
pricing models. Finally, we investigate the efficiency of the market in
pricing securities, and thus we propose a theoretical and empirical
validation of the efficient market hypothesis. The areas covered in
this section therefore include capital budgeting, securities valuation,
mean-standard deviation portfolio theory, asset pricing models and
informational market efficiency.
24 Principles of banking and finance is a compulsory course for
the BSc Banking and Finance. This is an important subject because it
establishes many of the fundamental concepts in banking and finance that
will be developed in later subjects in the degree, such as 92 Corporate
finance, 29 Financial intermediation and 143 Valuation and
securities analysis.
Note that the guide uses mainly US references, takes a US view and uses
US terminology.
Learning outcomes
By the end of this subject guide, and having done the relevant readings
and activities, you should be able to:
• discuss why financial systems exist, and how they are structured
1
24 Principles of banking and finance
• explain why the relative importance of financial intermediaries and
financial markets is different around the world, and how bank-based
systems differ from market-based systems
• understand why financial intermediaries exist, and discuss the role of
transaction costs and information asymmetry theories in providing an
economic justification
• explain why banks need regulation, and illustrate the key reasons for
and against the regulation of banking systems
• discuss the main types of risks faced by banks, and use the main
techniques employed by banks to manage their risks
• explain how to value real assets and financial assets, and use the key
capital budgeting techniques (Net Present Value and Internal Rate of
Return)
• explain how to value financial assets (bonds and stocks)
• understand how risk affects the return of a risky asset, and hence how
risk affects the value of the asset in equilibrium under the fundamental
asset pricing paradigms (Capital Asset Pricing Model and Asset Pricing
Theory)
• discuss whether stock prices reflect all available information, and
evaluate the empirical evidence on informational efficiency in financial
markets.
Essential reading
The following text has been chosen as the core text for this subject guide,
due to its extensive treatment of many (but not all) of the issues covered
in the subject guide and its up-to-date discussions:
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) sixth edition [ISBN 978032155112].
However, this core text does not cover the material for the entire subject
guide.
To analyse comparative financial systems, the essential reading also
includes:
Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) [ISBN 9780262511254].
To investigate issues of principles of finance (capital budgeting and
valuation of financial assets, risk and return of financial assets and
portfolios), the following text is also essential reading:
Brealey, R.A, S.C. Myers and F. Allen Principles of corporate finance. (Boston,
London: McGraw-Hill/Irwin, 2010) tenth (global) edition
[ISBN 9780071314176] Chapters 2, 3, 4, 5, 7, 8, 13 and 14.
The subject guide must be used in conjunction with these three essential
textbooks. At the head of each chapter of this guide, we indicate essential
reading from Mishkin and Eakins. Alternatively, when no relevant readings
are available in Mishkin and Eakins, we indicate reading from either Allen
and Gale or Brealey, Myers and Allen.
Several websites are indicated in the subject guide, mainly as references
for activities you are required to do. Please visit these websites whenever
indicated.
The following articles from academic journals are also indicated as
Essential reading in Chapters 5 and 6:
2
Chapter 1: Introduction
Dow, S. ‘Why the banking system should be regulated’, Economic Journal 106
(436) 1996, pp.698–707.
Dowd, K. ‘The Case for Financial Laissez-Faire’, Economic Journal 106 (436)
1996, pp.679–87.
Gordy, M.B. ‘A comparative anatomy of credit risk models’, Journal of Banking
and Finance 24 (1-2) 2000, pp.119–49.
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Bain, A.D. The Economics of the Financial Systems. (Oxford: Blackwell Publishers
Ltd, 1992) [ISBN 9780631181972] Chapter 4.
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (Boston,
London: McGraw-Hill/Irwin, 2008) tenth edition [ISBN 9780073368696]
Chapter 8.
Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004) fourth edition [ISBN 9780719067723]
Chapters 1, 2 and 17.
Copeland, T.E., J.F. Weston and K. Shastri Financial Theory and Corporate Policy.
(Boston, London: Pearson Addison Wesley, 2005)
[ISBN 9780321223531] Chapters 2, 4, 5, 6 and 10.
Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio
Theory and Investment Analysis. (New York: John Wiley & Sons, 2007)
seventh edition [ISBN 9780470050828] Chapter 17, pp.59 and 61.
Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.:
The MIT Press, 2008) [ISBN 9780262061933] Chapters 2, 8 and 9.
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy
(Boston, London: McGraw-Hill/Irwin, 2002) second edition [ISBN
9780072294330] Chapters 4, 5, 6, 9 and 10.
Heffernan, S. Modern Banking in Theory and Practice. (Chichester: John Wiley
and Sons, 2005) [ISBN 9780471962090] Chapters 2, 3, 4 and 5.
Luenberger, D.G. Investment Science. (New York: Oxford University Press, 1998)
[ISBN 9780195108095] Chapters 6 and 7.
Saunders, A. and M.M. Cornett Financial Institutions Management: a Risk
Management Approach. (New York: McGraw-Hill/Irwin, 2007) sixth edition
[ISBN 9780077211332] Chapters 2–6 and 8–12.
Sinkey, J.F. Commercial Bank Financial Management in the Financial-Services
Industry. (Upper Saddle River, NJ: Pearson Education Inc., 2002)
[ISBN 9780130984241] Chapter 16.
Smart, S.B., W.L. Megginson and L.J. Gitman Corporate Finance. (Mason, Ohio:
South-Western/Thomson Learning, 2004) [ISBN 9780324269604]
Chapters 4, 7 and 10.
3
24 Principles of banking and finance
References
For certain topics, we will also list journal articles or texts as
supplementary references to the additional reading. It is not essential
that you read this material, but it may be helpful if you wish to better
understand some of the topics in this subject guide.
A full bibliography of the supplementary references is provided below:
Akerlof, G. ‘The Market for “Lemons”: Quality, Uncertainty and the Market
Mechanisms’, Quarterly Journal of Economics 84(3) 1970, pp.488–500.
Allen, F. and R. Karjalainen ‘Using Genetic Algorithms to Find Technical Trading
Rules’, Journal of Financial Economics 51(2) 1999, pp.245–71.
Altman, E.I. ‘Managing the commercial lending process’ in Aspinwall, R.C. and
R.A. Eisenbeis Handbook of Banking Strategy. (New York: John Wiley and
Sons, 1985) [ISBN 9780471893141] pp.473–510.
Ball, R. and P. Brown ‘An Empirical Evaluation of Accounting Income Numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Bank of England Discussion Paper ‘The role of macroprudential policy’,
November 2009. Available at www.bankofengland.co.uk/publications/
news/2009/111.htm
Bank of England Financial Stability Report, no. 21 (London, 2007).
Basel Committee on Bank Supervision Overview on the New Capital Accord.
(Bank for International Settlements, January 2001) p.27.
Benston G. and C. Smith ‘A Transaction Costs Approach to the Theory of
Financial Intermediation’, Journal of Finance 31(2) 1976, pp.215–231.
Bernard, V. and J. Thomas ‘Post-earnings announcement drift: Delayed price
response or risk premium?’, Journal of Accounting Research 27(3) 1989
supplement, pp.1–36.
Boyd, J.H. and M. Gertler ‘Are Banks Dead? Or Are the Reports Greatly
Exaggerated?’ in The Declining(?) Role of Banking. (Chicago: Federal
Reserve Bank of Chicago, 1994).
Brock, W., J. Lakonishok and B. LeBaron ‘Simple Technical Trading Rules and
the Stochastic Properties of Stock Returns’, Journal of Finance 47(5) 1992,
pp.1731–764.
Bullard. J, J. Neely and D. Wheelock ‘Systemic risk and the financial crisis: a
primer’, Federal Reserve Bank of St. Louis Review, September/October 2009,
pp.403-17.
Carhart, M.M. ‘On Persistence in Mutual Fund Performance’, Journal of Finance
52(1) 1997, pp.57–82.
Chan, K.C., N. Chen and D. Hsieh ‘An Exploratory Investigation of the Firm Size
Effect’, Journal of Financial Economics 14(3) 1985, pp.451–71.
Chen, N. ‘Some Empirical Tests of the Theory of Arbitrage Pricing’, Journal of
Finance 38(5) 1983, pp.1393–414.
Chen, N., R. Roll and S. Ross ‘Economic Forces and Stock Market’, Journal of
Business 59(3) 1986, pp.383–403.
Cheng-few L., D.C. Porter and D.G. Weaver ‘Indirect tests of the HaugenLakonishok small-firm/January effect hypotheses: window dressing versus
performance hedging’, The Financial Review (1998) 33, pp.177–94.
Coase, R.H. ‘The Problem of Social Cost’, Journal of Law and Economics 3(1)
1960, pp.1–23.
Corbett, J. and T. Jenkinson ‘How Is Investment Financed? A Study of Germany,
Japan and the United States’, Manchester School of Economics and Social
Studies 65 (1997) supplement, pp.69–93.
DeBondt, F.M. and R. Thaler ‘Further Evidence on Investor Overreaction and
Stock Market Seasonality’, Journal of Finance 42(3) 1987, pp.557–80.
Diamond, D.W. ‘Financial Intermediation and Delegated Monitoring’, Review of
Economic Studies 51(166) 1984, pp.393–414.
4
Chapter 1: Introduction
Diamond, D.W. ‘Financial Intermediation as Delegated Monitoring: A Simple
Example’, Federal Reserve Bank of Richmond Economic Quarterly, 82/3,
1996, pp.51-66.
Diamond, D.W. and P.H. Dybvig ‘Bank Runs, Deposit Insurance, and Liquidity’,
Journal of Political Economy 91(3) 1983, pp.401–419.
Dimson, E., P. Marsh, and M. Staunton ‘Global evidence on the equity risk
premium’, Journal of Applied Corporate Finance 15(4) 2003, pp.27–38.
Dow, S., ‘Why the banking system should be regulated’, Economic Journal 106
(436) 1996, pp.698–707.
Dowd, K., ‘The Case for Financial Laissez-Faire’, Economic Journal 96(106)
1996, pp.679–87.
Fama, E. ‘Efficient Capital Markets: A Review of Theory and Empirical Work’,
Journal of Finance 25(2) 1970, pp.383–417.
Fama, E. ‘Banking in the theory of finance’, Journal of Monetary Economics 6(1)
1980, pp.39–57.
Fama, E. and K.R. French ‘Permanent and Temporary Components of Stock
Prices’, Journal of Political Economy 96(2) 1988, pp.246–73.
Fama, E. ‘Efficient Capital Markets: II’, Journal of Finance 46(5) 1991, pp.1575–
618.
Freixas, X, C. Giannini, G. Hoggart and F. Soussa ‘Lender of Last Resort: A
Review of the Literature’, Bank of England Financial Stability Review,
November 1999.
Goddard, J.A., P. Molyneux and J.O.S. Wilson European Banking. Efficiency,
Technology and Growth. (Chichester: John Wiley & Sons, 2001) [ISBN
9780471494492] pp.109–20.
Gordy, M.B. ‘A comparative anatomy of credit risk models’, Journal of Banking
and Finance 24(1–2) 2000, pp.119–49.
Grinblatt, M. and S. Titman ‘Mutual Fund Performance: an Analysis of
Quarterly Portfolio Holdings’, Journal of Business 62(3) 1989, pp.393–416.
Gurley, J.G. and E.S. Shaw Money in a Theory of Finance. (Washington D.C.:
Brookings Institute, 1960) [ISBN 9780815733225].
Hackethal, A. and R.H. Schmidt ‘Financing Patterns: Measurement Concepts
and Empirical Results’, Frankfurt Department of Finance Working Paper no.
125 (2004), p.30.
Haugen, R. and J. Lakonishok The Incredible January Effect. (Dow Jones-Irwin,
Homewood, Illinois, 1988) [ISBN 9781556238710].
Jacquier, E., A. Kane and A.J. Marcus ‘Geometric or Arithmetic Means: A
Reconsideration’, Financial Analysts Journal 59(6) 2003, pp.46–53.
Jegadeesh, N. and S. Titman ‘Returns to Buying Winners and Selling Losers:
Implications for Stock Market Efficiency’, Journal of Finance 48(1) 1993,
pp.65–91.
Jensen, M.C. ‘The performance of Mutual Funds in the Period 1945–64’,
Journal of Finance 23(2) 1968, pp.389–416.
Jensen, M.C., and W.H. Meckling ‘Theory of the firm: managerial behavior,
agency costs and ownership structure’, Journal of Financial Economics 3(4)
1976, pp.305–60.
Kay, J. ‘Narrow banking: the reform of banking regulation’, Centre for the study
of Financial Innovation, publication no. 88, September 2009.
Keim, D.B. ‘The CAPM and Equity Return Regularities’, Financial Analysts
Journal 42(3) 1986, pp.19–34.
Lacoste, P. ‘International capital flows in Argentina’, BIS Papers no. 23 (http://
www.bis.org/publ/bppdf/bispap23e.pdf, 2004)
Leland, H.E. and D.H. Pyle ‘Informational Asymmetries, Financial Structure,
and Financial Intermediation’, Journal of Finance 32(2) 1977, pp.371–387.
Lindgren, C., G. Garcia and M. Saal Bank Soundness and Macroeconomic Policy.
(Washington DC: International Monetary Fund, 1996)
[ISBN 9781557755995].
5
24 Principles of banking and finance
Lintner, J. ‘The Valuation of Risk Assets and the Selection of Risky Investments
in Stock Portfolios and Capital Budgets’, Review of Economics and Statistics
47(1) 1965, pp.13–37.
Lo, A. and C. MacKinlay ‘Stock Market Prices do not Follow Random Walks:
Evidence from a Simple Specification Test’, Review of Financial Studies 1(1)
1988, pp.41–66.
Markowitz, H.M. ‘Portfolio Selection’, Journal of Finance 7(1) 1952, pp.77–91.
Mayer, C. ‘Financial Systems, Corporate Finance, and Economic Development’
in Hubbard, R.G. (ed.) Asymmetric Information, Corporate Finance, and
Investments. (Chicago: University of Chicago Press, 1990)
[ISBN 9780226355856] pp.307–32.
Mortlock, G. ‘New Zealand’s financial sector regulation’, Reserve Bank of New
Zealand: Bulletin 66 (2003), pp.5–49.
Patell, J.M. and M.A. Wolfson ‘The Intraday Speed of Adjustment of Stock
Prices to Earnings and Dividend Announcements’, Journal of Financial
Economics 13(2) 1984, pp.223–52.
Poterba, J.M. and L.H. Summers ‘Mean Reversion in Stock Prices: Evidence and
Implications’, Journal of Financial Economics 22(1) 1988, pp.27–59.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Tests; Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.
Ross, S.A. ‘The Arbitrage Theory of Capital Asset Pricing’, Journal of Economic
Theory 13(3) 1976, pp.341–60.
Sharpe, W.F. ‘Capital Asset Prices: A Theory of Market Equilibrium under
Conditions of Risk’, Journal of Finance 19(3) 1964, pp.425–42.
Trueman, B., M.H. Wong and X.J. Zhang ‘The Eyeballs Have it: Searching for
the Value in Internet Stocks’, Working Paper, (University of California, April
2000).
Turner, A ‘The Turner Review: A regulatory response to the global banking
crisis’, Financial Services Authority, 2009. (download from www.fsa.gov.uk/
pubs/other/turner_review.pdf)
Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should receive your login details in your study pack. If you have not,
or you have forgotten your login details, please email uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Self-testing activities: Doing these allows you to test your own
understanding of subject material.
• Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
6
Chapter 1: Introduction
• Past examination papers and Examiners’ commentaries: These provide
advice on how each examination question might best be answered.
• A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
• Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
• Recorded lectures: For some courses, where appropriate, the sessions
from previous years’ Study Weekends have been recorded and made
available.
• Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
• Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
Unless otherwise stated, all websites in this subject guide were accessed in
2008. We cannot guarantee, however, that they will stay current and you
may need to perform an internet search to find the relevant pages.
The structure of the subject guide
Part I of the subject guide focuses on financial systems, Part II addresses
the key principles of banking and Part III investigates the principles of
finance. The content of the subject guide is as follows.
Part I: Financial systems
• Chapter 2 serves as grounding to financial systems by investigating the
functions and structure of financial systems. It thus focuses on each
of the three main entities that compose financial systems (financial
intermediaries, securities and financial markets).
• Chapter 3 presents a discussion of the features of bank-based systems
against market-based systems in different countries around the world.
7
24 Principles of banking and finance
Part II: Principles of banking
• Chapter 4 focuses specifically on the nature and process of financial
intermediation by presenting a discussion of the key theories of
financial intermediation (transformation of assets, uncertainty,
reduction in transaction costs, reduction of problems arising out of
asymmetric information).
• Chapter 5 provides an investigation of the theoretical and practical
aspects of regulation of banks, such as arguments for or against
regulation, traditional regulation mechanisms and alternatives to
traditional regulation.
• Chapter 6 presents discussion of the key risks in banking (credit risk,
interest rate risk, market risk and liquidity risk) and the main methods
of risk management in banks (such as screening, monitoring, duration
gap analysis, value-at-risk).
Part III: Principles of finance
• Chapter 7 outlines the concept and techniques of capital budgeting and
securities valuation. It focuses first on the valuation of real investment
projects using the Net Present Value (NPV), and provides a comparison
of NPV with alternative techniques. Then it moves to the models used
for the valuation of bonds and stocks.
• Chapter 8 discusses the basics of risk and return of securities and
mean-variance portfolio theory. It goes on to derive and discuss the
equilibrium asset pricing models (Capital Asset Pricing Model and
Arbitrage Pricing Model).
• Chapter 9 focuses on the efficiency of financial markets by providing a
theoretical derivation of the concepts of weak, semi-strong, and strong
efficiency. It then moves to the discussion of the empirical evidence in
favour of and against market efficiency.
How to use this subject guide
This subject guide is written for students studying 24 Principles of
banking and finance. The aim is to help you to interpret the syllabus.
It tells you what you are expected to know for each area of the syllabus
and suggests the reading which will help you understand the material. It
must be emphasised that this guide is intended to supplement the essential
textbooks, not replace them.
A different chapter is devoted to each major section of the syllabus and the
chapter order of this guide follows the order of the topics as they appear in
the syllabus.
You need to appreciate that different topics are not self-contained. There is
a degree of overlap between the topics and you are guided in this through
cross-referencing between different chapters in the guide. However, in
terms of studying this guide, the chapters are designed as self-contained
units of study, but for examination purposes you need to have an
understanding of the subject as a whole.
We suggest that for each topic in the syllabus, you first read through the
whole of the chapter in this guide to get an overview of the material to
be covered. Then reread the chapter and follow up the suggestions for
reading in the essential reading or further reading. After this you should
work through the activities.
8
Chapter 1: Introduction
Structure of each chapter
At the beginning of each chapter, you will find a list of aims and learning
outcomes. These tell you what you can expect to learn from that chapter
of the subject guide and the relevant reading. You need to pay close
attention to the learning outcomes and use them to check that you have
fully understood the topics.
You will then find the essential reading, further reading, and references.
The list of essential reading indicates what you need to read as a minimum
in order to cover the syllabus. Once you have read a chapter, check that
you have covered all the essential reading.
Each chapter contains ‘Activities’ which apply what you have just learnt in
a practical way. Activities are heterogeneous: they include the analysis of
institutional website material, numerical exercises and further readings on
the texts. It is very important that you do these activities. For numerical
activities (marked with an asterisk*) we provide answers in Appendix 1 at
the end of the guide.
Throughout the guide, there are a lot of key terms, all detailed in the
‘Key terms’ section at the end of each chapter. Compile your own glossary
with full definitions and comments on each of these terms, and use it for
revision.
At the end of each chapter, look out for sample examination questions,
similar to those asked in the final examination. We recommend that you
try these sample examination questions during your revision.
Examination
Important: the information and advice given in the following section
are based on the examination structure used at the time the guide was
written. Please note that subject guides may be used for several years.
Because of this we strongly advise you always to check both the current
Regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/instructions on the paper you actually sit and
follow those instructions.
Remember, it is important to check the VLE for:
• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best be
answered.
The Principles of banking and finance examination paper is three
hours in duration. You will be asked to answer four questions from a
choice of eight. The examination paper is in two sections. You will be
required to answer one question from Section A, one from Section B and
two further questions from either section. The Examiners ensure that all
the topics covered in the syllabus are examined.
Section A of the exam essentially tests your understanding of concepts
and theories from the syllabus. The questions in Section A are therefore
discursive and generally split into two or three parts. In answering Section
A questions Examiners will be looking for evidence of your understanding
of the concept or theory being asked about. The subject guide sets out
the essential points of theories/concepts that you can draw upon in
9
24 Principles of banking and finance
answering the question. The essential reading and further reading texts go
into further detail on these concepts and theories and you will generally
be expected to go deeper into the subject matter than that set out in
the subject guide if you want to get a very good mark. Please also note
that evidence of understanding of a theory or concept may sometimes
be demonstrated by the use of a relevant example. Examiners will also
reward answers that show an up-to-date knowledge of a topic. For
example, the regulation of banking is fast changing and the material in
the subject guide may not be fully up-to-date when you read it. Keeping
up-to-date with developments in relation to the topic areas of the syllabus
will provide you with an opportunity to demonstrate to Examiners your
understanding of the topic area.
Section B of the exam essentially tests your understanding of the
application of finance concepts and tools. As in Section A the questions in
Section B are split into a number of parts with some parts requiring you
to calculate something and other parts testing your understanding of the
techniques being applied or your understanding of the answers you have
calculated. Therefore to answer a Section B question fully requires you to
understand how to apply techniques to the data given in the question in
an appropriate way, to understand the assumptions and limitations of the
technique you are using and to be able to interpret your calculated answer.
Examples of section A type questions are provided at the end of Chapters
2, 3, 4, 5 and 9. Examples of section B type questions are provided at the
end of Chapters 6, 7 and 8 and 9.
You have to answer four questions, giving you 45 minutes to spend on
each question. You should attempt all parts or aspects of a question. Pay
attention to the breakdown of marks associated with the different parts
of each question. Some questions may contain both numerical and essaybased parts. Examples of these types of questions (or question parts) are
provided at the end of each chapter of this subject guide.
• For essay-based questions, remember to plan your answer: list the
main issue you want to discuss and the order of the discussion.
• Begin the essay-based question with an introduction stating the aims
of the essay, and conclude with a summary bringing together the main
issues investigated in the essay.
• Please use material only when relevant to the question. Answers
including a large amount of irrelevant material are likely to be marked
down.
• Answers that simply repeat the subject guide material in a relevant way
may be given a pass at best.
• Answers with a clear structure, a good understanding of the material
and originality in the approach are likely to achieve a good mark.
A Sample examination paper is provided in Appendix 2 to this guide.
10
Chapter 1: Introduction
Syllabus
Part I: Financial systems
1. Introduction to financial systems: Role of financial systems (role
of households, government and firms in terms of savings and
investments). Financial intermediaries, securities and markets.
Taxonomy of financial institutions. Nature of financial claims (debt
versus equity, bonds and notes, fixed and floating interest rates,
common and preferred stocks). Structure of financial markets (direct
and indirect finance, dealers and brokers, banks, mutual funds, pension
funds and insurance companies).
2. Comparative financial systems: Bank-based systems against marketbased systems. Legal aspects.
Part II: Financial intermediaries
3. Role of financial intermediation: Nature and process of financial
intermediation. Theories of financial intermediation (transformation
of assets, uncertainty, reduction in transaction costs, reduction of
problems arising out of symmetric information). Implications of
financial intermediation (Hirshleifer model, effect on economic
development).
4. Regulation of banks: Regulation of banks (free banking, arguments for
and against regulation, traditional regulation mechanisms, alternatives
to traditional regulation).
5. Risk management in banking: Market risks: liquidity risk, interest rate
risk, foreign exchange risk. Credit risk: screening and monitoring,
credit rationing, collateral.
Part III: Principles of finance
6. Financial securities: Risk and return; Portfolio analysis: mean-variance
portfolio theory. The portfolio selection process: the correlation of
securities returns (single-index model and multi-index models). Asset
pricing models: capital asset pricing models (CAPM) and arbitrage
pricing theory (APT).
7. Capital budgeting: Pricing of bonds and stocks. Net pricing value.
Project appraisal.
8. Financial markets: Transmission of information; Efficient markets.
Theory and empirical evidence. Concepts of weak, semi-strong and
strong efficiency. Concepts of excess return. Micro-structures.
11
24 Principles of banking and finance
Notes
12
Part I: Financial systems
Part I: Financial systems
Overview
Before we introduce you to the Principles of banking (Part II) and to
the Principles of finance (Part III), we begin our analysis by examining
financial systems. Two main areas of interest are investigated:
• What role does a financial system play in an economy? What is the
structure of a financial system? (Chapter 2)
• How does the structure of financial systems differ across countries
worldwide? (Chapter 3)
We answer these questions in Part I.
13
24 Principles of banking and finance
Notes
14
Chapter 2: Introduction to financial systems
Chapter 2: Introduction to financial
systems
Aims
The aim of this chapter is to investigate financial systems from both a
functional and a structural perspective. We set out a taxonomy of financial
intermediaries, securities and financial markets, and give an overview of
the peculiarities of national financial systems.
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you will be able to:
• explain why financial systems exist (i.e. explain the functions of
financial systems)
• outline the structure of financial systems (i.e. describe the three main
entities that compose financial systems: financial intermediaries,
securities and financial markets)
• describe which financial intermediaries operate in financial systems
in the USA in particular and, more generally, around the world (e.g.
depository institutions, contractual savings institutions and investment
intermediaries) and explain their characteristics
• explain which financial securities are traded on financial markets
(bonds, notes, bills and stocks), and explain their nature
• discuss the various theories that attempt to explain the shape of the
yield curve
• explain the structure of financial markets in the USA and around
the world (primary versus secondary markets, money versus capital
markets, organised versus over-the-counter markets, quote-driven
dealer markets versus order-driven markets and brokered markets).
Essential reading
Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) Chapter 3.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapters 1, 2 and 10.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (Boston,
London: McGraw-Hill/Irwin, 2010) Chapter 14.
Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004) Chapter 1.
Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The MIT
Press, 2008) Chapter 2.
Saunders, A. and M.M. Cornett Financial Institutions Management: a Risk
Management Approach. (New York, McGraw-Hill/Irwin, 2007) Chapters 2,
3, 4, 5 and 6.
15
24 Principles of banking and finance
Introduction
We start the unit with an overview of financial systems, their functions and
general structure. Then we investigate the nature and characteristics of the
three major entities that compose financial systems. These are financial
intermediaries, securities and financial markets. We will return to a more
detailed investigation of each of these entities in later chapters.
In our review of different countries, we restrict ourselves to large
economies with well-developed financial systems, notably the USA, UK,
France and Germany. Specifically, we take a US view and US terminology,
therefore in Part I other countries are compared with the US system.
Functions of financial systems
Financial systems perform the essential economic function of channelling
funds from units who have saved surplus funds to units who have a
shortage of funds. The units who have saved can lend funds: they are
known as lender-savers. The units with a shortage of funds must borrow
funds to finance their spending: they are the borrower-spenders. The
most important lender-savers are usually households; while the typical
borrower-spenders are firms and the government.
The channelling of funds from savers to spenders is very important for two
reasons:
• First, lender-savers (with excess of available funds) do not frequently
have profitable investment opportunities, while borrower-spenders
have investment opportunities but lack of funds.
• Second, even for purposes other than investment opportunities
in businesses, borrower-spenders may want to invest in excess
of their current income or to adjust the composition of their
wealth (reconciliation of the preferences for current versus future
consumption).
In direct finance, borrower-spenders borrow funds directly from lenders
in the financial markets by selling them securities. In indirect finance,
a financial intermediary stands between the lender-savers and the
borrower-spenders: the intermediary helps to transfer funds from one
to the other. This suggests that financial markets and intermediaries are
alternatives that perform more or less the same function but in different
ways (and perhaps with different degrees of success). Note, however,
that the process of indirect finance, known as financial intermediation, is
the most important way of transferring funds from lenders to borrowers.
This contrasts with the attitude of the media to focus mainly on financial
markets (as discussed in Chapter 4).
Another important function of a financial system is the monetary function.
The introduction of money into the economy enables savers and spenders
to separate the act of sale from the act of purchase and allows them to
overcome the main problem of barter, which is the ‘double coincidence
of wants’ (each of the two parties involved in a transaction has to want
simultaneously the good the other party is offering to exchange). The
financial system provides a variety of payment mechanisms e.g. cheques,
debit cards and credit cards to enable one party to pay another.
Financial systems also provide mechanisms for risk to be transferred. For
example insurance contracts allow a party such as a firm or household to
transfer the risk of loss of wealth due to theft or fire to another party such
as an insurance company. The firm or household will pay a fee (insurance
premium) for this transfer. The insurance company, by providing a large
16
Chapter 2: Introduction to financial systems
number of insurance contracts, is better able to manage the risk than an
individual firm or household as they can obtain benefits of pooling and
diversification. Thus a more efficient allocation of risk results.
In short, the main functions of financial systems are to:
• provide the mechanisms by which funds can be transferred from units
in surplus to units with a shortage of funds in order to directly or
indirectly facilitate lending and borrowing (as shown in Figure 2.1)
• enable wealth holders to adjust the composition of their portfolios
• provide payment mechanisms
• provide mechanisms for risk transfer
Activity 2.1
Throughout this guide, there are a lot of key terms, all collected in the ‘Key terms’ section
at the end of each chapter. Compile your own glossary with full definitions and comments
on each of these terms, and use it for revision.
DIRECT
Financial markets
Securities
Lenders
Cash
Cash
Deposits
Financial intermediaries
INDIRECT
Borrowers
Cash
Loans
Figure 2.1: Direct and indirect lending performed by a financial system
The structure of financial systems: financial markets,
securities and financial intermediaries
From a structural point of view a financial system can be seen in terms
of the entities that compose the system. A financial system comprises
financial markets, securities and financial intermediaries.
Financial markets are markets in which funds are moved from
people who have an excess of available funds (and lack of investment
opportunities) to people who have investment opportunities (and lack
of funds). They also have direct effects on personal wealth, and the
behaviours of businesses and consumers. Therefore, they contribute
to increase the production and the efficiency in the overall economy.
Financial markets (such as bond and stock markets) are markets in which
securities are traded.
Securities (also called financial instruments) are financial claims on
the issuer’s future income or assets. They represent financial liabilities for
the individual or firm that sells them (borrower or issuer of the financial
claim) in return for money, and financial assets for the buyer (lender
or investor in the financial claim). By definition, therefore, the sum
of financial assets in existence will exactly equal the sum of liabilities.
17
24 Principles of banking and finance
Governments and corporations raise funds to finance their activities by
issuing debt instruments (bonds) and equity instruments (shares, known
in the USA as stocks). Bonds are securities that promise to make periodic
payments of a sum of money for a specified period of time. Stocks are
securities that represent a share of ownership in the firm.
Financial intermediaries are economic agents who specialise in the
activities of buying and selling (at the same time) financial contracts
(loans and deposits) and securities (bonds and stocks). Note that financial
securities are easily marketable, while financial contracts cannot be
easily sold (marketed). Banks form the largest financial institution in our
economy. They accept deposits (loans by individuals or firms to banks)
and make loans (sums of money lent by banks to individuals or firms):
therefore, they borrow deposits from people who have saved and in turn
make loans to others. In recent years, other financial intermediaries, such
as mutual funds, pension funds, insurance companies and investment
banks, have been growing at the expense of banks.
Taxonomy of financial intermediaries
We begin by looking at the USA, the largest economy and financial system
in the world. Later we will turn to other countries. In the USA the three
major groups of financial intermediaries are: depository institutions,
contractual savings institutions and investment intermediaries (for an
overview of financial intermediaries around the world refer to the next
section).
Depository institutions
Depository institutions: intermediaries with a significant proportion of
their funds derived from customer deposits – include: commercial banks –
savings institutions and credit unions.
Commercial banks
Commercial banks accept deposits (liabilities) to make loans (assets)
and to buy government securities. Deposits are broad in range, including
checkable deposits (deposits on which cheques can be written), savings
deposits (deposits that are payable on demand, but do not allow
depositors to write cheques), time deposits (deposits with a fixed term to
maturity). Loans include consumer, commercial and mortgage loans.
In the USA, commercial banks are the largest group of financial
intermediary: in 2006 there were 7,402 with aggregate total assets of
$10.1 trillion (according to the FDIC Quarterly Banking Profile). Note
that the industry has experienced a recent consolidation as a result of
mergers and acquisitions (simply consider that in 1984 there were 14,416
commercial banks). The performance of US banks improved throughout
most of the 1990s, although it deteriorated slightly with the economic
downturn in the early years of the twenty-first century. In 2006 the return
on equity (ROE) of the US banking industry averaged 9.9 per cent.
Activity 2.2
Consult the American Banker Online available (2-week trial subscription) at
www.americanbanker.com/tools/ranking-the-banks.html. From the section on Banks,
thrifts and holding companies locate the Top World Banking Companies by Assets and
identify the 10 largest US depository institutions and compare their total assets value.
Identify the largest depository institution in your own country.
18
Chapter 2: Introduction to financial systems
The balance sheet structure of US commercial banks reflects the main
assets and liabilities of their business. The aggregated balance sheet
values for US banks in 2006 are reported in Table 2.1. As shown, loans
constituted around 58 per cent of their assets (compared with 62 per cent
in 1990), whereas investments in securities represented 16 per cent of
their assets. Interest-bearing deposits instead constituted 54 per cent of
their liabilities.
Total assets
10,090,626 Total liabilities and capital
Total loans & leases
Less: Reserve for losses
10,090,626
5,980,915 Non-interest bearing deposits
1,216,695
69,071 Interest bearing deposits
5,514,667
Net loans and leases
5,911,844 Other borrowed funds
Securities
1,665,743 Subordinated debt
149,795
4,721 All other liabilities
467,645
Other real estate owned
Good will and other intangibles
All other assets
1,711,411
358,472 Equity capital
2,149,832 Off-balance-sheet derivatives
1,030,413
132,162,947
Table 2.1: Aggregate balance sheet values for US commercial banks
($million, 2006)
Source: Table created using data from FDIC website (www2.fdic.gov/hsob/)
Savings and loan associations
Historically savings and loan associations (S&Ls) and thrift institutions
have concentrated mostly on residential mortgages by acquiring funds
primarily through savings deposits. In terms of number of institutions,
they are the second largest group of financial intermediaries (1,279
associations with $1.8 trillion of total assets in 2006 according to FDIC
Quarterly Banking Profile).
In the 1950s and 1960s, S&Ls grew much more rapidly than commercial
banks. However, between 1979 and 1982 the change in the monetary
policy of the Fed led to a dramatic surge in interest rates. (The Federal
Reserve Bank, known as The Fed, is the central bank for the US banking
system, as explained later in Chapters 3 and 5). This increase in the shortterm rates had two effects.
• First, S&Ls had negative interest spreads (interest income minus
interest expense) in funding the fixed-rate long-term residential
mortgages.
• Second, they had to pay more competitive interest rates on savings
deposits. Note that The Federal Reserve Bank’s Regulation Q ceilings
limited the interest rates payable on deposits by S&Ls.
To overcome the effects of rising rates and disintermediation, in the early
1980s the Congress passed acts allowing S&Ls to expand their deposittaking (i.e. to offer checking accounts) and asset-investment powers (i.e.
to make consumer and commercial loans). For many S&Ls the new powers
created safer and more diversified institutions. However, for a small – but
significant – group of S&Ls, they created an opportunity to take more
risk in the attempt to improve profitability. For example, in Texas in the
mid-1980s there had been a real estate and land prices crash, which led
to the default of many borrowers with mortgage loans issued by S&Ls. As
a result a large number of S&Ls failed at the end of the 1980s and as a
consequence, new legislation – the FIRREA of 1989 – was adopted.
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24 Principles of banking and finance
Activity 2.3
Read Mishkin and Eakins (2009), section beginning on p.491, to investigate the recent
reform of S&L. Then consult the section on Savings institutions in FDIC Quarterly Banking
Profile available online at: http://www2.fdic.gov/qbp/2010sep/sav1.html.
Draw a graph to show the trend in the number of institutions.
Write a short explanation of why this variation has occurred.
The evolution in the number and size (in terms of total assets) of both
commercial banks and S&Ls is shown in Figures 2.2 and 2.3.
12.000.000
Total assets ('000 US$)
10.000.000
8.000.000
6.000.000
4.000.000
2.000.000
0
2006
2005
2004
2003
2002
2001
2000
1999
Commercial banks
1998
1997
1996
1995
1994
S&L
Figure 2.2: Trend in the size of US depository institutions
12.000
10.000
Number
8.000
6.000
4.000
2.000
0
2006
2005
2004
2003
2002
2001
2000
Commercial banks
1999
1998
1997
1996
1995
1994
S&L
Figure 2.3: Trend in the number of US depository institutions
Source: Tables created using data from www2.fdic.gov/qbp/qbpSelect.
asp?menuItem=STBL
Credit unions
Credit unions are non-profit institutions mutually organised and owned
by their members (depositors). Their primary objective is to satisfy the
depository and lending needs of their members, who have to belong to
a particular group (identified by occupation, association, geographical
location). The members’ deposits are used to provide loans to other
members, and earnings from these loans are used to pay a higher rate of
interest to member depositors. They are the most numerous among the
institutions composing depository institutions, totalling about 8,535 in
2006 according to the Credit Union National Association.
20
Chapter 2: Introduction to financial systems
Contractual savings institutions
Contractual savings institutions acquire funds at periodic intervals on
a contractual basis. The industry is classified into two major groups:
insurance companies and pension funds. The liquidity of their assets is
less important than for depository institutions because they can predict
with reasonable accuracy the future payments due to their customers.
As a consequence they invest their funds in long-term securities (such as
corporate bonds, stocks and mortgages).
Insurance companies
The primary objective of insurance companies is to protect individuals and
firms (known as policy-holders) from adverse events. Insurance companies
receive premiums from policy-holders, and promise to pay compensation
to policy-holders if particular events occur. There are two main segments
in the industry: life insurance on the one hand, and property and causality
insurance on the other.
Life insurance protects against death, illness and retirement. Companies
acquire premiums from the policy-holders, and use them mainly to buy
corporate bonds, mortgages, and stocks (amount limited by legislation).
In 2006 in the US, life insurance companies were the largest group among
the contractual savings institutions with aggregate assets of $4.71 trillion
as reported by the Insurance Information Institute. Note that traditional
life insurance is no longer the primary business of many companies in
the life/health insurance industry. Today, the emphasis has shifted to the
underwriting of annuities. Annuities are contracts that accumulate funds
and/or pay out a fixed or variable income stream, which can be for a fixed
period of time or over the lifetimes of the contract holder and his or her
beneficiaries.
Property and causality insurance provides protection against personal
injury and liabilities such as accidents, theft and fire. In comparison to life
insurance companies, they hold more liquid assets because of a higher
probability of loss of funds in case of major disasters. In the USA this segment
is quite concentrated: the top 10 firms have a 51 per cent share of the market.
Pension funds
Pension funds provide retirement income (in the form of annuities) to
employees covered by a pension plan. They receive contributions from
employers or employees and invest these amounts in corporate bonds and
stocks. There are private pension funds and public pension funds. The
US government has promoted the establishment of pension funds, and
the expectation is of further developments in pension funds in terms of
number and variety of options.
In some countries pensions funds are very important (e.g. USA and UK)
whereas elsewhere they are not (e.g. France, Germany and Italy), because
of the different importance of State pension schemes.
Activity 2.4
What types of pensions are there? Visit the Financial Services Authority website (available
at www.moneymadeclear.fsa.gov.uk/products/pensions/pensions.html) to find out more
about the UK system.
Do you now understand how a pension fund operates? Look in Mishkin and Eakins
(2009), pp.561–62 to make sure. After reading Mishkin and Eakins (2009) do you think
pension funds are financial intermediaries, i.e. do they channel funds from saver-lenders
to spender-borrowers?
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24 Principles of banking and finance
Investment intermediaries
Investment intermediaries comprise mutual funds, finance companies,
investment banks and securities firms.
Mutual funds
Mutual funds pool resources from many individuals and companies
and invest these resources in diversified portfolios of bonds, stocks and
money market instruments. An open-ended mutual fund (the major
type of mutual fund) continuously allows shareholders to sell (redeem)
outstanding shares, and investors to buy new shares at any time. The
value of these shares is determined by the value of the mutual fund’s
holding assets. Two main advantages characterise mutual funds. First,
mutual funds provide opportunities to small investors to invest in financial
securities and diversify risk. Second, mutual funds take advantage of lower
transaction costs when they buy larger blocks of financial securities.
There are two segments in the mutual fund industry: long-term funds
and short-term funds. Long-term funds comprise bond funds (funds that
contain fixed-income debt securities), equity funds (funds that contain
stock securities) and hybrid funds (funds that contain both debt and stock
securities). Short-term funds are represented by money market mutual
funds, funds that contain various mixes of money market securities and
partially allow shareholders to write cheques against the value of their
holdings: the presence of deposit-type accounts makes money market
mutual funds to some extent similar to depository institutions.
In the USA mutual funds are the second most important financial
intermediary in terms of asset size. In fact, they are larger than the
insurance industry, but smaller than the commercial bank industry. The
combined assets of the nation’s mutual funds increased to $9.5 trillion in
2006, according to the Investment Company Institute’s official survey of
the mutual fund industry.
Activity 2.5
From the 2007 Investment Company Fact Book produced by the Investment Company
Institute (available online at www.icifactbook.org/pdf/2010_factbook.pdf) read the
summary on the significant events in the mutual fund industry (pp.210–12).
Then write a short explanation of how you think these events have determined the
historical trend of the industry as described in Table 1 ‘US Mutual Fund Industry Total Net
Assets, Number of Funds, Number of Share Classes, and Number of Shareholder Accounts,
(2010 Investment Company Fact Book, p.124).
Total intermediated funds: US$ 25.17 trillions
Insurance companies
Commercial banks
Mutual funds
S&Ls
Values in trillions of US dollars
Figure 2.4: Intermediated funds by type of financial intermediary
Source: Table created using data from FDIC website (http://www2.fdic.gov/hsob/)
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Chapter 2: Introduction to financial systems
Summing up, as shown in Figure 2.4, the total funds intermediated by US
financial intermediaries are US$25.17 trillion in 2006. Commercial banks
account for the highest proportion, followed by mutual funds, insurance
companies and S&Ls.
Finance companies
Finance companies make loans to individuals and corporations by
providing consumer lending, business lending and mortgage financing.
Some of their loans are similar to those provided by commercial banks.
However, finance companies differ from commercial banks because they
do not accept deposits. They raise funds by selling commercial paper (a
short-term debt instrument) and by issuing stocks and bonds. Moreover,
finance companies often lend to customers perceived as too risky by
commercial banks.
There are three major types of finance companies:
• Sales finance institutions that make loans to customers of a particular
retailer or manufacturer (e.g. Ford Motor Credit).
• Personal credit institutions that make loans to consumers perceived as
too risky by commercial banks (e.g. Household Finance Corp).
• Business credit institutions that provide financing to companies,
especially through equipment leasing and factoring (purchase by the
finance company of accounts receivable from corporate customers).
Investment banks and securities firms
Investment banks assist corporations or governments in the issue of
new debt or equity securities. Investment banking includes:
• the origination, underwriting and placement of securities in primary
financial markets (primary and secondary markets are discussed
later in this chapter). The process of underwriting a stock or bond
issue requires the investment bank to purchase the entire issue
at a predetermined price and then to resell it in the market. The
investment bank then bears the risk that they are not able to resell
the entire issue in which case it will hold the unsold stock on its own
balance sheet. In return for taking on this risk the investment company
receives an underwriting fee from the issuing company.
• financial advisory on corporate finance activities (such as advising on
mergers and acquisitions).
Typically, investment banks earn their income from fees charged to clients.
These fees are usually set as a fixed percentage of the size of the deal
being worked.
Securities firms assist in the trading of existing securities in the
secondary markets. There are two main categories of securities firms:
• brokers - agents of investors who match buyers with sellers of
securities. They earn a commission for their service;
• dealers - agents who link buyers and sellers by buying and selling
securities. They hold inventories of securities, and sell these securities
for a slightly higher price than they paid for them. They thus earn the
bid-ask spread, the difference between the best ask (lowest price
charged for immediate purchase of stock) and the best bid (highest
price received for an immediate sale of a unit of stock).
The main service offered by brokers is securities orders. Orders are trade
instructions specifying what traders want to trade, whether to buy or sell,
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24 Principles of banking and finance
how much, when and how to trade, and on what terms. Traders issue
orders when they cannot personally negotiate their trades. There are two
primary types of orders: market orders and limit orders. Market orders
are instructions to trade at the best price currently available in the market.
Market order traders pay the bid-ask spread (they demand immediacy).
It follows that there is price uncertainty. Large market orders can have
substantial and unpredictable price impacts. Limit orders instead are
instructions to trade at the best price available, but only if it is no worse
that the limit price specified by the trader. For example, you submit a limit
order to buy 100 shares of BP at (at most) 515p per share. The order will
be executed if there is a seller willing to give you his shares for 515p or
less. In such a case, there is no price uncertainty but there is execution
uncertainty. Note that standing limit orders (i.e limit orders that are not
immediately executed) provide the market with liquidity as they sit in
the order book allowing traders who submit a market order to obtain
immediate execution.
In the USA, the securities firms and investment banking industry includes
several types of firms:
• National full-line firms acting both as broker-dealers and underwriters.
The major US firms are Merrill Lynch and Morgan Stanley.
• National full-line firms that specialise more in corporate finance and
are highly active in trading securities; examples are Goldman Sachs
and Smith Barney.
• Specialised investment bank subsidiaries of commercial banks, such as
J.P. Morgan Chase
• Specialised discount brokers, stockbrokers that conduct trading
activities for customers without offering any investment advice (such as
Charles Schwab).
• Specialised electronic trading securities firms (such as E*trade)
enabling trades on a computer via the internet.
• Regional securities firms concentrating in the service of customers of a
particular geographical region.
Retail and wholesale banks
Commercial banking can also be separated into retail and wholesale
banking. The difference between retail and wholesale banking is
essentially one of size. Retail banks have traditionally provided
intermediation and payment services to individuals and small businesses
dealing with a large number of small value transactions. This is in contrast
with the wholesale banks, which deal with a smaller number of larger
value transactions.
In practice it is difficult to identify purely retail banks. In the UK, USA and
many other developed countries, large banks combine retail and wholesale
activities. Wholesale banks consist mainly of investment banks.
Financial intermediaries around the world
In the United Kingdom the banking system comprises commercial
banks, investment banks and building societies. Four big clearing banks
currently dominate commercial banking: Barclays, Royal Bank of Scotland
(RBS), HSBC, and Lloyds. They are essentially universal banks as they
provide a wide range of services to individuals and corporations (from
life insurance to underwriting). As London is an international financial
centre, the role of foreign commercial banks is extremely important there:
24
Chapter 2: Introduction to financial systems
they are roughly the same size as UK domestic banks. Investment banks
are involved in traditional investment banking activities, like in the USA.
Building societies, likeS&L’s in the USA, were originally devoted to
providing mortgages. Deregulation has allowed them to expand their
activities into traditional banking; as a result, they are now competitors
of the big four. Among contractual savings institutions there are pension
funds and insurance companies. They both constitute a large proportion
of household assets, significantly larger than in other countries. Insurance
services are provided by bank subsidiaries as well as insurance companies.
The insurance industry, unlike banking, is not dominated by a few large
players.
The banking sector in Japan comprises shareholder-owned banks
(ordinary banks, trust banks, and long-term credit banks) and cooperative
banks (credit unions and credit association). Ordinary banks, the
counterpart of commercial banks in other countries, provide mainly shortterm loans to individuals and corporations. Trust banks provide longterm loans to corporations, in addition to a range of services (ordinary
banking services, asset management, investment advisory services).
Long-term credit banks provide long- and medium-term loans (mainly
to large corporations) by using the funds raised from medium- and shortterm bonds. Cooperative banks provide banking services to small
corporations and are owned by their members. Among contractual savings
institutions, life insurance companies are significantly more important
in Japan than in other countries. These companies – that are mostly
mutual – provide traditional life insurance products, make long-term
loans to corporations and manage corporate pension funds. Property and
causality insurance companies are also important, but not as important as
life insurance companies. Pension funds in Japan are significantly more
important than in France and Germany, but less than in the USA and UK.
In France there are commercial banks, mutual and cooperative banks
and savings banks. Commercial banks are the most important industry
in the banking system, but mutual and cooperative banks are also
significant. There are several types of mutual and cooperative banks with
different specific purposes: Crédit Mutuel (to provide loans to individuals
with modest income); Crédit Coopérative (to provide loans to their
members, while receiving deposits from everybody); Crédit Agricole
Mutuel (to provide loans to farmers); Crédit Populaire (to provide loans to
the trade sector and medium-size industries). Savings banks can make
loans only to non-industrial or non-commercial entities or individuals.
Their unique feature is to offer accounts whose interest is tax-free up to a
given amount. French contractual savings institutions are mostly insurance
companies (similar to those in the Japanese financial system), whereas
pension funds are rare. Insurance services can be provided by commercial
banks as well as insurance companies.
Commercial banks, savings banks and cooperative banks constitute the
banking system in Germany. Commercial banks are universal banks
that provide a full range of products and services: deposits, short- and
long-term loans, life insurance, underwriting and even investing directly
in equity securities. The big three commercial banks are: Deutsche,
Dresdner and Commerzbank. Savings banks are non-profit maximising
entities but are operated in the public interest. Cooperative banks are
mutual organisations owned by their depositors. An interesting feature
of the German banking system is that the majority of organisations (in
terms of assets) are not profit-maximising entities. As in France, very few
household assets are held by pension funds, whereas insurance companies
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24 Principles of banking and finance
hold a large proportion of assets. Insurance services are provided by
universal banks as well as insurance companies and are usually organised
by groups (because of the legal requirement to separate life insurance
from other forms of insurance).
USA
Commercial banks
S&L
Credit Unions
UK
Commercial banks
Building societies
Japan
Ordinary banks
Co-operative banks
(Credit Unions
and Associations)
France
Commercial banks
Mutual and
Co-operative banks
Savings banks
Germany
Commercial banks
Co-operative banks
Savings banks
Institutions not found
in USA
Trust banks
Long-term credit banks
Your country
Table 2.2: Equivalent names of depositary institutions
Table 2.2 shows the different names used for the US institutions we looked
at above. Add your country to the table in the last row.
(Refer to Chapter 3 ‘Comparative financial systems’ to analyse the
historical developments of national financial systems and to understand
the reasons for the existence of bank-based and market-based financial
systems across countries).
Activity 2.6
In the following table, list the names of some major financial institutions and briefly note
down the special features of the financial system in each country.
Country
Examples of important financial
institutions
Special features of their system
USA
UK
Japan
France
Germany
Nature of financial instruments (securities)
Financial instruments (known as securities) can be classified into two
broad groups: debt instruments and equity instruments. Note that there
are also derivative instruments (such as futures, options and swaps),
which are financial instruments that derive their value from the value
of some other financial instruments or variables. (Although they are not
analysed here, they will be developed in later subjects in the programme,
such as 92 Corporate finance.) Remind yourself what a security is (see
the Essential reading and see also p.17 earlier in this chapter).
Debt and equity instruments
Debt instruments are instruments that promise the payment of given
sums to the investor. Examples of debt instruments are bills, notes and
bonds (described below). Bonds represent debt owed by the issuer to
the investor. They are claims that normally pay periodic interest (coupon
payments) until the maturity date, and pay back the par value (face value)
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Chapter 2: Introduction to financial systems
to the investor at the maturity date. The coupon payments are usually
based on a fixed interest rate. The interest rate is the cost of borrowing or
the price paid for the rental of funds (usually expressed as a percentage).
Equity represents claims to shares in the net income and assets of a firm,
and they do not have a maturity date. In terms of economic rights, equity
claims differ from debt instruments for several reasons.
• First, firms are not contractually obliged to make periodic payments to
equity holders: the payment of dividends is a discretionary decision of
the firm.
• Second, firms must pay all their debt holders before they make any
payment to equity holders: therefore equity holders are residual
claimants.
As a result, equity claims are riskier than debt instruments. In addition to
economic rights, equity claims confer ownership rights to equity holders.
The presence of ownership rights is in contrast with bondholders, who
have no ownership interest but are rather creditors of the firm.
Ownership rights have two main implications.
• First, equity holders can benefit from any increase in the income
or asset value of the company. In the case of stock price increases
(decreases) on the financial market, equity holders can obtain high
capital gains (losses), whereas this is very unlikely by investing in
bonds.
• Second, equity holders have the right to vote for directors or on certain
issues. The proportion of economic and ownership rights is different
between common stocks and preferred stocks (as discussed below).
Activity 2.7
If you expect a company to become bankrupt in a year’s time, would you rather hold
bonds or equities issued by the company? Or nothing?
Zero coupon bonds, coupon bonds and other types of bonds
Debt instruments can be classified into two main categories: zero coupon
bonds and coupon bonds. Zero coupon bonds are instruments under
which a borrower promises, at the current time, to pay one specified
nominal sum (face value) to the lender at one specified future date. In
return, at the current date the borrower receives the bond price. Zeros
are also known as discount bonds. Clearly, with positive interest rates,
the price of a zero coupon bond must be lower than the face value. Let
me give an example of a zero coupon bond: an 8-year zero issued today
and with face value of $1,000 would require the borrower to repay this
amount to the lender after this period of time. At the current date, the
borrower receives an amount of cash which must be less than $1,000
given the positive time value of money.
Coupon bonds are contractual agreements by the borrowers to make
regular payments (known as coupons or interest) until a specified date
(the maturity date), when the amount borrowed (principal) is repaid. The
maturity is the time to the expiration date of the debt instrument. Coupon
bonds deliver two different types of cash flow to the bondholder:
• Face value: at the end of the bond’s lifetime, the issuer repays the face
value of the bond to the holder. Face value is also known as par value
or principal.
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24 Principles of banking and finance
• Coupon payments: regular (often semi-annual) payments of cash to the
bondholder. These payments are generally a fixed fraction of the face
value. The interest rate is the cost of borrowing or the price paid for the
rental of funds (usually expressed as a percentage).
Let me give an example of a coupon bond: assume that a company issues a
three-year bond with a coupon rate of 5 per cent and face value of $1,000.
The bondholder receives the following ($) cash flows (note the semiannual coupon payments which are each half the total annual coupon):
Year
0.5
1.0
1.5
2.0
2.5
3.0
Cash flows ($)
25
25
25
25
25
1,025
Certain other popular bond types differ from standard coupon bonds
along certain dimensions. These include: perpetual bonds, floating rate
bonds and index-linked bonds. Perpetual bonds (also known as consols)
never mature. They simply pay coupons of a specified amount forever.
Floating rate bonds have coupon rates which vary over the bond’s
lifetime. Generally, the floating coupon rate is set at a premium over some
market interest rate (e.g LIBOR or the US T-bill rate) and is reset on a
pre-specified basis. For index-linked bonds, coupons and principal
grow in line with inflation (in the relevant country). First issued in the
UK, they are now increasingly frequently issued by governments. As such,
they can be thought of as real, risk-free securities (although in most cases
indexation is not perfect).
Certain bonds also have options embedded in them. These embedded
options will provide the issuer or holder with extra rights over and
above the usual. Examples include callable bonds, puttable bonds and
convertible bonds. Callable bonds can be repaid early (i.e. before
maturity) by the issuer if he/she so chooses. Early repayment might be
restricted to a specified date (European) or may be allowed at any time
prior to maturity (American). With puttable bonds the redemption date
is under the control of the holder (i.e. the opposite to the callable bond
case). Convertible bonds are debt instruments which can be converted
into a share in the firm’s equity (either at a specific date or at any time).
As such, this type of debt allows bondholders, as well as shareholders, to
participate in upside gains of a corporation.
On the basis of the country of sale in comparison to the issuer’s country of
origin, there are two special types of bonds: foreign bonds and Eurobonds.
A foreign bond is a bond issued by a borrower in a country different
from that borrower’s country of origin (i.e. the borrower is selling debt
abroad). The bond is denominated in the currency of the country in
which it is sold. Hence, if a Russian firm sells Sterling denominated debt
in the UK it has issued foreign bonds. Such Sterling denominated foreign
bonds are colloquially known as bulldog bonds. Eurobonds are bonds
denominated in the currency of one country but actually sold or traded
in another, different country. So, for example, a Eurosterling bond will be
denominated in Sterling but sold outside the UK. Coupons on these bonds
are generally paid on an annual basis. Note that London is one of the
major Eurobond markets.
Activity 2.8
Identify whether the following bonds are foreign bonds or Eurobonds:
1. A US firm issues a dollar denominated bond in London.
2. A Japanese firm issues a dollar denominated bond in New York.
3. A UK company issues a dollar denominated bond in Singapore.
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Chapter 2: Introduction to financial systems
On the basis of the maturity, debt instruments can be divided into: shortterm (maturity less than one year), intermediate-term (maturity between
one and ten years), and long-term (maturity of ten years or longer). Bonds
are generally defined to have lifetimes exceeding one year. Debt securities
with maturities less than a year are called money market securities.
Bonds, notes and bills by issuer
There are three main classes of institutions that issue bonds in the USA:
national governments, local governments and corporations. (As we saw
above, most US instruments and intermediaries have their parallels in
other industrial countries).
Government notes and bonds are issued in the USA by the US
Treasury to finance national debt. Notes have an original maturity of one
to ten years, while bonds have an original maturity of ten to twenty years.
Government notes and bonds are normally seen to be free of default risk
(risk that the issuer of the bond will default, that is, be unable to make
interest payments and principal repayment, as discussed in Chapter 6). In
fact, the issuer (the government) can always print money to pay off the
debt if necessary. As a consequence, they pay lower interest rates than
corporate bonds. Such bonds are known as gilts in the UK, Treasuries in
the USA and Bunds in Germany.
Note that among government debt instruments are Treasury bills. These
are money market securities, with an original maturity of less than one
year. They do not pay any interest, but they are issued at a discount from
their par value and they are repaid at the par value at the maturity date.
The difference between the issue value and the par value represents the
yield to the investor.
Municipal bonds are debt instruments issued by US local, county or
state governments to finance public interest projects. Municipal bonds
are not default-free and are not as liquid as Treasury bonds. In fact, such
bonds are usually secured on their own revenues and not guaranteed by
central government. However, they pay lower interest rates than Treasury
bonds. The reason for this is that their interest payments are exempt from
federal taxation, and thus this determines an implicit increase in the actual
interest rates received by investors.
Corporate bonds are issued by large corporations when they need
long-term financing. They usually make interest payments twice a year
(semi-annually). Clearly such debt is not risk-free and the level of risk will
depend on the nature of the corporation’s activities (e.g. contrast utilities
with biotech firms). The degree of risk, which depends on the default
risk of the company, is higher than for government and municipal bonds.
This determines the presence of higher interest rates. Moreover, this gives
bondholders senior claims on corporate assets in the event of bankruptcy.
Activity 2.9
Are each of the following statements true or false?
1. A bond only pays the holder a return if the company makes a profit.
2. Banks buy bonds and issue shares. They never buy shares or issue bonds.
Default risk and bond rating
A bond (generally) obliges a borrower to repay nominal cash flows at
specified dates. However, circumstances may arise whereby the borrower
is unable to meet the obligations. At such a time the borrower is said
to be in default. After a default, the bondholder generally has a senior
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24 Principles of banking and finance
claim on the borrower’s assets. Obviously, the likelihood of a borrower
defaulting will affect the terms on which individuals are willing to lend to
a borrower: if I consider agent A to be more likely to default than agent B,
I will charge agent A a higher rate of interest, a default risk premium.
As discussed in Chapter 4, certain commercial organisations help
characterise the default risk associated with bonds by providing credit
ratings. The two main players in this market are Moody’s and Standard
and Poor’s. They assign ratings to bonds such that highly rated bonds are
projected to have low default risk while very low rated bonds (junk bonds)
are believed to be quite likely to default.
The term structure of interest rates
The term to maturity influences the interest rate. Bonds with identical risk
may have different yields (interest rates) because of the difference in the
time remaining to maturity. A yield curve plots the yields (interest rates)
of bonds with different maturity but the same risk. Usually the yield curve
is constructed from government securities. These are often referred to as
the benchmark yield curve, as they are the basis for evaluating other yields
of similar maturity bonds. The yield curve can be: upward (the long-term
rates are above the short-term rates); flat (short- and long-term interest
rates are the same); and inverted (long-term interest rates are below
short-term interest rates).
There are a number of factors that influence the shape of the yield curve.
(a) Expectations theory
The expectations theory of the term structure of interest rates states that
in equilibrium, the long-term rate is a geometric average of today’s shortterm rate and expected short-term rates in the future.
This theory requires that there is an implicit relationship between current
bond yields and forward rates. The forward rate of interest is the rate of
interest that will be payable on funds beginning at some future date. For
example, if:
R represents the annual yield on a two-year bond,
r1 represents the annual return from a one year bond, and
r2 represents a one-year forward rate beginning in one year’s time
then the following relationship will hold:
(1 + R)2
= (1 + r1) x (1 + r2)
With the expectations theory of the term structure, an investor who
invests £1,000 in either a two-year bond, or a one-year bond subsequently
reinvesting the proceeds from the first year into another one-year bond,
will receive the same return from both strategies. According to the theory,
the existence of arbitrageurs in bond markets ensures that this relationship
holds.
Suppose that the yield on a two-year government bond, R is 9% p.a. and
the yield on an equivalent one year bond, r1 is 8% p.a. The yield implied
on a one year bond held during year two of the two year bond’s life, r2, is
given as:
£1,000 x (1.09) x (1.09) = £1,188.10 = £1,000 x (1.08) x (1 + r2)
r2 = 10.01%
In this example, there is an upward sloping yield curve as the 1 year bond
yield is lower than the two year yield. Usually we observe an upward
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Chapter 2: Introduction to financial systems
sloping yield curve, for example in 2008 the shape of the yield curve was
the one shown in Figure 2.5.
4.48
4.19
3.50
Yield
3.21
2.52
2.24
1.55
1.26
0.57
0.28
0.00
3 Month
6 Month
2 Year
3 Year
5 Year
10 Year
30 Year
Maturity
Figure 2.5: US Treasury yield curve rates (8 February 2008)
Source: Graph created using data from: http://bonds.yahoo.com/rates.html.
In the yield curve example above, the current long rate (after three years)
is higher than the current short rate, therefore short-term rates must be
expected to rise in the future. Conversely, if the current long rate is lower
than the current short rate then short-term rates are expected to decline
in the future: in this instance, we will observe a downward sloping yield
curve. Finally, if no change is expected in short rates, then the current
long rate will equal the current short rate, and we will observe a flat yield
curve. Hence, it should be clear that the shape of the yield curve will be
determined by expectations of future interest rates.
(b) Liquidity premium theory
Liquidity premium theory asserts that, in a world of uncertainty, investors
and lenders will want to hold assets which can be converted into cash
quickly. Therefore they will demand a liquidity premium for holding longterm debt. Conversely, the same dislike for uncertainty causes borrowers
(for example, firms and governments) to prefer to borrow for a longer
period at a rate which is certain now – therefore they will be willing
to pay a liquidity premium and, therefore, a higher rate of interest on
their longer-term debt. This implies that the yield curve will normally be
upward sloping, in the absence of any other influences. In reality, we need
to consider the combined effect of expectations together with liquidity
preference. A downward sloping yield curve will occur when expectations
of an interest rate fall are sufficient to offset the liquidity premium.
(c) Market segmentation
As well as the investors’ expectations with respect to future interest
rates and their preferences for liquidity, another theory, the market
segmentation theory, suggests that the bond market is actually made up of
a number of separate markets distinguished by time to maturity, each with
their own supply and demand conditions. Different classes of investors
and issuers will have a strong preference for certain segments of the yield
curve and, therefore, the curve will not necessarily move up, or down,
over its entire range.
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24 Principles of banking and finance
Activity 2.10
Now read Mishkin and Eakins (2009) pp.107–109 and then try and answer the following
questions:
1. According to the expectations theory, if the current short term rate is higher than the
current long term rate, what is expected to happen to interest rates in the future?
2. Which of the three theories best explains why yield curves normally slope upwards?
3. Why can’t the market segmentation theory explain why yields on bonds of different
maturities tend to move together?
Activity 2.11
Consult http://bonds.yahoo.com/rates.html. This shows the interest rates paid on US
Treasury bonds, municipal bonds and corporate bonds. Then try the following questions:
1. Why do 2-year Treasury bonds pay lower rates than 5-year Treasury bonds?
2. Why do 5-year municipal bonds pay lower rates than 5-year Treasury bonds?
3. Why do corporate bonds pay higher rates than government bonds?
Common and preferred stocks
Common stocks represent ownership interests in the firm. Common
stockholders receive dividends (when distributed), take capital gains (or
losses) when the stock price on the market increases (or decreases), and
have the right to vote.
Preferred stocks are equity claims with limited ownership rights in
comparison to common stocks. They differ from common stocks in several
ways. First, preferred stocks distribute a fixed constant dividend, which
makes them more similar to bonds than to common stocks. Second, the
price of preferred stocks is relatively stable, as the dividend is a constant
amount. Third, preferred stocks do not usually carry voting rights. Finally,
preferred stockholders have a residual claim on assets and income left over
after creditors have been satisfied, but they have priority over common
stockholders.
Structure of financial markets
Financial markets can be classified on the basis of several parameters:
the nature of the financial securities traded (primary versus secondary
markets), forms of organisation (organised exchanges versus over-thecounter markets), maturity of the financial instruments traded (capital
markets versus money markets), and forms of trade intermediation (quotedriven dealer markets, order-driven markets and brokered markets).
Primary and secondary markets
A primary market is a financial market in which new issues of financial
securities (both bonds and stocks) are sold to initial buyers. A secondary
market is one in which securities that have been previously issued are
resold. Primary markets facilitate new financing to corporations, but most
of the trading of securities takes place in the secondary markets.
Although some commentators have argued that secondary markets are
less important to the economy than primary markets, they serve two
important functions. First, they make financial securities more liquid. The
improvement in liquidity makes securities more desirable to investors, and
thus easier for the firm to sell them in the primary market. Second, they
set the price of the securities the firm sells in the primary market. This
means that the price of the securities’ issues on the primary markets is
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Chapter 2: Introduction to financial systems
partly determined by the price of similar securities traded in the secondary
market. These two reasons explain why we focus our attention on
secondary markets.
In the USA the New York Stock Exchange (NYSE) and American Stock
Exchange (AMEX) are the best known examples of secondary markets
for the trading of previously issued stocks. (In April 2007 NYSE was
combined with Euronext, as discussed below.) Note however that the US
bond markets, where previously issued private or governmental bonds are
traded, actually have a larger trading volume that the US stock markets.
Activity 2.12
In the table below, tick the column that shows where each of the intermediaries operate.
Operate in primary markets
Operate in secondary markets
Mutual funds


Finance companies


Investment banks


Securities firms


Exchanges and over-the-counter (OTC) markets
Secondary markets can be organised as exchanges or over-the-counter
(OTC) markets.
• In exchanges, buyers and sellers (through their brokers) transact in
one central location to conduct trades. Examples are the New York
Stock Exchange (NYSE) which recently acquired the American Stock
Exchange (AMEX) and the London Stock Exchange (LSE).
• In over-the-counter markets, dealers at different locations have an
inventory of securities, and are ready to buy and sell these securities
‘over-the-counter’ to anyone willing to accept their price. Because of
the technological links among dealers about prices, OTC markets are
competitive and not very different from organised exchanges. OTC
trading is most significant in the USA, where requirements for listing
stocks on the exchanges are quite strict. Examples of OTC markets
are: the US government bond market and the NASDAQ (National
Association of Securities Dealers Automated Quotation System) stock
exchange. The NASDAQ is the second largest US market. Traditionally,
it used to be a pure dealer market. Following controversies about
dealer collusion, since 1997 public limit orders are allowed to compete
with dealers. Market and limit orders can be entered onto the Small
Order Execution System (SOES), which automatically routes market
orders to the dealer quoting the best price.
(Read Mishkin and Eakins (2009), pp.262–64 for more information on the
NASDAQ.)
Activity 2.13
Visit the Nasdaq website at www.nasdaqomx.com/whoweare/quickfacts/ and summarise
the mission of Nasdaq.
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24 Principles of banking and finance
Money and capital markets
On the basis of the maturity of the securities traded, a distinction between
money and capital markets can be introduced.
• Money markets are financial markets where only short-term debt
instruments (maturity of less than one year) are traded. Money markets
are mainly wholesale markets (large transactions) where firms and
financial institutions manage their short-term liquidity needs (i.e. to
earn interest on their temporary surplus funds).
• Capital markets are markets in which long-term securities are traded.
These long-term instruments include equity instruments (infinite life),
government bonds and corporate bonds (original maturity of one
year or greater). Capital markets’ securities are often held by financial
intermediaries, such as mutual funds, pension funds and insurance
companies.
Quote-driven dealer markets, order-driven markets and brokered
markets
On the basis of how the trade intermediation occurs, a distinction between
quote-driven dealer markets, order-driven markets and brokered markets
can be made.
• In quote-driven dealer markets, a dealer or market-maker is on
one side of every trade. (Note that dealers are also known as market
makers, as they quote prices and stand ready to buy and sell at these
quotes, so that they provide liquidity). Dealers hold an inventory of the
security, which fluctuates as they trade. They profit from charging a
bid-ask spread and from speculating.
• In order-driven markets, buyers and sellers trade directly without
any intermediation. Most order-driven markets are auction markets.
Trading rules formalise the process by which buyers seek the lowest
available prices and sellers seek the highest available prices (price
discovery process).
• In brokered markets, brokers perform an active search role to
match buyers and sellers. They do not provide liquidity but they find
liquidity. They hold no inventory as they do not participate in the trade
themselves. The most important brokered securities markets are those
for large blocks of stocks and bonds.
Most major equity markets are hybrid markets in that they are not purely
order-driven or purely quote-driven, but a mixture of the two. For example
the NYSE is an explicitly hybrid market. Each stock is assigned a single
market-maker, known as a specialist. He must ensure that trade in the
stock in question occurs in a fair and orderly fashion. He must provide
quotes to everybody. However, the public can also submit limit orders
to the specialist. The specialist then maintains (and has exclusive access
to) the limit order book. When the specialist provides quotes to potential
customers, they may be his own or (partially) composed from public limit
orders. This implies that not all trades affect the specialist’s inventory.
Secondary markets around the world
In the United Kingdom, secondary financial markets are as sophisticated
as in the USA. The London Stock Exchange, the major organised stock
market in the UK, enables domestic and overseas companies to raise equity
capital. (Note that in August 2007 the London Stock Exchange merged
with Borsa Italiana, and nowadays the group leads the European equities
business.) For frequently traded stocks (constituents of the FTSE-100,
34
Chapter 2: Introduction to financial systems
the market index of the London Stock Exchange), the primary trading
venue is the electronic, order-driven system called SETS (Stock Exchange
Electronic Trading Services). Essentially, the London Stock exchange is
a hybrid market: while the exchange itself regards SETS as the primary
trading venue for FTSE-100 stocks, a lot of trade in these stocks is off the
SETS order book. Dealers still exist who are voluntarily willing to provide
liquidity in FTSE-100 stocks. Hence, the London Stock Exchange has some
quote-driven features too (and is not fully transparent or centralised).
As shown by Figure 2.6, in 2004 the total capitalisation of domestic listed
companies on the London Stock Exchange was much lower than the one
of NYSE. Note however that foreign companies, not included in the graph,
constitute a high proportion of listed companies in the UK. Bond markets
are important in the UK. The domestic bond market has been replaced
by the Eurobond market (market for the trading of bonds denominated
in a currency other than that of the country in which they are sold). The
Eurobond market is based in London, and accounts for the trading of most
(up to 80 per cent) of the new issues of international bonds.
12
Capitalisation domestic
listed companies
10
8
6
4
2
0
NYSE
Nasdaq
Tokyo Stock
Exchange
London Stock
Exchange
Euronext
Deutsche
Borse
AMEX
Figure 2.6: Stock market capitalisation ($trillion), 2004
Source: Graph created using data from NYSE website (www.nyse.com).
In Japan there are eight stock exchanges, with the Tokyo Stock Exchange
by far the most important. The total capitalisation of domestic listed
companies is similar to that of the London Stock Exchange. There is
also an OTC market, which has become more important in recent years.
The debt markets (for the debt of government, financial institutions and
companies) are also well developed.
In the Netherlands, France, Belgium and Portugal the stock
exchange is Euronext, which was formed on 22 September 2000 when
the exchanges of Amsterdam, Brussels and Paris merged. Euronext
expanded at the beginning of 2002 with the acquisition of LIFFE (London
International Financial Futures and Options Exchange) and the merger
with the Portuguese exchange BVLP (Bolsa de Valores de Lisboa e Porto).
Euronext represents a European cross-border exchange, integrating
trading and clearing operations on regulated and non-regulated markets,
and was formed in response to the globalisation of capital markets and
to create a pan-European exchange offering its participants increased
liquidity and lower transaction costs. In April 2007 NYSE Euronext (i.e.
the holding company created by the combination of NYSE and Euronext)
was established. NYSE Euronext operates the world’s largest and most
liquid exchange group and offers the most diverse array of financial
products and services.
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24 Principles of banking and finance
In Germany, the Deutsche Borse is composed of seven regional
exchanges, with Frankfurt being the most important. These markets have
been traditionally underdeveloped in Germany compared to most other
countries. The bond markets are more important than the stock markets.
Most of the debt traded is issued by the government and banks.
Activity 2.14
In your own country, if you or a company want to launch (primary market) or buy and
sell shares (secondary market), where do they do it? Note down what you’ve read about
your country’s stock exchange(s) and look at their websites. Ask your own bank what they
think of these and other financial markets and intermediaries.
Summary
In this chapter, we investigated financial systems by using a functional
perspective (analysing the functions of financial systems in order to
understand why they exist) and a structural perspective (to outline the
structure of financial systems and describe the main entities that comprise
financial systems).
• From a functional perspective, financial systems perform two essential
economic functions: the credit function and the monetary function.
• From a structural perspective, financial systems comprise financial
intermediaries, securities and financial markets.
With reference to the US financial system, we provided a taxonomy of
each of these three entities:
• Financial intermediaries comprise depository institutions (commercial
banks, savings and loan associations and credit unions), contractual
savings institutions (insurance companies and pension funds),
and investment intermediaries (mutual funds, finance companies,
investment banks and securities firms).
• Financial securities traded in financial markets are debt instruments
(bonds, notes and bills), and equity instruments (common and
preferred stocks).
• Financial markets can be classified as primary versus secondary
markets, organised exchanges versus over-the-counter markets, capital
markets versus money markets, quote-driven dealer markets versus
order-driven markets and brokered markets.
Furthermore, the chapter provided an overview of the differences between
national financial intermediaries and financial markets across the world.
36
Chapter 2: Introduction to financial systems
Key terms
Bi-ask spread
Bonds
Borrower-spenders
Brokers
Brokered markets
Building societies
Callable bonds
Capital markets
Commercial banks
Common stocks
Contractual savings
institutions
Convertible bonds
Corporate bonds
Coupon bonds
Credit unions
Dealers
Debt instruments
Default risk premium
Depository institutions
Direct finance
Economic function of a
financial system
Equity
Eurobonds
Expectations theory
Finance companies
Financial intermediaries
Financial markets
Floating rate bonds
Foreign bond
Government bonds
Government notes
Index-linked bonds
Indirect finance
Insurance companies
Interest rate term structure
Investment banks
Investment intermediaries
Lender-savers
Limit orders
Liquidity premium theory
Long-term credit banks
Market makers
Market segmentation theory Money markets
Market orders
Money market securities
Municipal bonds
Mutual/cooperative banks
Mutual funds
Order-driven markets
Ordinary banks
Organised exchanges
Over-the-counter markets
Pension funds
Perpetual bonds
Preferred stocks
Primary markets
Puttable bonds
Retail banks
Savings banks
Savings institutions
Secondary markets
Securities
Securities firms
Shares
Stocks
Treasury bills
Trust banks
Wholesale banks
Yield curve
Zero coupon bonds
A reminder of your learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you will be able to:
• explain why financial systems exist (i.e. explain the functions of
financial systems)
• outline the structure of financial systems (i.e. describe the three main
entities that compose financial systems: financial intermediaries,
securities and financial markets)
• describe which financial intermediaries operate in financial systems
in the USA in particular and, more generally, around the world (e.g.
depository institutions, contractual savings institutions and investment
intermediaries) and explain their characteristics
• explain which financial securities are traded on financial markets
(bonds, notes, bills and stocks), and explain their nature
• discuss the various theories that attempt to explain the shape of the
yield curve
• explain the structure of financial markets in the USA and around
the world (primary versus secondary markets, money versus capital
markets, organised versus over-the-counter markets, quote-driven
dealer markets, order-driven markets and brokered markets).
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24 Principles of banking and finance
Sample examination questions
1. a. What is a financial system? Frame your answer both from a structural and a functional perspective.
b. What is the primary function of depository institutions? How does
this function compare with the primary function of insurance
companies?
c. What is a mutual fund? What are the differences between shortterm and long-term mutual funds? Where do mutual funds rank in
terms of asset size among all financial intermediaries in the USA?
2. a. Explain how securities firms differ from investment banks. Which categories of firms are there in this industry? In what way are they
financial intermediaries?
b. What distinguishes stocks from bonds? What are the differences
with reference to the risk/return relationship?
c. ‘Because corporations do not actually raise any funds in secondary
markets, they are less important to the economy than primary
markets’. Comment.
3. a. With reference to examples, discuss globalisation of the financial markets around the world.
b. Compare and contrast quote- and order-driven markets
c. Explain the purpose of money markets and give examples of the
types of money markets and their users.
38
Chapter 3: Comparative financial systems
Chapter 3: Comparative financial systems
Aims
The aim of this chapter is first, to illustrate the main reasons for the
existence of bank-based and market-based financial systems across
countries, and to review the history of national financial systems and
analyse why countries chose one way rather than another. Second, it aims
to investigate the main causes of financial crises and their sequence of
events. In particular we focus on the recent global financial crisis of 2007.
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain why the relative importance of banks and financial markets is
different around the world
• discuss how the historical evolution of financial systems helps to
explain the existence of bank-based and market-based financial systems
• outline the main similarities and differences between the financial
systems of industrialised countries
• discuss the implications (in terms of households’ asset allocation, role
of indirect intermediation and firms’ financing) of the existence of
bank-based and market-based financial systems
• explain the main economic factors causing financial crises and the
sequence of events of financial crises
• discuss, with reference to examples from history, financial crises and
bubbles.
Essential reading
Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) Chapters 1, 2 and 3.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapter 18.
Further reading
Heffernan, S. Modern Banking. (Chichester: John Wiley and Sons, 2005)
Chapter 2.
References
Bank of England Financial Stability Report, no. 21 (London, 2007).
Bullard. J, J. Neely and D. Wheelock ‘Systemic risk and the financial crisis: a
primer’, Federal Reserve Bank of St. Louis Review, September/October 2009
pp.403-17
Corbett, J. and T. Jenkinson ‘How Is Investment Financed? A Study of Germany,
Japan and the United States’, Manchester School of Economics and Social
Studies (1997) 65 supplement, pp.69–93.
Lacoste, P. ‘International capital flows in Argentina’, BIS Papers no. 23
(www.bis.org/publ/bppdf/bispap23e.pdf, 2004).
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24 Principles of banking and finance
Lindgren, C., G. Garcia and M. Saal Bank Soundness and Macroeconomic Policy.
(Washington D.C.: International Monetary Fund, 1996).
Mayer, C. ‘Financial Systems, Corporate Finance, and Economic Development’
in Hubbard, R.G. (ed.) Asymmetric Information, Corporate Finance, and
Investments. (Chicago: University of Chicago Press, 1990)
[ISBN 9780226355856] pp.307–32.
Trueman, B., M.H. Wong and X.J. Zhang ‘The Eyeballs have it: Searching for
the Value in Internet Stocks’, Working Paper. (University of California, April
2000).
Turner, A ‘The Turner Review: A regulatory response to the global banking
crisis’, Financial Services Authority, 2009.
(download www.fsa.gov.uk/pubs/other/turner_review.pdf)
Introduction
In Chapter 2 we suggested that financial markets and intermediaries are
alternatives that perform more or less the same functions but in different
ways (and perhaps with different degrees of success). Our objective in this
chapter is to determine why we observe differences in financial systems
with regard to the relative importance of financial intermediaries and
financial markets, and hence why financial systems around the world can
essentially be divided into bank-based and market-based systems.
In terms of the relative importance of banks and markets, Figure 3.1
clearly indicates some important differences across countries. First, we can
see that the USA is at one extreme and Germany at the other. The equity
market capitalisation to GDP ratio for the USA was 107 per cent in 2009.
In contrast, the corresponding ratio for Germany was 39 per cent. The
US ratio of market capitalisation is almost three times that of Germany.
Accordingly, the ratio of bank claims on the private sector to GDP was 48
per cent for the USA and 127 per cent for Germany: the German ratio is
about 2.5 times that of the USA.
Second, other financial systems fall in between these two extremes. On
the one hand, in the UK, markets are more important than banks, but the
relevance of banks is high (129 per cent versus 123 per cent). On the other
hand, in Japan, banks are much more important than markets (127 per
cent versus 70 per cent). Therefore, the UK and the USA are examples of
market-based financial systems, where markets are more important than
banks; while Japan and Germany are examples of bank-based financial
systems, where the opposite situation occurs.
Third, several other financial systems are interesting intermediate cases,
where both markets and banks are important. In France, banks and
markets are roughly equally important. In other European countries
(Italy and Spain), banks are important, and markets are less so. However,
there are differences in the irrespective relevance (Banks are much more
important than markets in Italy). Why are there differences in the relative
importance of financial markets and intermediaries in different countries?
40
Chapter 3: Comparative financial systems
1,6
1,4
1,2
1
0,8
0,6
0,4
0,2
0
France
Germany
Italy
Spain
Bank claims/GDP
United Kingdom USA
Japan
Market capitalisation/GDP
Figure 3.1: International comparison of banks and markets, 2009
Sources: OECD Statistics (for GDP data); World Federation of Exchanges (for stock
exchange data); European Banks Federation; Bank of England; Federal Reserve Bank of
USA; Bank of Japan.
The relative importance of different financial institutions is heterogeneous
across countries. In terms of the different forms in which gross financial
assets are held (directly by households, by pension funds, by insurance
companies, by mutual funds), most assets are owned directly by
households (except for the UK). In the USA and UK, pension funds are
much more important than in other countries. In Germany, and to some
extent in Japan, pension funds are relatively unimportant (please refer
to Table 3.2 in Allen and Gale, 1998, p.48). Why are there differences in
the relative importance of different financial intermediaries in different
countries? What are the implications in terms of investment decisions of
individuals in different countries?
From the perspective of households, there is a clear difference between
the assets held in the USA, UK, Germany and Japan. As regard to the
total portfolio allocation of assets, households in the USA and UK hold a
greater proportion of their assets as shares than is the case in the other
countries we consider here (Germany, Japan and France). Overall (direct
and indirect holdings via pension funds, insurance companies and mutual
funds), equity constitutes 45 per cent of household assets in the USA, and
52 per cent in the UK (even more than in the USA). This contrasts sharply
with Japan and Germany, where the corresponding values are 12 per
cent and 13 per cent. For cash and cash equivalents (which include bank
accounts) and bonds the reverse is true. In Japan 52 per cent of assets
are held in cash and cash equivalents and 13 per cent in bonds, while in
Germany the figure is 36 per cent in both (please refer to Table 3.3 in
Allen and Gale, 1998, pp.50–51). In the USA only 19 per cent of assets are
held in cash and cash equivalents, and 28 per cent in bonds.
Activity 3.1
As you work throughout this section, fill in the table below on the household percentage
of assets owned.
USA
UK
Germany
Japan
Equity
Cash and cash equivalents
Bonds
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24 Principles of banking and finance
When you have completed the table in the Activity above you will see some sharp
differences. The question is – why should these differences exist? Also, what are the
implications in terms of risk for the investors of different countries?
From the perspective of firms’ fund raising, the dominance of financial
intermediaries over financial markets is clear in all countries. In all
countries, except Japan, retained earnings are the most important source
of finance. External finance is simply not very important. Loans represent
the most important source of finance in terms of funds raised externally:
they are the second source of finance in the USA, UK, Germany, Japan,
France and Italy (Mayer, 1990; Corbett and Jenkinson, 1997). On the
contrary, financial markets are not an important source of finance, as
further discussed in Chapter 4. Even in the USA and the UK, which, as we
saw above, have the highest financial market capitalisation to GDP, loans
from financial intermediaries are far more important for corporate finance
than are securities markets (bonds and stocks). In the countries with
the lowest financial market capitalisation to GDP (Germany and Japan)
financing from financial intermediaries has been almost ten times greater
than that from securities markets. What makes financial intermediaries so
important in the financing of firms?
Summing up, the UK and the USA are examples of market-based financial
systems, where:
• Financial markets (organised markets for securities, such as stocks,
bonds, futures and options) are more important than banks
• The proportion of gross financial assets owned by pension funds is
higher.
• The proportion of equity in the total portfolio allocation of assets by
householders is higher.
• Loans from financial intermediaries are more important for corporate
finance than marketable securities, but at a lower extent than in other
financial systems.
On the other hand, Germany and Japan are examples of bank-based
financial systems.
This chapter explains these points. Whether a country has a bank-based or
market-based financial system is important. Each type of system facilitates
the flow of funds from savers to borrowers, but each has different
implications for dealing with potential asymmetric information problems
that arise between those providing funds and those receiving them, as
discussed in Chapter 4. Is the ideal financial system – in terms of linking
savers and borrowers – one that relies heavily on banks through lending
and stock ownership or control to resolve these potential informational
problems, or one that relies heavily on financial markets?
42
Chapter 3: Comparative financial systems
Activity 3.2
Plot the different countries shown in Figure 3.1 on a graph like this.
High ratio
of bank
claims
High % of market
capitalisation
The evolution of financial systems
A basic knowledge of the historical development of financial systems
is essential if you are to understand the reasons for the existence of
market-based and bank-based systems. The stages that characterise the
development of financial systems are briefly described below. You can find
a full account of these in Allen and Gale (see Essential reading). We only
summarise the main points here.
Ancient practices
In the first phase, which started with the Mesopotanian financial system
(third millennium BC) and ended with the Roman empire (first century
AD), the main characteristics of the system can be stylised as follows.
• Financial instruments were initially limited to precious metals or
metallic (gold and silver) coins, but were then extended to loans and
mortgages. Loans were made to individuals for consumption needs
and for agricultural financing (from landlords to tenants). Mortgages
were a combination of a loan and an insurance contract, and they were
mainly used for foreign trade financing. The provider supplied funds to
finance a voyager; however in the event of a catastrophe, repayment
was not required (note the similarities with the equity instruments).
• Financial intermediaries were limited to money changers and banks.
Money changers emerged because of the existence of many different
types of coins. Banks began to operate in Athens in the late fifth
century BC. Their main functions were to accept deposits and make
loans.
Italian bankers
After the Romans, monetary systems did not develop in Europe until the
next period of progress, starting in 1200. This came again from Italy, this
time north of Rome in Tuscany and further north. These developments
led eventually to the Renaissance in the 1300s. You can find some of the
reasons explained in Allen and Gale – look out for the following factors:
the role of the pre-Reformation Church; the aristocracy, nation states and
taxation; the rise of Islam; trade routes between Asia and Europe (via
the Silk Road). As a result, several characteristics of the modern financial
system developed:
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24 Principles of banking and finance
• Financial instruments became more varied. They included, in addition
to trade credit and mortgages, bills of exchange, government and
corporate securities and insurance contracts. The innovation of bills
of exchange has been very important and opened up the way to banks
in a modern sense. Bills of exchange were debt instruments drawn
on the buyer of goods, which promised the payment of a specified
amount in the buyer’s hometown at some date in the future. Due to the
prohibition on usury imposed by the Roman Catholic Church, bills of
exchange could not be discounted. To overcome this prohibition, the
exchange rate specified in the transaction was such that there was a
de facto discount. Other new financial instruments appeared: (1) Debt
claims against amount borrowed by governments (such as that of the
Florentine Republic); (2) Corporate claims (equity-like instruments)
issued by partnerships and companies. Finally, maritime insurance
became important and life insurance was introduced.
• Financial intermediaries included early types of banks and insurance
companies. Banks were first established in Florence, Siena and Lucca
after the Middle Ages, then spread to Venice and Genoa. In the
fourteenth century Bardi and Peruzzi in Florence grew to a substantial
size: just to give a measure of their size, consider that they financed the
English side of the Hundred Years’ War. In the fifteenth century, Medici
banks in Florence achieved a sophistication that remained unbeaten
until the nineteenth century. The main activities of banks were: (1)
transferring money associated with international trade and the Roman
Catholic Church; (2) establishing networks in Europe.
• Informal markets appeared. To a limited extent, government and
corporate securities were transferable and traded.
It is worth mentioning that Jewish people were more important than the
Italians in northern Europe and went on to play important financial roles
in Spain and Poland. The Church’s rules against usury gave the Jewish
bankers their competitive advantage.
Dutch finance
The third phase of financial development took place mainly in Amsterdam
in the early 1600s. The Netherlands finally ejected their colonial masters –
the Spanish – after a long, costly war and their new-found independence
allowed a blossoming of trade and finance. The period is known to the
Dutch as their ‘Golden Era’ and the wealth that flowed down the River
Rhine from Germany, France and Switzerland led to new financial systems.
Other signs of increased wealth were the rise of Dutch painting, empirebuilding and successful wars against the English, culminating in a Dutch
king of England in 1689. As we see below, the Dutch also gave the English
a model for a ‘central bank’ as well as a new king.
• Financial markets became more formalised. The first formal stock
exchange developed as part of the Amsterdam Bourse, which was
established in 1608 as a market for commodities and also for securities
(although these were less important). The market soon developed
sophisticated trading practices. The reason for the development of
the Amsterdam Bourse was the tulip mania of 1636–37, the first
main financial bubble (please refer to the last section of this chapter):
the price of tulips rose quickly to very high levels, before collapsing
dramatically and causing the bankruptcy of many speculators.
• Financial instruments: options and futures contracts were traded on the
Amsterdam Bourse;
44
Chapter 3: Comparative financial systems
• Central banks appeared as the institutions through which governments
were involved in financial systems. The Bank of Amsterdam,
established in 1609, became a model for public banks set up by
governments. Its main purpose was to facilitate payments. Commercial
banks took deposits and made exchanges, but in general did not
provide credit.
The emergence of market-based and bank-based
systems
In the fourth phase, starting in the years 1719–20, when the South Sea
Bubble occurred in England and the Mississippi Bubble in France, two
distinctly different types of financial systems developed: the stock marketoriented US/UK model and the bank-oriented continental European
model. Whereas the UK repealed the heavy regulation of the stock
market (the so-called Bubble Act, which was a reaction to the South Sea
Bubble) at the beginning of the nineteenth century, France did not ease
restriction on the stock market until the 1980s. The French experience has
substantially affected the development of financial systems in continental
Europe, among them the German system. The historical development in
each of these main countries is analysed below.
United States of America
The National Bank Acts of 1863 and 1864 set up a national banking
system as a reaction to the chaos of the US Civil War. Fears of excessive
centralisation led to the banks in each state being granted limited powers:
each bank was confined to a single state; and banks were prohibited
from holding equity or paying interest on demand deposits. After a series
of panics in the system (1873, 1884, 1893, 1907), the Federal Reserve
System was established – with a regional structure – in 1913. In 1933
another major banking panic led to the closing of banks for an extended
period. This led to the Glass-Steagall Act of 1933, which introduced
deposit insurance and required the separation of commercial and
investment banking operations (and thus prohibited universal banking and
prevented banks from underwriting securities). As a result, throughout
the nineteenth century, the US banking system was highly fragmented,
without a nationwide system with extensive branch networks.
On the other hand, capital markets are more important than banks in the
USA. Several reasons explain the strength of the role of the USA’s financial
markets:
1. The Civil War helped to develop New York’s financial market (as wars
between England and France did in the eighteenth century with regard
to the London capital markets), and the First World War helped the
New York market to supplant London markets (as New York’s markets
were financing all parties).
2. The prohibition on banks’ holding equity and the fragmentation of the
banking system (particularly with regard to providing services to the
corporate sector).
3. The Great Crash of 1929, which led to the creation of the Securities
and Exchange Commission (SEC). This aimed to ensure the integrity of
the markets and the regulation of financial markets.
4. Financial innovation, by the introduction of new financial instruments
such as various derivative instruments (swap and complex options). At
the same time, new exchanges for options and financial futures have
appeared and become major markets.
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24 Principles of banking and finance
Recently, three restrictions on the banking system have been relaxed. First,
the erosion of the Glass-Steagall Act prohibitions. In 1987 the Federal
Reserve allowed affiliates of approved commercial banks to engage in
underwriting activities as long as the revenue did not exceed a specified
amount – which started at 10 per cent, but was raised to 25 per cent – of
the affiliates’ total revenues. In 1988 the Federal Reserve used a loophole
in Section 20 of the Glass-Steagall Act to allow three commercial banks
(Bankers’ Trust, Citicorp and J.P. Morgan) to underwrite corporate debt
securities and to underwrite stocks. Two competitive reasons determined
this legislative change. On the one hand, brokerage firms began to engage
in the traditional banking business of issuing deposits. On the other hand,
foreign banks’ activities in the USA eroded the position of national US
banks.
Second, the elimination of the Glass-Steagall Act. The Gramm-Leach-Bliley
Financial Services Modernization Act of 1999 allows securities firms and
insurance companies to purchase banks, and allows banks to underwrite
insurance and securities and engage in real estate activities.
Third, the relaxation of the historical restriction on banks crossing state
boundaries. The Riegle-Neal Interstate Banking and Branching Efficiency
Act of 1994 stated that after 1997 banks would be essentially unrestricted
with regard to interstate banking, except in states that opted out or
imposed other restrictions. Nationwide banks are now beginning to
emerge.
Read Mishkin and Eakins (2009), pp.450–79 for more detail on the
historical development of the US banking system. In particular focus
on why the regulators decided to separate banking and other financial
services companies (through Glass-Steagall) and then why they reversed
this when Glass Steagall was repealed. You will notice that one of
the consequences of the repeal of Glass-Steagall has been greater
consolidation of the industry through large mergers. This has created
a problem called the ‘too-big-to-fail problem’ which we will examine in
Chapter 5 of this subject guide.
The financial assets of households are mostly equity (45 per cent of the
total). Over a long period there has been a shift away from individuals’
holding equity directly to intermediaries (mainly pension funds and
mutual funds) holding it. We analysed this earlier: see pp.21.
United Kingdom
The financial system in the UK resembles that in the USA in that markets
play an important role. However, differences in the size and structure of
the banking sector are evident. Moreover, the UK system is characterised
by much less regulation than the US system.
The speculation on the stocks of the South Sea Company, a company set
up in 1711 to fund a portion of the government debt in exchange for a
payment to the company, determined a dramatic rise in its price. This led
to a large number of other stock issues by promoters who hoped to profit
from price appreciation. To prevent these other stocks from diverting
resources away from the South Sea Company, the Bubble Act was passed
in 1720. However, the Act did not prevent a dramatic fall in the price of
the South Sea Company, and many speculators went bankrupt (note the
similarities with the tulip mania that occurred in the Amsterdam Bourse).
The Act, not repealed until 1824, imposed the need to obtain a royal
charter to form a joint stock company. The effect of the Act was to create
barriers to company formation. This explains why the London capital
market did not become a source of funds for companies.
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Chapter 3: Comparative financial systems
However, it did become important for government financing. During the
nineteenth century, the London Stock Exchange, established in 1802,
steadily increased its importance as a source of funds for firms because of
several events:
• the repeal of the Bubble Act in 1824
• the freedom to form companies without specific parliamentary
approval, introduced in 1856
• the development of railways in Britain and abroad, which resulted in a
large demand for capital.
New York replaced London as the world’s major financial centre after
1918. To this day the UK remains a stock market-based financial system.
The UK banking system also developed strongly in the nineteenth century
due to several other events:
• The Bank of England, founded in 1694 as a private institution, was
initially intended to help the government market debt to finance the
Nine Years’ War with France. Its role became more important in 1742,
when it was granted a monopoly over note issues in England except
for private banks. Note that the growth of central banking activities in
England laid the foundation for the development of central banks in
other countries.
• Banks consolidated into nationwide networks: country banks needed
to have London branches because of the Bank of England’s role, and
London banks needed to have branches outside London.
• A visible concentration process took place (in contrast to the United
States). As noted earlier, commercial banking was traditionally
dominated by four clearing banks: Barclays, National Westminster,
Midland and Lloyds (now Barclays, Royal Bank of Scotland, HSBC
and Lloyds). Note that although there is no equivalent to the GlassSteagall Act and universal banking is allowed, commercial and
investment banking (merchant banking or securities firms in UK
terminology) were, until recently, traditionally separate because
of restrictive practices. However, in 1986, the ‘Big Bang’ brought
important structural changes in the London Stock Exchange, and as a
consequence all the securities firms became part of integrated financial
institutions.
• The foreign and domestic sectors of the banking industry are roughly
equal in size. This large foreign presence may in part explain the high
ratio of bank claims on the private sector to GDP. However, with a few
exceptions, foreign banks are not involved with the domestic sector.
Traditionally, one important characteristic of the banking system is that
banks did not engage in long-term lending to industry. This explains why
firms rely greatly on internal finance and markets for raising funds.
Germany
Germany is very different from the US/UK financial system because banks
play a far more important role and markets are less relevant, as shown in
the opening section by the banks’ claims and market capitalisation to GDP.
The historical development of the financial system explains its present
characteristics.
Prior to 1850, German financial markets were undeveloped relative
to those in the UK, and joint stock companies were rare. The markets
(Frankfurt and Berlin) were mostly for government debt and loans to
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24 Principles of banking and finance
princes, towns and foreign estate. During the same period, banks provided
the initial finance for industrialisation and subsequently managed the
issue of shares and bonds to repay the loans. Links between banks and
industry grew substantially during this period. Banks were represented
on the boards of companies, and industrialists held seats on the boards of
banks. This led to the development of the Hausbank system, where firms
have a long-term relationship with a given bank and use it for most of
their financing needs. This qualifies as a universal banking system,
where banks offer a full range of services to commercial customers and are
formally linked to their commercial customers through equity holdings.
Even today, the three major universal banks – Deutsche, Dresdner and
Commerzbank – dominate the allocation of resources in the corporate
sector. This explains why the most important sources of funds for firms
were bank financing and internal finance.
There are several reasons why financial markets in Germany remain
relatively undeveloped:
• The reliance on bank finance and the close relationship between banks
and industrial firms. This explains why bank loans are very important,
although retentions (funds internally generated by firms) are the single
most important source of finance.
• Few households participate directly in the financial market, because of
the lack of prohibitions on insider trading, which make participation by
unsophisticated investors unattractive.
• Limited availability of mutual funds. Overall this implies that German
investors have a limited range of equity instruments to invest in. This
explains why the allocation across assets is mostly in cash and cash
equivalents (36 per cent) and bonds (36 per cent), while equity is fairly
unimportant (13 per cent).
It is interesting to note the recent developments towards the creation of
a single market in banking in the countries of the European Union (EU).
In order to remove barriers to trade across European banking systems,
a single market in banking has been created by harmonising regulation
throughout the countries of the EU. The Second Banking directive of 1993
created the so-called EU passport, which entitles a bank in one member
country to provide core banking services throughout the EU on the basis of
the authorisation of their own member country. Moreover, complementary
directives are aimed at providing harmonisation of solvency regulation
across the EU (Basel Capital Requirements Directives). The original
Basel Accord (now referred to as Basel 1) was agreed in 1988 by the
Basel Committee on Banking Supervision. It helped to strengthen the
soundness and stability of the international banking system as a result of
the higher capital ratios that it required. Basel 2, a revision of the existing
framework taking effect from the end of 2006, had the effect of making
the framework more risk sensitive and representative of modern banks’
risk management practices (as discussed in Chapter 5).
Japan
The Japanese financial system is often seen as similar to the German
bank-based financial system. However, Japan has experienced a different
historical development in the role of the government. In Germany, the
Hausbank system developed in the private sector, whereas in Japan the
government was instrumental in the development of the main banking
system. The supervision by the Ministry of Finance and the Bank of Japan
extends over areas as diverse as the opening of new branches, opening
hours, credit volumes, interest rates and accounting rules.
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Chapter 3: Comparative financial systems
From the time of the abolition of feudalism and the Meiji Restoration
towards the end of the nineteenth century, the Japanese authorities
played a leading role in the growth of the modern industrial economy and
the establishment of a financial system. During wartime, from 1937 to
1941, the government introduced a system of central control of financial
resources, the so-called system of credit allocation. This determined a
close relationship between banks and companies in the keiretsu, which
is a group of industrial firms with a core group of banks. This led to the
development of the main characteristics of the banking system:
1. Long-term relationships between a bank and its client firm.
2. Holding of both debt and equity of non-financial firms by the bank.
3. Active intervention of the bank in case of financial problems in the
firm.
This explains why in Japan loans (and not retentions) are the most
important source of financing.
Traditionally Japanese banks have shown a high degree of segmentation
and specialisation, along functional lines. The reform of 1992 reduced
the amount of segmentation: different types of financial firms are now
allowed to enter new financial activities through separate subsidiaries. The
Japanese banking system experienced a major crisis between 1997 and
1998, when seven large financial institutions went bankrupt (as explained
in Chapter 4). Private financial institutions still have not fully recovered
from this crisis: in July 2007 only one Japanese bank (Mitsubishi UFJ
Financial Group) still maintains a global presence and occupies the
seventh position in The Banker’s ranking of the top 1,000 banks, whereas
in 1994 six of the 10 top places were occupied by Japanese banks.
For most of the past fifty years, the weakness of the securities market has,
to some extent, been self-perpetuating. On the one hand, the bank system
experienced an abundance of funds. This abundance has been mainly
determined by the large financial surplus of the personal sector, which in
turn has been determined by two facts: Japanese households are heavy
savers and they have limited investment opportunities in housing. This
explains the pattern of Japanese households’ asset allocation, which is
mainly cash and cash equivalents (52 per cent including bank accounts).
On the other hand, the equity market tends to be volatile and speculative
because of the dependence of companies on banks’ financing, which has
determined their very high leverage ratios (the amount of capital divided
by total assets, as explained in Chapter 5).
However, in recent years, financial markets have steadily become more
important. In order to gain international recognition, the Japanese
government relaxed several regulatory restrictions, such as the restriction
on issuing bonds. At the same time, large firms are able increasingly to
rely on financial markets to raise funds. Overall, this has resulted in the
development of fairly sophisticated financial markets. Nevertheless, the
historical development of the Japanese financial market has determined
the relative unimportance of equity and bonds in the asset allocation
of Japanese households (13 and 12 per cent respectively). Note that in
the 1990s the fall in individual ownerships has mainly been offset by
an increase in the holdings of banks, insurance companies and business
corporations.
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24 Principles of banking and finance
France
The Mississippi Bubble (see p.40) profoundly affected the subsequent
development of the stock market and banks in France. After the collapse,
an official Bourse was set up. However, markets for company securities did
not develop significantly during the nineteenth and twentieth centuries.
Similarly, the Mississippi Bubble retarded the development of banks for
many years. Two main institutions were founded in the 1938–62 period
with the aim of providing long-term loans for the industry. However,
they ended up providing short-term commercial loans and speculating in
foreign bonds. This suggests that the system of banks lending to industry
developed in a deeper way only in Germany.
Overall, the French financial system has traditionally been a bank-based
system (even if less pronounced than the German system), and markets
have played a less relevant role. However, in the 1980s, the government
made a strong effort to reform the financial system and bolster financial
markets. As a consequence, French financial markets have developed
greatly since the beginning of the 1980s because of:
1. Two main reforms. First, the creation of a single national market, so
that stocks from any of the seven exchanges could be traded at any
exchange. Second, the completion of a computerised trading system
(so-called CAC, Cotation Assistée et Continu).
2. The immediate success of derivatives markets (and MATIF in
particular), set up in the mid-1980s.
3. The substantial presence of collective investment scheme (such as
mutual funds), holding 19 per cent of financial assets, much higher
than in any other country. Note, however, that a high proportion of
assets (62 per cent) are held directly by households, and the main
categories of assets held are cash and cash equivalents (38 per cent)
and bonds (33 per cent).
This explains why the French system is now an intermediate case, where
both markets and banks are equally important.
Activity 3.3
Investigate the following financial crises on the internet: Tulip mania, South Sea Bubble,
Mississippi Bubble, Stock Market Crash of 1929. Then answer the following question:
How have financial crises influenced the development of the financial system in the UK,
USA and France?
(Don’t forget to do the Essential reading: Allen and Gale (2001) Chapter
2 to analyse in more detail the historical development of financial systems
across countries.)
Market-based versus bank-based financial systems:
implications
The presence of market-based and bank-based financial systems emerges
by comparing national banking structures on the basis of:
1. Integration of banking and commerce, which can operate either
by banks’ ownership of commercial firms or by commercial firms’
ownership of banks. In the USA and the UK there is virtually no
integration of banking and commerce. However in both Germany and
Japan there is a close relationship between banks and firms. The higher
amount of information available to banks operating in Germany and
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Chapter 3: Comparative financial systems
Japan – in comparison to US/UK banks – helps in monitoring the firms
and thus reducing the moral hazard problem. Moral hazard is one of
the problems intermediaries face in lending (as described in detail in
the next chapter) and represents the risk (hazard) that the borrower
engages in activities that are undesirable (immoral) for the lender after
the transaction is made.
2. Integration of the provision of bank and non-bank financial services.
Bank financial services refer to traditional deposit-based lending, while
non-bank financial services are those such as investment, underwriting,
insurance, trust and property services. A high level of integration
characterises universal banks of Germany, against the traditionally low
integration in the USA and UK. Note, however, that the regulations
of USA/UK have recently been reformed, and higher degrees of
integration are now possible. Other countries, such as France and Italy,
have limited forms of universal banking.
In other words, there is a clear distinction between market-based (USA
and UK) and bank-based systems (Germany, Japan and France). However,
several peculiarities make the picture more complex:
1. The USA, unlike the UK and other European countries, did not develop
a nationwide banking system with few banks.
2. In Germany and France, financial markets for company shares did not
develop until recent years. Instead banks have had a primary role in
providing funds to firms.
3. In Germany the ties between banks and firms are strong and intimate,
but in France the banking relationship developed in a less successful
way.
4. In Japan the government played an important role in the development
of the banking system, whereas in Germany the Hausbank system
developed without government intervention.
What is the economic reason for the existence of two broad types of
financial systems, one market-based and the other bank-based? The
answer is the different reactions to the instability associated with financial
markets. As a consequence of the South Sea Bubble in England, and the
Mississippi Bubble in France, two distinctly different types of financial
systems developed. This occurred because the UK repealed the heavy
regulation of the stock market (Bubble Act) at the beginning of the
nineteenth century, whereas France did not ease the restriction on the
stock market until the 1980s. Many other financial crises and speculative
bubbles (Tulip mania, Great Crash of 1929) affected the development
of financial systems. This suggests that financial systems are fragile and
crises are endemic. (The next section investigates the economic reasons for
financial crises.)
Financial markets did not develop spontaneously. As we have already
seen, various kinds of financial institutions were responsible for the
first financial transactions, mainly involving loans and transfers. Only
at the beginning of the seventeenth century, with the foundation of the
Amsterdam Bourse, was a formal market established. The presence of
market imperfections – transaction costs and asymmetric information, as
discussed in the next chapter, see p.64 – explains why for a long time most
financial systems have been much closer to the extreme where no financial
markets exist. Financial intermediaries are needed to overcome market
imperfections, and thus enable firms and investors to exploit the market
effectively.
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24 Principles of banking and finance
The implications of the existence of the two broad types of financial
systems affects households’ asset allocation, the role of indirect
intermediation (pension funds, insurance companies, mutual funds) and
firms’ financing.
With regard to households’ asset allocation, as shown in Figure 3.2, in
the UK/USA equity is a much more important component of household
assets than in Japan, France and Germany. Equity constitutes 45 per cent
of household assets in the USA and 52 per cent in the UK (even more than
in the USA), whereas it constitutes only 12 per cent and 13 per cent in
Japan and Germany. For cash and cash equivalents (which include bank
accounts) and bonds, the reverse is true. In Japan 52 per cent of assets
are held in cash and cash equivalents and 13 per cent in bonds, while in
Germany the figure is 36 per cent for both. In the USA only 19 per cent
of assets are held in cash and cash equivalents and 28 per cent in bonds.
Bonds are fairly unimportant in the UK and Japan. This implies that in the
USA and the UK households bear significant risk, while in Germany, France
and Japan they bear relatively little risk.
100%
Other
Real estate
Loan and mortgages
Foreign equity
Foreign bonds
Domestic equity
Domestic bonds
Cash and cash equivalents
80%
60%
40%
20%
0%
US
UK
Japan
France
Germany
Figure 3.2: Portfolio allocation of total financial assets owned by the
household sector (%)
Source: Figure created using data from Miles (1999), p.22.
In terms of the different forms in which gross financial assets are held
(directly by households, by pension funds, by insurance companies, by
mutual funds), as shown in Figure 3.3, most assets are owned directly
by households (except for the UK). In particular, individuals’ indirect
investments through intermediaries (pension funds and mutual funds)
are dominant in Germany, France and Japan. On the other hand, the
individual’s participation in the stock market (through direct transactions)
is high in the USA, although it has been falling. This implies that the
decisions individuals must take are of a different nature. However, the
general trend is that individuals are becoming less involved in making
transactions directly in financial markets, whereas pension funds and
mutual funds are increasing their share of the market. Specifically, in the
UK and USA, pension funds and insurance companies are much more
important than in other countries. In Germany, and to some extent in
Japan, pension funds are relatively unimportant.
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Chapter 3: Comparative financial systems
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
% held in mutual funds
% held by insurance
companies
% held by pension fund
(public and private)
% held directly by household
US
UK
Japan
France
Germany
Figure 3.3: Financial assets ultimately owned by the household sector
Source: Figure created using data from Miles (1999), p.21.
In terms of firms’ financing, the distinction between market-based and
bank-based systems is less clear. However there are differences in how
firms obtain funds from external sources. In the countries with the lowest
financial market capitalisation to GDP (Germany and Japan), firms’
financing from financial intermediaries has been almost ten times greater
than that from securities markets. However, even in market-based systems,
financial markets are not an important source of finance (as discussed in
the next chapter).
The current trend is towards market-based systems. Several government
policies support this argument.
• The European Union is moving towards a single financial market in the
countries of the European Union (EU) through harmonising regulation
throughout EU countries.
• France has chosen to increase the importance of financial markets since
the mid-1980s.
• Japan introduced various reforms of its financial system (known as the
‘Big Bang’) between 1998 and 1999.
Why are market-based systems suddenly so popular? There are two
reasons. First, government intervention has become discredited. Second,
economic theory emphasises the effectiveness of financial markets in
allocating resources. However, market imperfections, such as transaction
costs and asymmetric information, represent important limitations of
financial markets, as discussed in the next chapter.
Activity 3.4
Describe in two pages the historical development of the financial system in your country.
Does it represent a market-based or bank-based system?
Financial crises
Financial crises are defined as major disruptions in financial markets
that are characterised by sharp falls in asset prices and the failure of
many financial institutions (including banks). Financial crises have been
common in most countries throughout modern history in Europe and the
USA and have had a deep impact on the development of financial systems,
as described in the previous section. Moreover, many emerging countries
have had several banking problems in recent years: about three-quarters of
the member countries of the International Monetary Fund (IMF) suffered
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24 Principles of banking and finance
some form of financial crises between 1980 and 1996 (Lindgren, Garcia,
Saal, 1996). Given the historical importance of crises and their relevance
in emerging countries and more recently (following the global financial
crisis of 2007-09) in developed countries, it is important to understand
why they occur.
Financial crises occur where there is a large increase in asymmetric
information in financial markets. Asymmetric information occurs when
one party to a transaction has less information than the other party, and
thus is unable to make an accurate decision. (We discuss the asymmetric
information issue further in the next chapter; however, we also need to
introduce it here as part of our investigation into what causes a country to
have a market- or a bank-based system).
An increase in information asymmetries means a market becomes less
efficient as a channel for moving funds from savers to investors, and
therefore the market-based system becomes less attractive relative to the
banking system. A financial crisis can lead to economic activity contracting
sharply. To understand why financial crises occur, let us examine four main
factors.
1. Problems in the banking sector. Banks play a major role in the
financing of productive investments because of their ability to produce
information. Because banks have a mismatch between the maturities of
liquid liabilities and illiquid assets (as explained in the next chapter),
they are vulnerable to liquidity shocks. Deterioration in their balance
sheets implies that fewer resources are available to lend. This leads to a
decline in investment spending, which slows economic activities. In the
case of a severe crisis, the banks might fail. Fear can spread from one
bank to another. A panic at one bank can very quickly spread to other
banks as depositors rush to withdraw their deposits simultaneously.
In the absence of deposit insurance and being ignorant of the quality
of each bank’s loan portfolios, depositors at both good and bad banks
attempt to withdraw their funds simultaneously. However, the banks
will have insufficient funds to meet all these requests. Because banks
operate on a sequential service constraint (a first come, first served
basis), depositors have a strong incentive to run on the bank first.
Uncertainty about the health of the banking system can lead to runs on
banks both good and bad, and the failure of one bank can provoke the
failure of others (known as the contagion effect or systemic risk). These
multiple bank failures are known as bank panics. There are two
consequences of a bank panic. First, a loss of information in financial
markets and a loss of financial intermediation by the banking sector.
Second, a decrease in the supply of funds to borrowers (because of the
absence of lending), which leads to higher interest rates.
2. An increase in interest rates. A sharp increase in interest rates,
caused by either a decrease in the money supply or an increase in
the demand (you do not have to know this process to study this
unit), means that individuals and firms with the riskiest investment
projects are the only ones willing to pay the higher interest. Bad
credit risks are the only ones still willing to borrow (because of the
adverse selection problem – see Chapter 4 for details). In other words,
the only customers who still want to borrow when interest rates are
high are those who are likely to have weak, risky uses for the money.
The consequence is that lenders no longer want to make loans. This
decrease in lending leads to a decline in investment and aggregate
economic activity.
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Chapter 3: Comparative financial systems
3. Stock market decline. A sharp decline in the stock market is
another possible reason for a serious deterioration in firms’ balance
sheets, which in turn can provoke a financial crisis. Given that share
prices are the valuation of a firm’s net worth, a stock market decline
implies a reduction in the firm’s net worth. The lower value of net
worth implies a lower value of the collateral, which is property
promised to the lender if the borrower defaults. The decline in the net
worth makes banks less willing to lend because they are less protected
by this collateral, and this causes a reduction in investments and
aggregate economic activities. In addition, the decline in net worth
induces firms to take on more risky investments, as they lose less if they
have to default. As a consequence, lending is less attractive for banks,
and thus there is a reduction in investments and aggregate economic
activities.
4. An increase in uncertainty. The failure of prominent financial
institutions, a recession or a stock market crash create increased
uncertainty in the financial markets. Lenders become unable to screen
good and bad credit risks (again due to the adverse selection problem).
Once again, the decrease in lending results in a decline in investments
and aggregate economic activity.
Financial crises in the USA
The following sequence of events characterises many US financial crises:
• The four factors causing financial crises (described above) lead to an
increase in adverse selection and moral hazard problems.
• Lending, investment spending and aggregate economic activity decline.
• Depositors begin to withdraw their funds from banks, which can
result in a full-scale bank panic. The determinants of the depositors’
behaviour are the economic slowdown and the uncertainty about the
banking system.
• Interest rates increase even further and financial intermediation by
banks decreases because of the reduced number of banks.
• Adverse selection and moral hazard problems worsen.
• There is further economic contraction.
• In case of a sharp decline in prices, the recovery process is shortcircuited due to a further deterioration of firms’ net worth. This
phenomenon is known as debt deflation, or rather increased burden of
indebtedness for firms.
Activity 3.5
Refer to Figure 15.2 in Mishkin and Eakins (2009), p.390 to better investigate the
sequence of events in US financial crises. Many of the concepts such as adverse selection
and moral hazard will be examined in more detail in Chapter 4 of this subject guide. Now
study the features of the Great Depression, a description of which follows.
The Great Depression
The financial crisis in the Great Depression was the worst ever experienced
by the USA. In 1928–29, the stock market experienced a boom, during
which stock prices doubled. To curb it, the Federal Reserve pursued a
tight monetary policy, mainly through an increase in interest rates. The
stock market then crashed in 1929. By the middle of 1930, more than
half of the stock market decline had been reversed. However, after the
middle of 1930, the adverse shocks extended to the agricultural industry
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24 Principles of banking and finance
and the stock market continued to decline. This increased uncertainty
and economic contraction determined a worsening of adverse selection
and moral hazard in credit markets. From October 1930 to March
1933, a sequence of banks collapsed (over one-third of the US banks
went out of business). This determined a reduction in the amount of
financial intermediation and a decline in the ability of financial markets
to channel funds to firms with productive investment opportunities.
In the same period (1930–33), the price level fell by 25 per cent. This
triggered a debt deflation (i.e. net worth fell because of the increased
burden of indebtedness borne by firms). The decline in net worth and
the resulting increase in adverse selection and moral hazard problems in
the credit market led to a prolonged economic contraction in which the
unemployment rate rose to 25 per cent.
The global financial crisis 2007–09
The global financial crisis of 2007–09 was caused by a number of factors,
but two general developments lay at its core. First, the growth of global
macro-imbalances and second, financial market innovations. Large
current account surpluses developed in Asian economies such as China
and Japan as well as in oil exporting economies. The counterpart to this
was the growing current account deficits of economies such as the US
and some European economies such as the UK. The surpluses had been
used to buy large amounts of government debt in the US and Europe. The
consequence of this was to drive down interest rates in these countries.
Low interest rates in the US and Europe have also been a consequence
of low inflation as a result of low cost imports coming from fast growing
developing nations such as China. Low inflation has allowed central banks
to keep interest rates low. One consequence of low interest rates has
been a massive expansion of debt – particularly mortgage debt. A rapid
expansion of mortgage lending by banks fuelled a property price bubble as
house prices grew at very fast rates. This in turn led lenders to relax credit
standards leading to a rapid expansion of sub-prime mortgage lending in
the US (and in other European countries).
(The term sub-prime generally refers to borrowers who do not qualify
for prime interest rates because they have weakened credit histories,
low credit scores, high debt-burden ratios or high loan-to-value ratios.)
Another contributing factor has been the desire of investors to obtain
higher yields to offset the lower interest rates available in credit markets.
This desire for higher yields was satisfied by financial innovation, in
particular the process of securitisation whereby debt is packaged then
transferred off the balance sheets of banks and new securities issued.
Figure 3.4 illustrates the process. In Figure 3.4 the bank transfers the pool
of mortgages to a separate entity called a special purpose vehicle (SPV).
This should be independent of the bank and is normally set up as a trust.
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Chapter 3: Comparative financial systems
First transaction:
1
2
SPV
Originator
3
1
2
3
Market
3
The originator (here a bank) sells the mortgages, or assigns the income, to the SPV.
The SPV issues bonds to the market.
The SPV receives cash from the market and passes it to the bank.
Subsequent transaction:
SPV
Income
4
4
5
Market
5
Payments from customers (originally to the bank) now go to the SPV.
The SPV uses these to repay bonds (both interest and principal).
Figure 3.4 The securitisation process
The securities created from packages of residential mortgages were called
Residential Mortgage Backed Securities (RMBS). Sometimes additional
securities, known as collateralised debt obligations–CDOs), were created
by combining multiple RMBSs (or parts of RMBSs) and then selling
portions of the income streams derived from the mortgage pool or RMBSs
to investors with different appetites for risk. One of the original ideas
behind securitisation was to allow banks to transfer risk off their balance
sheet, thereby allowing them to diversify. The hope was that much of this
debt would be transferred to other parts of the financial system. However,
the majority of investors in the securitised debt were other banks that held
the securities in their trading books. The ratings agencies also assigned
high credit ratings to much of the securitised debt products, thus creating
the perception that the default risk on these securities was very low.
Problems occurred in 2006–07 when house prices in economies such as
the US fell. Many borrowers found that they owed more on their house
than it was worth. Many borrowers chose to default – particularly subprime borrowers who were more sensitive to the fall in house prices.
Rising loan defaults caused many RMBSs and CDOs that were backed by
residential mortgages to experience substantial losses. In late 2007, banks
such as Northern Rock in the UK, that depended heavily on securitisation
to fund expansion of its business, found that this source of funding dried
up as investors began to shun new issues of securitised mortgages. At the
same time banks holding securitised debt in their trading books began
to experience severe mark-to market losses. This led to concerns about
liquidity in markets as banks reduced lending to each other through
the inter-bank market as fears of insolvency increased. These strains
continued into 2008 as large institutions such as Fannie Mae and Freddie
Mac became reliant on government support in the US. A large drop in
confidence occurred in September 2008 as Lehman Brothers investment
bank failed, thus signalling that major institutions were not too big to fail.
The collapse in confidence in the banking sector in many economies
around the world led central banks and governments to intervene to
provide exceptional liquidity support, then recapitalisation of major banks,
to prevent further failures. The severely impaired state of the banking
system led to a large reduction in credit extension by banks thus resulting
in a severe economic recession in most economies in the world.
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24 Principles of banking and finance
Activity 3.9
Read Turner (2009), Chapter 1 and Bullard, Neely and Wheelock (2009) for a more
detailed discussion of the causes and consequences of the financial crisis of 2007–09.
You should focus on the following questions in your reading:
1. What were the macro-economic factors that contributed to the crisis?
2. What caused interest rates to be kept low in Western economies in the years before
the crisis?
3. Why did banks relax lending conditions in the years before the crisis?
4. How does the process of securitisation allow banks to fund new lending?
5. Why did the crisis in the banking sector lead to a contraction of economic activity
(recession) for most economies?
Note that we will follow up many of the problems revealed by the banking crisis in
Chapter 5 when we consider regulation of the banking system.
Financial crises in emerging market countries
In recent years, many emerging market countries have experienced
financial crises, as documented in Table 3.1. The sequence of events
characterising these financial crises is different from what occurred in
the USA in the nineteenth and early twentieth centuries mainly due
to differences in the institutional features of debt markets in emerging
market countries.
Beginning
Mexico
Ending Change in Change in Fiscal
deposits net worth costs
(%)
(%)
(%)
Net IMF
disbursement
($million)
Dec 1994
1996
–15
–64
19.3
10.67
1994
1995
–43
–6
15
–0.66
South Korea
July 1997
1999
–6
15
31.3
6.07
Indonesia
July 1997
1999
13
–183
56.8
10.35
Venezuela
Thailand
July 1997
1999
–2
58
43.8
3.21
Ecuador
1998
2001
–24
–59
21.7
0.3
Turkey
2000
2002
–27
97
30.5
13.42
Dec 2001
2003
–4.8
–37
11.4
–16
Argentina
Table 3.1: Financial crises in emerging market countries
Source: Adapted from Lacoste (2004), p.97.
The following factors have caused financial crises in emerging countries:
1. Deterioration in banks’ balance sheets due to the increase in loan
losses, which, in turn, was due to weak supervision by bank regulators
and lack of expertise in screening/monitoring borrowers at banks.
This factor affected Mexican and East Asian crises and determined an
erosion of banks’ capital. Note that Argentina, instead, had a wellsupervised banking system and no lending boom occurred before the
crisis; nevertheless in 1998 Argentina entered a recession that led to
some loan losses.
2. Increase in interest rates abroad and internally, which amplified
adverse selection (i.e. it was more likely that the parties willing to take
on the most risk would seek loans). This factor, consistent with the US
experience, affected Mexican and Argentine but not East Asian crises.
58
3. Stock market decline and increase in uncertainty. This factor, once
again consistent with the US experience, affected Mexico, Thailand,
South Korea and Argentina.
Chapter 3: Comparative financial systems
4. Fiscal problems of the government. As government budget deficits
could not be financed by foreign borrowing, the government forced
banks to absorb large amounts of government debt. As a consequence,
investors lost confidence in the ability of the government to repay its
debt. The price of government debt decreased and determined big
losses in banks’ balance sheets. This factor was typical of the Argentine
crisis, but not of the US, Mexican and East Asian crises.
5. Rise of interest rates abroad. The US Fed began to increase the
government rate to head off inflationary pressures. Although this
monetary policy was successful in the USA, it put upward pressures in
foreign countries (particularly in Mexico and Argentina).
These factors worsened adverse selection and moral hazard problems.
On the one hand, financial intermediaries experienced more difficulties
in screening out good and bad borrowers. On the other hand, the decline
in capital determined a decrease in the value of firms’ collateral and an
increase in firms’ incentives to make risky investments (because of less
equity to lose if the investments were unsuccessful).
At this point, speculative attacks developed in the foreign exchange
markets, plunging the economies into a full-scale crisis. Moreover, the
interaction of the institutional structure of debt markets with the currency
devaluations played an important role: as large proportions of firms’ debts
were denominated in foreign currencies, the depreciation of domestic
currencies implied an increase in indebtedness.
The collapse of currencies led to a rise in actual and expected inflation
rates, and consequently in market interest rates. The increased interest
payments caused reductions in the cash flows of households and firms.
The very short duration of debt contracts (typical of emerging market
countries) provoked a substantial effect on cash flows.
The sharp decline in lending led to an economic activity decline and to a
deterioration in balance sheets, which in turn led to a worsening banking
crisis. This materialised in substantial losses for banks because many
firms and households were no longer able to pay off their debts. Even
more problematic for the banks was the deterioration in their balance
sheet because of the large amount of short-term liabilities denominated in
foreign currencies, which experienced a sharp increase in their value after
the devaluation. The banking system would have collapsed in the absence
of a government safety net (e.g. the assistance of the IMF).
Activity 3.10
Read Mishkin and Eakins (2009), pp.391–95 to get further details on the financial crises
in emerging-market countries: Mexico (1994–95) and East Asia (1997–98). Try to identify
the common causes and consequences of the crises in Mexico and South East Asia.
Financial bubbles
Financial crises often follow what appear to be bubbles in asset prices. A
bubble occurs when an asset or commodity becomes overinflated in value.
These bubbles in asset prices typically have three distinct phases:
• Financial liberalisation results in an expansion in credit, which is
accompanied by an increase in asset prices such as real estates and
shares. They rise as the bubble inflates.
• The bubble bursts and asset prices collapse (often within a short period
of time).
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24 Principles of banking and finance
• Default of many firms and other agents that have borrowed to buy assets
at inflated prices. A banking crisis may follow, causing problems in real
sectors of the economy such as industry.
Historic examples of this type of crisis are the Dutch tulip mania (described
in the next section), the South Sea Bubble in England and the Mississippi
Bubble in France (discussed in the previous section). More recent examples
are bubbles in Japan (late 1980s), Mexico (1994–95) and East Asia (1997–
98) and housing market bubbles in the US, UK, Spain etc. prior to the 200709 crisis described above. Another recent case, the internet bubble of the
late 1990s, is described below.
Dutch tulip mania
The tulip mania (1636–37) was the first serious financial bubble. The prices
of tulip bulbs rose quickly to very high levels, before collapsing dramatically
and causing the bankruptcy of many speculators.
The following sequence of events characterised the tulip mania. The tulip,
introduced to Europe in the middle of the sixteenth century, experienced
a strong growth in popularity in the Netherlands, boosted by competition
for possession of the rarest tulips. The competition escalated until prices
reached very high levels. The flower rapidly became a luxury item and a
status symbol. In 1623, a single bulb of a famous tulip variety could cost as
much as a thousand florins (vs. the average yearly income of 150 florins).
Tulips were also exchanged for land and houses. By 1636, tulips were traded
on the stock exchanges of numerous Dutch towns and cities. People started
to trade their other possessions in order to speculate in the tulip market.
Some traders sold tulip bulbs that had only just been planted or those they
intended to plant (i.e. tulip future contracts, a type of derivative instrument).
After some time, the Dutch government started to introduce regulation
to help control the tulip mania. Consequently, a few informed speculators
started liquidating their tulip bulbs and contracts. Moreover, more tulip
bulbs were added to the supply due to people harvesting new tulip bulbs.
Suddenly tulip bulbs were not quite as rare as before. People began to
suspect that the demand for tulips could not last. The tulip market began a
slight downward trend.
In February 1637 the market experienced a widespread panic: everyone
realised that tulips were not worth the prices people were paying for them,
and began to sell. The bubble burst: in less than six weeks, tulip prices
crashed by over 90 per cent. Attempts were made to resolve the situation,
but these were unsuccessful. Ultimately, individuals were stuck with the
bulbs they held at the end of the crash. Note that lesser versions of the
tulip mania also occurred in other parts of Europe (e.g. England), although
matters never reached the state they had in the Netherlands.
The internet bubble of the late 1990s
During the internet bubble of the late 1990s, the remarkable market values
assigned to internet and related high-tech companies seemed inconsistent
with rational valuation. Equity valuations were based on uncertain future
forecasts. Even if all market participants rationally priced common stocks as
the present value of all future cash flows expected (which will be explained
in Chapter 7), it was still possible for inflated prices to develop. There were
two main reasons for the internet bubble of the late 1990s:
1. Outlandish and unsupportable claims were being made regarding the
growth of the internet (and the related telecommunications structure
needed to support it);
60
Chapter 3: Comparative financial systems
2. Unsustainable projections for the rates and duration of growth of these
‘new economy’ companies.
As an example of how difficult it is to value these companies, we recall
the following story about analyst recommendations. At the time when
Amazon.com stock was trading for $130 a share, a prominent analyst
issued a buy stock recommendation, even though official projections
led him to a valuation of only $30. Admitting that he could justify any
valuation between $1 and $200, the analyst stated his recommendation
was based on the company, its opportunities and its management.
During those years, professional investors argued that the valuations of
high-tech companies were proper, and professional pension fund and
mutual fund managers overweighted their portfolios with high-tech stocks.
Although it is now clear in retrospect that these professionals were wrong,
there were certainly no obvious arbitrage opportunities available.
While there were no profitable and predictable arbitrage opportunities
available during the internet bubble, and although stock prices eventually
did adjust to levels that more reasonably reflected the likely present value
of their cash flows, an argument can be maintained that asset prices did
remain ‘incorrect’ for a period of time. In the USA, the market index of the
internet stock industry went above 1,000 in February 2000, and fell to 200
in October 2000. Moreover, although internet firms represented 6 per cent
of the public equity market during February 2000, the pure internet sector
represented 19 per cent of the daily volume.
The above stylised facts about returns and volumes provide evidence of the
irrationality of financial markets. The result was that too much new capital
was allocated to internet and related telecommunications companies.
Therefore, the stock market may well have temporarily failed in its role of
efficiently allocating equity capital.
Summary
We showed in this chapter that differences in reactions to the instability of
financial markets explain the existence of market-based financial systems
(where financial markets are more important than banks) and bank-based
financial systems. Overall, there is a clear distinction between marketbased (USA and UK) and bank-based systems (Germany, Japan and
France), although the current trend is towards market-based systems.
The two types of financial systems have different implications for:
• Households’ asset allocation: in the market-based systems, equity (in
the sense of stocks and shares) is a much more important component of
household assets than in the bank-based systems; the reverse is true for
cash, cash equivalents (which include bank accounts) and bonds.
• The role of indirect intermediation (pension funds, insurance companies,
mutual funds): individuals’ indirect investments through intermediaries
are dominant in the bank-based systems, whereas individuals’ direct
participation to the stock market is high in the market-based systems,
especially the USA (although even there it is in decline).
• Firms’ financing: in the market-based systems, loans from financial
intermediaries are more important for corporate finance than
marketable securities, but at a lesser extent than in the bank-based
financial systems.
The final issue concerns financial crises, which are major disruptions
caused by a marked increase in the asymmetric information problem in
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24 Principles of banking and finance
financial markets. The four types of factors that lead to financial crises are
bank panics, increase in interest rates, stock market decline and increase
in uncertainty.
Key terms
asymmetric information
bank-based systems
Bubble Act
financial bubble
financial crises
firms’ fund raising
Glass-Steagall Act
Gramm-Leach-Bliley Act
gross financial assets
households
internet bubble
market-based systems
market capitalisation to GNP
Mississippi Bubble
tulip mania
universal banks
A reminder of your learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain why the relative importance of banks and financial markets is
different around the world
• discuss how the historical evolution of financial systems helps to
explain the existence of bank-based and market-based financial systems
• outline the main similarities and differences between the financial
systems of industrialised countries
• discuss the implications (in terms of households’ asset allocation, role
of indirect intermediation and firms’ financing) of the existence of
bank-based and market-based financial systems
• explain the main economic factors causing financial crises and the
sequence of events of financial crises
• discuss, with reference to examples from history, financial crises and
bubbles.
Sample examination questions
1. Analyse the historical evolution of financial systems in order to explain
the reasons for the existence of market-based and bank-based systems.
2. a. Compare and contrast the German and Japanese banking systems.
b. Explain the main implications of the presence of market-based
versus bank-based financial systems.
3. a. How did competitive forces lead to the repeal of the Glass-Steagall
Act’s separation of the banking and securities industries? What are
the recent changes in US regulation on the separation of the banking and securities industries?
b. In the light of the global financial crisis of 2007–09 discuss the case
for a new Glass-Steagall Act.
4. a. How can a stock market crash provoke a financial crisis?
b. Analyse the main events of financial bubbles. Refer to the internet
bubble of the late 1990s as a case study.
5. a. Analyse the causes of the global financial crisis of 2007–09.
b. What lessons can regulators learn from this crisis?
62
Part II: Principles of banking
Part II: Principles of banking
Overview
In Part II, the focus is on one of the three pillars of a financial system:
financial intermediaries. The aim is to introduce you to the principles of
banking. In Chapter 2 we proposed a taxonomy of financial intermediaries,
one of the three entities comprising a financial system. In Chapter 3 we
investigated the reasons for the differences in the relative importance of
financial intermediaries and financial markets in financial systems around
the world. But we still have to answer several important questions:
1. Why do financial intermediaries exist? What are the key economic
theories that enable us to justify the existence of financial
intermediaries? (Chapter 4)
2. Why do banks need to be regulated? What are the key economic
reasons for and against banking regulation? How does regulation
operate in practice? (Chapter 5)
3. What are the main risks faced by banks? How do banks manage these
risks? In particular, what are the techniques and models used by banks
to manage risk? (Chapter 6)
In the following chapters of Part II, we will answer each of these questions.
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24 Principles of banking and finance
Notes
64
Chapter 4: Role of financial intermediation
Chapter 4: Role of financial
intermediation
Aims
The aim of this chapter is to illustrate the main reasons for the existence
of financial intermediaries and to introduce the key economic theories
required to analyse this issue. Furthermore, it illustrates how these
economic theories can be applied to understand the existence (and
relevance) of financial intermediaries.
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain why financial intermediaries exist
• discuss how the presence of market imperfections explains the
importance of financial intermediaries (and the relative unimportance
of financial markets) in the financing of corporations
• explain how financial intermediaries are able to reduce the transaction
cost problem
• explain how financial intermediaries are able to reduce/solve the
problems arising from adverse selection and moral hazard
• discuss the expected developments affecting the role of the different
types of financial intermediaries (especially banks) in the future.
Essential reading
Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) pp.47–52.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapters 15 and 18.
Further reading
Bain, A.D. The Economics of the Financial Systems. (Oxford: Blackwell
Publishers Ltd, 1992) Chapter 4.
Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004) Chapter 2.
Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The MIT
Press, 2008) Chapter 2.
References
Akerlof, G. ‘The Market for “Lemons”: Quality, Uncertainty and the Market
Mechanisms’, Quarterly Journal of Economics 84(3) 1970, pp.488–500.
Benston, G. and C. Smith ‘A Transaction Costs Approach to the Theory of
Financial Intermediation’, Journal of Finance 31(2) 1976, pp.215–31.
Boyd, J.H. and M. Gertler ‘Are Banks Dead? Or Are the Reports Greatly
Exaggerated?’ in The Declining (?) Role of Banking. (Chicago: Federal
Reserve Bank of Chicago, 1994).
Coase, R.H. ‘The Problem of Social Cost’, Journal of Law and Economics 3(1)
1960, pp.1–23.
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24 Principles of banking and finance
Diamond, D.W. ‘Financial Intermediation and Delegated Monitoring’, Review of
Economic Studies 51(166) 1984, pp.393–414.
Diamond, D.W. ‘Financial Intermediation as Delegated Monitoring: A simple
example’, Federal Reserve Bank of Richmond Economic Quarterly, 82(3)
1996, pp 51–66.
Diamond, D.W. and P.H. Dybvig ‘Bank Runs, Deposit Insurance, and Liquidity’,
Journal of Political Economy 91(3) 1983, pp.401–19.
Fama, E. ‘Banking in the theory of finance’, Journal of Monetary Economics 6(1)
1980, pp.39–57.
Goddard, J.A., P. Molyneux and J.O.S. Wilson European Banking. Efficiency,
Technology and Growth. (Chichester: John Wiley & Sons, 2001) [ISBN
9780471494492] pp.109–20.
Gurley, J.G. and E.S. Shaw Money in a Theory of Finance. (Washington D.C.:
Brookings Institute, 1960) [ISBN 9780815733225].
Hackethal, A. and R.H. Schmidt ‘Financing Patterns: Measurement Concepts
and Empirical Results’, Frankfurt Department of Finance Working Paper no.
125 (2004), p.30.
Jensen, M.C. and W.H. Meckling ‘Theory of the firm: managerial behavior,
agency costs and ownership structure’, Journal of Financial Economics 3(4)
1976, pp.305–60.
Leland, H.E. and D.H. Pyle ‘Informational Asymmetries, Financial Structure,
and Financial Intermediation’, The Journal of Finance 32(2) 1977,
pp.371–87.
Introduction
Several facts about financial intermediation deserve your attention. First,
bank loans – and not stocks – are the most important source of funds
raised externally by firms, despite the fact that so much media attention
is focused on the stock market. Second, bonds are more important than
stocks in financing firms. Third, direct lending from people who save to
people who borrow to finance investment opportunities is less important
than indirect lending through a financial intermediary such as a bank.
This is despite the fact that it would seem more logical for the units with
surplus funds to lend these funds directly to units in deficit. This chapter
attempts to explain why most financing is indirect through intermediaries
and thus considers the following questions:
• What makes banks so important in the financing of businesses?
• What are the reasons for the lesser importance of the stock markets in
comparison to other external sources?
• Why are financial intermediaries more important than securities
markets for getting funds from savers to investors?
These empirical facts (or puzzles) need to be understood in order
to appreciate why financial intermediaries exist and how financial
intermediation works. The analysis focuses on the main reasons for
the existence of financial intermediaries and illustrates how a few (but
powerful) economic theories can be applied to understand their existence,
relevance and functioning.
The analysis also investigates the future for traditional intermediation
services provided by banks, given the decline observed in many countries
in recent years.
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Chapter 4: Role of financial intermediation
Some evidence on financial intermediation
Figure 4.1 shows the source of external funds used to finance firms over
the period 1970–2000 in the USA, Germany and Japan. The categories of
external funds are: bank loans, non-bank loans (loans by other
intermediaries), bonds (marketable debt securities) and stocks (issue of
new equity).
80
70
60
50
%
40
30
20
10
0
Bank loans
Non-bank
loans
USA
Germany
Bonds
Stocks
Japan
Figure 4.1: Sources of external funds for non-financial businesses in the
United States, Germany and Japan (1970–2000)
(Note: definitions of the categories of external funds are given in Mishkin and Eakins
(2009), p.367.)
Source: Graph created using data from Hackethal, A. and R.H. Schmidt ‘Financing
Patterns: Measurement Concepts and Empirical Results’, Frankfurt Department of Finance
Working Paper no. 125 (2004), p.30.
Pause and note down what you think Figure 4.1 shows.
First, loans are the most important source of funds raised externally in the
USA, Germany and Japan. Buckle and Thompson (2004) report a similar
finding for the UK. Although most funds raised by firms are internally
generated (i.e. retained profits) with the exception of Japan, banks have
the most important role in the external financing of businesses (56 per
cent in the USA and 86 per cent in Japan and Germany). Specifically, the
importance of banks is especially high in countries such as Germany (76
per cent) and Japan (78 per cent), the so-called bank-oriented systems as
discussed in Chapter 3. However, it has to be noted that the share of banks
in the financing of businesses has been declining in recent years.
Figure 4.1 leads us to ask this question: what makes banks so important in
the financing of businesses? A second equally important question is: what
is driving the recent decline in their relevance?
Activity 4.1
Find out the relative importance of sources of external funds for non-financial firms in
your country. See if you can relate what you find to the importance of bank-oriented
versus market-oriented systems.
Second, Figure 4.1 shows that stocks are the least important source of
external financing for firms. In an average year, US firms raise funds over
five times more through loans than with stocks. The issue of new equity
is even less important than bank loans in the rest of the world: about 10
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24 Principles of banking and finance
times less relevant in Germany, and about 20 times in Japan. Why are
stock markets less important than other external sources?
Third, bonds are more important than stocks in financing firms (32 per
cent versus 11 per cent in the USA). The difference in the relative share,
however, is less remarkable in Japan (9 per cent bonds versus 5 per cent
stocks). Nevertheless, the combined amount of stocks and bonds, which
constitutes marketable securities, represents 43 per cent in the USA, and
only 15 per cent in Germany and 14 per cent in Japan. What are the
reasons limiting the use of marketable securities by businesses to finance
their activities?
Fourth, only a small proportion of marketable securities (stocks and
bonds) were sold directly to households (direct finance); the majority
of these securities were bought primarily by non-bank financial
intermediaries (pension funds, mutual funds and insurance companies).
In this way, indirect finance, which involves the activities of financial
intermediaries, is many times more important than direct finance, in
which firms raise funds directly from lenders in the financial markets. This
seems odd on the face of it. Units with surplus funds can lend these funds
directly to units in deficit. On the one hand, the surplus units can obtain a
return. On the other hand, the units in deficit can finance their investment
opportunities. Why have indirect finance and financial intermediaries been
so important in financial markets?
Read about these four points in Mishkin and Eakins (2009) Chapter 15,
which contains a fuller treatment of the relative importance of financial
intermediaries and the relative unimportance of securities markets for the
financing of businesses.
Activity 4.2
Now read pages 47–52 in Allen and Gale (2001) and answer the following questions:
1. What is the percentage of direct finance versus indirect finance in the United States,
Germany and Japan? (Refer to Figure 3.3 to find out the percentage values of
marketable securities).
2. On the basis of your answer to the question above, discuss the relative importance of
financial intermediaries versus financial markets.
In order to answer the set of questions arising from the above
empirical evidence, we need to answer the question of why financial
intermediaries exist. The next section identifies and illustrates each of
the possible reasons for this, and the corresponding theories of financial
intermediation.
Why do financial intermediaries exist?
We described financial intermediaries in Chapter 2 and their place in the
financial system (see p.15). Now we will look deeper into their role. Why
do they exist?
To answer this question we need to appreciate each of the reasons for
the existence of financial intermediaries, and the relevant theories of
financial intermediation. Financial intermediaries exist to solve or reduce
market imperfections, such as: differences in the preferences of
lenders and borrowers (in terms of size, maturity, liquidity, risk), presence
of transaction costs, shocks in consumers’ consumption and asymmetric
information (which gives rise to both adverse selection and moral
hazard). Several theories have been developed to explain how financial
68
Chapter 4: Role of financial intermediation
intermediaries reduce/solve these market imperfections. They are the
theories of:
• asset transformation
• transaction costs reduction
• liquidity insurance
• informational economies of scale and delegated monitoring.
Together they account for the existence of financial intermediaries and
they provide a framework for the analysis, as summarised in Table 4.1.
Market imperfection
Theory of financial intermediation
Differences in the preferences of
lenders and borrowers (in terms
of size, maturity, liquidity, risk)
Theory of asset transformation
Presence of transaction costs
Theory of transaction cost reduction
Shocks in consumers’
consumption
Liquidity insurance theory
Adverse selection
Informational economies of scale theory
Moral hazard
Delegated monitoring theory
Table 4.1: Framework for the analysis of the existence of financial
intermediation
The framework based on transaction costs and asymmetric information
has been developed by Professor Charles Goodhart, a member of the
Financial Markets Group (FMG) Research Centre at LSE. The FMG is
directed by David Webb, an LSE Professor in Finance, and is now one of
the leading centres in Europe for academic research into financial markets.
In the following sections we will investigate each of the above theories.
Asset transformation
The simplest way to explain the existence of financial intermediaries is
to emphasise their role in transforming particular types of assets into
others, the process of asset transformation. Financial intermediaries
simultaneously satisfy both borrowers’ needs for permanent or long-term
capital and the desires of many lenders for a high degree of liquidity
in their asset holdings (assets may be turned into cash at short notice).
To reconcile the conflicting requirements of lenders and borrowers,
financial intermediaries transform the primary securities issued by firms
into the indirect securities required by lenders (Gurley and Shaw, 1960;
Fama, 1980). Specifically, they issue liabilities (deposit claims) with the
characteristics of low risk, short-term, high liquidity, and use a proportion
of these funds to acquire the larger size, high-risk and illiquid claims
issued by firms. Therefore, financial intermediaries undertake four main
transformations:
1. Maturity transformation: the liabilities of financial intermediaries
generally mature more quickly than their assets. The traditional role
of banks is to make long-term loans and fund them by issuing shortterm deposits, a process commonly referred to as ‘borrowing short and
lending long’. Financial intermediaries are said to be mismatching the
maturity of the assets they hold with the maturity of the liabilities they
issue.
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24 Principles of banking and finance
2. Size transformation: the amounts lenders make available are on
average smaller than the amounts required by borrowers. Financial
intermediaries collect the small amounts made available by lenders and
parcel them into the larger amounts required by borrowers.
3. Liquidity transformation: financial intermediaries provide
financial or secondary claims to depositors (e.g. bank accounts)
that often have superior liquidity features than direct claims (e.g.
bonds and stocks). Specifically, deposits are contracts that offer high
liquidity and low risk (and they are held in the liabilities side of banks’
balance sheets). Loans instead are illiquid and a higher risk asset than
deposits (and they are held in the assets side of banks’ balance sheets).
Financial intermediaries (and banks in particular) can hold liabilities
and assets of different liquidity features in their balance sheet through
diversification of their portfolios. The more diversification, the lower
the default probability.
4. Risk transformation: financial intermediaries transform risks to
reconcile the preferences of borrowers and lenders. The lenders who
hold the liability of the financial intermediaries must be able to regard
them as absolutely safe. The intermediaries’ loans, however, inevitably
bear some default risk (the risk that the borrower will default on his or
her obligations, that he or she will fail to pay interest or repay the loan
itself when it is due). The degree (and range) of risk transformation
qualifies the type of intermediary. Banks assume on their own the
widest degree (and range) of risks. What determines the ability of
banks to transform risky loans (assets) into virtually riskless deposits
(liabilities)? Try to answer this before reading on.
Banks do this in three ways:
a. Screening loan applications: this enables the risk of loss on
each individual loan to be minimised: the use of credit scoring is one
technique banks can use to select only the good borrowers (i.e. good
income/earnings or good record on repaying debt).
b. Diversifying risk: the spread of risks is achieved by lending to
different types of borrowers. Banks try to avoid a heavy concentration
in any single branch of economic activity or any single area of the
country, and to restrict the maximum size of any single loan. There are
many examples of the problems arising from interdependent risks. The
failure of 400 Texan banks over the period 1985–89, as a result of the
turmoil in the oil economy, was due to the heavy concentration of their
loan portfolio in real estate dependent on the oil business.
c. Pooling risks: the presence of a large number of loans, as a
consequence of the law of large numbers, reduces the variability of
losses. The large number of loans does not reduce the expected loss in
the portfolio of loans overall, but it is does give considerably improved
predictability and limits the maximum loss for which the intermediary
has to allow.
(Techniques that banks can use to evaluate and manage default risks are
discussed in Chapter 6.)
This pragmatic perspective highlights the existence of units in surplus
(lenders) and units in deficit (borrowers) with heterogeneous preferences
as regards the characteristics of financial resources lent and borrowed.
Therefore it enables us to move beyond the classical (ideal) world of
frictionless and complete financial markets, and introduces some (small)
market imperfections. These imperfections obstruct the conclusion of
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Chapter 4: Role of financial intermediation
financial transactions: lenders and borrowers are not able to diversify
perfectly and obtain optimal risk sharing. As a consequence, financial
intermediaries are needed to reconcile the conflicting requirements of
lenders and borrowers.
Although this perspective offers a useful preliminary justification of the
existence of financial intermediaries, it is has three main limitations. It
does not explain:
• why borrowers do not undertake their own asset transformation
• why there are different types of financial intermediaries
• how different types of intermediaries perform their monetary, credit
and allocation functions.
In the following sections, we illustrate the main theories about financial
intermediation, and we see that these theories provide answers to these
three questions. They are the theories of transaction costs, liquidity
insurance and asymmetric information.
Transaction costs
In financial intermediation, transaction costs are incurred because of
the time and money spent in performing financial transactions (Coase,
1960). The presence of transaction costs causes difficulties for a potential
lender in finding an appropriate borrower. There are four main types of
transaction costs:
1. Search costs: costs of searching out, and finding information about, a
suitable counterpart (incurred both by lenders and borrowers).
2. Verification costs: lenders incur costs to verify the accuracy of the
information provided by borrowers.
3. Monitoring and auditing costs: once a loan is made, lenders incur
costs to monitor the activities of borrowers, and their adherence to the
conditions of the contract.
4. Enforcement costs: in case the borrower is unable to meet the
conditions of the contract, the lender will need to ensure their
enforcement.
How financial intermediaries reduce transaction costs
Financial intermediaries reduce transaction costs by internalising them.
Benston and Smith (1976, p.215) state ‘The raison d’être for this industry
is the existence of transaction costs.’ Specifically, financial intermediaries
reduce transaction costs in a number of ways. First, they develop
branch networks and information systems, which enable lenders and
borrowers to avoid the need to seek out a suitable counterpart on each
occasion. Second, they provide standardised products, thereby cutting
the information costs associated with scrutinising individual financial
instruments. Third, they use tested procedures and routines. According
to the theory of transaction costs, financial institutions are able to reduce
transaction costs by taking advantage of the following:
• Economies of scale refer to the reduction in transaction costs
per dollar of output as the size (scale) of the financial transaction
increases. In symbols, in the presence of two outputs (Q1 and Q2),
total costs (C) are: C(Q1)<C(Q2) if Q1>Q2. Because of their large
size, financial intermediaries are able to combine the funds of many
investors. For example, a bank is able to use a standard loan contract
for a wide range of loans. The unit cost of the contract per loan is much
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24 Principles of banking and finance
smaller for the bank than for an individual who has a loan contract
drawn up when undertaking direct lending. Economies of scale are
also important in lowering the costs of fixed investments, such as
technology.
• Economies of scope are another area of cost savings for financial
intermediaries. These economies occur whenever there is a cost
advantage to producing more than one product jointly rather than
producing them separately. In symbols, C(Q1,Q2)<C(Q1) + C(Q2).
Economies of scope are essentially concerned with deposit and
payment services: deposits are the legal-financial claims by which
banks both collect funds to sustain their lending activities, and satisfy
the request of payment instruments.
• Expertise to lower transaction cost. For example, they have expertise
in information technology (e.g. ATM, automated teller machines, or
POS, point of sales) aimed at providing low-cost liquidity services.
Activity 4.3
Identify examples of the sort of transaction costs banks can reduce.
The theory of transaction costs explains several factors:
a. The distribution of financial transactions between financial
intermediaries and financial markets. This distribution is based on the
level of internalisation of transaction costs. Financial intermediaries
are able to internalise many of the transaction costs because they
have developed expertise and because they can take advantage of
economies of scale and/or economies of scope. The difference in the
level of internalisation of transaction costs explains why greater funds
flow through financial intermediaries compared to financial markets.
Therefore, the presence of transaction costs explains in part why
indirect finance is much more important than direct finance.
b. The distribution of financial transactions among different types of
intermediaries. Each type of intermediary sustains different levels of
transaction costs: from simple brokers (pure intermediation) to banks
(most complete absorption of transaction costs).
c. The presence of payment services (or liquidity services) provided by
financial intermediaries, especially by banks. These services make it
easier for customers to conduct transactions.
This perspective on transaction costs, however, does not help to explain
why a financial intermediary makes a better selection of investment
opportunities. Moreover, recent technological innovations and new
financial instruments have reduced transaction costs. Therefore, reduction
in transaction costs cannot be the main reason for explaining the existence
of financial intermediaries and additional theories are needed: these
include the liquidity insurance theory and the asymmetric information theory.
Liquidity needs
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Economic agents are unsure about when they will require funds to finance
consumption due to unforeseen events, and this creates a demand for
liquid assets. By the law of large numbers, a large coalition of investors
(such as a bank) will be able to invest in illiquid but more profitable
assets, while preserving enough liquidity to satisfy the needs of individual
investors. This means that financial intermediaries provide liquidity
insurance, as postulated in the liquidity insurance theory also known as
the consumption smoothing theory (Diamond and Dybvig, 1983).
Chapter 4: Role of financial intermediation
How are financial intermediaries able to satisfy liquidity needs? According
to the liquidity insurance theory, depository institutions are ‘pools
of liquidity’ that provide households with insurance against idiosyncratic
shocks that affect their consumption needs. Alternatively they can be
seen as ‘consumption smoothers’ that enable economic agents to
smooth consumption by offering insurance against shocks to a consumer
consumption path.
As long as the shocks in consumption needs across households are
not perfectly correlated (or rather, they tend not to move together as
explained in Chapter 8), the total cash reserve needed by a bank of size
N (a coalition of N depositors) increases less than proportionally with N.
This is the basic idea of the fractional reserve system, in which some
fraction of the deposits can be used to finance profitable but illiquid loans.
However, this is also the source of the potential fragility of banks – in the
event that many depositors decide to withdraw their funds for reasons
other than liquidity needs such as a general loss of confidence in the
ability of the bank to remain solvent (as we will see in Chapter 5). Note
that this theory is not specific to banks: it is also valid for any depository
institution and for insurance companies.
Asymmetric information: adverse selection and moral
hazard
As noted earlier, asymmetric information refers to the situation where one
party to a transaction has less information than the other party, and thus is
unable to make an accurate decision. This is an important aspect of most
types of transactions, and particularly of transactions in financial markets.
For example, potential investors in a firm have much less information than
the managers of the firm, as they do not know how good the projects to
be financed are, and they are not able to evaluate properly the risks and
returns of these projects. Also, life insurance companies do not know the
precise health of the purchaser of a life insurance policy. Similarly, banks
do not know how likely a borrower is to repay.
The consequences of asymmetric information can be ex-ante (adverse
selection) or ex-post (moral hazard):
• Adverse selection is the problem created by asymmetric information
before the transaction occurs. It arises when the potential borrowers
who are most likely to produce an undesirable (adverse) outcome
are the ones who most actively seek out loans. Thus adverse selection
increases the probability that bad credit risks will get loans. As a
consequence, lenders may decide not to give any loans, even to good
credit risks.
• Moral hazard is the problem that occurs after the transaction is
made. It is the risk (hazard) that the borrower will engage in activities
that are undesirable (immoral) for the lender. These activities
potentially reduce the probability that the loan will be repaid. Again,
the consequence is that lenders may decide not to make any loans.
Investors are more likely to behave differently when using borrowed
funds rather than when using their own funds.
Activity 4.4
As the concepts of adverse selection and moral hazard are extremely useful in
understanding the existence, nature and role of financial intermediaries, read the case
of Aunt Sheila, Aunt Louise and Uncle Melvin in Mishkin and Eakins (2009) p.27. Then
answer the following question:
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24 Principles of banking and finance
How does the adverse selection problem explain why you are more likely to make a loan
to a member of your family than to a person not belonging to your family?
The concept of asymmetric information was proposed in the seminal
contribution of Akerlof (1970). George Akerlof was a professor at the LSE
in the late 1970s. He claimed that ‘the difficulty in distinguishing good
quality from bad is inherent in the business world; this may explain many
economic institutions and may in fact be one of the most important aspects
of uncertainty’ (Akerlof, 1970, p.500). His analysis of the market for used
cars (consisting of good cars and poor-quality cars) refers to a market
where the seller has more information than the buyer regarding the
quality of the product. The price the buyer pays must reflect the average
quality of the cars in the market (between the low value of a poor-quality
car and the high value of a good car). As a result of the adverse selection
problem, only the owners of poor-quality cars will be happy to sell at
this price, while the owners of good-quality cars will be reluctant to sell
at this same price. The equilibrium in the market can be inefficient: the
predominance of poor-quality cars implies a low number of transactions
carried out in the market, because the buyers are reluctant to purchase a
car unless they can obtain additional information.
Applying this analysis to financial markets, in a market characterised by
asymmetric information, lenders have less information than borrowers.
Lenders will therefore charge an interest rate reflecting the average quality
(risk) of borrowers in the market. This will be higher than good quality
(low risk) borrowers will be willing to pay and so mainly poor quality
(high risk) borrowers will seek a loan. So there will be a higher probability
that a lender will lend to a high risk borrower. This will reduce the amount
of lending that takes place in the market.
Activity 4.5
Read the report on the Nobel Prize in Economics in 2001 awarded to George Akerlof,
Michael Spence and Joseph Stiglitz (available on the website http://nobelprize.org/nobel_
prizes/economics/laureates/2001/presentation-speech.html). Summarise the seminal
contribution of George Akerlof on the analysis of markets with asymmetric information.
Make sure you can see how their conclusions relate to financial intermediaries. (Do not
spend more than 30 minutes on this activity.)
Of interest here is how asymmetric information problems affect lending
and borrowing. Asymmetric information can lead to the selection of the
borrowers with the higher risk (adverse selection); or to an increase in
the risks attached to making a particular loan as a consequence of the
opportunistic behaviours of the borrowers (moral hazard). The next
section analyses how financial intermediaries attempt to solve these
problems.
How adverse selection influences financial structure
The adverse selection problem significantly affects the securities market
(stocks and bonds), where issuers have more information than potential
investors. When individual borrowers (firms) have private information
on the projects they wish to finance, the functioning of the market can be
inefficient. Given that a potential investor is not able to distinguish good
(high return/low risk) and bad (low return/high risk) firms, he is inclined
to pay a price reflecting the average quality. The owners (managers) of
good firms know that their securities are undervalued at this price, and
they are not willing to sell. Only bad firms are willing to sell at this price.
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Chapter 4: Role of financial intermediation
The consequence is that the potential investor has problems in selecting
firms to invest in, and is thus most likely to decide not to buy any security
in the market.
These asymmetries impede the functioning of financial markets: they
can either obstruct the conclusion of transactions (and cause the collapse
of the market), or influence the level (and the quality) of production
activities. Although the existence of organised financial markets partially
reduces some of these problems, the solution to them has been the
emergence of financial intermediaries, as shown in the next sections. The
adverse selection problem explains one empirical fact emphasised above:
why marketable securities – and stocks in particular – are not the primary
source of external financing for firms.
How to reduce/solve the problems arising from adverse selection
To solve the adverse selection problem in financial markets, full
information on the borrowers should be provided to the lenders. The
following solutions exist to reduce/solve the adverse selection problem:
1. Private production and sale of information.
2. Government regulation.
3. Financial intermediaries.
First, private companies can produce and sell the information needed by
potential investors to distinguish good and bad firms and to select their
securities. Information concerns the financial statements of firms and
their investment activities. In the United States, private companies such
as Standard and Poor’s, Moody’s and Value Line do this. Standard and
Poor’s categorises corporate bond issuers into at least seven major classes
according to perceived credit quality. The first four quality ratings – AAA,
AA, A, BBB – indicate quality investment borrowers.
(Read Mishkin and Eakins (2009), Table 10.2, p.249, for a description
of debt ratings.) The ratings below BBB are considered to be below
investment grade and are sometimes referred to as junk bonds. Why do
you think investors are willing to buy junk bonds?
Activity 4.6
Analyse the Credit Model developed by Standard and Poor’s. Find out relevant
information on their website (www.standardandpoors.com), under the section Products
and Services. How do you think a firm reacts to a low rating by Standard and Poor’s?
Adverse selection is not completely solved by the private production and
sale of information because of the free-rider problem. This occurs when
people who do not pay for information take advantage of information
acquired by other people. If you buy the information on the quality
of firms, as described in the last activity, you can use it to purchase
undervalued securities of good firms. However, other investors (freeriders), who have not purchased the information, may observe your
behaviour and buy the same security at the same time. The increase in the
demand for the undervalued security will cause a build-up in its price to
the true value. The effect is to negate the value of information. The freerider problem explains why investors are reluctant to buy information.
Thus the adverse selection problem remains.
Second, governments take steps to ensure that firms disclose full
information to potential investors. In fact, financial markets are among the
most heavily regulated sectors in the economy. In the USA, the Securities
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24 Principles of banking and finance
and Exchange Commission (SEC) is the government agency entrusted to
promote the adherence to standard accounting principles and disclosure
of information. However, disclosure requirements do not solve the adverse
selection problem, as the recent collapse of the Enron Corporation
demonstrates (refer to Box on p.374 of Mishkin and Eakins (2009)).
Activity 4.7
Visit the website of the Securities and Exchange Commission, SEC (www.sec.gov/about/
whatwedo.shtml).
Then find the equivalent authority in your own country, and what the main disclosure
requirements are. If they are different, see if you can work out why, on the basis of the
differences between your country and the USA.
Third, financial intermediaries, and especially banks, produce more
accurate valuations of firms and are able to select good credit risks thanks
to their expertise in information production. One particular advantage that
banks may have in relation to information production is information about
potential borrowers from the transactions on their bank accounts: banks
obtain a profile of the suitability for credit (and ability to repay the loan)
from the accounts of their customers. By acquiring funds from depositors
and lending them to good firms, banks earn returns on their loans that are
higher than the interest paid to their depositors. Although it does not take
into account the possibility that firms provide information to the market,
the asymmetric information theory offers a convincing explanation of the
existence of financial intermediaries.
An important element of this explanation is that banks are able to avoid
the free-rider problem because their loans are private securities, not traded
in the open financial market. Therefore investors are not able to observe
the bank and bid up the price of the loan to the point where the bank
makes no profit on the production of information.
Moreover, banks reduce the adverse selection problem by asking the
borrower to provide collateral against the loan. Collateral is property
promised to the lender if the borrower defaults. Therefore it reduces the
losses of the lender in the event of a default.
Activity 4.8
Can you explain how the presence of collateral reduces the adverse selection problem?
Try to use an example. For instance, you want to borrow £1 million to buy a health and
fitness club and you own a building whose value is £1.2 million.
Therefore, financial intermediaries solve the adverse selection problem,
whereas the private production of information and government regulation
only reduce it. The presence of adverse selection explains:
1. why bank loans are the most important source of funds raised
externally
2. why indirect finance is many times more important than direct finance.
Further, there are several interesting corollaries:
i. Banks are even more important in developing countries than in
developed countries, because information about private firms is even
harder to collect than in developed countries.
ii. Large and well-known corporations have easier access to securities
markets as the investors have more information about them.
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Chapter 4: Role of financial intermediation
iii. Recent improvements in information technology makes the acquisition
of information easier for firms, and thus reduces the lending role of
financial institutions.
The empirical evidence in the United States in the last 20 years confirms
this, as discussed in the last section of this chapter.
A theory on financial intermediaries and adverse selection:
informational economies of scale
In the presence of adverse selection, there are scale economies in the
lending-borrowing activity. In such a context, financial intermediaries can
be seen as ‘information sharing coalitions’ as argued by Leland and Pyle
(1977) in the informational economies of scale theory.
Entrepreneurs can ‘signal’ the quality of their projects by investing more
or less of their wealth in the firm. This partially reduces the adverse
selection problem, since good firms can be separated from bad firms
by the level of self-financing. However, if entrepreneurs are risk-averse,
the ‘signalling’ is costly (i.e. good entrepreneurs are obliged to retain a
substantial amount of the risk of their project). Nevertheless, information
(not publicly available) on the quality of the projects can be obtained with
an expenditure of resources. Interestingly, this information can benefit
potential lenders. If there are economies of scale in the production of this
information, specific organisations may exist to gather this information.
Two problems hamper firms that sell information to investors:
a. Quality of the information: buyers may not be able to ascertain the
quality of the information (i.e. the distinction between good and bad
information will not be apparent). As a consequence the price of the
information will reflect average quality (as in the analysis by Akerlof
above) so that firms that seek out high quality information will lose
money.;
b. Appropriability of returns, also referred to as free-rider problem (as
discussed above, buyers may be able to share or resell the information
to others, without diminishing its usefulness). Thus the firm that
originally collected the information may not be able to recoup the value
of the information.
Both these problems can be solved if the firm gathering the information
is a financial intermediary (such as a bank), buying and holding assets
on the basis of its specialised information. Thus the information becomes
embodied in its portfolio and hence, is not transferable. This provides
an incentive for the gathering of this information. Once an organisation
becomes better able than other lenders to sort classes of risks, borrowers
of good risk wish to be identified, and to deal with an informationally
efficient intermediary rather than with a set of lenders offering the value
of the average risk. With the best risk ‘peeled off’, the average risk is
less valuable, inducing borrowers of the next best risk to deal with the
intermediary. Ultimately, borrowers of all types of risk will deal with
intermediaries, with the only exception being the bottom class.
How moral hazard influences financial markets
Moral hazard has consequences for whether firms find it easier to raise
funds with debt rather than with equity contracts:
• Moral hazard in equity contracts qualifies as a special type known
as the principal-agent problem (Jensen and Meckling, 1976).
Stockholders (called principals) own most of the firm’s equity,
but they are not the same people as the managers (agents) of the
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24 Principles of banking and finance
firm. Managers have more information about their activities than
stockholders so that there is asymmetric information. The separation
of ownership and control, together with the asymmetric information,
induce managers to act in their own interest rather than in the
interest of stockholder-owners (i.e. managers have fewer incentives to
maximise profits than stockholders).
• Moral hazard in debt contracts is lower than in equity contracts but is
still present. Debt contracts require borrowers to pay fixed amounts
and let them keep any profit above this amount. Consequently,
borrowers have incentives to take investments riskier than lenders
would like.
How to reduce/solve the problems arising from moral hazard in
equity markets
Several tools can be used to reduce/solve moral hazard in the equity
market:
1. Monitoring.
2. Government regulation to increase information.
3. Financial intermediaries active in the equity market.
4. Debt contracts.
First, stockholders can engage in the monitoring (auditing) of firms’
activities to reduce moral hazard. Several reasons explain why monitoring
is needed:
• to ensure that information asymmetry is not exploited by one party at
the expense of the other
• the value of equity contracts cannot be certain when the contract is made
• the value of many financial contracts (i.e. future return on a stock)
cannot be observed or verified at the moment of purchase, and the
post-contract behaviour of a counterparty determines the ultimate
value of the contract
• the long-term nature of many financial contracts implies that
information acquired before the contract is agreed may become
irrelevant at the maturity due to changes in conditions.
Nevertheless monitoring is expensive in terms of money and time, or
rather it is a costly state verification. In addition, if you know that other
stockholders are paying to monitor the activities of the firm you hold
stocks in, you can free-ride on the activities of the others. As every
stockholder can free-ride on others, the free-rider problem reduces the
amount of monitoring that would reduce the moral hazard (principalagent) problem. This is the same as with adverse selection and makes
equity contracts less desirable.
Second, governments have incentives to reduce the moral hazard
problem (just as with adverse selection). Several measures are used
by governments: laws to force firms to adhere to standard accounting
principles (i.e. to make profit verification easier); laws to impose stiff
criminal penalties on people who commit the fraud of hiding/stealing
profits. However, these measures are only partially effective as these
frauds are difficult to discover.
Third, financial intermediaries operating in the equity market are
able to avoid the moral hazard problem. Venture capital firms are an
example of an intermediary able to reduce moral hazard and avoid the
free-rider problem.. They use their funds to help entrepreneurs to start
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Chapter 4: Role of financial intermediation
new businesses. In exchange for the use of the venture capital, the firm
receives an equity share in the new business. Venture capital firms have
their own people participating in the management of the firm (i.e. easier
profit verification and thus lower moral hazard). Moreover, the equity
in the firm is not marketable to anyone but the venture capital firm (i.e.
this eliminates the free-riding of other investors on the venture capital’s
verification activities).
Fourth, debt contracts are a way to reduce moral hazard. Moral hazard
affects equity contracts because they are claims on profits in all situations,
whether the firm makes or loses money. Consequently, there is the need
to structure a contract that confines moral hazard to certain situations,
and thus reduces the need to monitor managers. This is a debt contract,
a contractual agreement to pay the lender a fixed amount of money
independently from the profits of the firm. Therefore debt contracts are
preferred to equity contracts as they require less monitoring . The presence
of moral hazard in equity markets explains why stocks are not the most
important external source of financing for firms.
How to reduce/solve the problems arising from moral hazard in
debt markets
Although debt contracts reduce the amount of moral hazard in comparison
to equity contracts, they do not solve the problem. Borrowers have
incentives to take investments riskier than lenders would like: borrowers,
get all the gains from a risky investment if they succeed, but lenders lose
most, if not all, of their loan, if borrowers do not succeed. The solution
to the problems of moral hazard lies again in financial intermediaries.
However, other tools also enable us to reduce moral hazard. The full range
of tools includes:
1. making debt contracts incentive-compatible (i.e. align the incentives of
borrowers and lenders)
2. monitoring and enforcement of restrictive covenants
3. financial intermediaries.
First, borrowers are more likely to take on riskier investment projects
when using borrowed funds than when using their own funds. Thus the
moral hazard problem can be reduced by increasing the stake of borrowers
own personal net worth (the difference between personal assets and
liabilities) in the investment project. Now that borrowers could potentially
lose some of their wealth if the project fails they have an incentive to make
the project less risky. Thus, one way to reduce the moral hazard problem
is to make the debt contract incentive-compatible, or rather to align the
incentives of the borrowers and lenders.
Activity 4.9
How does the moral hazard problem explain why you are more willing to make a loan to
a borrower who uses his own capital to finance two-thirds of the total value of a project
than one who uses of one-third?
A second way in which the moral hazard problem can be reduced is by
introducing restrictive covenants into debt contracts. A restrictive covenant
is a provision aimed at restricting the borrower’s activity. There are four
types of possible covenants:
1. Those which discourage undesirable behaviour by the borrower (i.e.
not to undertake risky investment projects). Examples are:
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24 Principles of banking and finance
i. to use the debt contract only to finance specific activities, such as
the purchase of a fixed asset
ii. to prohibit the firm from issuing new debt, or disposing of its assets
iii. to restrict dividend payments if some ratios (such as the leverage
ratio, the ratio of debt to equity) has not reached a critical level
iv. to limit purchases of major assets or merger activities.
2. Those which encourage desirable behaviour from the lender’s point of
view. One example is a mortgage loan with a provision that requires
the borrower to purchase life insurance that pays off the loan in the
event of the borrower’s death.
3. Covenants that keep collateral valuable.
4. Covenants that provide information about the activities of the
borrowing firm, such as quarterly accounting and income reports.
The presence of covenants reduces moral hazard problems and explains
why debt contracts are often complicated legal documents.
Activity 4.10
Are accounts always reliable? In every country? Is this a problem where you live –
untrustworthy accounts? What does this mean for moral hazard?
Third, although covenants reduce moral hazard problems, they do not
eliminate them: it is not possible to rule out every risky activity. Moreover,
in order to make covenants effective, they must be monitored and
enforced.
Monitoring typically involves increasing returns to scale, which implies
that it is more efficiently performed by specialised financial institutions.
We made this point earlier in this chapter – look back to refresh your
memory. Individual lenders tend to delegate the monitoring activities
instead of performing them directly. Thus the monitor has to be given an
incentive to do its job properly.
However, because monitoring and enforcement are costly activities,
investors can free-ride on the monitoring and enforcement undertaken by
other investors. Thus in the bond market (as well as in the stock market)
the free-rider problem arises. The consequence will be that insufficient
resources will be devoted to these activities.
Financial intermediaries, and especially banks, can be seen to provide
solutions both to the incentive problem and to the free-rider problem.
They solve the incentive problem using several mechanisms, such as
reputation effects, and the option for depositors to withdraw their money
should the bank managers prove incompetent. They do not face the same
free-rider problem, as they primarily make private loans not traded on
the market. Banks therefore gain the full benefits of their monitoring and
enforcement activities and have an incentive to devote sufficient resources
to them. The possibility of overcoming moral hazard with adequate
instruments (such as screening and monitoring), favoured by the existence
of established long-term relationships, enables this theory to emphasise
the special nature and role of banks in the allocation process.
Activity 4.11
Explain how loan contracts solve free-riding problems in a better way than bond
contracts. If you need help, look at the Essential reading (Mishkin and Eakins, 2009,
Chapter 15).
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Chapter 4: Role of financial intermediation
A theory on financial intermediaries and moral hazard: delegated
monitoring
Since monitoring borrowers is costly, it is efficient for surplus units
(lenders) to delegate the task of monitoring to specialised agents such as
banks. Banks have a comparative advantage relative to direct lending in
monitoring activities in the context of costly state verification. In fact, they
have a better ability to reduce monitoring costs because of their ability to
diversify loans. This is the main idea of the delegated monitoring theory,
as formulated by Diamond (1984).
Several conditions are required for delegated monitoring to work:
• existence of scale economies in monitoring, which means that a typical
bank finances many projects
• small capacity of investors as compared to the size of investments,
which means that each project needs the funds of several investors
• low cost of delegation, which means that the cost of monitoring the
financial intermediary itself has to be less than the benefit gained from
exploiting scale economies in monitoring investment projects.
The framework of the delegated monitoring theory, as provided in
Diamond (1984), is based on: the existence of n identical firms that seek
to finance projects and the requirement by each firm of an investment of
one unit.
The cash flow y that the firm obtains from its investment is a priori
unobservable to lenders. This is where moral hazard arises. Moral hazard
can be solved by:
• either ‘monitoring’ the firm (at cost K)
• or ‘designing’ a debt contract characterised by a non-pecuniary cost C
(i.e. unmonitored direct lending)
Assume that K<C. If the firm has a unique financier, it would be efficient
to choose the monitoring option. However, assume that each investor has
available to lend only 1/m, so that m of them are needed for financing
a project. Assume also that the total number of investors is m*n, so that
all the projects can be financed. Direct lending implies that each of the m
investors monitors the financed firm: the total cost is n*m*K.
If a bank (financial intermediary) emerges, it can monitor each firm (total
cost n*K). The benefits of a bank monitoring the debt arises from the
specialised skill that a bank possesses and a reduction in the duplication
of effort. Thus it makes sense for the bank to become a delegated monitor,
which monitors borrowers on behalf of lenders (note that the bank is
not monitored by its lenders – the depositors). Financial intermediation
(delegated monitor) dominates direct lending as soon as n is large enough:
this means that diversification exists (i.e. a large number of loans is held
by the intermediary). Diversification is important because it reduces risk
to the bank and so increases the probability that the intermediary has
sufficient loan proceeds to repay a fixed debt claim to depositors.
Before moving to the next section, focus your attention on Table
4.2, which provides a summary of the corollaries of the asymmetric
information problem, the ways to reduce/solve the market imperfections
and the relevant financial intermediation theories.
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24 Principles of banking and finance
Type of asymmetric
information
Adverse selection
Moral hazard
Corollaries
Free-rider problem
Principal-agent problem
Ways to reduce/solve the
market imperfection
Private production
Monitoring of equity
contracts
Government regulation
Government regulation
Financial intermediaries
Debt contracts
Free-rider problem
Monitoring and
enforcement of covenants
Financial intermediaries
Theory of financial
intermediation
Informational economies
of scale (Leland and Pyle,
1977)
Delegated monitoring
(Diamond, 1984)
Table 4.2: Asymmetric information problems and ways to reduce/solve
them
What is the future for financial intermediaries?
The relevance of traditional banking has declined in recent years in
countries such as the USA and the UK. The share of financial assets held
by different types of US financial intermediaries changed over the period
1970–2005. As shown in Figure 4.2, since 1970 the bank share of financial
assets has steadily declined, and thrift institutions (primarily savings and
loan associations) have lost even more ground than banks. However,
over the same period some other types of intermediaries, notably mutual
companies, have increased their market share dramatically. (Read Boyd
and Gertler, 1994.)
Before reading further, see if you can guess why banks have lost out in
some ways. Do you think they have been able to make gains in other
directions? Think how they have done this. We shall see below that there
is an interesting story of both decline and increase.
The decline in the share of financial assets held by banks does not
necessarily indicate that the banking industry is in decline. In fact we have
two indicators that banks have been doing quite well. First, both the ratio
of US commercial bank assets to nominal gross domestic product (GDP)
and the ratio of commercial bank loans to nominal GDP increased over the
last four decades (Boyd and Gettler, 1994). Second, as shown in Figures
4.2 and 4.3, US banking profitability relative to GDP has shown a sharp
increase from 1992 and remained substantially stable over the 1993–
2006 period, after a bad performance in the late 1980s and early 1990s
(Mishkin and Eakins, 2009). Specifically, the US banking return on equity
(ROE) was 13.86 per cent in 1992 and 13.06 per cent in 2006,
with a maximum of 16.03 per cent in 1993; return on assets (ROA) was
0.94 per cent in 1992 and 1.33 per cent in 2006 with a maximum of
1.4 in 2003. Similarly, EU banking ROE rose to just under 20 per cent
in 2005 (up from 16.5 per cent in 2004) with a degree of dispersion of
performances around the average ROE considerably narrower in 2005
compared with 2004.
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Chapter 4: Role of financial intermediation
40
35
30
25
20
15
10
5
0
Insurance
companies
Pension
funds
Finance
companies
1970
Mutual funds
1980
1990
Commercial
banks
2002
S&Ls
Credit
unions
2005
Figure 4.2: Shares of financial assests held by different types of US
financial intermediairies over the period 1970–2005
Source: Graph created using data from US Federal Reserve Flow of Funds Accounts, 9
June 2005.
1,6
1,4
1,2
1
0,8
0,6
0,4
0,2
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
19
97
19
96
19
95
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94
19
93
19
92
19
91
19
90
19
89
19
88
19
87
19
86
19
85
19
84
19
83
19
82
19
81
19
80
0
Figure 4.3: Return on assets %
18
16
14
12
10
8
6
4
2
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
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19
96
19
95
19
94
19
93
19
92
19
91
19
90
19
89
19
88
19
87
19
86
19
85
19
84
19
83
19
82
19
81
19
80
0
Figure 4.4: Return on equity %
Source: Graph created using data fromt he FDIC website (www2.fdic.gov/qbp).
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24 Principles of banking and finance
This complex picture can be explained by looking at two main areas of
banking activity (Mishkin and Eakins, 2009, Chapter 18):
1. Reduction in cost advantages in acquiring funds: in the 1960s the
increase in inflation, associated with the regulatory restriction on
interest payable on checkable deposits, increased the investors’
sensitivity to interest rate differentials. Therefore low-cost deposits
from the public were not as readily available as a source of funds for
banks. This had three main consequences.
• First, a disintermediation process occurred: the low interest rate on
chequeable and time deposits induced investors to take their money
out of banks and to look for higher-yielding investment opportunities.
• Second, money market mutual funds appeared in the early 1980s and
grew dramatically in the USA: this new financial intermediary issued
shares (like mutual funds) to raise funds to be invested in short-term
money market securities, on which investors get interest payments.
Moreover, they enable the investor to write cheques against the held
shares (like banks), although they are not legally deposits and are not
subject to reserve requirements and prohibitions on interest payments.
As a result investors could both obtain checking account-like services
and earn high interest.
• Third, in the 1980s changes in regulation (elimination of ceilings on
time deposit interest rates) helped banks in the competitive process
for the acquisition of funds, but involved them in higher costs. Thus
banks experienced a reduced cost-competitive advantage over other
institutions.
2. Reduction in income advantages in using funds:
• First, improvements in information technology and the diffusion of
credit rating agencies make it easier for firms to issue securities directly
to the public. These securities are either short-term (commercial
papers) or long-term (bonds). Because investors can screen out bad
and good credit risks, firms go to the cheaper commercial paper
market – rather than to banks – to raise short-term funds. For the same
reason, firms go to the bond market – and use banks less often – even
if they are less well-known corporations with lower credit ratings. This
explains the development of the so-called junk bond market, or rather
long-term corporate bonds whose ratings have fallen below a given
score calculated in accordance with credit rating agencies (rated below
Baa by Moody’s rating agency or BBB by S&P).
• Second, improvements in information technology and statistical
methods favoured the process of securitisation, which is the process
of transforming illiquid financial assets (such as loans and mortgages)
into marketable securities (see Figure 4.5 to get a sense of the increase
in the relevance of securitisation in the EU). Financial intermediaries
can cheaply bundle together a portfolio of loans (e.g. mortgages, credit
card receivables, commercial and computer leases) with varying small
denominations (often less than $100,000), collect the interest and
principal payments on the loans in the bundle, and then pay them out
to third parties. By dividing the portfolio of loans into standardised
amounts, the claims to the principal and interests can be sold to third
parties as securities. These securities are liquid and well diversified.
Financial institutions make profits by servicing the loans and charge a
fee to the third party for this service. The development of securitisation
allows other financial institutions, and not only banks, to originate
loans, accurately evaluate credit risks, bundle these loans and sell
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Chapter 4: Role of financial intermediation
them as securities. Banks have therefore lost their advantage in the
loan business. Of course, securitisation reached a peak in 2007 but has
declined dramatically following the problems with securitised subprime mortgage debt and other securitised debt products during the
financial crisis of 2007–09 – see Chapter 3 for more details.
250
€ billions
200
150
100
50
0
'97
'98
'99
'00
'01
'02
'03
Figure 4.5: Securitisation activities in the EU (1997–2003)
Source: Graph created using data from www.europeansecuritisation.com.
Activity 4.12
What is the relevance of traditional banking in your country in comparison to the
situation in the USA?
How can you link this evidence with the arguments on bank-oriented systems and
market-oriented systems presented in Chapter 3?
What are the reactions of banks to this decline in their intermediation
role?
1. They have expanded into new, riskier areas of lending (e.g. lending
to real estate companies, to corporate takeovers and to leverage
buyouts). The higher risk associated with these new areas of lending
is well illustrated by the problems of the Japanese banking system in
the 1990s. As a consequence of the deregulation process, Japanese
banks expanded their lending rapidly during the 1980s. In particular,
bank lending was increasingly directed towards the real estate and
construction sectors. A sharp increase in interest rates in 1990 burst the
asset price bubble, and land prices declined sharply over several years.
This caused the emergence of a large number of ‘bad loans’ (loans that
would not be repaid in full, if at all). Moreover, the economic downturn
in Japan and the crisis in Asia have produced a further deterioration in
bank loan portfolios. During 1997, the problems in the banking system
became increasingly apparent when an attempted merger between the
tenth largest commercial bank in Japan – Hokkaido Takushoku Bank –
and a smaller regional bank stalled, leading to the collapse of the larger
bank. Similar problems affected banks in the US and Europe during the
financial crisis of 2007–09 as banks lent to borrowers to finance house
purchases in a period of rapidly rising house prices. When the housing
bubble burst the banks found themselves with large amounts of bad
debt. This created serious solvency problems for many banks.
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24 Principles of banking and finance
Activity 4.13
Read the International Monetary Fund Survey (August 17, 1998: pp.253–55) available at:
www.imf.org/external/pubs/ft/survey/pdf/081798.pdf. Write a one-page essay explaining
the reasons for the Japanese banking sector problems, emphasising the failure of
Hokkaido Takushoku bank.
2. Banks are now pursuing new off-balance sheet activities, such as
loan commitments and letters of credit. These activities produce fee
income instead of interest income. Note that total bank income can be
expressed as the sum of net interest income (earnings from balance
sheet assets net of interest costs) and non-interest income (non-interest
earnings from off-balance activities). There has been a strong increase
in income from off-balance sheet activities as a share of total bank
income in the period since the 1960s. Given that the total profitability
of banks has been substantially stable in this same period, this implies
that the share of traditional banking businesses has declined. However,
note that non-traditional activities might be riskier for banks.
3. Banks have also increased proprietary trading whereby they hold
positions in assets and derivatives for speculative purposes (hoping to
profit from price changes). This increased dramatically in the 15 years
prior to the 2007 financial crisis. Of course a bank’s trading activities
give rise to market risk which is discussed in more detail in Chapter 5.
Activity 4.14
Visit the FDIC website at www2.fdic.gov/SDI/SOB/ and answer the following questions
(produce a graph to support your answer):
What is the share of the income of US banks coming from off-balance sheet activities?
What was the trend during the period 1992–2006?
Summary
In this chapter we investigated how several theories explain why there are
financial intermediaries. They exist to:
• transform assets in order to satisfy simultaneously the different
requirements of lenders and borrowers in terms of maturity, size and
risk
• reduce transaction costs by taking advantage of economies of scale,
economies of scope and expertise
• satisfy the liquidity needs of individual investors
• reduce problems arising out of asymmetric information. On the one
hand, financial intermediaries reduce adverse selection thanks to their
expertise in information production and their ability to avoid the freerider problem by issuing private securities (loans) against collateral.
On the other hand, they reduce moral hazard because they gain the full
benefits of their monitoring and enforcement, and have an incentive to
devote sufficient resources to these activities.
The final issue concerns the future of financial intermediaries. The
traditional intermediation services provided by banks have declined in
recent years, and banks have sought to maintain profits by expansion into
other areas of business. However, this expansion exposed banks to new
and greater risks and contributed to the financial crisis of 2007–09.
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Chapter 4: Role of financial intermediation
Key terms
adverse selection
asset transformation
asymmetric information
delegated monitoring theory
disintermediation
diversifying risks
economies of scale system
economies of scope
fractional reserve system
free-rider problem
informational economies
of scale theory
liquidity insurance theory
liquidity transformation
market imperfections
maturity transformation
moral hazard
pooling risks
principal-agent problem
risk transformation
Securities and Exchange
Commision
securitisation
size transformation
transaction costs
theory of transaction costs
A reminder of your learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain why financial intermediaries exist
• discuss how the presence of market imperfections explains the
importance of financial intermediaries (and the relative unimportance
of financial markets) in the financing of corporations
• explain how financial intermediaries are able to reduce the transaction
cost problem
• explain how financial intermediaries are able to reduce/solve the
problems arising from adverse selection and moral hazard
• discuss the expected developments affecting the role of the different
types of financial intermediaries (especially banks) in the future.
Sample examination questions
1. Discuss how the key economic theories of financial intermediation
enable us to understand the existence (and relevance) of financial
intermediaries.
2. a.
Describe how the presence of market imperfections explains
the importance of financial intermediaries (and the relative
unimportance of financial markets) in the financing of
corporations.
b.
What are the forms of asset transformation undertaken by banks?
3. a.
Explain how financial intermediaries are able to reduce transaction costs in the economy.
b.
Explain how financial intermediaries are able to reduce/solve the
problems arising from adverse selection and moral hazard.
4. a.
b.
Explain the hypotheses, the framework and the main findings of
the delegated monitoring theory.
How is the free-rider problem related to information asymmetries
in financial markets?
5. ‘There is evidence that traditional banking has declined in recent years
in countries such as the USA and the UK.’ Discuss.
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24 Principles of banking and finance
6. a.
b.
88
What factors have caused the decline in the share of financial assets held by the US banks in recent years?
What have been the main consequences of disintermediation for
banks?
Chapter 5: Regulation of banks
Chapter 5: Regulation of banks
Aims
The aim of this chapter is to discuss the main reasons for the existence of
banking regulation in most countries, and to illustrate the key economic
reasons for and against banking regulation. Furthermore, it describes how
regulation occurs in practice by analysing general issues of regulation and
by giving some practical examples of the application of regulation (mainly
in the USA, UK and New Zealand). Finally it examines the deficiencies in
the regulatory framework revealed by the global financial crisis of 2007–
09 and examines the response of the regulatory bodies in their attempt to
address these deficiencies.
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain why banks need regulation
• illustrate the main cases of non-regulated banking systems in history
and explain their economic rationale
• explain the main arguments for and against the regulation of banking
systems
• explain how banks are regulated through traditional regulation
mechanisms
• discuss the problems with the traditional regulation mechanisms
revealed by the global financial crisis of 2007–09
• evaluate the response of the Basel Committee on Banking Supervision
to the global financial crisis of 2007–09
• illustrate alternative regulation mechanisms
• discuss the main implications of the recent trend in harmonising bank
regulation across the world.
Essential reading
Dow, S. ‘Why the banking system should be regulated’, Economic Journal
106(436) 1996, pp.698–707.
Dowd, K. ‘The Case for Financial Laissez-Faire’, Economic Journal 96(106)
1996, pp.679–87.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapter 20.
Further reading
Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004)] Chapter 17.
Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The MIT
Press, 2008) Chapter 9.
Heffernan, S. Modern Banking. (Chichester: John Wiley and Sons, 2005)
Chapters 4 and 5.
Sinkey, J.F. Commercial Bank Financial Management in the Financial-Services
Industry. (Upper Saddle River, NJ: Pearson Education, 2002) Chapter 16.
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References
Bank of England Discussion Paper ‘The role of macroprudential policy’,
November 2009 (download from www.bankofengland.co.uk/publications/
other/financialstability/roleofmacroprudentialpolicy091121.pdf)
Freixas, X. C. Giannini, G. Hoggart and F. Soussa ‘Lender of last resort: a review
of the literature’, Bank of England Financial Stability Review, November 1999
Kay, J. ‘Narrow banking: the reform of banking regulation’, Centre for the study
of Financial Innovation, publication no. 88, September 2009
(also download from www.johnkay.com/wp-content/uploads/2009/12/JKNarrow-Banking.pdf).
Mortlock, G. ‘New Zealand’s financial sector regulation’, Reserve Bank of New
Zealand: Bulletin (2003) 66, pp.5–49.
Introduction
Several arguments on banking regulation deserve our attention:
1. Banking regulation now exists in virtually every country with a welldeveloped banking system. In fact, it is practically impossible to
study the theory of banking without referring to bank regulation.
Nevertheless, non-regulated banking systems have been introduced in
some countries (so-called free banking).
2. In most countries the banking system is more heavily regulated than
any other sector of the economy.
3. Banking regulation takes several forms, through the adoption of
various regulation mechanisms.
4. A recent trend towards greater harmonisation of bank regulation across
the major banking systems of the world is occurring.
5. The financial crisis of 2007–09 revealed several deficiencies in the
system of bank regulation used in most countries.
We address the following questions:
• Why do banks need regulations?
• Why not permit free banking within a market system, with the users
making their own assessment of the quality of the liabilities issued by
banks?
• What are the reasons for and against regulation?
• Why are banks singled out for special regulation?
• What are the traditional regulation mechanisms?
• What are the main problems in traditional regulation methods revealed
by the financial crisis of 2007–09?
• What has been the response of the regulatory authorities to the
deficiencies in bank regulation revealed by the financial crisis?
• Is there any alternative regulation mechanism?
• What are the reasons for the recent international harmonisation in
banking regulation?
Free banking
As a starting point, consider why regulation is required at all. Take a
financial system that is unregulated – so-called free banking. This involves
a financial system with no central bank or any other financial or monetary
regulator, and no government intervention. It therefore allows financial
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Chapter 5: Regulation of banks
institutions to operate freely, subject only to market forces and the rules
of ‘normal’ commercial and contract law. Free banking is an example of
financial laissez-faire.
One example of a free banking era was to be found in the USA from
1838 until 1863. Other relatively unregulated systems have been those
in Scotland (1716–1845), Switzerland (after the Liberal revolution in
the 1830s and 1840s until 1881), Canada (1820–1935) and Hong Kong
(1935–64).
A free banking system consists of banks whose deposits are largely
repayable on demand and where those deposits are used as payment
instruments. However, there is no central bank, no supervision of or
restriction on the activities of banks, and no state insurance scheme for
deposits.
Free banks issue distinct private monies, called bank notes. These bank
notes are perpetual, non-interest bearing debt claims that can be redeemed
on demand. However, these bank notes are subject to the risk of failure of
the issuer, and redemption means having to travel to the issuing bank.
Two main arguments are made against private money issuance:
• Some banks can over-issue their currency, making the conversion
impossible (so-called wildcat banking).
• Transaction costs increase when thousands (three thousand in the case
of the USA and Canada in their periods of free banking) of distinct
bank notes circulate in a given geographical area.
The traditional, dominant view is that free banking is inherently unstable
because of market failures arising from factors, natural monopolies
and information symmetry. Free banking causes counterfeiting, wildcat
banking, fraudulent banking, over-issue of bank notes and over-expansion
by banks. Free banks are therefore prone to failures and lead to systemic
banking instability. As a consequence several reasons have been advocated
to justify banking regulation (as discussed in the next section). During the
US free banking era, bank failures in Indiana, Wisconsin and Minnesota
are usually cited as evidence of the instability of free banking.
This traditional, negative view has come under increased scrutiny since
the 1970s. Indeed, the failure of regulators to prevent the banking crisis
of 2007–09 has again raised doubts about the ability of regulators to
maintain a stable banking system. Even if bank regulation is present today
in virtually every country, a small but growing number of economists are
still in favour of free banking. One of the major arguments provided for
the soundness of a free banking system is that competition in the supply of
money forces banks to maintain either their reputation or convertibility of
their liabilities (bank notes or deposits) into species or real commodities,
which in turn prevents banks from over-issuing money. In contrast, a
self-correcting mechanism does not exist under a monopolised supply of
money by the government. Therefore free banking is more stable than
central banking.
In terms of regulation of the banking system, in the absence of a regulator
and deposit insurance system depositors would become much more aware
that if their bank failed they would lose their deposit. Depositors would
therefore require greater reassurance that their deposit is safe. How would
banks be able to provide that reassurance? There are essentially three
mechanisms that banks can use:
i. disclose lots of information including audited accounts
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24 Principles of banking and finance
ii. pursue prudent lending policies
iii. hold adequate amounts of capital.
These three mechanisms are interrelated with i more likely to lead to
the pursuit of ii and iii. The question of what constitutes an adequate
amount of capital is difficult to answer. The more capital a bank holds, the
more resilient it is in the face of shocks (i.e. the more able the bank is to
maintain its solvency in the event of losses). However, capital is costly –
shareholders have to be paid dividends. A discussion of the importance of
capital in the regulation of banking is covered later in this chapter. Free
bankers argue that in a competitive banking system market forces would
determine the optimal level of capital. If depositors want high levels of
reassurance they will choose to place their deposits in banks holding high
levels of capital.
Please read Dowd (1996), an advocate of free banking, for further
discussion. In your reading consider the following point in particular.
Free bankers argue that in a banking system with no regulator, the
market would regulate. Note that the market is essentially made up of the
providers of finance to the bank (i.e. depositors, shareholders etc.). Think
about how depositors and shareholders might regulate banks – note that
regulation aims to encourage good, and discourage imprudent, behaviour.
Why do banks need regulations?
Several economic and non-economic reasons have been given to justify
banking regulations. These include: to protect depositors, to assure the
safety and soundness of banks, to avoid (or to limit) the effects of bank
failures, to maintain monetary stability, to protect the payment system
and to encourage efficiency and competition in the financial system and
in the economy. Sudipto Bhattacharya, Professor of Finance at LSE, is an
expert of financial intermediation and has studied the economics of bank
regulation.
The economic arguments on bank regulation can be properly understood
by keeping in mind the pivotal position of banks in the financial system,
especially in the payment systems, and in the financing (as a dominant
or exclusive lender) of a large number of borrowers (as discussed in
the previous chapter). This section examines the pros and cons of bank
regulation in three domains: the fragility of banks, systemic risk and
the protection of depositors.
Fragility of banks
The history of financial systems (as discussed in Chapter 3) shows that
bank panics have been common in Europe and the USA throughout
modern history (and in many emerging countries in recent years). When
banks started to finance illiquid loans through demand deposits, most
recessions were accompanied by loss of public confidence in the banking
system, often leading to bank panics. At first, banks privately developed
cooperative systems to protect their collective reputation. These systems
were later taken on and transformed by central banks when governments
decided to impose controls on banking systems. Moreover central banks
started to offer ‘lender of last resort’ facilities in times of financial
crises: central banks act as the ultimate supplier of liquidity to bank(s)
threatened by a liquidity crisis. In recent times, central banks have led
lifeboat rescues, whereby healthy banks take over the deposits of the
troubled banks.
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Chapter 5: Regulation of banks
The fragility of banks derives from the combination of the two main
functions.
• One source of fragility is the role of banks in providing liquidity
insurance to households (as discussed in Chapter 4). Banks can be
considered as pools of liquidity to households that can deposit funds
as insurance against shocks that affect their consumption needs. Some
fraction of these deposits can be used by banks to finance profitable
but illiquid investments (the so-called fractional reserve system). This
represents a source of potential fragility of banks, if a high number of
depositors all at once decide to withdraw their funds for reasons other
than those of normal liquidity needs.
• A source of mitigation of fragility is the role of banks in screening and
monitoring borrowers who cannot obtain direct finance from financial
markets. As we saw in Chapter 4, banks are able to produce a more
accurate valuation of firms than other companies, and are also able
to select good credit risks thanks to their expertise in information
production.
The nature of these two core services to depositors and borrowers explains
the financial structure of banks: liquid liabilities (deposits) and illiquid
assets (loans). This in turn explains the vulnerability of banks to runs.
Systemic risk
A crucial role of bank regulation, and specifically of central bank
operations, is to prevent systemic risk (as we discussed in Chapter 3). This
is the risk that the failure of a particular bank spreads to other, solvent
banks. This happens because depositors are unable to distinguish between
good and bad banks. The run on one bank, which can be justified if the
bank has been imprudent, will lead to a run on solvent banks because
of the asymmetric information problem. A solvent bank facing a run will
quickly run out of liquidity to meet deposit withdrawals because most of
its assets are long term in nature and cannot easily be liquidated. This
is the fragility problem discussed above. A bank facing such a run may
engage in a ‘fire-sale’ of assets (where assets are sold cheaply in order
to achieve a quick sale) which will reduce the total value of the bank’s
assets. Thus a bank that was once solvent can become insolvent by its
attempts to generate liquidity. In a classic bank run retail depositors lose
confidence in their bank’s ability to remain solvent or see problems at
other banks and therefore join a run at their bank. However, in modern
banking, liquidity is provided not just by retail deposits but by wholesale
deposits through inter-bank and repo markets. Indeed, many banks
became heavily dependent on wholesale market funding and funding
through securitisation to finance their assets over the last decade. The
recent banking crisis demonstrated that runs can develop in the wholesale
markets as inter-bank lending drains away and lenders demand higher
collateral requirements.
Banks are therefore highly interconnected and a problem in one part of
the banking system can quickly spread to other parts. Given the pivotal
role of banks in intermediation and hence in underpinning economic
activity the consequences of systemic failure of the banking system can
be catastrophic. This is one of the primary reasons to justify external
regulation of the banking system.
Later in this chapter we examine why a build-up of systemic risk in the
banking sector was not recognised (or not acted on) by regulators in
the period before the financial crisis of 2007–09. This has led to calls for
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24 Principles of banking and finance
regulators to take a different approach to monitoring systemic risk through
macro-prudential regulation. We will examine macro-prudential policy
later in this chapter.
The protection of depositors
The protection of the public (especially depositors) and the safety of the
payment system represent good justifications for (solvency) regulations
of banks. Therefore prudential regulations are necessary because
of the lack of expertise and knowledge of individual depositors to assess
the quality of the bank. This suggests a differentiation in the degree
of regulation imposed on retail and wholesale banks, because of the
differences in the perceived expertise of their customers. (If you have
forgotten what these types of banks do, look back at Chapter 2). Retail
banking depositors are less knowledgeable than those of wholesale banks;
therefore the need for regulation is greater in retail banking. These banks
should be subject to fairly rigorous control, whereas wholesale banking
can be subject to a much lighter prudential control. The differentiation
of retail and wholesale (investment) banking became an issue following
the financial crisis of 2007–09. Many banks are both retail and wholesale
banks. The ending of Glass-Steagall in the USA allowed retail banks
to engage in investment banking activities – see Chapter 3 for more
discussion. Most banks in Europe are universal banks undertaking both
retail and investment banking. This makes it difficult for regulators to
regulate the retail banking operation more rigorously than the investment
banking operation, as the two are intertwined. The reason why this
became a concern following the recent financial crisis is that investment
banking is inherently more risky than retail banking, but regulators are
reluctant to let retail banks fail because of the consequences of such a
failure, discussed below. Thus many universal banks around the world
which got into severe financial difficulties, in large part because of the
speculative activities of their investment banking operations, had to be
rescued with state funds, so as to protect depositors’ funds in their retail
operations and to prevent an escalation of systemic risk. The financial
crisis is discussed in more detail in Chapter 3.
In the absence of any regulations, bank failures may have two main
consequences:
• First, they are very costly, especially to the financers of the failing
bank (such as depositors and the bank’s stockholders) and, to a lesser
extent, to borrowers with a close relationship with the failing bank.
In addition, they may also be very costly to other banks, because
interbank lending accounts for a significant proportion of banks’
balance sheets.
• Second, bank failures interrupt the payment system because of the
pivotal position of banks in the management of the payment system.
Bank failures are more serious than failures in the other sectors of the
economy for two reasons. The unique feature of banks is that their
creditors (depositors) are also their customers. Contrary to non-financial
firms whose debt is held by professional investors (especially banks),
the debt of banks is held in large part by uninformed, dispersed, small
agents (mostly households) who are not in a position to monitor the
bank’s activities. The general public (depositors) lack the information
and expertise to differentiate between safe and risky assets (banks). In
any case, for each individual to have to evaluate the soundness of a bank
would be time-consuming and inefficient. The justification for regulation is
conveniently summed up as ‘For the protection of depositors’.
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Moreover, banks’ managers would not choose the optimal solvency ratio.
Self-regulation faces the problem of conflicts of interest inside the banks
– between managers, stockholders and bondholders. For example, in the
case of a bank with a small number of deposit-holders who manage the
bank themselves, these owner-managers will tend to choose an investment
policy that is more risky than the rest of the depositors would like. Because
of the lack of financial sophistication/information of these non-owner
depositors, some institution or regulation must defend their interests.
Read Dow (1996), an advocate of bank regulation.
Activity 5.1
Download the two articles in essential reading: Dowd (1996) and Dow (1996), advocates
of free banking and bank regulation respectively. Read these articles and summarise the
main arguments for and against each of the two systems in relation to the following
criteria:
i. moral hazard
ii. cost
iii. efficiency
iv. systemic risk
Now try and explain why most banking systems around the world are heavily regulated.
Arguments against regulation
The arguments so far presented favour the regulation of banks. However,
several arguments suggest that regulation can itself be a source of costs,
negative effects and instability.
The first argument is related to the costs in the form of real resources on
both the regulators and the regulated. These costs are of four types:
• the administrative costs of the regulatory authorities (i.e. employing
staff to monitor banks)
• the administrative costs associated with the banks’ own compliance
activities (i.e. staff to produce return required by the regulator)
• the cost of dedicated capital to comply with capital requirements (as
discussed in the next section)
• the contribution to funds needed to compensate the clients of other
banks which have failed.
To give you the magnitude of the first type of costs, the budget for the
mainstream regulatory activities of the Federal Reserve System (FRS,
one of several regulators in the US banking system) was $3268.1 million
in 2007 (in comparison, the value added of the US banking industry to
the gross domestic product is $569,700 million); while for the Financial
Services Authority (FSA, the UK bank regulator) this cost was £298.9
million in 2006–07. Given that these costs are relatively high, it is a
question of cost-benefit analysis to evaluate whether the benefits gained by
prudential regulation outweigh the costs incurred. This trade-off explains
why regulation should not be excessive but maintained at the minimum
required to prevent bank runs.
Activity 5.2
Find out who the bank regulator for your country is, and what the budget is for regulatory
activities. Have there been any problems in recent years? Did they lead to a scandal and
lots of press coverage? If so, were there changes in the regulations?
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24 Principles of banking and finance
Then there is the danger of regulation becoming so excessive that it
reduces competition (i.e. regulation constrains banks’ diversification by
limiting their portfolio choices or by restricting branching), it raises costs
(and thus reduces profitability) and it lowers the rate of financial innovation.
Another problem with regulation is that it creates moral hazard. Banks
may take more risk if they know they are likely to be bailed out if they get
into difficulties. Depositors are less likely to monitor what banks are doing
if they know there is a regulator monitoring on their behalf and if the
deposit insurance scheme provides full compensation in the event of bank
failure. As a consequence depositors are more likely to place their deposits
in banks paying the highest interest rates, which are likely to be the banks
taking the most risk. Thus regulation may actually encourage risk taking –
the very thing it is attempting to curtail.
Finally, there is the danger that excessive regulation imposed in one centre
will lead to the movement of the activity to centres where regulation is
lighter. This explains the aim of the European Union regulator to achieve a
common (called ‘harmonised’) regulation system across banks operating in
different countries, sometimes referred to as the creation of a ‘level playing
field’.
Activity 5.3
Reflect for a moment on the job of the EU regulator of banking. We have seen how
each country has its own unique mix of markets and banks, each with its own monetary
history, and we can imagine how depositors in Italy and Sweden, in Greece and Belgium
differ in what they want from their banks. Imagine you are a EU regulator of banking and
think of the problems you’d have.
Traditional regulation mechanisms
Having established that there is a case for banking regulation, we
investigate how regulation occurs in practice. There are several basic
categories of traditional regulation mechanisms:
• creation of a central bank
• bank supervision (restrictions on entry, bank examination)
• government safety net (deposit insurance)
• bank capital requirements
• assessment of risk management
• monitoring of liquidity
• disclosure requirements.
Next we will look at each of these in turn. As we consider the possibilities,
ask yourself how they contribute to solving the information asymmetry
problem. (Note how this links to our discussion above about protection of
depositors.)
Creation of a central bank
The creation of a central bank is a response to the need to control money
supply. The usual argument for justifying the government monopoly in
money supply is that the private issuance of means of payment could
easily generate fraud, counterfeiting and adverse selection problems.
In addition, controlling the money supply helps to stabilise the price
level (so-called monetary control). Since the mid-1980s, most monetary
authorities have used interest rates to implement monetary policy for the
purpose of achieving price stability.
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Chapter 5: Regulation of banks
The second key function of a central bank is related to prudential control,
which is the minimisation of financial crises (because of the social costs
incurred in the event of a crisis). In this respect the role of ‘lender of last
resort’ of a central bank matters in times of financial crisis, especially in
the UK system. In contrast, in the USA there has always been a great deal
of concern about the fact that a lender of last resort function could go
against free competition in the banking industry. As a result the emphasis
has always been on a decentralised structure of the central bank.
The Bank of England, founded in 1694, laid the foundation for the
development of central banks in other countries. The Federal Reserve Bank
(FRS, know as The Fed) was created as a central bank for the US banking
system as late as 1913. The Fed is made up of 12 regional Federal Reserve
Banks and a Board of Governors. The primary function of The Fed is to
pool the reserves of each of these banks. One of the most recent central
banks is the European Central Bank (ECB), which was set up in Frankfurt
in July 1998. The ECB, together with the central banks of the member
states, forms the European System of Central Banks.
Activity 5.4
Visit the website www.ecb.eu/ecb/html/index.en.html and summarise the structure and
the main functions of the European Central Bank.
Activity 5.5
Describe the structure and the main activities of the central bank of your own country.
Bank supervision: restrictions on entry and bank examination
Bank supervision, also referred to as prudential supervision, aims at
overseeing those who operate banks, and how the banks are operated.
It helps to reduce moral hazard and adverse selection in the banking
industry through restrictions on entry and bank examinations.
Chartering and licensing banks are two ways to prevent undesirable firms
from entering into the banking sector, adopted respectively in the USA
and UK. In the USA to operate as a commercial bank, a firm must obtain a
national or state charter, granted by either the Comptroller of the Currency
(an official in the US Treasury Department, in the case of a national bank)
or by a state authority (in the case of a state bank). To obtain a charter, the
potential bankers have to submit an application containing the operational
plan of the bank. The regulatory authority then evaluates the soundness
of the application (quality of the intended management, level of estimated
future earnings, initial capital).
In the UK any firm seeking recognised bank status from the Bank of
England must offer a broad range of services (including deposit accounts,
overdraft and loan facilities). A banking licence will only be issued to a
firm that is well capitalised (paid-up capital and reserves of at least £5
million), has an adequate system of liquidity, internal control and a good
quality of management. Moreover, the EU Second Banking Coordination
Directive permits banks operating in other EU countries to set up branches
throughout the EU on the basis of the authorisation provided by their own
home supervision authority.
Activity 5.6
Find out about the entry requirements in the banking sector of your own country, and
briefly summarise them. Do you think they are sufficiently tough – or too tough? Could
they be designed to keep out foreign competition?
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24 Principles of banking and finance
Banks’ regulatory agencies are responsible for ensuring that authorised
banks continue to operate in a prudent manner (so-called prudential
supervision) by carrying out bank examinations. An internationally
recognised framework used by bank examiners to evaluate banks is the
CAMELS system. Banks are scored on a scale of 1 (the best) to 5 (the
worst), assessing six areas:
1. Capital adequacy
2. Asset quality
3. Management quality
4. Earnings’ performance
5. Liquidity
6. Sensitivity to market risk.
Regulators can take formal actions to alter a bank’s behaviour (or even
close the bank) if the CAMELS rating is sufficiently low.
Activity 5.7
Now visit the website www.frbsf.org/econrsrch/wklyltr/wklyltr99/el99-07.html and
summarise the main assessment areas of the CAMELS rating.
Government safety net
There are three ways in which governments provide a safety net for
depositors:
• central bank as a ‘lender of last resort’
• deposit insurance
• direct funding by the government to troubled institutions.
Lender of last resort
The lender of last resort function is the provision of liquidity by the central
bank to a bank (or the banking system as a whole) in times of financial
distress. The central bank provides liquidity in exchange for financial
assets. The function therefore increases the liquidity of the distressed
bank’s balance sheet but does not increase the value of its assets. Normally
the central bank only provides liquidity to banks that are solvent. However
the distinction between a solvent and insolvent bank is not always clearcut, especially during a financial crisis. As we saw in Chapter 3 central
banks around the world had to provide massive injections of liquidity into
their banking systems in response to a severe liquidity crisis.
The lender of last resort function can increase moral hazard as it may
lead banks to expect liquidity support from the central bank if they get
into difficulties. This may reduce the incentive of the bank to manage
its liquidity risk effectively. The solution to this is for the central bank to
provide liquidity support at rates that are higher than market rates in noncrisis periods.
See Freixas et al. (1999) for further discussion of the lender of last resort
role. Think about the moral hazard consequences of central bank liquidity
support to banks during and after the global financial crisis of 2007–09.
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Chapter 5: Regulation of banks
Deposit insurance
To avoid runs on banks and bank panics, governments have established
deposit insurance schemes to provide protection for depositors. It is based
on the notion that depositors have less incentive to join a run if they
know their deposit is protected by an insurance scheme in the event of a
bank failure. Under these schemes the bank pays a premium to a deposit
insurance company, such as the Federal Deposit Insurance Corporation
(FDIC) in the USA, and in exchange its depositors have their deposit
insured, up to a fixed limit, in case the bank fails.
In the USA deposit insurance mechanisms were developed in 1934 by the
Federal Reserve Bank as a response to the Great Depression bank panics.
The steep decline in the bank failure rate from 28.16 per cent in 1933 to
0.37 per cent in 1934 after the establishment of the FDIC is commonly
regarded as evidence of the effectiveness of deposit insurance in stabilising
the banking industry. Following the USA, deposit insurance was later
adopted by most developed countries with different modalities:
• Insurance may be compulsory (all the members of the Federal Reserve
System in the USA) or simply voluntary (non-members if they meet the
FDIC admission criteria).
• Insurance limits may differ widely from $250,000 in the USA to
£50,000 in the UK (the UK limit will rise to the £sterling equivalent of
100,000 Euros in January 2011).
• Insurance may cover different percentages of deposits, though the
financial crisis of 2007–2009 saw most authorities raise the percentage
of deposit covered to 100 per cent. Prior to October 2008 the UK
deposit insurance coverage was 100 per cent of the first £2,000 then 90
per cent of the next £33,000.
In the USA the FDIC uses two primary methods to handle a failed bank. In
the first method, called the payoff method, the FDIC pays off deposits
up to the $250,000 insurance limit. After the bank’s liquidation, the
FDIC lines up with other creditors of the bank and receives its share of
the proceeds from the liquidated assets. Typically, account holders with
deposits in excess of the $250,000 limit get back more than 90 per cent
(but the process can take several years). In the second method, called
purchase and assumption method, the FDIC finds a merger partner
who takes over all the deposits of the failed bank (not just those under
$250,000) so that no depositor loses any money. This method has been
used to implement the FDIC’s policy called too-big-to-fail: the big
insolvent banks would get a large infusion of capital from the FDIC, which
would then find a merger partner to take over the insolvent banks and
their deposits. Originally the policy was limited to the 11 largest US banks,
but has now been extended to big banks in general.
The main problem with a system of 100 per cent insurance of deposits is
that it creates a moral hazard problem. Depositors do not have incentives
to monitor a bank’s activities: they do not withdraw deposits when they
suspect that the bank is taking too much risk, as they know that they will
not suffer losses if the bank fails. As a consequence, a bank’s management
will have an incentive to undertake greater risks than they would
otherwise have done. In addition, the problem with the too-big-to-fail
policy is that it increases the moral hazard problem for big banks.
A solution to the moral hazard problem lies in the use of a least cost
approach for resolving bank failures, as adopted in the USA in 1991 by
introducing the Federal Deposit Insurance Corporation Improvement Act
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24 Principles of banking and finance
(FDICIA). Riskier banks are required to pay higher insurance premiums
to the FDIC. If there is a system of risk-based deposit insurance premiums
then banks will have an incentive to reduce these risks.
Another solution to the moral hazard problem is the use of a
co-insurance approach, which was the system in the UK prior to
October 2008. The amount of deposit insured under the scheme would
be less than 100 per cent (the coverage in the UK was, 100 per cent of
the first £2,000 and 90 per cent of the next £33,000). Depositors have
greater incentives to monitor (because of the threat of losing some of
the deposits), but the percentage lost has to be kept to a (low) level that
provides the incentive not to join a run. Note that banks pay a flat-rate
premium linked to their deposits.
Activity 5.8
Visit the website www.fdic.gov/deposit/insurance/risk/rrps_ovr.html and find an overview
on risk-based assessment system. Summarise the main characteristics of each group.
Too-big-to-fail problem
The too-big-to-fail problem (also known as the too-important-to-fail
problem) became a major issue during the 2007–09 financial crisis as
many large banks came close to collapse. Too-big-to-fail banks, or large
systemically important banks as they are often referred to, are banks
that are considered to be so important within financial markets that their
failure would have a catastrophic effect on those markets. The solution
used for large distressed systemically important banks during the financial
crisis was to use government funds to provide capital injections to the
banks. In the US a number of banks were provided with capital injections
under the Troubled Asset Relief Program (TARP). These included Citigroup
and Bank of America which both received $45 billion of capital from the
US government in return for the government having an equity stake in
those banks. In the UK Lloyds Group and Royal Bank of Scotland (RBS)
received capital injections from the government of £20.3 billion and £45.5
billion giving the government equity stakes of 41 per cent and 84 per cent
in these banks respectively.
These rescues have reinforced the view that some institutions are too
big to be allowed to fail and this clearly causes a moral hazard problem.
Before the crisis, though, there was a widely held view that large scale
meant diversification and sophistication and this justified large banks
having lower capital requirements. The repeal of the Glass-Steagall Act
was also partly based on the view that large diversified institutions were
beneficial due to economies of scale and diversification. Since the crisis
this view has been challenged and solutions have been sought for the toobig-to-fail problem. There are essentially three solutions:
i. actions to reduce the probability of failure of these institutions while
leaving the size and range of activities unchanged
ii. actions to reduce the size of these institutions or to make them less
interconnected or to separate activities within the institution
iii. actions to increase the range of resolution options, in particular to
set out in advance resolution and recovery plans (often called ‘living
wills’).
To achieve i, larger banks will be required to hold larger amounts of
capital and liquidity than smaller banks (a reverse of the policy pre-crisis).
This has been the approach adopted in Basel 3 discussed below. To achieve
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Chapter 5: Regulation of banks
ii one proposal put forward is to move to a system of ‘narrow banking’.
Under this proposal banks that take in insured retail deposits and provide
retail payments systems would only hold government bonds as assets. See
Kay (2009) for more detail. An alternative proposal is for a ‘new’ GlassSteagall Act that prohibits retail banks’ involvement in proprietary trading
of assets. In other words retail banks would not be allowed to engage in
trading assets such as CDOs that expose them to market risk. Finally, to
achieve iii, there is now widespread acceptance that large banks need to
produce ‘living wills’ that can be used to conduct an orderly-wind up of the
bank in the event that it gets into severe financial difficulties. In practice
regulatory authorities are likely to use a combination of all of these
solutions to mitigate the too-big-to-fail problem.
Activity 5.9
Download the report by John Kay on narrow banking from www.johnkay.com/wpcontent/uploads/2009/12/JK-Narrow-Banking.pdf
Can you see any problems with the concept of narrow banking? Would narrow banks be
intermediaries as defined in Chapter 4 of this subject guide?
Bank capital requirements
Bank regulations can reduce the bank’s incentive to take risks by
introducing restrictions on asset holding and bank capital requirements, in
particular:
1. restriction on holding risky assets (i.e. ordinary shares, known in the
USA as common stocks)
2. limitation on the amount of loans, in particular the categories of the
individual borrowers
3. reduction of the risk of the loan portfolio by diversification
4. maintenance of a sufficient level of bank capital.
This last point suggests that the level of a bank’s capital is important in
minimising the risk of insolvency of a bank (a long-term concept referring
to the prospective ability of the bank to meet all its liabilities). Let us think
a bit more about what exactly a bank’s capital is. A bank’s capital, equal
to issued share capital and accumulated reserves, is the margin by which
creditors are covered if the bank’s assets were liquidated. The capital
absorbs any losses incurred by the bank on assets, and thus protects
depositors and other creditors.
Example: Consider a bank that has the following balance sheet:
Assets($)
Liabilities ($)
Liquid assets
15
Government bills
20
Capital
10
Loans
65
Deposits
90
Total
100
Total
100
Suppose that a number of a bank’s customers unexpectedly default and
the value of loans in the balance sheet is reduced by $5. What would be
the consequence for the shareholders of the bank? The value of capital has
to be reduced by $5 as well. Thus the shareholders bear the risk taken by
the bank, while depositors are protected from asset losses by the bank’s
capital.
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24 Principles of banking and finance
Activity 5.10
What would be the consequence if the value of loans were reduced by $11?
Leverage capital ratio
A first measure of a bank’s capital requirement is the so-called leverage
capital ratio, which is the amount of capital divided by the bank’s total
assets.
Activity 5.11*
In the example above, what would the leverage capital ratio be?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
In the USA, under the Federal Deposit Insurance Corporation Improvement
Act (FDICIA), banks are now classified into five groups based on their
capital. Banks that are ‘well capitalised’ have a leverage capital ratio
exceeding 5 per cent, banks ‘adequately capitalised’ have a ratio higher
then 4 per cent, while banks ‘undercapitalised’ fail to meet capital
requirements. Banks in groups 4 and 5 are ‘significantly undercapitalised’
and ‘critically undercapitalised’, respectively.
The equivalent measure used in the UK is the so-called gearing ratio,
which is the amount of deposits and external liabilities divided by the
bank’s total capital and reserves. The lower the gearing ratio, the lower
the risk that the bank will lose its capital; therefore, the lower the risk
of insolvency. The Bank of England does not impose a specific ratio as
an acceptable measure: it will vary according to the nature of the bank’s
business and assets (consensus approach).
Risk–asset ratio under Basel 1
A second measure of a bank’s financial health is its risk–asset ratio,
which is required to be above a prescribed minimum. A risk–asset ratio
explicitly recognises that different assets on a bank balance sheet carry
different degrees of risk. Formally it is the ratio of capital to weighted risk
assets. The higher the risk associated with an asset, the greater the weight
the asset receives. All international banks supervised in member countries
(among the 100 countries are the USA, UK, Germany, France, Italy and
Japan) accept the measure stated in the Basel risk–asset ratio, under the
Basel Capital Adequacy Agreement of 1988 (now referred to as Basel
1, effective from January 1993). Under Basel 1, the minimum capital is
specified as a percentage of the risk-weighted assets of the bank:
Risk–asset ratio = Capital / Risk-weighted assets
For regulatory purposes a bank’s capital is divided into two components:
tier 1 and tier 2 capital. Tier 1 capital mainly consists of the issued share
capital and the disclosed accumulated reserves. Tier 2 capital is mainly
made up of medium- and long-term subordinated debt (debt instruments
that rank below all other debt in the event of a bank’s default), general
provisions and current year unpublished profits.
A risk-weighted asset is calculated as the value of the asset multiplied
by an appropriate risk rate. Four rates are used: 0 per cent (cash, cash
equivalents and government securities in OECD countries), 20 per cent
(interbank loans in OECD countries), 50 per cent (mortgages) and 100 per
cent (commercial loans). A higher risk weight implies a higher exposure
to credit risk. Off-balance sheet items are converted into credit risk
equivalents and then assigned an appropriate risk weight.
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Chapter 5: Regulation of banks
The Basel risk–asset ratio is set at a minimum of 8 per cent for the total
capital of each bank, and at a minimum of 4 per cent for Tier 1 capital.
Activity 5.12*
What risk–asset ratio would a bank have with capital of $1,600, cash $500, government
bills $1,500, mortgages $14,000 and commercial loans $12,000.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
The main problem of the risk–asset ratio is the underlying assumption of
risks’ independency, which permits a simple addition of the risk-weighted
assets. However, portfolio theory states that risks may be interdependent
in certain cases (we deal with this later in the guide): diversification
makes the risk of the whole portfolio lower than the sum of the risks of
individual securities (loans). Another problem with the risk–asset ratio is
that it treats all commercial loans as equally risky (that is, they are all riskweighted 100 per cent).
Market risk amendment
The risk–asset ratio of Basel 1 addressed a bank’s exposure to credit risk,
the risk that the promised cash flows from loans held by banks may not
be paid in full. An amendment to Basel 1 (introduced in 1998) aimed to
harmonise the treatment of market risk, the risk resulting from changes in
market prices (please refer to Chapter 6 for a further discussion on credit
and market risk). Market risk was incorporated into risk-based capital
by using the building block approach. A minimum market risk capital
requirement was set for any open positions in debt, equity and derivatives
held in the bank’s trading books (where trading refers to positions taken
with a view to resale for short-term profit). The long-term investments
held by the bank would be subject to the original credit risk capital
requirements. Therefore, the overall minimum capital requirement for a
bank will be given by the capital requirements to cover credit risk from
loans and long-term investments, and specific capital charges for market
risk arising from open positions.
An innovative feature of the market risk requirements is that they
provide, for the use of banks’ own internal ‘value-at-risk’ (VAR), models
for measuring market risk. The VAR model calculates an estimate of the
maximum amount a bank can lose on a particular portfolio over a given
holding period with an associate degree of statistical confidence (as
described in Chapter 6).
However, we saw in Chapter 3, in our discussion of the 2007–09 financial
crisis, that banks had massively increased their exposure to market risk
in the years preceding the crisis. When many of the securities giving rise
to the market risk exposure reduced significantly in value the capital held
against them was seen to be woefully inadequate. The response to this
by the regulatory authorities has been to dramatically increase capital
requirements for market risk – discussed below under Basel 3.
After implementation of Basel 1, the problems, discussed above, became
apparent and banks lobbied for a change in the rules. The Basel Committee
on Banking Supervision proposed a new capital accord (known as Basel 2).
Minimum capital under Basel 2
Under Basel 2, (effective from end 2006), no change was proposed for the
definition of capital, and the minimum capital coefficient of 8 per cent also
remained unchanged. However, two main changes were introduced:
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24 Principles of banking and finance
• The credit risk assessment was updated in two ways. First, the present
risk–asset ratio would be modified by separating commercial loans
into different classes according to their risk measured by credit ratings
from rating agencies (as described in Chapter 4). This is known as the
standardised approach. It overcomes the problem with the current
risk–asset ratio, which treats all loans as equally risky. Second, large
international banks would be allowed to use their own internally
generated credit rating (the Internal Ratings Approach) to determine
the riskiness of each loan. Both these new approaches have the effect of
reducing the capital required by banks.
• The current risk categories of credit risk and market risk are being
supplemented by a third risk category – operational risk, as described in
Chapter 6 – which in future will have to be explicitly backed by capital.
Under Basel 2, the minimum capital is specified as a percentage of the
risk-weighted assets of the bank plus capital charges for market risk and
operational risk:
Risk–asset ratio = Capital /Risk-weighted assets + (Capital charges for
market risk + Operational risk) x 12.5
Note, the 12.5 factor in this equation is used to convert the capital charges
to an 8 per cent minimum.
Another development in the Basel 2 Accord was to introduce the concept
of three pillars of regulation. The three pillars are:
1. minimum capital requirements – as discussed above
2. supervisory review –an assessment by supervisors of the risk
assessment processes used by banks
3. market discipline – greater disclosure of information by banks so that
markets can provide an additional element of monitoring of banks.
Activity 5.13
Visit the BIS website (www.bis.org/publ/bcbs107.htm) to get the full text of the
Accord. Moreover, visit the Bundesbank website www.bundesbank.de/bankenaufsicht/
bankenaufsicht_basel_saeule1.en.php and summarise the three main pillars of Basel 2.
Identify the innovations in comparison to Basel 1.
The financial crisis and Basel 3
Before Basel 2 had been fully implemented around the world the
financial crisis of 2007–09 occurred. However, as many countries had not
implemented Basel 2 before the financial crisis began in 2007, it is unfair
to say that the change to Basel 2 in some way created the crisis. However,
the crisis clearly revealed that banks operating under the Basel capital
adequacy framework (Basel 1 or 2) had insufficient capital in relation to
the risks they faced. This inadequacy of capital was in terms of exposure to
both credit risk and market risk.
104
Another criticism of the Basel capital adequacy framework is that it is
procyclical in its operation. That is, it exacerbated the strength of the
business cycle. Under the framework, capital requirements would tend
to fall during the economic upswing where lending growth is strong
and credit losses are low. This can tend to accentuate the upswing with
well-capitalised banks able to expand lending aggressively. Conversely,
in recessions capital requirements on banks increase as credit losses
accumulate and banks facing capital constraints may cut back lending
thus making the recession worse. As a consequence the amplitude of the
business cycle is increased.
Chapter 5: Regulation of banks
In response to these problems adjustments to the Basel Capital Accord
have been proposed by the Basel Committee (agreed in September 2010).
The adjusted Accord is known as Basel 3.
The main elements of Basel 3 are:
1. Common equity (defined as ordinary or common shares plus retained
earnings) should form a greater part of tier 1 capital. There will be
a minimum common equity to risk weighted assets ratio of 4.5%.
Note that under Basel 2 there is no formal definition of common
equity (sometimes referred to as core tier 1 capital). However, many
regulators imposed a minimum common equity to risk weighted assets
ratio of 2 per cent.
2. Tier one equity (made up of common equity plus other more strictly
defined capital instruments – mainly preferred stock) to risk weighted
assets must be greater than 6 per cent (compared to 4 per cent under
Basel 2).
3. Total capital (Tier 1 plus Tier 2 capital) to risk weighted assets must be
greater than 8 per cent (no change compared to Basel 2).
4. A capital conservation buffer equal to 2.5 per cent of risk weighted
assets and made up of common equity. This buffer will allow banks to
build up capital during ‘good times’ which can then be drawn on in
times of financial stress. Restricting banks from paying dividends as
capital approaches the minimum requirements will enforce this buffer.
5. In addition, national regulators will be able to impose an additional
2.5 per cent capital buffer when credit growth is judged to be excessive
and there is a build-up of system-wide risk (this is known as a countercyclical capital buffer). This capital buffer can then be released during
the downswing to enable banks to continue lending.
6. National regulators will also have further discretion to increase capital
requirements for large systemically important banks (to address the
too-big-to-fail problem discussed above).
7. There will also be a non-risk based leverage ratio to act as a ‘backstop’.
This will be a ratio of tier 1 capital to total assets. The level has not
been set at the time of writing but the proposal being tested is 3 per
cent. This will guard against banks increasing lending at an excessive
rate where this is not picked up by the risk-based measures.
8. Finally, there will be much higher capital requirements in relation to
market risk. These requirements will be implemented in 2011. This is
recognition that capital requirements against market risk were woefully
inadequate.
These requirements (except for 8) will be phased in between 2013 and
2019 to allow banks to increase their capital without harming economic
recovery as economies around the world recover from the economic
downturn that followed the financial crisis. It is important to note that the
level of common equity will go up from 2 per cent under Basel 2 to 7 per
cent (4.5 per cent + 2.5 per cent). In normal times banks will operate on a
7 per cent ratio. In times of financial stress banks will be allowed to reduce
the capital conservation buffer towards zero. In times of financial stress
the minimum common equity ratio will therefore be closer to 4.5 per cent.
So, under Basel 3, regulators are placing greater emphasis on common
equity to protect banks during times of financial stress. The procyclicality
problem is addressed by points (4) and (5).
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Activity 5.14*
The capital requirements for banks under Basel 3 can be summarised as (per cent of risk
weighted assets):
Common equity
Tier 1
Total Capital
Minimum
4.5
6
8
Conservation buffer
2.5
Minimum plus conservation
buffer
7.0
8.5
10.5
Counter-cyclical buffer range
0 – 2.5
Please see the following announcement from the Basel Committee on Banking
Supervision for more information – download from:
www.bis.org/press/p100912.pdf?noframes=1
Identify the following:
i. In normal times (when there is no financial stress) what is the minimum common
equity to risk weighted assets ratio?
ii. In times of financial stress what is the minimum common equity to risk weighted
assets ratio?
iii. Under Basel 3 and in normal times (where there is no financial stress) what is the
additional amount of total capital that banks have to hold in relation to risk weighted
assets compared to Basel 2?
iv. Where a regulatory authority applies the full counter-cyclical buffer to banks because
credit growth is expanding rapidly, what is the minimum common equity to risk
weighted assets that banks will be expected to meet?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Assessment of risk management
The assessment of risk management is a new trend in bank supervision.
Traditionally, the focus has been on assessment of the quality of the
bank’s assets at a specific point in time and on their compliance with
capital requirements. This is no longer felt to be adequate due to financial
innovation. The use of new instruments (e.g. derivatives trading) implies
that a bank that is quite healthy at a particular point in time can become
insolvent very rapidly because of trading losses. This concern was
heightened by the collapse of Barings in February 1995 following losses
sustained in derivates trading. (Read Mishkin and Eakins (2009), p.439 to
understand better Barings’ problem.) This problem was addressed in Basel
2 by (i) new capital requirements for operational risk and pillar 2 which
allows supervisors to assess the risk assessment processes and models used
by banks.
In the USA, bank examiners now place more emphasis on evaluating the
soundness of risk management systems (as described in Chapter 6). Now
bank examiners give a separate risk management rating to be included
into the management component of the CAMELS system.
Macro-prudential policy
The traditional approach to regulation described in this chapter is
prudential regulation of individual banks through setting rules on capital
and liquidity adequacy through to bank examinations. This approach
can be termed micro-prudential regulation as it is aimed at preventing
systemic failure of the banking system (the primary aim of regulation) by
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Chapter 5: Regulation of banks
preventing the failure of individual banks. However, the financial crisis
of 2007–09 showed that this approach failed to identify and prevent the
build-up of systemic risk in the banking sector through common exposure
to asset price bubbles and high degrees of inter-connectedness through
derivatives and wholesale funding of liquidity. This has led regulators to
consider an alternative approach to regulation – termed macro-prudential
regulation – that aims to identify the build-up of systemic risk in banking
due to external factors and to develop tools for intervening to reduce such
systemic risk. Basel 3 introduces a macro-prudential element to capital
controls with the capital conservation buffer and the discretionary capital
buffer regulators can impose when credit growth in the banking system
as a whole is growing excessively. This will need to be augmented with
other monitoring and intervention techniques by national regulators. This
is discussed further in a Bank of England discussion paper on the role of
macroprudential policy (2009).
Activity 5.15
i. Try to explain how the capital conservation buffer and the discretionary capital buffers
introduced under Basel 3 (and discussed earlier in this chapter) may help regulators
to manage systemic risk.
ii. Read again the section on financial bubbles in Chapter 3 and then think about how
regulators might intervene to prevent a financial bubble developing in the housing
market.
Monitoring of liquidity
Liquidity is a short-term concept referring to the inability of a bank to meet
deposit withdrawals even though it is viable in the long run. Liquidity
can be provided in several ways: holding cash or assets which are easily
liquefied, having an appropriate mismatching of portfolio cash flows from
maturing assets, maintaining an appropriately diversified deposit base and
having access to wholesale markets. These techniques are discussed in
more detail in Chapter 6.
Liquidity risk assessment was not given as much attention by regulators
as capital assessment in the years before the financial crisis. Many banks
became heavily reliant on wholesale funding and securitisation as sources
of liquidity. As concerns about the solvency of some banks and the quality
of securitisation products increased, these sources of liquidity began
to close down as banks found they could no longer securitise assets or
borrow easily from other banks through wholesale markets. As we saw in
Chapter 3 in our discussion of the financial crisis, the early stages of the
crisis showed up as liquidity problems at banks. Unprecedented levels of
liquidity support were required from central banks in order to sustain the
financial system and even with such extensive support a number of banks
failed, were forced into mergers or required resolution.The regulators
have therefore turned their attention to strengthening liquidity monitoring
of banks. The Basel Committee on Banking Supervision has proposed
that banks should hold more high quality liquid assets. The high quality
liquid assets should be assets that are capable of being sold (to generate
liquidity) even during periods of extreme financial stress. During the
2007–09 financial crisis government bond markets operated reasonably
normally; therefore bank regulators are likely to require banks to hold
more high quality government bonds.
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24 Principles of banking and finance
Activity 5.16
Think about the difference between a liquidity problem and an insolvency problem (where
assets are less than deposits). Try to understand why increasing the amount of capital at
a bank would help banks to increase their protection against insolvency but would not
directly protect them from liquidity problems.
Disclosure requirements
Bank regulators can require the adherence to certain standard accounting
principles and the disclosure of a wide range of information in order
to enable the market to assess the quality of a bank’s portfolio and the
amount of the bank’s exposure to risk. The disclosure of more public
information aims to solve the free-rider problem (described above), which
is the lack of incentives for individual depositors and other bank creditors
to produce private information about the quality of a bank’s assets.
The rationale is that market discipline has an important role to play in
constraining a bank’s risk exposure. As we note above the third pillar of
the Basel capital adequacy framework is market discipline.
The basic bank disclosure issue relates to the amount of detail that should
be supplied (i.e. with respect to non-performing assets, loan-loss reserves,
derivatives activities) because more effective disclosure means greater
transparency. In the USA the fact that bank regulators have become
more ‘user-oriented’ in terms of financial disclosure is a manifestation
of the ‘SEC effect’, which is the recognition of the need that (actual
and potential) stockholders have full information through disclosure
for making investment decisions. The ‘SEC effect’ mainly materialises
as follows. First, banking agencies must adopt disclosure requirements
substantially similar to the corresponding SEC regulations or publish
reasons for the difference. Moreover, The Fed and FDIC have established
Securities Disclosure Units (such as mini-SECs) within their own agencies.
A bank with 500 or more shareholders is subject to SEC disclosure
standards.
A bank regulatory system can also be totally founded on disclosure
requirements, as with the new alternative approach recently implemented
in New Zealand (see next section).
Alternatives to traditional regulation: disclosure-based
regulation of banking
An alternative to the traditional approach to the prudential regulation of
the banking system has been undertaken in New Zealand since 1996. This
system is based on disclosure requirements and uses market discipline
to police the behaviour of banks. The rationale of this system is largely
derived from the free banking approach previously discussed.
The focus in New Zealand is on providing depositors and investors with
reliable and timely information to assist them in making well-informed
investment decisions, and on requiring issuers of securities and providers
of financial services to comply with general consumer protection law.
Unlike many countries, which have explicit depositor and investor
protection objectives in the regulation of financial institutions and
markets, New Zealand has no deposit insurance scheme and no explicit
depositor protection objective in any financial sector regulation. Similarly,
there is no investor protection scheme.
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Chapter 5: Regulation of banks
In New Zealand the approach to bank supervision is based on three pillars.
The first pillar is ‘self discipline’, which involves reinforcing the incentives
for banks to maintain the systems and capacity to identify, measure,
monitor and control their risks and maintain prudent operations. This is
the most effective means by which systemic soundness can be promoted,
given that a bank’s directors and senior management team are best placed
to understand, and to take responsibility for, the management of their
banks’ risks. The aim is to align closely the incentives facing bank boards
and the public policy objective of promoting a sound financial system. The
main mechanisms for achieving this are:
• promoting high quality, regular and timely financial public disclosure
by banks, to sharpen the incentives for the prudent management of
risks
• promoting accountability for a bank’s directors, by requiring directors
to sign attestations in their bank’s public disclosure statement on
matters relating to the adequacy of their bank’s risk management
systems
• avoiding explicit or implicit government support for banks, and thereby
sharpening the incentives for bank directors and senior management to
take responsibility for their banks.
The second pillar is ‘market discipline’. This is an important complement
to self-discipline, as it helps to reinforce the incentives for the prudent
management of banks. In an efficient market, the market rewards wellrun banks through a number of mechanisms (including through lower
pricing for funding, greater access to funding, greater market share and
higher share price). In contrast, poorly run banks tend to be penalised
by the market. The ultimate market discipline for a bank is the capacity
for creditors – particularly retail and wholesale depositors – to run on
the bank, potentially forcing its closure. Effective market discipline is
implemented in a number of ways:
• maintaining a contestable and competitive banking system – there is no
limit on the number of banks that may be registered in New Zealand
• maintaining strong incentives for depositors to monitor and exert
discipline on banks, by not having deposit insurance
• ensuring that the market is well informed about a bank’s financial
performance and condition, by requiring banks to issue quarterly
disclosure statements and by requiring them to maintain and disclose a
credit rating
• maintaining a relatively low level of supervisory intrusion in the
banking system, to reinforce the market’s view that the central bank
(Reserve Bank of New Zealand) does not take responsibility for the
prudent management of banks’ risks.
The third pillar is ‘regulatory discipline’, or rather the use of limited
regulatory and supervisory mechanisms by the central bank to reinforce
incentives for banks to manage their risks prudently. The regulatory
intervention is kept to a minimum to avoid creating unintended distortions
to banking behaviour. The main involvement of the central bank
comprises:
• registering banks, by which the central bank seeks to ensure that only
entities of good standing and sound risk management capacity may
operate as registered banks
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24 Principles of banking and finance
• imposing selected prudential requirements on banks to reduce the
probability of bank distress or failure to a very low (but not zero) level.
Currently, the main prudential requirement relates to minimum capital
ratios relative to risk weighted exposures
• imposing particular corporate governance requirements on locally
incorporated banks relating to the composition of a bank’s board of
directors
• requiring banks to issue quarterly disclosure statements covering
a range of financial and prudential information and requiring the
disclosures to be externally audited at financial year’s end and subject
to audit review at the half year
• monitoring banks’ financial and prudential condition on a regular basis,
mainly using their public disclosure statements
• meeting with banks’ senior management on an annual basis to discuss
banks’ strategic direction and risk management issues, and meeting
with the boards of directors of systemically important banks and with
the auditors of banks on a regular basis
• taking actions to respond to financial distress events – such as acting as
lender of last resort to a solvent but illiquid bank, or giving directions
to a bank in acute financial distress.
The Reserve Bank has responsibility for the registration and supervision
of banks for the purposes of promoting the maintenance of a sound
and efficient financial system and of avoiding significant damage to the
financial system, which could result from the failure of a registered bank.
Unlike the supervisory authorities in many countries, the central bank does
not register and supervise banks for the purpose of depositor protection:
the focus is systemic stability. Another point of departure from the bank
licensing arrangements of many countries is that, in New Zealand, it is
not the business of banking that is subject to a licensing process; it is only
the right to use the word ‘bank’ in a name, title or (in some situations)
advertisements that is subject to registration. Any entity can conduct
banking business, including deposit-taking, without being registered
as a bank or being licensed in any other way. Indeed, registered banks
are the only financial institutions in New Zealand that are subject to a
comprehensive licensing and supervision framework.
Critics of the New Zealand approach mainly argue that:
• banks may be less willing to admit problems if that information is to be
made public
• depositors may not have the expertise to understand the information
disclosed
• unlimited liability for directors may discourage the best people from
taking these positions, thus weakening the management of banks.
International banking regulation
Particular problems in bank regulation derive from the international
nature of banking: banks can readily shift their business from one country
to another. While regulators can closely supervise the operations of
domestic banks in their own country, they have problems in examining
the foreign operations of domestic banks or foreign banks with domestic
branches. Moreover, in the case of international banking, it is not always
clear which national regulator should have primary responsibility for
supervising the bank.
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Chapter 5: Regulation of banks
A bank may exploit this by obtaining its licence in a country with weak
regulation but conduct most of its operations in other countries. Read
Mishkin and Eakins (2009) p.523 to better investigate the difficulties of
regulating international banking, highlighted by the Bank of Credit and
Commerce International (BCCI) scandal in 1991.
In July 1992 the problems revealed by BCCI led to the Bank for
International Settlements (and in particular, the Basel Committee) issuing
a new set of minimum standards for the supervision of international
banking. Under this agreement, a bank operating in many countries will be
supervised by a single home-country regulator, which can ‘capably perform
consolidated supervision’, with enhanced powers to acquire information.
In addition, where a regulator believes that the home country regulation
of a bank is not effective, it can restrict the operations of the foreign bank.
Following this development, cooperation among regulators in different
countries and standardisation of regulatory requirements represent the
new trend in banking regulation. In this direction there have been the
EU Second Banking directive (creation of the EU passport as discussed
in Chapter 3), and the complementary directives aimed at providing
harmonisation of solvency regulation across the EU (Basel 1,Basel 2 and
Basel 3, as previously described).
Summary
To explain why banks are singled out for heavier regulation than other
sectors of the economy is also to explain why banks should be regulated
at all (free banking against banking regulation). There are three main
reasons for banking regulation:
• the fragility of banks, due to their role in providing liquidity insurance
to depositors and in screening and monitoring borrowers
• the existence of systemic risk, due to a run on solvent banks owing to
the asymmetric information problem
• the need to protect depositors because of their lack of the necessary
expertise and knowledge to assess the quality of the bank.
Having established that there is a case for banking regulation, in this
chapter we investigated the traditional regulation mechanisms used in
most countries:
• creation of a central bank
• bank supervision (restriction on entry and bank examination to oversee
who operates banks and how they are operated)
• government safety net (mainly through deposit insurance to avoid bank
panics)
• bank capital requirements (restrictions on measures such as leverage
capital ratio and risk–asset ratio to reduce the bank’s incentives to take
risks)
• assessment of risk management, monitoring of liquidity and disclosure
requirements.
An alternative mechanism (implemented in New Zealand) is based on
disclosure requirements only and uses the market discipline to police the
behaviour of banks.
The financial crisis of 2007–09 revealed many important deficiencies in
traditional bank regulation mechanisms including capital requirements
for credit and market risk and assessment of liquidity. These have been
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partly addressed by Basel 3 capital requirement changes and related
developments in the areas of liquidity assessment.
The final issue examined is the trend towards greater harmonisation of
banking regulation across the world.
Key terms
assessment of risk
management
bank capital requirements
bank examination
bank supervision
banking regulations
bank’s capital
Basel 1,2 and 3
central bank
co-insurance approach
counter-cyclicality
deposit insurance
disclosure requirements
fragility of banks
free banking
gearing ratio
government safety net
least cost approach
lender of last resort
leverage capital ratio
macro-prudential policy
monitoring of liquidity
narrow banking
payoff method
procurement and
assumption method
procyclicality
protection of depositors
prudential regulation
prudential supervision
restrictions on entry
risk asset ratio
systemic risk
too-big-to-fail
A reminder of your learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain why banks need regulation
• illustrate the main cases of non-regulated banking systems in history
and explain their economic rationale
• explain the main arguments for and against the regulation of banking
systems
• explain how banks are regulated through traditional regulation
mechanisms
• discuss the problems with the traditional regulation mechanisms
revealed by the global financial crisis of 2007–09.
• evaluate the response of the Basel Committee on Banking Supervision
to the global financial crisis of 2007–09
• illustrate alternative regulation mechanisms
• discuss the main implications of the recent trend in harmonising bank
regulation across the world.
Sample examination questions
1. a.
b.
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Why do banks need regulations?
How can deposit insurance provide stability in the banking system?
2. a.
What are the forms of regulations designed to reduce moral hazard problems created by deposit insurance? Do they completely eliminate the moral hazard problem?
b.
What are the costs and the benefits of the ‘ too-big-to-fail’ policy?
What are the recent regulatory restrictions to the use of this policy?
Chapter 5: Regulation of banks
3. a.
Which bank regulation concerns bank capital requirements? Discuss the system of capital regulation under Basel 1 and the main innovations introduced by Basel 2.
b.
What forms does bank supervision take, and how does it help in promoting a safe and sound banking system?
c.
How can disclosure requirements be used in banking regulation?
Compare and contrast the experience of the USA and New Zealand.
4. a.
Discuss to what extent the new Basel 3 capital requirements solve
the problems revealed by the financial crisis of 2007–09.
b.
Discuss how effective the changes introduced in Basel 3 will be in
preventing systemic risk in banking.
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Notes
114
Chapter 6: Risk management in banking
Chapter 6: Risk management in banking
Aims
The aim of this chapter is to explain the importance of risk management
in modern banking, and to illustrate the economic rationale and technical
aspects of the main techniques and models used by banks to manage
credit risk, interest rate risk, liquidity risk and market risk. Furthermore
it describes with practical examples how banks’ managers use these
techniques and models in practice to protect against risk.
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain why risk management is important in modern banking
• illustrate the main types of risks faced by banks (credit risk, interest
rate risk, market risk, liquidity risk, operational risk)
• explain and use the main techniques employed by banks to manage
credit risk of single loans (screening and monitoring, credit rationing,
use of collateral, endorsement) and credit risk of a loan portfolio
(diversification)
• explain and use the main approaches developed to manage interest
rate risk (income gap analysis and duration gap analysis)
• explain how liquidity risk can be managed appreciating the benefits
and risks of the different methods
• explain the main method developed to manage market risk (value-atrisk).
Essential reading
Gordy, M.B. ‘A comparative anatomy of credit risk models’, Journal of Banking
and Finance 24(1–2) 2000, pp.119–49.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapter 24.
Further reading
Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The MIT
Press, 2008) Chapter 8.
Heffernan, S. Modern Banking. (Chichester: John Wiley and Sons, 2005)
Chapter 3.
Saunders, A. and M.M. Cornett Financial Institutions Management: a Risk
Management Approach. (New York, McGraw-Hill/Irwin, 2007) Chapters 8,
9, 10, 11 and 12.
References
Altman, E.I. ‘Managing the commercial lending process’ in Aspinwall, R.C. and
R.A. Eisenbeis Handbook of Banking Strategy. (New York: John Wiley &
Sons, 1985) [ISBN 9780471893141] pp.473–510.
Basel Committee on Bank Supervision Overview on the New Capital Accord. (Bank
for International Settlements, January 2001) p.27.
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Introduction
A major objective of banks is to increase returns to shareholders, without
incurring increased risks. The financial crisis of 2007–09 revealed in a
dramatic way the extent of the risks that banks had become exposed to
and the inadequacy of many techniques that banks had been using to
manage these risks. This has led to a rethink of risk management processes
by both banks and regulators.
Taxonomy of risk
Since the risks that a bank has to manage are diverse, several
classifications have been proposed, some of which are standard. The
classification we use stems from the classification of banking activities.
Thus, this section overviews the major risks facing banks:
• credit risk
• interest rate risk
• market risk
• liquidity risk
• operational risk.
The effective management of these risks is central to the banks’
performance, as explained in the following sections.
In this chapter we investigate how banks manage four of these risks: credit
risk, interest rate risk, liquidity risk and market risk. We also describe
the economic rationale and technical aspects of the main techniques and
models used by banks to manage their risks.
Credit risk
Credit risk is the risk that the promised cash flows from loans and
securities held by banks may not be paid in full. It is related to the risk of
default of a specific borrower, or to the risk of delay in servicing the loan.
In either case, the present value of the bank’s assets declines and this
undermines the solvency of the bank.
Clearly, credit risk is the most important risk connected with the assets
held by a bank. Figure 6.1 shows the percentage of total loans that were
more than 90 days overdue for repayment made by US commercial banks
and savings institutions since 1984. We can see from this figure that there
was an improvement over the 1990s in the credit quality of loans. The
credit quality then deteriorates sharply from 2007 as a result of the subprime mortgage crisis and the ensuing banking crisis and recession.There
are two main reasons for the improvement over the 1990s/early 2000s:
• First, the expansion of the US economy in the 1990s. Note, however,
that the recession in the economy determined a turnaround in this
pattern in the early years of the twenty-first century.
• Second, the improvements in the ways banks measure and manage
credit risk.
The sharp decline in credit quality in 2007 is driven mainly by defaults
on mortgage loans. One thing that is clear from Figure 6.1 is that an
important factor determining credit risk is the state of the economy.
As discussed later in this chapter, banks can manage credit risk by
screening and monitoring, credit rationing, use of collateral, endorsement
and diversification.
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Chapter 6: Risk management in banking
6.00 %
5.00 %
4.00 %
3.00 %
2.00 %
2010: Q2
2009: Q1
2007: Q4
2005: Q2
2006: Q3
2004: Q1
2001: Q3
2002: Q4
2000: Q2
1999: Q1
1997: Q4
1995: Q2
1996: Q3
1994: Q1
1991: Q3
1992: Q4
1990: Q2
1989: Q1
1987: Q4
1985: Q2
1984: Q1
0.00 %
1986: Q3
1.00 %
Figure 6.1: Non-current loan rate. FDIC-insured commercial banks and
savings institutions 1984–2010
(Note: Non-current loans are loans that are 90 days or more past due.) Graph created
using data from: Federal Deposit Insurance Corporation, Quarterly Banking Profile, 2010,
www.fdic.gov
Interest rate risk
Interest rate risk is the risk incurred by a bank when the maturities of
its assets and liabilities are mismatched and there are changes in market
interest rates. This risk derives from a primary function of banks, known
as maturity transformation (as described in Chapter 4): the liabilities
(deposits) of banks are on average of a much shorter maturity than their
assets (loans). A classic example of this type of mismatch was the large
number of thrift institutions that suffered insolvency when interest rates
unexpectedly increased in the 1980s. (Please refer to Chapter 2 for a
description of the activities of a thrift institution; and read Mishkin and Eakins
(2009), p.490–91 for a description of their insolvency during the 1980s).
The change in market interest rates determines two main risks for a
financial intermediary:
• Income effect. This is either:
the risk that the cost of reborrowing funds will be higher than the
returns earned on asset investments, in the presence of longer-term
assets relative to liabilities (known as refinancing risk).
Example: Consider a bank borrowing $100 (liability) for one year,
and investing in a $100 (asset) for two years. The maturity of its
asset is longer than the maturity of its liability. Suppose that the
cost of funds (liability) is 9 per cent per year, and the interest return
on the asset is fixed for the 2 years at 10 per cent per annum. The
bank faces the risk that interest rates change at the end of year 1. If
interest rates increase and the bank can only borrow a new oneyear liability at 11 per cent, the bank would experience a loss over
the second year of the investment (that is, 10 per cent asset return
minus 11 per cent cost of funds).
A good example is given by thrift institutions during the 1980s
(mentioned above).
or
the risk that returns on funds to be reinvested will be lower than the
cost of funds, when the bank holds shorter-term assets relative to
liabilities (referred to as reinvestment risk).
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24 Principles of banking and finance
Example: Consider a bank borrowing $100 (liability) at 9 per cent
(cost of funds) for two years, and investing $100 (asset) at 10 per
cent (return on assets) for one year. The maturity of its liability is
longer than the maturity of its assets. The bank is exposed to an
interest rate risk: it does not know at which rate it can reinvest
in the second period. Suppose that the interest rate earned on its
assets falls to 8 per cent at the end of the first year; in this case the
bank would face a loss (that is, 8 per cent asset return minus 9 per
cent cost of funds). In recent years, a good example of this exposure
has been provided by banks that borrowed fixed-rate deposits, while
investing in variable rate loans.
• Market value effect. This risk refers to the change in the present
value of the cash flows on assets and liabilities. As we will see in
Chapter 7, the price of an asset or liability is equal to the present value
of the relevant cash flows. Therefore, rising interest rates increase the
discount rate on those cash flows and reduce the price of the asset or
liability. Conversely, falling interest rates increase the price.
Banks protect themselves against interest rate risk by matching the
maturity of their assets and liabilities. Therefore, matching maturity is
generally seen as the best method to hedge interest rate risk for a bank.
Note, however, the matching maturities policy is not necessarily consistent
with the active asset transformation function (i.e. transforming shortterm deposits into long-term loans, as we described in Chapter 4) and
may also reduce profitability (i.e. lower returns from risk-bearing asset
transformation). As a result, in the real world, all banks tend to mismatch
their balance sheet maturities to some degree.
To manage interest rate risk, banks use two main methods: income gap
analysis and duration gap analysis (discussed later in this chapter).
Market risk
Market risk is the risk related to the uncertainty of a bank’s earnings on
its trading portfolio caused by changes in the market conditions, such
as interest rates, equity return, exchange rates, market volatility, and
market liquidity. Therefore market risk is actually a collection of different
risks including interest rate risk, equity price risk, commodity price risk
and foreign exchange risk. These risks are associated with active trading
of assets and liabilities (and derivatives) rather than holding them over
longer horizons. Note that assets held for trading are held in a bank’s
trading book which is distinct from the loans held in a bank’s banking
book. In recent years, trading activities of banks have risen considerably,
and the income from them has increasingly replaced the income from
traditional banking activities (loans and deposits). The financial crisis
of 2007–09 revealed the extent of the build-up of risk in banks’ trading
books and the inadequacy of the capital held to protect a bank against
trading book losses. One problem in particular that emerged was that
banks’ trading books had become increasingly exposed to credit risk as
banks held mortgage-backed securities and other structured securities such
as CDOs along with credit derivatives. These securities had (an indirect)
credit risk exposure as the value of them was linked to some underlying
set of loans. However, as they were securities they were put in the trading
book and benefited from lower capital requirements. The differences in
capital requirements for banking book and trading book exposures may
actually have contributed to regulatory arbitrage, encouraging banks to
securitise assets in the banking book and hold more credit risk exposures
in the trading book. In Chapter 5 we covered the changes to the regulatory
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Chapter 6: Risk management in banking
regime introduced after the financial crisis to try to eliminate this
regulatory arbitrage and to assess more appropriately the level of capital
banks need to set aside against market risk. Indeed, as we saw in Chapter
5, some commentators have suggested that banks should not be allowed to
engage in both collecting retail deposits and trading assets.
The method for measuring market risk exposures is to calculate the Value
at Risk (VaR) and then to hold capital to cover this. We examine the VaR
method later in this chapter.
Activity 6.1
Try to understand the difference between credit risk and market risk. Why do you think
regulators seriously underestimated the amount of capital banks had to set aside against
market risk prior to the financial crisis of 2007–09?
Liquidity risk
Liquidity risk for a bank comes in a number of forms. On the liabilities side
of the balance sheet it comes from loss of funding. A bank’s main funding
is essentially made up of two types: retail funding and wholesale funding.
As we will examine later in this chapter the increasing reliance by banks
on wholesale funding as a result of practising liability management has
increased banks’ exposure to loss of wholesale funding in times of financial
market stress. However, much of the literature on liquidity risk focuses on
the risk of an unexpected large withdrawal of funds by retail depositors
(and the consequent obligation for the bank to make payments) which
may oblige the bank to liquidate assets in a very short period of time and
at low prices. This type of risk comes from the specificity of the demand
deposit contract: depositors are allowed to demand repayment of their
money at any time. If enough depositors demand repayment then a ‘run’
develops on the bank and as we saw in Chapter 5, the ‘run’ mentality can
be contagious and this gives rise to systemic risk.
The assets side of the balance sheet liquidity risk can come from the
ability of a bank to sell/securitise assets to raise funding. This is a market
related liquidity risk as a banks’ ability to raise liquidity by selling/
securitising assets depends to a large extent on the state of the market it
is trying to sell/securitise into. In times of financial stress it may not be
possible to sell assets quickly or securitise them. Before the financial crisis
of 2007–09 many banks had come to rely upon regular securitisation of
mortgage assets to fund to new business. In times of financial stress it
may not be possible to securitise, so banks that had become dependent
on securitisation (e.g. Northern Rock in the UK) found themselves with a
severe illiquidity problem.
The management of liquidity risk by banks includes diversifying funding
sources and holding a greater stock of high quality liquid assets that can
be sold in times of financial stress. We will examine methods of liquidity
management later in this chapter. Mechanisms to limit the possible
contagion of liquidity problems including deposit insurance, lender of last
resort and capital requirements are explained in detail in Chapter 5.
Operational risk
Operational risk is ‘the risk of direct or indirect loss resulting from
inadequate or failed internal processes, people, and systems or from
external events’ (the definition provided by the Basel Committee on Bank
Supervision, 2001, Bank for International Settlements). The Bank for
International Settlements (BIS) is the principal organisation of Central
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24 Principles of banking and finance
Banks in the major economies of the world, and as we saw in Chapter
5, the Basel Committee issued the Basel 1, 2 and 3 Capital Accords. As
discussed in Chapter 5, under Basel 2, the Basel Committee has proposed
that operational risk will be a new type of risk to be considered in
determining a banks’ capital requirements.
Activity 6.2
Visit the Bank for International Settlements website www.bis.org/publ/bcbs42.htm and
summarise the main sources of operational risk.
Policies to reduce risk
We have looked at the five main risks faced by banks. Now we consider
in turn how banks (and other financial intermediaries) can minimise the
four most important risks: credit risk, interest rate risk, liquidity risk and
market risk.
Credit risk management
There are several ways to minimise credit risk:
• screening
• monitoring
• credit rationing
• use of collateral and endorsement
• diversification.
Screening
To overcome adverse selection in loan markets, banks have to screen
out the bad credit risks from the good ones in order to maximise the
shareholders’ value added through credit risk management. To accomplish
effective screening, banks have to acquire information on a potential
borrower. The reason for doing this is to measure the probability of the
borrower’s default, known as measurement of credit risk. At the retail
level, much of the information needs to be collected internally or bought
from external credit agencies.
There are several models to assess the default risk on loans. They vary
from the relatively qualitative to the highly quantitative models. We
classify them in three broad groups: (i) qualitative models, (ii) credit
scoring models and (iii) newer models based on financial market data.
Qualitative models
Qualitative models (also referred to as expert systems) are based on the
subjective judgment of the bank’s manager on the probability of default
of the borrower, and they are used in the absence of publicly available
information on the quality of the borrower. Information can be collected
from private sources (e.g. credit and deposit files) and commercial
external sources (e.g. credit rating agencies).
The quantity of information used is determined by the size of the loan
exposure and the cost of collecting information. Key information in the
overall credit decision can be divided into:
1. Borrower-specific factors that are idiosyncratic to each borrower. They
refer to: borrower’s reputation (or past credit history) arising from
the long-term borrowing–lending relationship; borrower’s leverage
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Chapter 6: Risk management in banking
(ratio of debt to equity) because in presence of large amounts of debt,
the probability of the borrower’s default increases (due to an increase
in the borrower’s interest charges, which have an impact on its cash
flows); volatility of the borrower’s earnings, which is negatively linked
with the borrower’s ability to meet fixed interest and principal charges.
2. Market-specific factors that have an impact on all borrowers at the
time of the credit decision. Examples of these factors are: the business
cycle phase and the level of interest rates (high interest rates denote
restrictive monetary policy and may encourage borrowers to take
excessive risks and/or to encourage only the most risky borrowers to
apply).
Activity 6.3
Which of the two sets of factors above is more likely to affect adversely small businesses
than large businesses in the credit-assessment process by a bank?
Credit scoring models
Credit scoring models are mathematical models used to observe the
characteristics of the loan’s applicant, either to calculate the applicant’s
probability of default (expressed by a score) or to sort borrowers into
different default risk classes.
Credit scoring models include two broad families: linear probability
models and linear discrimination analysis. The same models are
used to credit score individuals or corporations, though the variables
used to determine the score differ: an individual might be scored on the
basis of age, sex, marital status, number of children, income, employment
and past repayment records of loans and credit cards, whereas a firm
might be evaluated on different financial ratios (such as leverage ratio or
profitability ratio).
The linear probability models use data from past defaulters and healthy
borrowers to identify the explanatory variables (such as leverage or
earnings) that are statistically significant in explaining why an individual
or a firm defaults on a loan. The old borrower’s characteristics are used as
inputs into a model that explains the past repayment experience. The past
performance is then used to forecast the probability of a new borrower
defaulting at a later date.
Example: Suppose that there are two factors (Xi) affecting the past
default experience: the leverage ratio (D/E) and the volatility of a
borrower’s earnings (EV). Based on past experience, the linear probability
model is estimated as:
Z = 0.5 (D/E) + 0.6 (EV) where Z is the expected probability of default.
Assume that the borrower has D/E = 0.4 and E = 0.25, the expected
probability of default (Z) = 0.5 (0.4) + 0.6 (0.25) = 0.35.
Activity 6.4*
Suppose the estimated linear probability model is Z = 1.1 X1 + 0.1 X2 + 0.5 X3, where
X1 = 0.75 is the leverage ratio, X2 = 2.5 is the sales-asset ratio and X3 = 0.15 is the
borrower’s profitability ratio.
a. What is the projected probability of repayment for the borrower?
b. What is the projected probability of repayment if the leverage ratio is 0.4?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
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24 Principles of banking and finance
Discrimination models divide borrowers into high or low default risk
classes on their observed characteristics. For example, for US publicly
traded manufacturing firms a widely used model has been developed
by Altman (1985). The measure of the default risk (Zi) depends on the
value of various financial ratios of the borrower (Xi) and the weighted
importance of these ratios (based on past observed experience of
defaulting and non-defaulting firms). Altman’s discriminant
function can be written as:
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4+ 1.0X5
where X1= working capital/total assets; X2 = retained earnings/total
assets; X3= earnings before interests and taxes/total assets; X4 = market
value of equity/book value of long-term debt; X5 = sales/total assets. The
higher the value of Z, the lower the default risk.
There are several problems associated with discrimination models. First,
they usually discriminate only between two extreme cases: default and
non-default status. Second, there is no economic rationale for expecting
weights and variables to remain constant over short periods. Third, these
models ignore important – but difficult to quantify – characteristics, such
as reputation.
Newer models based on financial market data
The newer models are based on financial market data to make inferences
on the default probability. Therefore, they are most relevant to the
valuation of loans to large borrowers in the corporate sector. Two
examples of these newer approaches are: CreditMetrics and Credit Risk+.
CreditMetrics
J.P. Morgan and its co-sponsors introduced CreditMetrics in 1997. It uses
the value-at-risk (VaR) framework to value (and measure the risk) of nontradable assets (such as loans). The idea of this method is to answer the
following question: ‘If next year is a bad year, how much will the bank lose
on its loans or loans’ portfolio?’ (Please read the section on VaR later in
this chapter to appreciate the VaR concept.) Each borrower is assigned a
credit rating, and a transition matrix is used to determine the probabilities
that the borrower’s credit rating will be upgraded or downgraded, or
that it defaults. CreditMetrics calculates the portfolio value by randomly
simulating the credit quality of each borrower. The credit instruments are
then repriced under each simulated outcome, and the portfolio value is
simply the aggregation of these prices.
Credit Risk+
Credit Risk+ is a model developed by Credit Suisse Financial Products,
which attempts to estimate the expected loss of loans and the distribution
of those losses. The method – based on mathematical models used in the
insurance industry – aims to calculate the bank’s required capital reserves
to meet losses above a certain level.
Activity 6.5
Download and read the journal article by Gordy (2000) listed in Essential reading, section
3.3 only, and answer the following question: ‘How does the Credit Risk+ model differ
from the CreditMetrics model?’
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Chapter 6: Risk management in banking
Monitoring
To reduce the moral hazard problem, banks monitor the borrower’s
activities (and their risk). There are two ways of monitoring credit risk: to
write covenants into loan contracts and to establish long-term customer
relationships.
Writing covenants into loans
The loan contract may contain covenants restricting or encouraging
various future actions of the firm to enhance the probability of the
repayment (as described in the section on moral hazard in Chapter 4). The
rationale behind covenants is that the loan is backed both by the firm’s
assets and also by the stream of future cash flow produced by the firm.
Long-term customer relationship benefits
The existence of long-term customer relationships benefits the bank as
well as the borrower. In the case where the borrower has previous loan
contracts with the bank, there are lower costs of monitoring for the bank
because the monitoring procedures have already been established. As a
consequence of the lower costs, the borrower may obtain loans at lower
interest rates. Moreover, the borrower has the incentive to avoid risky
activities, even if these activities are not specifically addressed in the
covenants of the loan contract. In case the bank is not satisfied with the
borrower’s behaviour, the bank may discourage the borrower from these
activities by threatening to refuse new loans in the future. In Chapter 2 we
saw that long-term customer relations are more likely to be established in
bank-based systems.
Credit rationing
There are two forms of credit rationing:
1. A bank refuses to make a loan of any amount to a borrower, who is
willing to pay a higher interest rate.
2. A bank makes the loan but reduces the size of the loan to a lower
amount than the one the borrower requires.
The first type of credit rationing is justified by the adverse selection
problem. The loan rate should consist of a market rate, a risk premium
(the riskier the borrower, the higher the risk premium), and administration
costs. However, because of adverse selection, a borrower may agree to
pay a higher rate because she/he knows that her/his default probability
is high. High loan rates may increase the probability of loan default. The
bank would therefore not make any loan (even at the higher rate).
The second type of credit rationing aims to solve the moral hazard
problem. The larger the loan, the higher is the incentive of the borrower to
engage in activities that increase the default probability. As a consequence,
in retail markets, banks normally quote one loan rate (or a very narrow
range of rates) and then restrict the amount individuals or firms can
borrow according to some criteria (such as wealth).
Collateral and endorsement
Another way of managing credit risk is through collateral and endorsement.
Loans with collateral requirements are often referred to as secured loans.
Collateral are the assets used by the borrower to guarantee the repayment
of the debt. In case of bankruptcy, the lender can sell these assets and use
the proceeds. Once the asset is used as collateral, the borrower is assumed
not to dispose of it.
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24 Principles of banking and finance
Assets that are commonly used as collateral are: real estate properties, cars
and goods that can be mortgaged; equipment and inventories; accounts
receivable; securities and savings accounts. The bank determines the
maximum amount of the loan in proportion with the collateral. What
factors must the bank remember when accepting collateral? The higher
the volatility of the collateral’s value and the lower its marketability, the
smaller the amount of the loan. On average, banks can lend up to 90 per
cent of the value of high-trade treasury bills, but only up to 75 per cent of
the value of high-capitalisation stocks, and much less on inventories.
In the case of commercial loans, a particular form of collateral required
by banks is known as compensating balances: a firm receiving a loan must
keep a required minimum amount of funds in a cheque account at the
bank.
There is a difference between the USA and Europe, since in the USA shortterm loans tend to be unsecured, whereas in Europe they tend to be either
collateralised or endorsed by a third party.
If a loan is endorsed by a third party (just in case the borrower goes
bankrupt), the third party is committed to repaying the debt. This
additional guard against loss from default is similar to providing collateral
as far as the lending bank is concerned.
Diversification
The techniques discussed in the previous sections (screening and
monitoring, credit rationing, use of collateral, endorsement and loan
covenants) allow banks to measure and manage risk on individual loans.
However, banks own loan portfolios which are collections of risky assets.
Combining loans together in a portfolio should allow the bank to diversify
and so reduce the overall riskiness of its loan portfolio. Diversification
is achieved by lending to different types of borrowers (and avoiding a
concentration of loans to one type of borrower). As we show in Chapter
8 in relation to equity portfolios, diversification enables the bank to
reduce individual firm-specific credit risk (risk of default specific to the
borrowing firm associated with the specific projects undertaken by the
firm), but it leaves the bank exposed to systematic credit risk (factors
that simultaneously increase the default risk of all firms in the economy).
If banks choose loans that yield returns that are negatively correlated,
they are able to diversify away all non-systematic risk (see p.171 for a
definition of non-systematic risk).
Banks can use migration analysis to measure credit risk concentration
in their loan portfolios and concentration limits to manage the
concentration of risk in their portfolios.
Migration analysis
In migration analysis, banks monitor the credit ratings (as provided by
a ratings agency such as Standard and Poor’s or Moody’s) of a number
of firms in an industry. If they decline faster than the historical trend of
the industry, banks reduce the lending to that industry. A loan migration
matrix provides the probability of a pool of loans being upgraded,
downgraded or defaulting over some period.
Example: Consider the following hypothetical rating migration matrix
(each cell is made up of transition probability):
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Chapter 6: Risk management in banking
Risk grade at the end of the year
AAA-A
BBB-B
CCC-C
Default
Risk grade at
AAA-A
.85
.10
.04
.01
beginning of
BBB-B
.12
.83
.03
.02
the year
CCC-C
.03
.13
.80
.04
Table created using data from: Saunders, A. and Cornett, M.M. Financial institutions management: a risk management approach. (New York: McGraw-Hill/Irwin,
2007) p.349.
Consider loans graded BBB-B at the beginning of the year: historically
(on average) 12 per cent have been upgraded to AAA-A, 83 per cent have
remained at BBB-B, 3 per cent have been downgraded to CCC-C, and 2
per cent have defaulted by the end of the year. Suppose that a bank is
evaluating the credit risk of grade BBB-B rated borrowers. In the case
where over the last few years a higher percentage (e.g. 5 per cent) of
these grade BBB-B loans have been downgraded to CCC-C, and a higher
percentage (e.g. 3 per cent) have defaulted, the bank may restrict the
proportion of lower-quality loans (those rated BBB-B and CCC-C), and
increase the proportion of grade AAA-A loans.
Concentration limits
Concentration limits are set by banks in terms of the proportion of the
loan portfolio that can go to any single borrower or type of borrower.
Banks typically set concentration limits to reduce exposures to certain
industries and/or geographic areas. Bank regulators impose a limit on
loan concentration to individual borrowers equal to 10 per cent of a bank’s
capital.
Interest rate risk management
One of the most important risk management functions in banking
is asset-liability management or ALM, broadly defined as the
coordinated management of banks’ balance sheet activities driven by
interest rate risk. The two main ALM techniques, normally used to manage
interest rate risk, are:
• income gap analysis
• duration gap analysis.
Income gap analysis
The gap is the difference between interest-sensitive assets (assets whose
interest rates will be repriced at or near current market interest rates
within a certain time horizon) and interest-sensitive liabilities (liabilities
whose interest rates will be repriced over given future periods).
Under US Federal Reserve Bank regulations, each of the bank’s assets and
liabilities is classified according to the following maturities (known as time
buckets)– the asset or liability is repriced: overnight >one day–3 months;
>3 months–6months; >6 months–12 months; >12 months–5 years; >5
years. This model is known as the maturity gap approach (or repricing
model). Note that a simpler version of this method is known as basic
gap analysis, where the bank has to assess which assets and liabilities
are interest-sensitive that is, which have interest rates repriced within a
certain time horizon (usually within one year). The problem of the basic
gap analysis is that many of the assets and liabilities that are not classified
as interest-sensitive have different maturities.
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24 Principles of banking and finance
Under the income gap analysis (maturity gap approach), banks report the
gap in each maturity bucket, calculated as the difference between ratesensitive assets (RSA) and rate-sensitive liability (RSL) on their balance
sheets. This can be written as:
GAP = RSA – RSL
(6.1)
A positive GAP implies interest sensitive assets > interest sensitive
liabilities. A rise in interest rates will cause a bank to have interest
revenues rising faster than interest costs; thus the net interest margin and
income will increase. A decline in interest rates will increase liabilities
costs faster than assets returns; as a consequence the net interest margin
and income will decrease.
Bank managers can calculate the income exposure to changes in interest
rates in different maturity buckets, by multiplying GAP times the change in
the interest rate:
∆I = GAP * ∆i
(6.2)
where:
∆I = change in the banks’ income;
∆i = change in interest rate.
Some problems with income gap analysis
Income gap analysis is essentially a book value accounting cash flow
analysis of the income gap between interest revenues and interest costs
over given periods of time. Therefore, the main problem of income gap
analysis is that it ignores market value effects of interest rate changes. In
fact, when interest rates change, there is a market value effect (change
in the present value of the cash flows of assets and liabilities) in addition
to an income effect (immediate interest received or paid on them). As a
consequence, the income gap analysis is only a partial picture of the true
interest rate exposure of a bank. This contrasts with the market valuebased duration models discussed in the section below.
Another problem with income gap analysis is that rate-insensitive assets
and liabilities (whose interest rates are not repriced) actually have a
component that is rate sensitive. A bank receives a runoff cash flow
from these rate-insensitive items that can be reinvested at the current
market interest rates. Examples of these items are long-term assets and
liabilities, such as fixed-rate mortgages (e.g. mortgages with a 30-year
maturity repaid within one year by the homeowner) and savings deposits.
For example, some 30-year original maturity mortgages may have only
one year left before they mature; that is, they are in their 29th year. And
virtually all long-term mortgages pay at least some principal back to the
bank each month. As a result, the bank receives a runoff cash flow from its
conventional mortgage portfolio that can be reinvested at current market
rates. Bank managers can deal with this problem by identifying for each
rate-insensitive asset and liability the estimated runoff cash flow. For
example, 20 per cent of the fixed-rate residential mortgages are assumed
to be repaid within one year and 20 per cent of savings deposits become
rate-sensitive liabilities within one year. These runoff cash flows are then
added to the value of the rate-sensitive assets and liabilities.
Furthermore, the income gap analysis ignores the effects of the changes in
interest rates on off-balance sheet instruments.
126
Despite these problems, the income gap analysis provides a picture of
the overall balance sheet mismatches and the cash flow consequences of
interest rate changes. It still takes place in most banks, but it is used in
conjunction with other risk management tools.
Chapter 6: Risk management in banking
Activity 6.6*
Read Mishkin and Eakins (2009), pp.624–25 and consider the following balance sheet of
International Bank (in millions):
Assets
Liabilities and Equity
Variable-rate mortgages
$ 20
Money market deposits
$5
Fixed-rate mortgages (30 years)
$ 25
Savings deposits
$20
Commercial loans
$ 50
Variable rate CD (<1year)
$30
Physical capital
$5
Equity
$45
Total assets
$100
Total liabilities and equity
$100
Answer the following questions:
a. What will be the net interest income at the year end if interest rates increase by
1.5 per cent, from 8 per cent to 9.5 per cent? Explain with basic gap analysis.
(Use the following assumptions on the runoff cash flows: fixed-rate mortgages
repaid during the year: 20 per cent; proportion of savings deposits that are ratesensitive: 20 per cent).
b. What happens to the income, if the International Bank decides to convert $10
millions of its existing fixed-rate mortgages into variable-rate mortgages?
c. What happens to the income, if International Bank revises the estimate of the
percentage of the saving deposits that are rate-sensitive from 20 per cent to 15
per cent?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Duration gap analysis
A market value-based model of measuring and managing interest rate risk
is duration gap analysis. We first illustrate the concept of duration (and
its technical and economic meanings), and then explain why duration gap
analysis provides a more accurate measure of a banks’ interest rate risk
exposure than income gap analysis (described in the previous section).
Macaulay duration and modified duration
Duration has two main meanings:
• Macaulay duration measures the average financial life of an asset or
liability
• modified duration expresses the interest sensitivity of an asset or
liability’s value.
Macaulay duration takes into account the time of arrival (or payment) of
all the cash flows as well as the maturity of the asset (liability). Technically
the Macaulay duration is a weighted average of the maturities of the cash
payments, where the weights are the relative present values of each cash
flow. It measures the period of time required to recover the initial capital
investment.
The formula for the calculation of the Macaulay duration of any fixed-rate
security can be written as:
∑ CF x DF x t
∑ CF x DF
N
D=
t =1
t
t
N
t =1
t
t
∑ PV x t
∑ PV
N
=
t =1
t
N
t =1
(6.3)
t
where:
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24 Principles of banking and finance
D
=
Macaulay duration measured in years
CFt
=
Cash flows received on the security at the end of period t
N
=
Last period in which the cash flow is received
DFt
=
Discount factor = 1/(1+i)t, where i is the current market interest rate
PVt
Present value of the cash flow at t = CFt × DFt
=
Example: Consider a seven-year Eurobond with 8 per cent coupon and
yield; current market interest rate 11 per cent.
t
CFt
DFt
CFt x DFt
CFt x DFt x t
1
8
0.9009
7.21
7.21
2
8
0.8116
6.49
12.98
3
8
0.7312
5.85
17.55
4
8
0.6587
5.27
21.08
5
8
0.5935
4.75
23.75
6
8
0.5346
4.28
25.68
7
108
0.4817
52.02
364.14
85.87
472.39
D = 472.39/85.87 = 5.502 years
The Macaulay duration allows for the possibility that the average life of
an asset or liability differs from their respective maturities. The duration
is lower than the maturity because the bond pays some cash flows prior
to maturity. Note that it is only for zero-coupon bonds (bonds sold at a
discount from face value on issue, repaid at the face value on maturity,
with no intermediate cash flows) that Macaulay duration equals its
maturity.
The Macaulay duration of a portfolio of securities is the weighted average
of the durations of the individual securities, with the weights reflecting the
proportion of the portfolio invested in each security.
Activity 6.7*
Using the method illustrated in the above example, answer the following questions:
a. Calculate the duration of a three-year 6 per cent coupon bond when the market
interest rate is 4 per cent.
b. What is the Macaulay duration of the portfolio made up of 20 per cent invested
in the seven-year Eurobond (described in the example above) and 80 per cent in
the three-year coupon bond (described in (a)?
Then read the section on ‘Calculating duration’ in Mishkin and Eakins (2009), pp.61–68,
to analyse a different method of calculating the Macaulay duration.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
There are three important features of duration:
• Macaulay duration increases with the maturity of a bond (this can
be seen by calculating the duration of a five-year Eurobond with the
same coupon (8 per cent) and market interest rate (11 per cent) as the
Eurobond in the example above).
• Macaulay duration decreases as market interest rate increases: higher
rates discount later cash flows more heavily, and the weights of those
later cash flows decline when compared to earlier cash flows.
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Chapter 6: Risk management in banking
• Macaulay duration decreases as the coupon interest rate increases:
the larger the coupons, the more quickly cash flows are received by
investors and the higher the weights of those cash flows.
Modified duration is a direct measure of the interest rate sensitivity of
an asset or liability. It answers the question: how much will the security
price change for a given change in market interest rates (when interest
rate changes are relatively small)? This can be written as:
%∆P ≈ – Dx ∆i
1+i
(6.4)
where: %∆P = (Pt+1–Pt)/Pt is the percentage change in the price of the
security from t to t+1.
The larger the Macaulay duration, the more the price of an asset (or
liability) is sensitive to changes in market interest rates. From equation
(6.4), the so-called Modified duration (MD) can be calculated as Macaulay
duration divided by 1 plus the market interest rate; that is:
(6.5)
MD = D
1+i
Activity 6.8*
Recall from the previous activity the three-year coupon bond and answer the following
question:
If the interest rate decreases from 4 to 3 per cent, what will be the percentage change in
the price of the bond?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Duration gap analysis
Banks manage interest rate exposure, taking into account the effects
of changes in interest rates both on income and market value, by using
duration. Moreover, knowledge of the duration of their assets and
liabilities enables banks to immunise their balance sheets against interest
rate risk.
The additive property of duration allows bank managers to determine
the effects of a change in interest rates on the market value of net worth
by calculating the average duration for assets and for liabilities and then
using those figures to estimate the effects of the change in interest rates.
The overall duration gap (DURgap) can be calculated as follows:
(
L x DUR
l
A
(
DURgap = DURa –
(6.6)
where:
DURa = average duration of assets
DURl = average duration of liabilities
L = market value of liabilities
A = market value of assets.
Note that if the duration of assets and liabilities are matched (DURgap=0),
then the balance sheet is said to be ‘immunised against unexpected
changes in interest rates’. Immunisation can be used to obtain a fixed
yield for a given period of time because both sides of the balance sheet are
protected against interest rate risk.
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24 Principles of banking and finance
Duration gap can be used to calculate the change in the market value of
net worth (∆NW) as a percentage of total assets induced by a change in
interest rates (recall equation 6.4):
∆NW
∆i
≈ – DURgap x
A
1+i
(6.7)
Example: Suppose a bank’s management calculate that: Da = 5 years;
Dl = 3 years. Suppose also that interest rates are expected to rise from 8 to
9 per cent. The bank’s balance sheet is assumed to be:
Assets ($ millions)
Liabilities and equity ($ millions)
A = 100
L = 90
E = 10
100
The duration gap for the bank is:
(
(
DURgap = DURa –
(
L x DUR = 5 – 90 x3
l
100
A
(
100
= 2.3 years
The potential loss to equity holders’ net worth (as a percentage of assets)
is:
0.01 –
∆NW
∆i
= 0.0213 = – 2.13%
≈ – DURgap x
= – 2.3x
A
1+i
1.08
With total assets totalling $100 million, the fall in the market value of net
worth is $2.13 million.
Activity 6.9*
If the bank revises the estimates of the duration of the assets to four years and liabilities
to two years, what is the effect on net worth if interest rates rise by 1.5 per cent?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Regulators (Federal Deposit Insurance Corporation and Basel Committee)
are increasingly suggesting the use of this model to determine an
appropriate level of capital reserves for banks exposed to interest rate risk.
However, it is important to point out some problems with the duration
gap analysis. First, the duration measure assumes a linear relationship
between interest rates and asset values (flat interest rate yield curve and
parallel shifts). However, the relationship is normally convex. The greater
the convexity, the less useful is duration gap analysis. In addition, duration
gap analysis is based on the approximation in Equation (6.4), and thus
only works well for small changes in interest rates.
In order to overcome these problems, banks use more sophisticated
approaches to measure interest rate risk, such as the value-at-risk (VaR)
analysis (described later in this chapter).
Liquidity risk management
One important strategy that banks can adopt in managing liquidity risk
is to maintain a stable deposit base. One method of achieving this is
for banks to diversify their deposit base by attracting in deposits from
different types of depositors. This will bring about a greater independence
of withdrawal risks as it is unlikely, unless in times of crisis or loss of
confidence in the bank, that all depositors will look to withdraw deposits
130
Chapter 6: Risk management in banking
at the same time. Of course, retail deposits provide banks with core
(stable) deposits, as these depositors tend to be more loyal as they source
other services from the bank and have the protection of deposit insurance.
Another technique banks can use is to hold large stocks of liquid assets
that can be converted into cash at times of liquidity need. A bank
holding a buffer of reliable high-quality liquid assets, such as short-term
government securities, can draw on them immediately in the event of a
sudden withdrawal of market liquidity or an unexpected increase in its
funding requirement. Of course, safe, liquid assets offer lower returns
than other types of assets, so there is an opportunity cost in maintaining
such a liquidity cushion on the balance sheet. This opportunity cost led
banks to seek alternative ways of managing their liquidity risk in the
1970s and most banks turned to liability management. This involves
the active management of its liability structure to manage its liquidity
requirements. The greater emphasis placed on liability management has
allowed banks to reduce their holdings of liquid assets over time. For UK
banks the average ratio of liquid assets to total assets in the 1960s was
approximately 30 per cent. This ratio fell markedly over the next 40 years
so that in the years before the crisis it was less than 5 per cent.
Banks have increasingly relied upon liability management and later
securitisation to manage liquidity risk. Liability management is conducted
at both retail and wholesale level. At the retail level it involves setting
interest rates, levels of service etc. to maintain deposits. Of course if banks
wish to increase deposits they will need to offer a higher rate of interest
to retail depositors. This takes time and can be costly as the higher rates
are paid to all depositors. An alternative way of increasing deposits is to
borrow it from the wholesale markets (e.g. the inter-bank market). This
may involve paying a higher interest rate as higher rates are generally
paid on wholesale deposits. However, the higher rate is only paid on the
marginal amount raised from the wholesale markets. The lower cost and
flexibility of the use of wholesale funding has led most banks to increase
their reliance on wholesale deposit funding. However, the financial crisis
of 2007–09 demonstrated that wholesale funding is a more risky source
of funding. Inter-bank markets effectively dried up as banks became
concerned about lending to other banks as they were unsure which banks
were sound.
In the ‘search for yield’ in the years leading to the financial crisis of
2007–09 (see Chapter 2) there was a rapid expansion of structured
financial instruments; for example, where individual loans are packaged
into tradable securities, such as residential mortgage-backed securities,
or where the risk of a pool of loans is packaged into complex securities
offering different levels of exposure to the potential losses in the pool (a
collateralised debt obligation). The demand for these structured financial
instruments allowed many banks to take advantage of the new sources of
wholesale funds available from securitisation. By applying an originate and
distribute model many banks tapped this new source of funding on a large
scale (see Chapter 2 for more explanation of securitisation). However
when the ability to securitise disappeared at the start of the financial crisis,
those banks that had become dependent on the liquidity provided by
securitisation found themselves in severe illiquidity situations.
The problems with heavy reliance on wholesale funding and securitisation
to manage liquidity in times of financial stress has led regulators to force
banks to hold higher levels of high quality liquid assets (see Chapter 5).
In other words, banks are being forced to go back to the practice of asset
management to manage liquidity risk.
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24 Principles of banking and finance
Activity 6.10
Try to understand why relying on liability management to manage liquidity risk is less
costly but higher risk compared to asset management (holding a stock of liquid assets).
What are the risks to a bank of relying on liability management? What is likely to happen
to the profitability of banks if they are forced to increase their holdings of liquid assets?
Market risk management
Market risk measurement is important for several reasons. It provides
information on the risk exposure taken by a bank’s traders, which has
to be compared with the bank’s capital resources. It enables banks to
compare the returns to market risk in different areas of trading, in order to
identify the areas with the greatest potential returns per unit of risk where
they need to direct more capital and resources. Finally, under the current
regulations of the Basel Committee on Banking Supervision on market risk
and capital requirements, in certain cases banks are allowed to use their
own (internal) market risk models to calculate their capital requirements
(see the section on Bank capital requirements in Chapter 5).
Value-at-risk (VaR) approach
In its most general form, the Value-at-Risk (VaR) measures the potential
loss in value of a risky asset or portfolio over a defined period for a given
confidence interval. Thus, if the VaR on a portfolio is $10 million at a
one-day, 95 per cent confidence level, there is a only a 5 per cent chance
that the value of the portfolio will drop more than $ 10 million over any
given day. Another way of putting this is to say 95 days out of every 100
the value of the portfolio will drop by no more than $10 million. Note
that VaR is not a measure of the worst case scenario as with a 95 per cent
confidence interval 5 days out of every 100 the losses over one day on the
portfolio will exceed $10 million.
To calculate the VaR for an asset or portfolio the distribution of returns
on the asset or portfolio needs to be specified. This distribution can be
determined from historic data, from assuming that returns follow a normal
distribution or by a technique called Monte Carlo simulation.
The historical method is based on an evaluation of the past performance
of the asset or portfolio on the assumption that past performance is a fairly
accurate predictor of future performance. The returns performance of
the asset or portfolio are then ordered and the desired percentile is read
off. For example, consider a dealer working for a bank with a $20 million
portfolio. Suppose the dealer has compiled from historical information the
following information about the change in the value of a portfolio over a
one day period.
Change in Value
132
Probability
< -$1,000,000
.01
-$500,000 to -$999,999
.04
-$250,000 to -$499,999
.15
$0 to -$249,999
.30
$1 to $249,999
.30
$250,000 to $499,999
.15
$500,000 to $999,999
.04
> £ $1,000,000
.01
Chapter 6: Risk management in banking
From the above table we can easily define the daily VaR at a 95 per cent
confidence interval, which is -$500,000. There is a 4 per cent chance of
a loss of between $500,000 and $999,999 plus a one percent chance of
a loss of at least $1 million. Thus, the bank can expect to lose at least
$500,000 5 per cent of the time. Or 95 per cent percent of the time the
loss to the bank will be no more than $500,000. The bank can then set
aside an appropriate amount of capital to cover this potential loss.
One problem with the historical method is that the historical data used
to produce the distribution should be representative of all possible states
of the portfolio. To achieve this would require many years of returns data
which is unlikely to be available.
The second approach is to assume the returns on the asset or portfolio
follow some statistical distribution (e.g. normal, lognormal etc.). A typical
distribution used for estimating a VaR is the normal distribution. The
advantage of this approach is that relatively little information is needed
to construct the distribution and compute the VaR – just the mean and
standard deviation of the distribution.
0.34
0.475
0.135
–3
–2
–1
0
1
2
3
STDEV
Figure 6.2 Standard normal distribution
If a 95 per cent confidence level is required, meaning we wish to have 5
per cent of the observations in the left-hand tail of the normal distribution,
this means that the observations in that area are 1.645 standard deviations
away from the mean.
To take an example, if a portfolio of assets of value $10 million has
a standard deviation of returns of 12.48 per cent (note this standard
deviation will have been calculated using a portfolio approach and
knowledge of the covariances or correlations between returns on assets in
the portfolio – this approach is discussed further in Chapter 7). The 95 per
cent VaR is equal to 1.645 * 0.1248 = 0.205296. In $ terms the VaR = $10
million * 0.205295 = $2,052,960.
A stricter VaR would be one with a 99 per cent confidence interval
which implies one percent of observations would lie in the left tail of
the distribution. This would mean that the losses incurred would exceed
the VaR on only 1 day out of every 100. In this case, assuming a normal
distribution, the observations in the left hand tail of the distribution would
be 2.33 standard deviations away from the mean.
The main drawbacks of this approach are:
i. the variance-covariance approach assumes stable correlations over time.
We saw in the recent financial crisis that during times of financial stress
the correlations between asset returns tend to move towards +1.
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24 Principles of banking and finance
ii. it assumes a normal distribution which is not always appropriate.
Returns in markets are widely believed to have ‘fatter tails’ than those
of a normal distribution. A fatter tail implies that extreme events have
a higher probability (i.e. a greater chance of occurring) than that
predicted by a normal distribution.
This last technique of Monte Carlo Simulation basically involves the
development of a model for the returns on an asset or portfolio and then
randomly generating outcomes for returns to determine the distribution of
outcomes. We do not consider this method further in this sysllabus.
Activity 6.11
Try to answer the following questions:
1. Why is a Value-at-Risk measure no guide to a worst case scenario? How can
regulators address this problem when assessing a bank’s exposure to credit risk?
2. What were the main problems with the Value-at-Risk method revealed by the
financial crisis of 2007–09?
Summary
The main objective of banks is to maximise profits and shareholder value
added, and risk management is crucial to the achievement of this goal.
The chapter investigated the key financial risks modern banks are exposed
to (credit risk, interest rate risk, liquidity risk and market risk), and
considered how these risks should be managed. The main techniques and
models used by banks to manage risks were grouped in accordance with
the type of risk:
• Credit risk management of single loans uses screening and monitoring,
credit rationing, use of collateral, endorsement; whereas diversification
enables banks to manage credit risk of their loan portfolio.
• Interest rate risk management employs two main approaches: income
gap analysis and duration gap analysis.
• Liquidity risk management is achieved using diversification of deposits,
liability management and holding a stock of good quality liquid assets.
• Market risk management mainly uses the value-at-risk method.
Key terms
134
Altman’s discriminant
asset-liability management
concentration limits
covenants
CreditMetrics
credit rationing
credit risk
credit risk management
Credit Risk+
diversification
duration gap analysis
endorsement
expert systems
foreign exchange risk
income effect
income gap analysis
interest rate risk
linear
linear discrimination
analysis
liquidity risk
long-term customer
relationship
Macaulay duration
market risk
market value effect
maturity gap approach
migration analysis
Modified duration
monitoring
operational risk
probability models
refinancing risk
reinvestment risk
screening
use of collateral
Value-at-risk (VAR)
Chapter 6: Risk management in banking
A reminder of your learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain why risk management is important in modern banking
• illustrate the main types of risks faced by banks (credit risk, interest
rate risk, market risk, liquidity risk, operational risk)
• explain and use the main techniques employed by banks to manage
credit risk of single loans (screening and monitoring, credit rationing,
use of collateral, endorsement) and credit risk of a loan portfolio
(diversification)
• explain and use the main approaches developed to manage interest
rate risk (income gap analysis and duration gap analysis)
• explain how liquidity risk can be managed appreciating the benefits
and risks of the different methods
• explain the main method developed to manage market risk (value-atrisk).
Sample examination questions
1. a.
What are the purposes of credit scoring models? What types of credit scoring models exist?
b.
What are the main problems in using discrimination analysis to evaluate credit risk?
c.
Can a bank keep borrowers from engaging in risky activities if
there are no covenants in the loan contract?
d.
How do loan portfolio risks differ from individual loan risks? What is migration analysis? How do banks use it to measure credit
risk concentration?
2. a.
What is the income gap analysis? What is a maturity bucket in the
income gap analysis?
b.
What are some of the weaknesses of the income gap model?
c.
What is runoff cash flow, and how does this amount affect the income gap analysis?
d.
Calculate the duration on a five-year 8 per cent coupon bond when the interest rate is 3 per cent. If interest rates rise from 3 to 4 per cent, what will be the approximate percentage change in
the price of the bond?
3. The following balance sheet is available (amounts in $ millions and
duration in years) for First Bank:
Amount
Duration
Loans
2,725
4.0
T-bonds
300
2.2
Deposits
2,225
1.5
Equity
500
a. What is the average duration of all the assets?
b. What is the average duration of all the liabilities?
c. What is the duration gap? What is the interest rate risk exposure?
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24 Principles of banking and finance
d. What is the forecast impact on the market value of equity caused by
a 0.5 per cent increase in interest rates?
e. What is the forecast impact on the market value of equity caused by
a 0.25 per cent decrease in interest rates?
f. What are the limitations of duration gap analysis?
4. a. What is meant by liquidity risk?
b. Why did liquidity risk facing banks increase in the years leading up
to the financial crisis of 2007–09?
c. How can banks manage liquidity risk?
5. a. What is meant by market risk? Why is the measurement of market
risk becoming important in the management of banks?
b. Discuss the use of Value-at-Risk methods for evaluating a bank’s exposure to market risk.
136
Part III: Principles of finance
Part III: Principles of finance
Overview
As discussed in Chapter 2, securities and financial markets are two of the
three entities of a financial system, together with financial intermediaries.
But thus far we have not analysed the nature of financial securities and the
functions of financial markets. The key objective of this part of the subject
guide is to move to an examination of financial markets, and to answer the
following question:
How do financial markets perform the function of channelling funds from
saver-lenders to spender-borrowers?
In order to do so, this part answers the following consequential questions:
1. What real assets should spender-borrowers invest in? How can real
assets be evaluated? How can the securities issued by the spenderborrower be evaluated? (Chapter 7)
2. What are the risk and return characteristics of securities and
portfolios formed by saver-lenders? How can securities be priced in
equilibrium?(Chapter 8)
3. How good are financial markets in establishing ‘fair prices’ for
securities? Do security prices fully reflect all available information, a
condition referred to as efficient market hypothesis? (Chapter 9)
In Part III we will answer each of these questions, and thus provide an
overview of the so-called principles of finance.
The topics contained in these chapters are of necessity more mathematical
than those covered earlier in the syllabus. However, the mathematics used
has been kept at a basic level, and supplementing the chapters with the
relevant readings should provide you with all the technical tools.
137
24 Principles of banking and finance
Notes
138
Chapter 7: Capital budgeting and valuation
Chapter 7: Capital budgeting and
valuation
Aims
The aim of this chapter is to describe how to value real assets and financial
assets. It provides the economic rationale and technical aspects of the main
techniques used to value real assets and to choose among alternative real
assets (known as capital budgeting): Net Present Value (NPV), Internal
Rate of Return (IRR), and payback period. Furthermore, it describes
the methods used for the valuation of financial assets, both bonds and
common stocks. Practical examples on how to use these techniques and
methods are provided.
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain how to value real assets and financial assets
• calculate the present value of cash flows
• describe the Net Present Value (NPV) technique and its properties, and
use it to appraise real assets
• describe the Internal Rate of Return (IRR) technique and its limitations,
and use it to appraise real assets
• describe the payback period technique and its limitations, and use it to
appraise real assets
• evaluate the NPV method in relation to the other capital budgeting
techniques
• explain the valuation method of bonds, and be able to compute the
price of a bond
• explain the main valuation methods of common stocks, and be able to
compute the price of a common stock.
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (Boston,
London: McGraw-Hill/Irwin, 2010) Chapters 2, 3, 4 and 5.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapters 3 and 11.
Further reading
Copeland, T.E., J.F. Weston and K. Shastri Financial Theory and Corporate Policy.
(Boston, London: Pearson Addison Wesley, 2005) Chapter 2.
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
London: McGraw-Hill/Irwin, 2002) Chapters 9 and 10.
Smart, S.B., W.L. Megginson and L.J. Gitman Corporate Finance. (Mason, Ohio:
South-Western/Thomson Learning, 2004) Chapters 4 and 7.
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24 Principles of banking and finance
Introduction
As illustrated in Chapter 2, the main function of financial markets is
to channel funds from saver-lenders to spender-borrowers. A typical
spender-borrower is represented by firms, whereas a typical saver-lender
is constituted by stockholders and bondholders. Firms cannot forget about
investors when they analyse and choose investment projects, as investors
will buy the securities they issue on the financial markets to finance their
investments in real assets.
The choice about the real assets in which firms should invest is known as
capital budgeting. Real assets are investments that generate cash in the
future, but which are not traded on financial markets like financial assets.
In making capital budgeting decisions, the fundamental objective of firms
is to maximise the value of the cash invested by their stockholders and
bondholders. Investments in real assets by firms have to generate at least
adequate returns, where ‘adequate’ means returns at least equal to the
returns available to investors outside the firm in the financial markets.
The issue of securities by firms is needed to finance the purchases of
real assets. The value of real assets determines the value of the firm, and
thus the value of the cash flows that will be distributed to stockholders
and bondholders. Therefore securities and real assets are valued
(respectively by firms and investors) on the basis of the same principle: the
maximisation of the present value of the cash flows (generated by the real
asset or the security).
In this chapter we thus analyse the investment decision rules (known as
capital budgeting techniques) used by firms to evaluate real assets.
The main technique is the Net Present Value (NPV); alternative project
appraisal methods are the Internal Rate of Return (IRR) and the payback
period. Moreover, we investigate the methods used for the valuation of
securities, both bonds and stocks.
These techniques are explained in a wide range of textbooks. If for some
reason you do not have the essential readings available, make sure you
look for alternatives in the further reading.
The concept of present value
The first basic principle in finance is that one dollar today is worth more
than a dollar tomorrow. The reason for this is that the dollar today
can be invested, and start to earn interest immediately. This argument
characterises the time value of money. One method used to illustrate
the time value of money is the present value (also termed discounted
value). It represents the value today of a cash flow received in t years’
time, and is calculated by multiplying the cash flow by a discount factor.
Formally the present value (PV) of a future cash flow can be written as:
PVt =
Ct
(1+r)t
(7.1)
where:
Ct = cash flow generated by a real asset at time t
1 = discount factor, which is the value today of $1 received at time t
(1+r)t
140
r = annual compounded interest rate required to accept the delayed
payment, termed discount rate.
Chapter 7: Capital budgeting and valuation
The term ‘compounded’ means that there is the opportunity to earn interest
on interest payments already received. The opportunity to earn interest
on interest is not provided by an asset that pays simple interest. In this
chapter the implicit assumption is that discount rates are compounded rates.
Example: Assume a compounded interest rate of 8 per cent. The PV of
$1,000 to be received in two years’ time is:
(
1,000
1.082
(
$857 =
.
Present values obey the principle of value additivity: the present value of
many cash flows combined is the sum of their individual present values.
The PV of a cash flow stream (C1, C2, C3,…, CN received at years 1, 2, 3, ..,
N)
can be calculated as:
PV0 =
C1
(1 + r)
1
+
C2
(1 + r)
2
+
C3
(1 + r)
3
+ ... +
CN
(7.2)
(1 + r)N
Example: Assume a compounded interest rate of 8 per cent. The PV of
$1,000 to be received at years one to three is
(
1,000
1,000
1,000
+
+
2
1.083
1.08
1.08
(
$2,576 =
.
There are some special cases of the PV formula. When the cash flow
(Ct) will be generated forever (and thus t is infinity), this is termed a
perpetuity. A perpetuity is a stream of fixed cash flows (C) received at the
end of every year from now until the end of time. The PV of a perpetuity
can be calculated as:
C
PV = r
(7.3)
Example: Assume an interest rate of 8 per cent. The PV of a perpetuity
that promises a payment of $1,000 per year is
(
1,000
0.08
(
$12,500 =
.
Equation (7.3) can be generalised to allow the annual cash payment to
grow at a fixed rate. This is referred to as a growing perpetuity, which is
a perpetual cash flow stream that grows at a constant rate (denoted as g)
over time. The value of a growing perpetuity can be calculated as:
C
PV = r – g
(7.4)
Example: Assume an interest rate of 8 per cent. The PV of a growing
perpetuity that promises an initial payment of $1,000 and growth of 3 per
cent is:
1,000
.
$20,000 =
0.05
(
(
Activity 7.1*
Assume an interest rate of 7 per cent annually, and calculate the PV of the following cash
flows:
1. €5,000 to be received in five years’ time.
2. €5,000 to be received at the end of each of the first five years, and €2,000 at the end
of years six to eight.
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24 Principles of banking and finance
3. €5,000 to be received from year one to infinity.
4. €5,000 to be received as a growing perpetuity (growth rate = 4 per cent).
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Net present value (NPV) and the valuation of real assets
The Net Present Value (NPV) technique uses the discounting principle
based on the present value to evaluate real assets (also referred to as
investment projects). The NPV of a project is just the sum of the present
values of all the cash inflows (C) generated by the project to the firm in
each of the next t years, less the sum of the present values of the cash
investment (I) associated to the same project. We normally assume
one cash investment at the stat of the project. The formula for the NPV
calculation is:
N
Ct
(7.5)
–I
NPV = ∑
t
t =1 (l + r)
If the NPV is positive, the project should be accepted as it generates
receipts (cash inflows) higher than cash investments (payments). As its
worth is more than the cost, the project makes a net contribution to the
value of the firm. Conversely, if the NPV is negative, the project should be
rejected. If the NPV is zero, the firm is free to accept or reject the project.
The rate of return used to discount the expected cash inflows has to
be the rate of return offered by equivalent investment alternatives in
the capital market. This discount rate is termed opportunity cost of
capital. The label ‘opportunity’ derives from the fact that it represents
the return forgone by investing in the project rather than in financial
assets (securities). Consequently it is a market-determined opportunity
cost. The assumption is that shareholders can reinvest their money at this
market-determined rate. Note that in the context of a firm, the label ‘cost
of capital’ indicates that the costs of all the sources of capital (both equity
issues and debt issues) have to be taken into account.
Usually, managers use the same rate to discount cash flows occurring in
different years (and we do the same in the following sections). With a
flat interest rate term structure (short-term rates being approximately
the same as long-term rates as explained in Chapter 2), this assumption
is correct. However, when the term structure is not flat, different rates
should be used to discount cash flows in different years.
The cash flows discounted in equation (7.5) above are the incremental
cash flows, which are the additional cash flows from the project. Therefore
sunk costs have to be excluded from the above calculation, because
they are incurred whether or not the project is accepted. One implicit
assumption about cash flows associated with the investment project is
that they can be estimated without error. However, in the real world, the
cash flows associated with investment projects represent forecasts, and not
real values. Therefore the cash flows have to be estimated in an uncertain
framework. As we will see in Chapter 8, risk affects return. Following on
from this, an important principle in finance states that a safe dollar is
worth more than a risky one. This principle also affects the calculation of
NPV. Under uncertainty the NPV methodology still holds, but it has to be
modified. It requires the use of expected cash flows and expected rate of
return (as defined and calculated in Chapter 8).
Example: Consider a firm that has to decide on the purchase of new
equipment (termed project A). Assume that the relevant opportunity cost
142
Chapter 7: Capital budgeting and valuation
of capital is 9 per cent, and the investment cost is £1,500. The cash inflows
generated by the new equipment would be £500 over four years. The NPV
of project A is:
NPV =
500
500
500
500
– 1,500 = + £119.86
+
+
+
(1.09)3
(1.09)4
(1.09)1 (1.09)2
As the NPV of project A is positive, it should be accepted.
Activity 7.2*
Assume an interest rate of 7 per cent. Calculate the NPV of each of the following projects,
and state whether each of them should be accepted or rejected.
•• Project B costs $1,100 immediately and generates $600 for each of the next 5 years.
•• Project C costs $1,400 immediately. It generates $500 in year 1. It costs an extra
$300 in year 2, and generates $500 in years 3, 4 and 5.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
In the presence of well-functioning financial markets (offering identical
borrowing and lending opportunities, as defined later in Chapter 9), the
channelling of funds from saver-lenders to spender-borrowers makes both
parties better off. The condition for this to happen is that both parties
decide by following two equivalent rules:
• Net present value rule: firms have to invest in real assets with a positive
NPV. In fact, the maximisation of the NPV increases the market value of
the stockholder’s share in the firm.
• Rate of return rule: stockholders and bondholders have to invest in
securities with a return higher than the rate of return on equivalent
investments in the capital market.
Therefore the NPV rule enables firms to maximise shareholder wealth.
NPV and mutually exclusive projects
Mutually exclusive projects are a set of projects of which only one can be
chosen at a given time. Firms have to choose one project among several
that do the same job: for example, a manually controlled machine versus
a computer controlled machine. Given that present values obey the
additivity principle, it follows that the NPV also possesses the additivity
property. Assume that a firm has only two projects (X and Y); the NPV of
projects X and Y is equal to the NPV of project X plus the NPV of project
Y. (Note that the additivity property holds because present values are all
measured in today’s dollars.) This can be written as:
NPV (X+Y) = NPV (X) + NPV (Y)
(7.6)
The additivity property implies that the value of the firm is simply the sum
of the values of the separate projects. Because of the additivity property,
when there are mutually exclusive projects, the NPV method indicates that
the project with the largest positive NPV should be adopted. The reason
for this is that the project with the largest NPV generates the largest NPV
of the firm’s aggregated cash flows.
One example clarifies the point that the choice of project relies on the
additivity property. Assume that project X is a positive NPV project, while
project Y is a negative NPV. The joint project (X+Y) will have a lower NPV
than project X on its own. The NPV enables managers to avoid choosing
bad projects just because they are packaged with good ones.
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24 Principles of banking and finance
NPV and limited funds
The concept of limited funds refers to a situation where the amount of
money available is less than the total investment cost of all the projects.
With regard to the limited funds condition, we note that for safe projects,
most firms would have no difficulty in raising more capital from financial
markets and financial intermediaries. However, many large firms impose
capital budgets on their divisions and subsidiaries as part of their internal
control system, and this generates the situation of limited funds.
Even when there are limited funds, the NPV additivity property enables
firms to choose the best project. In practice, the choice of the projects
can be made as follows. First, by calculating the NPV of all the feasible
combinations of possible projects (by summing the NPV of all their
constituents thanks to the additivity property). Second, by choosing the
combination with the greatest NPV.
Other real asset appraisal techniques
The NPV method is the optimal technique for the valuation of real assets
because it enables the management to maximise the expected wealth of
shareholders. In practice, however, several other techniques are used, such
as the Internal Rate of Return (IRR) and the payback period (analysed
below).
Internal rate of return (IRR)
The internal rate of return (IRR) is the rate at which the present values of
the cash inflows associated with a project equal the cash investment. The
IRR is the discount rate that makes the NPV equal to zero. Mathematically,
the IRR is found by solving this equation:
N
NPV = ∑
t =1
Ct
(l + IRR)t
–I=0
(7.7)
The calculation of the IRR involves an iterative process, which can be
viewed as a trial and error procedure (most electronic spreadsheets and
financial calculators are able to do this).
The choice of projects is made by comparing the IRR to a required rate
of return termed hurdle rate (R*). If the IRR is higher than the hurdle
rate, the project has to be accepted. Conversely, if the IRR is lower than
the hurdle rate, the project has to be rejected. The hurdle rate is usually
represented by the risk-free interest rate where cash flows are riskless (as
assumed in the present analysis). The decision process can be represented
by a graph, where the NPV is on the vertical axis, and the discount rate on
the horizontal axis. In Figure 7.1, the IRR is higher than the hurdle rate
(R*), and thus the project represented by this curve should be accepted.
Note that if the hurdle rate is the opportunity cost of capital used in the
NPV calculation, then the two methodologies (IRR and NPV) would give
the same result, and thus the same investment recommendation.
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Chapter 7: Capital budgeting and valuation
NPV
Project A
IRR
0
R*
R
Figure 7.1: IRR and hurdle rate
Example: Consider the purchase of additional machinery. The investment
cost of the project is $9,500 today. Positive cash flows equal to $4,000,
$5,000 and $4,000 will be generated respectively in years 1, 2 and 3. This
cash flow structure can be summarised as follows:
Cash flows ($)
Project
C0
C1
C2
C3
A
–9,500
+4,000
+5,000
+4,000
Finally assume a risk-free rate of 7 per cent. The IRR is the rate in the
equation:
NPV = – 9,500 +
4,000
4,000
5,000
+
+
=0
(l + IRR)
(l + IRR)3
(l + IRR)2
Let us arbitrarily try a 10 per cent discount rate. The NPV is not zero, it
is positive (+ $1,273). As the NPV is positive, the IRR must be greater
than 10 per cent. Let us try a 20 per cent discount rate. The NPV becomes
negative (–$380). Therefore the IRR must be lower than 20 per cent. Plot
these two combinations on a graph like Figure 7.1, and choose the IRR
that gives the desired NPV of zero. This occurs when the IRR is 17.5 per
cent. The IRR is higher than the hurdle rate (equal to the risk-free rate, 7
per cent), and thus the project is accepted.
Instead of plotting the two points for NPV and discount rate on a graph
and reading off the IRR from the graph we can use a linear interpolation
method to estimate a value for the IRR. Here we assume the relationship
between NPV and discount rate between the two points is linear. In fact,
as we can see from Figure 7.1 the relationship is non-linear. By applying
linear interpolation we will always find an approximate value for the IRR.
Therefore, it is important that the two discount rates that we interpolate
between are reasonably close together. The closer they are together, the
more realistic our assumption of a linear relationship between NPV and
discount rate becomes and the more accurate is our estimate of IRR. Of
course, the two points we interpolate between must involve a positive
NPV and negative NPV so that the line between the points captures the
IRR (where NPV = 0). The formula for finding the IRR using linear
interpolation is:
IRR = r1 + [(NPV1 / (NPV1 + |NPV2|))] * (r2 – r1)
where:
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24 Principles of banking and finance
r1 = lower discount rate
r2 = higher discount rate
NPV1 = NPV estimated using r1
|NPV2| = NPV estimated using r2
(note |NPV2| = absolute value of NPV2
For the example above:
IRR = 10 + [(1,273 / (1,273 + 380))] * (20–10)
IRR = 17.70%
Note this is a slightly higher estimate than that obtained from reading off
a graph. Of, course, because of the shape of the curve representing the
relationship between NPV and discount rate, using linear interpolation
to estimate the IRR will always lead to an over-estimate. A more precise
estimate can be found by interpolating over a smaller range of discount
values, say between 15 per cent and 20 per cent. When the discount rate is
15% the NPV is $389. Interpolating between 15 per cent and 20 per cent:
IRR = 15 + [{389 / (389 + 380))] * (20 – 15)
IRR = 17.53%
Activity 7.3*
Consider project ABC that costs $1,300 immediately. It generates $500 in year 1. It costs
an extra $500 in year 2, and generates $1,600 in year 3. Assume a risk-free rate of 7 per
cent. Then answer the following questions:
1.
Calculate the IRR of project ABC, and state whether it should be accepted or rejected.
2.
Would your decision remain the same if you use the NPV as a decision rule?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Limits of the IRR method
In the IRR method, the discount rate is not the market-determined
opportunity cost of capital as in the NPV: the discount rate is the IRR.
The IRR assumption is that shareholders can reinvest their money at the
project’s own internal rate, which is the same IRR. In contrast, the NPV
assumes that shareholders can reinvest their money at the opportunity cost
of capital determined by the market. Under the IRR, this assumption about
the reinvestment rate implies that different rates can exist for projects
with the same risk. Why should investors be able to reinvest at different
rates for different projects with the same risk? Actually, in well-functioning
capital markets, investors are not able to do so. This suggests that where
there are perfect capital markets, it is the NPV and not the IRR method
that makes the correct assumption about the reinvestment rate.
Furthermore, in the evaluation of mutually exclusive projects, the IRR can
lead to choices that do not maximise shareholders’ wealth. This usually
happens when there are two projects (A and B), when one of the two
(project A) is a longer-lived asset project (larger cash flows but occurring
later). As shown in Figure 7.2, the IRR of both projects A and B exceed
the hurdle rate (R*). Moreover, the IRR of project B is greater than the
IRR of project A, and thus project B should be preferred. However, when
the discount rate is low, B has the higher NPV; when the discount rate is
high, A has the higher NPV. If we assume the hurdle rate is the opportunity
cost of capital (used in the NPV calculation), then the NPV of project A is
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Chapter 7: Capital budgeting and valuation
higher than the NPV of project B. Therefore project A should be preferred.
This implies that the additivity property does not apply to the IRR. The
project with the largest IRR (B) is not the project with the largest NPV, and
thus it is not the best choice in a set of mutually exclusive projects because
it does not maximise shareholder wealth. Many managers, however, would
choose project B on the basis of the IRR rule. The preference of managers
for the IRR method could be justified under the assumption of a shortage
of funds (see the previous comments on NPV and limited funds) because
the cash flows of the shorter-lived project could finance another later
project (whereas the longer-lived project would not allow them to do so).
NPV
NPV
NPV
A
Project A
B
Project B
0
R
R*
IRR
IRR
A
B
Figure 7.2: IRR and mutually exclusive projects
Finally, the IRR method can give either more than one solution or no
solution. Because of possible changes in the structure of cash flows over
time, several IRR can simultaneously satisfy equation (7.7). One example
of a project with two IRR is a coal-mining investment, with the following
cash flow structure: negative initial cash flows (creation of the mine),
series of positive cash flows, and final negative cash flow for the land
reclamation. As shown in Figure 7.3 below, for project C there are two
IRR that make NPV equal to zero. Which IRR should the firm’s manager
prefer in order to maximise shareholder wealth? The IRR does not give an
answer to this question.
NPV
Project C
0
IRR
C
IRR
C
R
Figure 7.3: Multiple IRR
It is also possible to have no IRR, as shown in Figure 7.4 (opposite).
Project D has a positive NPV at every discount rate, and thus is a very
good project. However there is no IRR. In a case where the signs of the
cash flows of project D were reversed (as in project E), the project would
have no IRR and always have a negative NPV. The absence of IRR does not
indicate whether a project creates or destroys value.
From the above analysis, it is clear that the IRR method has strong
limitations when evaluating real assets with the objective of maximising
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24 Principles of banking and finance
shareholders’ wealth. However, nowadays many companies use the IRR
technique, and not the NPV. Although IRR seems easier to understand by
non-financial managers, caution has to be used because of the limitations
outlined above. The main concern is related to the drawbacks of the IRR
rule in evaluating mutually exclusive projects, because of the inability of
non-financial managers to evaluate all the possible projects.
Project D
R
0
Project E
Figure 7.4: Non-existing IRR
Activity 7.4
What are the reinvestment assumptions of NPV and IRR? Which is the correct
assumption?
Payback period method
The payback period method evaluates real assets based on the number of
years needed to recover the initial capital investment for the project. The
firm decides a fixed payback period, for example two years. The project
is accepted if it generates enough cash flows in the first two years to
repay the initial investment. The project is rejected if it does not generate
enough cash during the first two years.
Example: Consider the following projects F and G:
Cash flows ($)
Project
C0
C1
C2
C3
F
–2,200
+600
+500
+2,000
G
–2,200
+350
+2,100
0
The payback period is three years for project F, and two years for project
G. Assuming an opportunity cost of capital of 9 per cent, the NPV of
project F is equal to +$314, while the NPV of project G is –$111. (As
a self-assessment exercise, check whether these NPVs are correct.) The
NPV rule says accept project F and reject project G. However, if the firm
uses the payback period rule with a cut-off period of two years, project G
would be accepted (positive cash flows of $2,450 higher than the initial
investment of $2,200) whereas project F would be rejected (positive cash
flows of $1,100 lower than the initial capital investment of $2,200). The
payback period rule supports an investment decision opposite to the one
indicated by the NPV method. The accepted project G would actually
decrease shareholder wealth. Note that where the firm chooses a cut-off
period of three years, both projects would be accepted.
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Chapter 7: Capital budgeting and valuation
Activity 7.5*
Consider the three projects I, L, M:
Cash flows ($)
Project
C0
C1
C2
C3
C4
I
–1,500
300
550
600
400
L
–300
100
200
200
–100
M
–6,200
2,000
3,000
2,000
5,500
a.
Calculate the payback period of each project.
b.
Which project does the firm accept if the cut-off period is three years?
c.
If the firm invests in projects with the shortest payback period, which project would it invest in?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Limits of the payback period method
The first limit of the payback period is that it ignores the cash flows after
the cut-off date. Project F is rejected with a cut-off period of two years
notwithstanding the large cash flow generated in year 3. The choice of the
cut-off date is extremely critical, and should be tailored to the project’s
life. Otherwise, poor, shorter-lived projects could be accepted at the
expense of good, longer-lived projects.
Secondly, the payback period rule ignores the time value of money
(a foundation principle in finance, applied in both the NPV and IRR
methods).
Example: Consider the same project G of the previous example and
project H, with the same cash flows, but with reversed occurrence dates.
Cash flows ($)
Project
C0
C1
C2
C3
G
–2,200
+350
+2,100
0
H
–2,200
+2,100
+350
0
The payback rule suggests that both projects G and H should be accepted.
However, the NPV of project H (+$21) is positive, while the NPV of project
G (–$111) is negative.
Activity 7.6
Here is a difficult question – see if you can answer it. How can we avoid the drawback?
This drawback could be avoided by discounting the cash flows generated
during the payback period. This alternative method, which takes into
account the time value of money, is termed a discounted payback period.
Nevertheless it does not avoid the first limitation of the payback period
method.
Overall, the payback period is a particularly simple ad hoc method,
with theoretical limits much stronger than the ones of the IRR method
(analysed in the previous section).
This completes our review of the main techniques used to value real assets
purchased by spender-borrowers.
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24 Principles of banking and finance
Valuation of financial assets (securities)
Next we look at techniques used to evaluate financial assets (securities)
issued by spender-borrowers on the financial markets to collect funds from
the saver-lenders.
The valuation of financial assets is based on the same present value
principle underlying real asset valuation. The value of any asset (real or
financial) equals the present value of all its future benefits (typically cash
flows). This implies that pricing a financial asset requires knowledge of
both its future benefits and the appropriate discount rate that converts
future benefits into a present value.
The degree of uncertainty about future benefits and discount rates
varies according to the type of financial asset. As described in Chapter
2, financial assets can be classified in several broad groups: government
bonds, corporate bonds, and preferred and common stocks. For
government bonds investors know the future benefits (stream of cash
flows) with a high degree of certainty. In contrast, for common stocks,
estimating future benefits is quite challenging. As a consequence of the
higher degree of uncertainty about future benefits, a higher discount rate
has to be used in discounting those benefits to present value.
In the following subsections we focus on the valuation methods of
bonds and common stocks. Note that in this chapter we do not consider
the relationship between risk and return for risky assets, which will be
investigated in Chapter 8.
Activity 7.7
What are the cash flows available to an investor in stocks? Which security (stock or bond)
is on average more volatile? Compare the problem of estimating stock cash flows to that
of estimating bond cash flows.
Bonds
As illustrated in Chapter 2, bonds can be classified into coupon bonds and
zero coupon bonds. The differences in the characteristics of these two
types of bonds require the use of different valuation methods.
Coupon bonds
The value of coupon bonds equals the present value of future interest and
principal payments to be paid to the lender (bondholder) by the borrower
(issuer of the bond).
Recalling the present value principle, the price of a coupon bond (Pcb,ann)
with annual coupon payments can be written as:
Pcb,ann =
N –1
∑
t =1
c×P
P×(1+c)
+
(1+rann)t
(1+rann)N
(7.8)
where:
P = principal payment
c = annual coupon rate, that is the interest rate
rann = annual compounded discount rate.
• The principal is the face value of the bond.
• The interest payment (coupon) is a specified percentage of the
principal. This percentage is represented by the annual coupon rate.
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Chapter 7: Capital budgeting and valuation
• The discount rate is the required annual compounded rate of return
on similar bonds. This is the return investors give up when they buy a
specific bond. (Note that risk affects the required rate of return, as we
will explain in Chapter 8.)
Example: Assume you buy on 1 January 2010, a 2012 UK Treasury bond,
with a coupon rate of 4 per cent and a face value of £1,000. The discount
rate is 2.5 per cent, which is the interest rate offered by other mediumterm UK Treasury bonds on 1 January 2010. The interest payments
received at the end of years 2010 and 2011 are £40 (= 4% of the face
value of £1,000). At the maturity date (end of 2012), the government pays
the principal (£1,000) plus the interest (£40). To value the bond, we need
to discount the cash flows at the discount rate (2.5 per cent):
Pcb,ann = PV =
40
40
40
= £1,042.83
+
+
2
(1.025)
(1.025)3
1.025
Activity 7.8*
Now try one for yourself. Calculate the price of a four-year coupon bond, with principal
$5,000, annual coupon rate 4 per cent, and required annual rate of return 8 per cent.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
In equation (7.8) the assumption is that coupon payments occur annually.
In practice, most US government bonds make coupon payments semiannually (every six months). Therefore the price of a coupon bond with
semi-annual coupon payments (Pcb,sem) is:
Pcb,sem =
2N –1
∑
t =1
c
c
P×(1+ )
×P
2
2
+
(1+rsem)t
(1+rsem)2N
(7.9)
where:
c/2 = semi-annual coupon rate (= annual coupon rate/2)
rsem = semi-annual compounded discount rate (= annual compounded
discount rate/2).
Example: Recall the previous 2012 UK Treasury bond, and assume it
makes semi-annual coupon payments. The semi-annual discount rate is
1.25 per cent (=2.5/2). Thus we have 6 six-month coupon payments of
£20. The price becomes:
Pcb,sem = PV =
20
20
20
20
1,020
20
+
+
+
+
+
2
3
4
5
(1.0125) (1.0125)
(1.0125)6
1.0125 (1.0125) (1.0125)
= £1,043.10
Activity 7.9*
How does your answer to Activity 7.8 change with semi-annual coupon payments and a
semi-annual discount rate of 4 per cent?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Zero coupon bonds
The price of a zero coupon bond (bond with no coupon payments, such
as a US Treasury bill) can be easily calculated by setting c=0 in equation
(7.8). Formally, the price of a zero coupon bond can be calculated as:
P
(7.10)
Pzcb =
(1+r)N
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24 Principles of banking and finance
Example: Consider a Treasury bill maturing in six months and paying
$10,000. Assuming a compounded annual rate of 4.08 per cent, the price
today is $9,800. The price today is determined by discounting the value in
6 months ($10,000) by the six-month discount rate (4.08/2 = 2.04%:
P = 10,000 / (1.0204) = $9,800
Common stocks (i.e. ordinary shares)
Like the pricing of bonds, the valuation of common stocks requires us to
calculate the present value of all future benefits. To value a share such as
Tesco plc, we can use discounted cash flow (DCF) models. DCF models
assume that the value of a stock is equal to the present value of the cash
flows the stockholders expect to receive from the firm.
Unlike bonds, which have contractual cash flows (interest and principal
payments), common stocks have unspecified cash flows. What are the
cash flows expected from common stocks? Common stockholders have
to consider how much cash the firm will generate now and in the future,
how much of that cash the firm will reinvest to finance growth, and how
much the firm will distribute to stockholders via dividends. Therefore
common stocks simply deliver a stream of uncertain future dividends to
stockholders.
However, we know that common stockholders receive payoffs in two
forms: cash dividends and capital gains (or losses).
Why are capital gains and losses apparently absent from the model used
for the valuation of common stocks? Is this a problem?
Dividend discount model
To answer the above questions let us start with the definition of expected
return on a stock over the next year (E(R)). It is a function of the expected
dividend and expected capital gain. Formally this can be written as:
E(R) =
DIV1+P1– P0
P0
(7.11)
where:
DIV1 = expected dividend to be paid at time 1
P0 = current price of the stock
P1 – P0 = capital gain on the stock.
(Please refer to Chapter 8 for an investigation of the expected rate of
return.)
Rearranging equation (7.11), we can predict the current price of a stock in
terms of forecasted dividends and expected price next year. Formally, this
is:
DIV1+P1
P0 =
(7.12)
1 + re
where:
re = required annual rate on similar equity stocks. This is the return that
can be earned in the financial market on securities of comparable risk.
This discount rate reflects not only the time value of money, but also the
riskiness of the stock (please refer to Chapter 8 to investigate the risk–
return relationship).
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Chapter 7: Capital budgeting and valuation
Equation (7.12) is the fundamental valuation formula. It represents a
market equilibrium condition: if it does not hold, stocks will be underpriced or over-priced (please refer to Chapter 9 to understand why this
equation represents an equilibrium condition in efficient markets).
When we come to use this equation, we immediately realise that we
must estimate the price of the stock at time 1 in order find the value
today. However, future stock prices are not easy to determine. What does
determine future stock prices?
The answer is contained in the same equation (7.12). The expected price
at time t can be expressed as the expected dividends at time t+1 plus the
price at the end of year t+1. Therefore, in equation (7.12), P1 could be
replaced by (DIV2+ 2)/(1+re):
P0 =
DIV1
DIV2+P2
+
1 + re
(7.13)
(1 + re )2
The current price of a stock relates to the expected dividends for two
years (DIV1 and DIV2) plus the forecasted price at the end of year two
(P2). Accordingly, in equation (7.13), P2 could be expressed as (DIV3+P3)/
(1+re).
Can you see that we can look as far into the future as we like? If we
consider a period of N years, by extending equation (7.13), we predict the
current price of a stock in terms of dividends over N years and the price at
the end of year N:
P0 =
=
DIV1 + P1
(1 + re )
+
DIVt
N
∑ = (1 + r )t +
t =1
e
DIV2
(1 + re )
2
PN
+
DIV3
(1 + re )3
+...+
DIVN+PN
(1 + re )N
(7.14)
(1 + re )N
As the horizon period N approaches infinity, the present value of
dividends accounts for an increasing proportion of the total present
value of dividends and terminal price (note that the total present value is
always equal to 100). At infinity, the present value of the terminal price
approaches zero. (Have a look at Figure 4.1 in Brealey, Myers and Allen as
an example of the decreasing relevance of the present value of the future
price, and the increasing relevance of the stream of dividends.) Therefore,
the value of common stocks equals the present value of future periodic
dividends that stockholders expect the firm to distribute forever. This is
known as the dividend discount model. Formally, the price today of a
common stock (P0) can be written as:
∞
P0 = ∑
t =1
DIVt
(1 + re )t
(7.15)
where:
DIVt = dividends to be paid annually at time t. Because a common stock
does not have a fixed lifetime, an infinite stream of dividends must be
forecast.
Even if capital gains do not appear in equation (7.15), it has been derived
from the assumption that the current price of a stock is determined by the
expected dividends and the capital gains over the next periods (remember
equation 7.12). In short, stock valuation does not ignore capital gains,
even if they do not appear in the valuation formula.
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24 Principles of banking and finance
Activity 7.10
What do you think of the following statement?
‘You say stock prices equal the present value of future dividends? That’s crazy. All
investors look for capital gains!’
Do you agree or disagree? See if you can find reasons for your view in what we say
above.
To implement equation (7.15) we need to know:
• all the future dividends received until infinity
• the appropriate discount rate.
It is impractical to use the model in its purest form because we do not
know the value of all the dividend payments to infinity. We therefore
have to make a simplifying assumption about how the future stream of
dividends evolves from the current dividend. Two possible assumptions are
now discussed.
Zero growth model
The simplest scenario assumes a constant dividend stream (DIV = DIV1 =
DIV2 =…= DIV∞). The valuation formula reduces to the equation for the
present value of a perpetuity (illustrated at the beginning of this chapter).
This is referred to as a zero-growth model. Formally, this is:
DIV1
(7.16)
P0 = r
e
Example: Consider stock ABC, which is expected to pay a dividend of
$9.5 forever. The price today of the stock, assuming a required rate of
return of 11 per cent, is $86.4.
Gordon growth model
Alternatively, expected dividends can be assumed to grow at a constant
rate g per annum. To value such a common stock we just use the present
value formula of a growing perpetuity (illustrated at the beginning of this
chapter). The constant growth model is commonly called the Gordon
growth model of equity valuation. The price of such a stock is:
D1
(7.17)
P0 = r – g
e
where:
D1 = dividend expected at time 1
g = constant growth rate.
Note that D1 is the next or expected dividend payment in the next period
(period 1). Sometimes this may be seen as the company having announced
its next dividend. More often this will not be known and we have to
estimate it from the current dividend (D0) using:
D1 = D0 (1+g)
A key input in this model is the growth rate, the estimation of which is
very challenging. The two main determinants of a firm’s growth rate are:
the size of the new investments made by a firm, and the rate of return of
the new investments. Another problem is that a firm’s growth may not
be constant. Small firms with a new product may experience very rapid
growth in their early years and then growth may slow down to more
normal levels before possibly declining. Another problem is that some
154
Chapter 7: Capital budgeting and valuation
firms may not pay dividends. Where this occurs, alternative valuation
methods are required (outside the scope of this syllabus).
Example: Consider stock WZY, which is expected to pay a dividend of $5
one year from now and this dividend is expected to grow at 5 per cent per
year forever. Assuming a required rate of return of 11 per cent, the price
today would be $83.3.
Activity 7.11*
Consider the following two stocks:
•• Stock X is expected to pay a dividend of $11 forever. Stock Y is expected to pay a
dividend of $6 next year. Thereafter the dividend growth is expected to be a constant
annual rate of 6 per cent forever.
Assuming that the required rate of return on similar stocks is 12 per cent, calculate the
price of the two stocks. Which one is more valuable?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Summary
In this chapter, we investigated how to value real assets and financial
assets (i.e. securities). Financial assets are issued by spender-borrowers
on the financial markets to collect money from saver-lenders, in order
to buy real assets. We use the same concept in the valuation of both real
and financial assets: discounting future cash flows back to their present
value. Capital budgeting, which refers to the choice among alternative
investments in real assets, uses several appraisal techniques. The NPV
method enables firms to make choices that maximise the wealth of
shareholders, whereas the IRR is sub-optimal in this regard. Investment
decisions among alternative securities use valuation methods to determine
the price of bonds and common stocks. These methods are differentiated
on the basis of the degree of uncertainty about future cash flows and
discount rates to be used in determining the present value.
Key terms
additivity property
capital budgeting techniques
discounted cash flow
dividend discount model
Gordon growth model
hurdle rate
incremental cash flows
Internal Rate of Return (IRR)
limited funds
multiple IRR
mutually exclusive projects
Net Present Value (NPV)
opportunity cost of capital
payback period method
present value
zero-growth model
A reminder of your learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain how to value real assets and financial assets
• calculate the present value of cash flows
• describe the Net Present Value (NPV) technique and its properties, and
use it to appraise real assets
• describe the Internal Rate of Return (IRR) technique and its limitations,
and use it to appraise real assets
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24 Principles of banking and finance
• describe the payback period technique and its limitations, and use it to
appraise real assets
• evaluate the NPV method in relation to the other capital budgeting
techniques
• explain the valuation method of bonds, and be able to compute the
price of a bond
• explain the valuation methods of common stocks, and be able to
compute the price of a common stock.
Sample examination questions
1. Consider a project with the following cash flows:
Cash flows (£)
Project
C0
C1
C2
A
–1,000
+2,000
+750
a. How many internal rates of return does project A have?
b. If the hurdle rate were 20 per cent, would you accept the project?
Explain your answer.
c. Describe the IRR method. Discuss the limitations of this method
when compared to the NPV technique.
2. Consider the two following mutually exclusive projects (B and C):
Cash flows (£)
Project
C0
C1
C2
C3
B
–1,500
+600
+500
+100
C
–1,500
0
+200
+1,400
a. Assuming an opportunity cost of capital of 10 per cent, what is the
NPV of the two projects? Which project would you accept?
b. What is the IRR of the two projects? Which project would you
choose if the hurdle rate is equal to the opportunity cost of capital
(10 per cent)?
c. Discuss the reinvestment assumptions underlying the NPV and IRR
method.
d. How can we appraise a set of investment projects when funds to
finance those investments are constrained?
3. At the end of January 2005, the interest rate on US government bonds
maturing in 2008 is about 2 per cent. Value a bond with a 4 per cent
coupon maturing in January 2008.
a. Assume annual coupon payments and annual compounding.
b. Assume semi-annual coupons and a semi-annual discount rate of 1
per cent.
c. Describe the techniques used to value financial assets. Compare and
contrast the methods used in the pricing of bonds and common stocks.
4. Consider the following three stocks:
• Stock A is expected to pay a dividend of $5,000 next year.
Thereafter the dividend growth is expected to be a constant annual
rate of 6 per cent forever.
156
Chapter 7: Capital budgeting and valuation
• Stock B is expected to pay a dividend of $5,000 next year.
Thereafter the dividend growth is expected to be a constant annual
rate of 20 per cent for 6 years (and zero thereafter).
• Stock C is expected to pay a dividend of $1,200 forever.
a. Assuming that the required rate of return on similar equities is 11
per cent, calculate the price of the three stocks. Which one is more
valuable?
b. Derive the dividend discount model for valuing stocks and discuss
the assumptions that can be made to make the model practical.
c. Why are capital gains apparently absent from the dividend discount
model?
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24 Principles of banking and finance
Notes
158
Chapter 8: Securities and portfolios – risk and return
Chapter 8: Securities and portfolios – risk
and return
Aims
The aim of this chapter is to outline how risk affects the return of a
security (or portfolio of securities), and hence how risk affects the value of
the security (portfolio) in equilibrium. First, we illustrate how to calculate
risk and return of individual securities and portfolios. Further, we explain
how mean-standard deviation portfolio theory enables us to identify the
optimal holding of securities for a risk-averse investor. Then we look at
two key economic theories on asset pricing: the Capital Asset Pricing
Model (CAPM) based on the mean-standard deviation framework, and an
alternative model known as Arbitrage Pricing Theory (APT).
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain how risk affects the return of a risky asset, and hence how risk
affects the value of the asset in equilibrium
• calculate risk and return for individual securities and portfolios, and
understand the basic statistical tools of expected returns, standard
deviations and covariances
• explain the mean-standard deviation portfolio theory, and the meaning
of its key concepts (efficient frontier, feasible region, capital market
line, and optimal portfolio)
• illustrate the effects of diversification
• explain the main assumptions and results of the CAPM
• illustrate the key concepts of the CAPM (beta and security market line)
• explain the main assumptions and results of the APT
• compare the theoretical and empirical validation of the CAPM and APT.
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (Boston,
London: McGraw-Hill/Irwin, 2010) tenth edition Chapters 7 and 8.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapter 4.
Further reading
Copeland, T.E., J.F. Weston and K. Shastri Financial Theory and Corporate Policy.
(Boston, London: Pearson Addison Wesley, 2005) Chapters 4, 5, and 6.
Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio
Theory and Investment Analysis. (New York: John Wiley & Sons, 2007)
pp.59 and 61.
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy. (Boston,
London: McGraw-Hill/Irwin, 2002) Chapters 4, 5 and 6.
Luenberger, D.G. Investment Science. (New York: Oxford University Press, 1998)
Chapters 6 and 7.
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24 Principles of banking and finance
References
Chan, K.C., N. Chen and D. Hsieh ‘An Exploratory Investigation of the Firm Size
Effect’, Journal of Financial Economics 14(3) 1985, pp.451–71.
Chen, N. ‘Some Empirical Tests of the Theory of Arbitrage Pricing’, Journal of
Finance 38(5) 1983, pp.1393–414.
Chen, N., R. Roll and S. Ross ‘Economic Forces and Stock Market’, Journal of
Business 59(3) 1986, pp.383–403.
Dimson, E., P. Marsh and M. Staunton ‘Global evidence on the equity risk
premium’, Journal of Applied Corporate Finance 15(4) 2003, pp.27–38.
Jacquier, E., A. Kane and A.J. Marcus ‘Geometric or Arithmetic Means: A
Reconsideration’, Financial Analysts Journal 59(6) 2003, pp.46–53.
Lintner, J. ‘The Valuation of Risk Assets and the Selection of Risky Investments
in Stock Portfolios and Capital Budgets’, Review of Economics and Statistics
47(1) 1965, pp.13–37.
Markowitz, H.M. ‘Portfolio Selection’, Journal of Finance 7(1) 1952, pp.77–91.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Tests; Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.
Ross, S.A. ‘The Arbitrage Theory of Capital Asset Pricing’, Journal of Economic
Theory 13(3) 1976, pp.341–60.
Sharpe, W.F. ‘Capital Asset Prices: A Theory of Market Equilibrium under
Conditions of Risk’, Journal of Finance 19(3) 1964, pp.425–42.
Introduction
In light of the main function performed by financial markets – to channel
funds from saver-lenders to spender-borrowers (as discussed in Chapter
2) – we now turn to the pay-off required by saver-lenders when they invest
in the financial assets (securities) issued on the financial markets by the
spender-borrowers (such as industrial firms) to finance their investments
in real assets (discussed earlier in Chapter 7). Two main attributes
characterise the pay-off of a security: return and risk. But thus far we have
said little about where the expected return used in the valuation methods
(as explained in Chapter 7) comes from, or about the relationship between
the two attributes. The objective of this chapter is to demonstrate how
the risk of a security affects the return required for it, and hence how risk
affects the value assigned to the security in equilibrium.
Risk and return of a single financial security
Risk and return are the two main attributes of a financial security. The
actual return of a security is the amount received divided by the amount
invested. However, when securities are originally acquired, their returns
are usually uncertain because their prices are subject to changes. For
instance, say I bought shares in XYZ company in 2000 expecting a return
of 10 per cent per annum for 7 years. Instead, my return was –20 per cent.
Can you see that the actual return is –20 per cent, not what I had hoped to
get?
This implies that a variety of return outcomes are likely to exist, each
occurring with a specific probability. Accordingly, the return measure of a
risky asset is considered to be a random variable. For analytical purposes
the uncertainty of the return is measured by the expected (average)
return. To provide a quantitative measure of the expected return we
normally use the weighted average of all possible returns, where the
weights are the probabilities of occurrence of that return. Formally, this is:
160
Chapter 8: Securities and portfolios – risk and return
(E)R = p1 R1 + p2 R2 + ... + pn Rn
(8.1)
where:
(E)R = expected return
Ri = return of the state of nature i
n = number of possible states of nature (outcomes)
pi = probability of occurrence of the return Ri.
Note that returns and their probabilities are not usually known. However,
in practice, historical average returns and number of past observations are
often used as proxies. Figure 8.1 shows a typical distribution for historical
returns on stocks in major corporations. Each point of the curve represents
a stock. Based on past performance in the overall market, we estimate
that the expected return is 13 per cent. We recognise that there can be
significant deviations from the mean (13 per cent). In fact it is quite
possible that return could be –10 per cent in one year and +35 per cent in
the next year. (Note that the return can become arbitrarily large, but can
never be less than –1, which represents the complete loss of the original
investment in the stock.)
Number of
observations
–1
13
Rate of return (%)
Figure 8.1: A typical distribution of past rate of returns on stocks
The variation around the expected return is a measure of the risk of a
security. This is a measure of how far the actual return differs from the
expected return. To provide a quantitative measure of the degree of
possible deviations from the expected return we normally use a measure
of dispersion of a distribution of historical returns: the variance. We
frequently use the square root of the variance, called standard deviation.
The standard deviation is a statistical measure of how variable the returns
are around the average return. More formally, to calculate the standard
deviation of returns we need to calculate the expected return (E)R, then to
subtract the expected return from each return to get a deviation. Then we
square each deviation and multiply it by the probability of occurrence of
that outcome. Finally we add up all these weighted squared deviations and
take the square root, that is:
σ = √ p1(R1−(E)R)2 + p2(R2−(E)R)2 + ... + pn(Rn−(E)R)2
(8.2)
The higher the standard deviation, the greater the variability, and hence
the higher the risk.
Example: Consider First Class, a stock with a return of 24 per cent onehalf of the time and 10 per cent one-half of the time. The expected return
is 17 per cent (=0.5*0.24+0.5*0.10). The standard deviation is 7 per
cent:
= √ 0.5(0.24 − 0.17)2 + 0.5(0.10 − 0.17)2
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24 Principles of banking and finance
Activity 8.1*
Consider Second Class, a stock with a return of 16 per cent two-thirds of the time and 9
per cent one-third of the time. Then answer the following questions:
1. What is the expected return of the stock?
2. What is the standard deviation of the returns on the stock?
3. Is the Second Class stock more or less risky than the First Class stock?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Empirical evidence on risk, return and their relationship
What are the levels of risk and return of financial securities around the
world? The next activity enables you to find out some empirical evidence
on risk and average returns associated with different classes of securities
(stocks and bonds) for different countries.
Activity 8.2
Download the Credit Suisse Global Investment Returns Yearbook 2010, available at:
http://tinyurl.com/DMS2010
Carefully read the country profiles for the 19 countries focusing on figure 3 in each profile
which shows the returns and risks of major asset classes from 1900 to 2009.
The empirical evidence provided in the ‘Global Investment Returns
Yearbook 2010’ shows both real and nominal returns. (Note that the
difference between nominal and real performance rates arises because
the purchasing power of income is reduced by inflation.) Among the 19
countries under investigation over 110 years, the best performer for stocks
over the very long term is Australia, with an annualised percentage real
return of 7.5 per cent since 1900, compared to a world average of 5.4 per
cent. The worst performer for stocks is Italy with an annualised percentage
real return of about 2.1 per cent since 1900. The best performer for
bonds is Denmark, with an annualised percentage real return of 3.0 per
cent since 1900, compared to a world average of 1.7 per cent. The worst
performer for bonds is Germany, with an annualised percentage real return
of about –2.0 per cent since 1900.
Let us now focus on the USA. To find out the risk and average returns
associated with different classes of securities in the US market, move to
the next activity.
Activity 8.3
Visit the Morningstar website at http://corporate.morningstar.com/ib/documents/
SampleContent/MktChartsImages.pdf and analyse the figure ‘Stock, Bonds, Bills and
Inflation’.
This Morningstar’s figure shows the amount available in 2006 by
investing $1 at the start of 1926 in each of the four security classes
(small companies’ stocks, large companies’ stocks, government bonds
and Treasury bills). Values take into account inflation (i.e. real returns).
By 2006, the performances in real terms are (in increasing order):
Treasury bills (a money market debt instrument) grew to $18, long-term
government bonds grew to $71, large stocks grew to $5658, and small
stocks grew to $13796. The performance of each security class coincides
with the intuitive risk ranking.
Following on, we turn our attention to the relationship between risk and
162
Chapter 8: Securities and portfolios – risk and return
9.07
9.01
13.00
13.0
13.04
17.0
19.12
16.48
14.24
12.00
9.36
7.12
4.48
2.24
0.00
6.00
sto
mm
on
S&
P
co
ck
s(
m
sto
Sm
all
fir
on
mm
Co
ck
s
0)
50
nd
bo
te
ra
po
Co
r
me
nt
ve
rn
Go
Risk premium (Extra return
versus T-bills)
s
s
nd
bo
ry
su
Tre
a
Average annual rate of
return (nominal)
Average annual rate of
return (real)
3.00
2.01
5.07
2.07
1.08
3.09
0.080
bil
ls
%
return. Figure 8.2 shows the risk (measured as risk premium, i.e. the
extra return versus Treasury bills) and return (as measured by the average
nominal and real annual rate of return) of US financial instruments over
the period 1926–2000. Treasury bills were the least profitable (3.9 per
cent nominal annual rate of return), but were also virtually risk-free (0 per
cent risk premium). Common stocks obtained the highest average return
(13 per cent nominal annual return), but also experienced the highest risk
(9.1 per cent risk premium).
Figure 8.2: Average rate of return and risk premium in the US
Source: Figure created using data from: Brealey and Myers, Principles of Corporate
Finance (2003) Table 7.1, p.186.
A first interesting fact about the relationship between risk and return
emerges: this relationship is positive. In other words, the performance of
each security class increases with the risk ranking. This occurs because
investors require compensation for bearing risk. The higher the risk
associated with a financial instrument, the higher the return investors
require to hold a financial asset.
Moreover the relationship between risk and return varies over time, as
shown in the next activity.
Activity 8.4
Visit the Morningstar website at http://corporate.morningstar.com/ib/documents/
SampleContent/MktChartsImages.pdf and analyse the figure on ‘Reduction of risk over
time’.
This Morningstar’s figure provides evidence on how risk reduces over time.
In the US market (with reference to the years 1926–2006), the level of risk
(measured in terms of variability of returns) decreases by holding financial
securities over longer periods of time. When the holding period is one
year only, the level of dispersion of returns is very high: between –50 per
cent and +135 per cent for small company stocks, and between 0 per cent
and +20 per cent for Treasury bills. When the holding period is up to 20
years, the level of variability of returns is much more limited: between +5
per cent and +20 per cent for small company stocks, and between 0 per
cent and +7 per cent for Treasury bills. Note that when the holding period
is up to 20 years, the average returns of different security class converge
towards the average nominal values analysed above. Specifically, they are:
12.6 per cent for small company stocks, 10.4 per cent for large company
stocks, 5.5 per cent for government bonds and 3.7 per cent for Treasury
bills.
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24 Principles of banking and finance
A second interesting fact about the relationship between risk and return
emerges: the relationship changes over different holding periods.
Specifically, the level of risk tends to reduce over longer holding periods.
Risk and return of a portfolio: portfolio analysis
A portfolio is a combination of different assets held by an investor. The
share of the value of each individual asset over the total value of the
portfolio is referred to as the weight of the asset in the portfolio. Obviously
the sum of the weights of all the assets of the portfolio must be one (unity).
Example: Consider an investor with a portfolio composed of two stocks:
75 The Coca Cola Company stocks and 50 Microsoft stocks. On 28 February
2008 the market prices of the two stocks were: The Coca Cola Company
$41.16, Microsoft $26.67. The total value of the portfolio is $4,420. The
portfolio weight for The Coca Cola Company is therefore 69.8 per cent.
Activity 8.5*
Calculate the portfolio weight for Microsoft.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
The expected return of a portfolio – (E)Rp – is simply the weighted
average of the expected returns of the individual stocks of which the
portfolio is composed, where the weights are the portfolio weights.
Formally, this is:
(E)Rp = w1 (E)R1 = w2 (E)R2 + ... + wn (E)Rn
(8.3)
where: wi = portfolio weight for stock i.
Going back to our example, assume that the expected return over the
coming year will be 10 per cent for The Coca Cola Company and 15 per
cent for Microsoft. The expected return of the portfolio of the investor is
11.5 per cent = (0.698 × 0.10 + 0.301 × 0.15).
The calculation of the risk of the portfolio is much more complex. We need
to understand the statistical concept of correlation, which measures the
degree to which two returns tend to move together. A positive correlation
means that the two returns tend to move together; a negative correlation
implies that the two returns tend to move in opposite directions; a zero
correlation indicates that the returns of the stocks are wholly unrelated.
A statistical measure of correlation is known as the correlation coefficient.
It is simply the covariance divided by the product of the respective standard
deviations. Formally the correlation coefficient is defined as follows:
σ1,2
(8.4)
ρ1,2 = σ σ
1 2
where: σ1,2 = covariance between stocks 1 and 2, which is a measure of
the degree to which the two stocks move together over time (covary).
The portfolio variance is the weighted average of several components: a)
the variance of the returns on each stock (σi2 with i = 1,2) multiplied by
the square of its portfolio weight (xi2); b) the covariance between stocks 1
and 2. Formally, this is:
2
σ 2p = w 21 σ 21 + w22 σ 2 + 2w1w2 ρ1,2 σ1σ2
(8.5)
The portfolio standard deviation is of course the square root of the
variance. Note that the standard deviation of a portfolio is simply the
weighted average of uncorrelated (i.e. ρ1,2= 0).
164
Chapter 8: Securities and portfolios – risk and return
Now, given the expected returns, return variances and correlation
coefficient for any set of assets, we should be able to calculate the
expected return and variance of a portfolio composed of these assets.
Example: Recalling our portfolio composed of The Coca Cola Company
and Microsoft, let us calculate its variance. In the past the standard
deviations were 35 per cent for The Coca Cola Company and 50 per cent
for Microsoft. Assume that the two stocks are positively – but not perfectly
– correlated (i.e. ρ1,2= 0.5). The variance of the portfolio is 11.9 per cent =
[(0.698)2 × (0.35)2], + [(0.302)2 × (0.50)2] + 2 (0.698 × 0.302 × 0.5 × 0.35 ×
0.50). Therefore the standard deviation is 34.5 per cent.
Activity 8.6*
Using the same weights and standard deviations given above, calculate the portfolio
return variance in these three cases:
1. Negative correlation between returns, ρ1,2 = – 0.3.
2. Perfect positive correlation between returns, ρ1,2 = 1.
3. Uncorrelated returns, ρ1,2 = 0.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Benefits of diversification
From most of the above calculations, you can note that the variance
of the portfolio return is lower than that of any individual asset. This
suggests that by forming portfolios (or by including additional assets in
the portfolio), risk-averse investors are able to reduce risk. This process
is referred to as diversification. The reason this works is that, in real
stock return data, the correlations between returns are less than perfect.
Note that diversification does not work in the extremely rare cases where
returns move perfectly together. Conversely, if returns are uncorrelated, it
is possible through diversification to reduce risk to zero.
As shown in Figure 8.3 diversification can significantly reduce risk. The
portfolio variance falls as the number of assets held increases. This benefit
can be achieved even with a relatively small number of stocks (around 20
stocks).
60
Portfolio standard deviation
50
40
30
20
10
0
0
5
10
15
20
25
Number of assets
Figure 8.3: Benefits of diversification
Source: Graph created using data from: Elton, E.J., M.J. Gruber, S.J. Brown and W.N.
Goetzmann Modern Portfolio Theory and Investment Analysis. (New York: John Wiley &
Sons, 2007) p.59.
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24 Principles of banking and finance
Activity 8.7
Read Mishkin and Eakins (2009), p.75 (footnote 2) and summarise their example of how
diversification works.
The effectiveness of diversification in reducing the risk of a portfolio varies
from country to country as shown in Figure 8.4. In Switzerland, Germany
and Italy stocks tend to move together (high covariance), and thus
diversification is less effective. Instead, in Belgium and the Netherlands,
much more of the risk of holding individual stocks can be diversified away
because of the low covariance.
90,00
80,00
70,00
60,00
50,00
40,00
30,00
20,00
10,00
0,00
Switzerland
Germany
Italy
UK
France
US
Netherlands
Belgium
International
stocks
Figure 8.4: Percentage of the risk on an individual security that can be
eliminated by holding a random portfolio of stocks (1975)
Source: Graph created using data from: Elton, E.J., M.J. Gruber, S.J. Brown and W.N.
Goetzmann Modern Portfolio Theory and Investment Analysis. (New York: John Wiley &
Sons, 2007) p.61.
Activity 8.8
Now think about what an investor in say, Germany, can do to achive greater risk
reduction.
The investor could invest some of their wealth in stocks listed outside
of Germany. In fact many investors and investment funds diversify
their portfolios internationally. However, this brings an additional risk
– exchange rate risk. That is, the value of the foreign investments may
decline due to changes in the exchange rate.
Mean-standard deviation portfolio theory
The aim of this section is to identify the optimal holding of risky assets for
a risk-averse agent, since the investor seeks to minimise risk. This is known
as the mean-standard deviation portfolio theory, and was developed by
Markowitz (1952). The assumption is that agents have preferences that
only involve expected portfolio returns and return standard deviations.
The utility function is increasing in expected portfolio returns, and
decreasing in return standard deviation.
Efficient frontier and optimal portfolio with no risk-free asset
Let us first consider two risky assets named X and Y. (We thus assume that
there is no risk-free asset.) The two assets can be combined, according to
some weights, to form a portfolio (a new asset). The diagram shown in
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Chapter 8: Securities and portfolios – risk and return
Figure 8.5 describes the mean (Y-axis) and the standard deviation (X-axis)
of any risky asset, and each point in this diagram represents an asset. As
the portfolio weights for the two assets vary from 0 to 1, the portfolio
goes from one that contains only asset X, to one that contains a mixture of
assets X and Y, and then to one that contains only asset Y. As the portfolio
weights vary, the new portfolios trace out a curve that includes assets X
and Y. This curve, which looks something like the curved shape in Figure
8.5, is named the mean-standard deviation frontier. It shows the
expected return and risk that could be achieved by different combinations
(portfolios) of the two risky assets, and enables understanding of how
investors view the trade-offs between means and standard deviations
when they choose the portfolio weights of the assets to include in their
portfolios. Note that an implicit assumption is made that investors are
prohibited from short selling the assets (and thus borrowing the required
money).
As the investor’s preferences are increasing in return and decreasing in
standard deviation (the investor wants to go up and to the right within
the area of the diagram), the optimal portfolio will always lie on the
frontier and to the right of the point labelled V. This point V represents the
minimum-variance portfolio (i.e. a portfolio that offers the minimum risk).
The minimum variance portfolio is found by differentiating the equation
for the portfolio variance (equation 8.5) with respect to one of the
weights, say, w1. The derivative of this equation is then set to zero and
solved for w1.
2
2
2
w1 = (σ 2 − σ1σ2 ρ1,2) / (σ 1 + σ 2 − 2 σ1σ2 ρ1,2)
The weight of the other asset (w2) in the minimum variance portfolio is
found from:
w2 = 1 – w1
Using the two calculated weights in equations 8.3 and 8.5 will give us
the expected return and standard deviation of the minimum variance
portfolio.
Expected return (E)R
Y
V
M -SD frontier
X
Standard deviation (σ)
Figure 8.5: Mean-standard deviation frontier (2 risky assets)
Only the upper part of the mean-standard deviation frontier will be of
interest to risk-averse investors. In fact only the portfolios on the frontier
and to the right of V maximise the expected return for a given standard
deviation. In the absence of a risk-free asset, this set of portfolios (on the
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24 Principles of banking and finance
Expected return (E)R
frontier and to the right of V) is termed the efficient frontier (as shown
in Figure 8.6). This is the group of portfolios that both minimise risk for a
given level of expected return, and maximise expected return for a given
level of risk.
B
A
Efficient frontier
v
Standard deviation (σ)
Figure 8.6: Efficient frontier (2 risky assets)
Activity 8.9*
Risky asset A has an expected return of 15% and a standard deviation of 25%
Risky asset B has an expected return of 35% and a standard deviation of 40%. If the
correlation between the returns on assets A and B is 0.25 and the assets are combined in
the following proportions:
A
B
1
1
0
2
.75
.25
3
.5
.5
4
.25
.75
5
0
1
Calculate
i. the expected return and standard deviation for the 5 portfolios
ii. the expected return and standard deviation for the minimum risk portfolio
iii. plot all the portfolios calculated in (i) and (ii) on a graph and identify the efficient
frontier.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
In order to identify the optimal portfolio (of two risky assets) for a
given investor, we need to identify a set of preferences for this investor.
This set of preferences towards risk and return can be represented by
an indifference curve. Figure 8.6 shows two indifference curves for
investors A and B respectively. The quite steep indifference curve on the
left represents a relatively risk-averse investor (investor A), while the
flatter indifference curve on the right represents a less risk-averse investor
(investor B). The optimal portfolio is the portfolio where the investor’s
indifference curve is tangent to the mean-standard deviation frontier.
These two optimal portfolios (for the two different investors) are identified
on Figure 8.6 at points A and B.
In Figure 8.7 we draw the mean-standard deviation frontier for N risky
assets using every possible weighting scheme. The set of all points
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Chapter 8: Securities and portfolios – risk and return
Expected return (E)R
representing portfolios made from N assets is called the feasible set or
feasible region. The shape of the frontier is the same as in the case of
two risky assets (as drawn in Figure 8.5). The difference is that the shaded
area represents feasible but inefficient portfolios, which do not maximise
the expected return for a given standard deviation.
Feasible region
Standard deviation (σ)
Figure 8.7: Mean-standard deviation frontier (N risky assets)
Activity 8.10*
Consider a rational investor who has to choose one portfolio. Which portfolio would
always be preferred for each of the following pairs of portfolios?
1. Portfolio A E(R) = 17%
σ = 16%
Portfolio B
E(R) = 17%
σ = 6%
2. Portfolio C E(R) = 15%
σ = 16%
Portfolio D
E(R) = 12%
σ = 16%
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Mean-standard deviation frontier with arbitrary correlation (ρ)
In the last section, the mean-standard deviation frontier has been
identified by assuming that the return correlation coefficient was between
plus and minus one. Figure 8.8 shows the locus of the return-standard
deviation frontier assuming different correlation coefficients. When there
is perfect correlation (ρ = +1), the return–risk combinations are represented
by a straight line. When the risky assets have less than perfect correlation
(ρ <+1), the investor can reduce the portfolio risk by diversification. (As
previously discussed, the standard deviation of this portfolio is less than
the weighted average of the two standard deviations.) This gives the
curvature to the left. The correlation determines the degree of curvature:
the lower the correlation, the more distended the curvature. Finally, when
the investor can include in the portfolio a risk-free asset with a return
perfectly negatively correlated (ρ = –1), the return-risk combinations are
represented by a pair of lines.
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24 Principles of banking and finance
Expected return (E)R
B
CML1
A
CML2
K
Rf
M -SD frontier
Standard deviation (σ)
Figure 8.8: Mean-standard deviation frontier with arbitrary correlation
The introduction of a risk-free asset: the capital market line
Expected return (E)R
Let us now introduce a risk-free asset, with expected return Rf and
zero standard deviation. (As discussed in Chapter 2, in the USA the
least risky asset is a US Treasury bill.) In Figure 8.9 we have plotted the
expected return and risk of a portfolio composed by the risk-free asset
and a combination of risky assets. A range of combinations of the risk-free
asset and a portfolio of risky assets exist and two possible combinations
(labelled CML1 and CML2) are shown in Figure 8.8. Note that CML stands
for capital market line.
ρ= −1
Rf
ρ= 0
ρ= −1
ρ= +1
Standard deviation (σ )
Figure 8.9: Mean-standard deviation frontier (risk-free asset and N risky
assets)
We now need to identify the optimal portfolio for an investor who
wants to hold a risk-free asset in addition to N risky assets. What is the
optimal portfolio of risky assets for the investor? The optimal portfolio is
represented by point K in Figure 8.8. The reason for this is that an investor
will prefer to be somewhere on CML1 rather than any other CML (joining
the risk-free asset to the efficient frontier (such as CML2).as all points
along CML1 are superior (in terms of return for a given risk) to points on
say, CML2. In presence of a risk-free asset and N risky assets, the efficient
set becomes the optimal capital market line (CML1).
We have achieved a very important result known as two-fund
separation. Any risk-averse investor can form the optimal portfolio by
combining two funds. The first is the risk-free asset, the second is the risky
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Chapter 8: Securities and portfolios – risk and return
asset portfolio K. The degree of risk-aversion determines the portfolio
weights placed on the two funds. For example, in Figure 8.9, investor A
is more risk-averse than investor B, and thus A puts more weight on the
risk-free asset. This result allows us to identify the optimal portfolio of
risky assets, K, that all investors who invest in risky assets will choose to
hold irrespective of their risk preference. The two-fund separation theorem
forms the starting point for the important Capital Asset Pricing Model,
discussed in the next section.
Optimal portfolios of the risk-free asset and the risky portfolio, K, lie along
CML1 such that points to the left of K represent lending portfolios where
the investor invests positive amounts in the risk-free asset. Points to the
right of K represent borrowing portfolios where the investor borrows
at the risk-free rate to increase the amount of funds they can invest in
the optimal risk assets portfolio K. An example will help to illustrate
this. Suppose an investor has $10,000 to invest. The expected return on
portfolio K is 15 per cent and the standard deviation of returns is 20 per
cent. The risk-free rate of interest is 5 per cent. A risk-averse investor may
wish to invest half of his/her wealth ($5,000) in the risk-free asset and
half ($5,000) in portfolio K. What is the expected return and risk for this
efficient portfolio, say, A?
E(RA) = 0.5 × 5% + 0.5 × 15% = 10%
σA = 0.5 × 0 + 0.5 × 20% = 10%
Note that the standard deviation of portfolio A is simply a linear weighted
average of the individual risks of the two funds. Of course, the standard
deviation of the risk-free asset is zero so the risk of this efficient lending
portfolio is simply the weight assigned to portfolio K multiplied by the
risk of portfolio K. A more risk-seeking investor may choose to borrow, at
the risk-free rate, an amount of $5,000 giving him/her a total of $15,000
to invest in portfolio K. The expected return and risk of this borrowing
portfolio, say B, is given by:
E(RB) = −0.5 × 5% + 1.5 × 15% = 20%
σB = −0.5 × 0 + 1.5 × 20% = 30%
Activity 8.11
How can investors identify the best set of efficient portfolios of common stocks? What
does ‘best’ mean?
Asset pricing models
The problem we want to solve in this section is to determine the correct,
arbitrage-free, or fair price of an asset in equilibrium. In order to do so, it
is necessary to identify theories that enable us to deduce this equilibrium
price of a risky asset. We analyse first the Capital Asset Pricing Model
(CAPM), which identifies the equilibrium price within the framework
of the mean-standard deviation frontier. We then move to the Arbitrage
Pricing Theory (APT), which does not require the assumption that
investors choose their portfolios on the basis of means and standard
deviations, but rather on the basis that two assets that are the same cannot
sell at different prices. The CAPM model has been developed primarily by
Sharpe (1964) and Lintner (1965), and the APT by Ross (1976).
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24 Principles of banking and finance
Capital Asset Pricing Model (CAPM)
To implement the mean-standard deviation frontier requires observing
the optimal portfolio, which is the tangent portfolio (as discussed in the
previous section). However, it is impossible to derive the tangent portfolio
simply from observed returns on large numbers of risky assets. We thus
need a theory that identifies the tangent portfolio from sound theoretical
assumptions. This section develops one such theory, the Capital Asset
Pricing Model (CAPM).
To begin our discussion of the CAPM, let us first present the assumptions
that underlie the theory:
1. Investors maximise their utility only on the basis of expected portfolio
returns and return standard deviations.
2. Unlimited amounts can be borrowed or loaned at the risk-free rate.
3. Markets are perfect and frictionless (i.e. no taxes on sales or purchases,
no transaction costs and no short sales restrictions).
4. Investors have homogeneous beliefs regarding future returns, which
means that all investors have the same information and assessment
about expected returns, standard deviations and correlations of all
feasible portfolios.
(Note that assumptions 1–3 were implicit in the mean-standard deviation
analysis, while assumption 4 is an additional one needed to develop the
CAPM.)
From these assumptions, the main conclusion of the CAPM is that in
equilibrium the tangent portfolio of risky assets must be the market
portfolio. From the two-fund separation theorem everybody will hold
a risk-free asset and a combination of risky assets. Furthermore, as
everybody shares the same beliefs, everybody will use the same efficient
fund of risky assets. This fund must be the market portfolio. Each investor
will hold the same portfolio as everybody else; in other words, everybody
will hold the market portfolio. The market portfolio is the portfolio
comprising all assets, where the weight on each asset is the market
capitalisation (also called market value) of that asset divided by the
total market capitalisation of all risky assets. These weights are termed
capitalisation weights. The market portfolio should include all risky assets
and therefore all stocks and bonds listed on all exchanges and those traded
over-the-counter as well as non-financial assets (such as real estate and
durable goods). Therefore, the exact composition of the market portfolio
is unobservable. Consequently, the implementation of the CAPM requires
using proxies for the market portfolio. A frequently used proxy is a broadbased equity index such as the S&P500 (500 typically larger market
capitalisation stocks traded on the NYSE and Nasdaq).
Capital market equilibrium requires that the demand for risky assets be
identical to their supply. The demand for risky assets is represented by the
optimal portfolio chosen by investors, whereas their supply is given by the
market portfolio. Under the CAPM assumptions, the equilibrium between
risk and return can be expressed as:
E(Ri*) = Rf + βi [E(RM) – Rf]
(8.6)
where:
βi = the covariance of the returns on asset i with the return on a market
portfolio, divided by the variance of the market return. Formally, this is:
βi = σiM / σ2M
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Chapter 8: Securities and portfolios – risk and return
E(RM) = expected return on the market portfolio
[E(RM) – Rf] = market risk premium, which is the amount by which the
return of the market portfolio is expected to exceed the risk-free rate.
The CAPM enables us to figure out what returns investors are looking
for from particular security. Specifically, under the CAPM framework, the
expected return of a given risky asset (or portfolio of assets) is equal to
the risk-free rate plus a market risk premium multiplied by the asset or
portfolio beta. To calculate this, we need three elements:
• risk-free rate
• beta
• market risk premium.
We showed estimates of the risk-free rate in the paragraph on ‘Empirical
evidence on risk, return and their relationship’; and we will do the same
for beta and market risk premium in the next paragraphs.
Beta
Under the CAPM framework, the standard deviation of an asset by itself is
no longer an important determinant of the expected return of that asset.
What is important is the beta of the risky asset (βi), which measures
the sensitivity of an individual security to the market movements. The
expected returns increase linearly with beta. Stocks with betas greater
than 1.0 tend to amplify the overall movement of the market: generally
speaking we expect aggressive companies or highly leveraged companies
to have high betas. Conversely, stocks with betas between 0 and 1 tend
to move less than the market: and therefore are typically conservative
companies. A stock with a beta equal to one will mimic the market.
Example: Consider the beta of Microsoft stock, which is equal to 1.527
(this estimate is provided by various data service organisations such as
Bloomberg, and it is calculated by using a record of past stock values).
This β value means that on average, when the market return increases by
an extra 1 per cent, Microsoft’s return will rise by an extra 1.527 per cent.
When the market decreases by an extra 2 per cent, Microsoft stock return
will fall an extra 2 ×1.572 = 3.144 per cent.
Activity 8.12
Visit the Yahoo finance website at http://finance.yahoo.com/. Download the beta values
for the following companies: Amazon.com, Coca-Cola Co, Exxon Mobil, General Electric,
General Motors, Google Inc., Hewlett Packard Co. (To do this, insert the name of the
company in the section ‘Get Quotes’, and then click on ‘Key statistics’ under ‘Company’).
Now rank these companies on the basis of their betas, identify the minimum and the
maximum value, and explain the reasons for the differences.
Activity 8.13
Decide whether each of the following statements is true or false.
The expected return of an asset with a beta of 0.5 is half the expected return of the
market.
If the beta of an asset is lower than 0, the CAPM implies that its expected return will be
lower than the interest rate.
The beta of a portfolio (βp) is simply the weighted average of the betas
of the individual assets in the portfolio (Bi), where the weights are the
portfolio weights (wi). Formally this is:
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24 Principles of banking and finance
βp =
∑wβ
i
i
(8.7)
Market risk premium
What about the value of the market risk premium? The market risk
premium cannot be measured with precision, and practitioners and
scholars are still debating about its magnitude and the method to be used
for the estimation. Specifically, it can be estimated either by using an
arithmetic average or a geometric average of historical returns.
2.24
7.05
6.02
5.08
5.06
4.05
7.04
4.00
5.03
5.02
3.01
6.01
6.08
4.08
6.06
5.03
6.04
8.02
10.00
3.04
4.06
5.07
5.00
4.04
3.02
3.36
2.07
4.48
4.06
6.00
5.09
7.12
7.01
7.00
8.24
9.06
8.05
9.36
9.05
10.48
10.06
With regard to the magnitude, some recent empirical evidence, as
summarised in Figure 8.10, shows that the annualised arithmetic equity
risk premium relative to bills was 7.05 per cent for the USA, 6.02 per
cent for the UK and 5.09 per cent for the world index for the years from
1990–2001. These values are somewhat lower than the historical average
risk premium over the longer period 1926–2000: for example, for the
USA the risk premium over 1926–2000 was equal to 9.1 per cent (= 0.13
– 0.039; see Figure 8.2). The value of the market risk premium varies
internationally: over the period 1990–2001, the risk premium in Denmark
was only 3.02 per cent (bottom end), whereas in Germany it was up to
10.0 per cent and in Italy to 10.06 per cent. Some of these variations may
reflect differences in risk (i.e. Italian stocks may have been particularly
variable and investors may have required a higher return to compensate).
Geometric
Arithmetic
1.12
US
UK
W
or
Au ld
str
ali
Be a
lgi
um
Ca
na
De da
nm
ar
k
Fra
nc
Ge e
rm
an
y
Ir e
l an
d
Ita
ly
Th
e N Jap
a
et
he n
r
So land
ut
h s
Af
ri c
a
Sp
ain
Sw
ed
Sw
en
i tz
er
lan
d
0.00
Figure 8.10: Market risk premium (relative to bills) around the world
(1990–2001)
Source: Figure created using data from Dimson, Marsh, Staunton (2003).
As regard to the method to be used for the estimation, Figure 8.10 reveals
that the risk premium measured by geometric averages is much lower than
the premium based on arithmetic averages. For example, the annualised
geometric equity risk premium relative to bills was 5.06 per cent for the
USA (instead of 7.05 per cent). Accordingly, the Global Investment Returns
Yearbook 2005 (LBS/ABN Amro) estimates that the plausible forwardlooking risk premium for the world’s major markets would be of the order
of 3 per cent relative to bills on a geometric mean basis, whereas the
corresponding arithmetic mean risk premium would be around 5 per cent.
Which method should be preferred? The arithmetic average is the norm
for the estimation, but the debate is still open (for example Jacquier et
al., (2003) show that the correct estimation requires compounding at a
weighted average of the arithmetic and geometric historical averages).
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Chapter 8: Securities and portfolios – risk and return
Security market line
The CAPM equilibrium relationship between risk and return has a very
simple graphical representation. The CAPM formula can be seen as a
linear relationship between the expected return and β, which is known
as the security market line (SML). As shown in Figure 8.11, beta is on
the horizontal axis, while the expected return is on the vertical axis. The
expected return on a risk-free asset is Rf. An asset with β of unity has
an expected return equal to that of the market E(RM): this asset is the
market portfolio (M). Therefore the security market line is a straight
line emanating from the risk-free point and passing through the market
portfolio. In equilibrium every stock must lie on the security market line:
no stock can lie below or above the security market line. This happens
because any investor can always obtain a market risk premium of
βi[E(RM) – Rf] by holding a combination of the market portfolio and the
risk-free asset.
Expected return (E)R
Example: Consider Microsoft stock. Given a beta equal to 1.527, a market
risk premium of 9 per cent, and a risk-free rate of 3.5 per cent, the
expected return for Microsoft must be 11.9 per cent [= 0.035 + 1.527 ×
(0.09 – 0.035)].
M
E(R M )
SML
Rf
1
Beta (β)
Figure 8.11: Security market line
Activity 8.14*
Assume that the return on US Treasury bills is 3 per cent, the expected return on the
market portfolio is 12 per cent. On the basis of the CAPM:
1. Draw a graph showing the relationship between the expected return and beta.
2. What is the risk premium on the market?
3. What is the required return on a stock with a beta of 1.5?
4. What is the beta of a stock if the market return is expected to be 12.5 per cent?
*The solution to part of this activity can be found at the end of the subject guide in
Appendix 1.
Diversifiable risk and market risk
In equilibrium two assets with identical expected returns must have
identical betas, although their standard deviations can differ. The reason
for the difference in the standard deviation is that a portion of risk can
be eliminated through diversification (as discussed before). The risk that
can be eliminated by diversification is known as diversifiable risk
(or unique, specific, non-systematic risk), which is the risk peculiar to a
company or its immediate competitors. Investors do not need any reward
to bear such risk, and hence diversifiable risk does not affect expected
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24 Principles of banking and finance
returns. However, there is some risk that cannot be avoided, regardless
of how much investors diversify. This risk is known as market risk (or
systematic, undiversifiable risk), which can be thought of as the risk
of the market as a whole. The exposure of an asset to such risk can be
summarised by beta.
For a reasonably well diversified portfolio only market risk matters. Recall
Figure 8.3, which shows that the portfolio standard deviation depends on
the number of securities in the portfolio. Following on, as shown in Figure
8.12, by adding securities, and therefore by diversification, portfolio
standard deviation decreases until all diversifiable risk is eliminated, and
only market risk remains. (If you have only one stock, diversifiable risk
is very important; however, if you hold a portfolio of 20 or more stocks,
only market risk matters.) The magnitude of market risk depends on the
average betas of the securities included in the portfolio.
σ
Diversifiable
risk
β
Market risk
Number of securities
Figure 8.12: Diversifiable and market risk
Theoretical and practical limitations of the CAPM
The tests of the CAPM investigate how well it describes reality. However,
even before we examine these tests, it is useful to develop an asset pricing
model based on more realistic assumptions. The CAPM developed in the
previous section is termed the standard CAPM because it provides a
complete description of the behaviour of capital markets if each of the
underlying assumptions are held. A wide literature examines the effects
of modifying these assumptions, with a special emphasis on two of them:
the ability to lend and borrow infinite sums of money at the risk-free rate
(in the real world, generally the risk-free rate is not a real rate because
of uncertainty about inflation, and borrowing rates are higher than
lending rates), and the absence of personal taxes. The removal of these
assumptions leads to the development of the non-standard forms of the
CAPM. (Note that in practice none of these modified versions is as widely
used as the standard CAPM.)
From a theoretical perspective, the implementation of the CAPM requires
the use of proxies for the market portfolio because the exact composition
of the market portfolio is unobservable (as explained earlier). As argued
by Roll (1977), the unobservability of the market portfolio makes the
CAPM untestable. Given that the quality of the proxies used for the market
portfolio cannot be guaranteed, it is not possible to test the CAPM. There
could be two alternative situations.
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Chapter 8: Securities and portfolios – risk and return
• First, it might be the case that the market portfolio is efficient (and
hence the CAPM is valid), but the proxy chosen is inefficient (and
hence the empirical tests incorrectly reject the CAPM).
• Second, the proxy for the market portfolio might be efficient (and
hence the empirical tests validate the CAPM), but the market portfolio
itself is not efficient (and hence the validation is false).
Academics have been debating whether the CAPM is testable for many
years without arriving at a consensus; nevertheless the model is widely
applied by practitioners and largely tested by researchers by using several
proxies for the market portfolio. These tests provide valuable – but not
conclusive – insights on the appropriateness of the CAPM. Overall, these
tests provide broad support for the CAPM by showing that the expected
return increased with beta over the period 1931–91, even if less rapidly
than the CAPM has predicted. However, critics of the CAPM pointed out
two problematic pieces of empirical evidence.
• First, in recent years the slope of the security market line has been
much flatter than one would expect from the CAPM. This means
that high-beta stocks performed better than low-beta stocks, but the
difference in their actual returns was not as great as the CAPM would
predict. This evidence is against the CAPM. However, the supporters
of the CAPM argue that the evidence could be due to the fact that the
CAPM itself is concerned with expected returns, whereas the tests only
use actual returns. Actual returns do reflect expectations, but they are
also largely affected by noise.
• Second, factors other than beta (such as firm size, book-to-market
ratio, price-to-earnings ratio and dividend yield) have all been found in
empirical studies to explain ex-post realised returns (after controlling
for beta). This contrasts with the CAPM, which predicts that beta is
the only factor that explains expected returns. For example, small
capitalisation stocks (known as small-cap) did better than large
capitalisation stocks over the period 1932–97. Although they have
higher betas, the difference in betas is not enough to explain the
difference in returns. It seems that investors saw risks in small-cap that
were not captured in their beta. One explanation for this result could
be ‘data-snooping’ or ‘data mining’. (This refers to the fact that many
researchers look at past sample returns, and they are bound to find a
strategy that, just by pure chance, has worked in the past.) Actually,
the supporters of the CAPM proved that the small–large cap results
vanished once they were discovered.
This empirical evidence can suggest either that the CAPM does not hold or
that tests do not prove anything about the CAPM because of Roll’s insights.
The controversial nature of the evidence and the difficulties in interpreting
this evidence have led to other asset pricing theories, such as the Arbitrage
Pricing Theory (discussed in the next section).
Arbitrage Pricing Theory (APT)
The alternative asset pricing paradigm, known as Arbitrage Pricing Theory
(APT) is, in some ways, less complicated than the CAPM. It simply requires
that the returns on any stock be linearly related to one factor (or a set of
factors), as with factor models (discussed below).
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24 Principles of banking and finance
Factor models
The basic idea of factor models is that all common variations in stock
returns are generated by movements in one factor (or a set of factors). The
simplest factor model is a one-factor model, which assumes that there is
only one factor. Formally, it can be written as:
Ri = ai + bi1F1 + εi, E(εi) = 0
(8.8)
where:
ai = expected level of return for stock i if all factors have a value of zero.
F1 = value of the factor 1 that affects the returns on stock i. The factor
is posited to affect all stock returns, although different stocks can have
different sensitivities. The factor can be represented by macroeconomic
conditions, financial conditions or political events. Examples are: market
index (e.g. S&P500), yield spread (return on long-term government bonds
less return on 30-day Treasury bills), interest rate (change in Treasury bill
return), change in the forecast of real GNP (Gross National Product), and
change in forecast of inflation.
bi1 = sensitivity of the returns on stock i to factor 1. High values of bi1
imply that variations in F cause very large movements in the return on
stock i; whereas small values indicate that stock i reacts only slightly to
changes in F.
εi = random error term. This random stock return is termed the
idiosyncratic return component for stock i. It has a mean equal to zero and
variance equal to σ2ei. Moreover, it is uncorrelated across stocks and with
F; thus Cov (εi, εj)= 0, and Cov (εi, F)= 0. The idiosyncratic return comes
from events that are unique to the firm. Examples of the idiosyncratic
return can be a legal action against the company of stock i, or the
unexpected departure of a company’s CEO.
A generalisation of equation (8.8) represents a multi-factor model, where
a set of j factors affects the returns on stock i:
Ri = ai + bi1F1 + bi2F2 + ...+ (εi),
E(εi) = 0
(8.9)
To determine the return on a portfolio, given the above factor structure,
we need to calculate the portfolio weighted averages of the individual
factor sensitivities. An example could clarify this simple calculation.
Example: Consider two stocks (X and Y), whose returns are determined
by the following one-factor model:
Rx = 0.03 + 0.9F1 + εx; RY = 0.06 + 0.8F1 + εY
To determine the return of an equally weighted portfolio of the two assets
(½ stock X and ½ stock Y), we simply need to form a weighted average of
the stock sensitivities of individual factors:
Thus the portfolio return can be written as:
ap =
1
1
(0.03 + 0.06) = 0.045 ; bp = (0.9 + 0.8) = 0.85
2
2
Thus the portfolio return can be written as:
RP = 0.045 + 0.85F1 + εP
Activity 8.15*
Assume that the portfolio weights of the above stocks (X and Y) are 0.25 and 0.75. Using
the data of the previous example, compute the portfolio return representation.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
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Chapter 8: Securities and portfolios – risk and return
Arbitrage Pricing Theory
The Arbitrage Pricing Theory (APT) is based on the primary – simple –
assumption that when returns are certain, investors prefer greater returns
to lesser returns. The mechanism for doing so involves the use of arbitrage
portfolios, and thus the following four assumptions:
1. There are no arbitrage opportunities. Arbitrage opportunities represent
the possibility of earning riskless profits by taking advantage of
differential pricing for the same asset. There are two possible ways to
define arbitrage strategies. First, to invest in a set of assets that yield
positive immediate cash inflow (obtained by the sale of assets at a
relatively high price and the simultaneous purchase of the same assets
at a relatively low price), with no loss in the future. Second, to invest
today in costless investment strategy, and to obtain positive future cash
inflows (as described above). In both cases, when returns are certain,
any investor who prefers greater returns to lesser returns would invest
as much as possible. Under the APT, these investment strategies should
not be permitted in properly functioning financial markets.
2. Returns of risky assets can be described by a factor model, as described
in the previous subsection.
3. Financial markets are frictionless (i.e. there are no transaction costs or
related market frictions).
4. There is a large number of securities and so investors hold welldiversified portfolios. This implies that diversifiable risk does not
exist. (Note that the sources of risk for any individual stock are: risk
arising from macroeconomic factors, which cannot be eliminated by
diversification; and diversifiable risk associated with events that are
unique to the firm, which can be totally eliminated by diversification.)
Under the APT, the absence of arbitrage opportunities places restrictions
on the relationship between the expected returns on individual assets (and
hence on a well-diversified portfolio) given the factor structure underlying
returns. The key to the APT is that a factor model with no arbitrage
opportunities implies that assets with the same factor sensitivities must
offer the same expected returns in financial market equilibrium. Therefore
the expected risk premium on an individual asset (equal to the expected
return on an individual asset minus the risk-free rate) depends on the sum
of the expected risk premiums associated with each factor multiplied
by the asset sensitivity to each of these factors. Thus the expected return
on an individual asset can be written as:
E(R*X)= Rf + b1x λ1 + b2X λ2 +...+bjX λj
(8.10)
where:
λj = (RFj– Rf), which is the risk premium over the risk-free rate associated
with factor j.
The risk premium is affected only by macroeconomic factors, and not
by unique risk (note the similarity with the CAPM). Moreover, it varies
in direct proportion to the asset’s sensitivity to the factor. For example,
consider a risk premium equal to 5 per cent for the real GNP factor. It
means that stocks with a positive average sensitivity to changes in real
GNP (i.e. with b = 1) give an additional return of 5 per cent a year
compared with stocks completely unaffected by real GNP. Conversely a risk
premium equal to –1 per cent for the inflation factor means that stocks
with average exposure to inflation give a 1 per cent less return than stocks
with no exposure to inflation. (Note that an asset with zero sensitivity to
each factor is essentially risk-free, and thus must be priced to offer the
risk-free rate.)
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24 Principles of banking and finance
Activity 8.16*
Consider a two-factor APT model. The factors and associated risk premiums are:
Factor
Risk premium
Change in GNP
6%
Change in long-term interest rates
1.5%
Assuming a risk-free rate equal to 6 per cent, calculate the expected rates of return on
the following stocks:
a. A stock whose return is uncorrelated with all the two factors.
b. A stock with a positive average exposure to each factor.
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Theoretical and empirical validation of the APT
The APT provides an interesting alternative perspective to that of the
CAPM on the nature of equilibrium. From a theoretical point of view,
however, the theory is far from easy to implement. The advantage
of the APT is that it does not require us to identify and measure the
market portfolio (solving most of the problems presented in the previous
subsection on the theoretical limitations of the CAPM). The disadvantage
is that it does not tell us what the underlying factors are (unlike the CAPM,
which collapses all the macroeconomic factors into the market portfolio).
Empirical research is still in the early stages as regards the APT, and is
not as well developed as the literature on the CAPM. Many studies have
been particularly interested in whether the APT explains the size effect
discussed about the CAPM. Although the evidence is not conclusive, the
majority of the studies (see among others: Chen, 1983; Chan, Chen and
Hsieh, 1985) find that the size effect becomes negligible in a multi-factor
framework. Other studies focused on the identification of the factors
with significant effects on risk premiums. Chen, Roll and Ross (1986)
emphasise the relevance of growth in real GDP, interest spread and
changes in default spreads.
Summary
180
The main objective of this chapter was to illustrate modern portfolio
theory. In order to do so, it began with an analysis of the risk–return
characteristics of individual securities and portfolios. It then moved to
the identification of the optimal portfolio of securities for a risk-averse
investor, taking into account the risk–return trade-off. This requires the
understanding of several important concepts, such as efficient frontier,
feasible region, and capital market line. The mean-standard deviation
analysis leads to a key result known as two-fund separation: any riskaverse investor forms an optimal portfolio by combining a risk-free asset
and a specific risky asset portfolio. This framework underlies the Capital
Asset Pricing Model (CAPM) used for the pricing of risky assets. The CAPM
states that in equilibrium the optimal risky portfolio must be the market
portfolio: thus the expected return of a risky asset has to be equal to the
risk-free rate plus a market risk premium multiplied by the asset beta
(β). An alternative asset pricing model is the Arbitrage Pricing Theory
(APT), which in a context of no arbitrage opportunities derives expected
returns on the basis of factor models. It asserts that assets with the same
factor sensitivities must offer the same expected returns in equilibrium.
A comparison of the theoretical and empirical validation of the two asset
pricing theories concluded the chapter.
Chapter 8: Securities and portfolios – risk and return
Key terms
actual return
Arbitrage Pricing Theory (APT) asset pricing models
beta
Capital Asset Pricing Model capital market line
(CAPM)
capitalisation weights
correlation coefficient
diversifiable risk
diversification
efficient frontier
efficient set
expected return
expected risk premium
factor models
feasible region
frontier
market risk
mean-standard deviation
minimum-variance portfolio modern portfolio theory
optimal portfolio
portfolio
risk
risk-free asset
security market line
standard deviation
two-fund separation
variance
A reminder of your learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain how risk affects the return of a risky asset, and hence how risk
affects the value of the asset in equilibrium
• calculate risk and return for individual securities and portfolios, and
understand the basic statistical tools of expected returns, standard
deviations and covariances
• explain the mean-standard deviation portfolio theory, and the meaning
of its key concepts (efficient frontier, feasible region, capital market
line, and optimal portfolio)
• illustrate the effects of diversification
• explain the main assumptions and results of the CAPM
• illustrate the key concepts of the CAPM (beta and security market line)
• explain the main assumptions and results of the APT
• compare the theoretical and empirical validation of the CAPM and APT.
Sample examination questions
1. a.
‘The more risk-averse investors are, the more likely they are to diversify.’ Is this statement true, false or uncertain? Explain your answer.
b.
When the number of assets included in a portfolio increases, what is the effect on the portfolio standard deviation? When the
number of assets increases towards infinity, towards what value
does the portfolio standard deviation converge to?
c.
What does the mean-standard deviation frontier look like in the presence of two risky assets (and no risk-free asset)? How does it change when there is a risk-free asset? Why does one
line, the capital market line, dominate all the other possible portfolio combinations?
d.
Explain the tangent portfolio.
2. An investor has two assets available named X and Y. Asset X has an
expected return of 7 per cent and a standard deviation of 4 per cent.
Asset Y has an expected return of 12 per cent and a standard deviation
of 6 per cent.
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24 Principles of banking and finance
a.
Assume the investor places portfolio weight ½ on asset X, and ½ on asset Y. Assuming that the returns to the two assets are perfectly positively correlated, calculate the expected return
and the standard deviation to the portfolio.
b.
How would your answer change if the correlation coefficient were 0.5?
c.
Graphically depict the mean-standard deviation frontier implied
in parts a) and b).
d.
In general, what does the mean-standard deviation frontier look
like when the correlation coefficient is between –1 and +1?
3. What is the two-fund separation theorem? What implications does it
have for the optimal portfolio of risky assets held by investors? How
does the CAPM address this problem?
4. Under the CAPM framework, what is the market portfolio? What is
the security market line? What is the significance of the beta of a risky
asset? Support your answer with graphical evidence.
5. What is a factor model? What does absence of arbitrage mean? How is
the Arbitrage Pricing Theory derived from the two previous notions?
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Chapter 9: Financial markets – transmission of information
Chapter 9: Financial markets –
transmission of information
Aims
The aim of this chapter is to investigate whether stock prices reflect all
available information in financial markets, and hence whether the efficient
market hypothesis holds. In this chapter we will explain that the main
objective of informational efficiency tests is the ability of investors to make
excess returns on a certain information set. We then analyse the three
broad observable information sets commonly used to define informational
efficiency: weak-form, semi-strong-form and strong-form efficiency. Finally,
we illustrate the key empirical evidence in favour of or against each of the
three forms of efficiency.
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• explain whether stock prices reflect all available information, and
hence whether the efficient market hypothesis holds
• explain the relevance of the efficient market hypothesis, and derive the
hypothesis from a theoretical perspective
• explain the concept of excess returns in the context of informationefficient markets
• describe the three main forms of market efficiency (weak-form, semistrong-form and strong-form)
• discuss the empirical evidence in favour of weak-form efficiency
(random walk behaviour of stock prices, uselessness of technical
analysis) and against weak-form efficiency (presence of calendar effect,
small firm effect and mean reversion)
• discuss the empirical evidence in favour of semi-strong-form efficiency
(incorporation of earnings-announcement information) and against
semi-strong-form efficiency (market overreaction and underreaction to
new information)
• discuss the empirical evidence in favour of strong-form efficiency
(mutual fund performance) and against strong-form efficiency (excess
return of corporate insiders).
Essential reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (Boston,
London: McGraw-Hill/Irwin, 2010) tenth edition Chapter 13.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapter 6.
Further reading
Copeland, T.E., J.F. Weston and K. Shastri Financial Theory and Corporate Policy.
(Boston, London: Pearson Addison Wesley, 2005) Chapter 10.
Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio Theory
and Investment Analysis. (New York: John Wiley & Sons, 2007) Chapter 17.
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24 Principles of banking and finance
Smart, S.B., W.L. Megginson and L.J. Gitman Corporate Finance. (Mason, Ohio:
South-Western/Thomson Learning, 2004) Chapter 10.
References
Allen, F. and R. Karjalainen ‘Using Genetic Algorithms to Find Technical Trading
Rules’, Journal of Financial Economics 51(2) 1999, pp.245–71.
Ball, R. and P. Brown ‘An Empirical Evaluation of Accounting Income Numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Bernard, V. and J. Thomas ‘Post-earnings announcement drift: Delayed price
response or risk premium?’, Journal of Accounting Research 27(3) 1989
supplement, pp.1–36.
Brock, W., J. Lakonishok and B. LeBaron ‘Simple Technical Trading Rules and
the Stochastic Properties of Stock Returns’, Journal of Finance 47(5) 1992,
pp.1731–764.
Carhart, M.M. ‘On Persistence in Mutual Fund Performance’, Journal of Finance
52(1) 1997, pp.57–82.
Cheng-few L., D.C. Porter and D.G. Weaver ‘Indirect tests of the HaugenLakonishok small-firm/January effect hypotheses: window dressing versus
performance hedging’, The Financial Review (1998) 33, pp.177–94.
DeBondt, F.M. and R. Thaler ‘Further Evidence on Investor Overreaction and
Stock Market Seasonality’, Journal of Finance 42(3) 1987, pp.557–80.
Fama, E. ‘Efficient Capital Markets: A Review of Theory and Empirical Work’,
Journal of Finance 25(2) 1970, pp.383–417.
Fama, E. ‘Efficient Capital Markets II’, Journal of Finance 46(5) 1991, pp.1575–
618.
Fama, E. and K.R. French ‘Permanent and Temporary Components of Stock
Prices’, Journal of Political Economy 96(2) 1988, pp.246–73.
Grinblatt, M. and S. Titman ‘Mutual Fund Performance: an Analysis of
Quarterly Portfolio Holdings’, Journal of Business 62(3) 1989, pp.393–416.
Haugen, R. and J. Lakonishok The Incredible January Effect. (Dow Jones-Irwin,
Homewood, Illinois, 1988) [ISBN 9781556238710].
Jegadeesh, N. and S. Titman ‘Returns to Buying Winners and Selling Losers:
Implications for Stock Market Efficiency’, Journal of Finance 48(1) 1993,
pp.65–91.
Jensen, M.C. ‘The performance of Mutual Funds in the Period 1945–64’,
Journal of Finance 23(2) 1968, pp.389–416.
Keim, D.B. ‘The CAPM and Equity Return Regularities’, Financial Analysts
Journal 42(3) 1986, pp.19–34.
Lo, A. and C. MacKinlay ‘Stock Market Prices do not Follow Random Walks:
Evidence from a Simple Specification Test’, Review of Financial Studies 1(1)
1988, pp.41–66.
Patell, J.M. and M.A. Wolfson ‘The Intraday Speed of Adjustment of Stock
Prices to Earnings and Dividend Announcements’, Journal of Financial
Economics 13(2) 1984, pp.223–52.
Poterba, J.M. and L.H. Summers ‘Mean Reversion in Stock Prices: Evidence and
Implications’, Journal of Financial Economics 22(1) 1988, pp.27–59.
Introduction
In Chapter 7 we learned the methods used for security valuation. The
main aim of this chapter is to investigate how good the financial market
is at establishing prices for securities by using all available information.
A financial market is referred to as informational efficient, when security
prices fully reflect all available information. This form of efficiency is
referred to as informational efficiency.
Informational efficiency is a more specific form of the general valuation
efficiency, which refers to whether the prices of the securities traded on
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Chapter 9: Financial markets – transmission of information
a market reflect the true fundamental (also termed intrinsic or fair) value
of the securities. Under valuation efficiency, all prices are always correct,
and reflect market fundamentals (items that have a direct impact on
future cash flows of the security). Therefore, the market price of a security
is the fair price, and has to be equal to the expected cash flows from the
security using all relevant information. Informational efficiency is a more
specific form of efficiency than valuation efficiency, because it assumes
that expectations are optimal forecasts using all available information, but
not that market prices reflect the fair value.
Valuation efficiency and informational efficiency are conditions for the
achievement of the most general efficiency condition of financial markets:
allocative efficiency. This refers to whether a market allocates
productive resources to the most productive investments in performing
its main function of channelling funds from saver-lenders to spenderborrowers (as described in Chapter 2). This requires asset prices to reflect
accurately the discounted stream of future cash flows the asset is expected
to generate over its existence (see Chapter 7). The price of an asset then
acts as a signal directing resources from savers into the common stocks
yielding the highest returns and from firms into the real assets yielding the
highest returns.
This relationship between informational efficiency and allocative efficiency
is captured in the following opening paragraph from Fama’s 1970 review
of the evidence on market efficiency:
The primary role of the capital market is allocation of ownership
of the economy’s capital stock. In general terms, the ideal is a
market in which prices provide accurate signals for resource
allocation: that is, a market in which firms can make productioninvestment decisions, and investors can choose among the
securities that represent ownership of firms’ activities under
the assumption that security prices at any time ‘fully reflect’ all
available information. A market in which prices always ‘fully
reflect’ available information is called ‘efficient’. Fama, (1970)
Informational efficient markets
The concept of informational efficient markets is of fundamental
importance for several reasons.
First, the main objective of capital budgeting is to maximise shareholder
wealth, which implies the maximisation of the value of the firm’s stocks
(please refer to our discussion on the Net Present Value in Chapter 7).
As a consequence, it is important that financial markets are able to value
the firm’s stocks correctly. The signal given by the financial market to
the stockholders (through the price) has to reflect the firm’s decisions on
investment projects in a correct way.
Moreover, capital budgeting techniques use a discount rate for the
appraisal of real assets. If financial markets were inefficient, it would
be virtually impossible for managers to take rational capital investment
decisions on behalf of stockholders because it would be impossible to
identify the opportunity cost of capital to be used in the Net Present Value
calculation. Therefore different investments with the same degree of risk
could generate different rates of return, and the managers would not be
able to choose the best available forgone rate of return.
Finally, one main assumption in portfolio theory is that a financial market
is reasonably efficient (please refer to our investigation of the mean185
24 Principles of banking and finance
standard deviation theory in Chapter 8). If a financial market is inefficient
in pricing securities, then the equilibrium return (measured by the Capital
Asset Pricing Model or the Arbitage Pricing Theory) would lose credibility.
Note that the concept of informational efficiency refers to individual
markets, and not to the markets as a whole. For example, market A can
be efficient, whereas market B can be inefficient. Moreover, the reference
is mainly to financial markets, because of their nature (low transaction
costs, continuous trading by skilled operators, and nature of the pay-offs
perceived on securities traded in these markets).
A theoretical framework
In order to derive a theoretical framework for informational market
efficiency, we need to recall from Chapter 7, equation 7.11 regarding
the estimation of the expected rate of return on a stock (E(R)). We can
generalise this equation for every financial asset (both bonds and stocks)
in any period t to t+1 by writing the following equation:
C+Pt+1 – Pt
(9.1)
E(R) =
Pt
where:
C
=
cash flow received from the security (dividend or coupon)
in the period t to t+1
Pt
=
price of the security at time t
Pt+1
=
price of the security at time t+1.
The efficient market hypothesis (EMH) assumes that financial
markets are efficient when security prices incorporate all available
information. Therefore, in efficient markets the expected value has to be
equal to the forecasted value using all available information. This means
that in efficient markets the expected return on a security (E(R)) will be
equal to the optimal forecast of the return using all available information
(RF), which formally can be written as:
E(R) = RF
(9.2)
Although we cannot observe the expected return, we learned in Chapter
8 how to measure the value of E(R). Therefore, equation (9.2) has
important implications for how prices of securities change on financial
markets. We know that in equilibrium (when the quantity of securities
demanded is equal to the quantity supplied), the expected return (E(R))
equals the equilibrium return (E(R*)), derived either with the Capital
Asset Pricing Model (CAPM) or the Arbitage Pricing Theory (APT), as
described in Chapter 8. Implicit in the notion of an efficient market is the
assumption that a fair price for a security exists. This fair price is known as
the equilibrium price. Formally, in equilibrium:
E(R)=E (R*)
(9.3)
To describe the pricing behaviour in efficient markets, we can replace E(R)
with E(R*) in equation (9.2). Thus we obtain:
E(R*)=RF
(9.4)
This means that current prices in financial markets have to be set so that
the optimal forecast of a security return equals the expected return in
equilibrium. The alternative way to express this concept is to say that in
efficient markets security prices fully reflect all available information.
Therefore from equation (9.1):
RF =
186
C + Pt+1 – Pt
= E(R* )
Pt
(9.5)
Chapter 9: Financial markets – transmission of information
Concept of excess returns
As we argued in Chapter 7, and explained in the previous section,
equation 9.1 is the fundamental valuation formula, and represents a
market equilibrium condition. Consider a stock with an actual return lower
than the return on other securities of equivalent risk, and hence an actual
price higher than the fair price. If the actual return is 10 per cent and the
expected return is 20 per cent, investors would shift their capital to other
securities. This process would decrease the current price of the stock,
thereby increasing its actual return. If the actual return of a stock was 40
per cent, and thus was higher than the expected return of 20 per cent, the
actual price would have been lower than the fair price. There would be an
excess return, and the adjustment process would reverse. Investors would
buy more of this stock, and this in turn would drive up its actual price
relative to the fair price.
In order to implement the calculation of excess return (also termed
abnormal return, unexploited profit opportunity or riskadjusted returns), we need to find a model to estimate the expected
return. As we learned in Chapter 8, several pricing models quantify the
expected return in equilibrium. These models are the CAPM and the APT.
The equilibrium price is one that produces a return that is just equal to
that which investors holding the security require. The equilibrium return
varies according to the riskiness of the securities (as fully explained in
Chapter 8).
A fairly popular choice of the model generating expected return is the
market model, which recognises that some stocks are more affected than
others by fluctuations in the market. It estimates the expected return on a
stock by regressing actual returns on the stock against those of the market.
As a consequence, this excess return measure abstracts from changes in
the stock prices resulting from marketwide influences.
Thus the excess return can be calculated as the difference between
the actual return on the market and the equilibrium expected return.
Therefore, the excess return at time t (RtX ) is:
Rtx = Rt – E(Rt*)
(9.6)
where:
Rt = actual return on the market at time t
E(Rt*) = expected equilibrium return at time t.
Activity 9.1*
The actual return on stock ABC is 10 per cent, and the equilibrium return is 12 per cent.
What is the excess rate of return on stock ABC? What if the actual return was 15 per cent?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
Let us now introduce the optimal forecast of return using all available
information (RF). The excess return notion still holds. Consider a stock
with an equilibrium return of 15 per cent, and a price at time t lower
than the expected price at time t+1. If the optimal forecast of the return
is equal to 30 per cent, there is an excess return. Investors can earn an
abnormally high rate of return because RF>E(R*). In an efficient market
this implies that investors would buy more of this stock, and this in
turn will drive up its current price relative to the expected future price,
thereby lowering RF. When the current price has increased sufficiently so
that RF=E(R*), the efficient market condition is satisfied. Similarly, if the
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24 Principles of banking and finance
optimal forecast of the return is 5 per cent, and the equilibrium return is
10 per cent, the stock would be a poor investment [RF<E(R*)]. Therefore,
investors would sell the stock, the current price will be driven down
relative to the expected future price, and the optimal forecast of the return
will increase until RF=E(R*).
If we assume this forward-looking perspective, we can still define excess
return by replacing the actual return of a security on the financial market
with the optimal forecast return. The excess return at time t (RtX) is the
difference between the optimal forecast of the return and the expected
return in equilibrium:
Rtx = Rt F– E(Rt*)
(9.7)
The objective of our attention when testing the efficient market hypothesis
is the excess return derived in equations (9.6) and (9.7). As described in
the next section, the efficient market hypothesis is concerned with the
ability of investors to make an excess return based on certain information
sets. In an efficient market, no investor can make excess returns based on
the available set of information. They can only earn normal returns, which
here means equilibrium returns.
The joint hypothesis problem
Before proceeding to the analysis of the different forms of market
efficiency resulting from the availability of different information sets, we
need to emphasise the main problem associated with the calculation of
excess returns. As illustrated in Chapter 8, there are strong theoretical and
empirical limitations in the validation of the CAPM and APT models. On
the one hand, the unobservability of the market portfolio makes the CAPM
untestable. On the other hand, the APT does not require identifying the
market portfolio (solving the main CAPM problem), but it does not tell us
what the underlying factors are (unlike the CAPM, which collapses all the
macroeconomic factors into the market portfolio).
Therefore the choice of the model used to adjust actual returns in the
excess return calculation may be wrong. This implies that abnormal
returns may be incorrectly quantified, and then used in the test of the
efficient market hypothesis. This implies that the same efficient market
hypothesis would become untestable because of the joint hypothesis
problem. The test is affected by two problems:
a. informational efficiency
b. accuracy of the equilibrium expected returns.
If the test indicates the presence of excess return, this would imply that
markets are inefficient. However, the inefficiency of the markets could
be determined by the use of an incorrect technique for the measurement
of the excess return. Therefore we do not know whether the market is
efficient but the excess return measurement is wrong, or the market is
actually inefficient.
Levels of informational market efficiency: weak, semistrong and strong forms
As previously stated, an efficient market is a market where excess returns
based on a set of available information are eliminated. In order to make
this definition useful in an empirical context and to test market efficiency,
we need to specify broad observable information sets. In this regard the
main reference is the famous survey of market efficiency proposed by Fama
(1970). The three varieties of market efficiency identified by Fama (1970) are:
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Chapter 9: Financial markets – transmission of information
• Weak-form efficiency: a market is said to be weak-form efficient
when prices fully reflect all historical information. Historical
information includes past prices and returns, past data on the financial
characteristics of the firms, and information on macroeconomic
conditions. If a market is efficient in the weak-form sense, investors are
unable to make consistently excess returns by analysing past data.
• Semi-strong-form efficiency: a market is termed semi-strong
efficient when prices fully, accurately and speedily reflect all new
public information. Furthermore, prices have to reflect all past public
information: if the market is semi-strong efficient, it will also be
efficient in the weak-form. New public information includes financial
accounts, company announcements and information in the financial
press. If a market is efficient in the semi-strong form, investors
are unable to make excess returns based on this publicly available
information, because this information will already be reflected in the
prices of the security on the market.
• Strong-form efficiency: a market is referred to as strong-form
efficient when prices reflect all information, both public and private.
This is the most extreme form of market efficiency. Private information
does not refer just to insider information (for example, a company’s
directors informed about future merger and acquisition plans), but
also to information that investors and analysts can get through their
own analysis (for example, managers of mutual funds). If a market
is efficient in the strong-form, then no investor is able to earn excess
returns for a sustained period of time based on any information
available. Because of the inability to beat the market consistently, there
is no point in paying for specialist advice because no one can have an
information advantage.
The scope of the information sets used in Fama’s definitions is increasing.
The largest information set is associated with strong-form efficiency
(relevant public and private information), the smallest to weak-form
efficiency (past data only). Note these information sets are nested so the
semi-strong information set contains the weak-form set and the strong
form set contains both the weak form and semi-strong form sets.
Activity 9.2
Is the following statement true, false or uncertain?
‘An efficient market is one in which no one ever profits from having better information
than the rest.’
The efficient market hypothesis has strong implications in terms of security
analysis and security trading.
If a financial market is efficient in the weak-form sense, trading rules
based on the examination of past prices are worthless. Therefore it
would be impossible to identify mispriced securities by using technical
analysis. Technical analysis is the study of charts of stock price
movements to discover particular recurrent patterns (such as trends
or cycles). When technical analysts realise that one of these patterns is
starting to develop for a specific stock, they believe they are able to predict
future stock prices. In a weakly efficient market, technical analysis is
worthless because past information is already reflected in current prices.
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24 Principles of banking and finance
Activity 9.3
Visit the StockCharts.com website at www.stockcharts.com/education/Overview/
techAnalysis1.html to familiarise yourself with the basics of technical analysis and chart
analysis. Note that the graphs provided in this website are illustrative and you do not
have to learn about them in detail.
If a financial market is semi-strongly efficient, trading rules based on
publicly available information are suspect. As a consequence, not only
technical analysis but also fundamental analysis would be worthless.
Fundamental analysts acquire a wide set of publicly available information
to determine the intrinsic value of a firm on the basis of their assumptions
about the company, the industry and the general economy. This value
is then compared with the market price to provide a buy, sell or hold
recommendation. (Fundamental and technical analysis will be developed
in later subjects in the programme, such as 143 Valuation and
securities analysis.) However, if the market is semi-strongly efficient,
the likely implications of publicly available information are already
reflected in market prices.
Activity 9.4
Visit www.investorguide.com/igustockfundamental.html to familiarise yourself with the
basics of fundamental analysis.
Finally, if strong-form efficiency exists, investors would not even be able
to get excess returns from inside information because stock prices would
reflect all public and private information. Note that this implies that
investing in funds run by fund managers with alleged superior forecasting
ability will not lead to sustained above normal profits, as no fund
managers could possess such private information.
Empirical evidence on efficient markets
The vast majority of the empirical literature tests the first two varieties of
market efficiency: weak-form efficiency and semi-strong-form efficiency.
The reason for this is that strong-form efficiency is more difficult to test.
In the following subsections, we focus our attention on the empirical
evidence in favour of or against each of the three forms of the EMH.
Evidence in favour of market efficiency
Early empirical tests of the efficient market hypothesis provide evidence
in favour of market efficiency, at least in the weak- and semi-strongforms. In the following subsections, we analyse the key phenomena used
by researchers to support the three forms of market efficiency. For each
of them we provide a theoretical explanation of why the phenomenon is
consistent with the relevant efficiency form, and then we illustrate the
main studies analysing the phenomenon and their results.
Random walk behaviour of stock prices and weak-form efficiency
It is said that prices of securities follow a random walk when they are
equally likely to go up or down on any particular day irrespective of what
happened to the price on the previous day.
Consider the following example to clarify the concept of random walk. You
are given $1,000 to play a game. At the end of each day a coin is tossed.
If it comes up heads, you win 4 per cent of your investment; if it is tails,
you lose 3 per cent. At the end of the first day it is equally likely to land on
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Chapter 9: Financial markets – transmission of information
heads or tails. Therefore your capital at the end of the first day can equally
be $1,004 or $997. At the end of the second day, the coin is tossed again.
The outcomes associated with the positive first-day outcome ($1,004) are
$1,044 or $974. This is a random walk because the changes in value are
independent of one another.
Activity 9.5*
At the end of the second day, what are the outcomes associated with the negative firstday outcome ($997)?
*The solution to this activity can be found at the end of the subject guide in Appendix 1.
If security prices follow a random walk, investors cannot gain information
about future prices on the basis of past prices. Any information contained
in past prices is already reflected in current prices. Therefore the financial
market is said to be weak-form efficient.
Early empirical evidence on whether future stock returns can be predicted
on the basis of current and past changes rejects this hypothesis. This
confirms that stock prices follow a random walk, and supports weakform efficiency. Refer to Figure 13.2 in Brealey, Myers and Allen to find
empirical evidence that supports the random walk behaviour of four
market indexes: FTSE 100 (UK), Nikkei 500 (Japan), DAX 30 (Germany)
and Standard & Poor’s Composite (USA). Each point in these scatter
diagrams shows the return in successive weeks on the index. The wide
scatter of points shows that there is almost no correlation between the
returns in successive weeks.
Activity 9.6
Is the following statement true, false or uncertain?
‘If financial markets are weak-form efficient, they have no memory’. Explain your answer.
Technical analysis and weak-form efficiency
As argued in the previous section, past stock prices cannot be used to
predict future price changes because prices of securities follow a random
walk. Therefore technical analysis, which identifies trading rules based on
past data to forecast future changes, should not be able to predict future
stock prices successfully. The consequence is that trading rules based
on technical analysis should not consistently be able to generate excess
returns. In fact, if investors observed the existence of such trading rules
generating excess returns, then they would adopt these rules and excess
returns generated in the past would be eliminated. This would support
market weak-form efficiency.
Overall, empirical evidence shows that technical analysis does not
outperform the market, and that successful past forecasting does not imply
future market outperformance. The proof that returns generated by rules
based on technical analysis do not outperform the market is provided by –
among others – Allen and Karjalainen (1999). This evidence supports the
weak-form efficiency of financial markets.
However, some other researchers are more favourable towards technical
analysis, and find that such trading rules can generate excess returns: for
example Brock, Lakonishok and LeBaron (1992) observed the success of
technical analysis for foreign exchange rates and the US stock index. Such
results do not support market efficiency in its weak form.
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24 Principles of banking and finance
Earnings announcements and semi-strong-form efficiency
Semi-strong efficiency implies that stock prices reflect all publicly
available information. Early empirical tests of semi-strong efficiency
related to the changes in stock prices determined by earnings or dividend
announcements. These studies found that if the information were publicly
available, after positive earnings or dividend announcements, there would
be no change in the stock price. The stock price increased in anticipation
of the earning/dividend increase, and once the increase had been
announced, the stock price maintained the new level. This supports semistrong-form efficiency (Ball and Brown, 1968).
In recent studies, the main concern in testing semi-strong efficiency
relates to the speed with which new and unexpected information is
incorporated into stock prices. (Note that this information has to be
new and unexpected.) Events analysed in the literature are: earnings
announcements, dividends announcements and news of a takeover. Let
us consider a positive (negative) unexpected earnings announcement
(a picture of the financial health of the firm). In a semi-strong efficient
market, we expect stock prices to increase rapidly in response to the
announcement of earnings higher than the expected level (good news
about the firm) or to decrease rapidly to the announcement of earnings
lower than the expected level (bad news).
Empirical evidence suggests that new information is quickly and accurately
reflected in stock prices. If actual income differs from the expected
income, the financial market typically has reacted in the same direction.
Unexpected earnings increase (decrease) experienced by the good (bad)
news firms lead to increased (decreased) prices (the seminal contribution
by Ball and Brown, 1968, provides this evidence). Moreover, the
adjustment to unexpected earnings or dividends announcements is rapid.
The major part of the adjustment in stock prices occurs within 5 to 10
minutes of the announcement (as shown by Patell and Wolfson, 1984).
Activity 9.7
Is the following statement true, false or uncertain?
‘If financial markets are efficient in the semi-strong-form, investors can trust stock prices.’
Mutual fund performance and strong-form efficiency
Strong-form efficiency implies that stock prices fully reflect all available
information, both public and private. Therefore there is no investor
with superior ability to beat the market. Empirical tests of strong-form
efficiency include studies of whether there is an investor or groups of
investors that have consistently earned excess returns. Because of the lack
of data, the group most frequently tested is managers of mutual funds.
Empirical evidence suggests that the managers of mutual funds do not
beat the market. Actually, actively managed mutual funds underperform
other broad-based portfolios with similar characteristics (for example
Carhart (1997) finds that nearly 1,500 US mutual funds underperformed
the market in approximately half the years between 1962 and 1992).
Moreover, even mutual funds that performed well in the past are not
able to beat the market again in the future (as shown by Jensen, 1968;
Grinblatt and Titman, 1989). The good performance in the past does not
indicate that the mutual fund (or investment adviser) will perform well in
the future. This is consistent with strong-form efficiency.
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Chapter 9: Financial markets – transmission of information
Activity 9.8
If your investment advisor has been right in seven previous buy and sell
recommendations, should you continue listening to his advice?
This empirical evidence on mutual funds, consistent with strong-form
efficiency, explains why many mutual funds have given up the pursuit of
superior performance by active management of the fund, and turned to
simply tracking a benchmark market index. This enables mutual funds to
maximise diversification and reduce management costs.
Evidence against market efficiency
All the early empirical evidence generally supports the market efficiency
hypothesis. However, in recent years, empirical studies have started to
show the existence of some anomalies which are inconsistent with the
efficient market hypothesis. In the following subsections we focus on these
anomalies by relating each of them to the relevant efficiency form.
Small firm effect and weak-form efficiency
A piece of empirical evidence inconsistent with random walk behaviour
is the so-called small firm effect. There is evidence that next period’s
returns of small firms’ stocks have been positively correlated with
previous returns even for weekly and monthly periods (as shown in Lo
and MacKinlay, 1988). As a consequence, a trading rule suggests forming
portfolios of small stocks to earn excess returns.
Several theories have been developed to explain the small firm effect:
• Low liquidity of small firms or inappropriate measurement of risk
for small firm stocks. Investors demand a higher expected return to
compensate for some risk, which is not captured in the beta under the
CAPM model (recall the empirical evidence against the CAPM due to
small-cap stocks, as illustrated in Chapter 8).
• Data-snooping, or rather the fact that the superior performance of
small-caps is a coincidence, due to the large number of researchers
analysing past performance to find out specific patterns (recall again
the data-snooping explanation used for small-caps in Chapter 8).
Actually, in the USA, the small firm effect is limited to a relatively short
period: the 1970s and the 1980s. Note, however, that the phenomenon
is pervasive, and can be observed in many other countries.
• Weak-form market inefficiency; an anomaly that provided investors
with an opportunity to make excess returns over a period of two
decades in the USA. However, although many investors tried to
exploit such an anomaly, it was very difficult to make profits out of it
consistently from the 1990s on.
Therefore it is not obvious that the return predictability for small stocks
implies weak-form market inefficiency.
Calendar effects and weak-form efficiency
A calendar effect represents a pattern in stock returns related to either
the day of the week, the week of the month or the month of the year. One
famous empirical finding is the so-called January effect, which shows
that stock returns (particularly for small stocks) are greater in January
than in any other month of the year. Other examples of calendar effects
are the lower returns on Monday than in other days of the week, and the
occurrence of most daily returns at the beginning and end of the day.
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24 Principles of banking and finance
Let us focus on the January effect. The January effect seems to indicate a
trading rule: buy small stocks at the end of December and sell them at the
end of January. In this way you will make a profit. Why is the existence
of the January effect problematic? Assume that all investors observe such
a January strategy generating excess returns. All investors would follow
it. But the consequence would be an increase in prices at the end of
December (because of the increase in demand), and a decrease at the end
of January (due the increase in supply). Therefore excess returns would
tend to be eliminated. The continued existence of the January effect is
puzzling. Specifically, it is inconsistent with random walk behaviour, and
gives strong indications against weak-form market efficiency.
Several hypotheses have been advanced to explain this effect. These
include:
• Association of the January effect with the small firms effect (analysed
in the previous paragraph): as reported in Fama (1991), over the
period 1941–81, the return experienced in January was 8.06 per cent
for small stocks and 1.342 per cent for large stocks. In both cases the
January return was higher than the average return in other months, but
also most of the January effect was associated with small stocks. Note
however that in recent years – the period 1981–91 – the difference in
January returns between large and small stocks was less pronounced.
• Taxation impacts (i.e. tax-selling hypothesis).
Activity 9.9
Explain why the tax issue can be a potential explanation of the January effect, and why it
is not completely plausible. Please compare your answer with the explanation below.
• Investors sell securities for which substantial losses have been incurred
before the end of the year, in order to benefit from a tax loss. Such
investors do not invest the proceeds back into the market until the
new year. The selling in December would depress prices, whereas
the purchasing in early January would generate increases in prices.
However, even this explanation does not seem completely plausible:
in fact, we do not observe in financial markets any negative December
effect when the tax-loss incentive induces selling the stocks.
• Implications of the remuneration structure of fund managers. Haugen
and Lakonishok (1988) hypothesise that portfolio manager behaviour
around the turn of the year may be a major cause of the January/
small firm effect and that the effect may result from window dressing
or performance hedging. Window dressing is a strategy used by fund
managers near the year or quarter end to improve the appearance of
the fund performance before presenting it to clients or shareholders.
To window dress, the fund manager will sell stocks with large losses
and purchase good performing stocks near the end of the quarter.
To understand performance hedging, note that fund managers are
compensated for achieving returns above some benchmark. Managers
will then sell risky stocks once the benchmark has been reached and
then buy them again in January after the bonus has been paid. Window
dressing can be value reducing (because of the unnecessary transaction
costs necessary to discern true rather than ‘dressed up’ portfolio
composition) whereas performance hedging may be associated with
investor value maximisation (thanks to the possibility to lock in
superior performance). Cheng-few, Porter and Weaver (1998) suggest
that the hypothesis of performance hedging is more likely than the one
of window dressing.
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Chapter 9: Financial markets – transmission of information
Mean reversion and weak-form efficiency
Mean reversion means that stocks with a low return today show a high
return in the future, and vice versa. Some empirical evidence shows that
stocks that have done poorly in the past three to five years will tend to do
well in the next three to five years (as demonstrated by Fama and French,
1988; and Poterba and Summers, 1988). Mean reversion enables investors
to predict changes in the future prices. Therefore, stock prices do not
follow a random walk. This seems to indicate inefficiency in the weakform.
Note, however, that the evidence on mean reversion is not conclusive,
as some empirical studies show a diminished importance of the mean
reversion phenomenon after the Second World War.
Activity 9.10
Draw a diagram with ‘time’ on the horizontal axis, and ‘excess return’ on the vertical axis.
Draw a curve showing the mean reversion behaviour of stock prices, as described above.
Market overreaction and semi-strong-form efficiency
There is another anomaly related to earnings announcements. Although
empirical evidence generally confirms rapid adjustment to new
information (see our previous evidence in favour of the semi-strong-form
efficiency), recent evidence shows that stock prices do not instantaneously
adjust. Two key anomalies are pointed out: stock price overreaction and
underreaction.
Market overreaction means that prices may disproportionately increase
(decrease) due to good (bad) news announcements, and the pricing error
is corrected only slowly. Some empirical evidence shows that adjustment
to extreme bad news takes several months: there is a market overreaction
and subsequent gradual adjustment (see for example the evidence in
Ball and Brown, 1968, then confirmed by Bernard and Thomas, 1989).
Bernard and Thomas (1989) calculate the Cumulative Abnormal Returns
(CAR) for 10 portfolios with different levels of unexpected good or bad
earnings over the years 1974–86. CAR are measured for the pre- and
post- announcement period. Portfolio 10 contains the 10 per cent of the
stocks with the highest earnings performance, portfolio 1 the lowest 10
per cent. As shown in Bernard and Thomas (1989, p.10), portfolio 10
(extreme good news) disproportionately increases its performance in the
days immediately preceding the announcement, and portfolio 1 (extreme
bad news) disproportionately decreases its performance. However, in the
medium-long term after the announcement, the performance of portfolio
10 decreases and the performance of portfolio 1 markedly increases. It
seems that there is an overreaction before the announcement, and then
the market needs subsequent gradual adjustments to correct the overreaction to the unexpected information. As a consequence investors
could get excess returns by implementing a trading strategy: to buy (sell)
stocks immediately after the announcement of bad (good) news, and sell
(buy) them after several months when the price has risen (fallen) again.
This trading strategy is known as contrarian strategy. The possibility to
implement a contrarian strategy profitably in such a framework is
inconsistent with semi-strong-form efficiency.
Some empirical studies (see, for example, DeBondt and Thaler, 1987)
indicate that portfolios composed of extreme ‘losers’ (stocks that have
performed poorly in the recent past) dramatically outperformed portfolios
composed of extreme ‘winners’ (stocks that have increased in price in the
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24 Principles of banking and finance
recent past). In the 36 months after each portfolio formation, extreme
loser portfolios earned 25 per cent more than extreme winner portfolios.
Once again, the evidence suggests the possibility of getting excess
returns from a contrarian strategy. But in this case, such a possibility
is inconsistent with the weak-form efficiency because the definition of
winners and losers is based on historical returns and not on the release of
a new piece of information.
Underreaction and semi-strong-form efficiency
Underreaction to earnings announcements means that stock prices do
not fully incorporate the new information embodied in the unexpected
earnings announcement. Looking again at Bernard and Thomas (1989,
p.10), portfolio 10 outperformed portfolio 1 in the two months following
the announcement, and the difference in the excess returns has been
equal to +4 per cent. Prices of good news stocks continue to rise in the
two months after the earnings announcement, whereas prices of bad
news stocks continue to fall. Investors thus can get an excess return in the
short term by buying good news stocks and selling bad news stocks. Such
a trading strategy is known as momentum strategy. The possibility
to implement a momentum strategy profitably in such a framework is
inconsistent with semi-strong-form efficiency.
Accordingly, in the context of weak-form efficiency, some empirical
evidence (see results in Jegadeesh and Titman, 1993) suggests buying
past winner stocks and selling past losers to get excess returns. Here the
definition of winners and losers is based on historical prices and not on
the release of any new information. To buy stocks that have increased
in price in the recent past and to sell those that have performed poorly
yields significant excess returns over 3- to 12-month holding periods. Once
again this evidence suggests excess returns associated with a momentum
strategy, but this evidence is inconsistent with the weak-form efficiency
(not the semi-strong-form) because the strategy is based on historical
prices only.
Note that both overreaction and underreaction alternatively characterise
the behaviour of prices in financial markets, and empirical evidence
provides a roughly equal number of examples of overreaction and
underreaction.
Corporate insiders and strong-form efficiency
Corporate insiders, for example a company’s directors, use insider
information to buy stocks prior to stock price rises and to sell prior to stock
price falls. Therefore they aim to earn excess returns from trading in their
own company’s stocks. Empirical evidence shows that insider trades can be
used to predict subsequent stock price changes. This is inconsistent with
strong-form efficiency.
Activity 9.11
Read Mishkin and Eakins (2009) p.141 and re-read the section on financial bubbles in
Chapter 3 of this subject guide. Now think about whether financial bubbles are evidence
against the EMH. Mishkin and Eakins refer to the concept of rational bubbles. Do you
think this provides support for the EMH in the presence of financial bubbles?
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Chapter 9: Financial markets – transmission of information
Summary
The chapter investigated whether stock prices reflect all available
information in financial markets. If the efficient market hypothesis holds,
investors are unable to make excess returns on a certain information set.
Commonly, three broad observable information sets are used to define
informational efficiency: weak-form, semi-strong-form and strong-form
efficiency.
The empirical evidence overwhelmingly suggests that financial markets
are weak-form efficient: just refer to the random walk behaviour of
stock prices, and to the uselessness of technical analysis. Nevertheless
several important anomalies have to be taken into account: calendar
effects, small size effect, and long-term mean reversion behaviour of
stocks. The evidence on semi-strong efficiency is more mixed. The rapid
incorporation of new and unexpected information is in favour of semistrong-form efficiency; whereas the phenomena of market overreaction
and underreaction to new information are against it. Anyway, the majority
of empirical evidence does suggest that prices fully, accurately and
speedily reflect all new public information in most stock markets. Strongform efficiency has received least attention in empirical studies because
intuitively it is more difficult to believe that markets are strongly efficient
and because it is more difficult to get empirical data. But despite these
difficulties, there is evidence that stock markets may be efficient in the
strong-form (mutual fund performance). At the same time, the evidence
on corporate insider profits goes against strong-form efficiency.
Overall we have seen that it is difficult to get a definitive answer on
informational market efficiency. Instead of dichotomised categories of
efficient and inefficient financial markets, it seems more sensible to define
different degrees of efficiency, and classify certain markets (or markets at
certain times) as being more efficient than others.
Key terms
abnormal returns
allocative efficiency
anomalies
available information
calendar effects
contrarian strategy
earnings announcements
efficient market hypothesis
excess return
informational efficiency
insiders
January effect
joint hypothesis problem
market overreaction
market underreaction
mean reversion
momentum strategy
random walk
semi-strong-form efficiency small firm effect
strong-form efficiency
technical analysis
valuation efficiency
underreaction
weak-form efficiency
A reminder of your learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you should be able to:
• understand whether stock prices reflect all available information, and
hence whether the efficient market hypothesis holds
• understand the relevance of the efficient market hypothesis, and derive
the hypothesis from a theoretical perspective
• explain the concept of excess returns in the context of informationefficient markets
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24 Principles of banking and finance
• describe the three main forms of market efficiency (weak-form,
semi-strong-form and strong-form)
• discuss the empirical evidence in favour of weak-form efficiency
(random walk behaviour of stock prices, uselessness of technical
analysis) and against weak-form efficiency (presence of calendar effect,
small firm effect and mean reversion)
• discuss the empirical evidence in favour of semi-strong-form efficiency
(incorporation of earnings-announcement information) and against
semi-strong-form efficiency (market overreaction and underreaction to
new information)
• discuss the empirical evidence in favour of strong-form efficiency
(mutual fund performance) and against strong-form efficiency (excess
return of corporate insiders).
Sample examination questions
198
1. a.
In what ways does informational efficiency affect capital budgeting and portfolio theory?
b.
What is the theoretical framework for the derivation of the efficient market hypothesis?
c.
What are excess returns? What techniques are used for their calculation?
d.
How does the joint hypothesis problem affect the interpretation
of results on efficient markets?
2. a.
Compare and contrast the weak-form, the semi-strong-form and the strong-form efficiency of financial markets in the test of
the efficient market hypothesis.
b
‘If stock prices follow a random walk, investors can earn excess
returns by using trading rules based on past data’. Is this statement true or false? Explain your answer.
c
What is the empirical evidence against weak-form market efficiency? Illustrate the phenomena identified by these studies.
d
What is the empirical evidence in favour of and against the semi-strong form of market efficiency?
Appendix 1: Solutions to numerical activities
Appendix 1: Solutions to numerical
activities
Answers to ‘Activities’ marked with an asterisk
Chapter 5
Activity 5.11
The leverage capital ratio is 10% (=$10/$100).
Activity 5.12
Risk-weighted assets are:
•• Cash (500*0%)0
Government bills(1,500*0%)
Mortgages (14,000*50%)
Loans (12,000*100%) Total •• Risk asset ratio =1,600/19,000=8.42%
0
7,000
12,000
19,000
Activity 5.14
i. 7%
ii. 4.5%
iii. 2.5% (10.5–8)
iv. 9.5%
Chapter 6
Activity 6.4
e. The projected probability of repayment for the borrower is 1.15.
f. If the leverage ratio is 0.4, the projected probability of repayment is 0.765.
Activity 6.6
a. Three steps are needed to answer point a.
i. To determine the amount of rate-sensitive assets:
Commercial loans
$50
Fixed-rate mortgages (=20%*25) $5
Variable-rate mortgages
$20
$75
ii. To determine the amount of rate-sensitive liabilities:
Money market deposits
$5
Variable-rate CD
$30
Savings deposits(=20%*20)
$5
$40
iii. What happens when interest rates increase by1.5%?
Increase in income on assets (=1.5%*75)
$1.125
Increase in payments on liabilities (=1.5%*40) $0.600
Increase in net income
$0.525
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24 Principles of banking and finance
b. Two steps are needed to answer point b.
i. To determine the amount of rate-sensitive assets:
Commercial loans
$50
Fixed-rate mortgages(=20%*15) $3
Variable-rate mortgages
$30
$83
The amount of rate-sensitive liabilities remains $40.
ii. What happens when interest rates increase by 1.5 percent?
Increase in income on assets (=1.5%*83)
$1.245
Increase in payments on liabilities (=1.5%*40) $0.600
Increase in net income
$0.645
c. Two steps are needed to answer point c.
i. To determine the amount of rate-sensitive liabilities:
Money market deposits
$5
Variable-rate CD
$30
Savings deposits (=15%*20)
$3
$38
The amount of rate-sensitive assets remains $75.
ii. What happens when interest rates increase by 1.5 percent?
Increase in income on assets (=1.5%*75)
$1.125
Increase in payments on liabilities (=1.5%*38) $0.570
Increase in net income
$0.555
Activity 6.7
a. The Macaulay duration of a three-year 6 per cent coupon bond is 2.838 years.
b. The Macaulay duration of the portfolio (20 per cent invested in the seven-year
Eurobond and 80 per cent in the three-year coupon bond) is 3.3708 years.
Activity 6.8
The approximate percentage change in the price of the bond is +2.75 per cent.
Activity 6.9
The duration gap for the bank is 2.2 years. The potential loss to equity holders’ net worth
(as a percentage of assets) is:
∆NW ≈ – DUR x ∆i = – 2.2 x 0.05 = – 0.03055 = – 3.055%
gap
1.08
1+i
A
With total assets totalling $100 million, the fall in the market value of net worth is $3.055
million.
Chapter 7
Activity 7.1
1. The PV of 5,000 euro to be received in five years’ time is 3,565 euro.
2. The PV of 5,000 euro to be received at the end of each of the first five years, and
2,000 euro at the end of years six to eight, is 24,242 euro.
3. The PV of a perpetuity that promises 5,000 euro per year is 71,428 euro.
4. The PV of a growing perpetuity that promises an initial payment of 5,000 euro and
growth of 4 per cent is 166,667 euro.
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Appendix 1: Solutions to numerical activities
Activity 7.2
•• The NPV of Project B is $1,461, and thus it should be accepted.
•• The NPV of Project C is –$50, and thus it should be rejected.
Activity 7.3
1. The IRR of project ABC is 8.1 per cent, and thus it should be accepted (IRR higher
than the hurdle rate equal to 7 per cent).
2. The decision remains the same under the NPV rule (positive NPV equal to $36).
Activity 7.5
a. Payback period of each project: Project I=4years; Project L=2years; Project M=3years.
b. The firm accepts Projects L and M if the cut-off period is three years.
c. If the firm invests by choosing projects with the shortest payback period, it would
invest in Project L.
Activity 7.8
The price of a four-year coupon bond, with principal $5,000, annual coupon rate 4 per
cent, and required annual rate of return 8 per cent, is $4,337.
Activity 7.9
In the case of semi-annual coupon payments and a semi-annual discount rate of 4 per
cent, the price of the bond in Activity 7.8 becomes $4,328.
Activity 7.11
The price today of stock X would be $91.67, whereas the price of stock Y would be $100.
Therefore, stock Y is more valuable than stock X.
Chapter 8
Activity 8.1
1. The expected return of Second Class stock is 13.67 per cent.
2. The standard deviation of the returns on the stock is 4.69 per cent.
3. Second Class stock is less risky than First Class stock.
Activity 8.5
The portfolio weight for Microsoft is 30.2 per cent.
Activity 8.6
The portfolio return variance in these three cases is:
1. 6.03 per cent with correlation of –0.3.
2. 15.6 per cent with correlation of 1.
3. 8.2 per cent with correlation of 0.
Activity 8.9
E(R)
σ
i. 1. 15
25
2. 20
22.3257
3. 25
24.8244
4. 30
31.3996
5. 35
40
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24 Principles of banking and finance
ii. w1 = 0.7826
w2 = 0.2173
hence
E(R) = 17.17
σ = 22.7954
Activity 8.10
1. Portfolio B would always be preferred over Portfolio A.
2. Portfolio C would always be preferred over Portfolio D.
Activity 8.14
2. The risk premium on the market is 9 per cent
3. The required return on a stock with a beta of 1.5 is 16.5 per cent.
4. If the market return is expected to be 12.5 per cent, the beta of the stock is 1.42.
Activity 8.15
The stock sensitivities on individual factors are:
ap = (0.25.0.03) + (0.75.0.06) = 0.0525
bp = (0.25.0.9) + (0.75.0.8) = 0.825
Thus the portfolio return can be written as:
Rp= 0.0525 + 0.825 F1+εp
Activity 8.16
a. If a stock return is uncorrelated with either of the two factors, the expected rate of
return on the stock is 6 per cent.
b. If a stock return has a positive average exposure to each factor, the expected rate of
return on the stock is 13.5 per cent.
Chapter 9
Activity 9.1
a. The excess rate of return on stock ABC is negative (–2 per cent), when the actual
return is 10 per cent and the equilibrium return is 12 per cent. It becomes positive
(+3 per cent) if the actual return is 15 per cent.
Activity 9.5
b. At the end of the second day, the outcomes associated with the negative first-day
outcome are $1,037 and $967.
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Appendix 2: Sample examoination paper
Appendix 2: Sample examination paper
Important note: This Sample examination paper reflects the
examination and assessment arrangements for this course in the academic
year 2010−2011. The format and structure of the examination may have
changed since the publication of this subject guide. You can find the most
recent examination papers on the VLE where all changes to the format of
the examination are posted.
Time allowed: three hours.
Candidates should answer FOUR of the following EIGHT questions: ONE
from Section A, ONE from Section B, and TWO further questions from
either section. All questions carry equal marks. A calculator may be used
when answering questions on this paper and it must comply in all respects
with the specification given in the Regulations.
Section A
Answer one question from this section and not more than a further
two questions. You are reminded that four questions in total are to
beattempted with at least one question from Section B.
1. a. What are the main implications of the presence of market-based and
bank-based financial systems nowadays? (12 marks)
b. Discuss the reasons and the consequences of the decline in the share
of financial assets held by banks in recent years. (13 marks)
2. a. How are financial intermediaries able to reduce/solve the problems
arising from adverse selection? (9 marks)
b. Discuss how to reduce/solve the problems arising from moral
hazard in equity markets. (7 marks)
c.
Explain the hypotheses, the framework and the main findings ofthe
delegated monitoring theory. (9 marks)
3. a. What are the methods used to handle a failed bank in the USA?
(8 marks)
b. What are the mechanisms of deposit insurance adopted in the USA
and in the UK? (4 marks)
c.
Explain the risk-asset ratio under Basel 1 and discuss the main
problems that have been identified with it. How will it changeunder
Basel 2? (13 marks)
4. a. Name and briefly describe the three types of market efficiency.
(6 marks)
b. Discuss the empirical evidence in favour of weak-form market
efficiency. Illustrate the key results identified by these studies.
(9 marks)
c.
Discuss the empirical evidence on market overreaction and
underreaction. (8 marks)
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24 Principles of banking and finance
Section B
Answer one question from this section and not more than a further
two questions. You are reminded that four questions in total are to be
attempted with at least one question from Section A.
5. a. Consider a three-factor Arbitrage Pricing Theory (APT) model.
Factor
Risk premium
Sensitivity to each factor
Change in GDP
5%
1
Change in interest rate
1%
0.5
Inflation ratio
2.5%
0
a. Assuming a risk-free rate of 4%, calculate the expected return of this
stock. (4 marks)
b. What are the assumptions under the APT? What is the expected risk
premium? (11 marks)
c. Under the CAPM framework, what is the optimal portfolio?
Explain your answer. (10 marks)
6. Consider the two following mutually exclusive projects (X and Y):
Cashflows(£)
Project
C0
C1
C2
C3
X
–2,200
0
+600
+2,000
Y
–2,200
+1,000
+800
+600
a. Assuming an opportunity cost of capital of 11 per cent, what is the
NPV of the two projects? Which project would you accept?
(4 marks)
b. What is the IRR of the two projects? Which project would you
choose if the hurdle rate is equal to the opportunity cost of capital
(11 per cent)?
(6 marks)
c. Explain the IRR method. Discuss the limits of this method when
compared to the NPV technique.
(10 marks)
d. Discuss the limits of the payback period method.
(5 marks)
7. At the end of January 2008, the interest rate on US government bonds
maturing in 2010 is about 2.5 per cent. Consider a corporate bond with
a coupon rate equal to 4 per cent, and maturity in January 2010.
a. Using the data shown above, determine the value of the
corporate bond by assuming annual coupon payments and annual
compounding.
(4 marks)
b. Calculate the duration of the US government bond assuming annual
coupons and annual discount rate.
(5 marks)
c. Formally derive and discuss the dividend discount model used for
the valuation of common stocks.
(9 marks)
d. What are the factors that affect Macaulay duration?
(7 marks)
8. What is meant by interest rate risk? What are the two main effects of
interest rate risk?
(5 marks)
a. Explain how a bank can use duration gap analysis and income gap
analysis to manage interest rate risk. Critically discuss the problems
associated with income gap analysis.
(8 marks)
204
Appendix 2: Sample examoination paper
b. Consider the following balance sheet of Bank One:
Assets(£)
Liabilities and Equity(£)
Variable-rate mortgages
10
Money market deposits
20
Fixed-rate mortgages
10
Savings deposits
30
Commercial loans
45
Equity
30
Physical capital
15
Total
80
Total
80
What will be the net interest income at the year end if interest rates
decreased by 0.5 per cent, from 4.5 to 4 per cent? Explain using basic gap
analysis. (Use the following hypothesis on the runoff of cash flows: fixedrate mortgages repaid during the year: 25 per cent; proportion of savings
deposits that are rate-sensitive: 25 per cent).
(12 marks)
END OF PAPER
205
24 Principles of banking and finance
Notes
206