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1.1 Introduction 1 1.2 Deregulation 3 1.3 Financial innovation 4 1.4 Globalization 7 1.5 Profitability 8 1.6 Conclusion 16 1.7 Summary 16
The main thrust of this chapter is to introduce the major changes that have taken place in the banking sector and to set the context for later discussion. Aggregate tables and statistics are employed to highlight the nature of the changes. It should also be noted that many of these changes are examined in more detail later on in the book. It is also necessary at this stage to explain the nature of various ratios, which we will use throughout this text. The relevant details are shown in Box 1.1.
Banking is not what it used to be. In an important study, Boyd and Gertler (1994) pose the question, 'Are banks dead? Or are the reports grossly exaggerated?' They conclude, not dead, nor even declining, but evolving. The conventional mono-task of taking in deposits and making loans remains in different guises but it is not the only or even the main activity of the modern bank. The modern bank is a multifaceted financial institution, staffed by multi-skilled personnel, conducting multitask operations. Banks have had to evolve in the face of increased competition both from within the banking sector and without, from the non-bank financial sector. In response to competition banks have had to restructure, diversify, improve efficiency and absorb greater risk.
Banks across the developed economies have faced three consistent trends that have served to alter the activity and strategy of banking. They are (i) deregulation, (ii) financial innovation and (iii) globalization. We will see that that the forces released by each of these trends are not mutually exclusive. The development of the eurodollar market arose out of a desire to circumvent regulation in the USA (euro-currency banking is examined in Chapter 5). Deregulation of the interest ceiling on deposits led to the financial innovation of paying variable interest rates on demand deposits. Deregulation has also allowed global forces to play a part in the development of domestic banking services which was thought to have barriers to entry.
There have been a number of comprehensive surveys of the process of financial innovation and deregulation in developed economies' banking systems. This chapter describes the trends in banking that have arisen as a result of the forces of deregulation, financial innovation and globalization, over the last two decades of the 20th century. What follows in the remainder of this book is an attempt to demonstrate the value of economic theory in explaining these trends.
The deregulation of financial markets and banks in particular has been a consistent force in the development of the financial sector of advanced economies during the last quarter of the 20th century. Deregulation of financial markets and banks has been directed towards their competitive actions, but this has been accompanied by increased regulation over the soundness of their financial position. This is called 'prudential control' and is discussed further in Chapter 11. Consequently, there is a dichotomy as far as the operations of banks are concerned; greater commercial freedom (i.e., deregulation) but greater prudential control (i.e., more regulation).
Deregulation consists of two strands; removal of impositions of government bodies such as the Building Societies Act discussed below and removal of self-imposed restrictions such as the building society cartel whereby all the societies charged the same lending rates and paid the same deposit rates. The process of deregulation across the developed economies has come in three phases but not always in the same sequence. The first phase of deregulation began with the lifting of quantitative controls on bank assets and the ceilings on interest rates on deposits. In the UK credit restrictions were relaxed starting with Competition and Credit Control 1971. In the USA it began with the abolition of regulation Q 1982. In the UK, the initial blast of deregulation had been tempered by imposition of the 'Corset' during periods of the 1970s to constrain the growth of bank deposits and, thereby, the money supply. By the beginning of the 1980s, exchange control had ended in the UK and the last vestige of credit control had been abolished. Greater integration of financial services in the EU has seen more controls on the balance sheets of banks being lifted.
The second phase of deregulation was the relaxation of the specialization of business between banks and other financial intermediaries allowing both parties to compete in each other's markets. In the UK this was about the opening up of the mortgage market to competition between banks and building societies in the 1980s. The Building Societies Act 1986 in turn enabled building societies to provide consumer credit in direct competition with the banks and specialized credit institutions. In the USA, the Garn-St Germain Act 1982 enabled greater competition between the banks and the thrift agencies. A further phase came later in 1999 with the repeal of the Glass-Steagal Act (1933) that separated commercial banking from investment banking and insurance services.
The third phase concerned competition from new entrants as well as increasing competition from incumbents and other financial intermediaries. In the UK, new entrants include banking services provided by major retail stores and conglomerates (Tesco Finance, Marks & Spencer, Virgin) but also the new financial arms of older financial institutions that offer online and telephone banking services (Cahoot - part of Abbey National, Egg - 79% owned by Prudential). In the USA new entrants are the financial arms of older retail companies or even automobile companies (Sears Roebuck, General Motors). Internationally, GE Capital owned by General Electrical is involved in industrial financing, leasing, consumer credit, investment and insurance. In 2002 this segment of General Electrical accounted for over one-third of its total revenue of $132bn.
1.3 FINANCIAL INNOVATION
'Financial innovation' is a much-overused term and has been used to describe any change in the scale, scope and delivery of financial services. As Gowland (1991) has explained, much of what is thought to be an innovation is the extension or imitation of a financial product that already existed in another country. An example is the introduction of variable rate mortgages into the USA when fixed rates were the norm and fixed rate mortgages in the UK, where variable rates still remain the dominant type of mortgage.
It is generally recognized that three common but not mutually exclusive forces have spurred on financial innovation. They are (i) instability of the financial environment, (ii) regulation and (iii) the development of technology in the financial sector. Financial environment instability during the 1970s was associated with volatile and unpredictable inflation, interest rates and exchange rates and, consequently, increased demand for new instruments to hedge against these risks. Regulation that tended to discriminate against certain types of financial intermediation led to regulatory arbitrage whereby financial institutions relocated offshore in weakly regulated centres. It was the regulation of domestic banks in the USA that led to the development of the eurodollar market offshore. At the same time, technological development has created a means of developing a wide range of bank products and cost reductions, thus meeting the demand for new instruments mentioned above. The advance of technology can be viewed in the same way as Schumpeter's waves of technological innovation and adaptation. The first wave can be thought of as the application of computer technology in the bank organization. This would not only be bank-specific but also applicable to all service sector enterprises that are involved in the ordering, storing and disseminating of information such as, for example, rating agencies. The second wave involves the application of telecommunication and computer technology to the improvement of money management methods for the consumer. The third wave involves the customer information file, which enables financial institutions to gather information about the spending patterns and financial needs of their clients so as to get closer to the customer. The fourth wave is the further development of electronic payment methods, such as smart cards, e-cash and on-line and home banking services.
Technological financial services are spread through competition and demand from customers for services provided by other banks and financial intermediaries. Figure 1.1 describes the process of financial innovation.
The three forces of financial instability, regulation and technology put pressure on banks to innovate. Innovation also creates a demand for new financial products which feed back into the banking system through customer reaction and demand. The influence of the three factors and the feedback from customer demand for financial services is shown in Figure 1.1.
Goodhart (1984) identified three principal forms of structural change due to financial innovation. They are in turn:
(1) The switch from asset management to liability management. (2) The development of variable rate lending. (3) The introduction of cash management technology.
Asset management fitted easily into the post-war world of bank balance sheets swollen with public sector debt and quantitative controls on bank lending. The basic idea behind the concept of asset management is that banks manage their assets regarding duration and type of lending subject to the constraint provided by their holdings of reserve assets. The move to liability management (namely, their ability to create liabilities by, for example, borrowing in the inter-bank market) came in the USA by banks borrowing from the offshore eurodollar market (often from their own overseas branches) in an attempt to circumvent the restrictions of regulation Q. The ceiling on the rate payable on deposits drove savers to invest in securities and mutual funds. In the UK, liability management was given a boost with the Competition and Credit Control Act 1971. With asset management, the total quantity of bank loans was controlled by restriction and deposits were supplied passively to the banking system.
Volatile inflation and interest rates during the 1970s led to the further development of variable rate lending. Blue chip customers always had access to overdraft facilities at variable rates but during the 1970s more and more companies switched to variable rate loans (linked to the London Inter Bank Offer Rate - LIBOR). Banks were able to lend to customers subject to risk, competitive pressure and marginal costs of lending. The total stock of bank loans became determined by the demand for bank credit (this implies a near-horizontal supply of bank loans curve). The development of liability management and variable rate lending led to the rapid expansion of bank balance sheets. Banks managing their liabilities by altering interest rates on deposits and borrowing from the inter-bank market satisfied the demand for bank loans. Thus, the simplest type of financial innovation was the development of interest-bearing demand deposits which enabled banks to liability-manage.
The pace of technological innovation in banking has seen the development of new financial products that have also resulted in a decline in unit costs to their suppliers - the banks. Credit cards, Electronic Fund Transfer (EFT), Automated Teller Machines (ATMs), Point Of Sale (POS) machines have had the dual effect of improving consumer cash management techniques and reducing the costs of delivery of cash management services. A good example is the use of debit cards over cheques. The costs of clearing a cheque are 35p per item compared with 7p per debit card transaction.
The globalization of banking in particular has paralleled the globalization of the financial system and the growth in multinational corporations in general. To some extent banking has always been global. The internationalization of banking in the post-war world has resulted from the 'push' factors of regulation in the home country and the 'pull' factors of following the customer. This explanation of the internationalization of banking fits particularly well with the growth of US banking overseas. Restrictions on interstate banking impeded the growth of banks, and restrictions on their funding capacities drove US banks abroad. The by-product of this expansion was the creation of the eurodollar market in London - the most liberally regulated environment at the time. The 'pull' factor was provided by the expansion of US multinationals into Europe. US banks such as Citibank and Bank of America expanded into Europe with a view to holding on to their prime customers. Once established in Europe they recognized the advantages of tapping into host country sources of funds and to offer investment-banking services to new clients.
Canals (2002) typifies the globalization process in terms of three strands. The first is the creation of a branch network in foreign countries. The most notable example of this strategy has been Citibank and Barclays. The second strand is merger or outright takeover. The third strand is an alliance supported by minority shareholding of each other's equity. The 1980s and 1990s have seen a raft of strategic alliances and takeovers in the EU, beginning with Deutsche Bank's purchase of Morgan Grenfell in 1984.
The progressive relaxation of capital controls has added to the impetus for globalization in banking. Table 1.1 shows the increasing foreign currency position of the major banking economies since 1983. Foreign claims refer to claims on borrowers resident outside the country in which the bank has its headquarters. The rapid growth of foreign asset exposure is particularly striking in the case of the UK, which has seen foreign currency assets increase its share from under 20% of total assets in 1983 to over 30% in 2003.
The pace of globalization in banking was furthered by the increasing trend to securitization (securitization is examined in greater detail in Chapter 9). 'Securitization' is a term that describes two distinct processes. First, it can be thought of as the process by which banks unload their marketable assets - typically mortgages, and car loans - onto the securities market. These are known as Asset Backed Securities (ABSs). Second, it can be thought of as the process of disintermediation whereby the company sector obtains direct finance from the international capital market with the aid of its investment bank. Large companies are frequently able to obtain funds from the global capital market at more favourable terms than they could from their own bank. Banks have often led their prime customers to securitize knowing that while they lose out on their balance sheets they gain on fee income.
The trend to harmonization in regulation has also facilitated the globalization process. The creation of a single market in the EU and the adoption of the Second Banking Directive 1987-8 was done with the view to the creation of a single passport for banking services. The second directive addressed the harmonization of prudential supervision; the mutual recognition of supervisory authorities within member states, and home country control and supervision. The result of further integration of the EU banking market will see a stronger urge to cross-border financial activity and greater convergence of banking systems.
The forces of competition unleashed by the deregulatory process have had stark implications for bank profitability. Banks faced competition on both sides of the balance sheet. Table 1.2 shows the evolution of bank profitability measured by the Return On Assets (ROA) - see Box 1.1. The effect of financial innovation and globalization has been to expand banks' balance sheets in both domestic and foreign assets. Profits as a per cent of assets declined in most cases both as balance sheets expanded and as competition put pressure on profitability. However, the banks of some countries have been successful in reducing costs and restoring ROA but the pressure on profits has been a consistent theme.
Excerpted from The Economics of Banking by Kent Matthews Excerpted by permission.
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Ch. 1 Trends in Domestic and International Banking 1
Ch. 2 Financial Intermediation: The Impact of the Capital Market 21
Ch. 3 Banks and Financial Intermediation 35
Ch. 4 Banking Typology 51
Ch. 5 International Banking 61
Ch. 6 The Theory of the Banking Firm 77
Ch. 7 Models of Banking Behaviour 93
Ch. 8 Credit Rationing 115
Ch. 9 Securitization 131
Ch. 10 Banking Efficiency and the Structure of Banking 147
Ch. 11 Banking Competition 171
Ch. 12 Bank Regulation 187
Ch. 13 Risk Management 209
Ch. 14 The Macroeconomics of Banking 243