Banks & Financial Institutions (Financial Markets & Regulation)

Question 1

How do banks achieve profits?

Answer 1

By being a financial intermeiary.

Banks accept saving deposits from savers and give them interest. They then convert these saving deposits into loans which they give to borrowers (who pay interest).

The banks return is the Net interest margin (difference between interest generated from loan and the interest paid out to savers).

Question 2

What are commercial banks?

Answer 2

A bank which provides financial services and products to retail customers. Its core functions are:

• Accept deposits
• Create deposits/loans
• Support the wider economy, e.g. Barclays, Santander.

Question 3

Why are commercial banks important for an economy?

Answer 3

• Supplies Finance - provides liquidity to the market.
• Payments System - ensures that money can be managed and used to pay for transactions.
• Insures Against Risk - support businesses to invest via lending facilities.
• Satisfy Incompatible Financial Needs and Wants - Banks can help match savers and borrowers together.

Question 4

Commerical banks objectives?

Answer 4

• Liquidity
• Security
• Profitability

Question 5

What are assets?

Answer 5

Claims that banks have against economic agents and are what the bank owns (which can provide future financial benefit). What the bank owns is an injection into the bank.

Question 6

What are liabilities?

Answer 6

Claims that agents have on the bank and these are used to finance the bank’s asset purchases. What the bank owes is a leakage out of the bank.

Question 7

What is the golden rule with a banks balance sheet?

Answer 7

Assets = Liabilities = Capital.

This is to protect the bank from solvency issues.

Some assets, e.g. loans, are riskier so are secured (backerd by collateral) or unsecured (cap on how much you can loan out).

Question 8

Explain why it’s important to have a balanced sheet?

Answer 8

If, e.g., retial deposits are withdrawn are unexpectdely, the bank needs liquidity on the assets (e.g. cash) to meet the liquidity on the liabilities side.

If there is insufficient liquidity from the asset side, banks must sell off other assets, e.g. bonds. Equity capital and retained profits act as a buffer to ensure the bank stays solvent.

This is not ideal as these assets may yet to mature and banks will sell them at a value lower than what they’re expected to generate, which creates losses on the asset side of the balance sheet.

This means that they then have to start drawing upon their equity capital, which will then draw away the safety and security of the bank overtime.

Question 9

What is the conflict with commercial banks?

Answer 9

There is a liquidity trade off:

• Banks want to hold enough liquid to meet any unexpected withdrawal on liabilities. But, liquid assets generate lower returns which harms profitability.
  
  • Trade off between making sure the bank maks profit to please shareholders, but also enough liquidity to please depositors, regulators and the economy.

Question 10

What are Investment Banks?

Answer 10

A bank which provides financial services and advice for investment purposes.

They typically work with high net worth individuals, financial institutions, large MNCs, governments.

Question 11

What are the core functions of investment banks?

Answer 11

• Underwriting Share Issues
• M&A advice
• Supports high net worth clients

Question 12

How do investment banks make most of their profits?

Answer 12

Fees paid by clients in return for carrying out certain financial activities.

Question 13

What are the activities of investment banks?

Answer 13

• Underwriting Share Issues = process of issuing and distributing newly issued securities to the market.
• M&A advice = consultancy advice on strategic approach companies should take when merging with another company.
• Propietary trading = Trading on the bank’s own behalf via financial markets.
• Fund management = overseeing and managing clients investment portfolios.

Question 14

What are universal banks?

Answer 14

A financial institution that offers the full range of financial services to customers (retail and investment divisions).

They have increased:

• Profits
• Scale
• Number of employees
• Number of customers
• Risk profile

Question 15

What activities do universal banks carry out?

Answer 15

As they are formed through multiple takeovers, they often carry out commercial and investment banking activities:

• Commercial = deposit-taking and lending activities.
• Investment = financial advisory work.

Question 16

How are losses prevented from one division of the bank to the other?

Answer 16

Firewalls.

If any losses are made in the retial division of the bank it hurts the taxpayer and economy who my have used financial support to bail them out.

Question 17

What did the 2011 Vickers Report conclude?

Answer 17

On the back of the financial crisis of 2008, ring fencing banks and their division is needed to make sure losses made in one division don’t spread to others. There must be a firewall between the management team of divisions so the same ideas and strategies are not circulating around in different divisions.

Question 18

What other financial institutions are there?

Answer 18

• Hedge funds
• Insurance companies
• Crowdfunding
• Building society
• Personal funds
• Private equity firm

Question 19

What do hedge funds do?

Answer 19

Pool of capital taken from individual investors or companies to invest in a mixture of assets across an economy. Portfolio balancing to get a return.

Question 20

What do insurance companies do?

Answer 20

Make sure losses will be repaid after a negative event has happened.

Question 21

What is crowdfunding?

Answer 21

Money raised for a particular cause. Individuals donate.

Question 22

What are building society’s?

Answer 22

Financial institution in which individual depositors become shareholders. If you put money in, you have a vested stake in the company.

Question 23

What are personal funds?

Answer 23

Contributions which generate retirement income we rely on later on down the line. Topped up by employers and the government. Investment into pension funds helps us to generate a return based on assets the pension funds are invested in.

Question 24

What are Private Equity Firms?

Answer 24

Firms which invest in private equity in markets. Dilute private equity within the market by investing lots of money. Portfolio balancing.

Question 25

What is the Shadow Banking Sector?

Answer 25

Financial Intermediaries involved in the creation of credit, but are not subject to regulatory oversight.

Question 26

What are non-bank financial institutions (NBFIs)?

Answer 26

Institutions do not have a banking license and operate on the periphery of the traditional banking sector.

Question 27

What are the characteristics of the shadow banking sector?

Answer 27

• Do not take and create subsequent deposits.
• Do not adhere to normal banking regulations and standards.
• No capital adequacy requirements.
• Higher liquidity risk.
• Higher solvency risk.
• Higher credit risk.

Question 28

How large is the shadow banking sector?

Answer 28

• Broad measure - 2015 = $92 trillion (lots of different countries, e.g. China).
• Narrow measure - 2015 = $36 trillion (excludes data from emerging economies).

Question 29

What is the big issue of the shadow banking sector?

Answer 29

They have large assets which can lead to negative events if it goes wrong. Some say the sector contributed to the 2008 financial crisis:

• Panic in financial system extended to shadow sector.
  
  • Regulatory controls couldn’t be extended to calm these markets.
    
    • However, whole financial system dependent on some areas of shadow sector.
    • Likewise disruption in standard credit markets disrupted the shadow sector.
      
      • Enhances systemic risk.

Question 30

What is Credit?

Answer 30

Money that is transferred from one party to another.

Question 31

What is the purpose of credit?

Answer 31

Credit is provided by financial institutions to the wider economy to facilitate consumer spending and business investment to further economic growth.

Question 32

What happens when a bank extends a loan to an individual?

Answer 32

It creates 2 things…

• Advance (loan): bank assets - client must repay.
• Deposit Account: bank liabilities - bank honours cash withdrawals.

Question 33

What is Cash Ratio?

Answer 33

The percentage of new deposits that are distributed towards cash reserves and creating new loans.

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