Banking in Theory and Practice - Universitetet i oslo...Facts, trends, and myths 3 Economics of Banking Microeconomics of banking Macroeconomics of banking Banking regulation in theory

Bank, Banking and Financial IntermediationThe of World of Banking in a Nutshell

Economics of Banking

Banking in Theory and Practice

Jin Cao(Norges Bank Research, Oslo & CESifo, Munchen)

August 23, 2017

J. C. Introduction

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Outline

1 Bank, Banking and Financial IntermediationWhat are banks?Why are banks needed?

2 The of World of Banking in a NutshellInside banks: numbers and jargonsFacts, trends, and myths

3 Economics of BankingMicroeconomics of bankingMacroeconomics of bankingBanking regulation in theory and practice

J. C. Introduction




Disclaimer

(If they care about what I say,) the views expressed inthis manuscript are those of the author’s and shouldnot be attributed to Norges Bank.

J. C. Introduction




What are banks?Why are banks needed?

What is a bank?

“An institution whose current operation consists in grantingloans and receiving deposits from the public” (Freixas & Rochet,2008)

“Current operation”: must be its main business;

“ Granting loans and receiving deposits”: it is anintermediary doing banking activities, although nowadays“ loans” and “ deposits” shall be interpreted in a broaderway;

Banks are highly regulated , much more than other financialintermediaries;

Banks usually have the access to central bank’s operationalfacilities.

J. C. Introduction





Bank as financial intermediary

Financial intermediary “specializes in the activities of buyingand selling financial claims” (Freixas & Rochet, 2008),including (not mutually exclusive)

Brokers who buy and sell securities on behalf of investors;

Dealers who trade securities for its own account ;

Collective investment entities who pool money frommany (small) investors by issuing securities which arerepresentative of a bundle of marketable securities theypurchase;

Banks. Since banks may contain the other three, in therest of this course, “ financial intermediary” and “ bank” areinterchangeable unless specified otherwise.

J. C. Introduction





Banks’ many faces: entities

Even by narrowest definition, banks differ from each othervery much by their customers, business models, servicesand roles in financial intermediation.

USA Commercial banks S&L Credit unions

UK Commercial banks Building societies

France Commercial banks Mutual and co-op Saving banks

Germany Commercial banks Co-op Saving banks

Japan Ordinary banks Co-op Trust banks

Norway Commercial banks Saving banks

J. C. Introduction





Banks’ many faces: services

By different business models, banking services can be roughlydivided into (again, they do not mutually exclude)

Retail banking providing services of accepting depositsand issuing loans to individuals and small businesses;

Wholesale banking providing large funding servicesbetween (mainly) financial institutions. Banks maycooperate as sydicate for very large loans

More international, more in foreign currencies;Often involved in trading assets such as securities viaoff-balance-sheet activities;Interbank market is the most important part of moneymarket (financial instruments with short maturity,comparing to capital market where maturity is longer).

J. C. Introduction





Banks’ many faces: services (cont’d)

Universal banking providing whole range of financialservices, deposits, loans, insurance, security services... e.g.,single entity like Deutsche Bank AG or banking holdingcompany with many subsidiaries like Citigroup;

Shadow banking providing banking services in non-bank,non-licensed financial institutions. It involves most largebanks, gets too big to be neglected, yet is still muchunder-regulated and poorly understood

In 2013, shadow banking accounted for one-fourth of globalfinancial intermediation, 50% of total bank assets, 81% inUSA, Euro Area and UK;Including hedge funds, special purpose vehicles (SPV),money market mutual f unds (MMMF), etc.

J. C. Introduction





Why are banks so special?

From the perspective of funding (liability side)

Bank deposits are repayable on demand at their face value,are used as immediate substitute for money ;By collecting deposits from a large number of investors,banks diversify risk of deposit withdrawal and may invest inlong term (illiquid) assets;

From the perspective of investment (asset side)

Bank loans are non-marketable assets with a great contentof private information;By screening and financing those loans with demanddeposits, banks have incentives (and exclusive information)to act as information producer and delegated monitor .

J. C. Introduction




Inside banks: numbers and jargonsFacts, trends, and myths

A stylized bank’s balance sheet

Assets Euro Liabilities Euro

Cash 100 On call deposits 3000Reserve deposited in the central bank Can be withdrawn anytime

Liquid assets 1000 Time deposits 2500Safe, e.g. government securities “Certificate of deposit”, term deposits

Loans 6000 Bonds 1000Risky, e.g. corporate loans, mortgages Borrowing from financial market

Fixed assets 200 Equity 800“Tangible”, properties, plants, etc. Shareholders’ claim of ownership

Total 7300 7300

J. C. Introduction





Stylized profit and loss (income) account

Here is the stylized bank’s financial statement from its profitand loss income account

EuroInterest income 700+ Non-interest (fee) income 600Less interest expenses (funding cost) 600Less operating expenses 500= Gross profit 200

J. C. Introduction





The key indicators

Here are some key indicators reflecting the bank’s profitability

Return on assets (ROA) = 2007300 × 100% = 2.7%

Return on equity (ROE) = 200800 × 100% = 25%

Net interest margin (NIM) = 700−6007000 × 100% = 1.4%

(only for interest-earning assets)

Leverage ratio (LEV) = 7300800 = 9.1

Operating expense (OE) ratio = 5007300 × 100% = 6.8%

J. C. Introduction





Total bank assets versus GDP

But... how different are banks in reality, comparing withthose we have in mind and learn from classes? Let’s have alook at the real world facts, trends, and mysteries.First: Why should we care about banking sector at all?Because it’s tooooooo big ! (Total bank assets / GDP ratio. Source:OECD, Federal Reserve Bank, ECB, Norges Bank, Deutsche Bundesbank)

Some countries, such as Ireland, the Netherlands and the UK, experienced dramatic changes in total banking sector assets up until the time where the financial crisis hit.

Chart 2.1: Total banking sector assets relative to the country's GDP

Sources: OECD, Bank of England (BoE), Deutsche Bundesbank (DBB), Banque National de Belgique (NBB), Statistics Sweden (SCB), Statistics Finland (SF), Danish Financial Authority (DFA), Norges Bank (NB), Federal Deposit Insurance Corporation (FDIC), De Nederlandsche Bank (DNB). Note: The banking sector of a country refers to domestic banking groups and stand-alone banks in addition to domestic subsidiaries of foreign controlled banks. In addition, foreign branches of domestic banks are included, whereas foreign subsidiaries of domestic banks and domestic branches of foreign banks are excluded. However, there are a few exceptions to this general rule: In the case of the Netherlands, the UK and Ireland, domestic branches of foreign banks are included. Ireland further distinguishes itself from the other countries in the sample, as foreign subsidiaries of domestic banks are included as well. Starting from 2007, data on Norwegian covered bond mortgage companies (OMF-foretak) are included. Also, Fokus Bank (Danske Bank) was a subsidiary until mid-2007 and was hence included in the data on Norway up until 2006. In the case of Ireland, the source of the data for 2010 and 2011 is the European Central Bank (ECB), while data for Finland were obtained from Statistics Finland. These series do not match/overlap perfectly with the data from the OECD, but present some minor deviations. See the appendix for further information and discussion.

The United States and the Nordic countries have the lowest total assets to GDP ratio in our sample. The US not only had the smallest banking sector throughout the period, but also showed a very stable total assets to GDP ratio, which actually never exceeded 100 percent. The Nordic countries, on the other hand, experienced a significant increase in the relative size of the banking sector, illustrated by the distinct increase in total assets to GDP ratios from 2005 onwards. In the case of Finland, total assets doubled between 2005 and 2011.

As for Norway, Chart 2.1 illustrates that the banking sector has increased substantially over the past decade. Total assets amounted to 93 percent of GDP in 1999, rising to around 160 percent of GDP in 2009. After the financial crisis, the relative size of the Norwegian banking sector remained stable, in contrast to the decline we observe in other countries.

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J. C. Introduction





Growth in bank assets

...and growing extremely fast! (Growth in total bank assets, withyear 2000=100. Source: OECD, Federal Reserve Bank, ECB, Norges Bank,Deutsche Bundesbank)

Hence, let Figure 2.4 presents the total assets of the banking sector indexed to the stock in year 2000, an arbitrarily chosen base year. We see that Ireland, but also the UK and the Nordic countries experienced a dramatic increase in banking sector assets up until the financial crisis hit in 2007-2008. Moreover, the growth in banking assets in Norway actually exceeded that of the other three Nordic countries as well as that of the UK.

From 2000 to 2011 the banking sector in Norway and Finland increased between three and four times. The two countries have experienced a banking sector growth that is not by any other northern European country. They also distinguished themselves from the rest of the countries in our sample, as their growth continued also after the financial crisis hit in 2008.

Chart 2.4: Growth in total banking sector assets (index 100=2000)

Sources: OECD, Bank of England (BoE), Deutsche Bundesbank (DBB), Banque national de Belgique (NBB), Statistics Sweden (SCB), Statistics Finland (SF), Danish Financial Authority (DFA), Norges Bank (NB), Federal Deposit Insurance Corporation (FDIC), De Nederlandsche Bank (DNB). Note: As a general rule, Tte banking sector of a country refers to domestic banking groups and stand-alone banks in addition to domestic subsidiaries of foreign-controlled banks. In addition, foreign branches of domestic banks are included, whereas foreign subsidiaries of domestic banks and domestic branches of foreign banks are excluded. However, there are a few exceptions to this general rule: in the case of the Netherlands, the UK and Ireland, domestic branches of foreign banks are included. Ireland further distinguishes itself from the other countries in the sample, as foreign subsidiaries of domestic banks are also included. Starting from 2007, data on Norwegian covered bond mortgage companies (OMF-foretak) are included. Also, Fokus Bank (Danske Bank) was a subsidiary until mid-2007, and was therefore included in the data on Norway up until 2006. In the case of Ireland, the source of the data for 2010 and 2011 is the European Central Bank (ECB), while the corresponding data for Finland are taken from Statistics Finland. These series do not match/overlap perfectly with the data from the OECD, but present some minor deviations. See the appendix for further information and discussion.

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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Ireland

Netherlands

Norway

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United States

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J. C. Introduction





Domestic financing: bank versus market

...and is the engine for the real economy. (Total domesticfinancing through banking sector versus financial market. Source: OECD)Chapter 3: Comparative financial systems

41

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

0

0,2

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0,6

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1

1,2

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1,6

France Germany Italy Spain United Kingdom USA Japan

Bank claims/GDP Market capitalisation/GDP

J. C. Introduction





Domestic financing: bank versus market (cont’d)

...while the cross-country differences are still very muchdistinguished

In countries with market-based financial system, such asUSA on one extreme, equity market is a much moreimportant source of funding, comparing with bank lending;In countries with bank-based financial system, such asGermany on the other extreme, equity market is a much lessimportant source of funding, comparing with bank lending;In countries with hybrid financial system, such as UK,equity market and bank lending are almost equallyimportant financing sources for the economy;

...and financial systems are evolving over time, too.

J. C. Introduction





Profitability in banking

You might think it leads to higher market power and pricemarkup, but... (Source: Federal Reserve Bank)

FRED Graph ObservationsFederal Reserve Economic DataLink: http://research.stlouisfed.org/fred2Help: http://research.stlouisfed.org/fred2/help-faqEconomic Research DivisionFederal Reserve Bank of St. Louis

USNIM Net Interest Margin for all U.S. Banks, Percent, Quarterly, Not Seasonally Adju

Frequency: Quarterly, End of Periodobservation_date USNIM

1984-01-01 3.781984-04-01 3.871984-07-01 3.911984-10-01 3.951985-01-01 3.971985-04-01 4.041985-07-01 4.041985-10-01 4.061986-01-01 3.941986-04-01 3.951986-07-01 3.931986-10-01 3.921987-01-01 4.011987-04-01 3.991987-07-01 4.031987-10-01 4.071988-01-01 4.011988-04-01 4.031988-07-01 4.081988-10-01 4.211989-01-01 4.211989-04-01 4.191989-07-01 4.121989-10-01 4.131990-01-01 4.001990-04-01 4.001990-07-01 4.001990-10-01 4.031991-01-01 4.081991-04-01 4.111991-07-01 4.161991-10-01 4.201992-01-01 4.331992-04-01 4.441992-07-01 4.491992-10-01 4.541993-01-01 4.511993-04-01 4.511993-07-01 4.521993-10-01 4.491994-01-01 4.91

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Net Interest Margin for all U.S. Banks (01.1984-07.2014)

J. C. Introduction





Profitability in banking (cont’d)

...Another example from UK, NIM of Barclays Group1979-2012 (Domestic banking versus international banking. Source:British Bankers Association)

J. C. Introduction






...However, return to shareholders is quite stable, exceptsome really lean years. Where does the profit come from?(Source: Federal Reserve Bank)

FRED Graph ObservationsFederal Reserve Economic DataLink: http://research.stlouisfed.org/fred2Help: http://research.stlouisfed.org/fred2/help-faqEconomic Research DivisionFederal Reserve Bank of St. Louis

USROE Return on Average Equity for all U.S. Banks, Percent, Quarterly, Not Seasona

Frequency: Quarterly, End of Periodobservation_date USROE

1984-01-01 11.971984-04-01 10.571984-07-01 11.111984-10-01 10.661985-01-01 12.331985-04-01 12.071985-07-01 12.191985-10-01 11.221986-01-01 11.881986-04-01 10.741986-07-01 10.771986-10-01 10.011987-01-01 11.431987-04-01 -5.961987-07-01 0.331987-10-01 1.551988-01-01 10.901988-04-01 11.371988-07-01 13.441988-10-01 13.321989-01-01 14.661989-04-01 14.211989-07-01 8.951989-10-01 7.711990-01-01 12.001990-04-01 10.921990-07-01 9.551990-10-01 7.541991-01-01 10.091991-04-01 9.211991-07-01 8.881991-10-01 8.011992-01-01 12.771992-04-01 13.331992-07-01 13.491992-10-01 13.241993-01-01 16.191993-04-01 15.641993-07-01 15.931993-10-01 15.631994-01-01 14.88

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Return on Average Equity for all U.S. Banks (01.1984-07.2014)

J. C. Introduction






International comparison (Return of average equity across countries.Source: OECD, Federal Reserve Bank, ECB, Norges Bank, DeutscheBundesbank)

half of previous decade, with average ROE up to around 13 percent, and delivers the highest ROE in the sample from 2008 onwards.

Chart 2.9: Return on shareholder equity (RoE) in the banking sector

Sources: OECD, Bank of England (BoE), Deutsche Bundesbank (DBB), Banque national de Belgique (NBB), Statistics Sweden (SCB), Statistics Finland (SF), Danish Financial Authority (DFA), Norges Bank(NB), Federal Deposit Insurance Corporation (FDIC), De Nederlandsche Bank (DNB). Note: The return on shareholder equity is defined as after-tax income relative to shareholder equity. The banking sector of a country, as a general rule, refers to domestic banking groups and stand-alone banks in addition to domestic subsidiaries of foreign-controlled banks. In addition, foreign branches of domestic banks are included, whereas foreign subsidiaries of domestic banks and domestic branches of foreign banks are excluded. However, there are a few exceptions to this general rule: In the case of the Netherlands, the UK and Ireland, domestic branches of foreign banks have been included. Ireland further distinguishes itself from the other countries in the sample, as foreign subsidiaries of domestic banks are included as well. Starting from 2007, data on Norwegian covered bond mortgage companies (OMF-foretak) are included. Also, Fokus Bank (Danske Bank) was a subsidiary until mid-2007, and was henceincluded in the data on Norway up until 2006. In the case of Ireland, the source of the data for 2010 and 2011 is the European Central Bank (ECB), while the corresponding data for Finland are taken from Statistics Finland. These series do not match/overlap perfectly with the data from the OECD, but present some minor deviations. See the appendix for further information and discussion. In the case of Belgium, the return on equity in the banking sector reached -41.7 percent in 2008. In Ireland the return on equity was -36.7 percent in 2008 and -65.2 percent in 2009. In order not to blur the picture for the years prior to 2008, these latter three values were not included in the chart.

Finally, we combine the yearly data on total assets to GDP presented in Chart 2.1 with thereturn on total assets presented in Chart 2.8, and present the relationship between size and returns in the banking sector in Chart 2.10.We are not able to comment on the causality

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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Ireland

USA

15

J. C. Introduction





Funding resources: deposit versus others

You might think banks are just deposit institutions... nolonger true. Where does the rest of money come from?(Share of deposits in bank liabilities. Source: OECD, Federal Reserve Bank,ECB, Norges Bank, Deutsche Bundesbank)

Chart 2.16: Customer deposits to total assets ratio

Sources: OECD, Bank of England (BoE), Deutche Bundesbank (DBB), Banque national de Belgique (NBB), Statistics Sweden (SCB), Statistics Finland (SF), Danish Financial Authority (DFA), Norges Bank (NB), Federal Deposit Insurance Corporation (FDIC), De Nederlansche Bank (DNB). Note: The banking sector of a country, as a general rule, refers to domestic banking groups and stand-alone banks in addition to domestic subsidiaries of foreign-controlled banks. In addition, foreign branches of domestic banks are included, whereas foreign subsidiaries of domestic banks and domestic branches of foreign banks are excluded. However, there are a few exceptions to this general rule: In the case of the Netherlands, the UK and Ireland, domestic branches of foreign banks have been included. Ireland further distinguishes itself from the other countries in the sample, as foreign subsidiaries of domestic banks are included as well. Starting from 2007, data on Norwegian covered bond mortgage companies (OMF-foretak) are included. Also, Fokus Bank (Danske Bank) was a subsidiary until mid-2007, and was hence included in the data on Norway up until 2006. In the case of Ireland, the source of the data for 2010 and 2011 is the European Central Bank (ECB), while the corresponding data for Finland are taken from Statistics Finland. These series do not match/overlap perfectly with the data from the OECD, but present some minor deviations. See the appendix for further information and discussion.

2.6 Cross-country differences in market structure

We next turn to an examination of the market structure of the Norwegian banking sector compared with that of the other countries in our sample. This section presents a brief cross-country comparison, focusing on differences across European banking sectors. A more thorough discussion of the market structure of the banking sector in Norway is provided in Section 4.

To obtain a comprehensive picture of the differences in competition across banking sectors in Europe, we take a closer look at two different indices of market concentration for a set of northern European countries.

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1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

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J. C. Introduction





Intermediation structure

You might think lending to / borrowing from banks is assimple as this

Households with cash surplus lend to banks, given that theymay withdraw when needed (demand deposits);Those who need cash borrow from banks, and banks makesure that they repay as scheduled;And banks profit from the spread between borrowing andlending rates (interest margin).

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4 Financial complexity and systemic risk

How many other [financial] innovations can you tell me that have been as import-ant to the individual as the automatic teller machine, which in fact is more of a mechanical than a financial one?

(Paul Volcker)

The modern finance is a system of extremely high complexity, with structures and products that are hardly understandable by outsiders. The complexity of the financial system grows exponentially with financial innovation in the past decade, but what such complexity implies for financial stability is seldom dis-cussed in the research (Brunnermeier and Oehmke (2009) is one of the few excellent reviews on this issue). During the current financial crisis, financial market is blamed to be over- complicated. In the financial turmoil, the panic grows mostly out of the suspicion that something indiscernible is rotten in the banks, and investors get tremendous loss from the financial products that are too complicated to understand. The financial system gets more and more complicated in many ways. One prominent feature is that the intermediation structure becomes much more soph-isticated than it used to be. An example by Shin (2010a) shows how the interme-diation chain for mortgage evolves. Traditionally, as Figure 4.1 shows, the bank takes short- term deposits from the households and issues loans to long- term bor-rowers. The bank collects the mortgage repayments from the borrowers and then returns some of the proceeds to the depositors. In contrast, the same thing is nowadays carried out through a very long inter-mediation chain (see Figure 4.2), involving many sophisticated financial products. First, the mortgages are pooled and financed by the mortgage- backed securities (MBS), and these securities are owned by the asset- backed securities (ABS) issuers and may be further tranched into new products such as collateralized debt

Households Bank HouseholdsMortgage Deposits

Figure 4.1 Short intermediation chain (source: Shin, 2010a, pp. 101).

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T&F PROOF

J. C. Introduction





Intermediation structure (cont’d)

...However, in reality the process goes through a lengthychain, involving institutions you may have never seen orheard about: why such a fuss?

In fact, banks sell your mortgage loans before theyoriginate. If they cannot sell, they wouldn’t even issue!

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Financial complexity and systemic risk 79

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obligations (CDO). The investment banks hold these CDO, but they get funding from the commercial banks in the repo market. The commercial banks raise funds by issuing short- term commercial paper. Money market funds buy such commercial paper, and the individual investors or the households hold the shares of the money market funds. This complicated procedure is not restricted to the mortgage business (whose failure is believed to be the trigger of the crisis), but also applies to many financial services such as credit cards and students’ loans. The advantage, as people claim, is that the financial innovation such as CDO helps grease the wheels so that in the normal time the financial institutions can easily raise funds in a very liquid market. However, as is seen in the crisis, such complexity undermines the stability of the financial system and leaves all the financial institutions in the quagmire when time turns bad. Financial complexity makes little trouble in the traditional theories of finan-cial economics, where the economic agents are rational in the sense that they know all the details of the economy and they are able to make optimal decisions based on all the information they acquire. However, financial complexity makes much difference in a more realistic setup, where the agents are only boundedly rational. Rubinstein (1998) presents numerous occasions where bounded ration-ality needs to be considered, among which two are of special interest to our dis-cussion. The first is that one can hardly get to know all the information in the financial system all the time; it is beyond anyone’s capability. The second is that even there is no asymmetric information and the complete set of information is available – the development of information technology such as the Internet helps make information widely available – the quantity of information is likely to be too huge for anyone to process, due to the limited computation capacity. As a result, the market participants are only able and willing to possess a subset of information. In a complicated financial system, this implies that financial institutions along the long intermediation chain may gradually lose the tracking and control of some risks. The asset prices may fail to reflect the true risks, and the financial institutions may hold too thin buffer to weather the systemic events.

ABS issuer

Mortgage pool

Households

Money market fund

Households

Securities firm Commercial bankABS

Mortgage

MBS

Money market fund shares

Short-term paper

Repo

Figure 4.2 Long intermediation chain (source: Shin, 2010a, pp. 101).

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T&F PROOFJ. C. Introduction





Intermediation structure (cont’d)

...Actually in reality the procedure looks like this!`

The Shadow Banking SystemConceptualized, designed and created by Zoltan Pozsar, The Federal Reserve Bank of New York, November, 2009

Short-Term Funding Short- to Long-Term Cash

MMDAsHouseholds, Businesses, Governments CDs

Equity Funding Long-Term Investments

Equity Equity

`

Equity

Short-Term Debt InstrumentsRegulated Money Market Unregulated Money Market

Agency MBS Agency Discount Notes Intermediaries Intermediaries

*Conforming mortgages RRsOther*

Liquidity Puts A1 *ARS, MMMFsA1 CP

AAA ABCPAA-BBB BDPEquity RRs

*Conforming student loans 2a-7 MMMFs Other*A1 *ARS, MMMFs, as well as A1

A1 (AAA) ABS Tranches CP MTNs and term ABS CPA1 ABCP ABCP

AAA BDP BDPAA-BBB RRs RRs Short-Term SavingsEquity Other* Other*

*Conforming SBA loans *TOBs and VRDOs A1 *ARS, MMMFs Money Market PortfoliosCP

ABCPBDPRRs

Other*A1 AAA Offshore (non-2a-7) MMMFs *ARS, MMMFs, as well as A1

AAA AA-BBB A1 MTNs and term ABS CPABCP AA-BBB LTD MTNs CP ABCP

Equity Repo Equity Supers CNs* ABCP BDPLTD Haircuts BDP RRs

Households Equity O/C High-Yield CLOs RRs Ultra-Short Bond Funds Other* Households and Nonprofits(LBO Loans) Other* A1 *MMMFs

A1 *TOBs and VRDOs CPAAA ABCP

AA-BBB BDP2nd Lien Equity RRs

Equity O/C O/C O/C Other*CP *FHC affiliate Consumer ABS *ARS, MMMFs, as well as A1

ABCP (Credit Card ABS) MTNs and term ABS CPBDP A1 ABCP

AAA BDPAA-BBB RRs

Equity O/C Equity Other* Nonfinancial CorporatesO/C *ARS, MMMFs

an BanksDW

AAA TAFAA-BBB FX Swaps

LTD MTNs Tri-Party Repo System TSLFSupers CNs* Federal, State TSLF

Nonfinancial Businesses Equity Tri-Party Clearing Banks* and Local Governments PDCFCPFFTALFAMLF

MMIFFML, LLC

Equity O/C O/C an Banks ML II, LLC

*BoNY and JP Morgan Chase ML III, LLC

LSAPs

RoWO/C Equity (Foreign Central Banks) Equity

RMBS(1st lien, private label) MTNs Cash Reinvestment Accounts

CP A1 A1ABCP AAA CPBDP AA-BBB ABCP

Equity BDP RoWGovernments RRs (Sovereign Wealth Funds)

Equity O/C Subprime ABS Other* *Done by custodian banks(2nd lien, subprime, HELOCs) Trading Book *MMMFs, MTNs, term ABS and on an agent basis.

A1 TOBs and VRDOsAAA

AA-BBBEquity

Haircuts Cash Reinvestment Accounts *Issued to central banksCMBS and High-Yield CLOs A1 in exchange for investibe FX

(LBO Loans) CP Long-Term SavingsA1 ABCP

AAA BDP Fixed Income Portfolios*AA-BBB RRs MTNs

Equity Equity Other* *Done by real money accounts*MMMFs, MTNs, term ABS and on a principal basis.

TOBs and VRDOs CNs*Bank, Shadow Bank and Corporate Debt

Consumer ABS(Card, Auto, Student Loan)

CP A1AAA Cash

AA-BBB MTNsEquity LTD Equity Portfolios*

Haircuts EquityEquity O/C Other ABS

(Floorplan, Equipment, Fleets)A1 AAA *Mutual Funds, ETFs, Separate Accounts

AAA AA-BBB *Bank and Corporate DebtAA-BBB MTNsEquity CNs*

O/CCP Middle-Market CLOs

ABCP (Loans to SMEs) Cash

LTD AA-BBB EquityEquity Equity Equity

*Term ABS and CDOdebt and equity tranches

Public Equity

CashMTNsLTD

Structured Credit EquityEquity

*Hedge Funds and Private Equity(only credit exposures)

Maiden Lane LLC

3/11/08 and 3/16/08, respectively

Portfolio Protection*

EquityHouseholds, Businesses, Governments

Households, Businesses, Governments Equity and the Rest of the World (RoW)

Equity

AA-BBBEquity Equity

Source: Shadow Banking (Pozsar, Adrian, Ashcraft, Boesky (2010))

Commercial Bank*

Step (7): Wholesale Funding (Shadow Bank "Depositors")

ABS Reserves

Warehouse Hedges

Long-Term Synthetic Liabilities Broker-dealer CVA desks, ABS pipeline hedges,

Counterparty Hedges Warehouse Hedges

Equity

Debt Insu-rance

TLGP

Who

lesa

le F

undi

ng(T

erm

Deb

t Fun

ding

)

*Funded by UST's $50 billion

No Explicit

Fees

GSEs, DoE, SBA Federal Government

Agency Debt PurchasesAgency MBS Purchases

Insurance Guarantees

Step (4): ABS Warehousing

Finance Company*

The "Synthetic" Shadow Banking System

Broker-Dealers*

Funded Synthetic CDOs*

Consumers

Finance Company*

Fannie and Freddie*

Credit Hedge Funds

(Credit-Linked Notes) Unfunded Synthetic CDOs*

Single-Name and Index

CDS Indices

Single-Name and Index

Assets Bond(s)

Sovereign CDS

Protection Bought

Protection Sold

Agency Debt Purchases

Proprietary trading desks, credit hedge funds, etc.

Term Savings

Commercial Banks

AA-BBB

Synthetic Exposures*Counterparty Risks*

Credit Bets

Term Savings

Hedgers*

Deposits

Bank EquityReal Money Accounts*

Equity Portfolios

Money Market "Portfolios"

Loans

The

Tra

ditio

nal B

anki

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Orig

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unfunded liabilities, etc.

Loans, ABS and

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Unfunded Protection

Referencing ABS and single-name CDS *Referencing single-name CDS indices, etc. *Inability to meet

TreasurysCDS

AAA AAAAAA[…]

Equity

Loan(s)

Structured Credit and Loan

negative basis traders, real money accounts, etc.

Speculators*

Unfunded Protection Protection

Sold

*Market Makers

Funded Protection

"Naked" Positions

Funded ProtectionCounterparty Hedges

HedgesFunded

Protection *Referencing corporate loan indices, etc.*Hedging Motives

Insured Assets

*Speculative Motives

indices, etc.

Ultimate CreditorsBond(s) CDS

Unfunded Protection Protection

Sold[…]

CDS Counterparty Hedges

Funded Protection

Ultimate Borrowers Corporate CDS CDPCs CPDOs* Short-Term Synthetic Liabilities

Warehouse Hedges

Synthetic Credit Liabilities

Priv

ate

Ris

k R

epos

itori

es

The

"Sy

nthe

tic"

Shad

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m(D

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ased

Risk

Rep

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ries)

Warehouse Hedges

Loans, ABS and

CDOs

Counterparty Hedges Warehouse Hedges Warehouse and Counterparty Hedges

AAALoans, ABS and

CDOs

9/19/2008 10/21/2008 11/10/2008

Subprime ABS Reserves

ABCP RMBS

10/7/2008 11/25/2008 3/24/2008 10/11/2008 12/12/2007 12/12/2007

Tri-Party Collatera

lReserves ABCP Reserves

Non-repo MM instrume

nts

Reserves$ FXCP

Reserves AAA Reserves Warehoused ABS

ReservesCDS on

CDOsReserves

CPFF TALF Maiden Lane III LLC TAF FX Swaps TSLF/PDCF

Equity Equity

Priv

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dit T

rans

form

atio

n

(T

ail R

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Prov

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Priv

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*Unaffiliated with originators!

Credit Insurance (Mortgage Insurers)

Cre

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s

PremiaCredit

Insurance PremiaCredit

Insurance Premia

Credit Insurance (Par Puts)

Client Funds

Cre

dit "

Ref

eren

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*Unaffiliated with originators! *Unaffiliated with originators!

MTNs

Equity TranchesMezz

ABSSuper Senior

Credit Insurance (AIG FP)

Credit Insurance (AIG FP)

[…]

MTNsLTD

Loans

AAA (A4)

*Public and Private Pension Funds,

Debt Tranches

Pension Funds, Insurance Companies*

Structured Credit Portfolios*

Term Savings

HG ABS

Super Senior

Structured Credit

Credit Insurance (Monolines)

A4 and AA-BBB ABS Tranches

AAA

Diversified Insurance Co.

LPFCs

Client Funds

Long-Term Debt

Alternative Asset Managers*

Pension Liabilities

Captive Finance Company *Capital Notes

Loans

AA-BBBREITs

BDPMTN

*Independent conduitIndustrial Loan Company*

A1

Loans ABCP LoansCP

LTD

The

"E

xter

nal"

Sha

dow

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king

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pend

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Repos

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A2 & A3 (AAA) ABS Tranches

Public Equity

Term SavingsABS

Agency LTD

Structured Credit

Long-Term nstruments (LTD)

Cash Collateral

ABCPLoans ABCP

MTNs LoansPrivate LTD

AA-BBB

*Broker-dealer affiliate *ARSs, TOBs, VRDOs *Medium-term debt

Inde

pend

ent S

peci

alis

ts' C

redi

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erm

edia

tion

Proc

ess

Standalone Finance Company Credit Hedge Fund

LoansLoans

*Finance company affiliate

[…]

Term SavingsLTDs

Cash Collateral

Securities Lending*Agency Debt*

Who

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le F

undi

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Securities Lent

Loans AAA (A2-A3)

Cash Collateral

LoansLong-Term Munis

Short-Term Munis

LoansAgency DebtABS

Industrial Loan Company* AAALocal Governments

LoansBrokered Deposits

AA-BBB

Tax Revenues

Muni Bonds

Brokered Deposits

Brokerage Clients' Cash

Balances

FX Reserves Bonds*Mezzanine CDOs Super

SeniorsPrincipal Securities Lending

BBB

Supers

*Broker-dealer affiliate

Savings: Export

Revenue"Equity"

Tax Revenues

State Bonds

*Broker-dealer affiliate AA-BBB

Loans AA-BBB Repos

EquityTax Revenues Bonds

State Governments AAA Prime Broker

Super Seniors

Repos

Loans

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AAA

Securities Lent

AA-BBB ABSHigh-Grade CDOs

Asset Manager,Off-

Bala

nce

Shee

t

Securities Lending*

Supers

Private MTNs Cash

CollateralLoans ABCP

Federal Government

Tax Revenues

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Credit Hedge Fund*

Broker-Dealer*

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med

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Medium-Term Instruments Agent Securities Lending

Loans

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Private Equity

Euro Deposits

Portfolio Companies

Firms

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LBO Loans

*European bank affiliated

AAAABCP

Arbitrage Conduit

Assets

LoansBusinesses

Reverse Repos

CRE CRE Loans

LoansBonds

Europe

AA-BBB

Businesses Europe

Savings: Excess Cash

"Equity"

Federal Reserve

Invest- ments

C&I Loans

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Deposits

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Who

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king

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securities collateral

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CP

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*FHC affiliate *ARSs, TOBs, VRDOs

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Goods &

ServicesLoans Loans AA-BBB ABCP

LoansMTNs

Sweep Accounts

Long-Term Munis

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Equity Liquidity Puts*

Off-

Bala

nce

Shee

t

AA-BBB

Loans

Structuring and

SyndicationLoans

Reverse Repos* ABCP

Equity AAA Savings: Excess Cash

BBB

SupersAAA

*BHC affiliate

"Equity"ABS

$1 NAV Shares

BDPs

BDPs

AssetsLoans

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ABCPHome1st Lien

Subprime Homeowners

$1 NAV Shares

AA-BBB Loans CP$1 NAV Shares$1 NAV

SharesHigh-Grade CDOs

AA-A

Supers *Capital Notes

$1 NAV Shares

SIV, SIV-Lite

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Bala

nce

Shee

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Term Savings

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redi

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edia

tion

Proc

ess

$1 NAV Shares

ReposCP

LoansABCP

AA-BBB

$1 NAV Shares

(Retained Portfolios)

Off-

Bala

nce

Shee

t

Loans*

Agency MBS

Discount Notes Loans A1Private

ABSAgency Debt

Munis ARSs TOBs

orVRDOs

FFELP ABS

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(Retained Portfolios)

CPABS

FH LBs Fannie and Freddie Cash "Plus" Funds

Agency Bills

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lic O

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Enhanced Cash Funds

$1 NAV Shares

Ultimate Borrowers CMOs Direct Money Market Investors Ultimate Creditors

Loans*

Agency Pass-

Throughs

Agency MBS

CMO Tranches

Corporate TreasurersA1

Off -Balance Sheet ABS Intermediation

On -Balance Sheet ABS Intermediation

The

GSE

s' C

redi

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erm

edia

tion

Proc

ess

FHLBs

(Time-Tranched Agency MBS)

Federal Government

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Bala

nce

Shee

t

Agency MBS

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The "Cash" Shadow Banking System Deposit Insurance (FDIC)

Liability Insurance (Federal Government)

Credit Insurance (GSEs, DoE, SBA)

Liability Insurance (Federal Government)

Liability Insurance (EU Government)

Insurance Premia

Deposit Insurance

FDIC

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Fees

No Explicit

Fees

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11/25/2008

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Publ

ic R

isk

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ries

(T

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ic C

redi

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Bank Equity

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Pension Funds

Client Funds

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ity F

undi

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radi

tiona

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endi

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roce

ss

Asset Managers*

Bank Treasurers

Bank EquityLoans

Bank Equity

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Loans

Exchange Stabilization Fund

$1 NAV Shares

Insurance Premia

*Asset Managers, Insurance Companies and

ABS

Implicit Insurance

9/18/2008

MMMF Guarantee

Households, Businesses

Checking Account

and the Rest of the World

The Traditional Banking System

CDs

Ultimate CreditorsDepositors

Deposits Equity

Step (1): Loan Origination

TBAMarket

Step (3): ABS Issuance

Short-Term

Savings

Ultimate Borrowers

Reserves

11/25/2008

No Explicit

Fees

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Deb

t Fun

ding

(Sho

rt an

d Lo

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erm

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Loans

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Who

lesa

le F

undi

ng(S

hort-

Term

Fun

ding

)

AA-BBB Arbitrage Conduit

No Explicit

Fees

Implicit Insurance

SBA ABS

(ABS Warehouse Conduits)

Structuring and

Syndication


(Warehouse and Term)

SIV

Loans ABCP

(Warehouse and Term)

Loans

Loans

Discount Notes

Step (2): Loan Warehousing

Agency Debt

Equity

Step (5): ABS CDO Issuance

Loans*

*Capital Notes

Off-

Bala

nce

Shee

t

ABCPMezzanine CDOs

Off-

Bala

nce

Shee

t

AA-BBB

Short-Term Munis

LoansBrokered Deposits AAA

and Life and P&C Insurance Companies

CDOs

Subprime, RMBS, CMBS

[…]

Mezz ABS

Hybrid Conduits*FHC affiliated

Maiden Lane II LLCMMIFFAMLF

Trading Books

Catalogue:,Shadow Bank Liabilities

Step (6): ABS "Intermediation"

Trading Books

Repo Conduits

ABCP

Off-

Bala

nce

Shee

t

Loans

Bonds

Assets

"Prime" Homeowners

*DBD affiliate

Loans


Multi-Seller Conduit* Broker-Dealer*

Multi-Seller Conduit*

Loans

Bonds

("Rent-a-Conduit")

Broker Sweep Accounts


ABS and

CDO Equity

Loans

ABS

Loans

ABSEquity

Hybrid Conduits

ABCP

CP

J. C. Introduction




Microeconomics of bankingMacroeconomics of bankingBanking regulation in theory and practice

Microeconomics of banking

The role of financial intermediation: Why is financialintermediation needed? – Economics of banking as a fieldof incomplete market and market failure;

Banks’ balance sheet choices

Theories of bank capital;Theories of bank debts, funding resources and liquidity risk;Lender-borrower relationship, screening and monitoring,credit risks;

Bank competition, market structure and banks’ risk takingincentives.

J. C. Introduction





Analytical tools and related fields

Game theory , contract theory and corporate finance

Important to understand banks’ strategic behavior, e.g., incompetition, risk taking, response to regulation;Second best solution under market (especiallyinformational) frictions;Mechanism design for contracts under which banks behaveas desired;

Industrial organization (IO) to better understand bankcompetition

The evolution of market structure and market power; whileMore focus on stability than efficiency.

J. C. Introduction





Macroeconomics of banking

The linkage of macro economy and banking is centralbank’s monetary policy , or, central banking

How does central bank conduct monetary policy? Targetsand instruments?What’s the optimal monetary policy? How to implement?

The next question is about transmission mechanism

How do banks react to monetary policy by adjustingbalance sheets?What does this imply to aggregate credit supply to firms?Impact on the real economy?

Banking and the real economy

How is business cycle amplified by the banking sector?The role of financial intermediation in growth and volatility?

J. C. Introduction





Banking regulation in theory and practice

Financial intermediation corrects market failure andincompleteness, while it creates new failures;

Comparing with other industry, banking regulation is veryspecial

Besides competition structure, banking regulation focusesmore on financial stability ;Needs to look at both the risks inside individual banks andthose in the system level (systemic risk);Macro-finance linkage implies banking regulation has hugeimpact on macro stability ;Unfortunately, exisiting regulatory rules are seldom wellfounded, and issues are poorly understood;Crisis resolution needs to be taken into account, ex anteand ex post.

J. C. Introduction

Documents

Banking in Theory and Practice - Universitetet i oslo...Facts, trends, and myths 3 Economics of Banking Microeconomics of banking Macroeconomics of banking Banking regulation in theory