BANKING – THE SCRIPT

Quiz 2: Teaching notes

Final exam: Week 6-15 (Chapter 4, Chapter 8, Chapter 9, Appendix A1) + Teaching materials

WEEK 1: INTRODUCTION TO BANKING (PRESENTATION)

Possible essays:

- The origin and development of banking

o Science of banking,
o Origin and evolution of banks
o Term: “Bank”
o Bank characteristics
o Bank definition
o Bank Secrecy
o Review of banks and its services
- Banks as subjects of financial market
o Functions of financial system
o Financial market
 Money market
 Capital market
o Banking system
o Structure of financial institutions
o Changes in the financial structure
o New trends in banking
- Commercial banking
o Types of banks
o Activity of banks
o Organization of banks
o Bank balance sheets
o Banking aggregates
- Basic banking principles
o Liquidity – a firm’s ability to meet its short-term obligations
o Solvency – a firm’s ability to sustain its activity into the long-term
- Central banking systems
o Activities of central bank
o Functions of central bank
o Differences between central and commercial banks
o Bank supervision
o Components of central bank balance sheets
o Monetary policy instruments of central bank
- Banking systems in FBiH and RS
 o Indicators of banking system of FBiH
o Indicators of banking system of RS
- Banking liabilities and bank capital
o Deposits
 Factors of deposit forming
 Deposit insurance
o Non-deposit liabilities
 Capital
 Functions of capital
 Capital adequacy
- Active and passive banking activities
o Types of bank loans
 Loan bank business
 Short-term loan business
 Long-term loan business
 Deposit bank business
- Other banking operations
- Analysis of BiH bank business activities (Student research)
- Banking services at Bosnian banking market (Student research)

WEEK 2: THE ORIGIN & DEVELOPMENT OF BANKING, REGULATORY

FRAMEWORK FOR BANKS IN FB&H, AND BANK REGULATION AND
SUPERVISION (+ CHAPTERS 1 AND 7)

TOPIC 1: THE ORIGIN & DEVELOPMENT OF BANKING

What is ‘Banking Science’?

Banking science is a science which explains by scientific methods one aspect of monetary factors and
transactions.

It examines:

- Roles of banks and banking operations as important institutions of financial and economic
system of country,
- Functions and roles of banking system,
- Organization of banking institutions,
- Banking operations (banking functions and operations),
- Theory and practice of monetary-credit and exchange policy,
- Credit-banking system and its influence on economic policy of country and on international
economic and financial relations,

Banking science considers both micro and macro point of view and it is considered an applied
economic discipline, which became a popular type of science in the second part of XIX century, since:

- It examines banking system and banking practice (banking techniques), and

- It examines main issues of credit system and credit
What type of activity is ‘Banking’?

Banking is:

- An essential activity,
- Activity in changes,
- One of the most regulated activities,
- Activity of collecting data,
- Activity of information transfer,
- Activity with fixed costs,
- Activity of business acquisitions,
- It belongs to service industry

Reasons why Banks are significant.

Banks are:

- The most important financial institutions,

- Main source of loans,
- Main source of working capital,
- The largest purchasers of government bonds,
- Lever for implementation of government stability programs,

When were coins invented?

Coins were invented between VII and V century BC.

What are the rudimentary operations in banking?

Rudimentary operations in banking are:

- Pledge operations, and

- Exchange operations

The origin and evolution of banks.

Stage 1: From Babylon to Reneisance (3.400 BC – 1.320 A.D.)

First banking building was built in the City of Uruk. In a period between 3.400 to 3.200 BC, banking
was being developed in Babylon. The temples at the time served as warehouses, and the goods
grouped in those warehouses were being lent with “interest”.

Hammurabi Code (1780 BC) is considered to be the Code of Banking. It is the only code that existed
until Roman laws were introduced. It is significant because:

- It specifies the banking business: cash loan, the interest, deposit in kind, the contract of
commission,
- Interest has been provided for loans in barley and dates and it amounted to 33%,
- In order to prevent usury, all loan contracts were subject of approval of king’s servants

Croesus of Phrygia is considered to be the king that first began to mint money, in the form of small
bullions (half-gold – half-silver), sometime in the VII century BC.

VI century BC in Ancient Greece is significant for development of banking since at the time:

- Banks were separated from temples,

 - A money exchange was started (Sarafi),
- Mortgage and commercial loans were started (trapazeri – bankers of Antiquity)

Templars are considered responsible for the invention of double keys and double-entry bookkeeping
(1.128 AD).

Lombard loans were used by the kings and nobility, but supplied by the Lombardi (1222) after the
Jews were expelled from France.

Stage 2: Renaisance of Banking

The first banking in history of banking, dealing with payment operations were established in Genoa,
Italy, at the beginning of the XIV century. These banks are:

- Banca di Genova (1320), and

- Casa de St. Georgo (1407)

Banking centers of the Middle Ages:

- Venice,
- Genoa,
- Siena, and
- Florence

Genoa + Venice = over a hundred banks established in the fifteenth and sixteenth century

First Modern Bank

Bank of Amsterdam, established in 1609, is considered to be the first modern bank. The bank
operated in a very strict and upright manner in a sense that deposits were almost sanctity and the
Bank did not approve loans.

The problems the Bank was facing resulted in its liquidation in 1819. These challenges are:

- First challenge: Louis XIV of France was approaching Amsterdam

- Second challenge: business operations with the Dutch company in east India, where bankers
were simultaneously its directors, and
- Third challenge: war with England in 1780: City of Amsterdam was increasingly borrowing
from the Bank

Stage 3

Stage 3 in banking started with the:

a) Establishment of Bank of England in 1694. The changes to banking implemented by the Bank
of England are the following:
- Money is separated from the metal base,
- Appearance of bonds (bank-notes)
- Payments in the metal with king’s promise,
- Monopoly of note issuing, and
- Regulation of banks’ lending policies
 b) Bankque Royale in 1716. The case of banking miracle – John Law as the best example of
what the bank can do with money. Since then the history of development of banking is
characterized by: a constant shift between euphoria and panic.

Stage 4

Beginning of XIX century in England until today.

Banks were established as JSCs (joint stock companies) with relatively large equity.

What is “Currency theory”?

Currency theory is considered applicable to stages 1 and 2 of banking development. It means that
the full cash value has a 100% coverage by reserves in precious metals.

What is the “Banking theory”?

Banking theory is considered applicable to stages 3 and 4 of banking development. It states that
cash value is based on trust, and money is being separated from the metal base.

Which are the first banks in Bosnia and Herzegovina?

The first bank established in Bosnia and Herzegovina is the Vienna Union Bank established in
Sarajevo in 1884. It was named “Privileged Division of Union Bank in BiH”.

On 12th of March 1898 a BH national shareholding bank in Sarajevo was established in Sarajevo.

First savings banks were established in the following cities:

- First savings bank in Brčko – 1889,

- Savings bank in Bijeljena – 1893,
- First savings bank in Banja Luka – 1894

What are the first and second most important discoveries in banking?

The greatest discovery in banking is credit. The second most important discovery is a banknote,
which enabled the money to become a promise.

What is a “Banknote”?

A banknote is a non-interest promissory note of the bank which is payable to the bearer on demand
in legal currency of the country.

What is the basis of the banking business?

Basis of the banking business is the public trust.

How do banks determine the level of the reserves they require?

Bank holds reserves by its experience, but also the reserve requirement rate is provided by the law.

What is a “Banking crisis”, why is it becoming more rear and how can a solvent bank cope with it?

Banking crisis is a loss of trust in the bank, which causes a massive rush of investors with the
requirements for withdrawal of deposits.

Today they rarely happen because of:

 - Deposit insurance,
- Strict regulation of the banking industry

The solutions for solvent bank:

- Selling assets to other banks,

- Central bank intervention

Why do banks exist?

Banks exist to facilitate contact between the depositors and the debtors appearing in the role of
mediator.

Why are “intermediaries” necessary?

Intermediaries are necessary because:

- Of high “information costs” that limit the ability of the creditor to find the right debtor:
o Research costs,
o Debtor’s credit rating costs,
o Monitoring costs,
o Expenses of collection
- Of opportunity for banks to manage liquidity,
- Of opportunity for banks to use the benefits of economies of scope and synergy effect.

Explain the term “Bank”.

The term “bank” derives from the Latin word banco and it means “bench” (or in today’s language:
counter).

What are the aims of the bank?

The bank:

- Aims to maximize profits on invested capital of shareholders,

- Gains profit by strict control of society because it generally work with borrowed money

Why do limitations to the banking business exist*

There are limitations to the business in order to protect the public interest.

What is the aim and subject of control of the banking business?

The aim of control: strengthening trust in the bank.

Subject of control: the general performance of the bank.

What is the consequence of the control of the banking business?

The consequence of the control of the banking business are stricter conditions for the establishment
of the bank.

What are the bank characteristics?

Bank characteristics are as follows:

- Doing business with money as specific commodity,

- Trading liabilities and receivables,
 - Financial mediation,
- Takes the risk, also protects against it,
- Performs a secondary issue of money,
- Operates according to specific principles,
- Has a relatively small equity,
- Optimizes the allocation of national financial resources

Define a Bank (9 points).

Bank is a:

- Specific and independent economic and commercial entity,

- Sui generis company, which by:
- Delegated authority and trust,
- Mediates the transferring of funds, primarily on a credit basis,
- Doing all deposit, lending and financial transactions between financial debtors and creditors,
- And by that performing secondary issue of money,
- With expression of high degree of professionalism, organization and adaptability to changes
in the environment,
- Which directly contributes to maximizing the effects of their own microeconomics and
- Indirectly affects the optimization of use of relatively scarce financial resources at the macro
level of economic system.

What is a “Banking secret” and where does it apply?

A banking secret is a obligation of banks, their management and supervisory bodies and all persons
employed in the bank to keep the secret of clients and their affairs and the affairs of the bank.

This particularly applies to:

- Names and addresses of customers,

- Amount and type of deposit,
- Deposit status,
- Number and type of securities and other items

The obligation of secrecy exists also after the termination of employment in the bank. It applies to
auditors, employees of the central bank, the banking agency and others who have access to the bank
records.

The aforementioned parties are not obliged to keep the secret if:

- Keeping that secret may be harmful for them,

- They are explicitly exempt from the keeping secret obligation by customer, or
- In other cases provided by the Law

TOPIC 2: BANK REGULATION AND SUPERVISION

Why is the regulation of banks needed?

Regulation is needed to ensure consumer confidence in the financial sector.

What are the main reasons for financial sector regulation?

Main reasons for financial sector regulation are:

1. To ensure systemic stability,

2. To provide smaller, retail clients with protection,
3. To protect consumers against monopolistic exploitation

What types of regulation exist?

Types of regulation are as follows:

- Systemic regulation
o Deposit insurance,
o Lender of last-resort
- Prudential regulation
o Mainly concerned with consumer protection
- Conduct of business regulation
o Focuses on how banks and other financial institutions conduct their business

What are the limitations of regulation?

The limitations of regulation are as follows:

- Regulatory arrangements create moral hazard,

- Too big to fail (TBTF) are Too important to fail (TITF) cases,
- Regulatory forbearance (renegotiation),
- Problems of “agency capture”

What are the causes of regulatory reform?

Causes of the regulatory reform are as follows:

- Need for harmonisation,

- Globalisation phenomenon,
- Financial innovation

What are the main objectives of the FSA (Financial Services Authority) in the UK?

The four main objectives are:

- To maintain confidence in the UK financial system,

- To promote public understanding of the financial system,
- To secure an appropriate degree of protection for consumers while recognising their own
responsibilities,
- To reduce the scope for financial crime

What are the pillars of Basel I arrangement?

The 1988 Basel Capital Accord (Basel I) has three basic pillars for Risk Management:

- Minimum capital requirement

- Supervisory review process
- Market discipline requirements

What are the Basel II pillars?

The 1999 Basel Capital Accord (Basel II) has the following pillars of financial stability:
 - Minimum capital requirements, for
o Credit risk
 Standardized approach,
 Foundation IRB Approach,
 Advanced IRB Approach,
o Market risk:
 Standardized approach,
 Internal VaR models,
o Operational Risk
 Basic indicator approach
 (Alternative) Standardized Approach,
 Advanced measurement approaches
- Supervisory Review Process,
o Framework for Banks (ICAAP)
 Capital allocation,
 Risk management
o Supervisory Framework
 Evaluation of internal systems of banks,
 Assessment of risk profile
 Review of compliance with all regulations,
 Supervisory measures
- Market discipline
o Disclosure Requirements for banks
 Transparency for market participants concerning the bank’s risk position
(scope of application, risk management, detailed information on own funds,
etc.)
 Enhanced comparability among banks

What are the pillars of Basel III?

The 2011 Basel Capital Accord (Basel III) has the following pillars:

- Enhanced Minimum Capital & Liquidity Requirements,

- Enhanced Supervisory Review Process for Firm-wide Risk Management and Capital Planning
- Enhanced Risk Disclosure & Market Discipline
TOPIC 3: REGULATORY FRAMEWORK OF BANKS IN FB&H

Define and explain the term “Bank” with respect to the regulatory framework of banks in FB&H.

The term “Bank” is defined in the Law on Banks in FB&H:

Banks are legal entities engaged in the business of receiving money deposits and extending credits,
and other activities in accordance with The Law on Banks in FB&H.

It is established and performs its business operations as a joint stock company.

The word “Bank” can be used for instutions dealing with the following matters (Banks may only
conduct the following activities):

1. Receiving money deposits, or other repayable funds,

2. Making and purchasing of loans and financial leasing,
3. Issuing all forms of monetary guarantees,
4. Participating, buying and selling for its own account or for account of customers of money
market and capital market instruments,
5. Providing payment system and money transfer services,
6. Buying and selling foreign currencies,
7. Issuing and managing payment instruments (including credit cards, travelers’ and bankers’
checks,
8. Safekeeping and managing of securities and other valuables,
9. Providing financial management services,
10. Purchase and sale of securities, and
11. Anything that shall be incidental to the foregoing from item 1 to 10

What does the “Bank’s charter” have to specify, according to the Law on Banks in FB&H?

Bank’s charter must specify:

1. Bank’s corporate name and address,

2. Its purposes,
3. The jurisdiction,
4. Authority of its bodies,
5. Amount of shares and other kind of capital,
6. The classes, numbers and nominal values of its shares,
7. The voting rights attaching to its shares,
8. Process of issuance of general acts,
9. Other significant questions related to the bank’s business

What are the bodies of the Bank, according to the Law on Banks of FB&H?

Bodies of the bank are:

- General Meeting of Shareholders,

- Supervisory Board,
- Management,
- Audit Board
Explain the role of General Meeting of Shareholders, as the body of a bank, according to the Law
on Banks in FB&H.

General Meeting of Shareholders is composed of shareholders, and is normally held in the place of
bank’s headquarter, at least once a year.

Supervisory Board shall convene General Meeting of Shareholders, and any shareholder who was
placed on the list of shareholders at the Registry 45 days before the date of GMS (General Meeting
of Shareholders) has a voting right.

Explain the role of the Supervisory Board of the bank, according to the Law on Bank of FB&H.

Supervisory Board is composed of a Chairman and at least 4 members, with a maximum of six
members. Members are being appointed and released of duty by the GMS.

The number of members of the Supervisory Board must be odd, when the Chairman is included, and
the Chairman and the members of Supervisory Board are appointed simultaneously for the period of
4 years.

A session of the Supervisory Board shall be held when necessary, and at least once a quarter.
Chairman of the SB shall convene session of the SB.

Finally, Chairman and members of the SB shall be either individually or jointly and severally liable for
damages caused by failure to comply or irregular compliance with their duties.

Explain the role of the Management as the body of a bank, according to the Law on Bank of FB&H.

Management:

- Organizes work and direct business operations,

- It consists of:
o Director,
o Executive directors, and
o Deputy director
- Director shall preside over Management, direct business operation, represent the bank and
be responsible for legality of business operation

Explain the role of Audit Board as a body of a bank, according to the Law on Bank of FB&H.

Audit Board:

- Is appointed by the Supervisory Board,

- Consists of 5 members appointed for terms of 4 years,
- Has oversight responsibilities for conduct and employment of an external audit firm to
prepare the annual audited financial statement,
- Must supervise all internal audit activities including the oversight of the annual balance
sheet,
- Upon request of shareholders with at least 10% of the shares must do auditing of financial
business operation of the bank

Explain the process of establishment of banks in FB&H, according to the Law on Banks in FB&H.

Banking Agency of Federation of Bosnia and Herzegovina (Banking Agency of FBH) shall grant licence
only if an amount of the bank’s capital stock has been paid.
The main requirement of the Agency is that:

- The minimum amount of share capital in cash of the bank and the lowest amount of net
capital which the bank must keep up shall not be less than KM 15.000.000.

The additional requirements of the Agency are:

- It needs to be confident that the bank will comply with provisions of Law and projections for
the future condition of bank are documented,
- It needs to be confident that the qualifications and experience of the Supervisory Board and
Management of the bank will be appropriate for the banking activities that the bank will be
licensed to engage,
- It needs to be confident that all holders of significant ownership interest are of sufficient
financial capability, and suitable business background.

What does the request for approval to open a representative office needs to include?

The request for approval to open a representative office needs to include:

1. Information on the name, legal status and headquarters of the bank,

2. The bank’s Charter,
3. Information on the financial operations of the bank,
4. Document on the establishment of the representative office,
5. Activities of the representative office,
6. Program of representative office’s operations,
7. Information on the senior employees of the representative office,
8. Authorization of the person responsible for the activities and representation of the
representative office,
9. Certified statement from the bank that confirms the bank’s willingness to take over all the
liabilities resulting from the operation of the representative office

What does the request for banking license include?

The request for banking license shall include:

1. Founding contract signed by all founders, draft of Charter, and other founding documents,
as directed by the Agency,
2. The qualifications and experience of the Supervisory Board and Management of the
proposed bank,
3. The amounts of capital stock and other forms of bank capital,
4. A business plan for the proposed bank, setting out the types of activities and the structural
organization of the future bank,
5. A list of owners of the bank

Define the capital of banks, in accordance with Law on Banks of FBH.

The minimum amount of share capital in accordance with the Law is BAM 15.000.000,00.

No bank can’t decrease its capital without authorization from the Agency.

Capital of bank is sum of:

- Core capital,
- Supplementary capital
 Net Capital of Bank = (Core Capital + Supplementary Capital) – Deductible Items

When the Agency can revoke a banking license?

Agency can revoke a license in the following cases:

1. Upon request of the bank,

2. An infraction,
3. Report of a provisional administrator,
4. The license or the authorization has been obtained on the ground of false or fraudulent
statements,
5. The bank has not submitted an application for registration in the court register on time,
6. A merger, acquisition or division of the bank has occurred,
7. The bank no longer possesses the minimum amount of capital and reserves required by
regulation of the Agency,
8. The owner or owners of the bank have decided to liquidate the bank or the bank has ceased
to exist as a legal entity

What restrictions are imposed on the potential bank shareholders, according to the Law on Banks
of FBH?

Two main restrictions:

- No physical or legal person, alone or acting in concert with one or more other persons, may
acquire significant voting rights in a bank, or increase the amount of his ownership of the
bank’s voting shares or capital in such a way that the thresholds of 10%, 33%, 50%, and 66,7%
are reached or exceeded without obtaining the approval from the Agency.
- Neither a political party nor a related legal entity of a political party can be a bank shareholder.

What restrictions are imposed on the bank investing program, according to the Law on Banks of
FBH?

There are four:

- Neither a bank nor a Subsidiary may invest in any legal entity that is primarily engaged in the
business of armaments, gambling, nor the selling or consuming of alcohol on its premises,
- Banks may not make a donation or loan to any political party,
- Bank may not deposit funds in a Related Bank or make loans to or invest in such bank that in
combination exceeds 25% of the bank’s Core Capital, or 40% of Core capital in the case of all
such Related Banks.
- Bank may not invest more than 50% of its core capital in fixed assets without the permission
of the Agency

How does the Law on Banks of FBH affect the level of credit risk of the banks under its jurisdiction?

The Law prescribes that:

- Bank shall observe the maximum ratios and risk exposures to be maintained by its concerning
its balance sheet and off-balance sheet items, assets and risk-weighted assets, capital and its
structure,
- Outstanding principal amount of all credit from a bank to a single borrower or a group of
related borrowers may not exceed the equivalent of 40% of the bank’s core capital.
 - The maximum amount of unsecured credit to a single borrower or a group of related
borrowers may not exceed the equivalent of 5% of the bank’s core capital.
- Any amount of credit to a single borrower or a group of related borrowers exceeding the
equivalent of 25% of the bank’s core capital must be fully secured by readily marketable
collateral whose good quality exceeds the amount of such credit

Which Law regulates the process of bankruptcy and liquidation of Banks in FB&H?

The process of bankruptcy and liquidation is conducted to the “Law on Bankruptcy and Liquidation”.

When can the Banking Agency of FB&H appoint a Provisional Administrator?

The Agency may appoint a Provisional Administrator when it assesses that:

1. There has been any violation of Law, regulation or decision of the Agency, seriously
undermining the interests of the bank’s depositors,
2. The bank has been conducting unsafe or unsound practice in the operation of the bank, which
has caused or is likely to cause a substantial deterioration in the level of the bank’s capital or
financial condition,
3. Books, papers, records, or assets of the bank have been concealed or withheld from the
Agency or any of its examiners or auditors,
4. Request for a provisional administrator received from the Supervisory Board, the Audit Board,
Director, or the General Meeting of Shareholders of the bank provides adequate justification
for such action

Which ways of action may be proposed by the Provisional Administrator?

Provisional administrator shall propose one or more of following measure:

1. A recommendation to revoke the banking license of the bank and to liquidate the bank with
an assessment of the amount of assets likely to be realized in a liquidation of the bank,
2. A detailed plan to restore the bank including an increase in the bank’s capital to the minimum
level,
3. Plan to sell the bank or to sell any part of the assets and purchase liabilities of the bank,
4. Merger or acquisition of one bank with another bank

What can the Liquidation administrator do?

Liquidation administrator has the authority to:

1. Sell the assets and redeem liabilities of the bank,

2. Sell the bank to an acquirer or merge the bank with another bank,
3. Liquidate the bank

Elaborate on ‘Bank Shareholders’, as described by the Law on Banks of FB&H.

Bank Shareholder is responsible for bank obligations up to the level of his share in the bank.

Bank shareholders, members of its Management and Supervisory Board will bear responsibility, jointly
or individually, for bank’s obligations with their entire property in these cases:

1. When a bank is used for fulfilling goals opposite to gaols of the bank as determined by the Law,
2. When there was no difference between bank property and personal property of the above
listed persons,
 3. When bank operated with a purpose to commit fraud against its creditors or against interest
of the creditors,
4. When a cause for bankruptcy or insolvency of the bank is found in intentional poor
management or lack of attention in managing the bank

What does the Law on Banks of FBH prescribe regarding the reporting of banks?

The bank shall publish the external auditor’s report in abbreviated form in one or more of the daily
newspapers in Bosnia and Herzegovina within 15 days after receiving it.

The bank is obliged to prepare and submit to the Agency reports concerning its administration and
operations, liquidity, solvency, and profitability, and those of its subsidiaries, for an assessment of the
financial condition of the bank and each of its subsidiaries on an individual and a consolidated basis at
such intervals as prescribed by regulation of the Agency.

CHAPTER 1: WHAT IS SPECIAL ABOUT BANKS?

Topics (possible essays):

- The nature of financial intermediation

Financial intermediaries and financial markets’ main role is to provide a mechanism by which funds
are transferred and allocated to their most productive opportunities.

A bank is a financial intermediary whose core activity is to provide loans to borrowers and collect
deposits from savers. In other words they act as intermediaries between borrowers and savers.

By carrying out the intermediation function, bank collect surplus funds from savers and allocated
them to those (both people and companies) with a deficit of funds (borrowers). In doing so, they
channel funds from savers to borrowers thereby increasing economic efficiency by promoting a
better allocation of resources.

- The role of banks

The main function of banks is to collect funds (deposits) from units in surplus and lend funds (loans)
to units in deficit. Deposits typically have the characteristics of being small-size, low-risk and high-
liquidity. Loans are of larger-size, higher-risk and illiquid. Bank bridge the gap between the needs of
lenders and borrowers by performing a transformation function:

1. Size transformation. By exploiting economies of scale associated with lending/borrowing

function, since banks have access to a larger number of depositors than any individual
borrowers, bank collect funds from savers in the form of small-size deposits and repackage
them into larger size loans. This is asset transformation.
2. Maturity transformation. Banks transform funds lent for a short period of time (mainly funds
deposited) into medium- and long-term loans.
3. Risk transformation. Banks are able to minimise the risk of individual loans by diversifying
their investments, pooling risks, screening and monitoring borrowers and holding capital and
reserves as a bugger for unexpected losses. This is important since savers wish to minimize
the risk and prefer their money to be safe, while borrowers carry a risk of default on their
loans.
 - Information economies

Banks provide an important source of external funds used to finance business and other activities.
One of the main features of banks is that they reduce transaction costs by exploiting scale and scope
economies and often, they owe their extra profits to superior information.

The information economies may apply to the banking industry due to:

1. Transaction costs,
2. Economies of scale,
3. Economies of scope,
4. Asymmetric information,
a. Adverse selection and moral hazard,
b. Principal-agent problems,
c. The free-rider problem,
d. Relationship and transaction banking,

- Why do banks exist? Theories of financial intermediation

There are five theories that explain why financial intermediation (banking) exists. These theories
relate to:

1. Financial intermediation and Delegated monitoring. One of the main theories put forward as
an explanation for the existence of banking relates to the role of banks as ‘monitors’ of
borrowers. Banks have expertise and economies of scale in processing information on the
risks of borrowers and, as depositors would find it costly to undertake this activity, they
delegate responsibility to the banks.
2. Information production. If information about possible investment opportunities is not free,
then economic agents may find it worthwhile to produce such information. If there were no
banks, then there would be duplication of information production costs. Moreover, banks
have economies of scale and other expertise in processing information relating to deficit
units, and when building up this information they become experts in its processing. The
confidence in banks rises, as surplus units (depositors) are more willing to place their funds
in their banks, knowing that appropriate borrowers will be found.
3. Liquidity transformation. This theory suggests that banks are institutions that enable
economic agents to smooth consumption by offering insurance against shocks to a
consumer’s consumption path.
4. Consumption smoothing.
5. The role of banks as a commitment mechanism

- The benefits of financial intermediation

The benefits of financial intermediation can be sorted into three categories:

- The benefits to ultimate lenders (surplus units)

- The benefits to ultimate borrowers (deficit units), and
- The benefits to society as a whole

What is ‘Direct finance’?

Direct finance is a process of obtaining funds directly from lenders in financial markets (no
intermediary).

What is a ‘Financial claim’?

A financial claim is a claim to the payment of a future sum of money and/or a periodic payment of
money.

What are the ways of redeeming a financial claim?

More generally, a financial claim carries an obligation on the issuer to pay interest periodically and
to redeem the claim at a stated value in one of three ways:

- On demand,
- After giving a stated period of notice,
- On a definite date or within a range of dates

When are financial claims generated? What form can they take?

Financial claim are generated whenever an act of borrowing takes place, and borrowing takes place
whenever an economic unit’s (individuals, households, companies, government bodies, etc.) total
expenditures exceeds its total receipts.

Financial claims can take the form of any financial asset, such as money, bank deposit accounts,
bonds, shares, loans, life insurance policies, etc.

What is other term is used instead of ‘borrowers’? How about ‘lenders’?

Borrowers are generally referred to as deficit units, and lenders are known as surplus units.

What are the barriers to the ‘Direct financing process’?

Two types of barriers can be identified to the direct financing process:

- The difficulty and expense of matching the complex needs of individual borrowers and
lenders,
- The incompatibility of the financial needs of borrowers and lenders

Lenders are looking for safety and liquidity. Borrowers may find it difficult to promise either.

What are the Lenders’ requirements? List and explain.

Lenders’ requirements are:

1. The minimisation of risk. This includes the minimisation of the risk of default (the borrower
not meeting its repayment obligations) and the risk of the assets dropping in value.
2. The minimisation of cost. Lenders aim to minimise their costs
3. Liquidity. Lenders value the ease of converting a financial claim into cash without loss of
capital value; therefore they prefer holding assets that are more easily converted into cash.

In summary, the majority of lenders want to lend their assets for short periods of time and for the
highest possible return.

What are the Borrowers’ requirements? List and explain.

Borrowers’ requirements:
 1. Funds at a particular specified date.
2. Funds for a specified period of time; preferably long-term,
3. Funds at the lowest possible cost.

In summary, the majority of borrowers demand liabilities that are cheap and for long-periods.

What are ‘Transaction costs’?

Transaction costs relate to:

- The costs of searching for a counterparty to a financial transaction,

- The costs of negotiating the contract,
- The costs of monitoring the borrowers, and
- The eventual enforcements costs should the borrower not fulfil its commitments

Transaction costs can be defined as the costs of running the economic system. In particular, it is
common to distinguish between co-ordination costs (e.g. costs of search and negotiation) and
motivation costs (e.g. costs due to asymmetric information and imperfect commitment). Transaction
costs can be measured in time and money spent in carrying out a financial transaction.

Why do information asymmetries arise?

Information asymmetries arise because one party has better information than the counterparty.

Why are bank traditionally different from other financial intermediaries?

Bank traditionally differ from other financial intermediaries for two main reasons:

1. Bank liabilities (i.e. deposits) are accepted as a means of exchange, and

2. Banks are only intermediaries that can vary the level of deposits and can create and destroy
credit

How can financial intermediaries reduce the risk associated with the lending process?

Financial intermediaries can reduce risks by ‘pooling’ or aggregating, individual risks so that in
normal circumstances, surplus units will be depositing money as deficit units make withdrawals.

This enables banks, for instance, to collect relatively liquid deposits and invest most of them in long-
term assets. Another way to look at this situation is that large groups of depositors are able to obtain
liquidity from the banks while investing savings in illiquid but more profitable investments.

What is the difference between economies of scale and economies of scope?

Economies of scope refer to a situation where the joint costs of producing two complementary
outputs are less than the combined costs of producing the two outputs separately.

List the problems (causes of problems) associated with information.

Three problems are relevant:

- Not everyone has the same information,

- Everyone has less than perfect information, and
- Some parties to a transaction have ‘inside’ information which is not made available to both
sides of transaction
Such ‘asymmetric’ information can make it difficult for two parties to do business together, and this
is why regulations are introduced to help reduce mismatches in information.

Asymmetric information, and the problems this gives rise to, are central to financial arrangements
and the way financial institutions behave to limit and manage risk.

What problems can arise from asymmetric information?

Information asymmetries, or the imperfect distribution of information among parties, can generate:

- Adverse selection problems,

- Moral hazard problems,
- Agency costs between the principal (e.g. bank) and agent (e.g. borrower)

What are the possible solutions to the problem of adverse selection?

The possible solutions for the problem of adverse selection are:

- Signalling – actions of the ‘informed party’ in the adverse selection process (e.g. seller
offering warranty to a product sold),
- Screening – actions of the ‘less informed party’ in an adverse selection process to determine
the information possessed by informed party (e.g. the action taken by an insurance company
to gather information about the health history of potential customers).

What is ‘Moral hazard’, when does it arise, and examples in banking?

Moral hazard (or hidden action) is an issue related to information asymmetries. It arises when a
contract or financial arrangement creates incentives for parties to behave against the interest of
others. An action taken in that direction is classified as moral hazard.

Examples of moral hazard in banking relate to:

- Deposit insurance, and

- The lender-of-last-resort function of the central bank

Why do principal-agent problems arise?

The problem arises:

- Because agent often has superior information and expertise (which may be the reason the
principals employs them),
- The agent can choose his or her behaviour after the contract has been established, and
because of this the agent is often able to conceal the outcome of the contract
- Agent cannot be efficiently or costlessly monitored

A typical example of principal-agent problem refers to a situation of separation of ownership and

control in a firm. Managers in control (the agents) may act in their own interest rather than in the
interest of shareholders (the principals) because the managers have less incentive to maximize
profits than shareholders.

What is the ‘free-rider’ problem?

The free-rider problems occur when people who do not pay for information take advantage of the
information that other people have paid for.
For example: you purchase information that tells you which firms are good and which are bad. You
believe the purchase is worthwhile because you can buy securities of good first that are undervalues
so you will gain extra profits. But free-rider investors see that you are buying certain securities and
will want to buy the same.

What are the potential solvers of free-rider problem?

1. Governments could produce information to help investors distinguish good from bad firms
and provide it to the public free of charge. The main drawback is that this action is politically
difficult and it never completely eliminates the problem.

The relational contract is a way to overcome: agency and adverse selection problems. Relational
contracts are informal agreements between the bank and the borrowers sustained by the value of
future relationships: when banks are investing in developing close and long-term relationships with
their customers.

What is Diamond’s study? Briefly explain.

Diamond’s study is one of the most relevant theories explaining why banks exist on the basis of
contract theory. According to him, delegated monitoring on behalf of small lenders provides the
main reason for existence of banking.

His approach is essentially developed around two interconnected factors:

- Diversification among different investment projects; this is crucial in explaining why there is
a benefit from delegating monitoring to an intermediary that is not monitored by its
depositors; and
- The size of the delegated intermediary that can finance a large number of borrowers

One issue arises, however, and it relates to who is ‘monitoring the monitor’.

List and briefly explain the benefits of financial intermediation to ultimate lenders (surplus units).

These may be summarised as follows:

- Greater liquidity – generally achieved by lending to a financial intermediary rather than

directly to an ultimate borrower,
- Lower risk – a consequence of pooling of risk inherent with financial intermediation, the
improved risk assessment that intermediaries are able to undertake and the portfolio
diversification that can frequently be achieved. This reduction in risk may be reflected in
guaranteed interest rates on deposits with a financial intermediary
- Marketable securities,
- Transaction cots
- The lending decision is simplified

What are the benefits that financial intermediation gives to ultimate borrowers (deficit units)?

Those may be summarised as follows:

- Longer loan availability time period,

- Larger amounts of loan available to be granted,
- Lower transaction costs,
- Lower interest rates,
- Loans are available when required
What benefits does financial intermediation has to society as a whole.

Can be summarized as follows:

- A more efficient utilisation of funds within an economy,

- Higher level of borrowing and lending to be undertaken,
- Improvement in the availability of funds to higher-risk ventures

Define the terms regulation, monitoring, and supervision.

Regulation relates to the setting of specific rules of behaviour that firms have to abide by – these
may be set through legislation (laws) or be stipulated by the relevant regulatory agency.

Monitoring refers to the process whereby the relevant authority assess financial firms to evaluate
whether the current regulations are being obeyed.

Supervision is a broader term used to refer to the general oversight of the behaviour of financial
firms.

What is bank contagion?

Bank contagion is a spread (effect) of the failure (trouble) of one financial intermediary to other
financial intermediaries in the financial system.

What is a bank run?

Bank run is a depositor behaviour pattern of withdrawing their savings within a short-period of time,
caused by a newly-discovered lack of confidence in a bank.

What are the main reasons for financial sector regulation?

The main reasons for financial regulation are:

- To ensure systemic stability,

- To provide smaller, retail clients with protection; and
- To protect consumers against monopolistic exploitation

What types of regulation exist?

It is possible to identify 3 different types of regulation:

1. Systemic regulation – regulation concerned mainly with the safety and soundness of the
financial system. It refers to all public policy regulation designed to minimise the risk of bank
runs that goes under the name of the government safety net.
2. Prudential regulation – regulation mainly concerned with consumer protection. It relates to
the monitoring and supervision of financial institutions, with particular attention paid to
asset quality and capital adequacy.
3. Conduct of business regulation – focuses on how banks and other financial institutions
conduct their business. This kind of regulation relates to information disclosure, fair business
practices, competence, honesty and integrity of financial institutions and their employees.

What is government safety net and what does it encompass?

Government safety net refers to all public policy regulation designed to minimise the risk of bank
runs. It encompasses two main features:

1. Deposit insurance arrangement. Deposit insurance is a guarantee that all or part of the
amount deposited by savers in a bank will be paid in the event that a bank fails. The
guarantee may be either explicitly given in law or regulation, offered privately without
government backing or may be inferred implicitly from the verbal promises and/or past
actions of the authority.
2. The lender-of-last-resort function. The LOLR function is one of the main functions of a central
bank. The central bank, or other central institution, will provide funds to banks that are in
financial difficulty and are not able to access any other credit channel. Through the LOLR
mechanism, the authorities can provide liquidity to the banking sector at time of crises.

How can the deposit insurance be offered?

Guarantee may be:

- Explicitly given in law or regulation,

- Offered privately without government backing, or
- Inferred implicitly from the verbal promises and/or past actions of the authorities

What benefits does conduct of business regulation provide?

Conduct of business regulation focuses on establishing rules and guidelines in order to reduce the
likelihood that:

- Consumers receive bad advice (possible agency problem),

- Supplying institutions become insolvent before contracts mature,
- Contracts turn out to be different from what the customers was anticipating,
- Fraud and misrepresentation takes place,
- Employees of financial intermediation and financial advisors act incompetently

What is the purpose of regulation?

The purpose of regulation should be limited to correcting market imperfections and failures
(information asymmetries, agency problems, etc.), which, in the absence of regulation, would
produce sub-optimal results and reduce consumer welfare.

What are the limitations of regulations?

The limitations of regulation are as follows:

- They create moral hazard, particularly due to ‘safety net’ arrangements. Deposit insurance
and LOLR can cause people to be less careful than they would be otherwise. Examples
include ‘too big to fail’ and ‘too important to fail’ cases, and regulatory forbearance.
- It can create problems of agency capture, that is the regulatory process can be ‘captured’ by
producers and used in their own interest rather than in the interests of consumers,
- Regulation is a costly business and the costs of compliance with the regulatory process will
be passed on to consumers, resulting in higher costs of financial services and possibly less
intermediation business. In addition, regulatory costs may act as a barrier to entry in the
market and this may consolidate monopoly positions.

WEEK 3: BANKS IN FINANCIAL MARKET, BANKING MODELS, ISLAMIC

BANKING, BANKING ORGANIZATION STRUCTURES MODELS, CHAPTER
3, CHAPTER 13, CHAPTER 15
PRESENTATION: BANKS IN FINANCIAL MARKET

What types of economic units, according to balance sheet, exist?

Types of economic units according to balance sheet items:

- Surplus units,
- Deficient units, and
- Balanced units

What is a ‘financial system’?

Financial system is:

- a set of institutions, instruments and mechanisms

- by which mobilization, concentration, transfer and allocation of financial resources and
savings of society are realized

What is the goal of the financial system?

The goal of the financial system is to construct institutions, instruments and mechanisms for efficient
and rational transfer of financial resources.

What does financial sector include?

Financial sector includes:

- Financial market,
- Financial institutions,
- Financial instruments,

What does financial system include?

Financial system includes:

- Financial sector
o Financial market,
o Financial institutions,
o Financial instruments
- Financial legislation

What are the three methods of financing?

The three methods of financing are:

- Self-financing (using own funds)

- Direct financing (direct transfer of funds between depositors and investors),
- Indirect financing (intermediaries: financial institutions)

What is a financial market?

A financial market is a organized marketplace for sale and purchase of financial resources, where
prices of financial resources are defined according to supply and demand.

Define lenders and borrowers.

Lenders are persons who do not spend part of their income in the current period, but increase their
income by receiving interest.

Borrowers are persons who get into debt and increase their income by investing in cost-effective
investments.

How can the financial market be classified?

Financial market can be classified:

- Geograhpically
o Local,
o National, and
o International
- Analytically
o Primary (involves the initial purchase and sale of securities. It can be:
 Direct, or
 Indirect (through particular institutions)
 The motive of purchase : PROFIT
o Secondary (re-transfer of securities before maturity date)
 The motive of purchase: LIQUIDITY
- Conventionally
o Credit market (personalized)
o Securities market (impersonalized)
- According to maturity date and purpose
o Money market (short-term funds up to 1 year)
o Capital market (long-term funds over 1 year)

Money market – what is its subject and what does it contain?

The subject of trade of the money market: short-term funds needed for liquidity, production of
commerce.

It contains:

- Money market – trade of short-term money and securities,

- Credit market – trade of short-term credits,
- Primary and secondary market of short-term securities

What is the purpose of the Capital market?

The capital market includes purchasing and selling of long-term funds.

It focuses on raising the capital by issuing:

- Bonds (loan capital –debt securities with maturity over one year), and
- Shares (equity)

What is the ‘banking system’?

The banking system is:

- a set of banking institutions, financial instruments and procedures

 - which are used in financial mediation between financially surplus and deficient sectors and
transactors

What adjustments need to be made in order to decrease banking assets?

Decrease of banking assets requires these adjustments:

- Lowering liquidity reserves,

- Investments in quick assets,
- Harmonization in term structure of loans

What types of the financial institutions exist?

Types of financial institutions:

- Depository – commercial banks and savings banks,

- Non-depository – insurance companies, retirement and mutual funds,
- State financial institutions – state development banks, agencies institutions (agriculture,
export, import, housing construction…)

What are the main types of financial institutions in developed financial markets?

Three main types of financial institutions in developed financial markets:

- Credit institutions, which approve loans for companies and households

o Commercial banks – deposit/credit,
o Savings banks – deposit/credit,
o Financial companies – non-deposit/credit
- Institutional investors:
o Insurance companies,
o Retirement funds,
o Investment funds
- Investment banks (stock exchange companies) which operate on primary and secondary
capital market and raise capital by issuing shares
o Investment banks
o Brokers and dealers (difference: brokers do not assume the risk, dealers DO)
o Merchant banks (which deal with the restructuring of large companies with their
valorization)
What are the new trends in banking?

New trends in banking:

- Deregulation,
- Infomration technology,
- Competition,
- Internationalization and globalization,
- Concentration – establishment of financial conglomerates

What are the banking perspecitives?

Are as follows:

- Further and emphasized marketization,

- Further deregulation – reregulation (removal of competition restrictions of financial
institutions)
- Continued internationalization,
- Decentralization of banks,
- Establishment of global banking,
- Development of financial engineering (in context of creation new bank products, especially
futher development of financial derivatives)

Danger: growth of instability of financial markets because of moral hazard

What are the reasons of decline of market share of commercial banks?

The reasons are:

- Market conditions – new types of financial institutions with a new range of financial
products,
- Excessive regulation,
- Increase of off-balance bank operations
PRESENTATION: BANKING ORGANIZATION STRUCTURES – MERGERS AND
ACQUISITIONS

PROČITAJ I PREZENTACIJU JOŠ JEDNOM

What models of banking operations exist?

There exist four models of banking operations:

- American model,
- German model,
- Japanese model, and
- Islamic model

Describe the American model of banking operations. What are its main characteristics?

The American model of banking operations was current until 2000, and was based on Glass-Steagall
Act from 1933.

The characteristics of the American model are as follows:

- Division of commercial and investment banking,

- Banks are grouped into syndicates or consortiums,
- Insurance companies, 3rd institutional component of American model,
- Divided banking market and a single capital market
SYSTEM FAVORABLE TO: Big companies, which can borrow funds directly on the market, without
intermediaries.

SYSTEM HARD ON: Smaller companies, which are not listed on stock market, but are still “forced” to
use commercial banks loans.

Bank’s branch network can be expanded outside of state of establishment in the American model
of banking operations (TRUE, from 1994).

Ownership cohesion between financial institutions and real sector IS ALLOWED in the American
model of banking operations (FALSE, it is not allowed).

What is ‘bancassurance’?

The bank insurance model (BIM), also sometimes known as bancassurance or allfinanz, is the
partnership or relationship between a bank and an insurance company whereby the insurance
company uses the bank sales channel in order to sell insurance products.

In other words, it is an arrangement in which a bank and an insurance company form a partnership
so that the insurance company can sell its products to the bank’s client base.

Why did bancassurance arise as a business model?

The following reasons:

- Cross-selling opportunities for banks (scope economies),

- Non-interest income boosted at a time of decreasing interest margins,
- Risk diversification,
- Banks converting into full-service financial firms (deregulation)

What are the characteristics of the German model of banking operations?

Are as follows:

- Higher importance of banks than in the American model,

- The main source of financing of all companies are Universal banks (approves loans, issues
securities but also buys stock of a company…),
- Less developed capital market,
- Taking over on capital market is rare (takeover is usually performed with the help of large
universal banks)

Describe the structure of management of companies in the German model of banking operations.

The management structure of companies:

- Vorstand – the board of directors, management consisted of executive managers – manges

all processes in the company ;
- Aufsichtsrat – supervisory board – consisted of representatives o universal banks and
insurance companies, and it makes the most important investment and financial decisions
- The General Meeting of Shareholders – consisted of shareholders. Share holders who have a
minority interest in a company can give shares to “hausebank” which influences the
decision-making process

Can universal banks have ownership in the real sector, according to the German model of banking
operations?
Universal banks MAY have ownership in real sector, but with particular restrictions (15% maximum
in one company and 60% maximum in all companies of the capital of the bank).

Why is there a trend of weakening influence of the banks in Japan?

The reasons are as follows:

- Lower demand for financial funds (now companies are developed and they need less funds
than previously),
- Firms are less dependent on banks,
- Households invest money in securities

Is it better to intermediate over open financial market or over banking mechanism and why?

Dynamically observed, it is better to intermediate over open financial market. The reasons are as
follows:

- Quicker effects of mechanism,

- Stronger influence on MGMT,
- More suitable for technologically innovative industries

Define the terms ‘merger’ and ‘acquisition’.

The fusion (merger) is the ownership integration of two or more baking institution of approximately
equal size (A+B = C).

The acquisition is the takeover of small banks by larger and financially stronger banks, when taken
smaller bank ceases to exist (A+B = A).

What are the determinants and effects of mergers and acquisitions?

Determinants and effects:

- The increase in market power. To increase its market power, a bank can adopt one of two
strategies:
o The strategy of internal growth – the bank itself creates a network through which it
expands operations,
o The acquisition – buying other banks that already have a client base
- Reducing costs and risks. Banks can reduce costs and risks:
o Through fusion,
o By reducing the number of branches,
o By savings in IT systems, market research, research and development,
o By reducing the overall risk through diversification
- Creating a very large banking institutions. The aim is to create large banking institutions able
to engage in global competitive environment. In addition to objective factors, there are the
subjective ambitions of bank managers to provide increased personal prestige as well as the
corresponding higher incomes (direct and indirect)
- The disappearance of insufficiently efficient banks. Banks that do not have sufficient capital
see their salvation in acquisitions by larger banks that have sufficient financial resources to
carry out their recapitalization.

How can one finance M&A?

One can finance M&A by:

 - Cash,
- Shares,
- Combination (shares + cash),
- Issuance of other securities (e.g. Bonds)

PRESENTATION: ISLAMIC BANKING

Define the terms ‘islamic banking system’ and ‘islamic economics’-

Islamic banking system is defined as a system whose principles of operations and activities are based
on Shariah rules.

Islamic economics is a special scientific-theoretical approach in the economic science, which has the
“different” way of seeking to explain economic phenomena and laws, and define a coherent
economic system that will have its basic foundation in the norms and values of Islam.

Which EU countries are hosting the Islamic finance?

The following:

- UK (lol),
- Germany,
- Luxemburg,
- Bosnia (lol)

What are the characteristic of the Islamic Economic System?

The characteristics of the Islamic economic system are as follows:

- The absence of interest,

- Freedom of entering the business transactions, contracts and ventures,
- The absence of extreme uncertainty,
- The absence of gambling,
- The absence of price control and manipulations,
- Doing transactions at fair prices,
- Presentation of adequate, accurate and precise information,
- Absence of preferential rights,
- Cooperation and solidarity,
- Public interest protection

Name some of the financing models used by Islamic banks.

These models can be sorted into two large groups:

- Equity-based models, and

- Debt-based models

Equity-based models are:

- Joint venture (Mushareka), and

- Trustee Partnership (Mudareba)

Debt-based models are:

 - Cost-Plus Sale (Murabeha),
- Deferred Delivery Sale (Selem),
- Manufacture-Sale (Istisn’a),
- Leasing (Idžara),
- Benevolent Loan (Qard Hasen)

CHAPTER 3: TYPES OF BANKING

Learning objectives:

- To distinguish between traditional and modern banking,

- To understand the differences between commercial and investment banking,

- To describe the main features of mutuality,
- To understand the differences between private and corporate banking,
- To outline the main aspects of Islamic banking

List and briefly explain the bancassurance business models.

Nowadays, the term ‘bancassurance’ encompasses a variety of structure and business models. The
development of each model has largely occurred on a country-by-country basis as the models are
tailored to the individual market structures and traditions. In broad terms, bancassurance models
can be divided between:
 - Distribution alliances. This model involves simply cross-selling of insurance products to
banking customers, as it involves retaining the customers within the banking system and
capturing the economic value added rather than simply acting as a sales desk on behalf of
the insurance company. This model entails sale of insurance firm’s products, by a bank, for a
fee.
- Conglomerates. The conglomerate model is where a bank has its own wholly owned
subsidiary to sell insurance through its branches

What is retail or personal banking? Which banks offer these services?

Retail or personal banking relates to financial services provided to consumers and is usually small-
scale in nature.

Banks offering retail / personal banking services:

- Commercial banks,
- Savings banks,
- Co-operative banks,
- Building societies,
- Credit unions, and
- Finance houses

Briefly explain the term ‘Commercial bank’.

Commercial banks are the major financial intermediary in any economy. They are the main providers
of credit to the household and corporate sector and operate the payments mechanism. Commercial
banks are typically joint stock companies and may be either publicly listed on the stock exchange or
privately owned.

Commercial banks deal with both retail and corporate customers, have well-diversified deposit and
loan portfolio, and generally offer a full-range of financial services.

While commercial banking refers to institutions whose main business is deposit-taking and lending it
should always be remembered that the largest commercial banks also engage in investment
banking, insurance and other financial services areas.

Explain ‘Savings banks’.

Savings banks are similar in many respects to commercial banks although their main difference
(typically) relates to their ownership features – savings banks have traditionally had mutual
ownership, being owned by their ‘members’ or ‘shareholders’ who are the depositors or borrowers.

It should be noted that savings banks adhere to the principal of mutuality and pursue objectives
relating to the social and economic development of the region or locality in which they operate.
Unlike commercial banks they may pursue strategic objectives other than maximizing shareholder
wealth or profits.

Typically their business focuses on retail customers and small businesses, but as some have become
very large they closely resemble commercial banks in their service and product offering.

Co-operative banks and building societies are similar to savings banks in a sense that both originally
had mutual ownership.
Building societies are a trait of the UK financial system, and they offer personal banking services.
They have mutual ownership and focus primarily on retail deposit-taking and mortgage lending.
They have no external shareholders requiring dividends, which enables them to run on lower costs
and offer cheaper services and better rates of interest on deposits than offered by competition.

What are ‘credit unions’?

Credit unions are non-profit institutions owned by their members. Member deposits are used to
offer loans to the members. Many staff are part-time and they are usually regulated differently from
banks.

Describe ‘finance houses’ or ‘finance companies’.

Finance companies provide finance to individuals (companies) by making consumer, commercial and
other types of loans.

They differ from banks because they typically do not take deposits, and they raise funds by issuing
money market and capital market instruments. Some types of financial companies are as follows:

- Sales finance institutions (loans made by a retailer or car firm to fund purchases),
- Personal credit institutions (that make loans to ‘non-prime’ or high-risk customers who
usually cannot obtain bank credit), and
- Business credit finance houses (that use factoring – purchasing accounts receivables , and
leasing to finance business activity)

What is ‘private banking’?

Private banking concerns the high-quality provision of a range of financial and related services to
wealthy clients, principally individuals and their families. Typically, the services on offer combine
retail banking products such as payment and account facilities plus a wide range of up-market
investment-related services. Market segmentation and the offering of high quality service provision
forms the essence of private banking and key components include:

- Tailoring services to individual client requirements,

- Anticipation of client needs,
- Long-term relationship orientation,
- Personal contact,
- Discretion

What is ‘corporate banking’?

Corporate banking relates to banking services provided to companies although typically the term
refers to services provided to relatively large firms.

Note, however that some banks do not explicitly make distinctions between companies based on
their size, making corporate banking the term denoting banking services provided to any company.
Otherwise, we can say that banks distinguish between:

- Business banking – services provided to small and medium-sized companies which are
relatively similar to personal banking services, and
- Corporate banking – wide range of services provided to large firms

Which services does a bank offer to small firms?

There are four main types of banking service on offer to small firms:

- Payment services. Banks play a pivotal role in the payments, by:

o Making sure that current account transactions are processed smoothly,
o By issuing credit and debit cards that enable customers to make payments, and
o By offering instant access to cash through their automated teller machines (ATMs)
and branch networks
- Debt finance.
- Equity finance.
- Special financing.

What are the major sources of external finance?

They are as follows:

- Main sources of external finance:

o Traditional bank loans,
o Overdraft finance
- Other main sources of external finance:
o Asset-based finance:
 Hire purchase agreements – result in the purchaser of the goods building up
ownership over a pre-determined period. On final payment the goods
belong to the individual or firm making the payments.
 Leasing – legal ownership of the good remains with the lessor, but is
otherwise similar to hire purchase agreement. The item being leased serves
as a collateral for the transaction.
o Factoring and invoice discounting:
 Factoring – the purchase by the factor and sale by the company of its book
debts on a continuing basis, usually for immediate cash. The accounting
functions are performed by the buyer (factor). It may be:
 Non-recourse factoring: the factor assumes the credit risk for
accounts within agreed limits,
 Recourse factoring: the risk remains with the seller
 Invoice discounting: similar to factoring, but here the sales accounting
functions are retained by the seller
o Shareholders and partners – individuals who provide their own personal finance to
the firm and this confers ownership rights
o Trade credit – credit given to firms by trading partners allowing the former to delay
payment
o Venture capital – long-term external equity provided by venture capital firms. The
venture capitalist is an equity partner who places greater emphasis on the financial
capital gain and is more dependent on the market value of the company. In addition
to finance, the venture capital firm (individual) will provide expertise, experience
and contacts to help develop the business
 o Other sources – this category includes a broad variety of alternative finance sources
that ranges from credit card borrowing, loans from private individuals conferring no
ownership, various government grants for small business, and so on.

Briefly describe ‘equity finance’ for small firms.

Private equity finance can be distinguished according to two main types:

- Formal equity finance, available from various sources including banks, special investment
schemes, and private equity and venture capital firms
- The informal equity finance refers to private financing by so-called ‘business angels’ –
wealthy individuals who invest in small unquoted companies

What are the banking services offered to mid-market and large (multinational) corporate clients

The core banking products and services typically focus on the following range of needs:

1. Cash management and transaction services. Arise as a result of:

a. Corporate recognition that excess cash balances result in a significant opportunity
cost due to lost or foregone interest, and
b. Firms needing to know their cash or working capital position on a real-time basis
These services include:
o Controlled disbursement accounts,
o Account reconciliation services,
o Wholesale lockbox facilities,
o Funds concentration,
o Electronic funds transfer,
o Cheque deposit services,
o Electronic sending of letters of credit
o Treasury management software,
o Computerised pension fund services,
o Online corporate advisory and risk management services,
o Electronic data interchange (EDI)
2. Credit and other debt financing facilities – loans, overdrafts, syndicated loans, commercial
paper, bonds and other facilities,
a. Short-term financing (for under one year):
i. Commercial paper,
ii. Euronotes (unsecured debt securities with interest rates based on interbank
rates),
iii. Repurchase agreements (repos) (involves pledging collateral in return for
short-term wholesale funds. At a set date, the funds will be repaid and the
collateral ‘released’).
b. Long-term financing:
i. Syndicated lending (a special category of loans in which an arranger, or
group of arrangers, forms a group of creditors on the basis of a mandate to
finance the company (or government) borrower)
ii. Eurobonds (securities that are issued, and largely sold, outside domestic
market of the currency in which they are denominated. They usually have
maturities around 10-15 years)
3. Commitments and guarantees,
 a. Commitments relate to services where a bank commits to provide funds to a
company at a later date for which it receives a fee
b. Guarantees relate to where a bank has underwritten the obligations of a third party
and currently stands behind the risk of the transaction
4. Foreign exchange and interest-rate transactions (mainly tools for managing foreign
exchange and interest rate risk). These instruments are broadly referred to as derivatives
5. Securities underwriting and fund management services
a. In the case of securities underwriting, the underwriter undertakes to take up the
whole or a pre-agreed part of a capital market issue (equity or bonds) at a pre-
determined price

What is the main role of investment banks?

The main role of investment banks is to help companies and governments raise funds in the capital
market either through the issue of stock (otherwise referred to as equity or shares) or debt (bonds).

List the activities of a investment bank.

Typically their activities cover the following areas:

- Financial advisory (M&A advice),

- Underwriting of securities issues (guaranteeing a price that the new equity or bond issue will
sell for),
- Trading and investing in securities on behalf of the bank or for clients. This activity can
include trading and investments in a wide range of financial instruments including bonds,
equities and derivatives products,
- Asset management – managing wholesale investments as well as providing investment
advisory services to wealthy individuals and institutions,
- Other securities services – brokerage, financing services and securities lending

What is the main difference between commercial banking and investment banking?

The main difference between commercial banking and investment banking is that the former relates
to deposit and lending business while the latter relates to securities underwriting and other security-
related business.

In terms of services offered to large companies, commercial banks typically provide cash
management, payments and credit facilities whereas investment banks arrange other types of
financing through the issue of equity and debt to finance company expansion.

In recent years, however, these distinctions have become blurred as large commercial banks have
either acquired or expanded their investment banking services to meet the increasing demands of
corporate clients.

CHAPTER 13: EUROPEAN BANKING (PP. 344-360)

What are the reasons for limited integration in the retail financial services in the European Union?

Overall, limited integration in the retail financial services in the European Union can be put down to:

- The nature of the retail banking/financial services relationship,

- Limited cross-border consolidation (due to economic/business factors mainly),
- Very limited cross-border provision without establishment, due to business reasons,
- Double taxation or discriminatory taxation of financial products when sold across frontiers,
- Consumer protection laws,
- Data transfer issues,
- Contract law differences,
- Legal definitions of collateral for retail mortgages,
- Definition of customers,
- Difficulties in implementing ‘know your customer rules’,
- Different ways of calculating prices, etc.

CHAPTER 15: BANKING IN THE US (PP. 391-399)

What are the main types of financial institutions operating in the United States?

The main types of financial institutions operating in the United States include:

- Depository institutions:
o Commercial banks,
o Savings institutions, and
o Credit unions,
o The main types of liabilities these institutions hold are deposits
- Contractual savings institutions:
 o Insurance companies, and
o Pension funds
o The main types of liabilities are the long-term future benefits to be paid to
policyholders and fund holders
- Investment intermediaries:
o Mutual funds,
o Investment banks,
o Securities firms, and
o Finance houses
o Liabilities are usually short-term money market or capital market securities

What types of deposits are there in the US?

The deposits can be sorted into:

- Demand and time deposits

o Demand deposits are deposits payable on demand,
o Time deposits are deposits that have a term
- Retail and wholesale deposits,
o Retail deposits are small household deposits,
o Wholesale deposits are high-value deposits from companies, banks and other
institutions

They can be denominated in home or foreign currency.

What are the main reasons for the foreign expansion of US banks?

In general, the main strategic reasons for the foreign expansion of US banks relate to the desire to:

- Increase profits by expanding distribution channels into new, potentially high-growth

geographic markets and across demographic groups,
- Provide commercial lending and capital markets products and services to complement the
international expansion plans of corporate and commercial clients,
- Increase revenue diversification, and
- Cross-sell and leverage existing product expertise in foreign markets

What are ‘pension funds’?

Pension funds provide retirement income (in the form of annuities) to employees covered by
pension plans. They obtain their income from contributions made by employees and employers and
invest these in a variety of long-term securities (bonds and equity) and other investments such as
property.

A distinction is made between:

- Private pension funds (pension funds that are administered by a bank, life insurance firm or
pension fund manager),
- Public pension funds (pension provision of the government)
WEEK 4: FINANCIAL STATEMENTS OF BANKS, COMMERCIAL BANKING,
CHAPTER 2, CHAPTER 8

PRESENTATION: BALANCE SHEETS OF BANKS

What is ‘balance sheet’?

Balance sheet gives information about assets, liabilities and equity. Also, it gives an overview of
banking inputs.

It shows:

- Amount and structure of liabilities which bank acquired for financing of lending and
investing operations, and
- How much money bank invested in loans, securities and other financial outputs

Balance sheet is consisted of assets and liabilities with specific elements.

Assets of bank:

- Cash,
- Securities,
- Loans,
- Leasing,
- Other assets

Liabilities:

- Deposits,
- Non-deposit liabilities,
- Equity

Assets = Liabilities (assuming that we include equity in liabilities). In other words this means that the
sources of banking funds are equal to the usage of banking funds.

What is ‘income statement’?

Income statement is an overview of cost prices of inputs and value of outputs.

It shows:

- How much costs the acquisition of deposits and other liabilities,

- Amount of income as result of investing these funds

Income statement represents amount of income and costs which were occurred in certain period.

What can be classified as ‘assets of the bank’ (active side of balance sheet)?

The assets are as follows:

- Cash and deposits of the bank (most liquid assets):

o Cash in treasury,
o Deposits held in other banks,
 o Cash in process of collecting,
o Reserve accounts in Central bank
- Investments in liquid securities (semi-liquid assets : more liquid than loans, less liquid than
cash)
o Short-term government securities,
o Commercial papers, and
o Term deposits of bank
- Investment in securities for income
- Loans:
o Category A – Performing assets,
o Category B – Special mention,
o Category C – Substandard,
o Category D – Doubtful, and
o Category E – Loss
- Reserves for loan losses (deductible items of assets)
o Category A – Performing assets: 2% of GLLR for GLR1
o Category B – Special mention: 5-15% SLLR for PLL
o Category C – Substandard: 16-40% SLLR for PLL
o Category D – Doubtful: 41-60% SLLR for PLL
o Category E – Loss: 100% SLLR for PLL
- Other assets
o Buildings, equipment, investments in subsidiaries, insurance, etc.
o Note: They are not unlimited, and are under strict supervision of the Agency

What can be classified as ‘liabilities of the bank’ (passive side of balance sheet)?

As follows:

- Deposits:
o Transactional,
o Non-transactional:
 Savings,
 Term deposits
o Deposits of public institutions
- Non-deposit liabilities:
o Securities issued as a source of financing,
o Loans from other banks and institutions,
o Repurchase agreements – REPO
- Capital:
o Shareholders’ equity,
o Subordinated debt,
o General Loan Loss Reserves

What is recorded on the off-balance?

Off-balance items of banks:

- Stand-by loan agreements,

1
GLLR – General Loan Loss Reserves, SLLR – Special Loan Loss Reserves, GLR – General Loan Risk, PLL –
Potential Loan Losses
 - Swap of interest rates,
- Credit obligations,
- Exchange rates list agreements etc.

What is recorded on the income statement of a bank?

The income statement records income and expenses of the bank, sorting them in following
categories:

- Income:
o Interest income:
 Interest and fees on loans,
 Interests from investments in securities,
 Other interests income
o Non-interest income:
 Fees for services related to deposits,
 Fees based on contracts concluded for renting equipment, facilities, etc.
- Expenses:
o Interest expenses:
 Interests on deposits,
 Interests on short-term debt,
 Interests on long-term debt
o Non-interest expenses:
 Salaries, daily allowances and other expenses of employees,
 Net cost of rent and equipment,
 Overhead costs,
 Provisions for possible loan losses,
 Taxes

How can a bank increase its profits?

By:

- Increasing of any assets item,

- Increasing assets with higher return,
- Reducing the interest on deposits,
- Searching the cheaper sources of financing,
- Reducing costs of business operations,
- Avoiding some taxes, if possible

PRESENTATION: COMMERCIAL BANKING

Numerate some bank activities.

Are as follows:

- Accepting deposits,
- Issuing e-money,
- Implementing or carrying out contracts of insurance as principal,
 - Dealing, managing or advising in investments,
- Safeguarding and administering investments,
- Arranging deals in investments and arranging regulated mortgage activities,
- Advising on regulated mortgage contracts,
- Entering into and administering a regulated mortgage contracts,
- Establishing and managing collective investment schemes,
- Establishing and managing pension schemes

List some of the services provided by banks.

Banking services are as follows:

- Payment services,
o Cheques,
o Credit transfers,
o Standing orders,
o Direct debts,
o Plastic cards,
o Credit cards,
o Debit cards,
o Cheque guarantee cards,
o Travel and Entertainment cards,
o Smart, memory or chip cards
- Deposit and lending services,
o Current or checking accounts,
o Time or savings account,
o Consumer loans and mortgages
- Investment, pensions and insurance services,
o Investment products,
o Pensions and insurance services
- E-banking
o E-money, and
o Remote payments

What are the current issues in banking?

Are as follows:

- Structural and conduct deregulation,

- Supervisory re-regulation,
- Competition,
- Financial innovation and the adoption of new technologies:
o Financial system/institutional innovations,
o Process innovations,
o Product innovations

What are the most common responses of banks to the forces of change?

Are as follows:

- Mergers and acquisitions – motives include:

o Economies of scale,
 o Economies of scope,
o Eliminating inefficiencies
- Conglomeration,
- Globalisation

CHAPTER 2: BANKING ACTIVITIES AND CURRENT ISSUES IN BANKING

How do banks create money?

In order to understand how banks create money we illustrate a simple model of the credit multiplier
based on the assumption that modern banks keep only a fraction of the money that is deposited by
the public.

This fraction is kept as reserves and will allow the bank to face possible requests of withdrawals.

Suppose that there is only one bank in the financial system and suppose that there is a mandatory
reserve of 10%. This means that banks will have to put aside as reserves 10% of their total deposits.

In the initial position (a) we assume that the bank has $ 50 million worth of deposits and is adhering
to a 10% reserve ratio. That is, for every $10 it receives in deposits, it keeps $1 in cash and can invest
the other $9 as loans.

Position (b) shows the effect of an increase in deposits by $50.000. However, as the bank earns no
money by simply holding excess reserves, it will wish to reduce it back to 10%.

In position (c) the bank returns to the initial 10% reserve holding as required by the reserve ratio. At
the same time, the bank will increase its loans by $45.000. IN this example, the credit multiplier is
defined as the ratio of change in deposits to the change in levels of reserves:
What are the limitations of the model with the credit multiplier?

Are as follows:

- The assumptions behind this simple model are not very realistic,
- There are leakages from the system
What types of ‘plastic cards’ exist?

The plastic cards include:

- Credit cards, which provide holders with a pre-arranged credit limit to use for purchases at
retail stores and other outlets,
- Debit cards, which are issued directly by banks and allow customers to withdraw money
from their accounts, either face-to-face or through automated teller machines (ATMs),
- Cheque guarantee cards,
- Travel and entertainment cards (or charge cards), which provide payment facilities and allow
repayment to be deferred until the end of the month, but they do not provide interest-free
credit
- Smart, memory or chip cards, which incorporate a microprocessor or a memory chip

What are the pluses and minuses of electronic banking?

The advantages:

- More effective communication with clients,

- Reduced risk of competitors accessing the bank’s client base,
- Greater revenues from cross-selling and customised solutions,
- Internet access and content that can be managed, tailored and packaged for different client
segments, and
- The opportunity to develop client relationships and loyalty
- Reduction in operational costs since it requires a smaller workforce and no physical branch
network

Disadvantages:

- Only relatively large companies require cross-border trading relationships, with a large
number of still large firms denied similar access to the foreign exchange market,
- Prices are not transparent, in that they are not immediately obvious to the buyer and may
have a large spread, depending on the range of banks approached, and
- Manual processes that limit the number of deals traders can handle and may result in delays
in transaction processing
- Advertising expenses and initial investments are high, while the number of new accounts
may not develop as expected,
- Customers’ habits are difficult to change,
- Concerns about security seem to be restraining the expansion of e-banking,
- Profitability may be threatened, if a strategy of very competitive pricing is used to gain
market share

What are the current issues in banking?

The current issues in banking are as follows:

- Structural and conduct deregulation:

o Financial deregulation essentially consists of removing controls and rules that in the
past have protected financial institutions, especially banks
o Structural deregulation, more generally, refers to the opening up, or liberalisation,
of financial markets to allow institutions to compete more freely
- Supervisory re-regulation
 o Re-regulation can be defined as the process of implementing new rules, restrictions
and controls in response to market participants’ efforts to circumvent existing
regulations
- Financial innovation and the adoption of new technologies
o Financial innovation is an ongoing process whereby private parties experiment to try
to differentiate their product and services, responding to changes in the economy. It
can be defined as the act of creating and then popularising new financial
instruments as well as new financial technologies, institutions and markets.
Specifically, we can distinguish:
 Financial system/institutional innovations. Such innovations can affect the
financial sector as a whole ; they relate to business structures, to the
establishment of new types of financial intermediaries, or to changes in the
legal or supervisory framework,
 Process innovations. These include the introduction of new business
processes leading to increased efficiency, market expansion, etc.
 Product innovations. Such innovations include the introduction of new
credit, deposit, insurance, leasing, hire purchase, derivatives and other
financial products.
- Conglomeration. Consolidation in the global banking industry has resulted in the emergence
of financial conglomerates that conduct an extensive range of businesses with a group
structure.
- Globalisation. Globalization can be defined as the evolution of markets and institutions such
that geographic boundaries do not limit financial transactions. It is caused by the process of
financial liberalisation and structural changes in the financial system and banking sectors, as
well as increased demand for services from financial institutions that operate corss-border.
- Other responses to the forces of change:
o Disintermediation – the process whereby economic units bypass banks and other
financial institutions in order to invest their funds directly in the financial markets
o Growth in OBS activities, and
o Securitisation – the process whereby loans and other financial assets are pooled
together for sale as securities to investors

What is a financial conglomerate?

Financial conglomerates are defined as a group of enterprises, formed by different types of financial
institutions, operating in different sectors of the financial industry.

Similar to, but different from, conglomeration is the establishment of jointly-owned enterprises
offering specialised services.

What are the three joint effects of deregulation and technology?

Are as follows:

- The loosening of banking laws, coupled with the advantages of technology, has encouraged
consolidation process. As a result the number of banks has shrunk virtually everywhere.
- The introduction of new technologies in a deregulated context intensified competition and
improved banks’ ability to adjust prices and terms of financial products,
 - The barriers between bank and non-bank financial institutions disappeared, allowing the rise
of universal banking activity

CHAPTER 8: BANKS’ BALANCE SHEET AND INCOME STRUCTURE

How can a bank be saved from illiquidity?

Two ways:

- Other banks can engage in rescue package to pump new capital into the troubled bank, or
- The authorities can decide to rescue the troubled bank using taxpayers money

What is the primary function of capital and how does it perform it?

In general, the primary function of capital is to reduce the risk of failure by providing protection
against operating and any other losses. It does this in five ways:

- By providing a cushion for firms to absorb unanticipated losses with enough margin to
inspire confidence and enable the bank to remain solvent,
- By protecting uninsured depositors (those not protected by deposit insurance scheme) in
the event of insolvency and liquidation,
- By protecting bank insurance funds and taxpayers,
- By providing ready access to financial markets and thus guarding against liquidity problems
caused by deposit outflows, and
- By limiting risk taking

Another function of capital is that it provides funds needed for real and financial asset investments.
What are the main liabilities of the investment bank?

The main items are:

- Collateralised securities – derive from the bank entering secured borrowing transactions and
securities sold under agreement to repurchase; this includes:
o Payables under repo agreements, and
o Payables under securities loand transactions
- Trading liabilities – include activities that the investment bank undertakes based on future
expectation such as trading securities and derivatives dealing and brokerage
- Commercial paper – consists of short-term negotiable debt instruments that the bank issues
to raise unsecured funding and that are traded in the money market

What are the main sources of revenues for investment banks’?

Investment banks’ revenues derive from the following four sources:

- Trading and principal investments,

- Investment banking,
- Asset management, portfolio service fee and commissions, and
- Interest income

Investment banks’ costs, on the other hand, include:

- Communication and technology,

- Occupancy and related depreciation,
- Brokerage, clearing and exchange fees,
- Professional fees,
- Marketing,
- Other expenses

Who is interested in the performance of the bank (Financial indicators)?

Why is bank performance calculated?

The bank performance is calculated, using ratio analysis, and assessed with the aim of:

- Looking at past and current trends, and

- Determining future estimates of bank performance

What ‘profitability ratios’ are used in banking?

Profitability ratios typically used in banking are:

- ROI (return-on-investment) ; Net income after tax / Operating revenue

- ROE (Return-on-equity) ; Net income after tax / Total assets ; indicates how much net
income is generated per $ of equity invested
- ROA (Return-on-assets) ; Net income after tax / Total equity ; indicates how much net
income is generated per $ of assets
- AU (asset usage/utilization) ; Operating revenue / Total assets
- NIM (Net interest margin) ; Net interest (interest income-interest expense) / Total assets ;
measures the bank’s spread per $ of assets ; HIGH NIM – difference between deposit rates
and interest earning assets rates are high
- C/I (Cost-income) ratio ; Non-interest expense / Total interest income (net interest income +
non-interest income)

What are non-performing loans?

Non-performing loans (NPLs) are loans on which debtors have failed to make contractual payments
for a pre-determined time. It should be noted that a loan classified as non-performing does not
necessarily lead to losses. If there is adequate collateral, losses might not occur.

When is shareholder value created?

Shareholder value is created when the:

 - Return on capital invested in the project ˃ Cost of capital to the firm, i.e. Return on capital ˃
Cost of capital

To calculate the Cost of capital, we use CAPM:

WEEK 5: CURRENCY BOARD – DOMESTIC AND INTERNATIONAL

EXPERIENCES, BASIC BANKING PRINCIPLES, LECTURE OF THE
DIRECTOR OF FBA BIH, CENTRAL BANKING SYSTEMS, CHPATER 5

PRESENTATION: BASIC BANKING PRINCIPLES

What are the basic banking principles?

The basic banking principles are as follows:

- Liquidity – the capability of subject to fulfil its current obligations at maturity ; assets and
liabilities ranked according to liquidity:
o Super liquid,
o Liquid, and
o Illiquid
Indicators of liquidity:
o Liquid assets / Total assets,
o Liquid liabilities / Total liabilities
- Solvency – long-term compliance of the structure of assets and liabilities – the capability to
pay all debts “finally” but by market prices. The bank is solvent if assets ˃ liabilities in the
case of liquidation
- Safety – capability of paying all obligations and claims with agreed deadlines and volume
- Profitability – the bank’s objective function. The bank aims to constantly increase
profitability.
- Efficiency – the principle by which bank approves funds for profitable projects and clients
who will use resources rationally. Efficiency = Liquidity + Profitability + Solvency + Safety

What are the three meanings of solvency?

The three meanings of solvency:

- The capability of bank to bear risk (in case of liquidation),

- Providing security to depositors (minimal risk for depositors),
- Macro-economic function of bank (in case of insolvency of only one bank there could be
decline of trust in all banks – the chain effect)
Which factors affect profitability of a bank?

There are two types of factors that affect the profitability of banks:

- Microeconomic factors of profitability:

o Quality of management,
o Assets quality,
o Economies of scale,
o Economies of scope,
o Off-balance operations,
o Operating expenses,
o Profit centers
- Macroeconomic factors of profitability:
o Phase of economic cycle,
o Sectoral crisis
o Interest rates

List and explain the ‘Liquidity strategies’.

Are as follows:

- The strategy of short-term commercial loans: this strategy entails maintenance of solvency
and liquidity by placement of deposit potential in short-term loans
- Strategy of marketable assets: this strategy entails maintenance of solvency and liquidity by
selling part of short-term securities and, also, part of the loan portfolio. It also entails loan
securitization, and sale of newly-formed securities to the interested institutional investors
- Strategy based on investments with anticipated income: it entails maintenance of solvency
and liquidity by investing in growth of medium and long-term loans on the basis of the
growth of saving and term deposits
- Liability management strategy: this strategy entails maintenance of solvency and liquidity by
withdrawing (taking) of loans instead of sale of short-term securities. It requires a strong
financial market with large resources that can be engaged by loan arrangements

What are the indicators of ‘illiquidity’?

Indicators of illiquidity:

- There are not enough funds to cover orders from the clients,
- Bank is not capable to pay out approved loans,
- Bank is unable to repay its loans,
- Bank holds a lower level of required reserves at Central Bank than prescribed

What is the primary liquidity reserve?

Primary liquidity reserve consists of money on deposit accounts at Central Bank.

What approaches of asset management exist?

There are three approaches of asset management:

- Stock approach: the bank should strive to have good assets. The focus is on the asset
management in order to ensure liquidity. Classification of bank’s assets by level of liquidity.
 - Flow approach: respect of maturity transformation future inflows and outflows. Bank
creates a ‘map of liquidity’ – examines the liquiditiy position in terms of 1-8 days, 8-30 and
30-90 days, and
- Combination of the previous two approaches: this is an optimal approach of asset
management

What mechanisms for engagement of loans for liquidity exist?

Mechanisms of engagement of loans for liquidity:

- Interbank liquidity loans – the mechanism for allocation of funds in accounts at the central
bank on credit basis with payment of interest. Smaller banks often have a primary surplus of
liquidity, so it is possible that those banks assign these funds to other banks at very short-
term with the interest
- Repurchase agreements (REPOs) – sale of financial asset with a seller’s obligation to buy that
same asset in some period of time by certain price which is agreed in advance. The buyer
earns interest at repo-rate, while seller solves problem of short-term liquidity. Government
bonds are used as collateral (they are considered as the safest mode of investment). Types:
o REPO with pre-arranged date (purchase can be made at the specified time), and
o Open REPO (purchase can be made at any time in the future)
- Certificates of Deposits (CDs),
- Liquidity loans at CB

What is ‘Discount window’, how does it work and what types of it exist?

Discount window is a CB approved loan to solvent banks which have short-term liquidity problems.
The banks can obtain super-short-term loans from CB with government securities as pledge.

Two concepts of interest rates for these loans:

- Below the market interest rate (there is a need for control that funds are used for its
purpose), and
- Above the market interest rate (penalties, banks are disinterested to use them).

There are three types of these loans:

- Adjustment of balance sheet structure,

- Cover of seasonal imbalances, and
- Elimination of consequences of unexpected events

What are the activities of the Central bank?

As follows:

- Issue of banknotes and coins,

- Management of foreign exchange reserves,
- Regulating the amount of the money,
- Organization of internal payment options and payments with other countries,
- Supervision and control of banks,
- Operations for account of the country

What are the basic functions of the CB?

As follows:
 - Monetary policy – main goals:
o Price stability,
o Economic growth,
o Full employment, and
o Balanced balance of payments
- Lender of last resort for banks,
o Provides liquidity of macro-system in conditions of expansions,
o Protects the liquidity of the banking system,
o Prescribes requirements for liquidity,
o Strict conditions in case of illiquidity,
o Makes banks protect its liquidity
- Supervision

What is CAMELS?

CAMELS:

- Capital – capital adequacy,

- Assets – quality of assets,
- Management – quality of administration and management,
- Equity – quality and level of bank’s profitability,
- Liquidity – adequacy of the bank’s liquidity,
- Sensitivity – sensitivity to market risk

CHAPTER 5: THEORY OF CENTRAL BANKING

What are the main functions of money?

Money serves four main functions in an economic system:

- Medium of exchange – a readily exchangeable item in the financial system, it provides the
owner with flexibility over the type and quantities of goods they buy,
- Unit of account – prices of all commodities can be defined and then compared to moeny,
- Store of value – provides individuals with a means of holding and accumulating wealth, and
- Standard of deferred payment

Define the monetary aggregates as defined by the ECB.

These are defined as follows:

- M1 (Narrow money):
o Currency,
o Balances immediately convertible into currency or usable for cashless payments
(overnight deposits),
- M2 (Intermediate money):
o M1,
o Deposits with a maturity ˂ 2 years, and
o Deposits at a period of notice ˂ 3 months
- M3 (Broad Money):
o M2,
o Marketable instruments issued by MFI sector
What instruments of monetary policy may be used by the Central banks?

As follows:

- Open market operations (OMOs),

- Discount windows (‘standing facilities’), and
- Reserve requirements

Why are OMOs are good idea when influencing short-term interest rates?

The main attractions of using open market operations to influence short-term interest rates are as
follows:

- They are initiated by the monetary authorities who have complete control over the volume
of transactions,
- Open market operations are flexible and precise – they can be used for major or minor
changes to the amount of liquidity in the system,
- They can be easily reversed,
- Open market operations can be undertaken quickly

What are the instruments of ‘portfolio constraint’?

The instruments of portfolio constraints are:

- Reserve requirements,
- Special deposits – deposits (in addition to the reserve requirements) that need to be placed
at the CB and are frozen afterwards,
- Moral suasion – range of informal requests and pressure that the authorities may exert over
banking institutions, and
- Direct control – issuing directives in order to attain particular intermediate targets

Why are portfolio constraints losing on popularity?

For the following reasons:

- Increase in the number and type of institutions that need to be controlled, caused by
deregulation and increasing competition,
- Disintermediation,
- Abolishment of foreign currency exchange control,
- They limit the business freedom and growth of banks and other intermediaries, causing a
distortion of the market and decrease of economic efficiency

What are the five major forms of economic policy?

As follows:

- Monetary policy – concerned with actions taken by central banks to influence the availability
and cost of money and credit by influencing the level of money supply and the structure of
interest rates,
- Fiscal policy – changes in the level and structure of government spending and taxation
designed to influence the economy
- Exchange rate policy – targeting a particular value of a country’s currency exchange rate
thereby influencing the flows within the balance of payments,
 - A prices and incomes policy – influencing the inflation rate by means of either statutory or
voluntary restrictions upon increases in wages, dividends, and/or prices
- National debt management policy – concerned with the manipulation of the outstanding
stock of government debt instruments held by the domestic private sector

PRESENTATION: CURRENCY BOARD ARRANGEMENT – DOMESTIC AND

INTERNATIONAL EXPERIENCES

What is currency board?

IMF defines Currency Board Arrangement as:

- Monetary regime based on an explicit statutory obligation of conversion of

- local currency in specific foreign currency,
- while institution that issues currency has certain limitations

What are the principles of currency board?

As follows:

- Demand deposits are convertible into currency of the monetary board at a fixed rate,
- Ratio between money in circulation and money supply is constant,
- Monetary policy is consisted of conversion of local currency into foreign currency at the
fixed rate

What are the characteristics of Currency Board?

As follows:

- Convertibility of any amount of domestic currency in stable foreign currency,

- Fixed exchange rate of domestic currency to reference currency,
- Full coverage of issued domestic currency by foreign currency reserves,
- Operates by the principle of golden bullion money system

PROČITAJ DO KRAJA PREZENTACIJU