loans

The Inverted Pyramid

admin — Mon, 12 Oct 2009 12:41:52 +0000

Bank liability structures are sometimes represented as an inverted pyramid and the following diagram is approximately to scale for a typical commercial bank. The ﬁrst thing to notice is just how small the equity base at the apex of the pyramid is. The bulk of their funding comes from customer deposits and these are relatively short term (the proportion of time deposits with a maturity beyond 90 days (three months) is usually very small). Long-term debt is usually only a small fraction of total liabilities.
Deposits from other banks are usually made to support a correspondent banking relationship where the bank provides a local ser vice to another bank operating in a different region or country. Some deposits arise from bank’s activities in the wholesale interbank markets where they lend to and borrow from one another, usually on relatively short terms.
The interbank market is an important source of funding for many foreign banks operating in emerging markets. Branching restrictions mean they frequently lack the local currency deposit base enjoyed by domestic banks. This does, however, tend to put them at a disadvantage in terms of funding costs relative to local banks. Interbank rates in developing markets are often rather volatile as a consequence of their lack of depth and liquidity.

Medium- and Long-term Finance

admin — Sun, 04 Oct 2009 12:40:44 +0000

Banks have a similar range of medium- and long-term ﬁnancing options as industrial and ser vice companies. These include equity raised through private placements or rights issues, straight bonds, conver tible bonds, preference shares and subordinated debt. These usually comprise only a relatively low propor tion of a bank’s funding and capital management factors are usually the main consideration in raising medium- to long-term ﬁnance.

Short-term Finance

admin — Mon, 28 Sep 2009 12:39:51 +0000

From a bank’s perspective there is little difference between a negotiable certiﬁcate of deposit (NCD) and a time deposit. The big difference to the holder of NCDs is that they can be traded in a secondar y market. NCDs are also generally relatively longer term than time deposits but shorter term than bonds. They may be issued in the local currency or a foreign currency, usually the US$. In the latter case proceeds may be used to ﬁnance foreign currency assets or swapped back into the local currency.

Retail and Wholesale Segments

admin — Sun, 20 Sep 2009 12:36:44 +0000

The deposit market can be conveniently divided into retail and wholesale segments, although the boundar y between these two segments has became somewhat blurred by the increase in the numbers of the “mass afﬂuent”. The retail and wholesale segments have very different characteristics. Retail deposits can be broadly characterized by the following:
Priced by banks. Retail deposits are priced on the basis of rates published by individual banks. These rates can be changed at will and retail depositors’ only choice is to accept those rates or take their deposits elsewhere.
Rates on retail deposits offered by banks in most countries have been highly regulated in the past and in many countries continue to be set centrally. In some countries regulators determine these rates, while in others they are set by individual banks acting as a cartel. The global trend over the past two decades has been towards de-regulation and liberalization.
Relatively sticky. Retail customers do not switch banks very often. There is a high degree of iner tia. This can be explained by the relatively high switching costs that are entailed with, for example, moving standing instructions to pay regular bills automatically from an account at one bank to an account at another bank.
These switching costs act as an impediment to competition and in some countries lawmakers have introduced legislation to require banks to transfer details of standing instructions set up for a customer at one bank to another bank when instructed to do so by the customer.
Relatively price insensitive. Most retail depositors do not move their deposits from one bank to another for the sake of an extra 50 basis points (bpts). The degree of price insensitivity depends partly on the size of the deposits and partly on the reason why the customer has made the deposit. A customer using an account primarily as a transaction account will be less price sensitive than a customer using the deposit account as a savings account or as a means to generate an ongoing income.
Location and convenience. Attracted on the basis of location, convenience and branding. The number and geographic spread of branches, opening hours, and access to automated teller machines (ATMs) are of particular impor tance.
High administrative costs. Can be relatively expensive in terms of operating costs per dollar of deposit, particularly if depositors make frequent, small deposits and withdrawals.
Wholesale deposits can be characterized by the following:
Prices set by supply and demand. Wholesale deposit rates are largely set by supply and demand and are usually priced against a market rate such as the three-month interbank rate. Wholesale depositors may be able to negotiate for better rates by threatening to move their deposits to another bank.
Very mobile. Wholesale deposits can be switched from one bank to another by means of electronic instruction.
Highly price sensitive. An extra 10 bpts on a $100m deposit is wor th $100 000 on a one- year deposit.
Highly counterparty credit quality sensitive. Wholesale depositors are conscious of their counter party risk and manage it actively. At the ﬁrst sign of any real problems, or even perception of problems, at a bank wholesale depositors will switch their funds to other banks perceived as lower risk.
Low administrative costs. They are very low cost per dollar to administer, and involve limited human inter vention.
Most commercial banks take both retail and wholesale deposits. They do have to make a strategic decision on competitive positioning. The choice is between maintaining a (relatively) large, expensive distribution network and attracting cheaper retail deposits and operating with a smaller number of branches, at relatively low cost, and rely on more expensive, higher risk wholesale deposits.
There has been a global trend towards the liberalization of deposit products. In many countries restrictions on regulated accounts have included the following:
Demand deposit accounts. An account on which US banks are not allowed to pay interest on any outstanding balance.
Savings accounts. A retail account offering a ﬁxed rate of return. Notice of withdrawal normally has to be given above a minimum prespeciﬁed limit.
Time deposits. Deposits with a ﬁxed rate and ﬁxed term. Early withdrawal is usually subject to a penalty fee or may even be prohibited.
NOW deposits. A US deposit account (negotiable order of withdrawal account). One of the ﬁrst US bank deposit accounts on which interest rates were deregulated.
The original objective of regulating the rates that banks could pay on deposits was to eliminate what was perceived as potentially dangerous, destabilizing price competition.
The reasoning being that some banks would bid up deposit rates to attract funds but then have to make higher-risk, high-yield loans to generate an economic return. Other banks would then be forced to match those rates to keep their own deposit base intact leading to a spiraling crisis. Ignorant retail depositors would not understand the higher risks they were accepting in return for the higher rates and would go to the bank with the highest rates.
There is some evidence to suppor t this. The Bank of Credit and Commerce International (BCCI), which collapsed in 1991, offered rates that were signiﬁcantly higher than at other banks. BCCI was widely referred to, in the City of London, by ﬁnancial professionals as the “Bank of Crooks and Criminals International”, well before it failed. But, many of its predominantly Asian depositors were unaware of its reputation or the risks they were taking and they all lost almost all of their deposits in the aftermath of its failure.

The Bank for International Settlements (BIS)

admin — Mon, 14 Sep 2009 12:35:21 +0000

The Bank for International Settlements (BIS) was established in Basel, Switzerland, in 1930 and hence its formation predates that of the IMF and the World Bank. The BIS is owned exclusively by the world’s central banks. Its primar y functions are to coordinate and facilitate banking and settlement ser vices between the world’s central banks. It is probably best known for helping to bring about the Basel Accord that established capital adequacy requirements for OECD banks. These are rules that deﬁne how much capital a bank should maintain relative to its asset size and risks under taken to comply with minimum international norms.
In common with the IMF and the World Bank the BIS conducts economic and monetary research, although it has a different focus. This diversity is probably positive as it results in a range of views. It also gives a lot of post-doctoral economists jobs. The BIS also under takes research and provides advice and training on reducing risks in settlement systems, both domestic and cross-border.

The World Bank

admin — Fri, 04 Sep 2009 12:34:22 +0000

The World Bank was established as the International Bank for Reconstruction and Development (IBRD). The latter, somewhat cumbersome, title provides a more accurate description of the bank’s role. The IMF has more of the functions and responsibilities one would expect from a world central bank.
The World Bank was set up to address long-term development issues and to reduce global poverty. It provides funding for basic infrastructure projects to developing countries. It is also mandated to facilitate reforms to reduce global poverty. This is clearly well intentioned but the evidence shows that it has had limited success. Its effor ts in sub-Sahara Africa have had few positive results, for example.
The gap in terms of wealth between developed and many developing economies has widened. The blame for this should not be laid at the feet of the World Bank, however. Its resources are a small fraction of private investment ﬂows and subsidies on agricultural products and other commodities by developed countries have taken their toll on incomes in developing countries.

The International Monetary Fund (IMF)

admin — Sat, 29 Aug 2009 12:32:36 +0000

The simplest way to view the IMF is that it is the world’s lender of last resort. The principal stated objectives of the IMF are as follows:
To promote international monetary cooperation, exchange stability, and orderly exchange arrangements; to foster economic growth and high levels of employment; and to provide temporary ﬁnancial assistance to countries to help ease balance of payments adjustment In practice the IMF’s most high proﬁle activity is to provide funding to countries experiencing balance of payment problems while imposing conditions on the governments of these countries to implement economic reforms in return for being given such loans:
Financing. The IMF is ﬁnanced by contributions from its member countries. Each member’s contribution is based on its relative economic size and condition. These contributions are referred to as quotas and are denominated in a special currency unit, the Special Drawing Right (SDR), based on a weighted basket of four major currencies (at the time of writing this basket was made up of the US dollar, the euro, the Japanese yen and UK sterling).
Quotas are reviewed periodically and may be adjusted to reﬂect changes in either an individual member’s economic condition or changes in the IMF’s ﬁnancing requirements. The latter depends largely on the state of the global economy.
The IMF pays interest on members’ positive balances based on short-term money market rates of the currency basket.
In addition to providing the IMF with its funding, quotas are used to deﬁne each member’s maximum contribution, and, in principle at least, to determine their ability to borrow from the fund in times of ﬁnancial distress.
Management. The head of the IMF is, by tacit agreement, always a European. Quotas are used to determine each member’s voting rights. As the world’s largest economy the US has a signiﬁcant inﬂuence on the IMF’s management and policies and the heaviest voting weighting.
In practice the IMF is run by an executive board. This 24-strong board is made up of permanent representatives from the USA, Japan, Germany, France, the UK, China, Russia and Saudi Arabia plus 16 other representatives from other countries elected for two-year terms. Few decisions are, however, made based on formal votes.
Borrowing rights. Member countries can borrow the equivalent of their quota in any given year and up to three times their quotas in total. In exceptional circumstances these lending limits may be lifted.
When trouble star ts politics become an overriding consideration, both domestic and international. Domestic politics affect the ability of governments to make reforms while international politics has an impor tant inﬂuence on the IMF’s willingness to provide funds.
Conditionality. Conditionality is the most controversial aspect of the IMF’s operations. Before making a loan to a distressed country the IMF will seek to impose conditions for economic, and sometimes political, reform to ensure that the ﬁnancing is genuinely short term and that the borrower will be able to repay the loan.
These conditions can be wide ranging and usually require the borrower to meet deﬁned monetary and budgetary targets, the removal of subsidies on selected products, the opening up of markets, reduction in import tariffs and removal of foreign ownership restrictions. These conditions frequently lead to hardship and with the IMF also being widely seen as a tool of US foreign policy tend to lead to popular political opposition in affected developing markets.
It is easy to make the IMF the bogeyman and it does not have a perfect record in terms of corrective action proscribed. These attacks miss the point. In an open global economy the world needs an organization such as the IMF. Trade and capital ﬂow imbalances in individual economies will occur from time to time. These may be the result of poor government or central bank policies. They may also be a consequence of supply side or demand side shocks, such as a sharp increase in energy prices or a fall in commodity prices.
It is also fair to add that many governments have taken advantage of the intervention of the IMF to impose unpopular policies that it can blame on the IMF but had actually wanted to pursue in any case. IMF conditions that a government reduces its ﬁscal deﬁcit do not normally deﬁne in detail exactly how this is to be achieved. A government may choose to cut public employees’ salaries, for example, but maintain its chosen level of military spending.