APC312 Money Banking and Finance

Part A: Discuss why banks need to be more regulated in terms of risks they face compared to other financial firms... The differences in terms of risks between banks and non-bank financia

ASSIGNMENT COVER SHEET UNIVERSITY OF SUNDERLAND

BA (HONS) BANKING AND FINANCE

Student ID: 149078874/1

Student Name: Nguyen Thi Kieu Anh

Module Code: APC 312

Module Name / Title: Money, Banking and Finance

Due Date: 16 Jan 2015

Centre / College: Banking Academy of Viet Nam

Hand in Date: 16 Jan 2015 Assignment Title: Individual assignment

Students Signature: (you must sign this declaring that it is all your own work and all sources of information have been referenced)

MONEY, BANKING AND FINANCE

APC312

Prepared by: Nguyen Thi Kieu Anh Student ID: 149078874/1

Submission Date: 16 Jan 2015

Number of words:

Part A: 1,330 Part B: 1,516

Part A: Discuss why banks need to be more regulated in terms of

risks they face compared to other financial firms

TABLE OF CONTENTS

INTRODUCTION 5 MAIN BODY 5

1 The differences in terms of risks between banks and non-bank financial institutions 5

2 Form and cost of regulations 7 CONCLUSION 8 REFERENCES 9

INTRODUCTION

In recent decades, the entire world economy plunged into a depression owing to the wholesale collapse of financial system The root of financial problems can be explained by absence or reduction of governmental controls that allowed financial institutions to operate beyond its range of activities, which so-called ‘deregulation’ Facing with the challenges in stabilizing financial system and recovering the economy, the government was forced to step forward in regulation, starting with regulating banks in terms of risks This study will discuss specifically the reason that banks need to be regulated in terms of risks they face compared to other financial firms

MAIN BODY

According to Herr and Kazandziska (2011, p.13), the financial system could be generally divided into banks and non-bank financial institutions such as mortgage companies, insurance companies, pension funds and investment banks…It is undeniable that banks offer wider range of financial services than any financial institution Banks accept deposits and create credit, that is, banks circulate capital resources from savers (the surplus-spending units) to borrowers (deficit-spending units) whereas non-bank financial institutions are not allowed to take deposits from the public Besides, banks also implement payment functions such as the transfer of deposits, payment of cheques, credit and debit card…whereas non-bank financial institutions play no direct role in payment system (Mbuya, 2008, p.22) This is also the reason why banks are considered as the lifeblood of the economy These two main activities help to distinguish between banks and non-bank financial institutions as well as cause higher level of risks and motivate for the entry of regulations in banking system compared to other financial firms

1 The differences in terms of risks between banks and non-bank financial institutions

The biggest difference in terms of risks between banks and non-bank financial institutions is

liquidity risk Liquidity risk is a ‘hot topic’ in finance industry It is the risk of not being able

to meet obligations in terms of funds demanded by clients (Faure, 2013) In the context of banking system, it arises from both sides of the balance sheet of banks Liabilities of banks mainly are short-term funds of depositors which have to pay back on demand anytime, especially sight deposits Meanwhile assets of banks might be short or long term loans, but

whether short or long it also has longer maturity than liabilities It is called ‘maturity

mismatch’ between assets and liabilities or can say that banks are engaged in the high degree

of maturity transformation (Howells, 2014, p.13) If the bank cannot balance assets and

liabilities, banks will face illiquid risk as banks cannot liquidate customers’ unexpected need for cash When depositors doubts about the health of bank holding their money, they may

rush to withdraw cash from the bank A “bank run” occurs leading to collapse of the bank

Northern Rock - a British bank is a well-known example of liquidity crisis Northern Rock followed a ‘reckless business model’ where nearly 30% of its funding was bought-in short-term wholesale funds that were used to finance long-short-term mortgage business (Financial Times, no date) Such business model caused lack of liquidity and the bank run in 2007 Unlike banks, non-bank financial institutions like life insurance companies only serves customers at the liability side of balance sheet It has a favorable liquidity position as illiquid liabilities versus liquid assets, that is, life insurance companies just compensate the financial risk as an agreement in event of untimely death of the policyholder which has long term maturity while it can use pool of these funds to invest in liquid assets such as government and corporate bonds which can sell anytime in case of unexpected event (Weert, 2011, p.23) Hence, liquidity risk is higher for banks than non-bank financial institutions

According to Altman (2013, p.548), liquidity risk tends to compound to other risks such as

credit risk, market risk…Credit risk is the risk that the borrower from a bank will default on

the loan/the interest payable or not perform in terms of the conditions under which the loan was granted (Faure, 2013, p.93) Credit risk is inevitable so it remains biggest challenge for banking sector For example, the development of subprime mortgages market in US caused credit crunch in 2008 since large number of borrowers was unable to meet their mortgage

repayments This, in turn, result in liquidity crisis in banks (Davies, 2014) Market risk

arises when there is a decline in the market value of financial securities (share, debt and derivatives) that caused by unexpected changes in market prices, interest rates…(Faure, 2013, p.84) Competition in banking industry creates incentives for banks to expand their trading activities by holding larger financial securities This development leads to illiquid risk or even collapse of the bank when there is a sudden decline in those financial instruments Indeed, by late 2007, mortgage-backed securities slumped in value, a lot of banks suffer losses such as Citygroup: $40.7 billion, UBS: $38 billion, HSBC: $15.6 billion… (BBC, 2008) It threatens to liquidity of banks and led to the collapse of Northern Rock in UK Non-bank financial institutions also face credit risk and market risk, however, Non-banks demand deposit so banks are subject to restrictions on their activities compared to other financial firms

Furthermore, these risks affect not only one bank but also the entire banking system The collapse of one bank causes a loss of confidence in banking in general, creates bad debts for

other banks and widespread collapse (financial panics) This is called “systemic risk” or

“risk of contagion” (Howells and Bain, 2007, p.362) Besides, it would cause delay of payment system resulting in significant disruptions in aggregate economic activity,

especially import and export activities which bring great economic benefits for all countries Thus, it requires to impose regulations to ensure stability and soundness of the payment system

A special case for intervention of regulations in banking industry is to protect customers as well as ensure the soundness of banking system from the informational imbalances or

‘asymmetric information’ Asymmetric information occurs between depositors and banks

Depositors are unable to define the bank holding their deposit is good or bad bank until they cannot withdraw cash on demand It causes adverse selection as customers have little choices and have high demand in holding deposits as means of payment Besides, as key player in payment system, banks have incentives to use mobilizing funds from customers to invest in risky assets to earn profits, which so-called moral hazard On the other hand, banks also can

be the victims of asymmetric information Borrowers have better information about level of risks they engaged when borrowing money from banks It is difficult for banks to appraise the investment project of customers when they intended to hide the risky action In the worst case, asymmetric information would lead to the collapse of banks and then create a domino effect on the stability of the entire financial system as economic crisis of 2008

2 Form and cost of regulations

In order to protect customers and ensure the safety and soundness in banking system, some regulations are imposed such as:

 Restrictions on assets and activities: In the US, the Glass-Steagall Act (1933) prevented

commercial banks from engaging in securities trading with their client’s deposits and prevented investment banks from taking deposits This is partly a response to a wave of bank failures following 1929 stock market crash and Great Depression (Crawford,

2011, pp.127-133)

 Capital adequacy: In Basel Committee member (UK, US, Canada…), Basel I (1988)

required to express capital in relation to risk-adjusted assets Basel II (2004) goes well beyond by allowing banks to use ‘internal risk-weightings’ to calculate required

regulatory capital (Howells, 2014, p.237)

 Liquidity requirements: Basel III required two liquidity ratios: Liquidity Coverage Ratio

and Net Stable Funding Ratio (BIS, 2010,p.9)

 Deposit insurance: In US, FDIC1 insures each depositor at a commercial bank up to a loss of $100,000 per account (Mishkin, 2004, p.40)

Nevertheless, in the dark side of regulations, it creates adverse selection and moral hazard problem For example, safety of deposits motivates savers to deposit money into the bank without reservation and tracking Similarly, a belief that government acts as lender of last resort is always willing to rescue banks from failure creating incentives for them to take greater risks (‘too big to fail’ problem) (Howells and Bain, 2007, p.365) Besides, presence of regulations is source of barriers to entry and compliance costs resulting in higher prices in banking services

CONCLUSION

Through analysis above, it is obvious that banks face more risks in business compared to other financial firms In unregulated market, it is easy to collapse and cause financial crisis worldwide Therefore, strict regulations are really necessary to limit banks’ exposures to risks However, regulations also cover certain costs that require government to concern and monitor in efficient manner

1

Federal Deposit Insurance Corporation was created in 1934 after the massive bank failures of 1930–1933, in which the savings of many depositors at commercial banks were wiped out

REFERENCES

1 Altman, E.I., Nimmo, R., Narayanan, P and Caouette, J.B (2013) Managing credit

risk: The Great Challenge for Global Financial Markets 2nd edn Canada: John

Wiley & Sons

2 BBC (2008) Timeline: Sub-prime losses Available at:

http://news.bbc.co.uk/2/hi/business/7096845.stm (Accessed: 07 December 2014)

3 BIS (2010) Basel III: A global regulatory framework for more resilient banks and

banking systems Switzerland: Bank for International Settlements

4 Crawford, C (2011) 'The Repeal Of The Glass- Steagall Act And The Current

Financial Crisis', Journal of Business & Economics Research, 9(1), pp 127-133

5 Davies, J (2014) Global Financial Crisis – What caused it and how the world

responded Available at:

http://www.canstar.com.au/home-loans/global-financial-crisis/ (Accessed: 08 December 2014)

6 Faure, A.P (2013) Banking: An introduction 1st edn Quoin Institute (Pty) Limited &

bookboon.com

7 Financial Times (no date) Definition of liquidity crisis Available at:

http://lexicon.ft.com/Term?term=liquidity-crisis (Accessed: 06 December 2014)

8 Her, H and Kazandziska, M (2011) Macroeconomic Policy Regimes in Western

Industrial Countries New York: Taylor & Francis e-Library

9 Howells (2014) Money, Banking and Finance APC312 United Kingdom: University

of Sunderland

10 Howells, P and Bain, K (2007) Financial markets and institutions 5th edn London:

Longman

11 Mbuya, J.C (2008) The Pillars of Banking United Arab Emirates: MP

12 Mishkin, F (2004) The economics of money, banking and financial markets 7th edn

The United States of America: Addision-Wesley

13 Weert, F.D (2011) Bank and Insurance Capital Management 1st edn United

Kingdom: TJ International Ltd

Part B: Critically analyze the competitive conditions in the

banking industry

TABLE OF CONTENTS

INTRODUCTION 12

MAIN BODY 12

1 Competitive approaches 12

2 Degree of competition in banking industry 14

3 The impact of regulations on competitive conditions in banking industry 15

CONCLUSION 16

REFERENCES 17

Banking sector plays a crucial role in economic growth of all nations through mobilizing and allocating funds in the economy Competition in banking sector, therefore, has received researchers’ attention worldwide As Bandt and Davis (2000, p.1045) showed, competition in banking sector has intensified significantly in recent years Deregulation, technological advancements as well as globalization phenomenon that allows foreign bank involved in domestic banking markets are underlying causes of changing competitive conditions This study will analyze in detail competitive conditions in banking industry

MAIN BODY

This study analyzes the competitive conditions based on three aspects: competitive approaches, the degree of competition and changes in competitive conditions in banking industry

1 Competitive approaches

 Interest rate competition

Interest rate is key tool to compete among banks for the need of increasing capital and expanding market share because it affects the economic decisions of the public When the lending rates are low, it encourages the public borrow money from the bank and vice versa Similarly, high deposit rates will encourage the public deposit money into the bank and vice versa A bank earns a spread on the money it lends out from the money it takes in as a

deposit, which are generally known as interest rate spread (IRS) (Fuhrmann, 2014) In other

words, the difference between deposit and lending interest rates generates profits for banks According to Croushore (2012, p.233), competition from other banks limits the profits a bank can earn by changing the spread If a bank tries to increase its spread by paying lower deposit interest rate than its competitors, then depositors will switch to other banks If a bank charges higher lending interest rate than its competitors, it will lose borrowers to cheaper competitors Competition keeps interest rates on both loans and deposits similar across banks In Vietnam, for example, VietNamNews (2013) reports that Vietnam financial market was witnessing a rare phenomenon that is lending and deposit interest rate got so close each other Interest rate (over 12 month deposits) of Agribank climbed to 8%, Vietinbank up to 7%, Vietcombank rose between 7 to 7.5% The deposit interest rate race seems more stressful when Techcombank raised the interest rate of less 12 month deposits up to 6.75-7.45% per year Besides, raising deposit interest rates, the banks also made efforts to cut their lending interest rate, sometimes lower than their deposit rate In the context of intense competition, interest