Money, banking and finance (APC 312) january 2015

Big banks are higher competitive compared to small banks because of their scale. While the competition among foreign banks and domestic banks depends much on how they operate and take the advantages. However, the banking industry have become more competitive with the reform of regulations to reduce the impacts of big banks and help the small banks have position in the market to compete.

ASSIGNMENT COVER SHEET UNIVERSITY OF SUNDERLAND

BA (HONS) BANKING AND FINANCE

Student ID: 149080615/1

Student Name: Tran Quyet Thang

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)

Title page

Money, Banking and Finance

APC 312

Banking Academy, Vietnam Submitted on January 16, 2015 Prepared by: Quyet Thang Tran Student ID: 149080615/1

Table of Contents

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

compared to other financial firms 1

Risks that banks and other financial firms have to face 1

Impact of banks’ failure 3

Impact of regulations 4

Part B: Critically analyze the competitive conditions in the banking industry 4

Competitive approaches 5

Degree of competition in the banking industry 6

Impact of regulations to competition in the banking industry 7

References 9

Tables Table 1: Net interest margins of five biggest banks in UK in 2011-2012 5

Part A: Discuss why banks need to be more regulated in terms of risks they face compared to other financial firms

There are several common differences between banks and other financial firms especially in terms of risks With the different features, functions and the impacts to the whole economy, banks have to take higher levels of risks such as credit risk, liquidity risk…This is the reason why banks are more regulated than non-bank firms The analysis below will shows some main types and levels of risks which banks and non-bank enterprises meet while operating Besides, customers’ protection is also the reason for banks to be more regulated Moreover, several regulations also are mentioned to reduce the negative impacts of bank failures and stable the financial system

Risks that banks and other financial firms have to face

Firstly, banks have the right to take the deposits The banks collect huge numbers of the short-term to medium-term deposits in order to provide the loans for customers for the long term Furthermore, by having ability to create money, the deposit liability of banks usually form the bulk of a country supply, so the quantity and growth of these deposits are often of considerable policy interest to the government and central banks (Howells & Bain, 2007) While non-banks without deposits taking are not under the pressures of these policies While performing the function of transforming assets, the financial intermediaries actually share risks with savers, change the maturity and quantity of funds by gathering short to medium term funds with small amount of money and then convert them into huge funds for long term The risks are arising through this process In a commercial bank, some of 74% of bank assets are in the form of loans, and they generally produced more than half of bank revenue (Mishkin & Eakins, 2011) Therefore, credit risk - the risk, that borrowers might default on their loans (Hubbard

& O’Brien, 2012) in banks, is very high It means that the ability of borrowers in paying money back is an important factor In order to make a loan, banks have to follow the requirements and processes carefully in order to prevent non-performing loans For example, in Vietnam, the ratio of non-performance loans is still very high about 15% based on the estimation of Moody's (Vietnamnet, 2014) Because of this problem, banks

do not willing to make loans and lead Vietnam economic growth to slow down The main cause is the asymmetric information between banks and borrowers Banks may

not know all information about the financial health and the purposes for taking loans of their customers As the result, this will increase the level of credit risk in banks Furthermore, banks usually take short-term deposits and make long-term loans This means that the maturity of deposits and loans are mismatched And because these loans can only transfer to cash when becoming mature so it can cause banks to lack money for cash demand It means that banks can meet the liquidity risk - the possibility that a bank may not be able to meet its cash needs by selling assets or raising funds at a reasonable cost (Hubbard & O’Brien, 2012) Additionally, because the depositors can freely be withdrawal, if many depositors want to withdraw their money in the banks at the same time, banks will have the obligation to return the funds back immediately This could lead banks to run out of cash and become insolvent like in the case of Northern Rock in September in 2007 It ran into short-term difficulties as a result of temporary market conditions - the troubled US sub-prime market and London Interbank Offered Rate (Libor) - rises to its highest level in almost nine years because Northern Rock grew rapidly by using securitization of mortgages (BBC, 2008) According to Bloomberg Businessweek, by early Sept 15, Northern Rock was reported to have paid out about $2 billion because customers worried about losing their savings (2007) Therefore, Bank of England acted as lender of the last resort to bail out this bank and reduce its impacts to the whole economy However, non-bank firms like pension funds

or investment trusts offer the different financial products such as pension funds, various types of insurance… in terms of contracts It means that the customers have to follow the terms of contracts and wait for the due date For example, the saver of pension fund cannot withdraw the pension whenever it suits (Howells, 2010)

Thirdly, banks also have another problem with the difference between the maturity of the deposits and loans Since the long-term interest rates at which banks lend and the short-term interest rates, at which they borrow, can fluctuate, banks run the risk of losing money if unexpected differences between the two arise (Bednar & Elamin, 2014) According to Basel Committee on Banking Supervision, 2004, excessive interest rate risk can pose a significant threat to a bank's earnings and capital base For example,

if the market rate increases and the bank interest rate is unchanged, banks will the opportunity costs for investing in other projects

Next, banks could meet the foreign exchange rate risk because of the fluctuation of values of different currencies Foreign exchange rate risk is measured by the standard

deviation of domestic-currency values of assets or liabilities attribute to unanticipated changes in exchange rates (Levi, 2007) Banks can be influenced directly by holding assets or liabilities in a foreign currency For example, Vietnam commercial banks can take deposits in USD and make loans in VND, so any changes in exchange rate between USD and VND could bring impacts immediately to banks’ assets However, banks still are affected by foreign exchange rate risk although banks do not hold foreign assets or liabilities For example, a Vietnam commercial bank holds a loan to a Vietnam exporter Let say, this exporter exports a good worth $1,000 and receive payment three months later If VND/USD three months later decreases, the actual payment that this exporter receiving in VND will be lower than estimated amount with current exchange rate Therefore, the profitability of exporter will be diminished and this impacts to loan repayment to banks

Impact of banks’ failure

Most of the bank liabilities are non-transaction deposits and checkable deposits Both types of deposits are money that savers put in the banks, so the failure of banks can cause losses for people, at least temporarily, access to the means of payment (Howells

& Bain, 2007) This means that banks play an important role as a payment system for the economy to circulate cash flows The payment system is an operational network - governed by laws, rules and standards - that links bank accounts and provides the functionality for monetary exchange using bank deposits (Summers, 2012) For example, a crucial payments system of Bank of England which processes payments worth an average £277bn a day had failed for nearly 10 hours and it causes that homebuyers and sellers around the country would be left unable to complete purchases

on time and that big businesses, which also use the system, would fail to make payments (Jill, et al., 2014) This problem interrupts the activities of trading home in UK Next, systemic risk - risk to the entire financial system rather than to individual firms

or investors (Hubbard & O’Brien, 2012) bring huge negative impacts to the whole economy system If there is any bank failed, this can make all depositors withdraw all their money not only in banks that are failure but also in other banks This process is called contagion Depositors react like that because of their fear about losing their funds

in the accounts in banks In order to prevent systemic risk, too-big-to-fail policy – a policy under which the federal government does not allow large financial firms to fail for fear of damaging the financial system – means that largest commercial banks will

be bailed out In this case, FED or central banks will have a role as lender of last resort However, this will lead moral hazard to increase It means that the banks will take more risky activities because they know that if they fail, they will be saved by the governments

Impact of regulations

Furthermore, because of asymmetric information, depositors have less information about what banks do with their money Therefore, regulations are carried out to reform banks’ activities to protect consumers For example, on 29 January 2014, the European Commission adopted a proposal on banking structural reform for a regulation to stop the biggest banks from engaging in the risky activity of proprietary trading (European Commission, 2014) Besides, there are many other areas of banks that need to be regulated such as liquidity, capital requirements…like Basel III required

On the other hand, regulations also bring out some costs for banks For example, the

“too big to fail” policy, to bail out the big banks, leads these banks take risky activities – this is called moral hazard In addition, there are some major regulation initiatives causing significant impacts on US banks such as higher capital requirements, higher liquidity requirement, tightening of derivatives regulation and enhanced consumer protection regulation (Elliott, et al., 2012) For example, the higher capital requirement

is implemented by Basel III and leads banks to take higher funding costs for operation Therefore, the profitability of banks will be affected Additionally, this also creates a barrier for new entrants to join in the banking industry

In conclusion, with higher levels of different risks compare to other firms, banks need

to be more regulated The failure of one banks can lead whole economy to slow down and face the financial crisis Nevertheless, besides create a safe environment in the banking industry, regulations also cost banks in some areas such as operations, profitability…

Part B: Critically analyze the competitive conditions in the banking industry

Like other industries, the competition among banks also exist In order to analyze the competitive conditions in banking industry, some approaches are used to measure such

as interest rate, market concentration, etc Furthermore, the levels of competition

between the big banks and small banks, domestic banks and foreign banks Lastly, the impacts of regulations to competitive condition in the banking industry are mentioned

Competitive approaches

Firstly, the operational efficiency – the provision of a good quality service at the lowest possible price (Howells, 2010) in banking industry can be evaluated through net interest margin because the products and services, that banks offer, are financial instruments Net interest margin (NIM) is the difference between the interest a bank receives on its securities and loans and the interest it pays on deposits and debt, divided by the total value of its earning assets (Hubbard & O’Brien, 2012) In other words, NIMs show the future profitability that banks can make based on their assets The table below will show NIMs of some big banks in UK as follows:

2011 2012 2011 2012 2011 2012 2011 2012 2011 2012 Net interest

margin

(basis

points)

203 185 192 193 207 193 251 232 230 230

Table 1: Net interest margins of five biggest banks in UK in 2011-2012

Source: KPMG LLP (UK) 2013

It can be seen clearly that NIMs of five big banks in UK are a little bit difference compare to each other Furthermore, the changes in NIM figures in two years 2011 and

2012 of these banks are small The interest rate in banks can be considered as the price for banking services and products In this case, the interest rate of five UK big banks is set similarly This means that banks have to highly compete to each other by offering reasonable price for attracting customers

Another way, to measure the competition of the banking industry, is contestability The behavior of banks in contestable markets is determined by threat of entry and exit (The World Bank, 2012) The increase in contestability in the banking industry can be explained through some entry conditions For example, in EU, the “single passport” system allows financial services operators legally established in one Member State to establish/provide their services in the other Member States without further

authorization requirements (European Commission, 2014) It means that a bank can easily expand its market to all EU countries with only a license to operate in one EU country

Another factor, that could influence the competition, is changes in technology especially the digital banking The development of the Internet and smart phones has brought many advantages for users Now customers of banking services can easily check their balance through digital apps on their phone or assess to the websites of banks Furthermore, there are many other transactions like transferring money, making payment that customers can conduct without going to a bank branch In the term of competition, taking a good location can be considered as a competitive advantage and

a barrier for new entrants because they need to find the places such as in urban areas, big streets…that make customers easy to come However, this changes; for instance in

UK banking industry, some new entrants (Shawbrook, Aldermore and Atom Bank for example) are actively choosing different means of service delivery, eschewing branches altogether, while others such as Metro and Handelsbanken are currently building branch networks in the low hundreds rather than the low thousands currently operated by the major banks because of 39% of small and medium enterprises use online banking at least once a day, with a further 30% using it at least once a week and only 7% never use it (Barty & Ricketts, 2014) This is not only the way for the new entrants entering market, but also the chances for all banks to improve their services to compete

Degree of competition in the banking industry

Market concentration can be used to measure competition in the banking industry through the size of banks For example, according to Labour leader Ed Miliband, Britain has one of the most concentrated banking systems in the world with just four banks - Barclays, HSBC, Lloyds Banking Group, and the Royal Bank of Scotland Group controlling 85% of small business lending (Chalabi, 2014) Therefore, these small banks in this local market might conduct M&A to be able to have more competitive to the four biggest banks With dominating the market, these big banks are very powerful to bring significant impacts to the market

Additionally, the high competition also happens between the foreign banks and domestic banks because of globalization Firstly, foreign banks can take a lot of advantages by providing services to many customers not only in one country compared

to domestic banks This can help the operations of foreign banks become more efficient Secondly, the products and services of foreign banks also are more diversified rather than domestic banks This allows foreign banks to spread their risk Moreover, the funding bases of foreign banks are larger than domestic banks and the abilities to access the funds from their parent banks It means that foreign banks can take funds for low costs so they will have good competitive position Lastly, foreign banks might take other numerous advantages from their economies of scale such as high skill labors

On the other hand, foreign banks also meet some barriers and find difficulty in operating compared to domestic banks The local banks might be able to collect more information about customers because they understand clearly about cultures and behaviors of customers in using banking services and products In addition, domestic banks know the policies and procedures better rather than foreign banks Moreover, they can be supported by governments in order to compete to foreign banks

Impact of regulations to competition in the banking industry

Moreover, the regulations also impact to the competition in the banking industry For instance, in October 2009 the European Commission required the UK banks that had received state aid in the crisis to sell off some of their activities in order to encourage more competition in future (Howells, 2010) By increasing the competition, there are several benefits such as cost reduction, making banks operate more efficiently If the banks are highly competitive, they will have to consider the net interest margin carefully to ensure both attractions to customers and profitability In addition, to compete with others, banks will try to provide services with high quality, give aid to customers whenever problems happen…Another reason for encouraging the competition in the bank industry is the concept of “too big to fail” With controlling 85% of small business lending, if there is any problem in these banks, it can bring huge damages for the economy Likewise, a high competitive banking industry could reduce the issues of moral hazard Additionally, making the system more competitive requires that the branches and other assets that are sold off are bought by non-bank firms, or alternatively by banks that do not currently operate in the UK (Howells, 2010) It means that the assets of banks in UK cannot increase by purchasing these activities Furthermore, in September 2013, the Payments Council launched a new free-to-use account switching service - the Current Account Switch Service to help consumers make switching current accounts from one bank to another, simpler, reliable and