Retail banking, 4th edition

31 4 Retail banks and the economy 42 5 Retail banking regulation 53 6 Competition in retail banking 67 Part II INSIDE tHE rEtaIL BaNK 75 7 Retail banking products 76 8 Retail banking ch

Keith Pond

Retail Banking

fourth edition

G

Keith Pond

Retail BanKing

fourth edition

GosbrookG

This edition published in 2017 by

Gosbrook Professional Publishing Ltd

20 Patrick Road

Reading RG4 8DD, UK

www.gosbrook.com

First published in 2007 by

Global Professional Publishing Ltd

Copyright © Gosbrook Professional Publishing Ltd

The right of Keith Pond to be identified as the author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act of 1988.

All rights reserved No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of the publisher Reprographic reproduction is permitted only in accordance with the terms and licences issued

by the Copyright Licencing Agency.

Disclaimer

The author and publisher believe that the sources of information on which this book is based are reliable and have made every effort to ensure the accuracy of the text However, neither the publisher nor the author can accept any legal responsibility whatsoever for consequences that may arise from errors or omissions, or from any opinion or advice given In particular, the contents of this book should in no way be taken to constitute legal advice.

Note

Throughout the text reference is made to fictitious organizations, including ‘Countryside Bank plc’ and ‘Riverside Bank Pte Limited’ These organizations are pure inventions by the author and any resemblance to any organization carrying these names or any similar names is entirely coincidental

ISBN 978 1 912184 00 2 (paperback)

ISBN 978 1 912184 01 9 (hardback)

ISBN 978 1 912184 02 6 (ePub)

ISBN 978 1 912184 03 3 (PDF)

Cover and text design: Anke Ueberberg

Cover image: Matthias Hloucha

to Judy Blink

to my grandchildren, Connor, Dylan, alfie and isabelle

(with thanks for the offer of help, alfie, but apologies that

the publisher did want more than four lines on each page)

and to eric and tracey Dobby for their support,

as publishers, for so many years

List of figures vi

List of tables vii

Preface to the fourth edition viii

Acronyms and abbreviations ix

Glossary xi

Part I tHE rEtaIL BaNKING ENVIrONMENt 1

1 the retail banking environment 2

2 What is retail banking? 17

3 How do retail banks work? 31

4 Retail banks and the economy 42

5 Retail banking regulation 53

6 Competition in retail banking 67

Part II INSIDE tHE rEtaIL BaNK 75

7 Retail banking products 76

8 Retail banking channels 91

9 Payments and payment systems 104

10 Credit appraisal 116

11 Banking securities 129

12 the recovery of money 140

Appendix A Personal credit scoring 151

Appendix B Business lending proposition 154 Appendix C Personal case studies 157

Supplementary material and a tutor Resource

are available from www.gosbrook.com/retailbanking4e

or http://keithpond.co.uk/extras.html

list of figures

1.1 Retail banking environment 3

1.2 Retail banking at work 5

2.1 A timeline of bank consolidation in the UK 18

2.2 Constituent parts of a universal bank 19

2.3 Lenders and borrowers 23

4.1 Liquidity spectrum 44

4.2 Transmission mechanism of monetary policy 49

5.1 Three pillars of Basel II 58

5.2 Functions of the Monetary Authority of Singapore (MAS) 62 5.3 ‘Ring-fencing’ bank assets 65

6.1 Average market share of four largest banks, 2000–07 68

6.2 Porter’s ‘five forces’ model of competition 71

7.1 Evolution of UK banking law 77

7.2 Saver’s life cycle 80

7.3 Insurable risks 86

7.4 Investment risks and returns 88

8.1 Retail banking systems in mid-20th century 93

8.2 Commercial bank branches per 100.000 adults, 2007 and 2014 94 8.3 ATMs per 100,000 population, 2007 and 2014 96

8.4 Anatomy of an ATM transaction 97

8.5 Evolution of internet banking 99

9.4 Anatomy of a mobile cheque transaction (UK) 108

9.5 Anatomy of a debit card 110

9.6 Flow of data and funds in a card transaction 112

9.7 Flow of data and funds in a mobile phone transaction 113 10.1 Lending life cycle 117

10.2 How credit scoring works 126

10.3 Credit-scoring probabilities 128

11.1 Global house prices index 137

12.1 Causes of non-repayment of loans 142

12.2 Bad debt risk strategies 144

12.3 Possible bank actions in bad debt situations 145

list of tables

2.1 Banking losses and compensation (2010–16) 27

2.2 Riverside Bank Pte Ltd balance sheet 28

2.3 Riverside Bank Pte Ltd balance sheet #2 29

2.4 Riverside Bank Pte Ltd balance sheet #3 29

2.5 Riverside Bank Pte Ltd balance sheet #4 29

3.1 Assets on a typical bank balance sheet 32

3.2 Riskiness of banking assets 35

3.3 Liabilities on a typical bank balance sheet 36

3.4 Estimating return on equity (ROE) 38

3.5 Example of interest and liquidity risk 40

4.1 Definitions of monetary aggregates in the UK 46

4.2 Extent of quantitative easing (QE) 50

5.1 Deposit insurance scheme limits – selected countries 55

5.2 Risk-weighted assets of Countryside Bank plc 57

5.3 Capital adequacy of Countryside Bank plc under Basel I 57

5.4 Capital adequacy of Countryside Bank plc under Basel II 60

5.5 Key ratios in Basel I, II and III compared 61

5.6 Types of banking risk 63

7.1 Types of savings account 78

7.2 Types of credit account 81

7.3 Mortgage loans around the world (2016) 83

7.4 Interest-rate types 84

7.5 Ratios of non-interest income to total income 85

7.6 Basic foreign exchange products 90

9.1 Qualities of cash 107

9.2 Typical fees in a card transaction 111

10.1 Common lending mnemonics 119

10.2 Lowest lending rates for retail bank products (selected countries) 124 11.1 Real estate ownership in various countries 131

11.2 Legal systems around the world 133

11.3 Key banking securities (offered by individuals, jointly, by partnerships or

by companies) 136

11.4 Key banking securities (offered by companies only) 136

11.5 Typical considerations when taking UK land as security – DIVAN 138 12.1 Insolvency choices 148

A.1 Riverside Bank Pte Ltd credit-scoring template 152

A.2 CAMPARI assessment 153

B.1 CAMPARI assessment 155

Preface to the fourth edition

Retail banks have undergone considerable changes in the last thirty years – and their capacity to react to economic, environmental, political, social and techno-logical pressures will guarantee further changes in the decades to come This edi-tion updates earlier versions of the book in its treatment of issues surrounding the industry It also emphasizes the priorities of retail banks today, and their regulatory and practical environment

The text itself is divided broadly into two parts, Chapters 1–6 covering banking concepts and the current banking environment, and Chapter 7–12, key retail banking operations

In the first half of the book, we consider what banking actually is and what banks do We discuss some key economic concepts that underpin much banking activity in both historical and modern-day contexts and we examine banking risks, along with some of the ways in which banks overcome or minimize the adverse impact of such risks We go on to review the position of banks within the economy, and their regulation by national and international bodies, and look at a bank’s profitability from the perspective of its annual accounts

In the second half of the book, we cover the key banking transactions – from the different types of bank account and product offered, to the use of payment systems (a necessary adjunct to intermediation) The book goes on to introduce the topic of lending, whereby some key credit risk tools are reviewed and applied, and basic securities are considered as a vital ‘secondary repayment method’ in the event of credit default The book ends with an overview of the recovery of money by means of court action and insolvency procedures

Throughout the book, you should consider the content in relation to ticular examples of practice in your own national and regulatory environment Often the differences in law, history and geography result in different banking responses to familiar questions and challenges This book cannot promise to be

par-an exhaustive review of all such practice, but it employs specific examples to highlight generic principles and common responses to them

While I have made every effort to ensure that the information contained in the text is accurate and up to date, errors may remain and I take full responsi-bility for them Your feedback is welcomed

Keith Pond

Loughborough University

April 2017

Loughborough University for allowing republication of materials previously

FOS Financial Ombudsman Service (UK)

FPC Financial Policy Committee (Bank of England)

FSa Financial Services Authority (UK, defunct)

FSMa 2000 Financial Services and Markets Act 2000 (UK)

G10 Group of 10 industrialized nations

ILa independent legal advice

IPartS integrity, purpose, amount, repayment, terms and security

ISa individual savings account

IVa individual voluntary arrangement

JCCC Joint Credit Card Company (later known as Access)

Libor London inter-bank offered rate

LOLr lender of last resort

LSE London Stock Exchange

LtV loan-to-value

M&a mergers and acquisitions

MarG maturity transformation, asset transformation (or aggregation), risk transformation and geographical location

MaS Monetary Authority of Singapore

3 Cs character, capability, capital

4 Cs 3 Cs plus connection

atM automated teller machine

B2B business-to-business

Basel I 1988 Basel Accord

Basel II 2004 Basel Accord (Revised

Capital Framework)

Basel III 2010–11 Basel Accord

BBa British Bankers’ Association

BCBS Basel Committee on Bank

Supervision

BCOBS Banking Conduct of Business

Sourcebook (UK)

CaMParI character, ability, means,

purpose, amount, repayment and

COB conduct of business

CPI Consumer Price Index

Cra credit reference agency

CrIS character, repayment, incentive

and security

CSFI Centre for Study of Financial

Innovation

CSr corporate social responsibility

CVa company voluntary

arrangement

DIVaN deposit, investigation,

valuation, authorization and

notification

ECB European Central Bank (Euro

area)

EPOS electronic point of sale

Euribor Euro inter-bank offered rate

FCa Financial Conduct Authority

(UK)

acronyms and abbreviations

aCROnYMS anD aBBReViatiOnS

PIN personal identification number

POSB Post Office Savings Bank (Singapore)

PPI payment protection insurance

Pra Prudential Regulation Authority (UK)

PSD Payment Services Directive (European Union)

PSr Payment Services Regulations

2009 (UK)

QE quantitative easing

rar reserve asset ratio

rBS Royal Bank of Scotland

rDr Retail Distribution Review

rOE return on equity

rWas risk-weighted assets

SME small or medium-sized enterprise

SOX US Sarbanes–Oxley Act of 2002

MaSt marketability, ascertainability

of value, simplicity of title and

OECD Organisation for Economic

Co-operation and Development

OFt Office of Fair Trading (UK,

defunct)

P2P peer-to-peer

ParSErS person, amount,

repayment, security, expediency,

remuneration and services

PC personal computer

PCP personal contract plan

PESt political, economic, social and

technological

PEStLE PEST plus legal and ethical/

environmental

by a bank in exchange for a commission or management charge Good asset managers will produce average or above average returns on investments for a low fee.

asymmetric information An economics concept that indicates that two parties to a transaction rarely have equal amounts of relevant information available In a lending scenario this is often seen

as the borrower knowing far more about the riskiness of the loan than the lender and it is up to the lender

to find out enough information on which to base a decision

automated teller machine ‘Teller’

is an old Scottish name for a bank cashier Adopted by the United States, the ATM automates some functions of the cashier

Bad debt Also known as performing loans (NPL), these are debts that will not be fully repaid Banks anticipate non-repayment on some loans and write the value of these down in their balance sheet

non-Bancassurance Name given to banks that have purchased or created insurance companies and pension funds as part of their ‘universal’ status

Bank statement Regular (typically monthly) account sent to the customer listing balances and transactions since the last statement Can be paper based or on-line

Bankruptcy A legal end to debt contracts whereby a debtor is

glossary

adverse selection This risk refers to

the fact that the most creditworthy

customers do not need to borrow

and only those without current

funds of their own request credit

Adverse selection is also heightened

by information asymmetry – that is,

the situation in which the borrower

has information that the bank does

not, which could change the bank’s

risk assessment if it were to be

revealed

alternative providers This describes

challenger banks and other

providers of banking facilities,

such as payment systems, loans

or savings accounts Peer-to-peer

lenders fall into this category

asset Typically, a revenue earning

item owned by a company and

accounted for on its Balance Sheet

In a manufacturing company an

asset would be its factory premises

In a bank an asset would be a loan

to a consumer

asset and liability management ALM

is the term given to balance sheet

management by a bank Banks must

not only maintain liquidity through

the maturities of loans and deposits

but also capital adequacy in terms

of risk assets ALM techniques,

deployed on a daily basis help

the bank to achieve liquidity and

strategic objectives such as balance

sheet growth

asset management A type of banking

where funds, owned by investors,

such as pension funds, are managed

Card scheme The global brand of companies such as Visa, Mastercard and JCB, that individual bank payment cards can be affiliated with Belonging to a card scheme ensures acceptance of cards globally

Central Bank The national bank

of a nation or currency area that determines interest rates for that area, acts as banker to the banks and provides liquidity in the markets (typically as a lender of last resort) The Bank of England, European Central Bank and Bank Nagara (Malaysia) are all examples

Cheque „Bill of Exchange A cheque

is a Bill of Exchange drawn on a bank rather than on another person

Collateral See also Security

A contract ‘side by side’ with a loan contract, typically providing rights

to a lender over a valuable asset as

a secondary or back-up repayment mechanism for a loan

Commercial banking Loose term used

to describe bank operations with consumer, business and corporate customers – client facing banks

Conditional purchase/Hire purchase Allows buyer to pay a deposit and then agree a loan for a fixed period, e.g 3 years for asset purchase Only after loan is repaid

is ownership of asset transferred to buyer

Consumer Price Index (CPI) A measure of inflation, typically estimated by governments based on the changes in prices of a ‘basket of goods’ available to consumers

Credit card A payment card issued to

an individual allowing the holder to draw on a revolving credit facility

Credit Crunch Any period of

relieved of the debt liability in

exchange for a period of financial

exclusion and release of available

assets and income to creditors

Basel accords The global regulatory

accords affecting internationally

active banks were first agreed in

the Swiss city of Basel and made

effective in 1988 The accords are

now in their third iteration

Bill of Exchange A payment

instrument used largely in

international trade (cheques are also

a form of Bill of Exchange) A bill

is a written instruction, drawn on

a person, to pay a specified sum in

money at some determinable time

to the bearer or named payee The

important features here are that

Bills can be payable in the future, to

whoever presents them or to whom

they are endorsed but only for a

specified sum

Bonds/Bills A bond is the name

given to corporate loans offered

by borrowers to the market A

borrower’s credit rating will help to

determine the interest rate attached

to the bond A bill is, typically, a

loan offered by the government –

Treasury bills are an example

Branch The physical local outlet for a

bank

Broking This activity comprises

buying and selling commodities,

financial instruments etc typically

for a commission rather than by

putting the broker’s own capital at

risk

Capital adequacy An integral part

of the Basel accords relating to the

amount of capital (Tier 1 equity and

Tier 2 capital) that a bank must hold

to cover the appropriate portion of

‘FinanCe COMPanY’

One example is a securitized loan package – derived from the loan obligations owed to a bank, bundled

up and sold in tranches to investors

Direct banking Phone or internet banking that is provided without the need for branches

Direct debit A payment instruction requested by the payer whereby the payee draws a specified or unspecified sum from the payer’s bank account on a regular basis Used to effect regular payments such

as loan repayments

Disintermediation The phenomenon whereby surplus and deficit units within an economy transact the deposit of funds/borrowing of money without the need for an intermediary such as a bank

P2P lending is an example of disintermediation

Equity A generic term relating to the

‘free’ balance available to the owner

of the asset or company Equity and reserves of profit on a balance sheet equate to the net worth of the company – assets minus liabilities For an asset held as security the value of the asset minus the amount required to repay the mortgage on the asset is ‘equity’

Exchange rate The rate of exchange between one national currency and another Impacted by relative interest rates as well as demand and supply and the stability/economic health of a nation

Exotic securities A colloquial term encompassing derivatives, complex financial instruments etc

Finance company Financial services company or part of a bank offering conditional purchase, hire purchase

availability to and from banks The

most recent example was in 2007–08

a part of which was the reluctance of

banks to provide liquidity to some

other banks

Credit score An index measure

relating to the creditworthiness of

individuals and businesses built

from reliable and available data and

based on the probability of default

as experienced by banks Credit

scores are typically reliable for

consumer loans and afford very

low-cost credit decision making

Credit transfer/Bank giro credit Paper

or digital/internet payment between

bank accounts Salaries, utility bills

and credit card bills can be paid

through CT/BGT mechanisms

Debit card A payment card issued to

an individual allowing the holder to

draw on a bank account

Deposit insurance Part of the

consumer protection for depositors

in regulated financial institutions

whereby a maximum (differs

between countries) monetary

amount is paid out if a deposit is

lost through the failure of a bank

The provision of deposit insurance

is supposed to give confidence to

depositors NOT to create a run on a

bank

Deregulation The removal of barriers

to trade In financial services

this can relate to the removal of

distinctions between stock jobbers

and brokers in 1986 (UK) so that

firms could perform both functions

and allow markets to work more

efficiently Often accompanied by

regulation to ensure that institutions

do not take disproportionate risks

Derivatives Financial instruments

derived from other transactions

rent the property to tenants The latter is also known as a ‘Buy to Let’ mortgage

Hire purchase „Conditional purchase Independent legal advice A

protection against legal ‘mistake’,

‘misrepresentation’ and possible

‘undue influence’ through which

a security form or loan agreement

is signed by the depositor/

borrower after advice is given by an independent solicitor

Information asymmetry The basic economic premise within any transaction whereby one party to the transaction holds more information, typically about risk, than the other It is particularly important

to recognize in loan or insurance agreements

Insolvency The situation where an individual or company cannot pay their debts as they fall due

Intensive care The colloquial name given to specialist departments within banks that nurse and hope

to rehabilitate financially distressed clients without recourse to formal insolvency procedures

Interchange fees Fees charged in a payment card transaction (credit or debit) by the Card Scheme

Intermediation Banks acting as

‘middlemen’ between lenders and borrowers in an economy and, importantly, taking on the risk of non-payment of loans by being liable for the repayment of all deposits

Internal ratings-based approach An aspect of the Basel I and Basel III accords IRB allows banks to estimate their own risk values for risk assets Regulators vet and

and leasing finance to consumers

and businesses

Fixed interest rate The rate is fixed at

the start of the loan period, resulting

in a fixed repayment amount

regard-less of movements in base rates

Floating charge Corporate security

covering all assets owned by a

company not subject to a fixed

charge The charge also allows

the holder (lender) to appoint an

Administrator in an insolvency

situation

Forward An agreement by a bank to

buy or sell currency at an agreed

rate at some time in the future Risk

of currency fluctuation is removed

for the buyer/seller as the rate of

exchange is known in advance

Forward contracts, once agreed,

must always be carried out

Freehold Ownership of land in

perpetuity in UK law Similar

concepts apply in many other states

Futures An agreement by a bank to

buy or sell currency at an agreed

rate at some time in the future Risk

of currency fluctuation is removed

for the buyer/seller as the rate of

exchange is known in advance

These differ from Forward contracts,

as they can be discarded by the

purchaser if the rate on the day of

the delivery of currency is more

favourable

Guarantee A promise (usually in

writing) for one person to pay the

debts of another if the borrower

defaults

House mortgage A term loan for

financing house purchase and

secured on the house/property

acquired Typically with monthly

repayments these can be available to

Liability A liability is something that is owed by an individual A borrower has a liability to the lender for the debt created A bank has a liability to depositors for the amount

of the deposit

Liabilities under guarantees can be said to be ‘contingent liabilities’ since a separate event is needed to trigger the liability

LIBOr London InterBank Offered Rate The rate of interest, set daily,

as the agreed rate at which financial institutions lend each other funds, normally for short periods As a cost of funds it becomes a clear benchmark for setting interest rates for customer loans Other financial centres such as the EU (EURIBOR) and Singapore (SIBOR) have their own, similar rate setting process

Life policy A contract between an individual and a Life Office whereby the Life Office agrees to pay a lump sum to the beneficiaries of the individual upon the death of that person Endowment Life policies also provide a savings element and can provide a lump sum at a certain time in the future (e.g age 60) or death, whichever is the earliest

Liquidation The bankruptcy of a company in UK law whereby the assets of the company are sold (liquidated) and shared amongst the company’s creditors in an order of priority set by law

Liquidity The ease with which assets

on a balance sheet can be converted

to cash

IRB allows larger banks to use

capital more efficiently than simple

application of the standard Basel

risk weightings

Internet banking „Direct banking

The key feature of internet banking

is that the customer carries out

many of the transaction processes

formerly reserved for banks, thereby

reducing the cost of transactions

Investment banking The type of

banking whereby banks handle

investments in financial markets for

their own account and on a broking

basis for clients

Islamic finance Generic term for

financial products that comply with

Sharia law Islamic Finance products

enter profit sharing agreements with

the recipients of funds as interest

payments are not allowed Deposits

do not attract interest

Land Real Estate and all that is

built on it Different national legal

systems ascribe different definitions

to ownership and the rights of the

owner As a scarce resource in high

demand (depending on location)

land can be a good security as it

rises in value over time

Leasehold Ownership of land for a

period of time in UK law Similar

concepts apply in other states

Leasing The rental of an asset for a

specified period, with the option to

buy the asset at a predetermined

price at the end of the period

or otherwise to hand back the

asset Common in relation to cars,

whereby the leasing company

restricts annual mileage to maintain

resale value of the vehicle

Letter of credit An instrument of

international trade backed by an

issuing bank whereby the holder can

hands of a small number of firms This can allow for anti-competitive actions, collusion between firms etc and is reviewed by governments in order to protect consumers

Ombudsman Literally ‘Complaints Person’ typically appointed under a regulatory regime to be an arbitrator for complaints against institutions such as banks The FCA employs a Financial Services Ombudsman

Option A financial transaction that gives the buyer the option to buy or sell a commodity at an agreed price

at some time in the future Like currency futures the option may not

be exercised if the prevailing price

is worse or better than the option price

Outsourcing A simple business mechanism whereby a firm contracts with an outside company

to perform a specific function A hotel may ‘outsource’ its laundry

to a laundry company A bank may outsource non-core activities such as printing, cheque processing, credit score compilation, to an outside agency

Overdraft The setting of a credit limit on a current account in a bank provides a revolving credit facility for a period of time for the account holder

Pay day loans Loans provided by non-bank lenders that, typically, are repaid when a borrower’s salary

is received Often such loans are available to less creditworthy clients and at higher than average interest rates

Payment Protection Insurance (PPI) Insurance that pays loan instalments should the holder

Loan-to-value (LtV) ratio Typically

the maximum percentage that a

bank will lend against the value of

an asset deposited as security LTV

ratios can be statutory or determined

by market forces depending on the

country involved

Merchant bank UK name (historic)

for a bank undertaking Investment

Bank functions

Mobile banking Banking facilities that

can be accessed via mobile phones

or tablets A previous era saw bank

branches contained within vans

or lorries being driven to remote

communities

Monetary Policy Committee The repo

rate setting committee of the Bank

of England

Money laundering The process by

which illegally obtained funds

(including tax avoidance schemes)

are ‘washed’ through bank accounts

so that authorities cannot discover

their source Bank vigilance

in opening accounts and bank

knowledge of the source of funds

credited to accounts is often backed

by criminal sanctions and fines

against banks

Money supply The amount of money

in circulation within a defined

economy The amount of money

and its speed of circulation offer

monetary authorities tools to

influence purchasing power in an

economy

Moral hazard This is the risk that a

borrower may act in such a way that

the level of risk changes after the

loan has been granted – possibly

because of the ‘safety net’ that bank

support provides

Oligopoly A market structure where

ring-fencing The financial isolation of retail banks within Universal bank structures following implementation

of the UK Vickers Report

risk-weighted assets An aspect of the Basel accords that assign discount rates or ‘risk weights’ to bank assets based on the risk of default A banks total risk weighted assets must be covered by a certain amount of capital

Security Term used to describe a valuable asset deposited as collateral for the performance of an obligation

In this way the right to sell a house

is given via a charge or mortgage to

a lender to be used if the borrower fails to repay the mortgage loan

Settlement The completion of a payment transaction through which the seller obtains the cash proceeds

of the sale

Sharia law „Islamic finance Special purpose vehicle

A company set up by (some) banks

to transact ‘exotic’ off balance sheet transactions in the years leading up to the 2007/08 credit crunch By establishing the SPV the liabilities created by the derivatives/securitizations of assets were not reported on the main bank balance sheet

Spot The purchase/sale of currency at the prevailing rate on the day of the transaction

work through illness PPI gained a

poor reputation in the credit crunch

of 2007/08 in the UK as it was

mis-sold to some borrowers

Peer-to-peer (P2P) lender See also

Disintermediation P2P lenders

facilitate the interaction of investors

with funds to lend and borrowers

(typically business borrowers) P2P

companies are not intermediaries in

the financial sense since they do not

absorb the lending risk but pass on

bad debts to the investors

Personal loan A loan to a consumer

for a fixed amount and fixed period

attracting monthly repayments

These loans are often used for asset

purchase or consolidation and

reduction of multiple debts

Private bank A bank or part of a bank

that specializes in the investment

preferences of a small number of

wealthy clients

Quantitative easing (QE) A tool of

monetary policy used when interest

rate changes can no longer impact

money supply (i.e when they are

already low) QE works by the

central bank buying bank assets for

cash, thus injecting liquidity into the

system to allow more credit to be

created

regulation Banks are subject to

systematic regulation (of the

industry/markets as a whole),

prudential regulation (rules to

ensure that banks are adequately

capitalized and liquid) and conduct

of business regulation (consumer

protection rules and codes of

conduct)

repo rate The official name given

to the base lending rate or Bank

rate by which the Bank of England

discounts short-term bills from

trade finance Term encompassing all financial instruments and processes that facilitate import and export trade, such as Bills of Exchange and Documentary credits as well as currency exchange facilities.

Universal bank Financial Services organizations that group together many different types of banking and financial services offerings

Variable/standard interest rate Bank standard mortgage rates, constructed based on cost of funds, liquidity and risk premiums May stay static even when base rates change

Virtual bank A bank that has no physical presence such as branches but transacts its businesses and processes via the internet

Zombie Company A company kept solvent only by the lending bank continuing to offer facilities Such companies are barely profitable and provide just enough cash flow to pay debt service charges

Spread Relates to interest rates where

a bank strives to maximize the

spread between the rate paid for

funds and the amount earned from

loans

Sub-prime Credit facilities, such as

mortgages and loans offered to low

creditworthy individuals These are

often marked by higher than average

interest rate costs and higher than

average risk

Swaps Instruments and deals in

currency exchange or interest rate

exchange between bank customer

accounts (normally corporate)

whereby the benefits of a future

exchange rate or interest rate agreed

with a provider is swapped or

exchanged with another company

that has different needs In this

way both companies can, in theory,

reduce risk and reduce costs

total debt servicing requirement

(tDSr) Singapore regulatory term,

mirrored in other jurisdictions,

relating to the ability of a consumer

to service debt For loans such as

house mortgages the repayments

and interest must be well within a

consumer’s budget

tHE rEtaIL BaNKING ENVIrONMENt

the retail banking environment

objectives

after studying this chapter, you should be able to:

describe the environments within which retail banks operate in a number of countries,

op-Although the chapter reviews these issues, the picture is dynamic and what have been influential issues in the past may not be so in the future In addition, it should be noted that while some issues are predictable and long-term in nature, such as population and other demographic issues, others are less predictable and may strike swiftly, such as a bank failure Many issues are complex and inter-related, defying categorization within the PESTLE framework In the European Union, for example, we have seen that a social issue, such as the ageing popula-tion and pensions crisis, can become a political issue and may result in new leg-islation or regulation The political implications are clear, social feeling is intense

Overall, any analysis should set the scene for understanding how and why bank strategies shift in the medium and longer terms, and where and how the retail banking features described in this book gain significance However, re-tail banking should not be seen from the perspective of the banks alone Retail banking is about people: bank staff and customers; shareholders and pensioners; borrowers and lenders Figure 1.1 illustrates the way in which banks and the people involved with banks are nested within a business framework that exists within a competitive market that is influenced by external forces

While the figure simplifies the interrelationships of environment, market and

a banking business, it also envelops two key ideas that you should keep in mind

as you read through this book: that the speed and complexity of change is able; and that managing risk is a bank’s own responsibility Major changes in the external environment, such as new regulation, economic growth or contrac-tion, and drops in business confidence, happen reasonably gradually and are often relatively easy to forecast Retail banks are able to plan and manoeuvre so that they can weather some such storms or benefit from favourable conditions, but they can rarely influence these drivers and are never able to control them Moreover, sudden and complex change – such as the 2007–08 financial crisis and credit crunch, or an oil crisis such as that which occurred in the 1970s – takes all organizations by surprise Those surviving are those that have sufficiently strong resources to resist the buffeting – but even they are at the mercy of the waves

vari-In the next layer in Figure 1.1, the competitive (operating or market) ment, the typical retail bank is still at the mercy of decisions made by competi-tors and new entrants to the market, but has rather more influence over its own response, its own plans and the ability of competitors to take advantage We rec-ognize this in Chapter 6 when we look at the extent to which many retail banks operate in markets that they dominate

environ-A retail bank, like any other organization, has most influence and control over its own business resources – that is, its structures, people and systems How the

External environment Competitive environment Business resources People

Decision makers Customers Lenders Borrowers

Domestic and international banks

Alternative providers

Assets and liabilities Products Brand image Risk appetite

The macro-economy Interest rates Regulation Society Technology

tHe Retail BanKing enViROnMent

bank marshals these to meet the uncertainties of the external and competitive environments is the key to its survival and success At the centre of the model – and the bank – are its people Banks rely on the skills and decision-making abili-ties of key staff, investing heavily in training and systems to support them

As you progress through this book, take time to consider how different banks might, or do, respond to the factors described

rEtaIL BaNKING

Retail banks are defined by the products they offer to the general public though different banks organize their operational units in different ways, some-times dealing with large corporate customers separately, the working definition

Al-of ‘retail banking’ for the purposes Al-of this text is: the Al-offering Al-of banking and other financial services to individuals and micro, small or medium-sized enter-prises (MSMEs)

Retail banks are often prominent in their communities, with a physical ence in towns and cities The advent of phone banking and internet banking, how-ever, has expanded the definition of retail banking Most banks with traditional branches also boast direct phone, mobile and internet banking as additional or alternative services for customers Some smaller organizations run internet- or mobile-only banks, saving themselves the costs of ‘bricks and mortar’, reducing their staffing requirements and even outsourcing key activities, such as database maintenance, call centres and plastic card production These can be almost ‘vir-tual’ banks, but although this increases competition, variety and creativity in the market, they really do nothing fundamentally different from the traditional branch-based banks

pres-A fuller description of key retail banking products and services is given later

in the book, when we review customers and their banking relationships; for now,

it is sufficient to categorize the products into two types – that is, interest-based and non-interest-based financial services The key distinction here is the nature

of the income gained by banks from these different activities Accepting deposits and granting loans provides banks with the opportunity to gain interest income Clearly, savings interest rates will be lower than loan rates and banks must de-duct their costs of operation from the difference if they are to arrive at a profit

We will see in Chapter 7 that some 50 per cent of bank incomes arise from these net interest earnings

The less risky – and also less profitable – area of income generation is the sale of financial services such as insurance, life assurance, pensions, foreign ex-change, and share purchase and sale An important part of bank income is also generated by the fees charged for arranging larger loans, for the transmission of money and as charges for unauthorized overdrafts

Figure 1.2 summarizes the value loop that retail banks operate It is a ‘value loop’ rather than a ‘value chain’ since suppliers (that is, those with deposits to

Retail BanKing

loop also mimics the flow of income in an economy What is clear is that the resources that flow through the loop and fuel banking are twofold: money and information

Retail banks collect funds from depositors to lend to borrowers From each interaction, the bank’s store of information about its market, its customer base and its environment is enhanced Retail banks use that information in pursuit

of their own profits – by selecting low-risk borrowers and potential buyers of financial services

The market is served by a variety of delivery channels either owned or shared

by banks Banks jostle for market position by varying the services that they vide, differentiating their offerings by means of brand awareness, service quality and risk management

of the national economy relies heavily on the banking system being stable and responsive to change

By 2006, the same survey suggested that the biggest risk was now the rise in

‘exotic’ financial instruments that were very complex and poorly understood,

Money and information management

tHe Retail BanKing enViROnMent

as well as poorly regulated (CSFI, 2008) In 2008, senior bankers reported bank liquidity as their top concern, although they focused on the lack of market li-quidity rather than on its potential regulation (CSFI, 2008) Moreover, as the credit crunch took hold, bankers were reflecting on their poor understanding of the financial forces that had heralded disaster

By 2012, respondents to the survey were focusing on macroeconomic tainty and the credit risk that stemmed from it (CSFI, 2012) Liquidity remained key in the list of concerns, but political interference and regulation had been relegated to sixth place

uncer-In 2016, political change in Europe and in the United States was doing little to settle these nerves, but the key issues reported could be said to be internal issues over which banks themselves are capable of exerting control or influence (CSFI, 2016) Focusing on the topic of financial inclusion, the annual survey suggested that a bank’s own strategy and risk management systems were respondents’ key concerns, with risk from regulation dropping in importance, but macroeconomic issues rising

It is clear, then, that the risks to retail banks are ever changing and ever creasing in complexity, with threats arising from areas as diverse as criminality, competition, repayment capacity and technology

in-POLItICaL aND LEGaL DrIVErS

As we will see in later chapters in the book, banks must keep legislation and case law under constant close scrutiny, because changes in statutes can require changes to operational procedures, can introduce new risks and almost invari-ably result in higher costs

The sources of law and regulation for retail banks are numerous and include (but are not limited to):

the government(s) of the country (or countries) in which the bank

•

operates,

the national courts (with appeals to the European Court of Human Rights

•

or the International Court of Justice in some cases),

central banks and national regulators,

POlitiCal anD legal DRiVeRS

The key sources of law will be seen in action in various chapters of this text This chapter covers only the key themes, rather than the detail

regulation

Many governments around the world see regulation as necessary to ensure that customers are protected Such regulation also acts to improve consumer confi-dence in financial services It ensures that consumers receive a good level of clear information about the financial products they are purchasing, inherent in which

is a warning about the risks involved

Regulation also helps to reduce criminal activity in the sector When the dustry was unregulated, it was easier for fraudsters to pass themselves off as investment advisers and thereby commit theft; now, investment advisers must

in-be appropriately qualified and are keenly regulated Moreover, the market centration of banking firms in many countries (see Chapter 6) can lead to abuse

con-of monopoly or oligopoly power and regulation is commonly in place to reduce the adverse effects of this situation

The regulation of capital adequacy, the aim of which is to prevent bank ures, is dealt with in more detail in Chapter 5, together with other major areas

fail-of regulation affecting retail banks Before 1988, national supervisory authorities such as the Bank of England in the UK oversaw the banks in their own countries Some high-profile bank failures and the subsequent harmful effects to domestic economies led the G10 countries to act to try to prevent this in the future The result, known as the Basel Accord (or Basel I), was followed by a second Accord effective in 2007 (Basel II) The global financial crisis that followed swiftly on its heels gave rise to further changes and stronger regulation of bank liquidity is consequently seen in the latest adaptation of the Accord (Basel III)

Supervisory regulation is detailed in Chapter 6 Here, it is sufficient to derstand that while the regulatory rules – such as those issued by the Financial Conduct Authority (FCA) in the UK or the Monetary Authority of Singapore (MAS) – are comprehensive and often seen as burdensome by bank staff, they are risk-based – that is, based on the key risks in banking and aiming to ensure that individual institutions do not undertake more risk than they can manage, physically or financially This is particularly important owing to the huge web

un-of inter-bank transactions in the modern financial services environment and the increasing complexity of financial instruments, such as derivatives and futures (for more information on which, see Stoakes, 2015) In theory, the failure of one bank could cause problems for others in the system and for the economy as a whole as a result of knock-on, or ‘contagion’, effects

We might also consider, briefly, the US Sarbanes–Oxley Act of 2002 (SOX) The aim of the US legislators was to restore confidence after the corporate collapses

of Enron and Worldcom, and to remove any doubt regarding the quality and ability of audited accounts The legislation is extraterritorial and consequently affects any UK company (including banks) that seeks a listing on the US ex-changes For UK banks and financial institutions, this means incurring the extra

reli-tHe Retail BanKing enViROnMent

costs of complying with a further audit standard It also potentially risks conflict with some areas of UK corporate governance In the UK, for example, statute and custom gives shareholders rights and voting power in meetings; by contrast,

US shareholders have little influence and must seek redress in the courts if they consider themselves to have been wronged

Taken together, the instruments and bodies that regulate banks are targeted at protecting the consumer from unfairness, from loss resulting from the reckless-ness of an individual bank and from economic instability These themes will be seen again in subsequent chapters

The 1980s were an unprecedented period of deregulation and financial alization throughout the developed world In 1979, the UK saw the removal of exchange controls that had been in place since the Second World War, allowing for freer capital movements between financial centres and helping London to be-come a global financial centre One effect of this was an increase in the number

liber-of international banks with a presence in the UK – although few liber-of these tured into the retail market at first

ven-In the UK, 1986 was a watershed for financial services institutions The reform

of the London Stock Exchange (LSE) – known as the ‘Big Bang’ – saw the ket’s previously protected firms now open to competition The banks perceived a golden opportunity to buy stockbroking firms and gain a foothold in the equities markets While some later came to regret their purchases, this willingness to in-vest was a sure sign of the widening scope of banks and a pointer towards their coming transformation into financial conglomerates

mar-It had been hoped that the picture emerging over the subsequent three cades would be one of increased competition – but this failed to materialize in all banking markets Pressures to grow, to provide better returns to shareholders, to achieve economies of scale and to achieve adequacy of capital to cover perceived risks all combined to militate against the aims of deregulation Instead, these and other drivers acted to increase merger activity and to further reduce the number

de-of institutions – with competition authorities sometimes stepping in to remedy the threat of oligopoly In retail banking in the UK, this was seen most keenly during the credit crunch, when EU rules on state aid required Royal Bank of Scot-land (RBS) Group and Lloyds Banking Group to divest themselves of branches.Regulation is thus a mixture of international agreements, national laws, market pressures and self-control It is a complex area to study, but this brief introduction and the following chapters aim to outline the most crucial areas of

eCOnOMiC DRiVeRS

ECONOMIC DrIVErS

This section concentrates on the impact on retail banking of macroeconomic ditions, including economic growth and inflation, among other things Dealing with money and, ultimately, consumer confidence, banks are particularly prone

con-to negative impacts on their business cycle To some extent, strategic decisions

to expand operations into another country, or globally, or to diversify product ferings can be seen as a way of mitigating against economic risks and protecting income in times of instability Global bank HSBC, for example, treats Asia, South America, and Europe and the United States as three distinct operations in the hope that any weakness in one regional economy will be offset by strength in the others

of-Since the economic downturn of the early 1980s, it has become clear that bank profits boom during times of growth and fall during recession, largely owing to bad debt write-offs Most of this volatility relates to the savings and loans part

of the business, and is affected by consumer incomes and their propensity to save or invest (which is greater when incomes are high) and to repay borrowing (which is lower when incomes fall) In the UK, because so many people in the UK aspire to owning their own homes, property prices are seen as a barometer – and sometimes a cause – of increased propensity to borrow This driver is not as ap-parent in mainland Europe, where long-term renting is more prevalent

In the 1980s, banks responded to losses by diversifying and increasing the contribution of fee-based services to their incomes, especially in the domestic markets They engaged in further merger activity and in swathes of redundan-cies, investing heavily in new technology as a way in which to further reduce staffing costs

Periods of recession since then have inevitably been associated with low ficial interest rates Low interest rates, however, are a double-edged sword for banks: while they allow capital to be raised more cheaply, and lower interest rates to be offered to depositors and relatively low rates to borrowers, helping to increase customers’ hunger for credit, doing so can mean that a bank stores up problems for the future

of-Consider the dilemma

With

• high inflation and interest rates (the two go hand in hand), a mortgage borrower may struggle to pay interest on a loan from their monthly salary This will limit the amount borrowed in the first place, meaning that there is less capital to repay In addition, the high inflation will erode the value of the capital sum, making that easier to repay in the longer run out of future income

Low

• inflation and interest rates increase the amount that can be

borrowed, because monthly interest is easier to pay This means that there

is a greater capital sum to repay Inflation, however, does not erode the capital sum and so this becomes relatively more difficult to repay from future earnings In the event that the borrower defaults on the loan (that

tHe Retail BanKing enViROnMent

is, does not pay it), the bank can seize and sell the property on which the mortgage is secured, but the proceeds may not be enough to repay the loan in full

It has also been suggested, based on the evidence that emerged during the cial crisis, that low interest rates and margins may prompt banks to engage in the riskier activities that offer the promise of bigger returns Rather than spread risk across a wider range of investors, banks were seen to have assumed ever more risk in an effort to boost short-term gains

finan-In a similar way, those relying on savings and investments or pensions backed

by shares will see lower returns during times of low inflation, and so an vidual must sacrifice more current income to provide a good pension Since few people do so, this this too stores up problems for the future – and the only way

indi-in which we might avoid a crisis is by improvindi-ing findi-inancial education The fear is that many individuals will reach retirement with large loans to repay and insuf-ficient income from pensions

Until 2007, institutions were typically strong and profitable, and most were well capitalized based on accepted measures Bank failures were rare; when they did occur, it was because of poor management and inadequate supervision rather than a lack of capital The consumer credit cycle became a threat, however, with improving incomes, rising asset prices, consumer confidence and expectations, and low interest rates all combining to create a boom in consumer borrowing.The UK bank Northern Rock (NR) is a key example of what could go wrong Newcastle-based NR was a major house mortgage lender Its growth in mortgage business was facilitated not only by market optimism in housing in the UK, but also by the availability of liquidity and funding through inter-bank lending and securitization of loans While the Treasury Committee report (House of Com-mons, 2008) found little evidence of recklessness in lending, it did highlight the withdrawal of funding by concerned financial institutions and the subsequent

‘run’ on the bank by depositors as evidence that the business model was tainable Doubts over one bank soon spread to others using similar models

unsus-By 2016, retail banks had written off much of the bad debt accumulated in the years before 2007, but there are suspicions that yet more will come For some companies – known as ‘zombie companies’ – the banks have rolled loans over, allowing the company to pay interest only in the hope that it will help it to re-main a going concern Should that not be the case, the consequences will be yet further write-offs

Clearly, then, banks are very prone to changes in the economic cycle and this has been amply demonstrated in the turmoil since the global financial crisis – and its consequences seen clearly in the subsequent credit crunch

SOCIaL DrIVErS

Like all businesses, banks rely on the demand created by individuals and

in-SOCial DRiVeRS

activity increase, banks can grow, and retail banks have largely benefited from this over the years Changes in our demographics and social norms, however, ensure that banks need to maintain constant vigilance if they are to provide the products and services that people actually want to buy

Some key trends over recent years have included:

a demand for immigration to fill job gaps, to a change in traditional family roles and to the employment of individuals until well past retirement age

To some extent, this is good news, but – like low inflation (see ‘Economic drivers’) – it can store up problems for the future Most particularly, this is al-ready being recognized in terms of the looming pensions crisis that is a key concern for both government and providers, as well as individuals

The crucial thing about social change is that banks must respond in both the short and the longer terms to these changes In terms of the pensions crisis, state pensions to retirees are funded from the National Insurance contributions of those currently in work With a growing disparity between increasing numbers

of retired people and fewer individuals of working age, a ‘black hole’ emerges

in the nation’s finances People are therefore being encouraged to provide more for their own retirements and not to rely solely on the state – and banks are responding to this by offering products that can make this additional saving possible

Managed immigration aiming to swell the workforce, along with an enlarged European Union within which workers have freedom of movement, has also led

to a diverse and ethnically mixed society This diversity has informed banks’ cisions to offer alternatives to traditional banking systems and products that will meet the various cultural and religious needs Even so, in some cultures, families are the first resort for credit, rather than banks, and extended families can ob-viate the need for substantial pension provision In short, traditional planning assumptions for the banking needs of a domestic population must be amended

de-to reflect social change

One interesting example of social change in the UK is the increasing sion of Islamic finance by mainstream banks ‘Islamic finance’ is a generic term

provi-tHe Retail BanKing enViROnMent

used to describe the types of financial product acceptable to Muslims under Sharia law (that is, the rules of their religion) Since Islam forbids the charging and payment of interest, many traditional banking products would fall foul of Sharia; hence banks offering Islamic finance construct deals that are based on lease mechanisms to the borrower or which offer rewards to the depositor, but

on which interest is neither charged nor paid

Among other social trends – some a by-product of increasing economic perity and government policies through the years – are rising consumer aspira-tions and increased financial self-reliance The boom in consumer credit in the years before 2007 owed as much to as to consumers’ desires to own the nicest home, the newest car and the latest electronic gadgets, and to go on exotic holi-days that were the preserve of the super-rich among their parents’ and grandpar-ents’ generations, as it does to the ready availability of credit Such aspirations have grown as educational standards have improved – and as mass media have shown us the possibilities

pros-At the same time, however, decreasing state support has demanded greater self-reliance Three areas worth mentioning here are pensions, home ownership and student loans All of these demands fuel a need for better-paid jobs and these, in turn, rely on an ever-growing economy – but some of these expecta-tions remain unmet, and the backlash is damaging the trust that former genera-tions had in government and banking institutions To some extent, that trust was commonly built on a direct, personal relationship with the ‘bank manager’;

it can consequently be argued that banks are now reaping the results of years of branch closures, staffing cuts and distancing customers by offering them remote banking facilities Further, the impact of the financial crisis and credit crunch has been a loss of trust globally in financial institutions – and trust is central to the smooth running of a credit-creating banking system Banks are consequently having to work hard to regain the trust of depositors and, in the meantime, they face the immediate consequence of bad debt: large numbers of bankruptcies in the UK are an indication that people are increasingly willing to turn to alterna-tives to repaying credit in full

Finally, banks must reflect changing social attitudes to the environment and

to ethical behaviour As global institutions, many banks play a key role in the nancing of civil and residential construction and industrialization Increasingly, shareholders, customers, staff and governments require environmental audits of projects, so that their benefits can be weighed against their economic and envi-ronmental costs Such audits may be published in corporate social responsibility (CSR) reports that are common among today’s banks, which recognize the value

fi-of delivering on their stakeholders’ desire to hold them to account

While this is necessarily only a summary introduction to the social forces driving the banking industry, it does serve to illustrate that banks cannot allow their strategies and stances to be static – that they must reflect social trends in their offerings – and that those banks that innovate that will survive into the future

teCHnOlOgiCal DRiVeRS

tECHNOLOGICaL DrIVErS

While some of the technologies that have become key delivery mechanisms for banks will be examined in more detail in later chapters, this section will offer an introduction to the use of technology and its implications with reference to the core competencies of banks, including:

Technology and computerization has accelerated in complexity, reliability and availability over the last sixty years From the first modern computers in the 1940s (machines so big they could fill an entire office block) to today’s smart-phones and tablets, banks have tried to harness the benefits of technology to support core functions

Banks gather and store large amounts of information about us, including formation on our jobs, homes, spending, and credit and repayment records They know when and where we spend our money, and they can forecast when we may need particular banking services The information is most obviously used in analysing the creditworthiness of customers and judging the credit risk inherent

in-in lendin-ing proposals Additionally, banks are in-in a unique position to monitor the repayment of loans and to forecast when problems can arise This can prompt them to take action to remedy a situation or to renegotiate a loan so that repay-ment is assured

Banks also communicate worldwide via computers, allowing them to offer access to world markets to their clients While most domestic clients will not require such wide-reaching services, the same basic technology is used to make customer information available at any branch or any internet terminal, allowing the customer to transact business at any branch or remotely (Years ago, cus-tomers had to attend their own branches to transact business.) Such commu-nication power also allows banks to interact with each other, providing swifter settlement of inter-bank debts, and offering access to stock exchange, insurance, investment and currency exchange services

Banks’ own costs can also be affected by technology In the short run, ment in computing power can be expensive both in financial terms and in poten-tial reputational terms if it does not work as expected Some banks have suffered bad publicity and experienced a decline in consumer trust when their internet

invest-tHe Retail BanKing enViROnMent

banking systems exposed private account information to those for whom it was not intended Such issues with data protection and security are not new, how-ever; rather, they are the same issues that have always existed in a new form

In the long term, investment in systems generates cost benefits The estimated costs of internet transactions are a fraction of the costs of branch-based ones The costs of processing electronic payment systems, such as debit cards, are far less than the costs of processing cheques Such increased cost benefits result not only from the lower fixed costs, but also because the information technology systems allow banks to reduce the numbers of staff required to engage in non-earning administrative tasks and help those staff remaining to cross-sell products to cus-tomers

A note of caution must, however, be sounded Technology can never replace human interaction, especially where complex financial products are concerned Banks embracing improvements in technology can reduce costs, and maximize flexibility and reach, but they will always have to employ people To some extent, the technology means that those people need not be based locally – many banks have outsourced their call centres to low-wage parts of the world such as India – but this too can have drawbacks for customer relationships

Additionally, the increasing availability of banking technology to any firm wishing to invest means that non-banking institutions, such as supermarkets, are entering the retail banking market, concentrating on smaller, profitable areas of the business rather than the whole range of products traditionally offered – and

in doing so are increasing competition In Chapter 6, we look more closely at the disruption and competition that technological and regulatory changes have introduced into traditional banking markets

SO, WHat IS It aLL aBOUt?

So what is retail banking all about? This is a central question that has shaped this book You may be able to imagine a world without computers, a world with different national and international boundaries, in which governments, social values, and tastes and preferences are all quite different, but it is unlikely that you will be able – for very long – to imagine a world without the key ingredients

of banking: people and money It is surely inevitable, then, that in any world banks will emerge to service their needs and aim to profit from so doing.The key to the success of any banking system, however, is trust – and we should take a moment to consider what this means in banking terms

The holistic trust needed if the banking system is to flourish – a phenomenon described in subsequent chapters – begins with the ability of individuals to trust the institution in which they have deposited their money Part of this trust is based on the secrecy that banks offer to their clients In dealing with money and people, however, retail banking treads a fine line between respect for the privacy

of the individual or company – a human rights requirement, as well as a legal

SO, WHat iS it all aBOUt?

In 2004, a report on secrecy detailed the legal protections available to sumers in EU member states and other major jurisdictions (EBF, 2004) It con-firmed that, in most national settings, banks are allowed to disclose information with the consent of the customer, but it also confirmed that they are in fact obliged to disclose such information under a growing number of statutes Such statutes protect the government’s right to collect taxes, aim to expose criminal activity and ensure compliance with other regulation

con-The issue of secrecy illustrates equally well the complex environment within which banks operate A body of statutes, case law and custom, built up over centuries, protects consumers; technology, however, makes the secure holding

of private information a very costly thing to achieve While banks benefit from huge efficiencies by managing information about customers and delivering ser-vices via mobile phones or the internet, they also risk that information being made available to unauthorized third parties, either by accident or as a result of cyber-attack Moreover, while people are ever more ready to share many intimate details via social media, few are prepared to share their private banking details, personal identification numbers (PINs) or passwords, because they understand very clearly that doing so would expose them to the risk of financial loss.Other questions to consider are as follows

In competitive terms, do you want to bank with an institution that leaks

by reading this book, you will get some insight into how retail banks work, what they do, and how and why they do it

summary

this chapter has covered:

the current and pervasive trends in the retail banking environment,

Centre for Study of Financial innovation (CSFi) (2005) Banana skins 2005: The CSFI’s

annual survey of the risks facing banks london: CSFi available at www.csfi.org/s/

Banana-Skins-2005-Final-UK-sen9.pdf

tHe Retail BanKing enViROnMent

Centre for Study of Financial innovation (CSFi) (2008) Banking banana skins 2008:

An industry in turmoil london: CSFi available at

www.csfi.org/s/Banking-Banana-Skins-2008.pdf

Centre for Study of Financial innovation (CSFi) (2012) Banking banana skins 2012: The

system in peril london: CSFi available at

www.csfi.org/s/Banking-Banana-Skins-2012-PDF.pdf

Centre for Study of Financial innovation (CSFi) (2016) Financial services for all: A CSFI

‘banana skins’ survey of the risks in financial inclusion london: CSFi available at www.

csfi.org/s/Banana-Skins_07-16_v8.pdf

european Banking Federation (eBF) (2004) Report on banking secrecy Brussels: eBF

available at 02083-01-e.pdf

www.ebf-fbe.eu/wp-content/uploads/2014/03/Bk_secrecy_Report04-2004-House of Commons, treasury Committee (2008) The Run on The Rock (HC 561-i, Fifth

report of session 2007–08) london: HMSO available at www.publications.parliament uk/pa/cm200708/cmselect/cmtreasy/56/56i.pdf

lascelles, D (2005) Other people’s money: The revolution in high street banking london:

institute of Financial Services.

Stoakes, C (2015) Know the City, 2015/16 edn aylesbury: Christopher Stoakes.

taylor, B and Morison, i (1999) Driving Strategic Change in Financial Services Cambridge: Woodhead Publishing limited.

What is retail banking?

objectives

after studying this chapter, you should be able to:

describe the key functions of different types of bank,

measures that banks take,

explain the benefits of intermediation,

to individuals and companies

The chapter begins with a brief review of the different types of banking and the constituent parts of the ‘universal’, or conglomerate, bank, aiming to distin-guish between them and to introduce some of the seemingly confusing termi-nology in this area Although the distinctions between functions are made clear, large banks go to great lengths to ensure that corporate customers in particular

do not see the joints (or the gaps) between them Instead, they aim to present

an integrated whole, using one brand image (consider, for example, the HSBC or Santander logos, which are used globally), often ‘fronted’ by a relationship man-ager, who accesses on behalf of the customer the different services that the bank provides Regulatory frameworks can, however, force artificial ‘walls’ between different parts of a universal bank Chapter 5 on bank regulation illustrates how this separation impacts on bank strategy

This chapter goes on to review some of the key concepts in banking that attempt to answer the question: What is it that retail banks actually do? The concept of intermediation will be explored, and some of the risks associated with

WHat iS Retail BanKing?

money and credit will be explained The chapter continues with an illustration of how the banking system creates credit and introduces the dissection of a typical bank balance sheet that will be explored in more depth in Chapter 3 (where the additional concepts of interest rate risk and liquidity risk will be discussed).Banks can make multibillion-pound profits annually owing to their size, the expertise of their staff and their command of banking technologies While reading this chapter, it may be instructive to ask yourself whether banks perform

a useful function for the economy – that is, to ask yourself: If banks did not exist, would they be invented?

tyPES OF BaNKING

Over the past century, where regulatory pressures, deregulation and competition have allowed, banks around the world have grown in size not only through ex-pansion, but also through mergers and joint ventures

Expansion, allowing access to larger capital and deposit resources, can often

be linked back to regulatory capital requirements The advance of technology, and economies of scale and scope, also present as drivers for consolidation Banking in the UK provides ample illustration of this phenomenon and a brief history is outlined in Figure 2.1

Consolidation and mergers have occurred not only geographically and zontally (that is, banks joining with similar banks), but between the different types of bank As we saw in Chapter 1, this was made possible by deregulation in the 1980s The result is a small number of global universal banks, many of which have retail banking functions in numerous territories

1866 154 ‘joint stock’ banks

1900 77 banks, over 2000 building societies

1914 16 banks

1918–1968 11 banks Commercial pressures

and opportunities

Universal banks emerge Building societies become banks

Big Bang 1986

Opportunistic take-overs Government rescues Credit Crunch 2007

19th and 20th centuries 21st century

regula-be separated from more speculative parts of universal banks – a practice known

as ring-fencing In the UK, for example, all banks need to ring-fence customer deposits to keep them safe from the impact of risky investments undertaken

in other parts of the bank For the bank, this has implications in terms of both growth and the efficient use of deposits

Commercial banking

‘Commercial banking’ refers to the traditional role of the banker as it relates to the taking of deposits and granting of loans Commercial banking activity is split into two types: retail banking and wholesale banking The key differentiation between the two is that retail banks borrow from and lend to members of the public and companies, while wholesale banks deal with other banks and with governments (national and overseas)

Note the terminology here: in a legal sense, banks borrow funds from tors The money deposited belongs to the bank with the normal condition that

deposi-it is returned to the deposdeposi-itor on demand (immediately) or on the expiry of a notice period (such as seven days) Actually, in practice, banks allow depositors to withdraw funds on demand even from term deposits, but charge a penalty by de-ducting the interest for the notice period We will see in Chapter 4 that customer deposits are recorded as liabilities in bank balance sheets and loans as assets.Just like individuals, however, banks themselves and governments need to de-posit funds and to borrow from other banks to maintain liquidity If a bank lends out only the funds deposited by its own customers, it may miss the opportunity

to expand its lending portfolio; if it lends out funds needed to repay deposits,

it can run out of money Any rumour that a bank may not be able to repay its

Countryside Treasury (Derivatives and Futures Trading)

Countryside Brokers Countryside Corporate Finance and Advice Countryside Asset Management Trade Finance

Countryside Private Bank

Countryside Insurance

(and Pensions)

Countryside Bank (Commercial)

Countryside Asset Finance

Countryside Bank plc

Countryside Bank (Retail) Countryside Investment Bank plc

WHat iS Retail BanKing?

depositors can cause those depositors to demand their money back – and if a large proportion of them do so all at once, the bank suffers what is known as

a ‘run on the bank’, which not only is normally fatal for the bank, but also can risk the failure of the whole banking system At the outset of the 2007–08 global financial crisis, just such a situation occurred in relation to Northern Rock plc – the first run on a UK bank since that on Overend Gurney and Co in 1866 (House

of Commons, 2008)

To remedy this ‘liquidity gap’, then, if one bank has funds deposited that it does not need to lend to customers, it can loan the excess to other banks either overnight or for a longer period This allows the bank to make a profit from its excess balances that it would not have earned had it left them idling in the cus-tomers’ accounts

Wholesale banking activities therefore ensure that any liquidity gap that the bank may estimate or calculate, on a daily basis, is covered by borrowing from other banks and that any surplus funds are invested by depositing them with (that is, lending them to) other banks or to the government For these activities, banks use their own interest rate – the London inter-bank offered rate (Libor) – and this rate is the key to understanding how government monetary policy

is effected through the banking system, at which we will look in more detail in Chapter 4

In providing this central intermediary function – especially between retail customers – banks have developed efficient and secure payment and settlement systems

Investment banking

Investment banks are an American creation, established by the US Glass–Steagall Act of 1933 The Act was passed in response to numerous bank failures during the Wall Street crash of 1929 and the subsequent Great Depression, when many banks had used their customers’ deposits to buy shares that lost all value in the crash The Act required the separation of the savings and loan activities of banks from their investment activities, aiming to protect depositors’ funds, and its ef-fect was that separate commercial and investment banks emerged with similar names, such as JP Morgan Chase and Morgan Stanley – a legacy that remains even though, in the latter half of the 20th century, commercial pressures blurred this distinction and the Act was repealed in 1999

Since the 1933 Act was not extraterritorial, it did not have an impact on purely British banks – and such an impact was unnecessary in any event, since the

UK already had a tradition of separating these functions In the UK, investment banks were known as ‘merchant banks’, taking their name from their origins as providers of trade finance In Figure 2.2, trade finance is illustrated as bounded within the investment bank – but there are no hard-and-fast rules and it might equally fall within the bank’s commercial remit

So, what is investment banking? Again, there are no rules defining the

func-tYPeS OF BanKing

trading on behalf of clients, in which capacity the bank acts as an agent ever, some activity can be for the bank’s ‘own account’, whereby the bank actively buys and sells securities and bonds, derivatives and futures at a profit – that is, so-called proprietary trading

How-In a traditional investment bank, the three key activities that can be identified are:

underwriting bond and share issues,

ac-Underwriting often follows the provision of advice to corporate customers wishing to raise finance by issuing shares to the public or issuing bonds (loan notes) to the public The reasons that some companies prefer to raise finance in this way are numerous and have to do with the fact that it is cheaper than bor-rowing from a commercial bank Underwriting is the mechanism whereby the investment bank agrees to buy or fund the share or bond issue, guaranteeing that the company will obtain the funding it seeks In turn, the investment bank will have made arrangements for other institutions to buy some, or all, of that issue; otherwise, the bank may be left with a large block of shares or bonds that nobody wants Without demand for the securities, these will reduce in value and cause the bank to lose money Clearly, successful underwriting needs an excellent understanding of the markets

With underwriting, therefore, banks can use some of their own capital if they end up owning any of the shares or bonds, although this is not their primary motive Once issued, the securities can be traded, in which capacity banks either work on behalf of their clients, providing advice and executing deals, or they can trade on their own account This activity also extends to asset management, whereby banks manage portfolios of shares and investments on behalf of cli-ents (Private banks are small investment banks that typically look after a select number of super-rich clients.)

Futures and swaps, among others, are risk mitigation tools (on which more formation can be found in Stoakes, 2015) Deployment of such tools on behalf of its clients, for a fee, has been a growing part of the investment bank’s activities Some such tools have, however, been on the receiving end of bad press since the 2007–08 financial crisis: the assumptions about risk spreading (‘casino banking’) and the underlying value of such ‘exotic’ securities should, it is said, have been better understood by traders

in-Likewise, proprietary trading must also be well understood and regulated, cause the currency of investment banking is information, as well as money, and banks must take great care not to profit from their own clients’ confidences