Mathieu De Baets 2017-2018
Global Banking
Lecture 1
The idea of global banks start with the globalization of the economy, which started in the 1990s. Until
2007 this seemed to be the way forward. Big banks had big ambitions to become global banks in a
global economy of peace. The illusion of a global economy with peace and free-trade was something
that we enjoyed until 2007. With the crisis, the idea had to be adapted to a new reality where it’s not
necessarily peace and not necessarily an economy that is going to be globalized forever with
protectionism, trade wars, currency wars,…
Goal of the course: understanding the financial system, banking environment and banking strategies.
Origin and role of banks
What are banks, what are they doing and why? And why is the society accepting banks?
**Around every 10 years, there’s a banking crisis and each time this goes together with a social
and political crisis.
Big difference between the real economy and the financial economy. When you talk about the real
economy, GDP is the key element. It is the sum of all the products and services, including what
governments do. The bank is a company and offers services, so banks as an institution is a part of the
real economy. The services these banks offer are part of the financial economy. The big difference
between real economy and financial economy is the ease of forecasting. When you try to forecast the
GDP of a country for 2 years, it’s fairly easy to forecast this. So the real economy is perfectly
forecastable. But there are big economic problems when we talk about recession (= 2 consecutive
quarters of slightly negative growth). When you try to forecast the S&P 500 in 2 years, you can’t
forecast is perfectly. So the financial economy, where a parameter can be the stock market or indexes,
is completely impossible to forecast.
=> The real economy is stable, but why? The real economy is based on human needs, or at least what
we perceive as a need. For example, we perceive smartphones as essential. Because we want to have
that, we will have to organize our life so that we can buy it. So we need an income, so you need to
work. Because you work, you produce. This is why the real economy is stable.
=> The key word in the financial economy is confidence. Because a financial contract (stocks, bonds,…)
is about confidence. As long as you’re confident that you will get your money back from the contract,
everything is good. They day you start to worry if the counterparty will be able to pay you back, the
value of the contract falls to zero. Every investment is based on confidence and is not a human need.
Definition of a bank: no generally accepted definition. What is called in Italy a bank, is not necessarily
called a bank in Belgium. Also because of technology, the activities and services of banks have evolved
through history. It’s a legal and dynamic concept. Definition according to EU law: “credit institution”.
Capital requirement regulation (art 4) gives a definition of a credit institution that all European
countries have to accept: a credit institution is an undertaking that has as a business to take deposits
from the public and to give loans with that money for their own account and in their own name. So
according to this definition, an investment bank is not a bank. Goldman Sachs, JP Morgan, until 2009
these were not considered as banks. (Glass Steagle act). This definition is an important issue, because
,Mathieu De Baets 2017-2018
each time we have a financial crisis, politicians say that banks are doing all kinds of things that are not
in line with the definition according to the law. They you get to narrow banking. After the crisis, in the
US this led to the dotfrank act, the UK: Viker’s model.
Why do we accept banks? Because if banks collapse, the economy collapses.. most economic crisis
started with a banking (financial) crisis. A crisis happens when people suddenly change their behavior,
because they get anxious. Why? Lots of reasons, but they suddenly lose trust in the future. If a
significant part of the economy loses confidence, the real economy doesn’t suffer at first, because this
is based on human needs. People still eat every day and still want to buy the things they perceive as a
human need. But the financial economy, which is about the trust in the future, collapses first. When
the financial economy collapses, people get poorer, because the contracts they have are worthless.
Because people get poorer, they spend less, you have to produce less, because you produce less, you
get unemployment and recession. And then the 2nd phase happens, the economic crisis. The first shock
is the financial crisis and the second shock is the economic crisis. POLITICAL ERROR: “because a
financial crisis is a predecessor of a real crisis, let’s put the financial system is an very narrow jacket”.
But the effect on the real economy of this is even worse and that’s what Europe is feeling now.
Fundamental problem!
In a free-market economy you have freedom of choice and everyone van freely decide what they want
to buy or not. The mechanism in the free market that is managing the expectations and behaviors of
all operators, is the price. The price is the result of supply and demand, which is the result of the
behavior of all operators. If there’s more demand than supply, the price goes up. And because of this,
a number of people than would have liked to buy, will not buy anymore because they think it’s too
expensive, which leads in demand going down. If there’s more supply than demand, the price goes
down, because there’s too much production of something. When the price goes down, that
good/service will not be profitable anymore to a certain extent, and suppliers will thus produce less of
that product.
The sum of individual rationality can be collective madness. This is why we need governments. Some
households in the economy will decide to save money to prepare for the future (accidents,
retirements, reserves,…) When everyone is saving, the result for the real economy is that there’s no
spending. This is thus a black hole in the real economy, because the sum of all production is bigger
than the sum of all spending. The result of this black hole will be that the suppliers have excess
production, so they will decrease production, so this will create a downward spending in the economy.
Less production, less work, unemployment, people are poorer, people buy even less….The more you
save, the more you undermine the growth of the real economy => the parasites are those who save.
(Keynes: someone who saves is stealing the food out of the mouth of the neighbor) **: negative
interest rate to penalize the savers
In the economy, there are operators that have no money, but would like to spend money. (white
knights). In normal times, the solution is a financial system which is the bridge between the + and the
-. Those with +, give their money to those who don’t have money, but would like to spend it.
(loan,equity,…). The + people see already the danger, because when they give their money to someone
else, they only get a signature “I will pay you back with interest”, but will this promise be really
realized? => huge risk
,Mathieu De Baets 2017-2018
As a financial system to form the bridge between the + and the -, you can organize a bank. A banks has
as a role to take the money of all the savings, and with all that money, give loans for its own account
and at their own risk. Banks are backed by the political system, so people don’t need to worry about
the promise of getting their money back. So the key competence of a bank is risk management. The
banks should be able to assess the probability that some of these contracts will not be paid back. The
bank has to organize itself in such a way, that even when that happens, they will still be able to pay
back the deposit holders.
After the big crisis in 1929, the first regulations on banks appeared. There’s a specific regulator that
has to approve and give a license to a bank, but they will also impose lots of controls to see if the banks
are not taking too much risk, because all the loans a bank give, are with the money of the population
(deposit holders). That’s also why the government will immediately intervene when a bank goes
bankrupt; because the government has given a license to a bank, so it’s responsible for a bank. The
government can’t afford that the savings of the population are gone.
In this way, you can think of a bank like an insurance company. The key for a bank to play the game of
giving loans with the money of the deposit holders and be able to give back the money to the deposit
holders, is PRICE.
PRICE => DIVERSIFICATION => BASEL REQUIREMENTS => GOVERNMENT INTERVENTION
Price: takes into account the expected probability of loss
Diversification: law of large numbers
Buffers: Possibility of losing more than expected
Government: when all other actions fail
The bank has to be able to quantify the probability of default of a client, and is going to adapt the price
of a loan according to the probability of default. (link with insurance company: they will also assess the
probability of for example a fire in a house. They will set the price (premium) accordingly. Ex: the
probability of a fire is 1:1000. You house costs 300 000. The premium you will have to pay is 300) There’s
a chance of 1 in 1000 that your house will burn down. In order to avoid that risk, the insurance company
will diversify. It will grant 1000 insurances for 1000 houses, hoping that the rule of large numbers will
play.
The pricing takes into account the expected probability of a loss. Start with pricing, then with
diversification. Further you have the probability that in certain years the number of losses in bigger
than you had expected. Therefore, the bank needs buffers. Two types of buffers (costly for the bank).
First buffer: The bank needs equity (shareholders) that put
their money in the bank. The shareholders is going to pay when Asset Liabilities
the loss is bigger than expected. The deposit holder is thus Loans Deposits
protected by the shareholder. Shareholders are in the fire line,
thus they will require high remuneration.
Second buffer: People bring deposits to banks for the ST, but Liquidity Equity
they will withdraw it immediately when they need it. The loans
that banks give are in the LT. (ST doesn’t make sense) Here confidence plays a very important
role. Legally, all the deposits could go away. As soon as the deposit holders lose confidence,
they could withdraw all their money and the banks will not be able to pay it all back. => Basel
regulations: the bank needs to keep liquidity, in case the deposit holders start to withdraw all
their money.
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**: government intervention can cause problems at the country level, because when too many banks
go bankrupt, the countries can get in trouble as well => new regulation.
Another option as a financial system to form the bridge, you can organize your intermediation in
another way => markets. In the market, you invite all those who want to get money to write down
their contract how much they want to pay as an interest rate and when they will pay the money back.
They go to the market and ask to the surpluses who wants to buy their contract. The + have to decide
to whom they are going to give confidence. It’s no longer the bank that takes the risk, it’s the person
with the surplus. If the person with the surplus is putting his money on a bank account, he’s called a
savor. If he puts his money in the market, he’s called an investor. If a company goes to a bank to get a
loan, it’s a borrower. If a company goes to the market, it’s an issuer. Golden rule in the “south”
(=market), those with a surplus are taking the risks. The market is also organized, there’s a regulation,
but not in a way to avoid accidents, just to make sure that the market is organized in an honest way.
(be honest about opportunities and risks => written down in the prospectus = booklet that has to be
approved by the market supervisor. The bank supervisor in Europe is the ECB, the market supervisor
in Europe is every country individually. Bank supervisor in US: Fed, market supervisor: SEC) Both
systems want the same thing: bring the money from the + to the -. Big question after 1930: Wall street
collapsed, which is a market. Politicians said that this was only the speculators who suffered. But one
year later, all banks were bankrupt, because they had also invested in the stock market. The legal
reaction to this was to build a Chinese wall between the north (commercial banks) and the south
(market), where banks should just do the north and other institutions should take care of the south
(like Goldman Sachs and JPM, they are no banks and have no access to the deposits of the public).
Consequences of these two different ways of organizing the financial system is that you have two
totally different cultures.
Banks dream about a lifetime relationships, while in the
market you only care about opportunities “where can I
make money tomorrow”. Banks want stability, whereas
investment bankers want volatility, because that’s when
they can make money. A bank is a black box, because the
bank is not explaining what it does with your money. In
the market, it’s all about transparancy (the prospectus)
The market supervisor in Belgium is the FSMA. The bank
supervisor in Europe is the ECB.
If you look at the reality of the financial systems, it’s always a mix of banking and markets. If you are a retailer,
you go to the commercial bank. Example: If you have 1000 euro, you will not invest in Chinese equity or if you
need 500 euro to buy an Iphone, you will not issue a contract in the market, but you will og to a bank. If you are
a big corporation or a government, you go to the market.
, Mathieu De Baets 2017-2018
In the Anglosaksian system, it’s
essentially a market system. Only the
things that markets can’t do, are done by
banks. For all the financial flows in the US,
80% is going through markets and only
20% is going through banks. That’s why in
the US you have small banks and not
many banks. In Europe, there’s a banking
system with just the opposite of in the US.
That’s why you have such huge banks in
Europe and a lot of them. Of all financial
flows in Europe, 80% goes through banks and only 20% goes through markets. That’s one of the reasons
why the banking crisis was such a catastrophy for Europe, and for the US much less worse. When huge
banks in Europe went bankrupt during the crisis, governments had to step in and had difficulties
themselves. In the US they have small banks, so it was not such a big problem.
=> The european commission want to go to a capital market union in Europe: shift some of the activities
of the banks to the market (copy paste the American system).At first: there was no difference between
north and south. After 1930 crisis: chinese wall with the glass steagle act in the US. From the 1990’s,
these laws were abandonned, because they said “market are more intereting to make money”. => banks
became mixed banks.
**In europe, there was a tradition that a bank became a financial supermarket, doing everything for everybody.
That’s why you have banks like BNP Paribas, KBC,… who are a bank, but also a private banks, a broker, who have
their own asset management and investment banking division. Whereas in the US there was a huge difference
between all those divisions and banks were even considered competitors from asset managers. Big discussion:
continue like that in Europe? For now, yes.
**shadow banking: institutions that do the things that banks do, but without taking deposits from the public,
because that’s the key to be a bank. Because these regulations for banks have become so huge since the crisis,
other players start to invade the territory of banks and starting to do the tings that banks do, but withut being a
bank. Ex: Rich families start to give directly loans with their own money, hedge funds,… => No regulation, because
they are not a bank. => Next crisis??
Banks are doing things that markets can’t do: banks transform financial flows. Tha saver brings money into the
bank for the ST, but the borrower wants money for the LT. Banks thus transfomr ST deposits into LT loans. Very
dangerous, because when all people suddenly withdraw their money, problem! Important activity of a bank,
because otherwise there would only be ST loans and thus financing a house or anything else would be impossible.
The role of banks: transformation and information.
Size
Maturity: ST => LT
Risk: Pricing and pooling so that risky investments become more or less risk-free.
A bank is not producing anything, but it’s all about having information and having better information that the
customers have. It’s about assymetric information. Banks are only living because they know more than you. In
information economics, a banks wants assymetric information, but only in the case where the banks knows more
than you. The risk in banking is when the client is going to do things that is against the interest of the bank. Ex:
Moral Hazard.
Moral hazard: when the client comes to a bank and asks for a loan, he will present himself as a prudent and
punctual person. The day the clients gets his money, he changes completely. People behave differently before
and after the contract. Typical example: the system of deposit insurance guarantee. Even if your banks fails, we
will pay your deposits back up until 100 000 euro. Governments are doing this for a good reason. They want to
avoid a run on the bank when there are rumors about a bank. Even if the rumors are false, when some people
