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modern banking shelagh heffernan professor of banking and finance cass business school city university london

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modern banking shelagh heffernan professor of banking and finance cass business school city university london

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copyright 2005 john wiley sons ltd the atrium southern gate chichester west sussex po19 8sq england telephone 44 1243 779777 email for orders and customer service enquiries cs-books@wiley.co.uk visit our home page on www.wileyeurope.com or www.wiley.com all rights reserved no part of this publication may be reproduced stored in a retrieval system or transmitted in any form or by any means electronic mechanical photocopying recording scanning or otherwise except under the terms of the copyright designs and patents act 1988 or under the terms of a licence issued by the copyright licensing agency ltd 90 tottenham court road london w1t 4lp uk without the permission in writing of the publisher requests to the publisher should be addressed to the permissions department john wiley sons ltd the atrium southern gate chichester west sussex po19 8sq england or emailed to permreq@wiley.co.uk or faxed to 44 1243 770620 designations used by companies to distinguish their products are often claimed as trademarks all brand names and product names used in this book are trade names service marks trademarks or registered trademarks of their respective owners the publisher is not associated with any product or vendor mentioned in this book this publication is designed to provide accurate and authoritative information in regard to the subject matter covered it is sold on the understanding that the publisher is not engaged in rendering professional services if professional advice or other expert assistance is required the services of a competent professional should be sought other wiley editorial offices john wiley sons inc 111 river street hoboken nj 07030 usa jossey-bass 989 market street san francisco ca 94103-1741 usa wiley-vch verlag gmbh boschstr 12 d-69469 weinheim germany john wiley sons australia ltd 33 park road milton queensland 4064 australia john wiley sons asia pte ltd 2 clementi loop #02-01 jin xing distripark singapore 129809 john wiley sons canada ltd 22 worcester road etobicoke ontario canada m9w 1l1 wiley also publishes its books in a variety of electronic formats some content that appears in print may not be available in electronic books british library cataloguing in publication data a catalogue record for this book is available from the british library isbn 0-470-09500-8 typeset in 10/12pt goudy by laserwords private limited chennai india printed and bound in great britain by biddles ltd king s lynn norfolk this book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production.

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this book is dedicated to my parents grh and gjh in their diamond anniversary year

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about the author professor shelagh heffernan is currently professor of banking and finance at cass business school city university london and has been a visiting professor at several universities modern banking is her fourth book a former commonwealth scholar at oxford university professor heffernan is also a past beneficiary of a leverhulme trust research award which funded new research on competition in banking and recently received a second award from the leverhulme trust she publishes in top academic journals ­ her paper `how do uk institutions really price their banking products journal of banking and finance was chosen as one of the top 50 published articles by emerald management review current research includes smes and banking services the conversion of mutuals to bank stock firms monetary policy and pass through funded by an esrc grant and m&as in banking professor heffernan is an associate member of the higher education academy and has received two distinguished teaching and learning awards.

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contents acknowledgements preface chapter 1 what are banks and what do they do 1.1 introduction 1.2 the meaning of banking 1.3 organisational structures 1.4 banking structures 1.5 financial conglomerates 1.6 central banking 1.7 summary why are banks special 1.8 conclusion ix xi 1 1 1 5 15 26 29 36 38 chapter 2 diversification of banking activities 2.1 introduction 2.2 the expansion of banks into non-banking financial services 2.3 the effect of non-interest income on banks total income 2.4 global markets and centres 2.5 international banking 2.6 banking issues in the 21st century 2.7 conclusion chapter 3 management of risks in banking 3.1 introduction 3.2 key financial risks in the 21st century 3.3 approaches to the management of financial risks 3.4 financial derivatives and risk management 3.5 management of market risk 41 41 41 51 55 64 72 98 101 101 103 113 125 142

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vi management of credit risk 155 risk management by major global bank 169 conclusion 171 contents 3.6 3.7 3.8 chapter 4 global regulation of banks 4.1 introduction 4.2 why regulate 4.3 international regulation 4.4 basel 2 ­ the three pillar approach 4.5 alternative or complementary approaches to basel 4.6 international financial architecture 4.7 conclusion chapter 5 bank structure and regulation uk usa japan eu 5.1 introduction 5.2 bank structure and regulation in the uk 5.3 bank structure and regulation in the usa 5.4 bank structure and regulation in japan 5.5 bank structure and regulation in the eu 5.6 conclusions structure and regulation of banks 173 173 173 179 192 210 213 219 221 221 222 242 258 262 285 chapter 6 banking in emerging economies 6.1 introduction 6.2 financial repression and evolving financial systems 6.3 banking reforms in russia china and india 6.4 islamic banking 6.5 sovereign and political risk analysis 6.6 conclusion 287 287 288 293 322 332 347 chapter 7 bank failures 7.1 introduction 7.2 bank failure ­ definitions 7.3 case studies on bank failure 7.4 the determinants of bank failure a qualitative review 7.5 bank failure quantitative models 7.6 conclusion 351 351 351 358 390 399 405

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chapter 8 financial crises 8.1 introduction 8.2 definitions and controversies 8.3 the south east asian financial crisis 1997­99 8.4 the japanese banking crisis 8.5 scandinavian banking crises 8.6 long term capital management ltcm 8.7 lender of last resort 8.8 conclusions appendix 8.1 japanese financial reforms big bang 1996 appendix 8.2 reform of the regulators chapter 9 competitive issues in banking 9.1 introduction 9.2 measuring bank output 9.3 x-efficiency scale economies and scope economies 9.4 empirical models of competition in banking 9.5 consolidation in the banking sector 9.6 conclusion vii contents 407 407 407 415 434 449 454 459 466 467 470 473 473 473 477 494 517 538 chapter 10 case studies 10.1 introduction 10.2 goldman sachs appendix 10.3 kidder peabody group 10.4 from sakura to sumitomo mitsui financial group 10.5 bancomer a study of an emerging market bank ´ 10.6 credit lyonnais 10.7 continental illinois bank and trust company 10.8 bankers trust from a commercial/investment bank to takeover by deutsche bank references/bibliography index 541 541 542 560 564 570 582 595 617 631 653 682

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acknowledgements many individuals helped with this book anonymous referees made useful suggestions which were incorporated into the book special thanks to amelia pais who read and provided such helpful feedback on several chapters and in record time peter sinclair was also generous with his time and comments on different parts of the book i am also grateful to other academics who provided input at various stages some without knowing it roy batchelor alec chrystal xiaoqing fu ted gardiner charles goodhart alfred kenyon david llewellyn shiv mathur phillip molyneux andy mullineux neil tomkin giorgio questa peter sinclair knut sandal giorgio szego and geoffrey wood thanks to participants at seminars and conferences including the lse financial markets group european association of teachers of banking and finance and suerf who gave helpful comments on papers parts of which have found their way into various parts of the book the stimulating hands on debates among mainly city practitioners at the seminar sessions organised by the centre for the study of financial innovation were very helpful over the years saadia mujeeb a cass graduate mick green and tim thomson of barclays bank provided good material for the chapter on risk management the leverhulme trust foundation has awarded two grants to look at competition in banking ­ some of the outputs from that research appear in chapter 9 nikki king and james sullivan did a super job helping out with the references and word-processing corrected chapters they are part of the team led by emma boylan who provide the cass faculty of finance with such great support i am very grateful also to alec chrystal associate dean of the finance faculty for his encouragement many students at cass business school city university assisted with the book in an indirect way by challenging ideas during lectures and case study sessions however several stand out for their special contributions such as chasing up data reading proofs and conducting web searches randeep brar olga bouchina katrin fuchs paul sawh and olga vysokova thanks go to the cass research committee which through a pump priming award funded katrin fuchs to help out with data collection for this book i am grateful to ingo walter director of the nyu salomon center who gave permission to use case studies from the new york university salomon center case series in banking and finance that appeared in modern banking in theory and practice wiley 1996 the cases in chapter 10 have been substantially revised and updated since then.

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x acknowledgements finally very special thanks to my dear partner peter for his tremendous support while i was writing this book an intellectual guru his capabilities are such that i learn something new from him every day such an environment cannot but help but inspire and improve the quality of any book all errors and omissions are my responsibility shelagh heffernan cass business school city university london uk november 2004

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preface this book is a sequel to modern banking in theory and practice published by john wiley sons in 1996 it is a sequel rather than a second edition because it does substantially more than merely update the 1996 text in fact this book has taken much longer to write than the 1996 book in the eight years since modern banking in theory and practice was published many aspects of banking have changed considerably though the key characteristics that distinguish banks from other financial institutions have not some might question the need for a book on banking rather than one on financial institutions while banks remain special and unique to the financial sector books need to be devoted to them modern banking focuses on the theory and practice of banking and its prospects in the new millennium the book is written for courses in banking and finance at masters mba or advanced undergraduate level bank practitioners who wish to deepen and broaden their understanding of banking issues may also be attracted to this book while they often have exceptional detailed knowledge of the areas they have worked in busy bankers may be all too unaware of the key broader issues and lack perspective consider the fundamental question what is unique about a bank what differentiates it from other financial institutions answering these questions begins to show how banks should evolve and adapt ­ or fail if bankers know the underlying reasons for why profitable banks exist it will help them to devise strategies for sustained growth unlike many other books in this field the focus of the book is on the microeconomic issues related to banks covering key areas such as what singles a bank out from other financial institutions the diversification of banks into non-banking financial activities different types of banks within a banking structure bank failures and so on there are many excellent books that study the role banks play in the macroeconomy and/or the contribution of financial institutions/financial sector to an economy there are also numerous excellent books with detailed descriptions of the financial system in the united states britain and other countries but they cover other types of financial firms and markets which gives them less space to devote to banking issues while recognising that banks are an integral part of any financial system this book is concerned with the key banking topics why they exist investment commercial and other types of banks how they have diversified risk management global regulation banking structures/regulations in key economies bank failure and crises banks in emerging markets and competitive issues the final chapter provides some case studies ­ practical applications of many of the ideas and themes covered in the book few books provide readers with a systematic treatment

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xii preface of the key micro banking issues and it is hoped this volume goes some way to rectifying the deficiency these are some of the main themes running throughout the text zzzzzzz information costs and the demand for liquidity explain why banks find it profitable to intermediate between borrower and lender banks undertake two core functions which single them out from other financial institutions they offer intermediary and liquidity services often a byproduct of these core functions is the provision of a payments service given that banks core activities involve money it also means banks play a special role in the monetary economy ­ their actions can even affect the money supply for shareholder owned banks profits are the prime concern so too are risks the way banks earn their profits through the management of financial risks further differentiates them the organisation of risk management and the development techniques and instruments to facilitate risk management are crucial to the successful operation of all banks the central intermediary role played by a bank is evolving through time from the traditional intermediation between borrowers and lenders through to more sophisticated intermediation as risk managers the objective functions of managers and bank regulators are quite different banks are singled out for close regulation because bank failures and crises can and do have social as well as private costs associated with them however as parts of banking become more complex regulators increasingly rely on the banks own risk management models to handle the associated risk given that bank managers do not allow for the social costs of bank failure is the increasing use of banks own internal risk management models by regulators a development to be welcomed another issue are regulators sophisticated enough to monitor the complex models of risk management in place at the top western banks finally regulation contributes to moral hazard problems so the regulatory environment needs to give the correct incentives to minimise these problems the international regulation of banks is growing in importance but controversial its importance stems not only from the globalisation of banking but also because many of the basel rules agreed by the basel committee are increasingly seen as the benchmark for good banking regulation by all countries and all types of banks even though the basel agreements were originally directed at international banks headquartered in the major industrialised nations identification of the causes of bank failure and financial crises should help to reduce their incidence thereby saving taxpayers from expensive bailouts banks in emerging markets are engaged in the core activities of intermediation and the provision of liquidity but they have a different agenda from those in the developed world because most face a different set of challenges no single model of banking applies to all emerging markets though many share similar problems such as shortages in capital and trained labour they have their fair share of crises too in addition there are different forms of banking islamic banking is one of the most important though not limited to emerging markets islamic banking has developed most in countries such as pakistan iran and malaysia.

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