Financial Markets Operations Management (18 page)

The simple answer to the question raised above is that it is a bank which acts as the intermediary. Banks do this by accepting deposits and using them for lending activities, either directly by lending to borrowers or indirectly through the capital markets. A bank, therefore, connects clients with excess capital with clients with a capital deficit.

From a borrower's perspective, there is a barrier to “direct financing”, mainly through (a) the difficulty and expense of matching the complex needs of individual borrowers and lenders and (b) the incompatibility of the financial needs of lenders and borrowers. Without exploring the details, we can summarise the needs of lenders and borrowers as follows.

Lenders want to lend their assets for short periods of time and for the highest possible return. They wish to:

• Minimise credit risk (e.g. borrower default) and market risk (e.g. assets dropping in value);
  
• Minimise the cost of lending and maximise the returns on lending;
  
• Hold assets that are more easily converted into cash (liquid).
  

In contrast, borrowers demand liabilities that are cheap and for longer periods. They wish to:

• Obtain funds at a particular, specified time in order to meet their borrowing requirements;
  
• Obtain funds for a specific period of time (either short term for working capital requirements or long term for capital equipment, etc.);
  
• Obtain funds at the lowest possible cost.
  

You can appreciate that there are conflicting points of view between lenders and borrowers; hence the need for an intermediary (i.e. the banks) that can transform small-scale, low-risk and liquid deposits into large-scale, riskier and more illiquid loans.

What do the banks offer the clients by way of products and services? As we will see later, the banks tend to classify their clients in terms of size, as shown in
Table 4.11
.

There are several ways that the banks are able to deliver their services through so-called
delivery channels
. These include one or more of the following:

• In-branch, face-to-face contact;
  
• Postal banking;
  
• Telephone banking;
  
• Internet banking;
  
• Mobile telephone banking.
  

The world's 14 largest banks by market capitalisation are listed in
Table 4.12
.

Following the banking crisis of the mid-2000s, organisations such as the Financial Stability Board (FSB) have been asked by the leaders of the G20 countries to: “… develop a policy framework to address the systemic and moral hazard risks associated with systemically important financial institutions (SIFIs)”.

In November 2011, the FSB published a document entitled
Policy Measures to Address Systemically Important Financial Institutions
¹⁵
in which SIFIs were defined as: “… financial institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity. To avoid this outcome, authorities have all too frequently had no choice but to forestall the failure of such institutions through public solvency support. As underscored by this crisis, this has deleterious consequences for private incentives and for public finances.” The initial list of G-SIFIs contains nothing but banks.

We will examine the different types of bank; please be aware that whilst there are banks that operate in perhaps only one of these capacities, many banks operate in most, if not all, of them. Experience has shown that combining investment banking with retail, commercial and corporate banking can cause problems, hence the introduction in the USA of the 1933 Banking Act (known as the Glass–Steagall Act, after the Act's two legislative sponsors). Most elements of this Act were later repealed by US President Bill Clinton in 1999, and it has been argued that allowing banks to re-combine banking-, insurance- and securities-related businesses led
to the banking crisis mentioned earlier. The arguments “for” and “against” the repeal are topics for another time and place.

In today's world, you and I have a relationship with a bank. You might take some or all of the services shown in
Table 4.13
.

Whether you take one or more of these services and products, the key point is that the bank is dealing with you as an individual and not as a company. The downside, however, is that the products and services are not tailored to suit particular client needs; they are designed to be mass produced and mass purchased.

We discussed high-net-worth individuals earlier, in the section on Private Wealth Management. Private banking is an extension of personal banking; there are certain similarities (e.g. bank accounts) but differences too. Whilst most personal bank accounts can be opened with as little cash as GBP 1.00, the minimum amount of assets required for an HNWI to benefit from the services of a private bank can be measured in millions of US dollars or equivalent. Even here, the clientele will be sub-divided into “mass affluent” at the lower end and “ultra affluent” at the top end. The key features of private banking can be summarised as follows:

• Services are tailored to meet the clients' individual needs; these might be transactional (see Retail Banking above) and/or advisory;
  
• Clients have a named private banker allocated to their account (i.e. personal contact);
  
• The private banker is often expected to anticipate the client's requirements;
  
• The client and private banker might expect to have a long-term relationship.
  

By contrast to retail and private banking, corporate banking focuses on companies, be they regarded as small, medium or large firms. In addition, for the larger firms, the banks will offer services specific to the type of industry the firm is involved in.

The larger the client firm, the more specialised the services required. We will refer to some of these needs later when we cover products.

Products and services for the smaller firm include:

• Payment services:
  Similar to personal banking but additionally give access to payment systems (high-value, same-day value, bulk payments, etc.).
  
• Debt finance:
  Hire purchase, leasing, invoice discounting and factoring.
  
• Equity finance:
  Private equity and venture capital.
  
• Specialist finance:
  Financing where there might be government initiatives involved, such as financing for technology-based or bio-chemical-based start-up firms.
  

Products and services for the medium-sized and larger firms include:

• Most of those offered to the smaller firms;
  
• Cash management services;
  
• Loans (bilateral and syndicated), short-term financing (overdrafts, commercial paper issuance) and bonds;
  
• Bank commitments and guarantees;
  
• Foreign exchange and interest rate transactions;
  
• Securities issuance and underwriting;
  
• Fund management services.
  

We have seen that the types of services and products offered by the banks to their commercial and retail banking clients are similar, i.e. deposit taking and lending, but differ in variety, complexity and scale. Investment banks, by contrast, are in the business of:

• Proprietary trading:
  Investing the bank's own money (in asset classes such as equities, bonds, derivatives, commodities) and taking long and short positions.
  
• Asset management:
  Managing wholesale investments (e.g. a pension on behalf of a corporate client).
  
• Securities financing:
  Securities lending and borrowing, repurchase (“repo”)/reverse repo and sell/buy-backs.
  
• Issuing securities for clients:
  Assisting clients to raise capital through the issuance of share capital and/or debt capital.
  
• Underwriting new issues of securities:
  Partially or fully guaranteeing that a new issue of securities will take place.
  
• Advising clients on mergers and acquisitions (M&As)
  .
  

Unlike the commercial/retail banks, investment banks do not hold retail deposits. The various business lines, noted above, are associated with higher levels of risk when compared with the commercial/retail banking business.

In the USA, specialist investment banks dominated this business, as commercial banks were not permitted to provide investment banking (refer to the Glass–Steagall Act, 1933). Since the Act was repealed in 1999, commercial banks have taken over investment banks; for example, Citigroup includes Citibank (commercial), Salomon Brothers (investment bank) and Smith Barney (brokerage firm).

According to the
Financial Times
,
¹⁶
five of the top ten investment banks (by fees earned) are from the USA, with two Swiss banks, one German, one Canadian and one British, as shown in
Table 4.16
.

These ten banks can be regarded as “full-service” investment banks; in addition there are financial service conglomerates that combine commercial banking, investment banking and, sometimes, insurance (e.g. Daiwa Securities, Crédit Agricole, Rabobank and Standard Chartered Bank), and independent investment banks (e.g. Cantor Fitzgerald, Cowen Group, Investec and Piper Jaffray).

Notable casualties from the 2008 banking crisis were investment banks such as:

• Bear Stearns – collapsed in 2008, assets acquired by JP Morgan Chase;
  
• HBOS – acquired by Lloyds TSB in 2009;
  
• Lehman Brothers – bankrupt in 2008, assets sold to Barclays Capital and Nomura Holdings;
  
• Merrill Lynch – acquired by Bank of America in 2008.