Acceptance of the principle that banks could be owned by large pools of shareholders was key to the evolution of modern commercial banks. Shareholder-owned banks could grow much larger than private banks by issuing or accumulating shareholder capital. The shareholder bank’s lifetime was indefinite, not contingent on the lives and deaths of individual partners. The Bank of England was originally incorporated with unlimited shareholder liability, meaning that in the event of failure shareholders would not only lose the capital they had invested, but were also liable for their share of any debts the bank had incurred. The same applied to private tanks constituted as partnerships. Unlimited liability was seen as essential, because banks had powers to issue banknotes, and might do so recklessly unless their shareholders were ultimately liable when the holders of banknotes demanded redemption.
The inscription that appears on all English banknotes “I promise to pay the bearer on demand the sum of X,” dates historically from the time when the Bank of England accepted a liability to convert any banknote into gold on request. The gold standard was abandoned by Britain at the start of WW1, reintroduced in 1925 but abandoned again, permanently, in 1931.
The year 1844 also saw the establishment of a banking code, comprising detailed regulations on governance, management, and financial reporting. With a framework now in place for the charter and regulation of banks, the case for shareholder banks to be granted limited liability status and brought under the wings of general joint stock company law gained traction.
Deprived of their powers to issue banknotes, the state-chartered banks survived by expanding deposit-taking, and benefitting from capital requirements that were generally lighter than those of federally-chartered banks. For much of the national banking area, federally-chartered banks and state-chartered banks in most states were subject to double, multiple, or unlimited shareholder liability. Under double liability, shareholders of failed banks could lose both their original investment, and an additional sum that usually approximated to the original investment.
Measures to restore confidence included the creation of the Federal Deposit Insurance Corporation to provide deposit insurance, a scheme guaranteeing that small depositors are reimbursed if their banks collapse; the extension of federal regulatory oversight to all banks for the first time; and the separation of commercial from investment banking.
Holding of cash, and deposits that are highly liquid and secure, are known as reserves.
Investment banking covers the provision of specialized banking and financial services, primarily to corporate customers, but also to wealthy private individuals and to governments. Investment banking also includes a number of trading activities on financial markets. Advisory services include the provision of advice and assistance in arranging mergers and acquisitions, and various other consultancy services. Investment banking also covers the provision of assistance to privately owned companies with stock market flotation, or governments with the privatization of state-owned companies. Underwriting of new issues of securities (corporate bonds, equities, or government bonds) usually involves a syndicate of investment banks each taking responsibility for selling an allocation of the new issue, and retaining its allocation if it fails to find a buyer. Investment banks are also involved in the provision of asset and wealth management services, and trading in securities, commodities, and derivatives, either on the bank’s own behalf (known as proprietary trading) or on behalf of corporate or private customers.
In 2016 HSBC, JPMorgan Chase, BNP Paribas, Bank of America, and Deutsche Bank were ranked 6th to 10th, respectively, in the list of the world’s largest banks by asset size. 4 of the top 5 banks were Chinese: Industrial and Commercial Bank of China, China Construction Bank, Agricultural Bank of China, and Bank of China. The list of the world’s 5 largest banks is completed by the Japanese bank Mitsubishi UFJ Financial Group.
A hedge fund pools the funds of its investors to purchase securities. Hedge funds may be structured as partnerships or limited liability companies. A hedge fund is administered by a professional management team, which may adopt a specific investment style or specialize in particular securities. Investors are charged a management fee. Unlike mutual funds, hedge funds can borrow and use leverage to achieve a preferred combination of expected return and risk for investors.
An exchange-traded fund (ETF) purchases assets such as shares, bonds, or commodities on behalf of its investors. Most ETFs track a particular market index, guaranteeing to match the index’s performance, and are traded in the relevant market. Since the investment strategy is passive, management fees are minimal.
Globally the shadow banking system (defined as non-bank financial intermediation) held assets of around $75T in 2013, or approximately half of the assets of all banks.
Bank deposits are liquid: making a deposit entails only a short-term commitment on the part of the depositor. By contrast, when a bank grants a loan, the bank’s commitment is long-term and illiquid.
An important element in the development of the securitized banking model was a growing tendency for banks to rely less heavily on deposits as a source of short-term funding, and more heavily on other sources. One such source, used widely by banks and some shadow banking institutions, is the repo (sale and repurchase) market. The bank (or any other party wishing to use the repo market to raise short-term liquid funding) sells a security (such as a government bond, corporate bond, or company share) to an investor, an agrees to repurchase the same security from the same investor at some later date, often the next day.
In traditional financial intermediation the deposits of small savers are guaranteed by government-banked deposit insurance. The latter, however, does not extend to large investors such as corporations, or shadow banking and other financial institutions. The repo market meets the needs of large investors for a market in short-term secured lending and borrowing.
A derivative is a security whose value depends upon the price of one or more underlying financial securities or indices, such as shares, bonds, share indices, interest rates, commodities, or exchange rates. Derivatives can be traded on organized exchanges or over-the-counter (OTC). OTC derivatives are negotiated and traded bilaterally by the two parties to the transaction. The main types of derivative are forwards, futures, swaps, and options. Forwards are OTC agreements between two parties to undertake an exchange at a specified date in the future baed on a price that is agreed today. Futures are similar to forward, but traded on an organized exchange. Swaps commit the parties to a series of exchanges of cash flows at agreed dates in the future. Common examples are interest rate, currency, and commodity swaps. Options provide the right, but not the obligation, for a party to either buy or sell a financial asset at a given price on, or sometimes before, a given date. A credit derivative is a derivative whose value depends on the credit risk associated with a portfolio of loans.
The term securitization refers to the practice whereby a bank bundles a large number of loans together, and sells the package to a Structured Investment Vehicle (SIV) set up by the bank to administer the loans.
The liabilities recorded in the central bank’s balance sheets are the sources of the funds used by the central banks to finance its trading activities, and the central bank’s capital (net worth). Currency issued or deposits created by the central bank, and held outside the banking system, are a source of funding, and are therefore treated as a liability.
The rationale for an emergency borrowing facility for countries is that in its absence, countries facing depletion of their foreign exchange reserves might need to adopt extreme and highly disruptive deflationary measures to curb a balance of payment deficit, and avoid defaulting on their commitments to international creditors. Alternatively, deficit countries might simply choose to default. The availability of an emergency borrowing facility helps promote international financial stability. Borrowing from the IMF is usually made conditional on the adoption of policy measures aimed at correcting any underlying macroeconomic imbalances deemed to have contributed to or caused the balance of payment deficit. The IMF has at times been criticized for imposing harsh conditionality on access to emergency funding.
In practice, foreign exchange intervention and direct lending to commercial banks are used less commonly than OMO in the day-to-day operation of monetary policy. In many countries foreign exchange intervention is targeted primarily at management of the exchange rate. Direct lending by the central bank to commercial banks, known as discount lending, is usually small except in times of crisis, when banks may have no option other than borrow from the central bank.
The narrow money supply, also known as the monetary base, comprises cash held by the non-bank public and commercial banks’ reserves (cash in the banks’ vaults, and their deposits with the central bank). Broad money supply measures include a wider range of liquid financial securities and bank deposits.
The deposit expansion multiplier in this example is 10: an initial $100 expansion of the narrow money supply effected via OMO leads to a $1000 expansion of the broad money supply. In reality the impact on the broad money supply may be less predictable than this example suggests. Two other factors may enter the picture, in a way that reduces the deposit expansion multiplier, as follows.
First, in the example, it is assumed that each bank prefers lending to holding reserves above the 10% target at the central bank, because it earns more interest on its lending than it earns on its reserves. However, lending is risky, and at times banks may opt for safety by increasing their reserves rather than lending the maximum amounts their balance sheets could support.
Second, if the bank customers who are the borrowers of the additional loans granted, or the suppliers of the goods and services purchased using borrowed money, decide to hold part of the additional monies they receive in the form of cash, rather than bank deposits, the process of deposit expansion is impeded.
As financial intermediaries, commercial banks use liquid liabilities (bank deposits) to finance illiquid assets (bank loans). Banks hold only a small proportion of their assets in the form of reserves, and cannot cope if all depositors demand the return of their funds simultaneously. Together with leverage, this makes banks inherently fragile, and creates the potential for one distressed bank to cause a loss of confidence in others. Regulation and supervision of the banking industry aims to protect individual banks, and the financial system as a whole, from the possibility of collapse.
The global financial crisis exposed a fundamental problem with the lender-of-last-resort concept. Suppose the secondary markets for the purchase and sale of the securities and loans held by banks as assets have ceased to function, owing to a general loss of confidence, so that up-to-date market prices for those assets are unavailable. It may become exceptionally difficult for the central bank to determine whether a bank seeking emergency short-term funding faces a temporary liquidity problem only, or is fundamentally insolvent. At the height of a crisis, and faced with the prospect that banks might collapse if short-term funding is withheld, central banks may err on the side of generosity in valuing assets. Before the crisis breaks, bank executives who anticipate that the lender-of-last-resort facility will be available if required may be inclined to take excessive risks in their lending.
Capital or equity, the difference between total assets and total liabilities, is a key indicator of the solvency of a bank. It provides a buffer against losses arising from loans not being repaid or investments declining in value. If balance-sheet assets have to be written down in value, these losses are absorbed through a reduction in the bank’s capital. A bank whose capital has been wiped out completely is no longer solvent. As soon as the bank’s creditors realize that the total value of the bank’s liabilities exceeds the total value of its assets, they will demand repayment and the bank, unable to meet these demands, will collapse. Regulation impose minimal capital adequacy requirements on banks to minimize the risk of failure.
The amount of capital a bank holds affects the return accruing to the bank’s shareholders, and also the risk associated with their investment. Other things being equal, the more capital a bank holds, the smaller is the return received by shareholders, but the smaller too is the risk that the shareholders will see the value of their capital wiped out by unforeseen losses.
For the most industries, competition policy is guided by the principle that competition between suppliers is beneficial for consumers. For banking, however, the comparison between an open market with intense competition, and one that is highly regulated with restrictions imposed upon competition, is by no means clear-cut. One view, known as the competition-fragility view, is that restrictions imposed upon competition between banks enhance financial stability. In the absence of competitive pressure, incumbent banks can earn monopoly profits and accumulate capital in the form of retained profits. This strengthens their capacity to absorb unanticipated losses, and discourage excessive risk-taking that carries the potential to destroy shareholder value. To the contrary, the competition-stability view suggests that restrictions on competition between banks give rise to financial instability. If incumbent banks exercise monopoly power, they tend to set higher interest rates for borrowers. Higher rates encourage borrowers to accept more risk in their investments or other activities in search of returns sufficient to service the original loan, or give borrowers stronger incentives to default. All of this tend to make the financial system less stable.
At the time, the practice of lending to borrowers who carried a high risk of never being able to repay may have seemed justified by ever-rising house prices. Provided house price inflation continued, borrowers would accumulate sufficient equity in their houses to refinance their mortgages after two years, repaying the old ARM to avoid the higher rate of interest, and taking out new ARM for the same or even larger principal.
Larger fees and commissions provided the incentives for individuals to overlook or actively hasten the erosion of lending standards at all stages of the mortgage supply chain: the mortgage brokers that arranged the loans for the borrowers; the retail banks that lent the money; the large investment banks that dealt with the mechanics of securitization when the mortgages were repackaged and sold to investors; and the credit-rating agencies that testified to the safety of complex and inadequately understood asset-backed securities.
Securitization weakened the incentive for originating lenders to screen borrowers prior to lending and monitor their performance subsequently.
Even if the conflicts of interest are set aside, the methods used by the agencies to produce their ratings were deeply flawed. Statistical models attached insufficient weight to events that would impact in a similar manner across the entire financial systems, such as a nationwide decline in house prices as opposed to a localized decline. In other words, the agencies underestimated systemic risk, as did many investors and regulators.
It is widely recognized that in the run-up to the global financial crisis, the structure of the compensation schemes of the banks’ top executives and traders created perverse incentives for excessive risk-taking. If a bank’s risk investments turn out to be successful, the bank’s top executives take the credit for the profits, and are rewarded with generous bonus payment. If the investments are unsuccessful, the top executives still draw their salaries, or in a worst-case scenario might be encouraged to vacate their posts voluntarily by an attractive “golden parachute” payment offer.
Bondholders also bear downside risk, without any prospect of sharing the upside gains. The bondholders’ returns are fixed provided the bank remains solvent; but if the bank’s capital is wiped out by trading losses, bondholders may be unable to recover the nominal value of their holdings upon redemption. All of this suggests that in the run-up to the crisis, top executives and traders developed a much stronger appetite for high-risk investment or trading strategies than the shareholders and bondholders whose money was used to finance these activities.
One of the key lessons of the sovereign debt crisis has been the symbiotic nature of the links between the balance sheets of banks and governments. On the one hand, governments have on many occasions ridden to the rescue of distressed banks; and bank bailouts have imposed strains on the public finances. On the other hand, banks hold sizeable portfolios of government debt. As soon as investors start to doubt the creditworthiness of governments, bank balance sheets deteriorate as government bonds are written down in value. If the banks rein in their lending to consumers or business, in an effort to address the deterioration in their balance sheets, there are adverse macroeconomic consequences through reduced spending on consumption and investment, and slow growth. Poor macroeconomic performance places the public finances under further strain, leading to heightened concerns over the risk of default on government debt. If property prices fall, the balance sheets of banks with assets linked to property (mortgages, or MBS) are likely to deteriorate further. The downward spiral becomes self-perpetuating and difficult to escape.
However, fast growth, together with flawed and deficient accounting data, masked severe underlying economic problems, including a lack of competitiveness evidenced by declining exports, low labor productivity, and widespread tax evasion and alleged corruption. These problems were manifest in large current account deficits (value of imports exceeds value of exports), large budget deficits (government expenditure exceeds tax revenue), and consequently high levels of government borrowing and debt.
From an historical perspective, the regulatory response follows a long-established pattern, whereby stricter regulation and supervision is enacted in response to a financial crisis, while pressure leading to financial deregulation tends to mount during times of prosperity, as the previous crisis recedes into history and the collective memory fades.
Critics have argued that QE is tantamount to “printing money” by electronic means, in the sense that the accounts of the commercial banks selling the securities are credited by the central bank with new reserves created electronically. The extent to which QE feeds through into an inflationary expansion of the money supply depends on the willingness of the banks use the newly created reserves to support additional lending.
History suggests that no system of regulatory arrangements is capable of providing a cast-iron guarantee of financial stability. Regulation often tends to be backward-looking, informed by the experience of the previous crisis. At the height of a crisis, supervisors may put off taking tough action to prompt the rescue of a distressed bank. Rescue may be the safer option for supervisors or politicians, fearful that collapse could have consequences for financial stability that are hard to foresee. Often, regulators and supervisors are themselves industry insiders, who have worked in the industry previously or hope to do so in the future. Bank executive salaries tend to be higher than those of employees or publicly-funded regulatory agencies. Accordingly, regulated banks may exert undue influence over regulators, a problem known as “regulatory capture.”
As with any regulation with less-than-universal geographical coverage, it has been argued that the market for executive talent is global, and restrictions imposed in one region would simply encourage executives or banks themselves to relocate to jurisdictions without restrictions.