Today’s goals
 Understand the role of maturity transformation,
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aggregation and risk transformation
Understand the credit creation multiplier
Understand the importance of the payment system and
how it operates
Describe the main products and services offered by banks
Understand the structure and customer base of the global
banking industry
Position the banking industry within the global financial
system
2
Casu, Girardone & Molyneux: Chapter 1.3
The theory of banking
 Banks, like other financial intermediaries, perform
three basic high level functions:
Size transformation
2. Maturity transformation
3. Risk transformation
1.
 In addition, banks provide intermediation products
and services at the time of their customer’s choosing
 Because of the central positioning of banks in the
financial system they can improve system liquidity,
reduce system cost and lower system risk
3
Casu, Girardone & Molyneux: Chapter 1.3
Size transformation
 Unlikely a saver will deposit the exact amount of funds
with a bank that a borrower demands on any given day
 Banks have multiple sources of liquidity to cover
mismatches in financial transaction size:
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Central bank liquidity windows
Interbank markets
Public money market or bond markets
 Banks can take a “portfolio management” approach to
the transformation of varying size requirements from
their broad customer base of savers and borrowers
4
Casu, Girardone & Molyneux: Chapter 1.3
Maturity transformation
 Unlikely a saver will deposit funds with a bank to the to
the exact maturity that a borrower demands on any
given day
 Banks manage “asset-liability” maturity mismatch risk
as part of their capital and liquidity management
framework
 Banks also take a “portfolio management” approach to
the transformation of maturity requirements – more
heavily regulated as Basel III approaches
5
Casu, Girardone & Molyneux: Chapter 1.3
Risk transformation
 Unlikely a saver will wish to deposit all its funds with a
single borrower, instead seeking to diversify its credit
risk across a broad range of borrowers
 Banks lend to a broad range of borrowers, offering
savers a diversified credit risk profile
 In addition, banks have a regulated capital structure
ensuring borrowers have a cushion against expected
and unexpected losses in the portfolio
6
Casu, Girardone & Molyneux: Chapter 1.4
Time and scale is money!
 Banks lend funds and take deposits at the time of
choosing of borrowers and savers respectively
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Reduces risk for borrowers that need certainty of funds on a
specific day
Reduces opportunity costs for savers who might otherwise
take additional time to find a borrower and thereby forfeit
interest receipts
 Banks reduce transaction, information and search
costs by exploiting economies of scale

Larger turnover, larger fund flows reduces unit costs and
increases economic efficiency
7
Casu, Girardone & Molyneux: Chapter 2.3
Credit creation
 Banks have very privileged position in the economy:
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Usually the most leveraged sector in he economy (15-30x
leveraged!)
Often the beneficiary of government deposit insurance /
guarantee schemes
Guaranteed access to regulatory pools of liquidity at all times
 All we ask is that as the sector responsible for creating
credit growth (via credit multiplier) banks behave
fairly, reasonably and professionally!
8
Casu, Girardone & Molyneux: Chapter 2.3
Credit creation
 When a bank accepts a deposit it is required to hold a
certain amount (eg say 10%) in approved reserves (eg
deposits with Central Bank, government securities)
 The balance can be lent to new borrowers who may
deposit into other banks, or purchase goods and
services from another economic entity who deposits
the proceeds in another bank
 That bank will then retain the reserve requirement
and further lend the funds to borrowers
 In practice things don’t work this smoothly but this is
the theory behind credit creation
9
Casu, Girardone & Molyneux: Chapter 2.3
Theory of credit creation
Bank
$ Deposit
taken
$ Loan
made
$ Reserve
held
A
50.0000
45.0000
5.0000
B
45.0000
40.5000
4.5000
C
40.5000
36.4500
4.0500
D
36.4500
32.8050
3.6450
E
32.8050
29.5245
3.2805
…
…
…
…
500.000
450.000
50.000
Total
 Under a 10% Reserve Ratio for each $1 deposit taken the banking system can
create $10 in new deposits
 Credit Multiplier = Change in Deposits / Change in Reserves = 500 / 50 = 10
10
Casu, Girardone & Molyneux: Chapter 2.4
Payment systems
 A Payment System is any organised system established
to arrange for participants to transfer money between
themselves
 Payments take place for many reasons:

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In exchange for goods and services
Creation or repayment of a financial liability/asset
 Banks historically have played a key role in global
payments systems
 Many points of access for participants – not to be
confused with the underlying money transfer
mechanism
11
Payment systems
 Large domestic payment systems use Real Time Gross
Settlement (RTGS) to transfer money between
participants
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All participants must hold some form of account with a bank
in the payments system
To effect payment a participant will instruct its bank to
transfer money from that participant’s account to the proper
account of another participant at its own bank
The two banks “settle” the transaction through adjustment of
their own accounts held with the relevant Central Bank
Central Banks usually manage RTGS systems
12
Payment systems
 International payment systems use Society for
Worldwide Interbank Financial Telecommunication
(SWIFT) to transfer money between participants
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SWIFT is does not alter the underlying mechanics of
individual currency payment systems
SWIFT is simply a system that arranges domestic payments
between participants in the same manner as previously
described
Unless the banks handling a SWIFT transaction are primary
deposit-taking institutions in the currency of the transaction,
instructions will be handled through a correspondent banking
arrangement
13
Casu, Girardone & Molyneux: Chapter 2.4
Payment systems
 Banks often hold accounts with other domestic or
international banks
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Nostro account: “our money held by you”
Vostro account: “your money held by us”
 When a bank holds an account with another bank it is
said to have a Correspondent Banking Relationship
 If a bank does not maintain an account with its Central
Bank it needs to have a correspondent banking
relationship with one that does
14
Casu, Girardone & Molyneux: Chapter 2.4
Ways to pay
 There are many ways of instructing payment:
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Cheques
Online transfers
Standing orders
Credit cards
Debit cards
ATMs
Smartphones
SMS
15
Casu, Girardone & Molyneux: Chapter 2.4
Banking products and services
 Retail and Corporate banks offer a wide range of products and services
– including:
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Current and chequing accounts
Term deposits
Consumer loans and mortgages
Credit and Debit Cards
Cash management services
Corporate and SME loans
Trade Finance
Financial market products and services
Capital Market products and services
Securitised or asset backed lending
Investment products and services
Insurance
Advisory services
Online banking
16
Casu, Girardone & Molyneux: Chapter 2.4
Mortgage products
 One of the most fundamental banking products
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A bank lends money to a borrower to purchase a house,
apartment or other property
Only a portion of the property purchase price is lent (eg 50%)
– the balance is funded from savings of the borrower
The borrower repays loan principal and interest over an
agreed time frame (eg 30 years)
The bank takes a “mortgage” over the property which entitles
it to seize and sell the property to repay the loan if the
borrower defaults
 Banks are at the heart of retail property financing
across the globe
17
Casu, Girardone & Molyneux: Chapter 2.4
Credit and debit cards
 A group of banks were responsible for the
development of widely used credit cards such as Visa
and Mastercard
 Card products offer the great convenience of being
cash-like and widely accepted
 Credit cards offer the holder an unsecured line of
credit that can be drawn to pay for goods and services
 Debit cards are accounts that must have positive fund
balances before they can be used to pay for goods and
services
18
Casu, Girardone & Molyneux: Chapter 2.4
Cash management services
 Corporate customers have complex daily cash
management requirements including:
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Multi currency cash accounts
Account sweeping and reconciliation
Lockbox facilities
Subsidiary account management
Foreign exchange
 Sophisticated online cash management solutions are
now offered by many banks to help corporate
customers manage their business flows
19
Casu, Girardone & Molyneux: Chapter 3.5
Trade finance
 Banks are central to the financing of trade flows across
the globe:
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Guaranteeing payments for exporters and importers through
correspondent banking relationships
Financing shipments of commodities as they flow around the
globe
Working capital finance for trading companies
Inventory financing
20
Casu, Girardone & Molyneux: Chapter 3.5
Financial market products
 Banks offer a range of financial market products and
services including:
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Foreign exchange and forwards
Money market products
Bond and share trading and underwriting
Merger and acquisition advisory
Syndicated loans
Derivative risk management products
Repo products
21
Investment products
 Banks have increasingly moved into many areas of
investment products including:
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Pension and mutual fund management
Trustee and custodial services
Private banking and advisory
22
Casu, Girardone & Molyneux: Chapter 3.5
Corporate banking products
 Bank corporate customers range from SME to mid
market to large listed multinational companies
(MNCs)
 These customers have a range of banking needs
including:
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Lease and hire purchase financing
Invoice and receivable discounting
Corporate loans and commercial paper (CP)
Pre IPO finance
Securities underwriting
Project finance
23
Securitised lending
 Discussion of securitisation often focuses on products
that help banks to manage there own balance sheets
 Much (probably most) of the assets that have been
securitised since the industry was born in the 1980s
have come from third party originators or corporates
 Banks structure, underwrite and distribute
securitisation transactions for their customers
24
Casu, Girardone & Molyneux: Chapter 3.2
Traditional versus modern banking
 Traditionally banks focused on deposit and lending
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products
In the 1980’s governments around the world embarked on a
process of banking deregulation and liberalisation
This resulted in a strong globalisation trend in the
industry where many banks grew their international
operations, applying for banking licenses across the globe
At the same time many countries floated their currencies,
and the derivatives market was born – creating an
explosion in new financial market products
The growth in new products and networks beyond
traditional deposit and lending created what we know as
modern banking today
25
Traditional banking customers
 Traditional banking customers broadly fell into
categories of:
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Household savers, or borrowers for purchases of property or
smaller ticket personal goods (eg cars)
Corporate borrowers entering into bilateral or club loans for
capital expenditure (capex), working capital or M&A
Governments funding infrastructure or deficits
26
Modern banking customers
 Post deregulation in the 1980s, the number and type of
bank customer has grown strongly
 Retail customers now also include:
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Financial market traders and speculators
Margin loan borrowers
Insurance customers
Fund management investors
Advisory customers (Private Banking, estate planning etc)
“Sub-prime” customers
Traditional deposit and consumer loan customers
Etc..
27
Modern banking customers
 Wholesale customers now also include:
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Private Equity funds
Pension and Mutual funds
Hedge Funds
Mortgage and other originators
NBFIs
Traditional corporate borrowers
Corporate risk managers
Capital Market issuers
Syndicated loan borrowers
Etc…
28
Banking in context
 Banks have played a central role in the global financial
system and its growth
 Growth of Capital Markets has seen a trend of
“disintermediation” in recent years
 Banks and NBFIs still play a central role in the
operation of Capital Markets, however their
intermediation role has reduced in relative importance
over the past few decades
29
Recall
Intermediation
Savers
Financial
Intermediaries
Borrowers
(Banks)
..versus Direct Finance
Savers
Financial
(Capital)
Markets
Borrowers
30
Bonds versus loans
 While some bankers focus on Capital Markets
business, many others compete with Capital Markets
for business
 In 2014 approx USD 4.5 trillion in bond issuance in
USD and EUR alone - across Investment Grade, High
Yield, Hybrid, Financials, ABS, Government
 In 2014 approx USD 4.0 trillion in Syndicated Loan
issuance
=> Capital Market volumes likely overwhelm bank
intermediation volumes in today’s financial markets
31