Banking: Opportunities and

Threats


Strategic Perspectives in Banking
21 July 2014
Aravindan | Gokul | Praneesh | Rajesh | Vinayak
Agenda
Why Financial intermediaries?
Why Banks?
What has changed?
What else will banks do?
Banks vs Finance Companies
Competition & Limits to growth
Trending opportunities

Nature of banking business
Relationship vs. transaction oriented
banking
Threats to the traditional relationship-
oriented banking
Advent of securitization & its effect on
bank loans
Problems innate to the banking industry
Transparency issues & free-riding
Remarks

Why FIs offer demand deposits and
loans
FIs have greater
market power
than individuals
FIs reduce
uncertainty by
pooling
FIs bring scale
economies
Reduce a firms
funding costs
Enhance
contractual
possibilities
Why Banks?
Both sides of Balance sheet
Governments favor them as creators
Optimal institutional arrangement for private contracting
Liquidity easy flow of credit
Re-distribution of wealth in impoverished economy
Create wealth opportunities
Govt. does NOT act as the bank itself a major borrower
Rents in deposit business: political advantage of taking a little from the many





Synergies in Banking
Liquidity insurance
Avg. maturity of finance company loan
50% higher than that of banks
Liquidity on demand Scale
economies
FIs usually go for longer term loans
Meets unexpecrted liquidity demands
Offers liquidity on both sides of balance
sheet
Co-insurance
Opaque opertaions High cost of
borrowing
Building reputation will take
considerable time
Other possibility is to invest in Illiquid
assets
Acts as con-insurance for liquid assets
Liquid Illiquid assets
Deregulation & Technological Change
ATM, Credit & Debit cards
Credit rating/history of a client/consumer
Reduced Transaction costs,
Provide funding on demand, not per se
Unlike Finance companies, banks lend outside their area of focus
Loan sales is a repeat sales market. -> incentive for borrowers to be
honest

Finance Companies vs Banks
Misconception
regarding fall in the
growth of banks due to
finance companies
Short notice finance still
provided by banks
Finance companies
have much better
match between interest
income they receive
and cost of funding it
Banks offer services for
certain class of
borrowers that cannot
be obtained via capital
markets
Secondary loan sales
market provides a
cushion effect
Competition
Increase due
to
deregulation &
technological
innovations
Opportunity
Banks most
valuable Asset
- Captive
Customer
One approach
increase
switiching
costs
Innovation-
means at
differentiation
Identify high
transaction
costs &
Reduce them.
Eg- Citibank
cross country
transactions
Automation - reduces costs but high investments required
Hence done by large banks leading to consolidation
New products Modern version of traditional ones
Fingerprint replacing money, plastic card, checks
Non traditional business underwriting a corporate security
Capabilities Providing liquidity, information gathering & transaction
processing
Limits to growth
Personnel
chahging roles,
perceived conflict
of pay equity
Perception of
Lemon Problem
Effect of new
businesses on
banks average
cost of borrowing
Trending Opportunities
Financial
inclusion
Technology
driven
products
Improving
Capital and
Business
efficiency
Climate Risk
Management
Functions of a bank
Non-marketable
assets(lend) funded
with liquid
deposits(borrow)
Difference in liquidity
reflected in rates
charged by banks
Information
sensitivity of banks
assets
Ability of banks to
economize on
search/matching
costs
Blurring boundaries
between modern &
traditional banking
Absorb
credit/placement risk
Qualitative asset
transformation
Nature of bank loans
Capital market financing vs. Bank lending
Mitigation of information asymmetries optimal information flow
Value of information & incentives for information acquisition
Enduring close relationships between bank & client
Nature of lending contracts flexibility & bargaining power
Advent of securitization: A threat to
traditional lending?
Primal activities of a banks lending function
Origination Screening prospective clients & pricing contracts
Funding Providing resources for the contract
Servicing Collection & client monitoring
Risk processing Hedging, diversification, & absorption of risks
Securitization Unbundling of financial services
Asset-backed securities & not deposits fund bank-originated assets
Securitization removes the funding activity
Securitization quality enhanced by issuing bank through risk absorption
Pooling benefits of securitization extendable to commercial loans?
Way forward for relationship banking
Shorter nature of relationships diminishes the value of information
Weak relationships disincentivise information acquisition
Relationship puzzle borrowers also need to invest in relationships
Relationship banking works even in cases of asymmetric information
Relationship paradox Competition threatens relationships but
incentivizes the need for relationships as differentiation factor

Transparency in banking
Opaqueness due to the nature of loans and not bank policies
Banks diversify into a wide range of activities
Evaluation of a banks performance becomes harder
Elevated cost of funds, thus ceding advantage to financial markets
Opaqueness leading to poor cost accounting & cross-subsidization


Proprietary trading & free-riding
Prop trading Bank trades with own money rather than depositors
Prop trading leads to a problem of free riding
Prop trading appears more profitable than it is
Prop trading unit does not internalize risks
Relationship-oriented activities face a high cost
Internal capital allocation becomes arbitrary and flawed
Cost of capital is risk dependent & hence not same for all units
Putting idle capital to use further elevates the cost of capital


Remarks
Relationship banking is characteristic of value-enhancing intermediation
Relationship banking has suffered from advent of transaction banking
Financial markets have gained market share & increased competition
Diversification of bank activities & increased importance given to trading
Banks may mistakenly conclude relationship banking is not profitable