Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 ASSIGNMENT COVER SHEET UNIVERSITY OF SUNDERLAND BA (HONS) BANKING AND FINANCE Student ID: 149078874/1 Student Name: Nguyen Thi Kieu Anh Module Code: APC 312 Module Name / Title: Money, Banking and Finance Centre / College: Banking Academy of Viet Nam Due Date: 16 Jan 2015 Hand in Date: 16 Jan 2015 Assignment Title: Individual assignment Students Signature: (you must sign this declaring that it is all your own work and all sources of information have been referenced) Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 MONEY, BANKING AND FINANCE APC312 Prepared by: Nguyen Thi Kieu Anh Student ID: 149078874/1 Submission Date: 16 Jan 2015 Number of words: Part A: 1,330 Part B: 1,516 Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 Part A: Discuss why banks need to be more regulated in terms of risks they face compared to other financial firms Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 TABLE OF CONTENTS INTRODUCTION MAIN BODY The differences in terms of risks between banks and non-bank financial institutions Form and cost of regulations CONCLUSION REFERENCES Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 INTRODUCTION In recent decades, the entire world economy plunged into a depression owing to the wholesale collapse of financial system The root of financial problems can be explained by absence or reduction of governmental controls that allowed financial institutions to operate beyond its range of activities, which so-called ‘deregulation’ Facing with the challenges in stabilizing financial system and recovering the economy, the government was forced to step forward in regulation, starting with regulating banks in terms of risks This study will discuss specifically the reason that banks need to be regulated in terms of risks they face compared to other financial firms MAIN BODY According to Herr and Kazandziska (2011, p.13), the financial system could be generally divided into banks and non-bank financial institutions such as mortgage companies, insurance companies, pension funds and investment banks…It is undeniable that banks offer wider range of financial services than any financial institution Banks accept deposits and create credit, that is, banks circulate capital resources from savers (the surplus-spending units) to borrowers (deficit-spending units) whereas non-bank financial institutions are not allowed to take deposits from the public Besides, banks also implement payment functions such as the transfer of deposits, payment of cheques, credit and debit card…whereas non-bank financial institutions play no direct role in payment system (Mbuya, 2008, p.22) This is also the reason why banks are considered as the lifeblood of the economy These two main activities help to distinguish between banks and non-bank financial institutions as well as cause higher level of risks and motivate for the entry of regulations in banking system compared to other financial firms The differences in terms of risks between banks and non-bank financial institutions The biggest difference in terms of risks between banks and non-bank financial institutions is liquidity risk Liquidity risk is a ‘hot topic’ in finance industry It is the risk of not being able to meet obligations in terms of funds demanded by clients (Faure, 2013) In the context of banking system, it arises from both sides of the balance sheet of banks Liabilities of banks mainly are short-term funds of depositors which have to pay back on demand anytime, especially sight deposits Meanwhile assets of banks might be short or long term loans, but whether short or long it also has longer maturity than liabilities It is called ‘maturity mismatch’ between assets and liabilities or can say that banks are engaged in the high degree of maturity transformation (Howells, 2014, p.13) If the bank cannot balance assets and Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 liabilities, banks will face illiquid risk as banks cannot liquidate customers’ unexpected need for cash When depositors doubts about the health of bank holding their money, they may rush to withdraw cash from the bank A “bank run” occurs leading to collapse of the bank Northern Rock - a British bank is a well-known example of liquidity crisis Northern Rock followed a ‘reckless business model’ where nearly 30% of its funding was bought-in shortterm wholesale funds that were used to finance long-term mortgage business (Financial Times, no date) Such business model caused lack of liquidity and the bank run in 2007 Unlike banks, non-bank financial institutions like life insurance companies only serves customers at the liability side of balance sheet It has a favorable liquidity position as illiquid liabilities versus liquid assets, that is, life insurance companies just compensate the financial risk as an agreement in event of untimely death of the policyholder which has long term maturity while it can use pool of these funds to invest in liquid assets such as government and corporate bonds which can sell anytime in case of unexpected event (Weert, 2011, p.23) Hence, liquidity risk is higher for banks than non-bank financial institutions According to Altman (2013, p.548), liquidity risk tends to compound to other risks such as credit risk, market risk…Credit risk is the risk that the borrower from a bank will default on the loan/the interest payable or not perform in terms of the conditions under which the loan was granted (Faure, 2013, p.93) Credit risk is inevitable so it remains biggest challenge for banking sector For example, the development of subprime mortgages market in US caused credit crunch in 2008 since large number of borrowers was unable to meet their mortgage repayments This, in turn, result in liquidity crisis in banks (Davies, 2014) Market risk arises when there is a decline in the market value of financial securities (share, debt and derivatives) that caused by unexpected changes in market prices, interest rates…(Faure, 2013, p.84) Competition in banking industry creates incentives for banks to expand their trading activities by holding larger financial securities This development leads to illiquid risk or even collapse of the bank when there is a sudden decline in those financial instruments Indeed, by late 2007, mortgage-backed securities slumped in value, a lot of banks suffer losses such as Citygroup: $40.7 billion, UBS: $38 billion, HSBC: $15.6 billion… (BBC, 2008) It threatens to liquidity of banks and led to the collapse of Northern Rock in UK Nonbank financial institutions also face credit risk and market risk, however, banks demand deposit so banks are subject to restrictions on their activities compared to other financial firms Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 Furthermore, these risks affect not only one bank but also the entire banking system The collapse of one bank causes a loss of confidence in banking in general, creates bad debts for other banks and widespread collapse (financial panics) This is called “systemic risk” or “risk of contagion” (Howells and Bain, 2007, p.362) Besides, it would cause delay of payment system resulting in significant disruptions in aggregate economic activity, especially import and export activities which bring great economic benefits for all countries Thus, it requires to impose regulations to ensure stability and soundness of the payment system A special case for intervention of regulations in banking industry is to protect customers as well as ensure the soundness of banking system from the informational imbalances or ‘asymmetric information’ Asymmetric information occurs between depositors and banks Depositors are unable to define the bank holding their deposit is good or bad bank until they cannot withdraw cash on demand It causes adverse selection as customers have little choices and have high demand in holding deposits as means of payment Besides, as key player in payment system, banks have incentives to use mobilizing funds from customers to invest in risky assets to earn profits, which so-called moral hazard On the other hand, banks also can be the victims of asymmetric information Borrowers have better information about level of risks they engaged when borrowing money from banks It is difficult for banks to appraise the investment project of customers when they intended to hide the risky action In the worst case, asymmetric information would lead to the collapse of banks and then create a domino effect on the stability of the entire financial system as economic crisis of 2008 Form and cost of regulations In order to protect customers and ensure the safety and soundness in banking system, some regulations are imposed such as:  Restrictions on assets and activities: In the US, the Glass-Steagall Act (1933) prevented commercial banks from engaging in securities trading with their client’s deposits and prevented investment banks from taking deposits This is partly a response to a wave of bank failures following 1929 stock market crash and Great Depression (Crawford, 2011, pp 127-133)  Capital adequacy: In Basel Committee member (UK, US, Canada…), Basel I (1988) required to express capital in relation to risk-adjusted assets Basel II (2004) goes well beyond by allowing banks to use ‘internal risk-weightings’ to calculate required regulatory capital (Howells, 2014, p.237) Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1  Liquidity requirements: Basel III required two liquidity ratios: Liquidity Coverage Ratio and Net Stable Funding Ratio (BIS, 2010,p.9)  Deposit insurance: In US, FDIC1 insures each depositor at a commercial bank up to a loss of $100,000 per account (Mishkin, 2004, p.40) Nevertheless, in the dark side of regulations, it creates adverse selection and moral hazard problem For example, safety of deposits motivates savers to deposit money into the bank without reservation and tracking Similarly, a belief that government acts as lender of last resort is always willing to rescue banks from failure creating incentives for them to take greater risks (‘too big to fail’ problem) (Howells and Bain, 2007, p.365) Besides, presence of regulations is source of barriers to entry and compliance costs resulting in higher prices in banking services CONCLUSION Through analysis above, it is obvious that banks face more risks in business compared to other financial firms In unregulated market, it is easy to collapse and cause financial crisis worldwide Therefore, strict regulations are really necessary to limit banks’ exposures to risks However, regulations also cover certain costs that require government to concern and monitor in efficient manner Federal Deposit Insurance Corporation was created in 1934 after the massive bank failures of 1930–1933, in which the savings of many depositors at commercial banks were wiped out Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 REFERENCES Altman, E.I., Nimmo, R., Narayanan, P and Caouette, J.B (2013) Managing credit risk: The Great Challenge for Global Financial Markets 2nd edn Canada: John Wiley & Sons BBC (2008) Timeline: Sub-prime losses Available at: http://news.bbc.co.uk/2/hi/business/7096845.stm (Accessed: 07 December 2014) BIS (2010) Basel III: A global regulatory framework for more resilient banks and banking systems Switzerland: Bank for International Settlements Crawford, C (2011) 'The Repeal Of The Glass- Steagall Act And The Current Financial Crisis', Journal of Business & Economics Research, 9(1), pp 127-133 Davies, J (2014) Global Financial Crisis – What caused it and how the world responded Available at: http://www.canstar.com.au/home-loans/global-financialcrisis/ (Accessed: 08 December 2014) Faure, A.P (2013) Banking: An introduction 1st edn Quoin Institute (Pty) Limited & bookboon.com Financial Times (no date) Definition of liquidity crisis Available at: http://lexicon.ft.com/Term?term=liquidity-crisis (Accessed: 06 December 2014) Her, H and Kazandziska, M (2011) Macroeconomic Policy Regimes in Western Industrial Countries New York: Taylor & Francis e-Library Howells (2014) Money, Banking and Finance APC312 United Kingdom: University of Sunderland 10 Howells, P and Bain, K (2007) Financial markets and institutions 5th edn London: Longman 11 Mbuya, J.C (2008) The Pillars of Banking United Arab Emirates: MP 12 Mishkin, F (2004) The economics of money, banking and financial markets 7th edn The United States of America: Addision-Wesley 13 Weert, F.D (2011) Bank and Insurance Capital Management 1st edn United Kingdom: TJ International Ltd Money, Banking and Finance APC312 10 Nguyen Thi Kieu Anh - ID 149078874/1 Part B: Critically analyze the competitive conditions in the banking industry Money, Banking and Finance APC312 11 Nguyen Thi Kieu Anh - ID 149078874/1 TABLE OF CONTENTS INTRODUCTION 12 MAIN BODY 12 Competitive approaches 12 Degree of competition in banking industry 14 The impact of regulations on competitive conditions in banking industry 15 CONCLUSION 16 REFERENCES 17 Money, Banking and Finance APC312 12 Nguyen Thi Kieu Anh - ID 149078874/1 INTRODUCTION Banking sector plays a crucial role in economic growth of all nations through mobilizing and allocating funds in the economy Competition in banking sector, therefore, has received researchers’ attention worldwide As Bandt and Davis (2000, p.1045) showed, competition in banking sector has intensified significantly in recent years Deregulation, technological advancements as well as globalization phenomenon that allows foreign bank involved in domestic banking markets are underlying causes of changing competitive conditions This study will analyze in detail competitive conditions in banking industry MAIN BODY This study analyzes the competitive conditions based on three aspects: competitive approaches, the degree of competition and changes in competitive conditions in banking industry Competitive approaches  Interest rate competition Interest rate is key tool to compete among banks for the need of increasing capital and expanding market share because it affects the economic decisions of the public When the lending rates are low, it encourages the public borrow money from the bank and vice versa Similarly, high deposit rates will encourage the public deposit money into the bank and vice versa A bank earns a spread on the money it lends out from the money it takes in as a deposit, which are generally known as interest rate spread (IRS) (Fuhrmann, 2014) In other words, the difference between deposit and lending interest rates generates profits for banks According to Croushore (2012, p.233), competition from other banks limits the profits a bank can earn by changing the spread If a bank tries to increase its spread by paying lower deposit interest rate than its competitors, then depositors will switch to other banks If a bank charges higher lending interest rate than its competitors, it will lose borrowers to cheaper competitors Competition keeps interest rates on both loans and deposits similar across banks In Vietnam, for example, VietNamNews (2013) reports that Vietnam financial market was witnessing a rare phenomenon that is lending and deposit interest rate got so close each other Interest rate (over 12 month deposits) of Agribank climbed to 8%, Vietinbank up to 7%, Vietcombank rose between to 7.5% The deposit interest rate race seems more stressful when Techcombank raised the interest rate of less 12 month deposits up to 6.75-7.45% per year Besides, raising deposit interest rates, the banks also made efforts to cut their lending interest rate, sometimes lower than their deposit rate In the context of intense competition, interest Money, Banking and Finance APC312 13 Nguyen Thi Kieu Anh - ID 149078874/1 rate spread is too low even not able to cover operating costs so earning profits from interest rate spread is close to zero The competition in terms of interest rate among banks tends to decrease When interest rate competition does not attract customers, banks start a new challenge on the track of services and utilities  Products and services competition In order to create competitive advantages, banks have created product differentiation and product diversification Products are differentiated on features such as size, design, prices, and benefits…For example, HSBC India provides exceptional features on credit card like fuel surcharge waiver and exclusive rewards programme Unique benefit of a fuel surcharge waiver helps customers save 2.5% fuel surcharge at any pump any place in India (HSBC, 2014a) The reward programme on HSBC credit card gives bonus points that customers can redeem these points for an exciting range of redemption options including cosmetics, garments, home appliances (HSBC, 2014b) As for product diversification, banks can offer wider range of products to enable cross-selling However, products in banking sector are very susceptible to copy, it requires banks innovate constantly and promote the creativity of their own In terms of services, quality of services reflected in a transactional manner and employees’ behaviors (so-called business culture) are the first concern The reason is that while products are vulnerable to copying, business culture is assessed highly by customers and brings long-term competitive advantages for banks Nevertheless, it needs long time to build; especially banks have extensive network and large number of employees, but will be a key competitive advantage for customer retention in long-term Besides, banks are also trying to increase operational efficiency by enhancing employees’ performance for the purposes of cheaper banking services  Technology competition Technology adoption allows banks to provide services for customers at lower cost since there is no distance between banks and customers anymore Electronic banking like automated teller machine (ATM) that have large number of booth and available for use 24/7 allows customers implement transactions any time at anywhere Electronic money (e-money) exists in electric form, substitute for cash as well (Mishkin and Eakins, 2012, p.462) It is very convenient for customers when buying high value goods Thanks to these benefits, it brings huge competitive advantages for banks that can take full advantages of it In technology competition, larger banks have more advantages than smaller banks Larger banks have strong economic potential and operate on both domestic and international levels so it can Money, Banking and Finance APC312 14 Nguyen Thi Kieu Anh - ID 149078874/1 cover high costs in adopting technology compared to smaller banks For example, Citibank have applied webcam banking that allows customers deal with enquires without meeting bankers face to face However, as estimated it is very costly so it just suitable for Citi’s most mature markets in the West (Citibank, 2013) Degree of competition in banking industry  Bank size According to G20 (2008, p.68), larger banks have more market power than smaller banks as large banks have more competitive advantages than smaller ones Large banks can take benefit from their good reputation, economies of scale and ability to adopt modern technology while maintaining financial stability; thereby allowing them to price their product and services more competitively Medium and small-sized bank, therefore, have trend to merger and acquisition (M&A) to consolidate market share, increase market power and reduce intensity of competition EU Number of banks Year 1990 1995 2000 2005 Austria Belgium Denmark Finland France Germany Greece Italy Luxembourg Netherlands Portugal Spain Sweden United Kingdom Total number bank EU Average % change EU 1,210 115 189 523 1,981 3,913 15 1,138 177 180 33 327 12 47 9,860 1,041 923 873 143 118 101 114 99 98 351 342 338 1,453 1,108 814 3,500 2,575 1,949 18 17 21 959 827 770 220 202 155 174 87 72 37 42 43 318 281 269 13 23 26 40 44 30 8,381 6,688 5,559 % decrease 1990-2005 28 12 48 35 59 50 -40 32 12 60 -30 18 -118 36 44 Table 1: Number of banks and concentration ratios over the period 1990-2005 (G20, 2008) The table above shows a significant decline in the number of banks in EU countries over the period of 1990-2005 that reflected increased concentration in recent years  Domestic banks versus foreign banks The issue of competition is becoming more intense when domestic banks can expand to foreign countries and vice versa, foreign banks also penetrate to compete with banks in Money, Banking and Finance APC312 15 Nguyen Thi Kieu Anh - ID 149078874/1 domestic market According to Wu (2009, p.7), Eastern and Central European countries have the highest average foreign bank penetration level based on total asset (43.76%) The high level of foreign bank penetration creates competitive pressures on host banking system when foreign banks always catch up with technology advancements, product innovation and diversification…Thus, domestic banks need to improve product quality, upgrade technology and optimize resource allocation so as to compete with foreign banks However, foreign bank penetration has improved efficiency of domestic banking system, which contributes to economic growth  The growth of universal banks Universal banking refers to financial institutions that may offer the entire range of financial services which is combination of commercial banking (deposit-taking, loan-making), investment banking (issuing, underwriting, investing and trading in securities) and insurance services (Suresh and Paul, 2010, p.521) German is a prototype for running the universal banking system There are many countries move towards universal banking afterwards such as Canada, Switzerland, and India The trend towards universal banking is to pursuit economies of scale and scope, whereby result in cost savings and bring opportunities for cross-selling, increasing customer base However, it would spur intense competition in banking system of countries that allow developing universal banks High level of competition could lead to instability or even failure of banking system Especially the collapse of one universal bank could have serious impacts for the entire financial system Hence, despite the growing popularity of universal banks in a global context, the United States, Japan continue to prevent commercial banks from engaging in securities transaction and underwriting (Cheang, 2004, p.46) The impact of regulations on competitive conditions in banking industry Regulation has a significant impact on competitive conditions in banking industry In the 1980s, many countries undertook the deregulation of their financial systems White and Vittas (1986) summarized that the barriers being eroded include: restrictions on capital markets, credit ceiling and exchange controls; and restrictions on foreign banks entry and the activities of foreign banks in domestic markets (Mullineux, 1987, p.4) Reduction of these barriers increased degree of competition in banking sector As BIS (2001, p.24) showed, deregulation of financial services led to dramatic increase of presence of foreign banks in emerging economic in second haft of the 1990s For example, in Latin America, the market share of foreign banks rose to 40% in 2000 from an average of 7% a decade ago Such thing Money, Banking and Finance APC312 16 Nguyen Thi Kieu Anh - ID 149078874/1 caused adverse selection and moral hazard problem due to unhealthy competition Consequently, it resulted in global banking crisis 2007/8 and left serious consequences to the world economy After the banking crisis, there are many suggestions to reform the regulatory system for the purpose of making financial system healthier One of them is Dodd-Frank Wall Street Reform Act of 2010 which was passed by US Congress It required banks to hold more capital to cushion against large losses, included strategies to keep companies from becoming too big to fail and required that derivatives be moved onto exchanges for better monitoring (Amadeo, 2014) Besides, reform package like Basel III was also passed by Basel Committee to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, thus reducing the risk of spillover from the financial sector to the real economy (BIS, 2010, p.1) Nevertheless, the need to reform regulation in the wake of financial crisis reduced competition among banks which in turn decreased operational efficiency in banking sector CONCLUSION To sum up, competition in banking industry varies from bank size to changes in regulations across countries It requires banks create more competitive advantages to compete with other banks both on domestic and international levels Competition helps banks operate more efficient but it also caused financial loss when exist unhealthy competition among banks Hence, it is very hard to determine whether promoting competitiveness in banking industry is bad or good for the economy, which in turn difficult for authorities to make right decisions for economic growth Money, Banking and Finance APC312 17 Nguyen Thi Kieu Anh - ID 149078874/1 REFERENCES Amadeo, K (2014) Deregulation Available at: http://useconomy.about.com/od/glossary/g/deregulation.htm (Accessed: 14 December 2014) Bandt, D and Davis, E P (2000) 'Competition, Contestability and Market Structure of European Banking Structures in the European Banking Sectors on the Eve of EMU', Journal of Banking and Finance, 24(6), pp 1045-1066 BIS (2001) The banking industry in the emerging market economies: competition, consolidation and systemic stability Switzerland: Bank for International Settlements BIS (2010) Basel III: A global regulatory framework for more resilient banks and banking systems Switzerland: Bank for International Settlements Cheang, N (2004) Practices of Universal Banks and Macao’s Banking Activities Monetary Authority of Macao, pp.45-61 Citibank (2013) Web Cam Available at: https://www.citibank.co.id/english/services/webcam.htm?eOfferCode=IDSRLNTRT (Accessed: 13 December 2014) Croushore, D (2007) Money and Banking: A Policy-Oriented Approach United States: Cengage Learning Fuhrmann, R.C (2014) How Banks Set Interest Rates On Your Loans Available at: http://www.investopedia.com/articles/investing/080713/how-banks-set-interest-ratesyour-loans.asp (Accessed: 11 December 2014) G20 (2008) Competition in the Financial Sector Available at: http://g20russia.ru/load/780983084 (Accessed: 13 December 2014) 10 HSBC (2014a) Fuel Surcharge Waiver Available at: http://www.hsbc.co.in/1/2/personal/credit-cards/fuel-surcharge (Accessed: 13 December 2014) 11 HSBC (2014b) Rewards Programme Available at: http://www.hsbc.co.in/1/2/personal/credit-cards/rewards-programme# (Accessed: 13 December 2014) 12 Ly, T (2013) Deposit, lending rates inch ever closer Available at: http://vietnamnews.vn/economy/247776/deposit-lending-rates-inch-ever-closer.html (Accessed: 12 December 2014) 13 Mishkin, F (2004) The economics of money, banking and financial markets 7th edn The United States of America: Addision-Wesley Money, Banking and Finance APC312 18 Nguyen Thi Kieu Anh - ID 149078874/1 14 Mishkin, F S and Eakins, S, G (2012) Financial Markets & Institutions 7th edn The United States of America: Pearson Education International 15 Mullineux, A.R (1987) U.K Banking After Deregulation London: Croom Helm 16 Suresh, P and Paul, J (2010) Management Of Banking And Financial Services 2nd edn India: Dorling Kindersley Pvt Ltd 17 Wu, J., Jeon, B N, and Luca, A (2009) 'Foreign bank penetration, resource allocation and economic growth: evidence from emerging economies', MPRA Paper, 34946 (22), p.7  ... International Ltd Money, Banking and Finance APC312 10 Nguyen Thi Kieu Anh - ID 149078874/1 Part B: Critically analyze the competitive conditions in the banking industry Money, Banking and Finance APC312. . .Money, Banking and Finance APC312 Nguyen Thi Kieu Anh - ID 149078874/1 MONEY, BANKING AND FINANCE APC312 Prepared by: Nguyen Thi Kieu Anh Student... economics of money, banking and financial markets 7th edn The United States of America: Addision-Wesley Money, Banking and Finance APC312 18 Nguyen Thi Kieu Anh - ID 149078874/1 14 Mishkin, F S and Eakins,