0273693026_COVER.qxd 7/3/06 11:13 Page 1 INTRODUCTION TO BANKING TO INTRODUCTION Introduction to Banking is a comprehensive and up-to-date introduction to the business of banking, written by expert authors. The book covers both theoretical and applied issues relating to the global banking industry, highlighted by examples from across Europe and the wider international arena. It is organised into four main sections: introduction to banking; central banking and bank regulation; issues in bank management; comparative banking markets. • Familiarises students with the reasons banks exist, the different services they offer, and the recent trends impacting on the banking business. • Covers contemporary central banking and bank regulation issues, comparing the UK, Eurozone and the US, INTRODUCTION TO BANKING providing students with the most up-to-date information on banking practice. • Strong focus on bank management issues, including insight into risk management techniques used by banks, prepares students to understand the different financial features of commercial and investment banks. Barbara Casu Claudia Girardone Philip Molyneux • Recent developments in developed, emerging and transition banking and financial systems are covered in detail, familiarising students with different types of banking systems and how global trends impact on different types of banking markets. Audience Suitable for all undergraduate students taking a course in banking, as well as professionals entering the banking industry. It also provides solid background reading for postgraduate students of banking. About the authors Casu Girardone Molyneux Casu Girardone Dr Barbara Casu is Senior Lecturer in Financial Studies at the University of Wales, Bangor. Her research interests are in Banking and Finance and Performance Measurement. She has published widely in these areas, including recent publications in: the Journal of Banking and Finance, the Journal of Business, Finance and Accounting, and Applied Financial Economics. Dr Claudia Girardone is Lecturer in Finance at the University of Essex. Her main research interests are in the areas of Bank Performance and Efficiency Analysis and her recent publications appear in: Applied Economics, Applied Financial Economics, and the Journal of Banking and Finance. Philip Molyneux is Professor in Banking and Finance and Director of the Institute of European Finance at the University of Wales, Bangor, and has a chair at Erasmus University, Rotterdam, Netherlands. Professor Molyneux has published widely in banking and acted as a consultant to: the World Bank, the European Commission, the UK Treasury, and various other international banks and consulting firms. He has recently been appointed as one of eight expert financial sector advisers to the European Union's Economic and Monetary Affairs Committee which implements financial services regulations for the European Community. ISBN 0-273-69302-6 9 780273 693024 www.pearson-books.com An imprint of Cover image © Alamy Images ITBG_A01.QXD 8/3/06 9:09 am Page i INTRODUCTION TO BANKING Barbara Casu University of Wales, Bangor Claudia Girardone University of Essex Philip Molyneux The University of Wales, Bangor ITBG_A01.QXD 8/3/06 9:09 am Page ii Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at: www.pearsoned.co.uk First published 2006 © Pearson Education Limited 2006 The rights of Barbara Casu, Claudia Girardone and Philip Molyneux to be identified as authors of this work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP. ISBN-10 0-273-69302-6 ISBN-13 978-0-273-69302-4 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data A catalog record of this book is available from the Library of Congress 10987654321 10 09 08 07 06 Typeset in 9/12pt Stone Serif by 30 Printed and bound by Ashford Colour Press Ltd., Gosport The publisher’s policy is to use paper manufactured from sustainable forests. ITBG_A01.QXD 8/3/06 9:09 am Page iii To my husband Martin. To my parents Claudia and Antonio and to my sister Alessandra. To S.J., S.G. and A.M. (BC) To my husband Marc and to our new life with Matteo. To my parents Nieves and Sandro, for a lifetime of encouragement and support. (CG) To my wife Del and cheeky kids – Alun, Catrin, Gareth, Gethin, Lois and Rhiannon. Also to my parents who celebrated their 50th wedding anniversary in 2005. (PM) ITBG_A01.QXD 8/3/06 9:09 am Page iv ITBG_A01.QXD 8/3/06 9:09 am Page v Contents List of figures xxii List of tables xiv List of boxes xvii Preface xix Acknowledgements xxiii List of abbreviations and acronyms xxvii Part 1 INTRODUCTION TO BANKING Chapter 1 What is special about banks? 3 1.1 Introduction 4 1.2 The nature of financial intermediation 4 1.3 The role of banks 7 1.4 Information economies 8 1.5 Why do banks exist? Theories of financial intermediation 14 1.6 The benefits of financial intermediation 17 1.7 Conclusions 18 Key terms 19 Key reading 19 Revision questions and problems 19 Chapter 2 Banking activities and current issues in banking 20 2.1 Introduction 21 2.2 What do banks do? 21 2.3 Banks and other financial institutions 22 2.4 Banking services 25 2.5 Current issues in banking 37 2.6 Responses to the forces of change 41 2.7 Conclusions 47 Key terms 48 Key reading 48 Revision questions and problems 48 ITBG_A01.QXD 8/3/06 9:09 am Page vi vi Contents Chapter 3 Types of banking 49 3.1 Introduction 50 3.2 Traditional versus modern banking 50 3.3 Retail or personal banking 54 3.4 Private banking 57 3.5 Corporate banking 59 3.6 Investment banking 68 3.7 Universal versus specialist banking 70 3.8 Islamic banking 71 3.9 Conclusions 73 Key terms 74 Key reading 74 Revision questions and problems 74 Chapter 4 International banking 74 4.1 Introduction 76 4.2 What is international banking? 76 4.3 A brief history of international banking 77 4.4 Why do banks go overseas? 78 4.5 Types of bank entry into foreign markets 85 4.6 International banking services 88 4.7 Increasing role of foreign banks in domestic banking systems 102 4.8 Conclusions 104 Key terms 105 Key reading 105 Revision questions and problems 105 Part 2 CENTRAL BANKING AND BANK REGULATION Chapter 5 Theory of central banking 109 5.1 Introduction 110 5.2 What are the main functions of a central bank? 110 5.3 How does monetary policy work? 111 5.4 Monetary policy functions of a central bank 115 5.5 Why do banks need a central bank? 124 5.6 Should central banks be independent? 127 5.7 Conclusions 129 Key terms 129 Key reading 130 Revision questions and problems 130 ITBG_A01.QXD 8/3/06 9:09 am Page vii Contents vii Chapter 6 Central banks in practice 131 6.1 Introduction 132 6.2 The Bank of England 132 6.3 The European Central Bank (ECB) 140 6.4 Federal Reserve Bank 148 6.5 Performance of central banks: a comparison 155 6.6 Conclusions 157 Key terms 158 Key reading 158 Revision questions and problems 158 Appendix 6.1 The NCBs of the EU (the European System of Central Banks – ESCB) 159 Chapter 7 Bank regulation and supervision 160 7.1 Introduction 161 7.2 The rationale for regulation 161 7.3 Types of regulation 162 7.4 Limitations of regulation 164 7.5 Causes of regulatory reform 167 7.6 Financial regulation in the United Kingdom 169 7.7 EU financial sector legislation 176 7.8 Bank capital regulation 179 7.9 Conclusions 191 Key terms 191 Key reading 192 Revision questions and problems 192 Part 3 ISSUES IN BANK MANAGEMENT Chapter 8 Banks’ balance sheet and income structure 195 8.1 Introduction 196 8.2 Retail banks’ balance sheet structure 196 8.3 Investment banks’ financial statements 208 8.4 Bank performance and financial ratio analysis 212 8.5 Conclusions 221 Key terms 222 Key reading 222 Revision questions and problems 222 ITBG_A01.QXD 8/3/06 9:09 am Page viii viii Contents Chapter 9 Managing banks 224 9.1 Introduction 225 9.2 Asset–liability management (ALM) 226 9.3 Liquidity management and the importance of reserves 228 9.4 Capital adequacy management 228 9.5 Off-balance sheet (OBS) business in banking 229 9.6 Loan sales and the process of securitisation 248 9.7 Conclusions 254 Key terms 254 Key reading 254 Revision questions and problems 254 Appendix 9.1 Securitisation glossary: a brief jargon buster 255 Chapter 10 Banking risks 258 10.1 Introduction 259 10.2 Credit risk 259 10.3 Interest rate risk 261 10.4 Liquidity (or funding) risk 264 10.5 Foreign exchange risk 266 10.6 Market (or trading) risk 269 10.7 Country and sovereign risk 270 10.8 Operational risk 272 10.9 Off-balance sheet risk 273 10.10 Other risks 273 10.11 Capital risk and solvency 275 10.12 Interrelation of risks 276 10.13 Conclusions 276 Key terms 277 Key reading 277 Revision questions and problems 277 Chapter 11 Banking risks management 278 11.1 Introduction 279 11.2 General risk management 279 11.3 Credit risk management 282 11.4 Managing the lending function 284 11.5 Managing interest rate risk 291 11.6 Managing liquidity risk 296 11.7 Managing market risk 298