THE ECONOMICS OF BANKING

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2 THE ECONOMICS OF BANKING

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4 THE ECONOMICS OF BANKING KENT MATTHEWS and JOHN THOMPSON

5 Copyright # 2005 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England Telephone: (þ44) (for orders and customer service enquiries): cs-books@wiley.co.uk Visit our Home Page on 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, scanning or otherwise, except under the terms of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London W1T 4LP, UK, without the permission in writing of the Publisher. Requests to the Publisher should be addressed to the Permissions Department, John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England, or ed to permreq@wiley.co.uk, or faxed to (þ44) This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on the understanding that the Publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought. Other Wiley Editorial O ces John Wiley & Sons Inc., 111 River Street, Hoboken, NJ 07030, USA Jossey-Bass, 989 Market Street, San Francisco, CA , USA Wiley-VCH Verlag GmbH, Boschstr. 12, D Weinheim, Germany John Wiley & Sons Australia Ltd, 33 Park Road, Milton, Queensland 4064, Australia John Wiley & Sons (Asia) Pte Ltd, 2 Clementi Loop #02-01, Jin Xing Distripark, Singapore John Wiley & Sons Canada Ltd, 22 Worcester Road, Etobicoke, Ontario, Canada M9W 1L1 Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Library of Congress Cataloging-in-Publication Data Matthews, Kent. The economics of banking / Kent Matthews, John Thompson. p. cm. Includes bibliographical references and index. ISBN (pbk. : alk. paper) 1. Banks and banking. 2. Microeconomics. I. Thompson, John L. II. Title. HG1601.M ödc British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN ISBN Project management by Originator, Gt Yarmouth, Norfolk (typeset in 10/12pt Bembo) Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire This book is printed on acid-free paper responsibly manufactured from sustainable forestry in which at least two trees are planted for each one used for paper production.

6 TABLE OF CONTENTS About the Authors Preface vii ix 1. Trends in Domestic and International Banking 1 2. Financial Intermediation: The Impact of the Capital Market Banks and Financial Intermediation Retail and Wholesale Banking International Banking The Theory of the Banking Firm Models of Banking Behaviour Credit Rationing Securitization The Structure of Banking Bank Regulation Risk Management The Macroeconomics of Banking 205 References 225 Index 233

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8 ABOUT THE AUTHORS Kent Matthews received his economics training at the London School of Economics, Birkbeck College and the University of Liverpool, receiving his PhD for Liverpool in He is currently the Sir Julian Hodge Professor of Banking and Finance at Cardi Business School, Cardi University. He has held research appointments at the National Institute of Economic and Social Research, Bank of England and Lombard Street Research Ltd and faculty positions at the Universities of Liverpool, Western Ontario, Leuven, Liverpool John Moores and Humbolt. He is the author and co-author of six books and over 60 articles in scholarly journals and edited volumes. John Thompson worked in industry until 1967 when he joined Liverpool John Moores University (then Liverpool Polytechnic) as an assistant lecturer in Economics. He took degrees in Economics at the University of London and the University of Liverpool and obtained his PhD from the latter in He was appointed to a personal chair in Finance becoming Professor of Finance in 1995 and then in 1996 Emeritus Professor of Finance. He is the author and co-author of nine books and numerous scholarly papers in the area of Finance and Macroeconomics.

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10 PREFACE There are a number of good books on banking in the market; so, why should the authors write another one and, more importantly, why should the student be burdened with an additional one? Books on banking tend to be focused on the management of the bank and, in particular, management of the balance sheet. Such books are specialized reading for students of bank management or administration. Students of economics are used to studying behaviour (individual and corporate) in the context of optimizing behaviour subject to constraints. There is little in the market that examines banking in the context of economic behaviour. What little there is, uses advanced technical analysis suitable for a graduate programme in economics or combines economic behaviour with case studies suitable for banking MBA programmes. There is nothing that uses intermediate level microeconomics that is suitable for an undergraduate programme or nonspecialist postgraduate programmes. This book is aimed at understanding the behaviour of banks and at addressing some of the major trends in domestic and international banking in recent times using the basic tools of economic analysis. Since the 1950s great changes have taken place in the banking industry. In particular, recent developments include: (i) Deregulation of nancial institutions including banks with regard to their pricing decisions, though in actual fact this process has been accompanied by increased prudential control. (ii) Financial innovation involving the development of new processes and nancial instruments. New processes include new markets such as the Eurocurrency markets and securitization as well as the enhanced emphasis of risk management by banks. Certi cates of Deposit, Floating Rate Notes and Asset Backed Securities are among the many examples of new nancial instruments. (iii) Globalization so that most major banks operate throughout the world rather than in one country. This is evidenced by statistics reported by the Bank for International Settlements (BIS). In 1983 the total holdings of foreign assets by banks reporting to the BIS amounted to $754,815bn. In 2003 this gure had risen to $14,527,402bn. (iv) All the above factors have led to a strengthening in the degree of competition faced by banks. This text covers all these developments. Chapters 1^3 provide an introduction surveying the general trends and the role of the capital market, in general, and banks, in particular, in the process of nancial intermediation. Chapters 5 and 6 cover the di erent types of banking operation. Discussion of theories of the banking rm takes place in Chapters 6 and 7. Important recent changes in banking and bank behaviour are examined in Chapters