THE ECONOMICS OF BANKING

THE ECONOMICS OF BANKING

THE ECONOMICS OF BANKING KENT MATTHEWS and JOHN THOMPSON

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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 19 3. Banks and Financial Intermediation 33 4. Retail and Wholesale Banking 51 5. International Banking 63 6. The Theory of the Banking Firm 77 7. Models of Banking Behaviour 91 8. Credit Rationing 113 9. Securitization 129 10. The Structure of Banking 141 11. Bank Regulation 161 12. Risk Management 183 13. The Macroeconomics of Banking 205 References 225 Index 233

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 1984. 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 1986. 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.

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