The Expansion of Banks into Non-banking Financial Services - Modern Banking

This section looks at the growing diversification of banks. Of course, many of the savings banks or small British building societies continue to focus mainly on the core banking activities. However, the norm is for the key 5 to 10 banks in any western country1 to be diversified financial institutions, where traditional wholesale and retail banking are important divisions, but a wide range of financial services are also on offer. For example, universal banks, even if in the restricted form, offer virtually every other financial service, from core banking to insurance.

Non-bank financial services include, among others, unit trusts/mutual funds, stock broking, insurance, pension fund or asset management, and real estate services. Customers demand a bundle of services because it is more convenient to obtain them in this way. For example, buying a basket of financial services from banks helps customers overcome information asymmetries that make it difficult to judge quality. A bank with a good reputation as an intermediary can use it to market other financial services. Thus, some banks may be able to establish a competitive advantage and profit from offering those services.

Most banks are also active in off-balance sheet (OBS) business to enhance their profitability. OBS instruments generate fee income and are therefore typical of the financial products illustrated in Figure below, and do not appear as assets or liabilities on the traditional bank balance sheet. Some OBS products have been offered by banks for many years. They include, among others, credit cards, letters of credit,2 acceptances, the issue of securities (bonds, equity), operation of deposit box facilities, acting as executor of estates, fund management, global custody and sales of foreign exchange. In addition, over the last 20 years, an increasing number of banks have been using or advising on the use of derivatives and securitisation.

Derivatives

The rapid growth of OBS activities of major global banks increased from the mid- 1980s onward, largely due to the expansion of the derivatives markets and securitisation.

The growth of global banking and other financial markets exposed investors and borrowers to greater currency, market and interest rate risks, among others. Derivatives, which are contingent instruments, enable the banker/investor/borrower to hedge against some of these financial risks. Their growth has been phenomenal. They increased 13-fold between 1980 and 2000, at an average annual rate of 29.4%, though the growth rate had slowed to about 10% per annum by the new century.

A derivative is a contract that gives one party a contingent claim on an underlying asset (e.g., a bond, equity or commodity), or on the cash value of that asset, at some future date. The other party is bound to meet the corresponding liability. The key derivatives are futures, forwards, swaps and options. Table below shows that in 1988, outstanding traded derivatives stood at $2.6 trillion, rising to $165.6 trillion by 2002. Some of these derivatives are traded on organised exchanges, such as the London International Financial and Futures Exchange (LIFFE), the Chicago Board of Options Exchange, the Chicago Mercantile Exchange, the Philadelphia Board of Trade, the Sydney Futures Exchange or the Singapore Monetary Exchange. All organised exchanges have clearing houses, which guarantee the contract between the two parties; traders must be members of the clearing house. In the early years (1988) about half the derivatives were traded on organised exchanges, compared to just over 14% in 2002, testifying to the phenomenal growth in the over the counter market.

Over the counter (OTC) instruments are tailor-made for particular clients. In 1988, the size of the exchange traded and OTC markets was about the same. By 2002, OTC instruments accounted for about 86% ($141.7 trillion) of the total derivatives market. Note how interest rate contracts (swaps, options and forward rate agreements) are the predominant OTC contract. In 2001, interest rate options overtook interest rate futures as the leading exchange traded derivative.

The Size of the Global Derivatives Market

The Size of the Global Derivatives Market

Derivatives can be used to hedge against financial risks and are an important part of banks’ risk management techniques, thereby enhancing profitability and shareholder value-added. Derivatives may also assist the bank to meet capital standards and avoid regulatory taxes, which stem from reserve requirements and deposit insurance levies. A bank may also give clients advice on the use of (or arrange) derivatives to hedge risks in their portfolio. The other side of hedging is speculation on the derivatives market, with features typical of speculation on any market. One concern is the absence of a clearing house in the OTC markets, which could be a source of financial instability. The Group of 303 has singled out the risks arising from OTC instruments, and called for self-regulation, with member banks adhering to guidelines on the role of senior management, the way risk is valued and measured, and satisfactory systems for operations, accounting procedures and disclosure.

Securitisation

The growth of securitisation has also been very rapid. The term includes the issue of bonds, commercial paper and the sale of asset backed securities. Banks are usually involved in these securities issues, but play an indirect role, unlike the direct intermediation identified as a core banking activity.

Bonds and commercial paper

A bond is an agreement to pay back a specified sum by a certain date. Short-term bonds have a maturity of up to 5 years, a medium-term bond matures in 5–15 years, while long bonds mature after 15 years or even longer, such as the 30-year US Treasury bonds. Bonds can be placed privately – sold privately to a group of professional investors. It is common for a bonds issue to be handled by a syndicate of banks, with one bank acting as lead manager. For a fee (since they incur the risk that investors don’t buy the bond), the banks underwrite the placement of the bond on the market. Government bonds are often sold by auction. For example, the Ministry of Finance auctions 60% of government bond issues in Japan.

Bonds can also be issued by corporations, largely in the USA, where the market is very large. There is a weaker tradition of bond issues in Europe, though the market is growing. If the bond is backed by security, it is known as a debenture, and a convertible bondis one that can be converted into another instrument (e.g., another type of bond or equity). In Japan, the falling stock market (since 1990) has meant bonds issued in 1990, to be converted 10 years later, face a situation where the conversion price is higher than the current share price. Foreign bondsare issued by non-residents. For example, if a US company issues a bond in the Australian market. They differ from eurobonds, which are issued by some firms but in a market outside the country where the firm is headquartered. For example, a US firm with headquarters in Miami may issue dollar bonds on the London market. Junk or high yield bondsoriginated in the United States in the 1970s. They consist of bonds with a credit rating of less than BBB. They were used to fund some hostile takeovers in the United States, but the market collapsed in 1990, and again after the Asian crises and Russian default (1997, 1998). They continue to be issued from time to time.

Commercial paper, as the Goldman Sachs case study shows, dates back to the 1800s. Corporations issue a promissory note, which agrees to repay the bearer at some specified date in the future. The USA has outstanding commercial paper issues of more than $1 trillion, but they have only been issued in European countries since the 1980s, and the size of the market is much smaller, amounting to about $17 billion in the UK.

Asset Backed Securities

The issue of asset backed securities is the process whereby traditional bank assets (for example, mortgages) are sold by a bank to a trust or corporation, which in turn sells the assets as securities. The bank could issue a bond with the pooled assets acting as collateral, but the credit rating of the bank is assigned to the new security, the proceeds of the bond are subject to reserve requirements, and the assets are included in any computation of the bank’s capital ratio.

The bank can avoid these constraints if a separate entity is established (special purpose vehicle, SPV, or trust). The bank sells the asset pool to the SPV, which pays for the assets from the proceeds of the sale of securities. Effectively, while the process commences in an informal market (the bank locates borrowers and makes the loans), asset backed securitization means a large number of homogeneous loans (in terms of income streams, maturity, credit and interest rate risks) are bundled together and sold as securities on a formal market.

The process involves the following steps.

  • Origination: Locating the customer, usually via the bank.
  • Credit analysis: Estimating the likelihood of the potential borrower paying off the loan.
  • Loan servicing: Ensuring the debt and interest is paid off on time by the agreed schedule, i.e., enforcing the loan contract.
  • Credit support: In the event of the debtor encountering difficulties, deciding whether the loan should be called or the debtor given a grace period until he/she can pay.
  • Funding: Loans themselves must be financed, usually through reliance on retail/wholesale deposits, or in the case of finance companies, borrowing from banks.
  • Warehousing: Ensuring loans with similar characteristics (e.g., risk, income streams) are in the same portfolio.

Many of the above functions continue to be performed by the bank. However, the portfolio of loans is sold to a special purpose vehicle (trust or corporation), which engages an investment banker (for a fee) to sell them as securities. Assets are moved off-balance sheet provided a third party assumes the credit risk. Also, manufacturing firms with their own finance companies (e.g., General Electric, General Motors and Ford) offer loans which they securitise. Some banks have dropped out of the auto loan market because they cannot obtain a large enough interest rate spread to stay in business.

Banks undertake asset backed securitisation for a number of reasons. First, they can reduce the number of assets on the balance sheet and so boost their risk assets ratio or Basel capital ratio, provided the credit risk is passed to a third party. If a bank continues to have recourse in the process of securitising assets, then regulators will require them to hold capital against the credit risk exposure of the OBS item. A problem could arise if low-risk assets are securitised, which, in turn, could lower the quality of a bank’s balance sheet. However, Obay (2000), based on a 1995 comparison of 95 securitising banks matched with 105 non-securitising banks, could find no evidence to support the idea that banks securitise their best assets, thereby reducing the quality of the loan book. Thus, the riskiness of loan portfolios does not increase among the securitising banks. Obay also found that banks engaging in securitisation have significantly lower risk-based capital ratios, which is consistent with one motive behind securitisation by banks: it helps them comply with the Basel capital ratio standards.

Second, asset backed securitisation raises liquidity because it frees up funding tied to existing loans, thereby allowing new loans to be funded. An extreme case is that of the troubled Bank of New England, which sold its credit card receivables to raise liquidity and prevent closure. Third, assets are made more marketable, because they can be traded on secondary markets, unlike assets on a bank’s balance sheet which are not traded.

Finally, securities issues based on an asset pool often have a higher credit rating than the bank holding them as loans. For example, banks often hold US government backed or US government agency backed securities because it lowers their Basel capital requirement.

In the USA (Obay, 2000), securitisation is concentrated among a relatively small number of US banks – the top 200 commercial banks accounted for 85% of securitisation in 1995.

Of these, five banks were involved in 60% of the securitised assets.6 Of securitised assets in the USA, 25% are credit card receivables.

Mortgage Backed Securities

The Federal National Mortgage Association (Fannie Mae) was set up in 1948 by the government to encourage home ownership in the United States. Fannie Mae supported saving and loans banks (S&Ls)7 in the USA, by buying mortgages which local (but federally chartered) S&Ls could not fund through deposits. In 1968, the organisation was split into Fannie Mae and Ginnie Mae (the Government National Mortgage Corporation). Ginnie Mae is a wholly owned corporation of US government departments. It claims to have introduced the first mortgage backed security (MBS) in 1970. Though shareholder-owned, Fannie Mae is a US government-related agency, along with Freddie Mac (the Federal Home Loan Mortgage Corporation), also created in 1970. Their respective charters do not say the US government guarantees their debt but as government-sponsored enterprises, they can expect to be bailed out.

Fannie Mae and Freddie Mac share the same charters and regulation but claim to compete with each other and to have separate business strategies. These government agencies are subject to a number of restrictions. Mortgages must be for residential property and may not exceed a limit of up to $332 700. Freddie and Fannie are prohibited from originating mortgages – they must buy them from banks and S&Ls.

After the 1970 issue, MBSs grew rapidly. Currently they hold or guarantee nearly half the US outstanding mortgages, and have close to $3 trillion in liabilities.8 Their success encouraged financial institutions to securitise commercial mortgages, mobile home loans, credit card receivables, car loans, computer and truck leases, and trade receivables.

Collateralised Mortgage Obligations

CMOs originated in the USA in 1983 after they were introduced by First Boston and The Federal Home Mortgage Loan Corporation. They go through the same stages as MBSs (e.g., origination, pooling, placement of the pooled mortgages with a SPV, etc.) until the security reaches the investment bank. Instead of selling the MBS/ABS to investors, the investment bank places the security as collateral in a trust, and, essentially, splits it, offering groups of investors a series of tranches (a portion of the payments) associated with the security – a CMO. Suppose the investment bank creates three tranches or investment classes. Each class has fixed coupon, which may be paid monthly, quarterly or semi-annually. In addition, the investor is holding a bond – they are owed a certain amount. Mortgagees in the pool pay their monthly principal and interest, but there will always be some who unexpectedly prepay (or default on) the full amount of the mortgage. The investment bank issuing the CMO will pay out the interest owed to the first group, plus all the principal paid by the mortgagees, including those who have prepaid. The second class of investors is also paid the fixed interest owed, but does not get any of the principal until the first class has been paid in full and the bond retired. Likewise for the third tranche – no principal is repaid until the second class has been paid off in full, and the associated bond retired. The number of tranches can vary from 3 to 30. There can also be a zero or Z-tranche, where the investor is not paid interest9 or principal until all the other classes are retired.

The CMO is an example of a pass through security: cash flows, interest and principal, from the underlying security (e.g., a mortgage) are passed through to the investor. There are other forms of security apart from mortgages – the generic term is collateralised debt obligation (CDO). A CDO is backed by a pool of debt obligations, such as corporate loans or structured finance obligations. Once pooled, like an MBO, they are split into a number of security tranches, and offered to different groups of investors. The performance of the underlying pool of debt obligations determines the payment of interest and principal, and when the security is actually retired. They are attractive because they offer investors a greater range of risk/return choices than the standard MBS/ABS. For example, with a MBO, the investor can choose to incur a high degree of prepayment risk (by opting for the first tranche) or very little such risk (by investing in the third class). Also, an investor in the first class will find the security is retired relatively quickly, but the debt can be retired 20+ years later for the higher tranches.

Other CDOs include collateralised bond obligations(CBOs), consisting of collateralized bonds and collateralised loan obligations (CLOs), which involve collateralised pools of corporate loans or other credit facilities. After being pooled and turned into a security, they are split into different investment classes or security tranches. The bank loans used as collateral for CLOs are typically at investment grade level, whereas the CBOs are usually a mix of investment grade and sub-investment grade, but collateralised by higher yielding securities. CLOs originated in the 1990s and consist of a pool of investment grade revolving/term loans, standby letters of credit and even derivatives. Unlike the original ABS/MBS, the components of the pool can be quite diversified, and the originator remains the owner of the underlying portfolio.

For the bank arranging them, CDOs offer a number of benefits:

  • release of core capital and thus increased efficiency of the capital allocation;
  • illiquid loans become liquid, tradable securities;
  • investors are attracted to the bank because they can have a choice of different tranches to meet their risk/return needs.

The tables below summarise the US data for various types of securitisation. In 2002, the outstanding volume of US agency mortgage backed securities was $3.2 trillion, compared to $1.5 trillion for US agency backed securities (excluding MBSs).

These can be compared to $110.9 billion for MBSs in 1980. In 1995, US ABSs were valued

US Asset Backed Securities, 2002

US Asset Backed Securities, 2002

AgencyMortgage Backed Securities ($bn)

Agency∗Mortgage Backed Securities ($bn)

AgencyCollateralised Mortgage Obligations ($bn)

Agency∗Collateralised Mortgage Obligations ($bn)

at $316.3 billion, rising to $1.5 trillion by 2002. Credit card receivables had 26% of the ABS market in 2002, followed by home equity (19%) and auto ABSs (14%). The market share has remained largely unchanged since 1995. The CMO market grew from $0.9 billion in 1987 to $926 billion by 2002.

Compared to the USA, the market for ABSs in Europe is relatively new and smaller.In 2002, ABS issuance stood at ¤31.7 billion; MBS issuance was ¤42.5 billion. Securitised assets in the UK, with by far the largest market, was ¤34.5 billion, virtually all of which was MBS securities. The market leader in Europe is the Pf and brief, which originated in Germany – the first jumbo Pf and brief (minimum of ¤500 million) was issued in 1995. Unlike the standard ABS, the Pf and brief remains on the balance sheet of the issuing institution, and there is no prepayment risk, so the spread over a sovereign bond will be determined by credit and liquidity issues alone. There are two types, the Hypotheken or mortgage backed bonds and Offentliche or public sector bonds. Most of the jumbo Pf and briefs are backed by public sector loans. Issues were worth ¤160 billion in 2002. Compare this to the value of US asset backed securities in 2002 – $1.5 trillion.

One key reason for the difference in size of the American and European markets is the number of subsidies enjoyed by Ginnie Mae, Fannie Mae and Freddie Mac. First, though the government has never provided formal guarantees, the public is under the impression that their loan portfolios and MBSs enjoy implicit government guarantees. These agencies do not pay state or local income taxes, and are exempt from SEC14 fees and disclosure requirements. Their assets receive a risk-reduced risk weighting under Basel, and these securities qualify as eligible collateral. Freddie and Fannie are regulated by the Office of Federal Housing Enterprise Oversight (OFHEO), avoiding the tough system of multiple regulation faced by banks and other financial institutions in the USA. Fannie and Freddie argue that their large share of the MBS market has reduced mortgage rates for home owners by one-quarter to three-eighths of 1%. They purchase and hold mortgages originated by mortgage lenders and guarantee the MBSs, which are taken to be a government backed guarantee. It means they are assuming the credit risk associated with loans in the MBS and loans held in their own portfolio.

Some experts advocate the withdrawal of the implicit government guarantee because these agencies crowd out the private sector, tax-paying competitors. A study by the Congressional Budget Office in 2002 estimated the cost of implied government backing was about $10.6 billion per year,15 and about 40% of this goes to the managers and shareholders of the two organisations. There are concerns over their credit and interest rate exposure, because Freddie and Fannie, recognising that the implied guarantee means they can raise finance more cheaply, have, in recent years, opted to profit from holding the high yield mortgages on their own balance sheets rather than turning them into securities and selling them on, as they have done since they were established. As a result, they hold increasing amounts of debt in their portfolio, leaving them highly exposed in the mortgage market.

It is estimated that by 2003 they will carry over one-third of the related interest rate risk and three-fifths of the credit risk for the mortgages they are authorised to buy. Though derivatives are used to hedge against interest rate risk, comprehensive risk management systems were not in place until 2002. With the sharp decline in US interest rates (2002/3), the number of prepayments has soared as householders opt for a new mortgage at lower, fixed rates. This has increased the mismatch between revenue from mortgage bonds and their debt obligations.

The combined on balance sheet debt of Freddie and Fannie in 2003 was (roughly) $1.5 trillion, which puts them in the category of ‘‘too big to fail’’ (TBTF). US regulators can deem a bank to be a ‘‘systemic risk exception’’. A bank is placed in this category if it is thought to pose a threat to the US financial system, and will be rescued not by taxpayers but through high risk premia paid by banks. Fannie and Freddie are not banks, so the taxpayer may be left to bail them out. Long Term Capital Management (LTCM) was a hedge fund, not a bank. Though its rescue in 1998 was organised by the Federal Reserve Bank of New York, it was the banks with a vested interest in LTCM that financed it, at a cost of $3.6 billion. The bill will be considerably greater should Freddie and Fannie fail, and it is unclear whether any body other than the government/taxpayer will pay.

In June 2003, Congress began formal hearings on the way Freddie and Fannie are regulated. In the same month, the OFHEO replaced the entire management team at Freddie Mac after an internal audit revealed questionable practices. Earlier, the Chief Executive had been sacked for failing to cooperate with OFHEO regulators. The regulator has assured the public that Freddie is not in financial difficulty, but that some of the senior staff condoned questionable reporting of its earnings.

A traditional bank acts as intermediary between depositors and lenders. As a consequence, the focus is on their banking book – management of assets and liabilities. The growth of derivatives and securitisation has expanded the intermediary role of some banks to one where they act as intermediaries in risk management.


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