Week 1: FINS3650 - Thursday 2 March 2017

Overview Lecture Notes & Readings

Why do we Manage risk and enable wealth creation

need banks? Reach a wide range of borrowers (diversify)
Maturity transformation
Asset transformation
Liquidity transformation
Risk transformation
Bank of Dad The genius of banking is maturity, liquidity and quality transformation: holding assets
Lessons that are longer, less liquid and of lower quality than the funding liabilities.

A banking system is solvent only if it is believed by the public to be going concern.

Engage in banking = systematic risk = regulatory supervision required

Banking = joint venture with the public sector
Publics ex-ante demand for liquidity at par > publics ex-post demand
If ex-ante demand = ex-post demand, banking system is insolvent, cannot deliver
Shadow Difference b/w conventional and shadow banks?
Banking - financial intermediaries involved in facilitation creation of credit
- NOT subject to regulatory oversight
- Financial intermediation w/o explicit public liquidity and credit guarantees from
governments
- Earn net interest margin associated with maturity, liquid and quality transformation
WITHOUT regulatory burden of conventional banks

- Examples:
hedge funds, unlisted derivatives and other unlisted instruments
credit default swaps
Lenders of Funds
money market mutual funds
Gather Funds issue commercial
(MMFs), bond funds, and
paper, repurchase agreements
other entities. Manage Capital Flow
(borrowing money
investors money instead of Potential borrowers
while using assets as collateral),
accepting deposits they are
credit instruments
not subjected to existing
banking oversight.

Risks of Shadow Banking:

 - non-banks loan money using investors cash and rotating lines of credit. Especially
risky when skittish investors who bet on short term gains withdraw their money at
once. SHORT TERM to fund long-term illiquid loans

- Moral Hazard - investors funds are not insured by central banks, and entities cannot
rely on central banks as the lender of last resort

- asset side, unregulated shadow activities = origination of low quality assets and the
accumulation of excessive risks

- underground nature = serious systemic risks - system is interconnected and parties

are highly leveraged (slowing growth trigger default of borrowers)
Regulating Shadow Banking:

Pros: Cons:
taxes shadow activities and subsidizes regulation = cost of foregoing profitable
regulated activities to implement an even investments
superior allocation
slower economic growth due to increased
TRANSPARENCY incapable of accounting for cost of credit
the negative externality it poses on society

recent credit crunch demonstrated that

shadow banking amplifies effects of financial
crises - lesser extent effects had the sector
been regulated
Subprime Derive value by reference to an underlying asset or index
derivatives 1. Bank lends money to homebuyer
Mortgage 2. Bank sells mortgage to Fannie Mae = more funds to bank
Backed 3. Fannie Mae resells MBS on security market = value derived from a bundle of mortgages
Securities 4. MBS bought by hedge fund
(MBS) 5. Hedge fund slices MBS and combines with other similar risk level MBS and resells portion
(TRANCHE) to other hedge funds

6. HOUSE PRICE DECLINE OR INTEREST RATE RISE = demand for housing falls = harder to sell
homes = default of mortgages
Mortgage holders found they could no longer afford the payments.

7. Banks + Hedge funds had lots of derivatives with value declining and cannot sell

8. Banks stopped lending to each other afraid of receiving more defaulting derivatives
and collateral
Shadow Why is shadow banking growing in Asia/China?
Banking - Increased regulation and supervision of commercial banks following GFC
China - Higher interest rates, tougher reserve requirements and more conservative credit
quotas
 - it channels vital capital to the private sector starved of debt financing and also allows
savers to earn higher returns than through conventional bank deposits.

1. Commercial & Investment Banking selling trusts, wealth management, financial

leasing companies
2. Quasi financial Institutions micro loan companies, financial guarantee companies
3. Informal financial institutions

What are the key risks associated with this shadow banking?
- Global propagation risks
- Leverage Risk - when credit conditions change, highly leveraged firms may come
under stress

- Maturity and Liquidity Mismatch - Disruptions in market condition may adversely

impact the shadow banking sector

- Indirect risks from interaction b/w shadow banking entities and regular banks -
direct credit exposures and interdependence in funding

- Regulatory arbitrage - Incentives may exist for financial activities to move from the
regulated sector to the shadow banking sector to avoid more stringent bank
regulations and oversight

What should countries do to address these issues?

- Increased monitoring of activities of the largest Chinese FIs
- Chinese Government must reform the lending system to offer more investment
incentives to lenders in order to create regulated bonds and other financial products
International Bretton Woods Agreement (1994)
Monetary - Fixed exchange system: USD used as base currency
System IMF assist in balance of payment or currency crisis
World Bank assist countries in economic development
Banking Correspondent Foreign Rep Foreign Agency Foreign Branch
Foreign
Structures Subsidiary
Arrange w/ Service customers Wider scope to Extension of Separate foreign
other banks to in foreign Foreign Rep, parent bank, entity with own
serve as agents countries but cannot keep equity CAPITAL +
local deposits investment CHARTER
+ Low cost
+ Direct contact w/ customers Can do loans, Parent company
- Agency issues, deposits an equity holder
poor marketing + Knowledge of foreign risks OR JV only
presence Capital regulated by 1
- Difficult to attract and retain regulated by 2 local govt.
competent staff govts.
+ JV = Loss sharing
+ Stronger
presence (access + Parent only
to wholesale liable for
markets) repatriated
 earnings
+ Diversification
- Higher + Single regulation
competition only
erodes profits
- Difference in
- Globalisation management
reduces culture
diversification
benefits - Inability for
parent to take
- Double swift action
regulation GOVT issues

- Ownership
restrictions

Drivers of Lower trade barriers

Global Deregulation and liberalization to improve efficiencies
Banking New financial instruments
Technological innovation (overcome geographical barriers)
Australian Discuss the possible reasons why Australian banks have not gone to other countries to
Banking a significant extent
- Consistent with the view that international expansion can pose higher risks,
numerous cases of disproportionate credit or operational losses in their
international exposures
- Operational and Legal risks could be relatively high, including in offshored support
functions or businesses where the bank does not have full managerial control
- Disruptions in Asian markets, implications to domestic financial stability
- risk that the counterparty to the transaction typically a global bank is unable to
honour its obligations

International - International banks take part in global banking rather than international banking.
Banking vs. - Principle difference is the way they finance their foreign assets international
International banking uses funds raised in domestic market, whilst international banks use funds
Banks raised in a foreign market to fund foreign assets
- International banking concentrates on cross-border business whereas international
banks focus on serving local markets locally.
- E.g. Bank headquartered in US loaning to borrowers in Japan.
- Take deposits from US residents to lend to Japan vs deposit into Japanese affiliate
with US bank that then lends to entity in Japan.
- There is blurry line though as international banks may do international banking (in
terms of cross-border lending)
Fintech Review how traditional banking will be challenged by Fintec companies
Companies Disrupt and create global revenues estimated at $4.7trillion p.a and $470billion in profits
- Net interest margin: peer to peer lending; using data more adroitly to determine
creditworthiness than a loan officer
 - Charging for making payments OVERCOME through mere tap of a phone (ApplePay),
extending credit to customers (PayPal)
- Brokerage fees online money transfers circumvent high exchange rate costs
(Western Union, Travelex)

What are the barriers which Fintech companies may face to compete with banks?

- Meeting regulation and maintaining compliance continuously

- Payment & Money transfer - extremely expensive to process payments due to the
risks involved for each transaction, fraud, required security measures, governmental
requirements

- Consumer Trust - Will the average consumer trust them with their financial and
personal information? Is the value being provided enough to cause people to change
their behaviour?

Crowd What is crowdfunding?

Funding - Crowdfunding is the practice of using internet platforms, mail-order subscriptions,
benefit events and other methods to find supporters and raise funds for a project or
venture.
What are the factors that may drive growth in crowd funding?
- Small businesses/ventures = high risk, banks turn them down can borrow elsewhere
- No track record required
- Money received not need to be repaid or P2P unsecured so no need for collateral
- Less onerous process to apply for loan (less time and effort taken)
Are there any risks to the financial system due to crowd funding? Can the risks be
mitigated?
- Verification of creditworthiness of firm: overcome by due diligence on hosted
projects or operations
- Moral Hazard (funds not utilised in the way promised)
- Crowdfunding, transactions are one time and not continuous
- Creators requesting funding have great ideas, but maybe no business expertise
- Tax law issues (funding happens across borders, do international tax laws apply)

Blockchain What is the concept of blockchain?

- Blockchain refers to an electronic cash system that is fully peer-to-peer with no
trusted third party.

- Blockchains = giant ledger that keeps track of who owns how much bitcoins.

How a typical blockchain transaction may be processed?

- There is a historical record of all people who have owned the bitcoin as a new
block of currency information is added to the chain on transferal of ownership.
- No central arbiter is required for transactions only a large number of computers
that ensure system is running.
 - Miners around the world authenticate transactions and agree what the latest
version of the blockchain should be like to get newly minted bitcoins.
- Bitcoin chain prevents anyone from spending the same bitcoin twice.
- As the miners all have a copy of the bitcoin, it cannot be changed as the computer
only accepts the bitcoin that majority submits. There is no central bitcoin bank.

What are the challenges in blockchain concept being widely accepted?

- Ability to be replicated and re-engineered for Ponzi schemes and non-currency
purposes
- Only can process seven transactions per second vs. Visa that can process tens of
thousands (half an hour to process a transaction, which involves a lot of power
wasted in mining)
- Fraud and hacking of crypto currency and wallet
- Need for blockchain IT personnel to train the banking staff, as forgotten password
cannot be used here due to permanent nature of anything recorded in blockchain.
- High data mining costs

What do you think about the future of block chain concept?

- Consumer mistrust in traditional banking could spur growth in block chain as NO
third party involved
- Completely transparent ledgers only protected by clever cryptography, growth
prospects due to transparency
- Banks may integrate it for their use adopting private blockchains to facilitate bank
to foreign bank transaction w/o correspondent bank (3rd party)