Banking and Capital Markets

Module Introduction and Overview

Contents
1 Introduction to the Module 2

2 The Module Authors 4

3 Study Resources 5

4 Module Overview 6

5 Learning Outcomes 10
1 Introduction to the Module
It is widely recognised by academic economists and policymakers that
developed and efficient banking and capital markets are an important
prerequisite for economic growth. However, it is also recognised that
banking and financial crises can cause abrupt slowdowns or reversals of
growth. The drive to understand these phenomena has generated a large
body of research, leading to new theories and empirical studies of key
features of banking and capital markets. This literature provides the
underpinning for the subject material of this module.
You are probably familiar already with the history of several major financial
crises. For example, the 1997–98 Asian Crisis saw currency values fall
dramatically in several countries. Banks were unable to meet their
obligations to creditors, because their assets were denominated in the
devalued local currencies, but their liabilities were denominated in US
dollars. During the 2007–09 global financial crisis, several major banks and
other financial institutions failed, and the entire banking and financial
system came close to collapse.
In this module we examine the contribution made by banking and capital
markets, and also the risks they represent, but we enable you to take a step
back from events, and to think about core principles underlying the
operation of banking and financial markets. Since theoretical knowledge is
never fully established or ‘proven’, we enable you to examine opposing
points of view, as well as to evaluate critically a number of important
published studies.
While studying this module, you will develop an understanding of the
functioning of the financial sector as a whole, and become familiar with
some of the most important theoretical and historical developments. This
should enable you to be more effective in your own research on financial
institutions, and provide you with a deeper understanding of core principles
of banking and finance. This understanding should help you make the right
decisions in a professional capacity. The module focuses on developing a
deeper understanding, and it is not a ‘how to do it’ course – it does not aim
to teach applied business skills for use in the financial sector.
There are several overarching themes running through the module. One
theme concerns the nature and purpose of financial intermediation. A
second theme concerns the impact of imperfect information on the efficient
functioning of banking and capital markets. A third theme is the inherent
fragility of banks, as well as financial intermediaries in general and the
financial system.

Theme 1: The nature and purpose of financial intermediation

Banks are so familiar and ubiquitous in everyday life we seldom ask the
most basic question of all: why do financial intermediaries in general, and
banks in particular, exist? It appears to be a simple question that must have a
 Specimen Examination

simple answer, but some simple questions turn out to be more difficult than
they appear.
Try it yourself. Pause for a minute and try to answer the question ‘why do
banks exist?’
You might say it is because they operate the payments system, enabling us
to receive and make payments easily. And that is, indeed, an important
service provided by banks. But why do banks exist as financial
intermediaries, accepting deposits from savers and using these funds to
provide loans to borrowers? Why could savers and borrowers not transact
directly with one another, cutting out the need for any financial
intermediary? Another aspect of this theme concerns the distinction between
banks and capital markets in their roles of managing risk, disseminating
information and funding investment. More generally, what are the relative
strengths and weaknesses of bank-oriented versus market-oriented financial
systems as channels for the flows of funds between savers and borrowers?

Theme 2: Imperfect information

Asymmetric information is a feature of many of the transactions and
contracts entered into by banks and other financial institutions. Asymmetric
information gives rise to problems of adverse selection and moral hazard.
Adverse selection arises when one party to a transaction has less information
about the quality of the item being traded than the other party. It becomes
difficult for the party with less information to know whether the price is fair,
and faced with this situation they may withdraw from the transaction.
For example, a firm wishing to borrow from a bank to finance a new
investment project might know more about the project’s prospects, and its
risks, than the bank can know. The bank is aware of the borrower’s
advantage in terms of access to relevant information, and elects for safety by
abstaining from lending. Unable to raise finance, the firm is unable to
proceed with its investment project.
Moral hazard arises when people are allowed to escape the consequences of
the risks they take, and are more likely to behave recklessly as a
consequence. For example, having lent the funds needed to finance an
investment project, how can the bank be certain that the borrower is
managing the project prudently? Much of our modern understanding of
finance is based on the recognition that there are incentives to construct
regulations and private financial and corporate governance arrangements
that minimise the problems arising from asymmetric information. Well-
developed financial systems are successful because they incorporate such
mechanisms.

Theme 3: The fragility of the financial system

Banks and other financial institutions are eager to convey an impression of
strength and solidity; but throughout history, the financial system has been
susceptible to periodic bursts of instability, culminating in banking and
 financial crises. Banks accept deposits, which can be withdrawn at short
notice, to finance loans and other investments, which often cannot be
liquidated rapidly if needed to satisfy the demands of depositors for
withdrawals. This financial intermediation business model makes even the
strongest and longest-established banks inherently vulnerable to the
possibility of collapse. At a systemic level, one recurring manifestation of the
tendency for instability is the common failure of credit markets to operate
sustainably. Phases of exuberance, when credit is cheap and banks seem to
lend excessively, are interspersed with phases of credit rationing, when
credit is tight and banks are unwilling to lend. We will examine the
theoretical reasons why banks may lend either too little or too much, with
destabilising consequences for banks themselves, and for the financial
system. This discussion is illustrated with historical examples of banking
and financial crises. We also examine the regulatory architecture that is
designed to enhance financial stability and prevent the onset of banking and
financial crises.

2 The Module Authors

John Goddard is Professor and Head of Aberystwyth Business School in
Aberystwyth University. Originally trained as an economist, he holds a
Bachelor’s degree from Lancaster University, and a Master’s from the
University of London. He worked for several years in life insurance, before
pursuing an academic career that includes previous appointments at Leeds
University, Abertay University, Swansea University and Bangor University.
His areas of research include the economics of the banking industry,
financial markets and institutions, and the economics of professional
football. He has teaching experience in the areas of finance, economics and
statistics. He is co-author of the textbook Industrial Organization: Competition,
Strategy, Policy (Pearson, 2017), and the introductory guide Banking: A Very
Short Introduction (Oxford University Press, 2016).
Bassam Fattouh graduated in Economics from the American University of
Beirut. He obtained his Master’s degree and PhD from the SOAS, University
of London. He is a Professor in Finance and Management and Academic
Director for the MSc in International Management for the Middle East and
North Africa at the Department for Financial and Management Studies,
SOAS. He is also Senior Research Fellow and Director of the Oil and Middle
East Programme at the Oxford Institute for Energy Studies at the University
of Oxford. He has published in leading economic journals, including the
Journal of Development Economics, Economics Letters, Economic Inquiry,
Macroeconomic Dynamics and Empirical Economics. His research interests are
mainly in the areas of finance and growth, capital structure and applied non-
linear econometric modelling, as well as oil pricing systems.
Luca Deidda completed his doctoral studies in 1999, while he was a lecturer
in the Department of Economics at Queen Mary and Westfield College,
University of London. He joined the Centre for Financial and Management
 Specimen Examination

Studies at SOAS in that same year, as lecturer in financial studies. His

research focuses on financial and economic development, markets under
asymmetric information and welfare effects of financial development. He is
currently working at the Università di Sassari, Sardinia.
Norman Williams taught at the University of Greenwich in the areas of
bank management, international capital markets, the economic context of
banking, managerial finance, and finance. His research concerned pensions,
investment management, banking, capital and financial markets, and
property markets. He also worked in HM Treasury, the Bank of England,
and Barclays Capital.

3 Study Resources
This study guide is your main learning resource for the module and it
directs your study through eight study units. The units include readings
from the key texts and from supplementary resources which are included in
the module readings.

 Key texts
The first reference for this module is a book by Kent Matthews and John
Thompson:
Matthews K and J Thompson (2014) The Economics of Banking. 3rd Edition.
Chichester UK, John Wiley & Sons.
This concise title provides coverage of topics covered in every unit of the
module, and you will be directed to read relevant chapters and sections as
you progress through the study guide. The extent and depth of coverage in
this book varies between topics, and where appropriate you will be directed
to other sources for additional reading on specific topics.
The second reference for this module is a book by Xavier Freixas and Jean-
Charles Rochet:
Freixas X and J-C Rochet (2008) Microeconomics of Banking. 2nd Edition.
Cambridge MA, The MIT Press.
This text provides a more advanced treatment of the topics covered in Unit
2, Unit 3, Unit 4, Unit 7 and Unit 8.
You should read the indicated chapters and sections of the key texts in
conjunction with the study guide, as directed in each unit, to strengthen
your understanding and to gain an alternative perspective on many of the
topics.
These texts, like the study guide, present some of the theoretical content of
the module using mathematical notation. Some of this content involves
elementary calculus, including differentiation and optimisation.
 Module readings
In most units we also provide readings of articles and other material. These
are different from a key text, which is more oriented to giving an overview
of different authors’ points of view. When you study a reading, you should
be prepared to consider the author’s point of view so that if you disagree
with it you can express your reasons for this disagreement; and if you agree
with it, you can equally explain why. In other words, you should critically
evaluate the readings. The other function which many of the readings have
is that they include more empirical material and case studies, which
complements the study of theoretical principles in the units and the key
texts.

4 Module Overview
Unit 1 Banks and Financial Markets
1.1 Introduction
1.2 Financial Intermediaries, Financial Markets, and the Flow of Funds
1.3 The Financial System and the Flow of Funds
1.4 Comparative Financial Systems
1.5 Law, Politics and Financial Systems
1.6 Bank-oriented versus Market-oriented Financial Systems
1.7 Conclusion

Unit 2 Financial Intermediation

2.1 Introduction
2.2 Principles of Financial Intermediation
2.3 Financial Intermediation and Transaction Costs
2.4 The Financial Intermediary as a Means of Alleviating Asymmetric Information
Problems
2.5 The Financial Intermediary as a Liquidity Insurer for Depositors
2.6 Conclusion

Unit 3 Risk Management

3.1 Introduction
3.2 Interest Rate Risk
3.3 Market Risk
3.4 Credit Risk
3.5 Liquidity Risk
3.6 Conclusion

Unit 4 Credit Rationing

4.1 Introduction
4.2 Financial Repression
4.3 Credit Rationing due to Adverse Selection: The Stiglitz–Weiss Model
4.4 Over-lending
4.5 Credit Rationing due to Moral Hazard
4.6 Conclusion
 Specimen Examination

Unit 5 Shadow Banking and Securitisation

5.1 Introduction
5.2 Shadow Banking: Entity-based Classification
5.3 Shadow Banking: Activity-based Classification
5.4 Traditional Banking and Shadow Banking
5.5 The Role of Shadow Banking in the Global Financial Crisis 2007–09
5.6 Regulation of Shadow Banking
5.7 Conclusion

Unit 6 Competition and Efficiency in Banking Markets

6.1 Introduction
6.2 The Theory of the Banking Firm
6.3 Measures of Competition in Banking
6.4 The Structure-Conduct-Performance Paradigm
6.5 The New Empirical Industrial Organisation
6.6 Measures of Banking Efficiency
6.7 Mergers and Acquisitions in Banking
6.8 Conclusion

Unit 7 Banking and Financial Crises

7.1 Introduction
7.2 Bank Runs in the Diamond and Dybvig Model
7.3 The Asian Financial Crisis 1997–98
7.4 Risk-shifting and Asset Price Bubbles
7.5 The Global Financial Crisis 2007–09
7.6 Deposit Insurance and Moral Hazard
7.7 Conclusion

Unit 8 Bank Regulation

8.1 Introduction
8.2 Systemic Risk
8.3 Lender of Last Resort
8.4 Deposit Insurance
8.5 Risk-adjusted Capital Adequacy Requirements
8.6 Stress Testing
8.7 Conclusion

Unit 1 Banks and Financial Markets

The module begins by identifying the key characteristics of the financial
systems operating in different countries. In a bank-oriented financial system,
savers lend their funds to financial intermediaries in the form of deposits,
and the intermediaries provide finance to borrowers in the form of loans.
Savers are predominantly households, and borrowers are predominantly
firms. In a market-oriented financial system, firms issue equity and debt
securities that are either purchased directly by households, or by
institutional investors such as pension funds and mutual funds on the
households’ behalf.
It has been suggested that a country’s legal system has a major influence on
the evolution of either a bank-oriented or a market-oriented financial
system. Common law legal systems are considered to be more conducive to
the evolution of a market-oriented financial system, because they typically
provide a greater degree of investor protection than civil law systems.
Other explanations focus on historical and political factors, including the
possibility that parties with vested interests in maintaining a bank-oriented
system may inhibit the development of sophisticated financial markets. We
compare the effectiveness of bank-oriented and market-oriented financial
systems in areas such as corporate governance, managing risk and
disseminating information.

Unit 2 Financial Intermediation

Why do we require financial intermediaries? Why aren’t the functions of
banks performed more efficiently by savers or lenders interacting directly
with borrowers in financial markets? A traditional answer is that banks fulfil
the functions of size, maturity and risk transformation: deposits are, on
average, small in value, short-term, and low-risk; while the average bank
loan is for a larger amount, long-term, and higher in risk. Alternatively,
banks may be able to reduce the transaction costs of acquiring information
and negotiating contracts. As noted above, asymmetric information
describes a situation where one party to a financial transaction has more
information than the other party, making it difficult for both parties to agree
terms on which they can transact. Banks’ lending policies may help
overcome these problems. According to the ‘coalition of borrowers’
hypothesis, borrowers signal the quality of their investment projects to
lenders by retaining an equity stake in their projects. Alternatively,
according to the ‘delegated monitoring’ hypothesis, a bank centralises and
reduces the costs lenders would otherwise incur in monitoring borrowers.
Finally, according to the ‘liquidity insurance’ hypothesis, the role of the bank
from a depositor’s perspective is to help smooth uncertain future outlays on
consumption.

Unit 3 Risk Management

One of the most important functions of banks is risk management.
Acceptance of risk can be viewed as a fundamental part of a bank’s business
model, because it involves the transformation of short-term liabilities into
long-term assets. Credit risk is the risk that borrowers default on their loan
repayment commitments. The theoretical credit risk spread (the difference
between the return on a risky asset and a risk-free asset) may be calculated
using an exogenously determined default probability; or imputed using
option-pricing theory. Practical methods for costing credit risk include
credit-scoring models, distance-to-default, and an adaptation of Value at
Risk. Other types of risk include interest-rate risk, which is the risk that
changes in the interest rate adversely affect the values of a bank’s assets and
liabilities. Market risk is the risk that the bank incurs losses on its
investments in stocks, bonds or other securities. Liquidity risk is the risk that
 Specimen Examination

a bank is unable to fund its lending or meet depositors’ demands for

withdrawals. Mechanisms devised to contain liquidity risk include reserve
requirements, deposit insurance, and the central bank lender-of-last-resort
facility.

Unit 4 Credit Rationing

A common complaint from business is that creditworthy investment projects
are sometimes unable to raise finance. Several modern theories of credit
rationing are based on the idea of information asymmetry between
borrowers and lenders. The probability that a loan is eventually repaid may
be affected by adverse selection, if clients with low-risk projects are deterred
from borrowing by a higher interest rate; or by moral hazard, if a higher
interest rate reduces the incentive for borrowers to take effective measures to
maximise the probability that their projects succeed. It may become
impossible for banks to specify an interest rate at which their willingness to
lend matches the amounts that clients wish to borrow. In other words, the
market for credit may fail to clear. It is also possible that banks may lend
more than they should, by funding some projects that are not capable of
delivering a return that covers the cost of capital.

Unit 5 Shadow Banking and Securitisation

The shadow banking system performs many of the same activities as the
traditional banking system, but operates largely beyond the scope of
regulation. Key activities are securities financing transactions, including
repo and securities lending, and securitisation. Shadow banking entities are
susceptible to runs, in the same way as traditional banks, but in the shadow
banking system the participants are financial institutions, and withdrawals
take the form of increasing ‘haircuts’, or a refusal to renew or roll over repo
agreements. The design of appropriate regulatory arrangements for shadow
banking institutions remains a topic for debate.

Unit 6 Competition and Efficiency in Banking Markets

Much early empirical research on competition in banking was based on the
notion of price competition that underpins the theory of the firm in
microeconomics. A more recent approach draws inferences about the nature
of competition from observed pricing behaviour. Measurement of efficiency
in banking focuses on two dimensions of efficiency. First, to what extent do
banks obtain the full benefits of economies of scale? And second, is there
scope for banks to achieve enhanced technical efficiency, by producing a
higher level of output from a given set of inputs, or improved allocative
efficiency, by changing the mix of inputs? A process of consolidation has
greatly reduced the number of banks operating in most industrialised
countries. Consolidation may be motivated by profit or by other objectives.
Enhanced efficiency may be an important motive for mergers and
acquisitions in banking; although the empirical evidence is mixed as to
whether post-merger efficiency gains are usually achieved.
 Unit 7 Banking and Financial Crises
Several theoretical explanations for banking and financial crises focus on the
events that can trigger a run on a bank. According to one highly influential
theoretical model, a sudden collective loss of depositor confidence may see
depositors rushing to withdraw their funds, in order to avoid being at the
back of the queue for repayment. Other explanations focus on moral hazard
problems, which encourage investors drawing on borrowed funds to pay
more than the underlying value for a risky asset, in the knowledge that if the
asset underperforms, the bank as lender will bear part of the cost. Banks are
also subject to a moral hazard problem, if their lending decisions are
influenced by the prospect that the government ‘safety net’ may provide a
bailout if investments fail to deliver their expected returns. Moral hazard
problems of this kind can give rise to asset price bubbles in equities or real
estate, of a kind that is often seen prior to the onset of a banking or financial
crisis. Several crises, including the Asian crisis of 1997–98 and the global
financial crisis of 2007–09, contain features that appear consistent with the
theory.

Unit 8 Bank Regulation

Systemic risk, or risk to the stability of the financial system as a whole, is the
main justification for a relatively intrusive supervisory and regulatory
regime that is commonly applied to the banking industry. Key elements of
the regulatory regime, known as the ‘safety net’, are lender-of-last-resort
support from the central bank for banks that are fundamentally solvent but
facing a shortage of liquidity; and government-backed deposit insurance to
strengthen depositor confidence and reduce the prospect of a run on the
bank. These forms of state-sponsored support raise moral hazard concerns
about the risk appetites of banks. Risk-weighted capital regulation ensures
that bank balance sheets contain safety buffers that can absorb unanticipated
losses without destroying the bank’s solvency. Stress tests are a useful tool
for assessing the resilience of a bank’s capitalisation to unanticipated shocks.

5 Learning Outcomes
When you have completed your study of this module, you will be able to:
• explain the functions of financial intermediaries, and evaluate the
strengths and weaknesses of bank-oriented and market-oriented
financial systems.
• critically evaluate theories of the banking firm which focus on the role
of the bank as a provider of liquidity insurance for depositors, and as a
delegated monitor of borrowers.
• explain the methods available to a bank to manage credit risk, interest
rate risk, market risk and liquidity risk.
• explain why credit markets may fail to clear, and critically evaluate
theories of credit rationing and overlending.
 Specimen Examination

• discuss the methods used by shadow banking institutions to raise

finance, and the risks to financial stability presented by shadow
banking.
• critically evaluate methods for measuring the efficiency of banks, and
the intensity of competition in deposits and loans markets.
• explain how a loss of depositor confidence, and asset price bubbles,
can trigger banking and financial crises.
• critically evaluate the effectiveness of regulatory arrangements for the
banking industry in promoting financial stability.