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Intermediation services
Activity
Read Chapter 2 of this guide and identify the main features of asset transformation
undertaken by a financial intermediary. In Chapter 2 of this guide we examined the
nature of the process of financial intermediation undertaken by banks. In particular
we saw that in transforming the characteristics of funds a bank is exposed to two
main risks:
2. Default risk – the main asset held by banks are advances and default risk refers
to the risk of the interest and/or capital on these advances not being repaid. Banks
must manage these risks to prevent failure of the bank.
Here we focus on the strategies that banks can use to manage these risks:
There are two main strategies a bank can adopt to manage this problem:
Cash inflows (from new deposits and loan repayments) would normally fund cash
outflows (deposit withdrawals and new loans). However, the stock of liquid assets
held by the bank acts as a buffer which can be drawn on when there is an
imbalance of outflows over inflows. Normally liquid assets are held according to a
maturity ladder with assets running from cash to overnight deposits to bills and
short-term deposits etc. The bank will obtain some return on its liquid asset
holdings (other than cash) but this will be lower than on its main earning asset of
advances. Therefore banks will be looking to hold just enough liquid assets to meet
unexpected cash outflows.
Liability management
In the last 30 years banks in most developed countries have moved away from
reserve asset management towards liability management. Liability management
involves a bank managing its liabilities to meet loan commitments or replenish lost
liquidity. One form that this could take is simply to adjust interest rates on its
deposits. However if a bank is reliant solely on retail deposits then increasing
deposit rates is costly because it has to be done for existing deposits as well as
new deposits attracted. However, the development of wholesale deposit markets
(market loans in table 3.1), in particular an overnight inter-bank market, has
allowed banks to use such markets as a marginal source and use of funds. For
example, if a bank at the end of a working day has made more loan commitments
than it can meet from current funding then it can borrow funds from another bank in
the overnight market. Conversely, if a bank has a surplus of funds at the end of a
working day then it can lend this overnight.1
The existence of the inter-bank markets allows banks to exploit profitable lending
opportunities as they arise without being too concerned about raising the funding to
meet the loan.
Screening
Banks can minimize the risk of default for each individual loan by considering the
purpose of the loan and the financial circumstance of the borrower. The bank
should be aiming to select good risks only. Credit scoring is increasingly being
used by banks in this process of risk analysis and the advantage of credit scoring is
that it can be largely automated.4 Credit scoring is a method of evaluating the
credit risk of loan applications using a scoring model. The scoring model is
developed using historical data to identify which borrower characteristics provide a
good prediction of whether a loan performed well or badly. Each characteristic will
be weighted in the model according to its importance in predicting default.
Characteristics which might be used in a credit scoring model for personal loans
include the length of time the applicant has been in the same job, monthly income,
outstanding debt etc. Fair, Isaac and Company in the US were the pioneers of
credit scoring models. In the past, banks used credit reports, personal histories and
the bank manager’s judgment to determine whether to grant a loan. Credit scoring
is now widely used in personal lending, especially credit card lending and is
increasingly being used in mortgage lending. The use of credit scoring has enabled
banks to make lending decisions over the telephone and so has helped facilitate
the establishment of telephone-based banks.
Pooling
Banks can undertake a large number of small loans rather than a small number of
large loans. This is an application of the law of large numbers to the loan portfolio,
which reduces the variability of loan loss, so increasing the predictability of loss
through default.
Diversification
Banks can diversify the loan portfolio by lending to a wide range of different types
of borrowers. For example a bank should lend to both individuals and businesses
and within lending to businesses should lend to businesses in different industries.
This has the effect of offsetting the firm specific-risks within the portfolio. A simple
example illustrates the principle of diversification. A bank may lend to a number of
firms producing ice cream and a number of firms producing raincoats and
umbrellas. If a particular summer is mainly rainy then not much ice cream will be
sold and some ice cream producing firms may default on their loans to the bank.
However, the firms producing raincoats and umbrellas will prosper during a rainy
summer and the incidence of loan default amongst these firms will be low. If the
summer is mainly hot then the reverse will occur with ice cream firms prospering
and raincoat and umbrella firms doing badly and the incidence of loan default will
be the reverse. So by spreading its loans, the bank will not suffer high default risk
across its whole portfolio of loans in the event of either an extremely hot or
extremely rainy summer. By diversifying its loan portfolio a bank makes its
borrower-specific loan risks more independent. It should be noted that banks that
specialize in lending to one particular sector, region or industry, will be limited in
their ability to diversify. Examples include banks that specialize in mortgage lending
or lending to a particular region or industry (e.g. agricultural banks).
Collateral
A bank may ask for collateral (or security) to be provided by the borrower. If the
loan then goes to default then the bank is able to sell the collateral and so recover
some or the entire loan. Collateral also has the effect of reducing moral hazard as
the threat of loss has the effect of reducing the incentive of the borrower to engage
in undesirable activities.
Capital
Finally, a bank should hold capital. This provides a cushion against loss in the
event of default losses which protects depositors from its effects. Regulators
impose requirements on banks regarding the amount of capital a bank should hold
in relation to the friskiness of its assets.