Corporate and Wholesale Banking 02BSC024 Identify and discuss the main forces which are causing unprecedented change in the corporate and wholesale financial markets. Explain why these forces have had such an impact on these markets. Clare F Thomas 9934287 May 2003 Clare F Thomas Corporate and Wholesale Banking B INTRODUCTION The traditional function of commercial banks has been to act as financial intermediaries between deficit and surplus sectors. This assumes that banks can intermediate at lower costs than those prevailing with direct financing.

However developments in corporate and wholesale financing have significantly undermined this cost imperative. This essay aims to identify and discuss the main forces behind these developments and explain why they have had such an impact on the corporate and wholesale financial markets. Llewellyn (1994) highlighted some key forces and resultant developments when he stated that two major determinants of structural change in the banking industry were likely to emerge: 1. A further reduction of barriers to entry through deregulation would allow more institutions other than banks to provide traditional financial services. . Banks would continue to diversify into a wider range of non-traditional banking services, in particular, more of banks’ business will be conducted off-balance sheet. Both of these determinants have been and still are features of the corporate and wholesale financial markets. However other factors have also played a crucial role in shaping the industry, in particular, new technological developments have broken down barriers to entry and led to increased disintermediation of banks.

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These forces and their impacts on the corporate and wholesale financial markets will now be discussed in greater detail. 1 Clare F Thomas Corporate and Wholesale Banking B WHAT ARE THE MAIN FORCES CAUSING CHANGE; HOW AND WHY HAVE THEY HAD SUCH AN IMPACT? Changes in Regulation Domestic banking has been somewhat protected from the full effects of supply and demand as it has been tightly controlled by high regulation and cartels.

Through operating in a generally weak competitive environment, banks have been induced to develop cost structures that are unsustainable in more competitive and unregulated environments such as the international financial markets. Domestic banks were keen to move into this completely contrasting environment as the deregulation of financial markets allowed freer capital movements, greater competition, fewer restrictions on place and scope of activities and rapid innovation without the need for massive government intervention.

However, banks ceased to benefit from what was in practice, protective regulation and Bisignano (1998) discusses the near or actual failure of major financial institutions around the globe following financial deregulation in the mid-1980s. The results of this deregulation are evident; global competitive pressure has increased: not only has competition between banks increased due to the global nature of the competitive arena but also institutions other than banks are able to provide traditional financial services too.

One way in which banks have reacted to this change is through mergers and acquisitions of competitors. It is important to note that there is an argument for re-regulation of the international banking environment, particularly where mergers and acquisitions are concerned as banks are becoming so large that they could be deemed anti competitive. Reregulation has also been required after unprecedented growth over a short period of time in the securities market. Securities are contingent liabilities and therefore offbalance sheet activities.

Regulation was required due to the fast growing nature of the securities market, but as banks are controlled through balance sheet ratios, there was no way of regulating the banks where securities were concerned as they did not appear on the balance sheet. Changes in the way the risk asset ratio was calculated were made in order to bring these activities ‘on-balance sheet’. Securitisation will be discussed later on. New Technology New technology has reduced barriers to entry. Originally the banking sector was based on branch networks; in order to operate overseas, a bank required a branch in that country.

Now, thanks to new technology, in particular the internet, the physical presence of a bank is not as important and branches are no longer a requirement to operating overseas as physical proximity does not determine where money can be raised. For example electronic trading technology has allowed the creation of companies such as E*Trade and is providing new distribution channels and shifting the balance of power to the consumer. Thus technology has changed the way in which money is lent and banks have had to become more innovative both in the way in which their financial services are delivered and the services they offer.

Direct banking (telephone and internet banking) is becoming comparatively more important and the branch network, which used to be a major competitive advantage because it created a barrier to entry is now becoming one of banks’ most expensive problems (Llewellyn 2 Clare F Thomas Corporate and Wholesale Banking B 1994). In the UK, the Prudential has launched its new banking service Egg and is rapidly moving to expand its services using the internet. New technology is also largely responsible for moving the markets towards a more perfect situation in that it has reduced information asymmetry.

Banks used to possess privileged information that was not available to the public, however new technology has increased the availability and reduced the cost of information. International rating agencies such as Standard and Poor rate and provide information on the credibility of companies and this information is available for anyone who wants to invest in these companies, Information on global financial markets and stocks for example can be found out easily and therefore the banks’ exclusivity and comparative advantage is being eroded and the market is moving towards a more perfect situation.

The banks’ major role now is to advise their clients. This in turn has lead to disintermediation in the banking industry. Disintermediation is the process whereby companies raise money directly on the world’s financial markets and ‘bypass’ the banks. Bisignano (1998) states that asymmetric information is the fundamental characterisation of financial intermediation. With continued increase in the availability of and reduction in the cost of information, could banks be completely squeezed out in the future?

Howcroft (1997) highlights significant disintermediation of commercial banks by large companies over the past twenty years as one of the main forces which has caused unprecedented change in the corporate and wholesale financial markets as banks have had to diversify their activities and be innovative in the services that they offer in order to compete. Also as companies become increasingly international, their funding operations must take on an equally global perspective.

As large national and international companies increasingly raise finance on the world’s capital markets, the amounts borrowed from banks will continue to decline and this has significant implications for bank loan portfolios; disintermediation could have a tendency to reduce profitability and increase loan portfolio risk by increasing the incidence of small companies and businesses.

Electronic cash (E-cash) provides an interesting illustration of a technological innovation that could potentially impact the future structure of intermediation in that it would replace many debit, credit and smart card transactions and would permit instant crediting or debiting of accounts for transactions negotiated on the internet. However while e-cash performs only an exchange function, there is still a role for banks, and customers are often slow to accept new money transmission services.

Developments in technology and the erosion of entry and regulatory barriers into banking means that it is easier for non-bank financial institutions and non-financial institutions to diversify into banking, and banks will face competition from a wider range of potential competitors. Examples of this include GE Capital, the financial services subsidiary of General Electric, and Tesco who now offer financial services including credit cards, loans and insurance.

Increasing Global Competitive Pressure The factors discussed previously have lead to increased global competitive pressures and the emergence of excess capacity; there are too many banks competing for a finite amount of business. This has a very important influence in changing the nature of 3 Clare F Thomas Corporate and Wholesale Banking B how business is conducted; the manner in which excess capacity is removed will prove to be one of the major strategic issues that banks have to face in the years ahead.

The recent increase in mergers and acquisitions activity demonstrates how international and wholesale banks have reacted to this situation. Llewellyn (1994) stated that there was likely to be a consolidation into a smaller number of larger banks. Frazer (1991) commented that a ‘merger movement’ had become a pronounced feature of the US banking industry as it was viewed as a solution to excess capacity, a lack of capital and poor profitability. There had also been a marked increase in the number of mergers and acquisitions in banking in EU countries.

Valdez (2000) also states that we can be certain that this present spate of mergers will continue. It is important to remember that whilst banks may benefit from economies of scale through mergers and acquisitions, after a certain size, diseconomies of scale take effect and banks could just be getting larger without necessarily becoming more profitable. Consolidation could also take the form of mergers between banks and nonfinancial companies.

Evolution of Strategic Objectives Banks have historically put emphasis on volume and asset growth but there has been a shift in focus to the quality of assets; a move from transaction oriented (high volume) activity to market oriented (relationship) activity and maintaining long term sustainable activities. This has lead to new strategies concerning customer awareness, relationship management, and customer profitability and retention. Diversification In the face of increasing non-traditional competition, together with the growth in domestic and international capital markets, banks are attempting to redefine their businesses.

The traditional financial intermediation role of banks to take loans and offer deposits is likely to become a relatively less important part of the overall business, as banks diversify into providing a wider range of services such as unit trusts, stock broking facilities, insurance policies, pension funds, asset management, and real estate. Rabczynski (1996) states that commercial banks have responded to these changes by becoming more investment bank oriented. Traditional on-balance sheet services for large companies have therefore been largely replaced by he offbalance sheet activities of providing investment advice, making placements and the provision of stand by facilities. Howcroft (1997) states that from the commercial banks’ perspective, there has been a strong imperative to develop what was traditionally regarded as “ancillary business” and so by definition the traditional core services have changed, bringing about an equally marked change in income structure; greater emphasis is now placed on fee rather than interest income.

Modern banks are typically either highly specialised in a narrow range of activities, or they offer a broad range of financial services. The original demarcation lines between international and domestic markets are now less clear, for example investment banks are linked to domestic banks. 4 Clare F Thomas Corporate and Wholesale Banking B Securitisation As stated earlier, the existence of banks is sometimes viewed as a response to imperfect and incomplete markets.

The process of financial innovation and the creation of a wider range of financial instruments (spectrum filling as described in Llewellyn (1985)) have reduced the degree of market imperfections and incompleteness. The unprecedented growth in Euronote facilities is a demonstration of innovation and growth over a short period of time. Van Horne (1985) also argues that securitisation and financial innovation have lead to more complete markets. The growing importance of the securities market has stemmed from a significant change in investor demand preferences.

Modern investors are not risk averse and are more interested in capital growth than liquidity, therefore they no longer put their money in bank deposits but into securities such as bonds. Increasingly banks will securitise a significant proportion of their assets and issue subordinated loan stock in order to raise finance, with major implications. First it implies that fee income will become an increasing proportion of banks’ total income relative to margin income. Secondly it implies that the relative size of the capital market and of banks in the inancing of the corporate sector will shift towards the capital markets. Thirdly it implies that the liquidity of banks’ balance sheets will increase. Fourthly the nature of the banking business will change as banks become managers of securitised assets (The Economist 1992). Securitisation implies that the rate of growth of banks’ balance sheets is likely to be considerably lower in the future than in the past. The growth of the securities market had expanded the role of banks to one where they act as intermediaries in risk management.

Banks are now acting as agencies and also providing underwriting facilities. CONCLUSION It is evident that the world’s corporate and wholesale financial markets are undergoing major changes such as disintermediation, diversification, increasing competition from non-financial institutions and the changing nature of banks’ income. These changes have been brought about by a reduction in barriers to entry through deregulation and technological advances. Banks have had to become innovative and diverse in the services that they offer.

The ethos of banks has evolved to one of ‘quality of service and not quantity’, along with the increasing importance of longterm sustainable activities and customer retention. To maintain a competitive advantage in the financial market place, banks will have to continue to adapt to the changing nature of intermediation, new technology and ever-changing consumer preferences so that while the structure of the financial firm may change, the role of banking will evolve rather than decline or disappear.

Word count: 1999 5 Clare F Thomas Corporate and Wholesale Banking B BIBLIOGRAPHY BISIGNANO, J; Towards an Understanding of the Changing Structure of Financial Intermediation, SUERF, Amsterdam, 1998. ECONOMIST, Time to Leave, 2 May 1992. FRAZER, P; US Banks: Merger Mania Takes Hold, Banking World, November 1991. HEFFERNAN, S; Modern Banking In Theory And Practice, Wiley 1996. HOWCROFT, J B; The Dynamics of Responsibility and Risk in Corporate and Wholesale Finance, LUBC Research Paper No. 116/97, 1997.

LLEWELLYN, D T; Evolution of the British Financial System, London, Institute of Bankers. LLEWELLYN, D T; The Future of Banking: is Banking a Declining Industry? LUBC Research Paper No. 84/94, 1994. RABCZYNSKI, T M; Investment Banking: its Evolution and Place in the Financial System, Investment Banking Theory and Practice, Gardener, E. and Molyneux, P. (eds), 2nd Edition, Euromoney Books, London. VALDEZ, S; An Introduction to Global Financial Markets, Macmillan, 2000. VAN HORNE, J; Of Financial Innovations and Excesses, Journal of Finance, July 1985, pages 621-631. 6