Section A: 4 questions (10 marks), Section B: Essay choose 1 out of 2 (20 marks)

1. Chapter 4: International Banking (Essay Q’s)

a. Why do they go international?
i. Factor prices and trade barrier theories: Firms go overseas to take advantage of factor price
differentials lower manual labor cost countries and headquarters where skilled labor costs are
low. Where trade barriers and costs are high, the firm establishes itself in countries to access
markets.
ii. Arbitrage and the cost of capital: Overseas banks can be purchased cheaper due to currency
depreciation and the overall returns from the acquired firm will be higher due to higher return
on capital. For a simple example, the substantial 20–30 per cent depreciation of the US dollar
against the euro and British sterling during 2003 meant that European investors could acquire
US banks for 20–30 per cent cheaper than they could do previously.
iii. Ownership advantages: Advantages which help banks that locate overseas to compete with
original banks on many aspects such: Technological expertise, marketing know-how, production
process efficiency, managerial expertise, innovative products and services.
iv. Diversification of earnings: Banks can enhance the earning diversity by doing similar business
activity in different countries and by expanding into new areas such as insurance, mutual funds,
investment banking etc., both at home and abroad. Due to less correlated earnings in the
foreign country and the home market, risk is reduced.
v. Theory of excess managerial capacity: Banks may require the use of certain managerial and
other resources that can be only fully utilised when they achieve a certain size. For instance, if a
firm has a highly specialized management team it may not get the best use of this team if it only
focuses on business in one particular geographical market.
vi. Location and the product life cycle: The product life cycle has three main stages: innovative or
new product, maturing product and standardised product.

vii. Other theories on the rationale for international banking:

• Firm specific advantages: Large banks with a wide arrangement of financing sources
may benefit from scale and scope economies.
• Location advantages: Certain location benefits relate to a variety of production,
distribution and selling attributes of a product or service
• To obtain new customers, to follow their large corporate customers abroad, to follow
their competitors, performance and efficiency advantages, managerial/govt. motives
b. Opportunities and Challenges
 c. Methods
i. Correspondent banking: It is the lowest level of exposure to the foreign market. It involves using
a bank located in the overseas market to provide services to a foreign bank. Smaller banks use
correspondent banking services to do business in markets where they have no physical
presence. The services are mainly payment and other transaction services and trade credit
facilities. Correspondent banks earn a fee from the foreign banks for providing these services.
ii. Representative office: Slightly greater exposure to a foreign market. Representative offices are
usually small and cannot do banking business-they cannot take deposits or make loans. They are
used to prospect for new business and act as marketing offices for parent banks. Typically, a
bank will set up a representative office in risky markets as the cost of running such small offices
is negligible and they can be easily closed if commercial prospects are not good.
iii. Branch office: It is a higher level of commitment to the foreign market compared with the
representative office. A branch is a part of the same legal entity as the parent bank. and it acts
as a functional part of the parent’s head office. A branch can perform all functions that are
allowed to do in host country for example accepting deposits and giving loans or other types of
products and services.
iv. Agency: The term agency mainly refers to a separately incorporated branch of a foreign bank.
Agencies are similar to branches in that they form an integral part of the parent bank. They lie
somewhere between branches and representative offices as they can do less than the former
and more than the latter. Agency banks cannot make loans or take deposits in their own name;
rather, they do so on behalf of the parent bank in the foreign country. Just as a clarification, an
agent bank is a bank that acts in some capacity on behalf of another bank.
v. Subsidiary: It is a separate legal entity from the parent bank, has its own capital and is organised
and regulated according to the laws of the host country. Where branches expose the whole
capital of the parent bank to risk from overseas activity, the risk exposure of a subsidiary is
limited by its own capital exposure.

For the banking group as a whole, costs of doing business may be lower under the branch structure than
under the subsidiary structure.

• The subsidiary structure may, in principle, be better for containing losses in the event of distress
(or failure) of an affiliate.
• All else equal, one could expect global retail banks to have a preference for subsidiarization,
while global universal banks for branching.
• In practice, when choosing a legal form of incorporation in foreign jurisdictions, banking groups
also take into account a range of home/host country characteristics that may outweigh the
business model considerations.
 2. Chapter 7: Regulation/Supervision (Essay Q’s)
a. Regulation, Monitoring and Supervision
i. Regulation: Relates to the setting of specific rules of behavior that firms have to abide by – these
may be set through legislation (laws) or be stipulated by the relevant regulatory agency
ii. Monitoring: Refers to the process whereby the relevant authority assesses financial firms to
evaluate whether the imposed rules are being obeyed.
iii. Supervision: Refers to the general oversight of the behavior of financial firms.
b. Rationale for Regulations
The main reasons for financial sector regulation is to ensure systemic stability, to ensure the safety and
soundness of individual financial institutions and to provide smaller, retail clients with protection, and to
protect consumers against monopolistic exploitation.
c. Types of Regulations
i. Systemic (or macro-prudential) regulation: They aim to ensure that large, systemically important
financial institutions (SIFIs) are subject to more stringent prudential requirements and
supervision than smaller players.
a. It has two main objectives: strengthen the resilience of the financial system and limit
the build-up of systemic financial risks.
b. Macro-prudential policies focus on the interaction between the financial institutions,
markets, infrastructure, and the wider economy.
c. It uses prudential tools to limit systemic risk and to mitigate its effects on the real
economy.
d. Macro-prudential supervision is concerned with the aggregate effect of individual banks’
actions
ii. Prudential (or micro-prudential) regulation: Prudential regulations target individual institutions,
regardless of the institution’s impact on the financial system and is concerned with consumer
protection. The case for prudential regulation is that consumers are not able to judge the safety
and soundness of financial institutions due asymmetry information.
a. The objective is to limit the distress of individual financial institutions.
b. Micro-prudential supervision checks that individual financial firms are complying with
financial regulation
c. Involves the collection and analysis of information about the risks that the firms take,
their systems and their personnel.
iii. Conduct of business regulation: Focuses on how banks and other financial institutions conduct
their business. It relates to information disclosure, fair business practices, competence, honesty
and integrity of financial institutions and their employees.
a. The focus is on establishing rules and guidelines to reduce the likelihood that:
consumers receive bad advice , supplying institutions become insolvent before contracts
mature, contracts turn out to be different from what the customer was anticipating,
fraud and misrepresentation , employees of financial intermediaries and financial
advisors act incompetently, insider trading and money laundering
 d. Financial Safety Net

A financial safety net is a comprehensive system for enhancing and ensuring a country’s financial
stability. It consists of five elements:

i. Regulation and supervision:

ii. Deposit insurance schemes: A guarantee that all or part of the amount deposited by savers in a
bank will be paid in the event that the bank fails.
a. Four types of models: Paybox, Cost Reducer, Resolution Facilitator and Supervisor
iii. Lender of last resort: The central bank provides funds to banks that are in financial difficulty and
are not able to access any other credit channel
iv. Bank insolvency/resolution laws.
v. Co-operation and resolution processes

e. Limitations of Regulations

Regulations enhances ‘safety net’ moral hazard

• Too Big to Fail (TBTF): As managers of large banks believe that they will be bailed out by the
authorities, they might get into financial difficulty then this increases the moral hazard
incentives for big banks, resulting in banks taking on even greater risks to increase profits and
executive remuneration
• Agency Capture: the regulatory process can be ‘captured’ by producers (in this case by banks
and other financial institutions) and used in their own interest rather than in the interests of
consumers.
• Costs of Compliance: Regulation is a costly business and the costs of compliance with the
regulatory process will be passed on to consumers, resulting in higher costs of financial services.
In addition, regulatory costs may act as a barrier to entry in the market and this may consolidate
monopoly positions.
f. Costs and Benefits of engaging in forbearance

Regulatory forbearance is looseness in regulatory agencies' roles of supervision, oversight, and

enforcement. Benefit: When financial intermediaries are in trouble, there may be pressures not to apply
existing regulations, for example, to impose higher capital or liquidity requirements. It could worsen the
problem. Costs: Forbearance may lead to expectations of similar behavior in future cases, causing other
financial institutions to observe regulations less carefully. This may result in a loss of public confidence in
how banks and the financial system in general are being regulated.

g. Causes of Regulatory Reforms

• Financial scandals and the consequent political pressures generated.
• Financial innovation: As new financial products and services emerge and gain in market
significance, there are often calls for new regulations.
 3. Chapter 9: Performance/ Analysis
a. ROE Decomposition and limitation. Does ROE affect profitability?

ROE is probably the most important indicator of a bank’s profitability and growth potential. It is the rate
of return to shareholders or the percentage return on each dollar of equity invested in the bank.

Limitations of ROE:

• Banks that generated high ROE prior to the 2007-2008 crisis, performed poorly during the
financial crisis,
• An ECB report (2010a) discusses the reliability of using ROE as a benchmark particularly in
periods of high volatility and weak economic conditions.
• ROE is an accounting number, and thus it is subject to manipulations
• ROE is missing crucial elements such as the proportion of risky assets and the level of solvency.
• ROE fails to distinguish the best-performing banks from others because it is essentially a short-
term indicator and thus cannot measure the potential for sustainable (long-term) results of the
bank.
• Ratios do not stand in isolation: they are interrelated.
• Ratios relate to a particular point in time and there are seasonal factors that can distort them.
• Ratios reflect past performance.

Does ROE affect profitability?

• The higher the ROE, the more efficient the company is at generating profits with the money it
has. A return of between 15-20% is considered good.
• The higher a company's ROE percentage, the better. A higher percentage indicates a company is
more effective at generating profit from its existing assets. Likewise, a company that sees
increases in its ROE over time is likely getting more efficient.
 4. Chapter 11: Banking risk
a. Focus on four types of risk
i. Credit risk: the potential that a bank borrower or counterparty will fail to meet its obligations in
accordance with agreed terms. Can be managed through servicing, monitoring and screening.
ii. Interest rate risk: risk associated with unexpected changes in interest rate.
a. A rise in market interest rates has the effect of increasing banks’ funding costs because
the cost of variable rate deposits and other variable rate financing increases. If loans
have been made at fixed interest rates this obviously reduces the net returns on such
loans. Meanwhile, banks will be vulnerable to falling rates if they hold an excess of
fixed-rate liabilities
iii. Liquidity risk: generated in the balance sheet by a mismatch between the size and maturity of
assets and liabilities. It is the risk that the bank is holding insufficient liquid assets on its balance
sheet and thus is unable to meet requirements without impairment to its financial or
reputational capital.
iv. Foreign Exchange Risk: risk that exchange rate fluctuations affect the value of a bank’s assets,
liabilities and off-balance-sheet activities denominated in foreign currency.
a. A bank may be willing to take advantage of differing interest rates or margins in another
country, or simply to invest abroad in a currency different from the domestic one. A
bank that lends in a currency that depreciates more quickly than its home currency will
be subject to foreign exchange risk.
v. Market Risk: is the risk of losses in on- and off-balance-sheet positions arising from movements
in market prices. It pertains in particular to short-term trading in assets, liabilities and derivative
products, and relates to changes in interest rates, exchange rates and other asset prices.
vi. Operational Risk: Risk associated with the possible failure of a bank’s systems, controls or other
management failure (including human error).
vii. Technology Risk: risk occurs when technological investments do not produce the anticipated
cost savings in the form of either economies of scale or scope; this risk also refers to the risk of
current delivery systems becoming inefficient because of the developments of new delivery
systems.
viii. Off balance sheet risk: risk relates to the risks incurred when banks deal in activities that imply
the increase in contracts that obligate them to perform in various ways but do not appear in the
bank balance sheet
ix. Regulatory risk: the risk associated with a change in regulatory policy. For example, banks may
be subject to certain new risks if deregulation takes place and barriers to lending or to entry of
new firms are lifted. Changing rules relating to products and dealing with customers are other
examples of potential regulatory risk
x. Country risk: the risk that economic, social and political conditions of a foreign country will
adversely affect a bank’s commercial and financial interests
xi. Sovereign risk: Governments, as sovereign powers may enforce their authority to declare debt
to external lenders void or modify the movements of profits, interest and capital.
5. Chapter 19: Merger and Acquisition
a. Motivation for Bank Mergers
• Mergers and acquisitions (M&As) refer to the combining of two or more entities into one new
entity.
o A merger is when two, usually similarly sized, banks (or any other firms) agree to go
forward as a new single entity rather than remain separately owned and operated. Such
operation implies the combination of all the assets and liabilities of the two banks.
o An acquisition or takeover is when a bank (the acquirer or bidder) takes over another
one (the target or acquired bank) by purchasing its common stock or assets and clearly
becoming the new owner.
• Three types of mergers: horizontal, vertical and conglomerate.
o Horizontal: same market
o Vertical: different roles in the same industry
o Conglomerate: between companies in unrelated lines of business
• Motives:

•
 6. Chapter 20: Competition and Financial Stability
a. Competition Stability vs Fragility View

Competition fragility view:

• The traditional view is that competition would lead to excessive bank risk taking, and could
therefore, result in a higher possibility of individual bank failure.
• Bank failures can costly lead to infection in the banking market as well the whole systemic
failure.
• As a consequence, the banking industry has been historically very heavily regulated. This
traditional view is known as the “competition-fragility view”
• This banking view states that banks under higher level of competition pressure choose more
excessive risk, as a result higher fragility.
• In the aftermath of the 2007-2009 financial crisis, supporters of the “competition-fragility view”
point to the house price bubble, for the most part in the US, the UK and Ireland that led up to
the banking crisis. They claimed that banks were competing so aggressively in the lending
market, mainly in the market for residential mortgages, banks neglected to estimate the true
risk of borrowers. They use this example as a clear indication that competition in banking leads
to increased risk taking.

Competition stability view:

• A more recent view is by those who debate that competition can be stable on the banking
system.
• Competition is generally considered as an essential force in the economy as it should encourage
firms to be more efficient. In the banking sector, higher efficiency should bring lower costs,
which should then be passed on to bank customers in the form of lower charges, higher deposit
rates and reduced lending costs.
• One argument is that as loan interest rates are lower in a competitive system, this means that
fewer borrowers are likely to default and that is such a positive result then “competition can aid
stability”
• Yet, several theoretical studies point to evidence of this “competition-stability view” that has
also been confirmed in a number of empirical studies.

The impact of bank competition on financial stability remains a highly debatable issue which is the
subject of both academic and policy debates. A recent OECD report (2011) states: Studies exploring the
complex interactions between competition and stability in retail and commercial banking come to the
unsettled and open-to-debate conclusion, that competition can be both good and bad for stability.
Overall, there is no an absolute agreement to the relationship between competition and risk in banking.
As it has been highlighted in the evidence provided either theoretically or in the empirical banking
studies. A reason, the fact that empirical studies often use different competition measures and risk
indicators as well as varying bank samples and methodologies to investigate such relationships. So policy
makers need to be cautious in implementing policies designed to boost competition unless they are
certain that such reform does not lead to excessive risk taking.