A survey of the pattern of Bank Evolution and the Business of Banking

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Offline Deanfbe

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Continuation .....
The Roots of Modern Banking:

The first goldsmith-bankers cannot be traced with certainty to any specific time or place. There is evidence that such activities took place in Mesopotamia sometime during the first millennium B.C. In Ancient Greece goldsmith operations existed in Delphi, Didyma. And Olympia at least as early as the seventh century B.C. By the sixth century B.C., banking was well developed feature of the economy of Athens [Miller and Vanhoose, 2001]

Banking operations also started in the Mediterranean world, in cities such, Jerusalem and further east in Persia. Banking facilitated trade because merchant who shipped goods to far away locations typically need loans to fund their operations. After receiving payment from the purchasers of their goods, the merchants would then repay those who had provided loan financing. These lenders then became known as merchant banks. Merchant banking ultimately became a linchpin of the trade linking the principalities of the Roman Empire.

The Italian Merchant Bankers:

The modern term ‘bank’ drivers from the merchant’s bench, or banco, on which money changed hands in the market places of medieval Italy. The Term bankruptcy refers to the “breaking of the bench” that occurred when an Italian merchant banker overextended, then experienced a run on his notes, and failed. During the medieval periods of twelfth and thirteenth centuries AD, merchant banks flourished throughout Italy.

By the time of Italian renaissanance during the fifteenth and sixteenth centuries, merchant bankers such as the medice family of Florence had accumulated enormous wealth and political power. Although these Italian merchant bankers directed some of their wealth to financing the fabulous art of masters such as Michelangelo and Leonardo da vinci, Ultimately, they squandered much of it by building armies and conducting wars over territories and riches.

Others in Europe eventually copied the banking practices of Italian merchant bankers. Merchant banks from the Lombardy region of Italy continued to maintain their merchant banking operations in other European cities like London and Berlin. In London, The Italian merchant banks became such an important institution that the city’s financial dealings were centered around the Lombard Street which even today remains the financial heart of the city. The German central bank, Deutsche Bundesbank, called one interest rate at which it lent funds to private banks the ‘Lombard Rate’. Even after the Italian city states fell in to political disarray, Italian merchant bankers hailing from Genoa financed the activities of the rising Hapsburg Empire of seventeenth and eighteenth century Europe.

Others in Europe eventually copied the banking practices of the Italian merchant bankers. The banking business took on three key features. First, as in the days of earliest gold smiths, banks took deposits from customers. First, as in days of the earliest goldsmiths, banks took deposits from customers and maintained accounts on their behalf. Second banks managed payments on behalf of customers by collecting and paying checks, notes and other “banking currency”. Finally, like the old merchant banks, these loans and the fees that the banks charged for accounting and deposit services was the banks’ sources of revenue, ultimately, profits.
The Evolution of bank activities:

We noted earlier that banking evolved as a combination of financial intermediation and payments. It did so because there were economies of scope between these two activities. Economies of scope have also led banks into various related businesses as indicated below.

Economies of scope related to payments:

While economics of scale result from doing more of the same thing, economics of scope result from doing different, but related, things. A firm can sometimes benefit from branching out in to new lines of business that are closely related to what it is doing already. It may already possess the necessary tools and know-how, making entry in to new lines of business less costly than it would be for a firm starting from scratch. A great deal of innovation is the result of such branching out, and it can be important source of profit. Different lines of business can offer a bank such economies of scope.

One possibility is to offer to process firm’s incoming cheques and to ensure that they clear as quickly as possible. A bank will receive fee for such a service. Since the banks may have much of the needed technology and trained personnel, providing the service will be relatively very expensive.

Banks provide payments service not only to household and business, but also to the financial markets. An efficient and reliable system of settling transactions is essential to the proper functioning of the securities markets. In addition to payments proper, banks provide a variety of related service. They offer cash management services that enable corporations to speed the payments they receive and delay the payments they make.

Banks also provide their customers with foreign exchange to enable them to make payments to other countries. And they also provide credit cards and process credit card accounts for small bank and non bank issuers. The payment system is of great importance to the economy. Payments are an inseparable part of trade in goods and services. The lower the transaction costs of making payments, the more trade there will be and the greater will be the gains from trade. How well the payment system does its job has tremendous effect on the overall efficiency of the economy. Today, with the introduction of payments with credit card, electronic payments and payment of the internet etc., the merchant is guaranteed payment the moment you place the order, the goods can be shipped immediately.
The payment system is also of great importance to financial institutions. For many, the provision of payments services is a substantial source of income. An estimate suggests that in the United States for the 25 largest bank holding companies, between 30% to 40% of their operating revenue came from payments related services (Radecki, 1999). You cannot understand banking without an understanding of this aspect of the business. 

Payments mechanisms are a key element in the structure of financial markets. You cannot make sense of overnight lending or the government securities market without understanding how payments are executed. Furthermore, the increasing globalization of financial markets has transformed the trading of foreign exchange----one part of the payment system---into a growth industry. Worldwide trading volume in foreign exchange reached $ 1.5 trillion a day in 1999.

Economies of Scope Related to Intermediation :

In the process of intermediation, banks assess the creditworthiness of borrowers and back their judgment by guaranteeing a return to lenders. Banks can engage in these two activities---assessing creditworthiness and providing guarantees--- without actually intermediating the loan. That is they can broker and guarantee, explicitly or implicitly, direct lending from lender to borrower.

The Security Business:
The reason why the securities business is attractive to banks is again economies of scope. There is a great deal of similarity and complementarity between the work involved in financial intermediation and work involved in underwriting trading in publicly traded securities. In particular both intermediation and securities business require the gathering and processing of information on the creditworthiness of borrowers and monitoring their behavior after credit has been extended. Moreover, if a firm is already borrowing from a bank, the bank will be familiar with its creditworthiness and it will be in a good position to help the firm issue securities or to make a market in its securities.

The securities activities of banks, therefore, include the underwriting of new issues, market-making of new issues, advice to firms in putting together mergers and acquisitions, and monitoring and supervising corporate management on behalf of investors. In addition many banks provide trust and custodial services. They manage portfolios of securities for corporations, institutions, and individuals and they manage mutual funds. They hold securities for their clients. They execute the payment of interest and dividend for issuers of stock and bonds, and they execute purchases and issuance of securities in mergers and acquisitions. They monitor compliance with covenants associated with bond issues.

Loan Origination:
In underwriting securities, banks assess creditworthiness, but do not provide the funding themselves. There are additional ways in which banks can originate a loan but not fund it. The lead bank in a syndication or participation does this, and so does a bank that pools its loans and sells them in securitization. In all of these cases, banks receive fees for originating the loan, for servicing it and perhaps for guaranteeing it. However, it does not earn an interest rate margin as it would if it were funding the loan itself.


When it underwrites securities, the bank does not provide those investing in securities with any guarantee. In the syndications and securitizations, guarantees are possible, but unusual. In some circumstances, however, banks do provide guarantees. Such guarantees are important in the market for commercial paper.

Commercial paper has a very short maturity, typically 30 days or less. Issuers commonly roll over their commercial paper: that is, they issue new commercial paper to pay off the old as it matures. Lenders are concerned that the issuer, for whatever reason, may be unable to roll over its commercial paper and will therefore default. To protect lenders from this danger, the bank can provide the issuer with a line of credit. The bank promises, if necessary, to lend the issuers the funds to pay off the old paper in effect converting the commercial paper into a bank loan.

Banker’s acceptance

Banker’s acceptance is a variation of commercial paper that involves the bank even more closely in guaranteeing the credit of the customer. The banker’s acceptance is essentially a guaranteed post dated cheque.


In the 1980s, competition from financial markets made it necessary for banks to shift to more value-added products, which were better adapted to the needs of customers. To do so banks offered more sophisticated liquidity management technique, such as, loan commitments, credit lines and guarantees. They also developed swaps and hedging transactions, and underwrote securities. From an accounting viewpoint, none of these operations correspond to a genuine liability (or asset) for the bank, but only to a random cash flow. This is why they have been classified as off-balance-sheet operations.

Banks earn fee income through guaranteeing commercial paper and from providing banker’s acceptances---that is from credit substitution. Banks are able to substitute their credit in this way because evaluating the credit risk of their customers and monitoring their loan performance are precisely the activities banks are good at. Indeed, helping a customer issue money market paper allows a bank to perform much of its traditional lending functions without usually putting the loan on its own books. Such off-balance-sheet banking has a number of advantages for a bank.

Off-balance-sheet banking effectively increases a bank’s leverage. The bank increases its exposure to credit risk, but because the loan does not appear on its balance sheet, its formal equity-to loan ratio is unaffected. Off-balance-sheet banking also relieves a bank of the liquidity risk involved in funding the loan itself. If the depositors wish to withdraw the fund before the loan is repaid, the bank must somehow find the necessary funds. With off-balance-sheet banking, the bank is no longer responsible for the liquidity of the loan and it no longer bears the associated costs.

The factors that have fostered the growth of off-balance-sheet operations have different natures. Some are related to the bank’s desire to increase their fee income and to decrease their leverage; others are aimed at escaping regulations and taxes. Still the very development of these services shows that firms have a demand for more sophisticated custom-made financial engineering.

Forward Transaction
Banks have extended their activities also into forward transactions. Banks offer forward transactions in foreign exchange. Buying and selling foreign exchange is a natural outgrowth of their foreign exchange business. Banks also offer forward transaction related to interest rates. The most important is the swap. This is an arrangement that allows borrowers to exchange fixed interest payments for payments that fluctuate with current market rates.

Economies of Scope in Marketing

The relationship between a bank and its customers, both depositors and borrowers provides it with an opportunity to sell them other products. Moreover, banks’ branch network may provide service to its customers almost without any additional cost. This is an important part of economies of scope between banking and securities business. When new issues are to be sold to investors, the banks’ branches provide a distribution network and its depositors provide a natural clientele. When depositors-investors hold securities, a bank can help its customers to trade them.

There are opportunities for marketing other products. One that seems natural for marketing to a bank’s customers is insurance. There are no obvious economies of scope between banking and insuring. But a bank need not have to be an insurer in order to sell insurance. It is well placed to sell to its customers insurance policies provided by insurance companies.

Three Key factors in the evolution of banking Industry:
Banks and other financial industries tend to become more profitable as they become larger. Large banks may derive the economies of scale in terms of the following:

Economies of scale
Financial, Operational and reputational Economies
First, there are the financial economies of scale that result from better pooling as the pool becomes larger.  The Liquidity cost of a large bank is lower because the larger volume of transactions allows for more netting of deposits and withdrawals. Because larger banks can be more diversified, they can either make loans that are riskier and so higher yielding. Or they can reduce the ratio of capital to assets. In either case, the bank is more profitable. Recent studies have shown that when the financial economies are taken in to account, bigger is always the better [ Hughes,2000].

Second, there are the operational economies of scale that result from the element of indivisibility of fixed costs. Because fixed costs increase less than proportionally with the size of  bank, the burden is lower for the large banks . The increasing importance of information technology has increased the operational efficiency of scale. Recent studies have found that the minimum efficient scale of bank in terms of operational economies is in the range of $10 billion to $ 20 billion assets [ Mishikin and Strahan].

Third, there are reputational economies of scale: People tend to trust large banks more. Large banks are indeed inherently safer because of the financial economies and operational economies. But they are also more trustworthy, since they have more to loose if they harm their reputation by taking advantage of their customers.   

The competitive Advantage of Large Banks:
Because of these types of economies of scale, large banks should be able to out compete small ones, they should be able to operate at lower cost and to offer their customers better terms---lower lending rates and higher deposit rates. Small banks unable to compete should disappear, either closing down or being taken over by larger banks.

However, there may be limitations to such a process. At some point, economies of scale may be balanced by diseconomies. Large banks become more difficult to control, and the cost of management begins to rise. it is the existence of such diseconomies of scale that guarantee that the whole banking industry will not be taken over by a single gigantic bank. Technology of communications and regulatory barriers were two principal obstacles in the way to geographic expansion and huge growth of a bank.

Technology of Communications:

Early banks had branches in various towns and cities. However, managing these branches was a perennial problem. Poor communications made control and coordination difficult, and the absence of systematic accounting procedures made it hard to monitor performance. Because they could not consult head office on important decisions, branch managers had a great deal of independence. To protect their own reputation, banks felt obliged to stand behind the actions of their bank managers. So a lazy or dishonest branch manager could, and did, ruin the whole firm. Poor communications remain  barriers to branching until well into the second half of the nineteenth century.

Offline shafayet

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Re: A survey of the pattern of Bank Evolution and the Business of Banking
« Reply #1 on: March 13, 2017, 06:41:49 PM »
Thanks for the post :)