Modern banking theory and practice pdf

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Defines an Islamic bank, notes their rapid growth in the last twenty years and explains the financial instruments they use to conform with the prohibition on interest.

Modern Banking: Theory and Practice

Lewis Mervyn K. Modern Banking in Theory and Practice. Modern banking in theory and practice. This article gives a survey of literature on the new theories of the banking firm. First it is argued that financial intermediaries exist to facilitate the financing process with respect to varions information costs.

Bank are then analysed as " information processors " and ' liquidity insurers ". At last, some missing ingredients of the news theories are considered such as off balance sheet activities or multinational operations. Modem Banking in Theory and Practice. But there were in fact many paths to banking, and banks grew out of notaries, tax collectors, brewers and distillers, traders and industrialists.

Some of the earliest bankers were merchants; for example, the Florentine banking houses of the fourteenth and fifteenth centuries. For a merchant, the granting of credit is a natural extension of trade dealings and banking develops when a merchant's business becomes specialized in financial dealings and it seeks the use of others' funds to undertake them. This emphasis upon the lending function rather than upon bank deposits is echoed in the new theories of banking.

Banks used to be thought of as unique because they created liabilities which serve as money. Emphasis in the recent " existence " literature has swung more to the view that banks are special on the asset rather than the liabilities side of the balance sheet because of the peculiar information services of banks acting as " social accountants " or " delegated monitors ".

In another strand of the literature banks have a special role as " liquidity insurers ", providing liquidity services to risk averse depositors who are uncertain about the timing of their future consumption needs. Note, however, that this liquidity role of banks has nothing to do with bank deposits serving as transactions media. On our reading the exclusion of payments services from the new literature is unwarranted, and the present day structure of banks can be understood best by allowing for some possible informational and other economies of scope with tie the provision of transactions services to banks' intermediation services.

It is also argued here that banks operate in other ways not considered in the new theories — namely, off-balance sheet banking activities, the range of financial services produced and multinational operations — and that these aspects of modern banking can be readily blended with the new ideas. The plan of the paper is as follows. Next we examine the existence question. Then we look in turn at banks as " information processors " and " liquidity insurers ".

Some of the missing ingredients are then considered, and the final section draws some conclusions. The existence question. Earlier analyses of banking either took the existence of banks as given, typically specifying a bank in terms of assets or liabilities without reference to any production process, or saw their operations as exploiting certain economies of scale in borrowing and lending.

As an example of the latter tradition, Gurley and Shaw [] in their study of banks and financial intermediation cited economies of scale in the management of investments, risk reduction through diversification and the ability of banks to rely upon the law of large numbers when managing liquidity. By contrast, the new literature has at its starting point that the presence of banks must be explained: their existence is traced to what can be termed various " information economies ".

The new literature has been much shaped by the predominance of the " perfect markets paradigm " in financial analysis for, in one form of another, all of the major hypotheses which make up the modern theory of finance draw upon perfect market assumptions. This framework has been a major intellectual hurdle to the development of an analysis of banking and intermediation activities.

In an ideal world of complete and perfect capital markets, with full and symmetric information amongst all market participants, economic decisions do not depend in any way upon the financial structure. All of the potential gains from adding banks are assumed away because every transactor is completely informed and honest about the environment, and frictions and indivisibilities do not exist. If banks do operate, they do so as traders or equity-financed mutual funds e. Fama [] since households and firms have the information to arrange their own maturity transformation and their own risk diversification.

Consequently, the emphasis in the new existence literature is upon market imperfections, and how " agents " or " coalitions " of agents — loosely identified as banks or financial intermediaries — might emerge as an endogenous response to the imperfections by providing information services of one kind or another. Some in fact argue for example, Stiglitz and Weiss [, ] that financial markets are inherently imperfect to the extent that there is uncertainty about the completion of financial transactions.

What is being dealt with is a set of promises to deliver at some future date. Unlike many commodity market transactions which involve a contemporaneous two-way exchange of commodity and means of payments, with no obligation for a future transaction, and in which the identity of the transactors is often irrelevant, the value of a financial promise to a potential lender depends upon the perceived character of the individual issuing the promise as regards honesty, unwarranted optimism and future prospects, etc.

In standard economic analysis e. Arrow-Debreu , individuals may borrow with repayments contingent upon various states of the world and thus not under their control.

Incentive problems are, however, excluded so that individuals cannot influence those circumstances. Also excluded from consideration is any adverse selection problem arising from the identity of those making the promises. Market institutions thus exist to facilitate the financing process with respect to various information costs.

First there are search costs. Second, there are verification costs. Adverse selection can occur when an asymmetry in information costs exists due to lenders' inability to observe the attributes of borrowers and the contingencies under which they operate.

Third, monitoring costs3 are incurred when overseeing the actions of the borrower for consistency with the terms of the contract, and ensuring that any failure to meet the delivery promised is for genuine reasons. Moral hazard refers to the problems which may flow from the inability of lenders to ascertain and exercise control over the behaviour of borrowers, either with respect to the.

Fourth, enforcement costs1 arise should the borrower be unable to meet the commitments as promised, and a solution must be worked out between the borrower and lender or other aspects of the contract may need to be enforced.

Left to themselves, potential holders of securities have access to information provided by rating agencies, newspapers and financial journals at low cost. Routine accounting information and knowledge about the issuing firm's past history in meeting timely payments of interest and other regular commitments can be gathered relatively cheaply. But detailed information about the firm's prospects is hard to acquire, and it is too costly for individuals, as " outsiders " not intimately connected with the running of a firm, to keep themselves informed about happenings inside the firm and influence its behaviour.

Market analysts and investment bankers are unwilling to keep track of the activities of the many small firms which might turn out to be occasional minor borrowers. Their use also gives rise to " principal-agent " difficulties much as lenders would themselves confront.

Many features of debt contracts are structured for dealing with agency problems. A bond requires that the borrower pays a contracted amount to the holder, usually at specified intervals, unless the borrower is bankrupt, when he or she then pays nothing. Bond convenants are designed to ensure that the non-bankrupt " state " ensues. Restrictions and priorities upon dividend payments are mechanisms to constrain the behaviour of management and shareholders and so control the conflict of interest between managers and shareholders vis-a-vis bondholders in productive enterprises.

Cash-flow constraints and the maintenance of specified financial ratios e. Such solutions create their own difficulties for they are costly to design, put in place and enforce.

They are also inflexible, for a firm unable to meet interest payments or temporarily in breach of covenants may be reconstructed or wound up unnecessarily. They also add to the considerable costs of " going public ", i. Provision of information publicly may of itself be a major drawback when there are industrial secrets to protect or hostile takeovers are being contemplated.

Banks as " information producers ". One strand of the new literature sees banks as producers of information, supplementing or substituting for the information available through other sources. In particular, they provide credit or market-enhancing guarantees for activities which, because of price sensitive information or high evaluation, monitoring and enforcement costs, cannot easily be funded by the issue of securities in the open market.

However, the new literature takes this further by arguing that banks may have special information advantages over other market participants. Characteristics of information. Banks' role as financers is shaped by characteristics of the market for information.

Because of the information asymmetries between " insiders " and " outsiders ", a prospective lender needs to be given full details of the prospects of the investment project. Provision of this information by the borrowing enterprise involves it in the risk that the knowledge advantage it has may be given away in the process.

Banks have evolved in different ways to resolve this potential conflict of interest. One way is for the bank to take an equity interest in the firm or to have business links with the firm through interlocking directorships or shareholdings.

This, broadly speaking, is the German and Japanese solution where banks acquire stock of companies and often sit on the board Germany or form part of linked groups Japan. It also typifies the activities of the French banque d'affaires which originate participations in a company and retain sufficient holdings to control its policy, and UK banks' financing of venture capital where the banks may hold up to a quarter of the capital of individual enterprises.

An alternative way of resolving the conflict of interest, more in the Anglo- Saxon tradition, involves creating much more of an arm's length relationship but nevertheless one in which there is a confidential transfer of information.

In effect, banks establish a reputation for handling knowledge about a firm's plans responsibly. An implicit contract is made with the customer in which the bank is provided with a regular flow of price sensitive information which it voluntary undertakes not to exploit in competition with the customer: the information is instead " internalised " in the bank's loans to the customer's business and in credit-enhancing guarantees which facilitate other market transactions. This implicit contract may be- reinforced by explicit legislation.

Table 1 compares the indebtedness of Japanese and German companies with those of some other countries. Close links between banks and industry of the type which exist in Japan and Germany are said to allow, to varying degrees, improved monitoring of corporate performance, a ready conduit for information flows, and risk-sharing within a group of affiliated firms, resulting in higher leveraging without raising bankruptcy rates. Accompanying the Anglo-Saxon tradition there has tended to be a greater reliance upon equity finance with well developed and open securities markets.

Financing under the alternative tradition is much more credit-based and capital markets are less developed, although this may be beginning to change, especially in Japan. When a country is reconstructing and industrializing rapidly, a large number of its borrowers will lack market access, and be reliant upon bank lending.

The supply of securities will be restricted and the rating and other informational infrastructure needed to support equity, bond and commercial paper issues may be undeveloped.

As economic growth proceeds and firms develop a track record, more borrowers can be expected to move from the use of credit to greater use of capital markets. A " life-cycle " may operate as new borrowers use banks initially, then enter securities markets with bank credit-enchancement, and finally gain stand alone access to markets. Bank contracts. Banks take a position in the business of their customers by writing special contracts with the individuals and firms concerned.

These contracts are designed with covenants and collateral to overcome lending risks, but also reflect the liquidity and other services offered by banks. Consequently, banks can be thought of simply as a collection of contracts, some of which appear on the balance sheet as assets and liabilities, others of which form part of the off- balance sheet position.

There is an evolving — and increasingly inconclusive — literature on the incentive compatibility of different forms of contracting in the face of information difficulties of various sorts. The choice is usually posed in terms of " debt versus equity ", i. This result depends on returns being costly to observe ; the loan contract ceases to be optimal if the lender has information about the project Gale and Hellwig [] ; Williamson [].

Thus the analysis excludes the possibility that the entrepreneur might credibly take the lender bank into his confidence within an implicit intertemporal contract of the type outlined earlier.

The position becomes more clouded when we consider other ways in which ex ante and ex post information asymmetries could be handled. When entrepreneurs know better than lenders of the riskiness of the projects they want to finance, one response of lenders envisaged in the literature is for them to offer contracts designed to encourage entrepreneurs to self-select appropriately. Kahn [] and Terlizzese [] argue that safer projects will be financed by equity in the face of adverse selection ; the private information about the riskiness of the project is revealed by entrepreneurs when they choose from amongst the contracts on offer, and opt for an equity contract, with repayments conditional upon the states.

Moral hazard, we should note, is ignored. A lender's doubts about the entrepreneur's amount of effort favours a debt contract, while moral hazard over project choice may suggest an equity arrangement Bester and Hellwig []. Of course, the real difficulty comes when all of the conditioning factors — costly verification, adverse selection, monitoring costs, moral hazard, enforcement costs, bankruptcy costs, risk aversion, and liquidity preferences — are examined simultaneously.

Vol. 4 No. 35 (2020)

Subject Economics Subject Headings Banks and banking. Language English. Modern banking theory and practice. Author S D. Muraleedharan Author.

Modern banking0470095008, 9780470095003, 9780470020043

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Save extra with 2 Offers. Muraleedharan Book Summary: Technological innovations and advancements have spread into every sphere of life and banking is no exception. With competition being tough and fierce, business, especially banking, has to adopt new methods and techniques. Modern banking essentially implies use of modern technology and communication tools, for example, computer and the Internet, for bringing about more efficiency and speed in banking operations and making them more and more customer friendly and customer focused.

MODERN BANKING: THEORY AND PRACTICE

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