Traditional banks play a non-substitutable role in the collection of money from savers and allocate the money to the society where needed, which is usually called intermediaries - maturity transformation . However, over the past twenty years, many factors contribute to the trends of the corporate and wholesale banking industry to transform from traditional financial services as intermediaries. The paper concentrates in the corporate and wholesale banking industry and firstly identifies the trends and then analyses several of the contributors of these trends happened in the past 20 years, critical discuss about the risk problem in the industry will be given in the end.
Early from the 1970s, the deregulation of the controls on bank assets have taken place in many developed countries, as a beginning the Competition and Credit Control which concentrates in encouraging competition and abolishing cartel in the bank industry was issued in United Kingdom in 1971, after that there were several acts issued in the UK which enhance the competition within the banks. The same process also happened in many other countries. The abolition of the Reg.Q in 1982 and the announcement of Japan's Big Bang in 1996 were all good examples.Since the deregulation process is different from country to country, the purposes of those laws to relax the boundary of banks and other financial institutions and in the meanwhile to attract the foreign capital are just the same.
The process of deregulation, together with the dramatic improvement of the information technology in computer and internet, help to reduce the cost of banks to supply financial services in the other countries. As a result, the competition from new entrants in the banking industry has increased which threatens the profitability of the traditional banks in their own country. More and more multinational companies' funding operations also depend on globalised perspective thus create a high level of demand for international banking services.
Under the threat of profitability and global banking competition environment, wholesale banking industry has unprecedented financial innovations to find new services in either scope, scale or delivery. Meanwhile, in the capital market, as the overall trend of real interest rates in western countries is falling, a trend with the break down of individual, segregated and protected, capital markets into one, increasingly world-wide, capital market is shown. The result of this trend is the construction of ever more efficient forms of raising capital, particularly in the form of debt financings. (Kravitt, J. Mayer. Brown&Platt. 1998). It's also mentioned in Modern Banking (Heffernan, S. 2005), “Households and institutional investors begin to hold more securities and equity in the market oriented financial system”, data collected from BIS annual report in appendix 1 also shows the significant growth of the securities market from 1984-1996. Securities and equity which not only supply households with higher level of return and liquidity with the help of secondary market but also help companies to bind the cost of borrowing money with their business performance compared to fixed level of interest paid to the bank for the capital borrowed, are playing a more important role in financial markets.
Just like the other industry, the wholesale banking industry has supply and demand, banks also have responsibility for their shareholders thus have to pursue profit. Thus the corporate and wholesale banking industry has a strong trend from the traditional financial intermediaries to financial agencies which engaged in finance wholesaling, fund management, and many other off-balance sheet activities such as underwriting, consultancy, mergers and acquisitions. As shown in figure1,
In the new market, credit risk seem to pass through to the end investors directly, banks seems don't have to carry all the risk in liquidity and interest rate like they used to do.
Fee rather than interest income attracted more attention, for example, in 1979, 28.6% of commercial bank in the UK was generated from fees but in 1995, this has increased to 43.3% . Thus the trend of disintermediation of the wholesale banking industry emerged, especially in the debt market.
From the above, mutually relative contributors like deregulation, globalization, technology improvement and the modification of the capital market forced the banks to change their services, formed strong financial innovation. In the dramatic global competition environment, according to sophisticated investors with different demand in risk and return, the wholesale banking has invented sorts of new products and services. Some new services and products invented recently have very important influence on the whole industry.
Firstly, the growth of the credit derivatives market attracts the wholesale banking industry. According to the British Bankers Association, the market for credit derivatives has expanded from about 180 billion in 1997 to 893 billion in 2000. Credit derivatives have been broadly used as instruments to hedge risk of funds against certain conditions. However, though designed to hedge risk, the use of derivatives can result in large losses to the investor, either the long or the short. With technical expertise, vast network of contacts and access to critical financial market information, the wholesale banking industry supply services to the end users in such risk management transactions.
Secondly, together with the change of the capital market, a structured finance process that distributes risk by assembling debt in a pool, then issues new securities backed by the pool has been invented. In fact, from the mid-1990s, there was explosive growth in both scale and complexity in the market of securitized credit. (FSA, 2009). When the economical environment is booming, those products seem to be with high profitability. As a result, under financial innovation, the wholesale banking industry join in the securitization game and invented many instruments among which there are some complicated ones, for example, CMO, CDO and subprime mortgage.
From 1990s, more and more complicated financial instruments were developed in the industry. Some of the products seem to be attractive both to the banks and investors, but whether enough attention has been paid to risk problem in liquidity and credit should be doubted.
Firstly, problems lie in the risk of liquidity. In recent years, the wholesale banking industry increased aggregate maturity transformation continuously and developed an increasing reliance on liquidity of assets with long-term maturity under the assumption that the assets with long-term maturity could be sold rapidly in the capital market when needed. This seems to be valid in the favorable macro-economic environment. But just like what happened in 2008, when there was a financial crisis and many firms were in the liquidation position, banks would be in a very serious cash crisis - even a Fed guarantee of funding could not save Lehman from bankruptcy protection.
Secondly, we should focus on the credit risk. In the process, “some banks were truly doing 'originate and distribute', but the trading operations of other banks (and sometimes of the same bank) were doing ‘acquire and arbitrage'.” (FSA, 2009). The fair value of the banks' liabilities would be affected by any change in the creditworthiness. The truth is that, in the complicated transformation, if one bank's creditworthiness deteriorated, the value of its liabilities would decrease which will result in a chain reaction to the wholesale banking industry.
Last but not least, in the preferred economical environment, driven by strong desire to improve the performance, some commercial and investment banks has designed some intensively complicated financial products as a trick to improve performance. But as the products are so complicated, the risk lie in those products can hardly be known to the consumers, even the banks themselves couldn't evaluate the risk in fact. For example, recently a 2,000 pages report by Anton Valukas to probe reasons for Lehman's failure in 2008 has found out that Lehman has used certain transactions like “Repo 105” to flatter its financial health and hide its loss after the housing market destroyed in the USA. Examples could also be found that JPMorgan accounts list sales - the sort of deals Lehman undertook - and purchases, which imply it did the similar trades. (Hughes J, Baer J. 2010)
The corporate and wholesale banking industry plays a vital role in maintaining a stable financial environment, thus though nowadays the competition in wholesale banking industry is fierce, banks under financial innovation should also pay attention to the risk of liquidity and credit. Certain ways to monitor the products and services provided by banks are still in great needed.
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