Modern Bank Behaviour

This text presents an updated insight into key facts impacting on financial institutions after the financial crisis, and highlights areas of major policy and academic interest. The book includes a selection of papers on this issue which were presented at the past European Association of University Teachers of Banking and Finance Conference (otherwise known as the Wolpertinger Conference) held at the Universitat de Valencia, Spain, in September 2011. From a range of perspectives and approaches the chapters analyse a number of topics related to banking and the financial markets, such as payment protection insurance, intellectual capital, cost efficiency and its relation with bank branch distance and size, bank restructuring and bank stability, credit and liquidity risk, and business models for the wealth management industry among others.

In January 2009, the UK competition law judgement body, the Competition Commission (hereafter CC), stated that the joint sale of credit or payment protection insurance (hereafter PPI) with lending, including unsecured, mortgage and credit card borrowing, was to be prohibited after 2010. This judgement also required that single premium insurance policies should not be employed in this market, demanded that greater customer information provision be provided, and required PPI to be unbundled from other financial services when sold. Although these measures were legally challenged in October 2009 by Barclays pic on the grounds that prohibiting the sale of credit insurance reduced customer convenience, they were largely upheld in a provisional decision by the Competition Appeal Tribunal, published in May 2010 (CC, 2010).

Over the past decade, both the mortgage market and real estate sector have experienced a dramatic growth. The current financial crisis, which started in 2008 and significantly affecting the whole banking industry, has been attributed largely to the excessive growth of the mortgage and property markets. It started with the US subprime mortgage meltdown, but other countries (principally Ireland and Spain) experienced similar problems. The rapid growth of real estate prices and mortgage loans was extensively documented across many countries. (Wolswijk, 2006; Miles and Pillonca, 2008). In an international context, bank lending and property prices have a strong correlation . This stylized fact is supported by abundant cross-country evidence (Egert and Mihaljek, 2007; Lacoviello and Minetti, 2008; Goodhart and Hofmann, 2008; Davis and Zhu, 2010), as well as the indications from individual countries such as the USA (Capozza et al., 2002), Spain (Gimeno and Martinez-Carrascal, 2006; Carbo-Valverde and Francisco Rodriguez, 2010) and Ireland (Fitzpatrick and McQuinn, 2007). China has also witnessed rapid growth in the real estate industry. The percentage of real estate investment to GDP rose sharply, from 5 per cent in 1999 to 12 per cent in 2010 (see Figure 2.1). Meanwhile we also document the soaring property prices and the mortgage credit boom in the domestic market. At the same time, China experienced a substantial reform in both the banking and the mortgage financing systems.

The objective of this chapter is to examine whether or not banking sector restructuring produces significant improvements in bank stability. Restructuring is targeted at distressed banks, and common resolution strategies include injecting liquidity and/or capital, sanitizing bank balance sheets, and consolidating troubled banks with healthier banks through a process of mergers and acquisitions (M&A). Restructuring is often accompanied by legal reforms to strengthen the competitive environment facing banks. Repeal of restrictions on foreign banks is one example. Withdrawing the influence of government in the banking sector through privatization is another. These reforms are expected to increase banking sector stability, because the performance of non-intervened banks should improve — otherwise market share can be lost to resolved incumbents and/or new foreign entrants. An assessment of the effectiveness of bank restructuring must evaluate the impact of legislative changes upon the banking sector per se as well as analysing the post-resolution performance of resolved banks.

Trade credit is one of the most important financial sources for Spanish firms. It facilitates trade between firms and diversifies their funding sources. One of the main objectives of trade credit is to permit sellers to delay payment to their customers, depending on their financial needs. On the other hand, customers are able to operate with higher liquidity margins.

The recent financial crisis has shown how rapidly and acutely liquidity risk, in terms of both market liquidity risk and funding risk, can manifest itself in financial markets and how it can affect banks’ stability and indeed the entire financial system. This has highlighted the need to pay more attention to liquidity risk and its interactions with other banking risks.

During recent decades, banks have progressively moved towards larger, centralized and hierarchical organizational structures. An increased investment in non-interest-generating activities has also implied performance vulnerability, whose effects have been particularly destabilizing during the recent financial crisis. In this economic and financial contest, several banks have become increasingly concerned with controlling and analysing their costs and revenues, as well as measuring the risks taken to produce acceptable returns.

Efficiency can be measured by applying different methodologies from two principal groups: parametric¹ and nonparametric.² There is no consensus on the best method of determining the production frontier or on the unit of best practice to measure relative efficiencies; the approaches used most often to evaluate the efficiency of financial institutions differ in the assumptions made about the shape of the frontier, the treatment of random error and the distributions assumed for inefficiency and random error.

During the 1990s there was a rapid evolutionary shift in the established paradigm underlying the dominant model for business practices and execution. For over 200 years the success of a company was generally based on its efficient use of physical capital. However, on entering the third millennium it has become intellectual, rather than physical, capital which appears to have become the established cornerstone for a bank’s future viability and success in the ‘new knowledge economy’. Pulic and Bornemann (1999, p. 1), for example, wrote that in ’this new economy ...intellectual capital has become the one and only competitive advantage of a bank’, as well as the pivotal component of future prosperity, growth and development. The changes in the major underlying pivotal factor of a business and national infrastructure during the 1990s raises several questions about the possible impact on related disclosures practices by banks. Two major questions can be summarized as follows:

In 1992, Fama and French published a landmark paper in which they provided, by means of a cross-sectional analysis, strong evidence of explanatory power by size and book-to-market factors, compared with little or no ability by the market factor to explain differences in equity returns. After this, a large body of literature came out evidencing the beta model’s weakness in explaining asset returns. Empirical works have mostly used US data, and most of them reject the beta Capital Asset Pricing model (CAPM — see, for example, Grinold, 1993). In another paper, Fama and French (1993), using a time-series approach, found basically the same evidence. However, further evidence for their model (Lakonishok et al., 1994; Haugen, 1995), highlighted the role of investor overreaction (De Bondt and Thaler, 1985) in explaining the value anomaly. Based on the overreaction/under-reaction argument to information, Jegadeesh andTitman (1993) and Rouwenhorst (1998) document the existence of a momentum anomaly: over a medium time horizon, firms with high returns over the previous three months to one year continue to outperform firms with low past returns over the same period.

Literature on strategic planning puts forward alternative choices that a company can make between standardization and customization of business processes, as suggested by the seminal works of Lampel and Mintzberg (1996) and Gilmore and Pine (1996, 1999). Recent studies reconsider mass customization (Salvador et al., 2009; Logina, 2010) and suggest that a designed mix of standardization/customization may drive alternative business models in the right direction (Sheehan and Vaidyanathan, 2007; Xia and Rajagopalan, 2009; Markides and Oyon, 2010; Berman, 2010).