Corporate and Wholesale Finance
In these past few decades financial market had expand substantially before it collapse from credit crunch in 2007. This paper will examine the main trends that drive corporate and wholesale banking in the past decades and its impact that resulted in a financial crisis in 2007. According to Mathew (2005), there are three main trends that force the banking industry to restructure and adapt themselves to new environments which are deregulation, financial innovation and globalization.
It is worthwhile to mention the high oil price hike incident in 1978 leads to a change of nature and activities or disintermediation of wholesale banking and international banking from being intermediaries which gain profit from giving out loan to a more diversify services or off-balance sheet income. The tremendous amount of deficit in non-OPEC LDC countries which IMF and World Bank didn't have enough funds to aids those countries. Richard O'Brian (1992) stated that in the pre-securitization decade the recycling from oil exporting countries to deficit oil importing countries was conduct by banks making loans through Euro market rather than investment banks placing bonds in the market. This provided a new market for commercial bank to exploit by giving out loans at a very low rate or underpriced their products and services (Lewellyn 1994). However, the economic recession and high interest rates and low risk offered by bank in the industrialize country attracted private sector from LDC countries resulted in capital flight (Howcroft 1998). Eventually, the LDC countries government went bankrupt, consequently large number of industrialize bank were facing bad debt and the need of reschedule debt. These resulted large numbers of large bank were downgraded and being disintermediation by multinational company raising fund directly from capital market, this expands securities markets, direct and portfolio investments (Richard O'Brian 1992, Lewellyn 1994). Lewellyn (1994) stated that the non-bank institution is becoming the major competitor for wholesale banking in which technology, financial innovation and globalisation is the main driving forces. This impact wholesale banking to change its structure of its income to emphasize on OBS activities, net non-interest income rose from 36% in 1984 to 41% in 1991 (Leqellyn 1994). This could leads banking business in becoming managers of securitised assets (Economist 1992).
According to Gardener (1989), the deregulation and liberalization of financial market is mainly to increase competitiveness between financial institutions through market forces instead of supervision from the government. This allows the market to decide on the allocation and pricing which eliminate exchange and capital controls which initially began from the collapse of Bretton Woods in 1971 (Richard O'Brian 1992). Methew (2005) stated that there are three phases in deregulation of financial market. The main objective for the first phase was to set a standard system of monetary policy for all kind of financial institutions to rely on price mechanism and abolished direct controls on lending allowing bank to be more competitive (Anthony Loehnis 1987). The liberalization of control on bank assets and ceilings on the interest rate deposits In the U.K. is known as “Competition and Credit Control 1971” and follow by the U.S. in 1982 called the “Abolition of Regulation Q” (Matthew 2005). Moreover, the abolition of Capital Controls in the U.S. and U.K. exchange controls during 1970s-1980s led to significant amount of money outflows to international financial market especially euromarket and swap transactions (Kasi 1990). The deregulation of phase one forces international banking to move from asset management to liability management (Matthew 2005). The second phase is the relaxation of barriers of competition between commercial banks and building societies or thrift. In the U.K. the Building Societies Act 1986 allowed building societies to compete with bank for consumer unsecured lending (Matthew 2005). This creates a more aggressive and competitive market, which in turn bank also entered the mortgage market and this gave pressure on their capital ratios, this forces both banks and building societies to move mortgage-backed assets to their OBS by securitizing (Anthony Loehnis 1987). While in the U.S. the Garn-St Germain Act 1982 allowed thrift agency to becoming a more like bank that compete in commercial loan (Sherman 2009). According to Sherman 2009, because of financial innovation and globalization financial product become more complex, Glass-Steagal Act (1933) had prevented banks from underwriting or dealing in securities market which make banks less competitive and they wanted to enter the municipal bonds market and other securities market. This repeal became successful in 1999 called Gramm-Leach-Biley Act that allowed banks to combine with banking, securities, and insurance operation and investment banking. In U.K. the Financial Services Act 1987 also allow bank to operate universally. Finally, according to Matthew (2005) the third phase is the new player in the financial market which is from non-financial sector. This entrant of new financial intermediaries gives rise of competition in the industry. G.E. capital is a good example in international market; they provide industrial financing, leasing, investment and insurance etc. Financial institution also extends their service through new kind of services for instance Egg that owned 79% by Prudential, Tesco Finance and Mark Spencer are an example of retail business offering banking services in U.K.
Gardener (1986) defined that financial innovation derive in two forms; product innovation is the change of product or service that offered to the market and process innovation takes place when the nature of utilisation of an input changes or alters. Llewellyn (1988) imply that in 1980s the financial innovation had change the traditional of fund raising through financial institution towards direct financing by credit financing these led to a structural change in financial system. This is in line with Matthew (2005) that international banking are changing their structure influenced from financial innovation which are moving from asset management to liability management and development of variable rate lending. Financial innovation is mainly driven by three main forces according to Matthew (2005) which are instability of the financial environment, regulation and technological development. In 1970s financial innovation played an important role in making international financial market more efficient by providing new financial instruments such as variable rate lending to hedge against interest and exchange rate exposure (BIS 1986). In example, between 1983 to 1996 fixed rate bonds were always three or four times higher than FRN, however there was uncertainty on interest rate in 1998 because there was a issue that London will join the Euro or not, this resulted a dramatic shift from “straights” to “FRN” in an amount of 227.7$bn and 647.5$bn (fig 2) respectively (BIS annual report). Another example for reducing risk in interest rate and exchange risk to other party is through SWAP and future, forward rate agreements and options. In addition, the shift from asset management to liability management, Gardener (1986) stated that international bank is moving from funds provider to placing of debt instruments to investor or securitisation. In Turner Review stated that corporate and wholesale finance sector growth had increased dramatically and surprisingly outpaced the real sector economy for both for the U.S. and U.K market since 1987, when comparing debt as a percentage of GDP (see fig1). This was resulted from an evolution of securitisation credit model, significant increase in leverage by using off balance sheet vehicle (SIVs) and the creation of financial innovation such as CDO and increasing number of shadow banking. However, it could also be argue that these financial innovations expand too quick which there is no regulatory control and prudential which gave rise to credit crisis in 2007 (Bernanke), even though it has been warned from BIS 1986 report on how too rapid growth in new financial instrument could have triggered a systematic risk. As the securitisation main objective is to reduce systematic risk for the whole banking system however it didn't seems to be, as you can see from fig. 3 growth of SIV debt finance increased almost triple from 100$bn to 250$bn approximately, this create huge amount of contingent risk to financial institution which bank had the highest loses (fig.4).
The third trend is the globalisation which is the major forces that drives international banking which provide financial market to conduct at cheaper transaction cost, more wide range of product and more flexibility (Zdeněk Tůma2006), Alan Greenspan also commented that "the increasing interaction of national economic systems.". Globalisation has brought each nation financial market integrated into a single market by using computer technology and electronic communication (Eyüp Kahveci and Güven Sayılgan 2006). Richard O'brien (1992) supported the idea of integrated financial market that it enhances wider and deeper sets of relationships between borrower and investor. Globalisation also create new demand from clients which led to innovation of a more complex financial instrument (Mookerjee 1991). In the early period, globalisation was driven by ‘push' and ‘pull' factors. The push factor for U.S. bank is the demand for growth which was restricted by The Bank Holding Act 1956, U.S. bank were seeking fund from international market or Eurodollar market. As large companies are becoming international player, this created a pull factor for U.S. bank to open branch in host country to provide funds and services (Matthew 2005).
as large multinational companies started finance directly from credit market instead of bank loans, large banks innovate new financial instrument in form of OBS activities for example during 1970s and 1980s, large international banks had lost its competitiveness in the capital market
The deregulation of phase two had significantly boost financial sector growth through evolution of securitisation credit model, increasing of leverage (heavily in off balance sheet vehicle)
In these past few decades' corporate and wholesale finance sector growth have increased dramatically and surprisingly outpaced the real sector economy for both for the U.S. and U.K market since 1987, when comparing debt as a percentage of GDP (see fig1). However, the liabilities and assets of financial sector should have a same trend as the real sector (Turner Review).
Economist (1992), “time to leave”, 2 May 1992
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