GLOBAL BANKING – 2025
PART I – INTRODUCTION TO BANKS AND THE BANKING SECTOR
I – WHAT IS SPECIAL ABOUT BANKING?
The nature of financial intermediation
Why/when do people or companies borrow money?
Borrowers are people who need money from the bank, they are short on cash but not short on value. If you would
be short on value too, banks will not give you money. Borrowers have a positive economic value because they are
expected to generate a profit in the future, or they will not be able to pay back the loan. For example, a recently
graduated dentist is setting up his own practice which requires a significant investment. The bank expects him to
have a high income and will therefore have a high economic value. Without banks the young dentist would need
to work for many years before he could set up his own practice. Borrowers are liquidity constraint, they cannot sell
part of their assets to raise cash because these assets are illiquid.
Borrowers (deficit units) Lenders (surplus units)
➔ Economic units whose total expenditure ➔ Economic units whose total receipts
exceeds their total receipts. exceeds their total expenditure.
➔ Minimization of costs. ➔ Minimization of costs
➔ Funds at a specific date. ➔ Minimization of default risk and the risk of
➔ Timing of repayment over a specific period. assets (loans) dropping in value.
➔ Liquidity: the ability to convert an asset into
cash without incurring a loss in value.
There is a gap between lenders, who give money to the bank and want their money to be available when needed,
and borrowers, who want long term fixed payments and loans.
Direct finance
You need money and go to the market yourself, borrowers and lenders do business directly with each other. An
example is a company issuing a bond. There is still some form of intermediation (investment banks), but the funds
are raised from the market directly, not from the
intermediary. There are 2 problems:
1. The incompatibility of the needs and
preferences of lenders and borrowers.
2. Difficulty and cost of matching lenders and
borrowers, find someone to buy it.
Financial intermediation
The solution for the 2 problems above. In this situation there is a bank in between who pools lots of loans. They do
not need to match lenders and borrowers one-on-one. Costs are lower due to economies of scale. Although this
solves the problems above, there still are information asymmetries that lead to substantial transaction costs
(assessing the client, negotiating the loan, monitoring the borrower, recovery in case of default, …).
Some recent evolutions are securitization and shadow banking:
➔ Securitization: banks convert illiquid assets on their balance sheet into tradable financial instruments
that they sell to investors in return for cash to create new loans. This way assets are removed from their
balance and are transferred to and traded on the financial markets.
➔ Shadow banking: non-banking entities with no regulation that provide the services a bank would provide,
which can create problems. The ECB uses the concept of ‘Non-bank financial intermediation’ or NBFI.
1
,The role of banks
Size transformation
Typically, depositors hold smaller amounts of money with the bank than borrowers need. Banks transform the
smaller amounts of deposits in larger amounts for loans (no matching one-on-one) and enjoy economies of scale,
allowing them to pool small deposits into larger loans.
Maturity transformation
Banks convert demand deposits into medium- and long-term loans, they can borrow short and lend long. As a
result, there is a mismatch between the assets and the liabilities of a bank. This mismatch creates liquidity risk,
the risk of not having enough liquid funds to meet client’s demands.
Risk transformation
Individual borrowers can default. The bank can reduce this risk by diversifying their loans over many different
clients and screen/monitor their borrowers. Banks also hold excess capital to cover unexpected losses.
Information economies
Asymmetric information
Part of the transaction costs comes from asymmetric information. Nobody knows everything and the information
between certain people is different. Some information might also be ‘inside information’ that is not available to
both sides of a transaction, one person knows more than the other. Banks need to be sure that they have enough
information about for example the ability of households to repay before giving out mortgages. It costs the bank
money to get the needed information, but it is a necessity.
Transaction costs and economies of scale
Dealing with the asymmetry of information leads to transaction costs. If borrowers need to obtain a loan without
intermediation and would need to find a lender on the financial markets, the transaction costs would be extremely
high. Banks on the other hand generate significant economies of scale by pooling many borrowers and lenders,
and lowering transaction costs significantly.
➔ Banks transform primary securities (loans) into secondary securities (bank accounts) and enjoy some
economies of scope.
➔ Secondary securities cannot exist without primary ones, but primary securities can exist without financial
intermediation.
Adverse selection and moral hazard
This is the last element that makes issuing loans costly. For example, buyers of a second-hand car cannot tell
whether a car is any good or not, they have less information about the car than the seller. Buyers don’t trust the
cars being offered and therefore all cars of the same type sell at the same low price (‘lemons’, you can’t differ the
good ones from the bad ones). The market will turn into a ‘lemons market’. To avoid this there are two principles.
➔ Signalling (sellers): actions performed by the informed party to solve the adverse selection problem. For
example, providing a type of warranty/guarantee on the car.
➔ Screening (buyers): actions performed by the less informed party, facing adverse selection. For example,
insurance companies make their clients go to the doctor before going for a life insurance.
For banks, adverse selection occurs because creditors with financial
difficulties are more in need of loans than others, but they are also more
likely to default on them. A bank solves this by screening (request a lot of
information when one applies for a loan) and by how they price loans.
Charging higher interest rates prevents creditors with a weak financial
situation from applying for a loan. On the other hand, creditors with a bad
financial situation have nothing to lose and might not care about the high
price. For creditors with a good financial situation, such high interest
2
,rates make no sense. So, if interest rates are too high, banks face a lemons market. For the bank itself, higher
interest rates mean higher profits. At some point good creditors will stop applying for a loan because of the high
price and the bank is left with only bad creditors.
Adverse selection is an ‘ex ante’ issue (before the transaction), moral hazard is the risk that one party to a contract
behaves in a way that is against the interest of the other party after the contract or transaction has been concluded.
For example, those who obtained an insurance might take greater risks than before, or those who got a loan for a
“safe” investment might actually use it for a risky investment. Banks use monitoring to reduce the issue of moral
hazard. For example, corporate clients need to submit financial information to banks on a regular basis, if such
information would not be public in the first place.
Why do banks exist? (5 main theories that explain why banks exist)
The first 2 theories see the information asymmetry and the related transaction costs as the reason banks exist:
1. Delegated monitoring
Lenders delegate the screening and monitoring to banks because they have economies of scale, which allows
them to significantly reduce transaction costs that result from asymmetry of information. Banks can also diversify
the credit risk over a large number of creditors, reaching levels of diversification that individual lenders couldn’t.
2. Information production
Reducing the transaction costs is seen as the main reason why banks exist. As with delegated monitoring, it is
considered too expensive for individual lenders to collect all the required information. The main role of banks is
similar to that of rating agencies: collect information based on which screening and monitoring activities can be
performed. Banks can also diversify credit risk, but this is not the main reason they exist. Wealthy individuals could
also diversify credit risk, but they would not be able to enjoy economies of scale, as this requires a lot of loans.
➔ Neither of these theories needs that banks disclose any of this information to the deposit holders.
The next 2 theories do not focus on the asymmetry of information:
3. Liquidity transformation
Bank accounts have higher liquidity and lower credit risk than almost any other financial asset. Lenders could
achieve the same low risk by investing in large diversified portfolios of loans, which would be just as illiquid as the
underlying loans. Banks invest in illiquid loans, but issue liquid deposits against them. They transform short term
deposits into long term loans, which creates liquidity risks for themselves. This is all based on the trust of clients.
4. Consumption smoothing
The practice of optimizing our standard of living by ensuring a proper balance between spending and saving during
the different phases of our lives. Those who overspend and put off saving for retirement to enjoy a higher standard
of living often have to work longer or reduce their standard of living in retirement. Those who oversave will live a
more frugal lifestyle while working to enjoy a better lifestyle while retired.
For example, assume there are no banks, hence obtaining a loan is very difficult for small economic agents like
households or self-employed people (high transaction costs). Without the possibility of getting a loan you will have
to work very hard to get to doing certain investments. You will have to save up money until you accumulate enough
wealth. This is sub-optimal, because the person might have a positive economic value. If banks existed, he would
be in a position to get a loan.
3
, The last theory focusses on the liquidity risk that banks are exposed to and sees this liquidity risk as necessary:
5. Commitment mechanisms
Loans are difficult to sell as they are really illiquid assets, banks hold the most liquid assets (bank accounts)
against the most illiquid assets (loans). Banks hold huge numbers of loans on their balance and make decisions
of providing a loan or not on a daily basis. Communicating all this information to deposit holders is impossible, we
don’t actually know what a bank does with our money. As a bank, you need the depositors to believe you are doing
a good job at managing the assets. The bank does not disclose this information.
The benefits of financial intermediation: overview
Lenders Borrowers Society as a whole
➔ Liquid bank accounts ➔ Loans will have longer ➔ More efficient use of
and illiquid loans. maturities than when funds, because of the
➔ Less risk, due to the borrowing directly from more improved lending
pooling of risks. lenders. decisions.
➔ Lower transaction ➔ Loans will be more ➔ Way higher levels of
costs because of the available when they are borrowing/lending
economies of scale and required and for larger because of lower risks
a simplified lending amounts. and transactions costs.
decision: banks have ➔ The lower transaction ➔ More funds available
less borrowers than costs. for high-risk ventures as
deposit holders. It is ➔ Lower interest rates banks can diversify and
also easier to decide because of the lower absorb risk.
where to deposit your transaction costs and
money than where to diversification of risk.
get a loan.
II – BANK ACTIVITIES AND SERVICES
What do banks do?
According to the IMF (International Monetary Fund) banks are intermediaries between depositors (who lend
money to the bank) and the borrowers (to whom the banks lend money). The amount banks pay for deposits and
the income they receive on their loans are both called interest. The loans don’t make the bank a bank, a credit
institution for example also gives out loans but they do not take deposits.
Banks and other financial institutions
Monetary financial institutions = Deposit taking institutions = Banks
Deposits are discretionary, savers can make discretionary decisions about how much money to put in a bank
account, and for how long. This is different from other financial institutions, where the flow of funds is contractual.
For example, an insurance policy or a leasing contract.
Banking services
Banks typically hold deposits and give payment services, both lending and payment services can also be done by
others, but deposits can only be done by banks. Other financial services like investment services, leasing,
factoring, … are not typical of banks. They can provide such services as they prefer.
4
PART I – INTRODUCTION TO BANKS AND THE BANKING SECTOR
I – WHAT IS SPECIAL ABOUT BANKING?
The nature of financial intermediation
Why/when do people or companies borrow money?
Borrowers are people who need money from the bank, they are short on cash but not short on value. If you would
be short on value too, banks will not give you money. Borrowers have a positive economic value because they are
expected to generate a profit in the future, or they will not be able to pay back the loan. For example, a recently
graduated dentist is setting up his own practice which requires a significant investment. The bank expects him to
have a high income and will therefore have a high economic value. Without banks the young dentist would need
to work for many years before he could set up his own practice. Borrowers are liquidity constraint, they cannot sell
part of their assets to raise cash because these assets are illiquid.
Borrowers (deficit units) Lenders (surplus units)
➔ Economic units whose total expenditure ➔ Economic units whose total receipts
exceeds their total receipts. exceeds their total expenditure.
➔ Minimization of costs. ➔ Minimization of costs
➔ Funds at a specific date. ➔ Minimization of default risk and the risk of
➔ Timing of repayment over a specific period. assets (loans) dropping in value.
➔ Liquidity: the ability to convert an asset into
cash without incurring a loss in value.
There is a gap between lenders, who give money to the bank and want their money to be available when needed,
and borrowers, who want long term fixed payments and loans.
Direct finance
You need money and go to the market yourself, borrowers and lenders do business directly with each other. An
example is a company issuing a bond. There is still some form of intermediation (investment banks), but the funds
are raised from the market directly, not from the
intermediary. There are 2 problems:
1. The incompatibility of the needs and
preferences of lenders and borrowers.
2. Difficulty and cost of matching lenders and
borrowers, find someone to buy it.
Financial intermediation
The solution for the 2 problems above. In this situation there is a bank in between who pools lots of loans. They do
not need to match lenders and borrowers one-on-one. Costs are lower due to economies of scale. Although this
solves the problems above, there still are information asymmetries that lead to substantial transaction costs
(assessing the client, negotiating the loan, monitoring the borrower, recovery in case of default, …).
Some recent evolutions are securitization and shadow banking:
➔ Securitization: banks convert illiquid assets on their balance sheet into tradable financial instruments
that they sell to investors in return for cash to create new loans. This way assets are removed from their
balance and are transferred to and traded on the financial markets.
➔ Shadow banking: non-banking entities with no regulation that provide the services a bank would provide,
which can create problems. The ECB uses the concept of ‘Non-bank financial intermediation’ or NBFI.
1
,The role of banks
Size transformation
Typically, depositors hold smaller amounts of money with the bank than borrowers need. Banks transform the
smaller amounts of deposits in larger amounts for loans (no matching one-on-one) and enjoy economies of scale,
allowing them to pool small deposits into larger loans.
Maturity transformation
Banks convert demand deposits into medium- and long-term loans, they can borrow short and lend long. As a
result, there is a mismatch between the assets and the liabilities of a bank. This mismatch creates liquidity risk,
the risk of not having enough liquid funds to meet client’s demands.
Risk transformation
Individual borrowers can default. The bank can reduce this risk by diversifying their loans over many different
clients and screen/monitor their borrowers. Banks also hold excess capital to cover unexpected losses.
Information economies
Asymmetric information
Part of the transaction costs comes from asymmetric information. Nobody knows everything and the information
between certain people is different. Some information might also be ‘inside information’ that is not available to
both sides of a transaction, one person knows more than the other. Banks need to be sure that they have enough
information about for example the ability of households to repay before giving out mortgages. It costs the bank
money to get the needed information, but it is a necessity.
Transaction costs and economies of scale
Dealing with the asymmetry of information leads to transaction costs. If borrowers need to obtain a loan without
intermediation and would need to find a lender on the financial markets, the transaction costs would be extremely
high. Banks on the other hand generate significant economies of scale by pooling many borrowers and lenders,
and lowering transaction costs significantly.
➔ Banks transform primary securities (loans) into secondary securities (bank accounts) and enjoy some
economies of scope.
➔ Secondary securities cannot exist without primary ones, but primary securities can exist without financial
intermediation.
Adverse selection and moral hazard
This is the last element that makes issuing loans costly. For example, buyers of a second-hand car cannot tell
whether a car is any good or not, they have less information about the car than the seller. Buyers don’t trust the
cars being offered and therefore all cars of the same type sell at the same low price (‘lemons’, you can’t differ the
good ones from the bad ones). The market will turn into a ‘lemons market’. To avoid this there are two principles.
➔ Signalling (sellers): actions performed by the informed party to solve the adverse selection problem. For
example, providing a type of warranty/guarantee on the car.
➔ Screening (buyers): actions performed by the less informed party, facing adverse selection. For example,
insurance companies make their clients go to the doctor before going for a life insurance.
For banks, adverse selection occurs because creditors with financial
difficulties are more in need of loans than others, but they are also more
likely to default on them. A bank solves this by screening (request a lot of
information when one applies for a loan) and by how they price loans.
Charging higher interest rates prevents creditors with a weak financial
situation from applying for a loan. On the other hand, creditors with a bad
financial situation have nothing to lose and might not care about the high
price. For creditors with a good financial situation, such high interest
2
,rates make no sense. So, if interest rates are too high, banks face a lemons market. For the bank itself, higher
interest rates mean higher profits. At some point good creditors will stop applying for a loan because of the high
price and the bank is left with only bad creditors.
Adverse selection is an ‘ex ante’ issue (before the transaction), moral hazard is the risk that one party to a contract
behaves in a way that is against the interest of the other party after the contract or transaction has been concluded.
For example, those who obtained an insurance might take greater risks than before, or those who got a loan for a
“safe” investment might actually use it for a risky investment. Banks use monitoring to reduce the issue of moral
hazard. For example, corporate clients need to submit financial information to banks on a regular basis, if such
information would not be public in the first place.
Why do banks exist? (5 main theories that explain why banks exist)
The first 2 theories see the information asymmetry and the related transaction costs as the reason banks exist:
1. Delegated monitoring
Lenders delegate the screening and monitoring to banks because they have economies of scale, which allows
them to significantly reduce transaction costs that result from asymmetry of information. Banks can also diversify
the credit risk over a large number of creditors, reaching levels of diversification that individual lenders couldn’t.
2. Information production
Reducing the transaction costs is seen as the main reason why banks exist. As with delegated monitoring, it is
considered too expensive for individual lenders to collect all the required information. The main role of banks is
similar to that of rating agencies: collect information based on which screening and monitoring activities can be
performed. Banks can also diversify credit risk, but this is not the main reason they exist. Wealthy individuals could
also diversify credit risk, but they would not be able to enjoy economies of scale, as this requires a lot of loans.
➔ Neither of these theories needs that banks disclose any of this information to the deposit holders.
The next 2 theories do not focus on the asymmetry of information:
3. Liquidity transformation
Bank accounts have higher liquidity and lower credit risk than almost any other financial asset. Lenders could
achieve the same low risk by investing in large diversified portfolios of loans, which would be just as illiquid as the
underlying loans. Banks invest in illiquid loans, but issue liquid deposits against them. They transform short term
deposits into long term loans, which creates liquidity risks for themselves. This is all based on the trust of clients.
4. Consumption smoothing
The practice of optimizing our standard of living by ensuring a proper balance between spending and saving during
the different phases of our lives. Those who overspend and put off saving for retirement to enjoy a higher standard
of living often have to work longer or reduce their standard of living in retirement. Those who oversave will live a
more frugal lifestyle while working to enjoy a better lifestyle while retired.
For example, assume there are no banks, hence obtaining a loan is very difficult for small economic agents like
households or self-employed people (high transaction costs). Without the possibility of getting a loan you will have
to work very hard to get to doing certain investments. You will have to save up money until you accumulate enough
wealth. This is sub-optimal, because the person might have a positive economic value. If banks existed, he would
be in a position to get a loan.
3
, The last theory focusses on the liquidity risk that banks are exposed to and sees this liquidity risk as necessary:
5. Commitment mechanisms
Loans are difficult to sell as they are really illiquid assets, banks hold the most liquid assets (bank accounts)
against the most illiquid assets (loans). Banks hold huge numbers of loans on their balance and make decisions
of providing a loan or not on a daily basis. Communicating all this information to deposit holders is impossible, we
don’t actually know what a bank does with our money. As a bank, you need the depositors to believe you are doing
a good job at managing the assets. The bank does not disclose this information.
The benefits of financial intermediation: overview
Lenders Borrowers Society as a whole
➔ Liquid bank accounts ➔ Loans will have longer ➔ More efficient use of
and illiquid loans. maturities than when funds, because of the
➔ Less risk, due to the borrowing directly from more improved lending
pooling of risks. lenders. decisions.
➔ Lower transaction ➔ Loans will be more ➔ Way higher levels of
costs because of the available when they are borrowing/lending
economies of scale and required and for larger because of lower risks
a simplified lending amounts. and transactions costs.
decision: banks have ➔ The lower transaction ➔ More funds available
less borrowers than costs. for high-risk ventures as
deposit holders. It is ➔ Lower interest rates banks can diversify and
also easier to decide because of the lower absorb risk.
where to deposit your transaction costs and
money than where to diversification of risk.
get a loan.
II – BANK ACTIVITIES AND SERVICES
What do banks do?
According to the IMF (International Monetary Fund) banks are intermediaries between depositors (who lend
money to the bank) and the borrowers (to whom the banks lend money). The amount banks pay for deposits and
the income they receive on their loans are both called interest. The loans don’t make the bank a bank, a credit
institution for example also gives out loans but they do not take deposits.
Banks and other financial institutions
Monetary financial institutions = Deposit taking institutions = Banks
Deposits are discretionary, savers can make discretionary decisions about how much money to put in a bank
account, and for how long. This is different from other financial institutions, where the flow of funds is contractual.
For example, an insurance policy or a leasing contract.
Banking services
Banks typically hold deposits and give payment services, both lending and payment services can also be done by
others, but deposits can only be done by banks. Other financial services like investment services, leasing,
factoring, … are not typical of banks. They can provide such services as they prefer.
4
