Lecture 1

Introduction to Principles
of
Banking and Finance

Real-life Cases in Banking & Finance

F&N

QE3

What are the Topics?

1. Introduction to Principles of Banking & Finance
2. Introduction to Financial Systems
3. Comparative Financial Systems
4. Role of Financial Intermediation
5. Regulations of Banks
6. Risk Management in Banking
7. Capital Budgeting & Valuation of Shares/Bonds
8. Risk and Return (Shares and Portfolios)
9. Financial Markets Transmission of Information

Course Map

Market-based or
Financial System

Bank-based

Banks

Securities

Regulations

Valuation

Risks

Risk /Return trade-off

What is the Aim of this Course?

This subject aims to introduce the principles of

banking and finance.

It covers a broad range of topics using an economic

perspective, and aims to give a general background
to any student interested in the subject of banking
and finance.

Financial Systems

Chapter 1

Introduction syllabus, study guide, textbooks, examination.

investigates the functions and structure of financial systems. It then focuses on each of

Chapter 2

the three main entities that compose financial systems (financial intermediaries,
securities and financial markets)

Chapter 3

discusses the features of bank-based systems against market-based systems in different

countries around the world.

Principles of Banking

Chapter 4

focuses on the nature and process of financial intermediation by discussing the key theories of
financial intermediation (transformation of assets, uncertainty, reduction in transaction costs,
reduction of problems arising out of asymmetric information).

Chapter 5

investigates the theoretical and practical aspects of regulation of banks, such as arguments
for or against regulation, traditional regulation mechanisms and alternatives to traditional
regulation.

Chapter 6

discusses the key risks in banking (credit risk, interest rate risk, market risk) and the main
methods of risk management in banks (such as screening, monitoring, duration gap analysis,
value-at-risk).

Principles of Finance

Chapter 7

Chapter 8

securities valuation. It focuses on the

valuation of real investment projects using the Net Present Value (NPV), and

compares NPV with

alternative techniques. Then it moves to the models used for the valuation of bonds and stocks.

discusses the basics of risk and return of securities and mean-variance portfolio theory. It goes on to derive
and discuss the equilibrium asset-pricing models (Capital Asset Pricing Model and Arbitrage Pricing Model).

Chapter 9

outlines the concept and techniques of capital budgeting and

focuses on the efficiency of financial markets by providing a theoretical derivation of the concepts of weak,
semi-strong, and strong efficiency. It then discusses the empirical evidence in favour of & against market
efficiency.

What are Essential Readings?

Principle of Banking and Finance- Subject Guide by M. Buckle (2012)

compulsory reading

Financial Markets and Institutions by Mishkin, F. and S. Eakins.

(Boston, London: Addison Wesley, 2009) (Core Text)

Comparing Financial Systems by Allen, F. and D. Gale.

(Cambridge, Mass.: MIT Press, 2001)
(To analyze comparative financial systems)

Principles of Corporate Finance by Brealey, R.A, S.C. Myers and F. Allen. (Boston, London:
McGraw-Hill/Irwin, 2010) tenth (global) edition
(Chapters 2, 3, 4, 5, 7, 8, 13 & 14)
To investigate issues of principles of finance (e.g. capital budgeting and valuation of financial assets,
risk & return of financial assets and portfolios)
The subject guide must be used together with these 3 essential textbooks

How to Approach each Chapter?

10

List of Aims and Learning Outcomes

tell you what you can expect to learn from that chapter of the subject guide and the relevant reading.
use them to check that you have fully understood the topics.
Essential reading, further reading, and references

indicates what you need to read as a minimum in order to cover the syllabus.
Activities

the analysis of institutional website material, numerical exercises and further readings on the texts.
For numerical activities (marked with an asterisk*) we provide answers in Appendix 1 at the end of the
guide.

How to Approach each Chapter?

11

Key Terms

Compile your own glossary with full definitions and comments on each of these terms, and use it for
revision.

Sample Examination Questions

similar to those asked in the final examination.

recommend that you try these sample examination questions during your revision.

VLE
12

Why is VLE important?

13

Self-testing activities

test your own understanding of subject material.

Electronic study materials

The

printed materials that you receive from the University of London are available to download,
including updated reading lists and references.

Student discussion forum

an

open space for you to discuss interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.

Why is VLE important?

14

Videos
recorded

academic introductions to the subject, interviews and debates and, for some courses,
audio-visual tutorials and conclusions.

Recorded lectures
For

some courses, where appropriate, the sessions from previous years Study Weekends have
been recorded and made available.

Study skills
Expert advice on preparing for examinations and developing your digital literacy skills.

Make use of Online Library to access

journal articles and other resources

What is the Exam Structure?

15

3 hours
Answer 4 questions (45 minutes each) from a choice of 8.
Must answer at least 1 question from each section.

Section A (4 Questions)

Tests your understanding of concepts and theories.

Section B (4 Questions)

Tests your understanding of application of finance

concepts and tools.

Generally expected to go deeper into the subject

matter than that set out in the subject guide.

Test your understanding how to apply techniques to

the

Use of relevant/up-to-date example as evidence of

understanding

data

given,

what

are

the

limitations

and

assumptions of the techniques, and how to interpret

your calculated answers.

What is the Exam Structure?

16

The examiners ensure that all the topics covered in the subject guide are examined.

Some questions may contain both numerical and essay-based parts.

Example of these types of questions (or parts of questions) are provided at the end of each chapter of
the subject guide.

How to score in Exams?

17

For essay-based questions, remember to plan your answer:

List the main issue you want to discuss and the order of the discussion;

Begin the essay-based question with an introduction stating the aims of the essay; and

Conclude with a summary bringing together the main issues investigated in the essay.

How to score in Exams?

18

Use materials only when relevant to the question. Answers with loads of irrelevant materials
will be marked down.

Repeat simply subject guide materials may be given a pass at best.

Clear structure, good understanding of material and originality of approach will help
you to achieve an excellent score.

How to score in Exams?

19

check both the current Regulations for relevant information about the examination and the VLE where you
should be advised of any forthcoming changes.

check the instructions on the paper you actually sit and follow those instructions.

Remember, it is important to check the VLE for:

up-to-date information on examination and assessment arrangements for this course

where available, past examination papers and Examiners commentaries for the course which give advice
on how each question might best be answered.

Example of Examiners commentaries

20

Chapter 2

Introduction to Financial
Systems (Part 1)

What is the Aim of this Chapter?

22

Investigate financial systems from functional and structural perspectives

Financial
Markets

Financial
Intermediaries

Securities

What are you expected to learn?

23

Explain the functions of financial systems.

Describe the three main entities that compose financial systems (financial intermediaries,
securities & financial markets)

Describe and explain the characteristics of the financial intermediaries (e.g. depository
institutions, contractual savings institutions and investment intermediaries) in the USA and the
world.

What are you expected to learn?

24

To explain the type and features of financial securities (i.e. bonds, notes, bills and stocks) traded
on financial markets.

To discuss the theories related to the shape of the yield curve.

To explain the structure of financial markets in the USA and the world (e.g. UK, France and
Germany).

Functions of Financial
Systems

What are the Functions of Financial Systems?

26

Source: M. Buckle (2012) Principle of Banking and Finance, ch2

What are the Functions of Financial Systems?

27

Mechanism for funds to transfer from units in surplus to units with shortage in order to directly
and indirectly facilitate lending and borrowing.

Enable wealth holders to adjust the composition of their portfolios (current vs future
consumption).

Provide payment mechanism.

Risk transfer mechanism.

Economic function of financial systems

28

channeling funds from units who have surplus funds (i.e. saving) to units who have a shortage of
funds (borrowing)
lender-savers: The units who have saved can lend funds, usually households.
borrower-spenders: The units with a shortage of funds borrow funds to finance their spending,
typically the firms and the government

Economic function of financial systems

29

Direct Finance

Indirect Finance

Borrowers borrow
directly from
lenders in financial
markets by
selling/issuing
financial
instruments (e.g.
equities, bonds)

Borrowers borrow
indirectly from
lenders via financial
intermediaries (e.g.
banks, securities
firms)

The process of indirect finance, known as financial intermediation, is the most important way of
transferring funds from lenders to borrowers.

Monetary function of financial systems

30

Money enables spenders and savers to separate the act of sale from the act of purchase.
Overcome the main problem of barter trade.
Provides a variety of payment mechanisms, e.g. cheques, debit cards, credit cards, e-payment and
mobile wallet.

Risk transfer function of financial systems

31

Firm or household transfers the risk of loss of wealth due to theft /

fire to an insurance company by paying a fee, i.e. insurance
premium.
The insurance company can allocate the risk more efficiently by
pooling and diversification through a large number of insurance
contracts.

Structure of Financial
Systems

Structure of Financial Systems

33

Financial Markets [Primary vs Secondary Markets; Money vs Capital Markets;

Dealer OTC vs Broker Auction Markets]

Markets in which securities are traded (e.g. bond & shares).

Markets where funds are moved from people who have excess funds (but lack
of investment opportunities) to people who have investment opportunities (but
lack of funds).

Have direct effects on personal wealth and the behaviours of businesses &
consumers.

Increase the production & efficiency of the economy.

Financial Markets

Financial
Intermediaries

Securities

Structure of Financial Systems

34

Securities (or financial instruments)

Financial claims on the issuers future income or assets.

Financial assets for lender or investor in the financial
claim.

Financial liabilities for borrower or issuer of

Financial Markets

the financial claim in return for money.

Financial
Intermediaries

Securities

Structure of Financial Systems

35

Securities (or financial instruments)

Governments & corporations raise funds by issuing:

Shares (shares or equity instruments)

- represent a share of ownership in the firm.

Bonds (debt instruments) - promise

Financial Markets

to make periodic payments of a sum

of money for a specified period
of time.

Financial
Intermediaries

Securities

Structure of Financial Systems

36

Financial Intermediaries

Economic agents who specialise in buying & selling

financial contracts (loans & deposits) not easily marketable

financial securities (bonds & stocks) easily sold.

(a) Banks

Form the largest financial institution in our economy.

Borrow deposits from depositors & make loans to borrowers.

(b) Other Financial Intermediaries

Include mutual funds, pension funds,

insurance companies & investment banks,
which are growing at the expense of banks.
Financial Markets

Financial
Intermediaries

Securities

Three Major Groups of Financial Intermediaries

(in US context)
37

Depository institutions
(intermediaries with significant
portion of funds derived from
customer deposits)

(i) commercial banks

(ii) savings institutions
(iii) credit unions

Contractual Savings Institutions (i) insurance companies

(intermediaries that acquire funds at (ii) pension funds
periodic intervals on a contractual
basis)
Investment Intermediaries

(i) mutual funds

(ii) finance companies
(iii) investment banks
(iv) securities firms

Depository Institutions

Commercial Banks
39

Largest group of financial intermediary in the USA - 2006:7,402 with $10.1

trillion assets according to FDIC Quarterly Banking Profile.

Accept deposits (liabilities) to make loans (assets) & to buy government

securities.
Assets
Commercial Loan
Consumer Loan
Mortgage Loan

Liabilities
Savings Deposits
Checkable Deposits
Time Deposits

Commercial Banks
40

Many US banks were consolidated through M&A,

reduced from 14,416 in 1984 to 7,402 in 2006.

Return on Equity (ROE) of the US banking industry

averaged 9.9% in 2006.

Based on aggregated balance sheet values of US

banks in 2006, loans constituted 58% of their assets,
and investment in securities, 16%. Interest bearing
deposits represented 54% of their liabilities.

41

Singapore Commercial
Banks?

Retail Banks vs Wholesale Banks

42

2 types of commercial banking: (i) retail banking

(ii) wholesale banking.

Retail Banks

Lending
Lending

and
and

payment
payment

Wholesale Banks

services
services

for
for

individuals &
& small
small businesses;
businesses;
individuals

Deal with
with aa large
large number
number of
of small
small value
value
Deal
transactions.
transactions.

For wholesale
wholesale business
business (e.g.
(e.g. investment
investment
For
banks);
banks);

Deal with
with aa smaller
smaller number
number of
of larger
larger value
value
Deal
transactions.
transactions.

Retail Banks vs Wholesale Banks

43

Size is the key difference between retail and wholesale banking.

In practice, it is difficult to identify purely retail banks.

Large banks combine retail & wholesale activities in UK, US & developed countries.

Savings & Loan Associations (S&L)

44

2nd largest group of financial intermediaries, after commercial banks.

1950-1960: grew more rapidly than commercial banks.

1,279 entities with $1.8 trillion in assets in 2006.

Historically, mainly on residential mortgages (by acquiring funds primarily
through savings deposits).

1979-1982: slowdown due to monetary policy (increase in interest rates).

Savings & Loan Associations

45

Regulatory solutions:

Problems of higher short term rates:

1. Negative interest spreads (interest income < interest
expense)

when

funding

the

fixed-rate

long-term

residential mortgages.

2.

Pay more competitive (higher) interest rates on

savings deposits.

1.

Expand sources of deposits (i.e. offer

Pros:

Resulted in safer & more

diversified S&Ls.

checking accounts) and

2. Expand uses of funds (i.e. make consumer

loans, commercial loans).

Cons:

Incentivise to improve profitability

by taking more risk.

Credit Unions
46

Non-profit institutions.
Mutually organised & owned by their members, i.e. depositors.
Provide deposit & loan to their members (identified by
association, geographical location).

occupation,

Members deposits are used to provide loans to other members.

Loans earnings are used to pay a higher interest rate to
depositors.

member

Depository Institutions around the world

47

USA

Commerical
Banks

S&L

UK

Commercial
Banks

Building
Societies

Japan

Co-operative
Banks (Credit
Ordinary Banks
Unions and
Associations)

France

Commercial
Banks

Mutual and Cooperative

Banks

Savings Banks

Germany

Commercial
Banks

Co-operative
Banks

Savings Banks

Credit Unions

Trust Banks,
Long Term
Credit Banks

Contractual Savings
Institutions

Contractual Savings Institutions

49

Acquire funds at periodic intervals on a contractual basis.

Liquidity of assets less important (than for depository institutions).
Can predict reasonable accuracy the future payments due to their

customers.
Invest their funds in long-term securities (e.g. corporate bonds,

stocks & mortgages).

2 groups: (i) insurance companies & (ii) pension funds.

Insurance Companies
50

To protect the policy-holders (i.e. individuals & firms) from adverse events;
Receive premiums from policy-holders; and
Pay compensation to policy-holders if particular events occur.
Property & Casualty Insurance

Protection against personal injury & liabilities, e.g. accidents / theft/ fire; and
Hold more liquid assets because of a higher probability of loss of funds.

Insurance Companies
51

Life insurance

Protects against death, illness and retirement.

Forms the largest contractual savings institutions in US in 2006, with $4.71 trillion aggregate assets
(by Insurance Information Institute).
Instead of traditional life insurance products, current emphasis is on annuities (i.e. contracts that
accumulate funds & pay out a fixed / variable income stream for a fixed period of time /over the
lifetimes of the contract).

Pension Funds
52

Provide retirement income (annuities payment) to employees covered by a pension plan. (eg. CPF Life)

Receive contributions from employers or employees.

Invest in corporate bonds & stocks.

2 types: private pension funds & public pension funds.

More important in USA & UK, than in other countries (e.g. France, Italy & Germany).

Investment
Intermediaries

Mutual Funds
54

Pool resources from many individuals & companies.

Invest in diversified portfolios (bonds, stocks & money markets).

Commercial bank industry ($10.1T) Mutual funds industry ($9.5T) insurance industry ($4.7T Life

nd

most important financial intermediary (by asset size - $9.5 trillion in 2006) in the USA.

Insurance).

Mutual Funds
55

Mutual Funds
56

Open-ended mutual fund

major type of mutual fund

continuously allows shareholders to sell (redeem) outstanding shares & investors to buy new shares at any
time

value of shares depends on the value of the mutual funds holding assets

Advantages of mutual funds:

provide opportunities to small investors (to invest in financial securities & diversify risk)

lower transaction costs (when they buy larger blocks

of financial securities)

Mutual Funds
57

Long-term Mutual Funds

bond funds (funds that contain fixed-income debt securities)

equity funds (funds that contain stock securities)

hybrid funds (funds that contain both debt and stock

securities)

Mutual Funds
58

Short-term Mutual Funds

Comprise money market mutual funds (funds that contain

various mixes of money market securities)

partially allow shareholders to write cheques against the

value of their holdings

the presence of deposit-type accounts makes money

market mutual funds to some extent similar to depository
institutions

Finance Companies
59

Provide loans to individuals and corporations (e.g. consumer lending, business lending, mortgage
financing).

Similar to commercial banks (except do not accept deposits).

Raise funds by selling commercial paper (a short-term debt instrument) and by issuing stocks and
bonds.

Lend to customers (as second tier/mezzanine lenders) as customers are perceived as too risky by
commercial banks (first tier lenders).

Finance Companies
60

3 types of Finance Companies:

Sales finance institutions - loans to customers of a particular retailer or manufacturer (e.g. Ford Motor
Credit).

Personal credit institutions - loans to consumers perceived as too risky by commercial banks (e.g.
Household Finance Corp).

Business credit institutions - financing to companies through equipment leasing & factoring (purchase
by the finance company of accounts receivable from corporate customers ). Eg: International Factors
Singapore IFS

Investment Banks
61

Assist corporations or governments to issue new debt or equity securities.

Investment banking services includes:

origination
Underwriting (see notes below)
placement of securities in primary financial markets
financial advisory (e.g. advising on mergers & acquisitions).

o charge fee as a fixed percentage of the size of the deal.

Investment Banks
62

Underwriting of stock or bond issue

Purchase the entire issue at a predetermined price and resell it in the market. (With or Without a Green
Shoe Option)

Bears the risk that they are not able to resell the entire issue (then it will hold the unsold stock on its
own balance sheet). Best Effort or Firm Basis

Receives underwriting fee from the issuing company.

Securities Firms
63

Assist in the trading of existing securities in the secondary markets.

Dealers (OTC Market)

Agents who link buyers and sellers by buying & selling securities.

Hold inventories of securities.

Sell these securities for a slightly higher price than they paid for them.

earn bid-ask spread (= ask bid)

Securities Firms
64

Brokers (Auction Market)

Agents of investors who match buyers with sellers of securities;

Earn a commission;

Main service: securities orders; (Market vs Limit Orders)

Securities orders are trade instructions specifying what counters traders want to trade, whether to
buy or sell, how much, when & on what terms.

Securities Firms
65

Type of Orders
Market Orders

Limit Orders

Instruct
Instruct to
to trade
trade at
at the
the best
best price
price currently
currently available
available in
in the
the

instruct
instruct to
to trade
trade at
at the
the best
best price
price available,
available, but
but only
only ifif itit is
is

market.
market.

Market
Market

no
no worse
worse than
than the
the limit
limit price
price specified
specified by
by the
the trader.
trader.

order
order traders
traders pay
pay the
the bid-ask
bid-ask spread
spread (they
(they

demand
demand immediacy).
immediacy).

standing
standing

limit
limit orders
orders (i.e
(i.e limit
limit orders
orders that
that are
are not
not

immediately
immediately executed)
executed) provide
provide the
the market
market with
with liquidity
liquidity as
as
they
they sit
sit in
in the
the order
order book.
book.

ItIt follows
follows that
that there
there is
is price
price uncertainty.
uncertainty.
Large
Large

market
market

orders
orders can
can

unpredictable
unpredictable price
price impacts.
impacts.

have
have substantial
substantial and
and

Investment Banking and Securities Industry (in

USA)
66

National full-line firms - acting both as broker-dealers & underwriters (e.g. BoA, Morgan Stanley).

National full-line firms - specialise more in corporate finance and are highly active in trading securities
(e.g. Goldman Sachs).

Regional securities firms - concentrating in the service of customers of a particular geographical region .

Investment Banking and Securities Industry (in

USA)
67

Specialised investment bank subsidiaries of commercial banks (e.g. J.P. Morgan).

Specialised discount brokers - stockbrokers that conduct trading activities for customers without
offering any investment advice (e.g. Charles Schwab).

Specialised electronic trading securities firms (e.g. E*trade) enabling trades on a computer via the
internet.

Sample Exam Questions

68

1.

What is a financial system? Frame your answer both from a structural and a functional perspective.

2.

What is the primary function of depository institutions? How does this function compare with the
primary function of insurance companies?

Sample Exam Questions

69

3.

What is a mutual fund? What are the differences between short-term and long-term mutual funds?
Where do mutual funds rank in terms of asset size among all financial intermediaries in the USA?

4.

Explain how securities firms differ from investment banks. Which categories of firms are there in this
industry? In what way are they financial intermediaries?

References
70

M. Buckle, E. Beccalli (2012) Principles of Banking and Finance Subject Guide, Chapters 1
and 2.