Increasingly banks use their position as financial intermediaries to create loans and then ‘package’them up and sell them of in the form of bond issues. This process is called securitization. The bond investors assume the credit risk on the loan book in return for a rate of interest greater than they could earn on government securities. The banks recycle the capital they were originally provided with by their shareholders and
depositors so that they have funds available to create new loans. They analyse risk, manage risk and then distribute the risk through the public bond markets.
The boundaries between the different types of financial institutions are becoming increasingly blurred in the modern financial markets. Earlier in the last century the demarcation lines seemed rather more rigid. The Glass–Steagall Act of 1933, for example, created a firm distinction in the US between what became known as investment banking and commercial banking. Commercial banks took in deposits and made commercial loans. They assumed credit or default risk and contained this risk by carefully evaluating the creditworthiness of borrowers and by managing a diversified portfolio of loans. By contrast, investment banks underwrote new issues of securities and dealt in shares and bonds in the secondary markets. (A primary market is a market
for creating or originating new financial instruments; a secondary market is a market for trading existing instruments.) They took underwriting risk. This arises when a bank or a syndicate of banks buys an issue of securities from the issuer at a fixed price and takes over the responsibility for selling or placing the stock into the capital markets.
At the time of Glass–Steagall the US Congress believed that a financial institution faced a conflict of interest if it operated as both an investment and a commercial bank, and duly passed the legislation. As a consequence the great banking house of Morgan split into two separate organizations. The commercial banking business later merged to form Morgan Guaranty Trust and is now part of the JP Morgan Chase Bank. The with Dean Witter. By contrast, Merrill Lynch emerged from the securities broking and trading business in the US and only over time expanded its range of activities and its international reach to become a fully-fledged global investment bank.
In the UK similar divisions of responsibility used to apply until the barriers were progressively removed. After the Second World War and until the 1980s the new issue business in London was largely the province of so-called merchants banks who were members of the Accepting Houses Committee. Retail and corporate banking was dominated by the major clearing or ‘money centre’banks such as Barclays and National Westminster Bank (now part of the Royal Bank of Scotland group). Trading and broking in UK and European shares and UK government bonds in London was investment banking business was formed into Morgan Stanley which later combined
conducted by a number of small partnership-based businesses with evocative names such as James Capel, Wedd Durlacher and Kleinwort Benson. The insurance companies were separate from the banks, and the world insurance market was dominated by Lloyds of London. These segregations have all since been swept away. Nowadays large UK financial institutions offer a very wide range of banking and investment products and services to corporate, institutional and retail clients.
In the US the constraints of Glass–Steagall were gradually lifted towards the end of the twentieth century. US commercial banks started to move back into the new issuance business both inside the US itself and through their overseas operations. One factor that spurred this development goes under the rather ungainly title of bank disintermediation. In the last decades of the twentieth century more and more corporate borrowers decided to raise funds directly from investors by issuing bonds (tradable debt securities) rather than by borrowing from a commercial bank or a syndicate of banks.
This development was particularly marked amongst top-quality US borrowers with excellent credit ratings. In part the incentive was to cut out the margin charged by the commercial banks for their role as intermediaries between the ultimate suppliers of capital (depositors) and the ultimate users. In part it reflected the overall decline in the credit quality of the commercial banks themselves. Prime quality borrowers discovered that they could issue debt securities and fund their capital requirements at keener rates than the great majority of commercial banks. Disintermediation (cutting out the intermediation of the lending banks) developed apace in the US and then spread to other financial markets. Later on even lower credit quality borrowers discovered that they could raise funds very effectively through the public bond markets.
The advent of the new single European currency, the euro, has stimulated the same sort of process in continental Europe. Before the single currency Europe developed as a collection of relatively small and highly fragmented financial markets with many regional and local banks. Banks and corporations had very strong mutual relationships cemented by cross-shareholdings— in Germany the major banks and insurance
companies owned large slices the top industrial companies. Most corporate borrowing was conducted with the relationship bank. Shares and bonds were issued and traded primarily in domestic markets and in a range of domestic currencies. There were restrictions on the extent to which institutional investors could hold foreign
European markets.
Now all this is being swept away, at great speed. Banks around Europe are consolidating and unwinding their cross-shareholdings to free up capital to invest in their own businesses. In Germany the government has promoted legislation to make this process more tax efficient. Borrowers are increasingly looking to the new issue markets to raise funds. Investors in Europe can now buy shares and bonds and other securities denominated in a single currency that are freely and actively traded across a whole continent. Stock and derivatives exchanges which originated in national markets are merging and re-inventing themselves as cross-border trading platforms.
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