Principles of banking and fi nance
M. Buckle, E. Beccalli
FN1024, 2790024
2011
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
M. Buckle, MSc, PhD, Senior Lecturer in Finance, European Business Management School,
Department of Accounting, University of Wales, Swansea.
E. Beccalli, Visiting Senior Fellow in Accounting, London School of Economics and
Political Science.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the authors are unable to enter into any correspondence relating to, or aris-
ing from, the guide. If you have any comments on this subject guide, favourable or unfavour-
able, please use the form at the back of this guide.
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Website: www.londoninternational.ac.uk
Published by: University of London
© University of London 2008
Reprinted with minor revisions 2012
The University of London asserts copyright over all material in this subject guide except where
otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,
or by any means, without permission in writing from the publisher.
We make every effort to contact copyright holders. If you think we have inadvertently used
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Contents
i
Contents
Chapter 1: Introduction .......................................................................................... 1
General introduction to the subject ................................................................................ 1
Learning outcomes ........................................................................................................ 1
Essential reading ........................................................................................................... 2
Further reading .............................................................................................................. 3
References .................................................................................................................... 4
Online study resources ................................................................................................... 6
The structure of the subject guide ................................................................................. 7
How to use this subject guide ........................................................................................ 8
Structure of each chapter ............................................................................................... 9
Examination .................................................................................................................. 9
Syllabus ....................................................................................................................... 11
Part I: Financial systems ....................................................................................... 13
Overview ..................................................................................................................... 13
Chapter 2: Introduction to financial systems ....................................................... 15
Aims ........................................................................................................................... 15
Learning outcomes ...................................................................................................... 15
Essential reading ......................................................................................................... 15
Further reading ........................................................................................................... 15
Introduction ................................................................................................................ 16
The structure of financial systems: financial markets, securities and financial
intermediaries ............................................................................................................. 17
Taxonomy of financial intermediaries............................................................................ 18
Nature of financial instruments (securities) ................................................................... 26
Structure of financial markets ...................................................................................... 32
Summary ..................................................................................................................... 36
Key terms ................................................................................................................... 37
A reminder of your learning outcomes .......................................................................... 37
Sample examination questions ..................................................................................... 38
Chapter 3: Comparative financial systems ........................................................... 39
Aims .......................................................................................................................... 39
Learning outcomes ...................................................................................................... 39
Essential reading ......................................................................................................... 39
Further reading ............................................................................................................ 39
References ................................................................................................................. 39
Introduction ............................................................................................................... 40
The evolution of financial systems ................................................................................ 43
The emergence of market-based and bank-based systems ............................................ 45
Market-based versus bank-based financial systems: implications .................................. 50
Financial crises ............................................................................................................ 53
Financial bubbles ......................................................................................................... 59
Summary ..................................................................................................................... 61
Key terms .................................................................................................................... 62
A reminder of your learning outcomes .......................................................................... 62
Sample examination questions ..................................................................................... 62
24 Principles of banking and finance
ii
Part II: Principles of banking ................................................................................ 63
Overview ..................................................................................................................... 63
Chapter 4: Role of financial intermediation ........................................................ 65
Aims ........................................................................................................................... 65
Learning outcomes ...................................................................................................... 65
Essential reading ......................................................................................................... 65
Further reading ............................................................................................................ 65
References ................................................................................................................. 65
Introduction ................................................................................................................ 66
Some evidence on financial intermediation .................................................................. 67
Why do financial intermediaries exist? ......................................................................... 68
Asset transformation ................................................................................................... 69
Transaction costs ......................................................................................................... 71
Liquidity needs .......................................................................................................... 72
Asymmetric information: adverse selection and moral hazard ....................................... 73
What is the future for financial intermediaries? ............................................................ 82
Summary ..................................................................................................................... 86
Key terms .................................................................................................................... 87
A reminder of your learning outcomes .......................................................................... 87
Sample examination questions ..................................................................................... 87
Chapter 5: Regulation of banks ........................................................................... 89
Aims .......................................................................................................................... 89
Learning outcomes ...................................................................................................... 89
Essential reading ......................................................................................................... 89
Further reading ............................................................................................................ 89
References ................................................................................................................. 90
Introduction ................................................................................................................ 90
Free banking ............................................................................................................... 90
Why do banks need regulations? ................................................................................. 92
Arguments against regulation ..................................................................................... 95
Traditional regulation mechanisms .............................................................................. 96
Alternatives to traditional regulation: disclosure-based regulation of banking ............. 108
International banking regulation ................................................................................ 110
Summary ................................................................................................................... 111
Key terms .................................................................................................................. 112
A reminder of your learning outcomes ........................................................................ 112
Sample examination questions ................................................................................... 112
Chapter 6: Risk management in banking ........................................................... 115
Aims ........................................................................................................................ 115
Learning outcomes .................................................................................................... 115
Essential reading ....................................................................................................... 115
Further reading .......................................................................................................... 115
References ............................................................................................................... 115
Introduction .............................................................................................................. 116
Taxonomy of risk ....................................................................................................... 116
Policies to reduce risk ................................................................................................ 120
Credit risk management............................................................................................. 120
Interest rate risk management ................................................................................... 125
Summary ................................................................................................................... 134
Key terms .................................................................................................................. 134
Contents
iii
A reminder of your learning outcomes ........................................................................ 135
Sample examination questions ................................................................................... 135
Part III: Principles of finance .............................................................................. 137
Overview ................................................................................................................... 137
Chapter 7: Capital budgeting and valuation ...................................................... 139
Aims ......................................................................................................................... 139
Learning outcomes .................................................................................................... 139
Essential reading ....................................................................................................... 139
Further reading ......................................................................................................... 139
Introduction .............................................................................................................. 140
The concept of present value ..................................................................................... 140
Net present value (NPV) and the valuation of real assets ............................................ 142
Other real asset appraisal techniques ......................................................................... 144
Valuation of financial assets (securities) ..................................................................... 150
Common stocks (i.e. ordinary shares) ......................................................................... 152
Summary ................................................................................................................... 155
Key terms .................................................................................................................. 155
A reminder of your learning outcomes ........................................................................ 155
Sample examination questions ................................................................................... 156
Chapter 8: Securities and portfolios – risk and return ....................................... 159
Aims ........................................................................................................................ 159
Learning outcomes .................................................................................................... 159
Essential reading ....................................................................................................... 159
Further reading ......................................................................................................... 159
References ................................................................................................................ 160
Introduction .............................................................................................................. 160
Risk and return of a single financial security ............................................................... 160
Risk and return of a portfolio: portfolio analysis .......................................................... 164
Benefits of diversification ........................................................................................... 165
Mean-standard deviation portfolio theory .................................................................. 166
Asset pricing models .................................................................................................. 171
Arbitrage Pricing Theory (APT) .................................................................................... 177
Summary ................................................................................................................... 180
Key terms .................................................................................................................. 181
A reminder of your learning outcomes ........................................................................ 181
Sample examination questions ................................................................................... 181
Chapter 9: Financial markets – transmission of information ............................. 183
Aims ........................................................................................................................ 183
Learning outcomes .................................................................................................... 183
Essential reading ....................................................................................................... 183
Further reading ......................................................................................................... 183
References ................................................................................................................ 184
Introduction .............................................................................................................. 184
Informational efficient markets................................................................................... 185
Concept of excess returns .......................................................................................... 187
Levels of informational market efficiency: weak, semi-strong and strong forms ............ 188
Empirical evidence on efficient markets ...................................................................... 190
Summary ................................................................................................................... 197
Key terms .................................................................................................................. 197
24 Principles of banking and finance
iv
A reminder of your learning outcomes ........................................................................ 197
Sample examination questions ................................................................................... 198
Appendix 1: Solutions to numerical activities .................................................... 199
Answers to ‘Activities’ marked with an asterisk ........................................................... 199
Chapter 5 .................................................................................................................. 199
Chapter 6 .................................................................................................................. 199
Chapter 7 .................................................................................................................. 200
Chapter 8 .................................................................................................................. 201
Chapter 9 .................................................................................................................. 202
Appendix 2: Sample examination paper ............................................................ 203
Chapter 1: Introduction
1
Chapter 1: Introduction
General introduction to the subject
This subject guide provides an introduction to 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.
The contents of the subject guide can be broken down into three main parts:
• In Part I, we investigate the structure and functions of financial
systems. We focus on each of the three main entities that compose
a financial system: financial intermediaries, securities and financial
markets. We then investigate the difference in the relative importance
of financial intermediaries and financial markets around the world,
and thus propose a historical and economic investigation of the reasons
behind the emergence of bank-based systems and market-based
systems in different countries.
• In Part II, we examine the issues that come under the broad heading
of principles of banking. Here we examine the key economic reasons
used to justify the existence of financial intermediaries (and specifically
banks). We then investigate the special nature of banking regulation.
Finally we outline the key risks in banking and the main methods
used for risk management. Thus the areas covered include the role
of financial intermediation, banking regulation and banking risk
management.
• In Part III, we move to the issues known as principles of finance. Here
we will examine the techniques used by firms to value real investment
projects, and the models used by investors to value bonds and stocks.
We then investigate the issues related to the formation of an optimal
portfolio by investors, and we derive the main equilibrium asset
pricing models. Finally, we investigate the efficiency of the market in
pricing securities, and thus we propose a theoretical and empirical
validation of the efficient market hypothesis. The areas covered in
this section therefore include capital budgeting, securities valuation,
mean-standard deviation portfolio theory, asset pricing models and
informational market efficiency.
24 Principles of banking and finance is a compulsory course for
the BSc Banking and Finance. This is an important subject because it
establishes many of the fundamental concepts in banking and finance that
will be developed in later subjects in the degree, such as 92 Corporate
finance, 29 Financial intermediation and 143 Valuation and
securities analysis.
Note that the guide uses mainly US references, takes a US view and uses
US terminology.
Learning outcomes
By the end of this subject guide, and having done the relevant readings
and activities, you should be able to:
• discuss why financial systems exist, and how they are structured
24 Principles of banking and finance
2
• explain why the relative importance of financial intermediaries and
financial markets is different around the world, and how bank-based
systems differ from market-based systems
• understand why financial intermediaries exist, and discuss the role of
transaction costs and information asymmetry theories in providing an
economic justification
• explain why banks need regulation, and illustrate the key reasons for
and against the regulation of banking systems
• discuss the main types of risks faced by banks, and use the main
techniques employed by banks to manage their risks
• explain how to value real assets and financial assets, and use the key
capital budgeting techniques (Net Present Value and Internal Rate of
Return)
• explain how to value financial assets (bonds and stocks)
• understand how risk affects the return of a risky asset, and hence how
risk affects the value of the asset in equilibrium under the fundamental
asset pricing paradigms (Capital Asset Pricing Model and Asset Pricing
Theory)
• discuss whether stock prices reflect all available information, and
evaluate the empirical evidence on informational efficiency in financial
markets.
Essential reading
The following text has been chosen as the core text for this subject guide,
due to its extensive treatment of many (but not all) of the issues covered
in the subject guide and its up-to-date discussions:
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) sixth edition [ISBN 978032155112].
However, this core text does not cover the material for the entire subject
guide.
To analyse comparative financial systems, the essential reading also
includes:
Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) [ISBN 9780262511254].
To investigate issues of principles of finance (capital budgeting and
valuation of financial assets, risk and return of financial assets and
portfolios), the following text is also essential reading:
Brealey, R.A, S.C. Myers and F. Allen Principles of corporate finance. (Boston,
London: McGraw-Hill/Irwin, 2010) tenth (global) edition
[ISBN 9780071314176] Chapters 2, 3, 4, 5, 7, 8, 13 and 14.
The subject guide must be used in conjunction with these three essential
textbooks. At the head of each chapter of this guide, we indicate essential
reading from Mishkin and Eakins. Alternatively, when no relevant readings
are available in Mishkin and Eakins, we indicate reading from either Allen
and Gale or Brealey, Myers and Allen.
Several websites are indicated in the subject guide, mainly as references
for activities you are required to do. Please visit these websites whenever
indicated.
The following articles from academic journals are also indicated as
Essential reading in Chapters 5 and 6:
Chapter 1: Introduction
3
Dow, S. ‘Why the banking system should be regulated’, Economic Journal 106
(436) 1996, pp.698–707.
Dowd, K. ‘The Case for Financial Laissez-Faire’, Economic Journal 106 (436)
1996, pp.679–87.
Gordy, M.B. ‘A comparative anatomy of credit risk models’, Journal of Banking
and Finance 24 (1-2) 2000, pp.119–49.
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Bain, A.D. The Economics of the Financial Systems. (Oxford: Blackwell Publishers
Ltd, 1992) [ISBN 9780631181972] Chapter 4.
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (Boston,
London: McGraw-Hill/Irwin, 2008) tenth edition [ISBN 9780073368696]
Chapter 8.
Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004) fourth edition [ISBN 9780719067723]
Chapters 1, 2 and 17.
Copeland, T.E., J.F. Weston and K. Shastri Financial Theory and Corporate Policy.
(Boston, London: Pearson Addison Wesley, 2005)
[ISBN 9780321223531] Chapters 2, 4, 5, 6 and 10.
Elton, E.J., M.J. Gruber, S.J. Brown and W.N. Goetzmann Modern Portfolio
Theory and Investment Analysis. (New York: John Wiley & Sons, 2007)
seventh edition [ISBN 9780470050828] Chapter 17, pp.59 and 61.
Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.:
The MIT Press, 2008) [ISBN 9780262061933] Chapters 2, 8 and 9.
Grinblatt, M. and S. Titman Financial Markets and Corporate Strategy
(Boston, London: McGraw-Hill/Irwin, 2002) second edition [ISBN
9780072294330] Chapters 4, 5, 6, 9 and 10.
Heffernan, S. Modern Banking in Theory and Practice. (Chichester: John Wiley
and Sons, 2005) [ISBN 9780471962090] Chapters 2, 3, 4 and 5.
Luenberger, D.G. Investment Science. (New York: Oxford University Press, 1998)
[ISBN 9780195108095] Chapters 6 and 7.
Saunders, A. and M.M. Cornett Financial Institutions Management: a Risk
Management Approach. (New York: McGraw-Hill/Irwin, 2007) sixth edition
[ISBN 9780077211332] Chapters 2–6 and 8–12.
Sinkey, J.F. Commercial Bank Financial Management in the Financial-Services
Industry. (Upper Saddle River, NJ: Pearson Education Inc., 2002)
[ISBN 9780130984241] Chapter 16.
Smart, S.B., W.L. Megginson and L.J. Gitman Corporate Finance. (Mason, Ohio:
South-Western/Thomson Learning, 2004) [ISBN 9780324269604]
Chapters 4, 7 and 10.
24 Principles of banking and finance
4
References
For certain topics, we will also list journal articles or texts as
supplementary references to the additional reading. It is not essential
that you read this material, but it may be helpful if you wish to better
understand some of the topics in this subject guide.
A full bibliography of the supplementary references is provided below:
Akerlof, G. ‘The Market for “Lemons”: Quality, Uncertainty and the Market
Mechanisms’, Quarterly Journal of Economics 84(3) 1970, pp.488–500.
Allen, F. and R. Karjalainen ‘Using Genetic Algorithms to Find Technical Trading
Rules’, Journal of Financial Economics 51(2) 1999, pp.245–71.
Altman, E.I. ‘Managing the commercial lending process’ in Aspinwall, R.C. and
R.A. Eisenbeis Handbook of Banking Strategy. (New York: John Wiley and
Sons, 1985) [ISBN 9780471893141] pp.473–510.
Ball, R. and P. Brown ‘An Empirical Evaluation of Accounting Income Numbers’,
Journal of Accounting Research 6(2) 1968, pp.159–78.
Bank of England Discussion Paper ‘The role of macroprudential policy’,
November 2009. Available at www.bankofengland.co.uk/publications/
news/2009/111.htm
Bank of England Financial Stability Report, no. 21 (London, 2007).
Basel Committee on Bank Supervision Overview on the New Capital Accord.
(Bank for International Settlements, January 2001) p.27.
Benston G. and C. Smith ‘A Transaction Costs Approach to the Theory of
Financial Intermediation’, Journal of Finance 31(2) 1976, pp.215–231.
Bernard, V. and J. Thomas ‘Post-earnings announcement drift: Delayed price
response or risk premium?’, Journal of Accounting Research 27(3) 1989
supplement, pp.1–36.
Boyd, J.H. and M. Gertler ‘Are Banks Dead? Or Are the Reports Greatly
Exaggerated?’ in The Declining(?) Role of Banking. (Chicago: Federal
Reserve Bank of Chicago, 1994).
Brock, W., J. Lakonishok and B. LeBaron ‘Simple Technical Trading Rules and
the Stochastic Properties of Stock Returns’, Journal of Finance 47(5) 1992,
pp.1731–764.
Bullard. J, J. Neely and D. Wheelock ‘Systemic risk and the financial crisis: a
primer’, Federal Reserve Bank of St. Louis Review, September/October 2009,
pp.403-17.
Carhart, M.M. ‘On Persistence in Mutual Fund Performance’, Journal of Finance
52(1) 1997, pp.57–82.
Chan, K.C., N. Chen and D. Hsieh ‘An Exploratory Investigation of the Firm Size
Effect’, Journal of Financial Economics 14(3) 1985, pp.451–71.
Chen, N. ‘Some Empirical Tests of the Theory of Arbitrage Pricing’, Journal of
Finance 38(5) 1983, pp.1393–414.
Chen, N., R. Roll and S. Ross ‘Economic Forces and Stock Market’, Journal of
Business 59(3) 1986, pp.383–403.
Cheng-few L., D.C. Porter and D.G. Weaver ‘Indirect tests of the Haugen-
Lakonishok small-firm/January effect hypotheses: window dressing versus
performance hedging’, The Financial Review (1998) 33, pp.177–94.
Coase, R.H. ‘The Problem of Social Cost’, Journal of Law and Economics 3(1)
1960, pp.1–23.
Corbett, J. and T. Jenkinson ‘How Is Investment Financed? A Study of Germany,
Japan and the United States’, Manchester School of Economics and Social
Studies 65 (1997) supplement, pp.69–93.
DeBondt, F.M. and R. Thaler ‘Further Evidence on Investor Overreaction and
Stock Market Seasonality’, Journal of Finance 42(3) 1987, pp.557–80.
Diamond, D.W. ‘Financial Intermediation and Delegated Monitoring’, Review of
Economic Studies 51(166) 1984, pp.393–414.
Chapter 1: Introduction
5
Diamond, D.W. ‘Financial Intermediation as Delegated Monitoring: A Simple
Example’, Federal Reserve Bank of Richmond Economic Quarterly, 82/3,
1996, pp.51-66.
Diamond, D.W. and P.H. Dybvig ‘Bank Runs, Deposit Insurance, and Liquidity’,
Journal of Political Economy 91(3) 1983, pp.401–419.
Dimson, E., P. Marsh, and M. Staunton ‘Global evidence on the equity risk
premium’, Journal of Applied Corporate Finance 15(4) 2003, pp.27–38.
Dow, S., ‘Why the banking system should be regulated’, Economic Journal 106
(436) 1996, pp.698–707.
Dowd, K., ‘The Case for Financial Laissez-Faire’, Economic Journal 96(106)
1996, pp.679–87.
Fama, E. ‘Efficient Capital Markets: A Review of Theory and Empirical Work’,
Journal of Finance 25(2) 1970, pp.383–417.
Fama, E. ‘Banking in the theory of finance’, Journal of Monetary Economics 6(1)
1980, pp.39–57.
Fama, E. and K.R. French ‘Permanent and Temporary Components of Stock
Prices’, Journal of Political Economy 96(2) 1988, pp.246–73.
Fama, E. ‘Efficient Capital Markets: II’, Journal of Finance 46(5) 1991, pp.1575–
618.
Freixas, X, C. Giannini, G. Hoggart and F. Soussa ‘Lender of Last Resort: A
Review of the Literature’, Bank of England Financial Stability Review,
November 1999.
Goddard, J.A., P. Molyneux and J.O.S. Wilson European Banking. Efficiency,
Technology and Growth. (Chichester: John Wiley & Sons, 2001) [ISBN
9780471494492] pp.109–20.
Gordy, M.B. ‘A comparative anatomy of credit risk models’, Journal of Banking
and Finance 24(1–2) 2000, pp.119–49.
Grinblatt, M. and S. Titman ‘Mutual Fund Performance: an Analysis of
Quarterly Portfolio Holdings’, Journal of Business 62(3) 1989, pp.393–416.
Gurley, J.G. and E.S. Shaw Money in a Theory of Finance. (Washington D.C.:
Brookings Institute, 1960) [ISBN 9780815733225].
Hackethal, A. and R.H. Schmidt ‘Financing Patterns: Measurement Concepts
and Empirical Results’, Frankfurt Department of Finance Working Paper no.
125 (2004), p.30.
Haugen, R. and J. Lakonishok The Incredible January Effect. (Dow Jones-Irwin,
Homewood, Illinois, 1988) [ISBN 9781556238710].
Jacquier, E., A. Kane and A.J. Marcus ‘Geometric or Arithmetic Means: A
Reconsideration’, Financial Analysts Journal 59(6) 2003, pp.46–53.
Jegadeesh, N. and S. Titman ‘Returns to Buying Winners and Selling Losers:
Implications for Stock Market Efficiency’, Journal of Finance 48(1) 1993,
pp.65–91.
Jensen, M.C. ‘The performance of Mutual Funds in the Period 1945–64’,
Journal of Finance 23(2) 1968, pp.389–416.
Jensen, M.C., and W.H. Meckling ‘Theory of the firm: managerial behavior,
agency costs and ownership structure’, Journal of Financial Economics 3(4)
1976, pp.305–60.
Kay, J. ‘Narrow banking: the reform of banking regulation’, Centre for the study
of Financial Innovation, publication no. 88, September 2009.
Keim, D.B. ‘The CAPM and Equity Return Regularities’, Financial Analysts
Journal 42(3) 1986, pp.19–34.
Lacoste, P. ‘International capital flows in Argentina’, BIS Papers no. 23 (http://
www.bis.org/publ/bppdf/bispap23e.pdf, 2004)
Leland, H.E. and D.H. Pyle ‘Informational Asymmetries, Financial Structure,
and Financial Intermediation’, Journal of Finance 32(2) 1977, pp.371–387.
Lindgren, C., G. Garcia and M. Saal Bank Soundness and Macroeconomic Policy.
(Washington DC: International Monetary Fund, 1996)
[ISBN 9781557755995].
24 Principles of banking and finance
6
Lintner, J. ‘The Valuation of Risk Assets and the Selection of Risky Investments
in Stock Portfolios and Capital Budgets’, Review of Economics and Statistics
47(1) 1965, pp.13–37.
Lo, A. and C. MacKinlay ‘Stock Market Prices do not Follow Random Walks:
Evidence from a Simple Specification Test’, Review of Financial Studies 1(1)
1988, pp.41–66.
Markowitz, H.M. ‘Portfolio Selection’, Journal of Finance 7(1) 1952, pp.77–91.
Mayer, C. ‘Financial Systems, Corporate Finance, and Economic Development’
in Hubbard, R.G. (ed.) Asymmetric Information, Corporate Finance, and
Investments. (Chicago: University of Chicago Press, 1990)
[ISBN 9780226355856] pp.307–32.
Mortlock, G. ‘New Zealand’s financial sector regulation’, Reserve Bank of New
Zealand: Bulletin 66 (2003), pp.5–49.
Patell, J.M. and M.A. Wolfson ‘The Intraday Speed of Adjustment of Stock
Prices to Earnings and Dividend Announcements’, Journal of Financial
Economics 13(2) 1984, pp.223–52.
Poterba, J.M. and L.H. Summers ‘Mean Reversion in Stock Prices: Evidence and
Implications’, Journal of Financial Economics 22(1) 1988, pp.27–59.
Roll, R. ‘A Critique of the Asset Pricing Theory’s Tests; Part 1: On Past and
Potential Testability of the Theory’, Journal of Financial Economics 4(2)
1977, pp.129–76.
Ross, S.A. ‘The Arbitrage Theory of Capital Asset Pricing’, Journal of Economic
Theory 13(3) 1976, pp.341–60.
Sharpe, W.F. ‘Capital Asset Prices: A Theory of Market Equilibrium under
Conditions of Risk’, Journal of Finance 19(3) 1964, pp.425–42.
Trueman, B., M.H. Wong and X.J. Zhang ‘The Eyeballs Have it: Searching for
the Value in Internet Stocks’, Working Paper, (University of California, April
2000).
Turner, A ‘The Turner Review: A regulatory response to the global banking
crisis’, Financial Services Authority, 2009. (download from www.fsa.gov.uk/
pubs/other/turner_review.pdf)
Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should receive your login details in your study pack. If you have not,
or you have forgotten your login details, please email uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Self-testing activities: Doing these allows you to 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.
Chapter 1: Introduction
7
• Past examination papers and Examiners’ commentaries: These provide
advice on how each examination question might best be answered.
• A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
• Videos: There are 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.
• Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
Unless otherwise stated, all websites in this subject guide were accessed in
2008. We cannot guarantee, however, that they will stay current and you
may need to perform an internet search to find the relevant pages.
The structure of the subject guide
Part I of the subject guide focuses on financial systems, Part II addresses
the key principles of banking and Part III investigates the principles of
finance. The content of the subject guide is as follows.
Part I: Financial systems
• Chapter 2 serves as grounding to financial systems by investigating the
functions and structure of financial systems. It thus focuses on each
of the three main entities that compose financial systems (financial
intermediaries, securities and financial markets).
• Chapter 3 presents a discussion of the features of bank-based systems
against market-based systems in different countries around the world.
24 Principles of banking and finance
8
Part II: Principles of banking
• Chapter 4 focuses specifically on the nature and process of financial
intermediation by presenting a discussion of the key theories of
financial intermediation (transformation of assets, uncertainty,
reduction in transaction costs, reduction of problems arising out of
asymmetric information).
• Chapter 5 provides an investigation of 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 presents discussion of the key risks in banking (credit risk,
interest rate risk, market risk and liquidity risk) and the main methods
of risk management in banks (such as screening, monitoring, duration
gap analysis, value-at-risk).
Part III: Principles of finance
• Chapter 7 outlines the concept and techniques of capital budgeting and
securities valuation. It focuses first on the valuation of real investment
projects using the Net Present Value (NPV), and provides a comparison
of NPV with alternative techniques. Then it moves to the models used
for the valuation of bonds and stocks.
• Chapter 8 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 focuses on the efficiency of financial markets by providing a
theoretical derivation of the concepts of weak, semi-strong, and strong
efficiency. It then moves to the discussion of the empirical evidence in
favour of and against market efficiency.
How to use this subject guide
This subject guide is written for students studying 24 Principles of
banking and finance. The aim is to help you to interpret the syllabus.
It tells you what you are expected to know for each area of the syllabus
and suggests the reading which will help you understand the material. It
must be emphasised that this guide is intended to supplement the essential
textbooks, not replace them.
A different chapter is devoted to each major section of the syllabus and the
chapter order of this guide follows the order of the topics as they appear in
the syllabus.
You need to appreciate that different topics are not self-contained. There is
a degree of overlap between the topics and you are guided in this through
cross-referencing between different chapters in the guide. However, in
terms of studying this guide, the chapters are designed as self-contained
units of study, but for examination purposes you need to have an
understanding of the subject as a whole.
We suggest that for each topic in the syllabus, you first read through the
whole of the chapter in this guide to get an overview of the material to
be covered. Then reread the chapter and follow up the suggestions for
reading in the essential reading or further reading. After this you should
work through the activities.
Chapter 1: Introduction
9
Structure of each chapter
At the beginning of each chapter, you will find a list of aims and learning
outcomes. These tell you what you can expect to learn from that chapter
of the subject guide and the relevant reading. You need to pay close
attention to the learning outcomes and use them to check that you have
fully understood the topics.
You will then find the essential reading, further reading, and references.
The list of essential reading indicates what you need to read as a minimum
in order to cover the syllabus. Once you have read a chapter, check that
you have covered all the essential reading.
Each chapter contains ‘Activities’ which apply what you have just learnt in
a practical way. Activities are heterogeneous: they include the analysis of
institutional website material, numerical exercises and further readings on
the texts. It is very important that you do these activities. For numerical
activities (marked with an asterisk*) we provide answers in Appendix 1 at
the end of the guide.
Throughout the guide, there are a lot of key terms, all detailed in the
‘Key terms’ section at the end of each chapter. Compile your own glossary
with full definitions and comments on each of these terms, and use it for
revision.
At the end of each chapter, look out for sample examination questions,
similar to those asked in the final examination. We recommend that you
try these sample examination questions during your revision.
Examination
Important: the information and advice given in the following section
are based on the examination structure used at the time the guide was
written. Please note that subject guides may be used for several years.
Because of this we strongly advise you always to check both the current
Regulations for relevant information about the examination, and the VLE
where you should be advised of any forthcoming changes. You should also
carefully check the rubric/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.
The Principles of banking and finance examination paper is three
hours in duration. You will be asked to answer four questions from a
choice of eight. The examination paper is in two sections. You will be
required to answer one question from Section A, one from Section B and
two further questions from either section. The Examiners ensure that all
the topics covered in the syllabus are examined.
Section A of the exam essentially tests your understanding of concepts
and theories from the syllabus. The questions in Section A are therefore
discursive and generally split into two or three parts. In answering Section
A questions Examiners will be looking for evidence of your understanding
of the concept or theory being asked about. The subject guide sets out
the essential points of theories/concepts that you can draw upon in
24 Principles of banking and finance
10
answering the question. The essential reading and further reading texts go
into further detail on these concepts and theories and you will generally
be expected to go deeper into the subject matter than that set out in
the subject guide if you want to get a very good mark. Please also note
that evidence of understanding of a theory or concept may sometimes
be demonstrated by the use of a relevant example. Examiners will also
reward answers that show an up-to-date knowledge of a topic. For
example, the regulation of banking is fast changing and the material in
the subject guide may not be fully up-to-date when you read it. Keeping
up-to-date with developments in relation to the topic areas of the syllabus
will provide you with an opportunity to demonstrate to Examiners your
understanding of the topic area.
Section B of the exam essentially tests your understanding of the
application of finance concepts and tools. As in Section A the questions in
Section B are split into a number of parts with some parts requiring you
to calculate something and other parts testing your understanding of the
techniques being applied or your understanding of the answers you have
calculated. Therefore to answer a Section B question fully requires you to
understand how to apply techniques to the data given in the question in
an appropriate way, to understand the assumptions and limitations of the
technique you are using and to be able to interpret your calculated answer.
Examples of section A type questions are provided at the end of Chapters
2, 3, 4, 5 and 9. Examples of section B type questions are provided at the
end of Chapters 6, 7 and 8 and 9.
You have to answer four questions, giving you 45 minutes to spend on
each question. You should attempt all parts or aspects of a question. Pay
attention to the breakdown of marks associated with the different parts
of each question. Some questions may contain both numerical and essay-
based parts. Examples of these types of questions (or question parts) are
provided at the end of each chapter of this subject guide.
• 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.
• Please use material only when relevant to the question. Answers
including a large amount of irrelevant material are likely to be marked
down.
• Answers that simply repeat the subject guide material in a relevant way
may be given a pass at best.
• Answers with a clear structure, a good understanding of the material
and originality in the approach are likely to achieve a good mark.
A Sample examination paper is provided in Appendix 2 to this guide.
Chapter 1: Introduction
11
Syllabus
Part I: Financial systems
1. Introduction to financial systems: Role of financial systems (role
of households, government and firms in terms of savings and
investments). Financial intermediaries, securities and markets.
Taxonomy of financial institutions. Nature of financial claims (debt
versus equity, bonds and notes, fixed and floating interest rates,
common and preferred stocks). Structure of financial markets (direct
and indirect finance, dealers and brokers, banks, mutual funds, pension
funds and insurance companies).
2. Comparative financial systems: Bank-based systems against market-
based systems. Legal aspects.
Part II: Financial intermediaries
3. Role of financial intermediation: Nature and process of financial
intermediation. Theories of financial intermediation (transformation
of assets, uncertainty, reduction in transaction costs, reduction of
problems arising out of symmetric information). Implications of
financial intermediation (Hirshleifer model, effect on economic
development).
4. Regulation of banks: Regulation of banks (free banking, arguments for
and against regulation, traditional regulation mechanisms, alternatives
to traditional regulation).
5. Risk management in banking: Market risks: liquidity risk, interest rate
risk, foreign exchange risk. Credit risk: screening and monitoring,
credit rationing, collateral.
Part III: Principles of finance
6. Financial securities: Risk and return; Portfolio analysis: mean-variance
portfolio theory. The portfolio selection process: the correlation of
securities returns (single-index model and multi-index models). Asset
pricing models: capital asset pricing models (CAPM) and arbitrage
pricing theory (APT).
7. Capital budgeting: Pricing of bonds and stocks. Net pricing value.
Project appraisal.
8. Financial markets: Transmission of information; Efficient markets.
Theory and empirical evidence. Concepts of weak, semi-strong and
strong efficiency. Concepts of excess return. Micro-structures.
Notes
24 Principles of banking and finance
12
Part I: Financial systems
13
Part I: Financial systems
Overview
Before we introduce you to the Principles of banking (Part II) and to
the Principles of finance (Part III), we begin our analysis by examining
financial systems. Two main areas of interest are investigated:
• What role does a financial system play in an economy? What is the
structure of a financial system? (Chapter 2)
• How does the structure of financial systems differ across countries
worldwide? (Chapter 3)
We answer these questions in Part I.
Notes
24 Principles of banking and finance
14
Chapter 2: Introduction to financial systems
15
Chapter 2: Introduction to financial
systems
Aims
The aim of this chapter is to investigate financial systems from both a
functional and a structural perspective. We set out a taxonomy of financial
intermediaries, securities and financial markets, and give an overview of
the peculiarities of national financial systems.
Learning outcomes
By the end of this chapter, and having completed the essential readings
and activities, you will be able to:
• explain why financial systems exist (i.e. explain the functions of
financial systems)
• outline the structure of financial systems (i.e. describe the three main
entities that compose financial systems: financial intermediaries,
securities and financial markets)
• describe which financial intermediaries operate in financial systems
in the USA in particular and, more generally, around the world (e.g.
depository institutions, contractual savings institutions and investment
intermediaries) and explain their characteristics
• explain which financial securities are traded on financial markets
(bonds, notes, bills and stocks), and explain their nature
• discuss the various theories that attempt to explain the shape of the
yield curve
• explain the structure of financial markets in the USA and around
the world (primary versus secondary markets, money versus capital
markets, organised versus over-the-counter markets, quote-driven
dealer markets versus order-driven markets and brokered markets).
Essential reading
Allen, F. and D. Gale Comparing Financial Systems. (Cambridge, Mass.: MIT
Press, 2001) Chapter 3.
Mishkin, F. and S. Eakins Financial Markets and Institutions. (Boston, London:
Addison Wesley, 2009) Chapters 1, 2 and 10.
Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (Boston,
London: McGraw-Hill/Irwin, 2010) Chapter 14.
Buckle, M. and J. Thompson The UK Financial System. (Manchester:
Manchester University Press, 2004) Chapter 1.
Freixas, X. and J.C. Rochet Microeconomics of Banking. (Boston, Mass.: The MIT
Press, 2008) Chapter 2.
Saunders, A. and M.M. Cornett Financial Institutions Management: a Risk
Management Approach. (New York, McGraw-Hill/Irwin, 2007) Chapters 2,
3, 4, 5 and 6.
24 Principles of banking and finance
16
Introduction
We start the unit with an overview of financial systems, their functions and
general structure. Then we investigate the nature and characteristics of the
three major entities that compose financial systems. These are financial
intermediaries, securities and financial markets. We will return to a more
detailed investigation of each of these entities in later chapters.
In our review of different countries, we restrict ourselves to large
economies with well-developed financial systems, notably the USA, UK,
France and Germany. Specifically, we take a US view and US terminology,
therefore in Part I other countries are compared with the US system.
Functions of financial systems
Financial systems perform the essential economic function of channelling
funds from units who have saved surplus funds to units who have a
shortage of funds. The units who have saved can lend funds: they are
known as lender-savers. The units with a shortage of funds must borrow
funds to finance their spending: they are the borrower-spenders. The
most important lender-savers are usually households; while the typical
borrower-spenders are firms and the government.
The channelling of funds from savers to spenders is very important for two
reasons:
• First, lender-savers (with excess of available funds) do not frequently
have profitable investment opportunities, while borrower-spenders
have investment opportunities but lack of funds.
• Second, even for purposes other than investment opportunities
in businesses, borrower-spenders may want to invest in excess
of their current income or to adjust the composition of their
wealth (reconciliation of the preferences for current versus future
consumption).
In direct finance, borrower-spenders borrow funds directly from lenders
in the financial markets by selling them securities. In indirect finance,
a financial intermediary stands between the lender-savers and the
borrower-spenders: the intermediary helps to transfer funds from one
to the other. This suggests that financial markets and intermediaries are
alternatives that perform more or less the same function but in different
ways (and perhaps with different degrees of success). Note, however,
that the process of indirect finance, known as financial intermediation, is
the most important way of transferring funds from lenders to borrowers.
This contrasts with the attitude of the media to focus mainly on financial
markets (as discussed in Chapter 4).
Another important function of a financial system is the monetary function.
The introduction of money into the economy enables savers and spenders
to separate the act of sale from the act of purchase and allows them to
overcome the main problem of barter, which is the ‘double coincidence
of wants’ (each of the two parties involved in a transaction has to want
simultaneously the good the other party is offering to exchange). The
financial system provides a variety of payment mechanisms e.g. cheques,
debit cards and credit cards to enable one party to pay another.
Financial systems also provide mechanisms for risk to be transferred. For
example insurance contracts allow a party such as a firm or household to
transfer the risk of loss of wealth due to theft or fire to another party such
as an insurance company. The firm or household will pay a fee (insurance
premium) for this transfer. The insurance company, by providing a large
Chapter 2: Introduction to financial systems
17
number of insurance contracts, is better able to manage the risk than an
individual firm or household as they can obtain benefits of pooling and
diversification. Thus a more efficient allocation of risk results.
In short, the main functions of financial systems are to:
• provide the mechanisms by which funds can be transferred from units
in surplus to units with a shortage of funds in order to directly or
indirectly facilitate lending and borrowing (as shown in Figure 2.1)
• enable wealth holders to adjust the composition of their portfolios
• provide payment mechanisms
• provide mechanisms for risk transfer
Activity 2.1
Throughout this guide, there are a lot of key terms, all collected in the ‘Key terms’ section
at the end of each chapter. Compile your own glossary with full definitions and comments
on each of these terms, and use it for revision.
Figure 2.1: Direct and indirect lending performed by a financial system
The structure of financial systems: financial markets,
securities and financial intermediaries
From a structural point of view a financial system can be seen in terms
of the entities that compose the system. A financial system comprises
financial markets, securities and financial intermediaries.
Financial markets are markets in which funds are moved from
people who have an excess of available funds (and lack of investment
opportunities) to people who have investment opportunities (and lack
of funds). They also have direct effects on personal wealth, and the
behaviours of businesses and consumers. Therefore, they contribute
to increase the production and the efficiency in the overall economy.
Financial markets (such as bond and stock markets) are markets in which
securities are traded.
Securities (also called financial instruments) are financial claims on
the issuer’s future income or assets. They represent financial liabilities for
the individual or firm that sells them (borrower or issuer of the financial
claim) in return for money, and financial assets for the buyer (lender
or investor in the financial claim). By definition, therefore, the sum
of financial assets in existence will exactly equal the sum of liabilities.
Financial markets
Lenders
Borrowers
Financial intermediaries
INDIRECT

DIRECT
Securities


Cash


Cash


Cash

Deposits


Loans

24 Principles of banking and finance
18
Governments and corporations raise funds to finance their activities by
issuing debt instruments (bonds) and equity instruments (shares, known
in the USA as stocks). Bonds are securities that promise to make periodic
payments of a sum of money for a specified period of time. Stocks are
securities that represent a share of ownership in the firm.
Financial intermediaries are economic agents who specialise in the
activities of buying and selling (at the same time) financial contracts
(loans and deposits) and securities (bonds and stocks). Note that financial
securities are easily marketable, while financial contracts cannot be
easily sold (marketed). Banks form the largest financial institution in our
economy. They accept deposits (loans by individuals or firms to banks)
and make loans (sums of money lent by banks to individuals or firms):
therefore, they borrow deposits from people who have saved and in turn
make loans to others. In recent years, other financial intermediaries, such
as mutual funds, pension funds, insurance companies and investment
banks, have been growing at the expense of banks.
Taxonomy of financial intermediaries
We begin by looking at the USA, the largest economy and financial system
in the world. Later we will turn to other countries. In the USA the three
major groups of financial intermediaries are: depository institutions,
contractual savings institutions and investment intermediaries (for an
overview of financial intermediaries around the world refer to the next
section).
Depository institutions
Depository institutions: intermediaries with a significant proportion of
their funds derived from customer deposits – include: commercial banks –
savings institutions and credit unions.
Commercial banks
Commercial banks accept deposits (liabilities) to make loans (assets)
and to buy government securities. Deposits are broad in range, including
checkable deposits (deposits on which cheques can be written), sa