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APC312 Money Banking and Finance

Money, Banking and Finance APC312 1
Nguyen Thi Kieu Anh - ID. 149078874/1

Student ID: 149078874/1
Student Name: Nguyen Thi Kieu Anh
Module Code: APC 312
Module Name / Title: Money, Banking and Finance
Centre / College: Banking Academy of Viet Nam
Due Date: 16 Jan 2015

Hand in Date: 16 Jan 2015

Assignment Title: Individual assignment

Students Signature: (you must sign this declaring that it is all your own work and all sources of
information have been referenced)

Money, Banking and Finance APC312 2
Nguyen Thi Kieu Anh - ID. 149078874/1


Prepared by: Nguyen Thi Kieu Anh
Student ID: 149078874/1

Submission Date: 16 Jan 2015

Number of words:
Part A: 1,330
Part B: 1,516

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Part A: Discuss why banks need to be more regulated in terms of
risks they face compared to other financial firms

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INTRODUCTION ..................................................................................................................... 5
MAIN BODY............................................................................................................................. 5

The differences in terms of risks between banks and non-bank financial institutions ... 5


Form and cost of regulations........................................................................................... 7

CONCLUSION .......................................................................................................................... 8
REFERENCES .......................................................................................................................... 9

Money, Banking and Finance APC312 5
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In recent decades, the entire world economy plunged into a depression owing to the
wholesale collapse of financial system. The root of financial problems can be explained by
absence or reduction of governmental controls that allowed financial institutions to operate
beyond its range of activities, which so-called ‘deregulation’. Facing with the challenges in
stabilizing financial system and recovering the economy, the government was forced to step
forward in regulation, starting with regulating banks in terms of risks. This study will discuss
specifically the reason that banks need to be regulated in terms of risks they face compared to
other financial firms.
According to Herr and Kazandziska (2011, p.13), the financial system could be generally
divided into banks and non-bank financial institutions such as mortgage companies, insurance
companies, pension funds and investment banks…It is undeniable that banks offer wider
range of financial services than any financial institution. Banks accept deposits and create
credit, that is, banks circulate capital resources from savers (the surplus-spending units) to
borrowers (deficit-spending units) whereas non-bank financial institutions are not allowed to
take deposits from the public. Besides, banks also implement payment functions such as the
transfer of deposits, payment of cheques, credit and debit card…whereas non-bank financial
institutions play no direct role in payment system (Mbuya, 2008, p.22). This is also the
reason why banks are considered as the lifeblood of the economy. These two main activities
help to distinguish between banks and non-bank financial institutions as well as cause higher
level of risks and motivate for the entry of regulations in banking system compared to other
financial firms.
1. The differences in terms of risks between banks and non-bank financial institutions
The biggest difference in terms of risks between banks and non-bank financial institutions is
liquidity risk. Liquidity risk is a ‘hot topic’ in finance industry. It is the risk of not being able
to meet obligations in terms of funds demanded by clients (Faure, 2013). In the context of
banking system, it arises from both sides of the balance sheet of banks. Liabilities of banks
mainly are short-term funds of depositors which have to pay back on demand anytime,
especially sight deposits. Meanwhile assets of banks might be short or long term loans, but
whether short or long it also has longer maturity than liabilities. It is called ‘maturity
mismatch’ between assets and liabilities or can say that banks are engaged in the high degree
of maturity transformation (Howells, 2014, p.13). If the bank cannot balance assets and

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liabilities, banks will face illiquid risk as banks cannot liquidate customers’ unexpected need
for cash. When depositors doubts about the health of bank holding their money, they may
rush to withdraw cash from the bank. A “bank run” occurs leading to collapse of the bank.
Northern Rock - a British bank is a well-known example of liquidity crisis. Northern Rock
followed a ‘reckless business model’ where nearly 30% of its funding was bought-in shortterm wholesale funds that were used to finance long-term mortgage business (Financial
Times, no date). Such business model caused lack of liquidity and the bank run in 2007.
Unlike banks, non-bank financial institutions like life insurance companies only serves
customers at the liability side of balance sheet. It has a favorable liquidity position as illiquid
liabilities versus liquid assets, that is, life insurance companies just compensate the financial
risk as an agreement in event of untimely death of the policyholder which has long term
maturity while it can use pool of these funds to invest in liquid assets such as government and
corporate bonds which can sell anytime in case of unexpected event (Weert, 2011, p.23).
Hence, liquidity risk is higher for banks than non-bank financial institutions.
According to Altman (2013, p.548), liquidity risk tends to compound to other risks such as
credit risk, market risk…Credit risk is the risk that the borrower from a bank will default on
the loan/the interest payable or not perform in terms of the conditions under which the loan
was granted (Faure, 2013, p.93). Credit risk is inevitable so it remains biggest challenge for
banking sector. For example, the development of subprime mortgages market in US caused
credit crunch in 2008 since large number of borrowers was unable to meet their mortgage
repayments. This, in turn, result in liquidity crisis in banks (Davies, 2014). Market risk
arises when there is a decline in the market value of financial securities (share, debt and
derivatives) that caused by unexpected changes in market prices, interest rates…(Faure, 2013,
p.84). Competition in banking industry creates incentives for banks to expand their trading
activities by holding larger financial securities. This development leads to illiquid risk or
even collapse of the bank when there is a sudden decline in those financial instruments.
Indeed, by late 2007, mortgage-backed securities slumped in value, a lot of banks suffer
losses such as Citygroup: $40.7 billion, UBS: $38 billion, HSBC: $15.6 billion… (BBC,
2008). It threatens to liquidity of banks and led to the collapse of Northern Rock in UK. Nonbank financial institutions also face credit risk and market risk, however, banks demand
deposit so banks are subject to restrictions on their activities compared to other financial

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Furthermore, these risks affect not only one bank but also the entire banking system. The
collapse of one bank causes a loss of confidence in banking in general, creates bad debts for
other banks and widespread collapse (financial panics). This is called “systemic risk” or
“risk of contagion” (Howells and Bain, 2007, p.362). Besides, it would cause delay of
payment system resulting in significant disruptions in aggregate economic activity,
especially import and export activities which bring great economic benefits for all countries.
Thus, it requires to impose regulations to ensure stability and soundness of the payment
A special case for intervention of regulations in banking industry is to protect customers as
well as ensure the soundness of banking system from the informational imbalances or
‘asymmetric information’. Asymmetric information occurs between depositors and banks.
Depositors are unable to define the bank holding their deposit is good or bad bank until they
cannot withdraw cash on demand. It causes adverse selection as customers have little choices
and have high demand in holding deposits as means of payment. Besides, as key player in
payment system, banks have incentives to use mobilizing funds from customers to invest in
risky assets to earn profits, which so-called moral hazard. On the other hand, banks also can
be the victims of asymmetric information. Borrowers have better information about level of
risks they engaged when borrowing money from banks. It is difficult for banks to appraise the
investment project of customers when they intended to hide the risky action. In the worst
case, asymmetric information would lead to the collapse of banks and then create a domino
effect on the stability of the entire financial system as economic crisis of 2008.
2. Form and cost of regulations
In order to protect customers and ensure the safety and soundness in banking system, some
regulations are imposed such as:

Restrictions on assets and activities: In the US, the Glass-Steagall Act (1933) prevented
commercial banks from engaging in securities trading with their client’s deposits and
prevented investment banks from taking deposits. This is partly a response to a wave of
bank failures following 1929 stock market crash and Great Depression (Crawford,
2011, pp. 127-133).

Capital adequacy: In Basel Committee member (UK, US, Canada…), Basel I (1988)
required to express capital in relation to risk-adjusted assets. Basel II (2004) goes well
beyond by allowing banks to use ‘internal risk-weightings’ to calculate required
regulatory capital (Howells, 2014, p.237).

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Liquidity requirements: Basel III required two liquidity ratios: Liquidity Coverage Ratio
and Net Stable Funding Ratio (BIS, 2010,p.9).

Deposit insurance: In US, FDIC1 insures each depositor at a commercial bank up to a
loss of $100,000 per account (Mishkin, 2004, p.40).

Nevertheless, in the dark side of regulations, it creates adverse selection and moral hazard
problem. For example, safety of deposits motivates savers to deposit money into the bank
without reservation and tracking. Similarly, a belief that government acts as lender of last
resort is always willing to rescue banks from failure creating incentives for them to take
greater risks (‘too big to fail’ problem) (Howells and Bain, 2007, p.365). Besides, presence of
regulations is source of barriers to entry and compliance costs resulting in higher prices in
banking services.
Through analysis above, it is obvious that banks face more risks in business compared to
other financial firms. In unregulated market, it is easy to collapse and cause financial crisis
worldwide. Therefore, strict regulations are really necessary to limit banks’ exposures to
risks. However, regulations also cover certain costs that require government to concern and
monitor in efficient manner.


Federal Deposit Insurance Corporation was created in 1934 after the massive bank failures of 1930–1933, in
which the savings of many depositors at commercial banks were wiped out

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1. Altman, E.I., Nimmo, R., Narayanan, P. and Caouette, J.B. (2013) Managing credit
risk: The Great Challenge for Global Financial Markets. 2nd edn. Canada: John
Wiley & Sons.
2. BBC (2008) Timeline: Sub-prime losses. Available at:
http://news.bbc.co.uk/2/hi/business/7096845.stm (Accessed: 07 December 2014).
3. BIS (2010) Basel III: A global regulatory framework for more resilient banks and
banking systems. Switzerland: Bank for International Settlements.
4. Crawford, C. (2011) 'The Repeal Of The Glass- Steagall Act And The Current
Financial Crisis', Journal of Business & Economics Research, 9(1), pp. 127-133.
5. Davies, J. (2014) Global Financial Crisis – What caused it and how the world
responded. Available at: http://www.canstar.com.au/home-loans/global-financialcrisis/ (Accessed: 08 December 2014).
6. Faure, A.P. (2013) Banking: An introduction. 1st edn. Quoin Institute (Pty) Limited &
7. Financial Times (no date) Definition of liquidity crisis. Available at:
http://lexicon.ft.com/Term?term=liquidity-crisis (Accessed: 06 December 2014).
8. Her, H. and Kazandziska, M. (2011) Macroeconomic Policy Regimes in Western
Industrial Countries. New York: Taylor & Francis e-Library.
9. Howells (2014) Money, Banking and Finance APC312. United Kingdom: University
of Sunderland.
10. Howells, P. and Bain, K. (2007) Financial markets and institutions. 5th edn. London:
11. Mbuya, J.C. (2008) The Pillars of Banking. United Arab Emirates: MP.
12. Mishkin, F. (2004) The economics of money, banking and financial markets. 7th edn.
The United States of America: Addision-Wesley.
13. Weert, F.D. (2011) Bank and Insurance Capital Management. 1st edn. United
Kingdom: TJ International Ltd.

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Part B: Critically analyze the competitive conditions in the
banking industry

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INTRODUCTION ................................................................................................................... 12
MAIN BODY........................................................................................................................... 12

Competitive approaches ................................................................................................ 12


Degree of competition in banking industry .................................................................. 14


The impact of regulations on competitive conditions in banking industry ................... 15

CONCLUSION ........................................................................................................................ 16
REFERENCES ........................................................................................................................ 17

Money, Banking and Finance APC312 12
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Banking sector plays a crucial role in economic growth of all nations through mobilizing and
allocating funds in the economy. Competition in banking sector, therefore, has received
researchers’ attention worldwide. As Bandt and Davis (2000, p.1045) showed, competition in
banking sector has intensified significantly in recent years. Deregulation, technological
advancements as well as globalization phenomenon that allows foreign bank involved in
domestic banking markets are underlying causes of changing competitive conditions. This
study will analyze in detail competitive conditions in banking industry.
This study analyzes the competitive conditions based on three aspects: competitive
approaches, the degree of competition and changes in competitive conditions in banking
1. Competitive approaches

Interest rate competition

Interest rate is key tool to compete among banks for the need of increasing capital and
expanding market share because it affects the economic decisions of the public. When the
lending rates are low, it encourages the public borrow money from the bank and vice versa.
Similarly, high deposit rates will encourage the public deposit money into the bank and vice
versa. A bank earns a spread on the money it lends out from the money it takes in as a
deposit, which are generally known as interest rate spread (IRS) (Fuhrmann, 2014). In other
words, the difference between deposit and lending interest rates generates profits for banks.
According to Croushore (2012, p.233), competition from other banks limits the profits a bank
can earn by changing the spread. If a bank tries to increase its spread by paying lower deposit
interest rate than its competitors, then depositors will switch to other banks. If a bank charges
higher lending interest rate than its competitors, it will lose borrowers to cheaper competitors.
Competition keeps interest rates on both loans and deposits similar across banks. In Vietnam,
for example, VietNamNews (2013) reports that Vietnam financial market was witnessing a
rare phenomenon that is lending and deposit interest rate got so close each other. Interest rate
(over 12 month deposits) of Agribank climbed to 8%, Vietinbank up to 7%, Vietcombank
rose between 7 to 7.5%. The deposit interest rate race seems more stressful when
Techcombank raised the interest rate of less 12 month deposits up to 6.75-7.45% per year.
Besides, raising deposit interest rates, the banks also made efforts to cut their lending interest
rate, sometimes lower than their deposit rate. In the context of intense competition, interest

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rate spread is too low even not able to cover operating costs so earning profits from interest
rate spread is close to zero. The competition in terms of interest rate among banks tends to
decrease. When interest rate competition does not attract customers, banks start a new
challenge on the track of services and utilities.

Products and services competition

In order to create competitive advantages, banks have created product differentiation and
product diversification. Products are differentiated on features such as size, design, prices,
and benefits…For example, HSBC India provides exceptional features on credit card like fuel
surcharge waiver and exclusive rewards programme. Unique benefit of a fuel surcharge
waiver helps customers save 2.5% fuel surcharge at any pump any place in India (HSBC,
2014a). The reward programme on HSBC credit card gives bonus points that customers can
redeem these points for an exciting range of redemption options including cosmetics,
garments, home appliances (HSBC, 2014b). As for product diversification, banks can offer
wider range of products to enable cross-selling. However, products in banking sector are very
susceptible to copy, it requires banks innovate constantly and promote the creativity of their
own. In terms of services, quality of services reflected in a transactional manner and
employees’ behaviors (so-called business culture) are the first concern. The reason is that
while products are vulnerable to copying, business culture is assessed highly by customers
and brings long-term competitive advantages for banks. Nevertheless, it needs long time to
build; especially banks have extensive network and large number of employees, but will be a
key competitive advantage for customer retention in long-term. Besides, banks are also trying
to increase operational efficiency by enhancing employees’ performance for the purposes of
cheaper banking services.

Technology competition

Technology adoption allows banks to provide services for customers at lower cost since there
is no distance between banks and customers anymore. Electronic banking like automated
teller machine (ATM) that have large number of booth and available for use 24/7 allows
customers implement transactions any time at anywhere. Electronic money (e-money) exists
in electric form, substitute for cash as well (Mishkin and Eakins, 2012, p.462). It is very
convenient for customers when buying high value goods. Thanks to these benefits, it brings
huge competitive advantages for banks that can take full advantages of it. In technology
competition, larger banks have more advantages than smaller banks. Larger banks have
strong economic potential and operate on both domestic and international levels so it can

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cover high costs in adopting technology compared to smaller banks. For example, Citibank
have applied webcam banking that allows customers deal with enquires without meeting
bankers face to face. However, as estimated it is very costly so it just suitable for Citi’s most
mature markets in the West (Citibank, 2013).
2. Degree of competition in banking industry

Bank size

According to G20 (2008, p.68), larger banks have more market power than smaller banks as
large banks have more competitive advantages than smaller ones. Large banks can take
benefit from their good reputation, economies of scale and ability to adopt modern
technology while maintaining financial stability; thereby allowing them to price their product
and services more competitively. Medium and small-sized bank, therefore, have trend to
merger and acquisition (M&A) to consolidate market share, increase market power and
reduce intensity of competition.

Number of banks






United Kingdom
Total number bank EU
Average % change EU


1,453 1,108
3,500 2,575 1,949
8,381 6,688 5,559

% decrease

Table 1: Number of banks and concentration ratios over the period 1990-2005 (G20, 2008)

The table above shows a significant decline in the number of banks in EU countries over the
period of 1990-2005 that reflected increased concentration in recent years.

Domestic banks versus foreign banks

The issue of competition is becoming more intense when domestic banks can expand to
foreign countries and vice versa, foreign banks also penetrate to compete with banks in

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domestic market. According to Wu (2009, p.7), Eastern and Central European countries have
the highest average foreign bank penetration level based on total asset (43.76%). The high
level of foreign bank penetration creates competitive pressures on host banking system when
foreign banks always catch up with technology advancements, product innovation and
diversification…Thus, domestic banks need to improve product quality, upgrade technology
and optimize resource allocation so as to compete with foreign banks. However, foreign bank
penetration has improved efficiency of domestic banking system, which contributes to
economic growth.

The growth of universal banks

Universal banking refers to financial institutions that may offer the entire range of financial
services which is combination of commercial banking (deposit-taking, loan-making),
investment banking (issuing, underwriting, investing and trading in securities) and insurance
services (Suresh and Paul, 2010, p.521). German is a prototype for running the universal
banking system. There are many countries move towards universal banking afterwards such
as Canada, Switzerland, and India...The trend towards universal banking is to pursuit
economies of scale and scope, whereby result in cost savings and bring opportunities for
cross-selling, increasing customer base. However, it would spur intense competition in
banking system of countries that allow developing universal banks. High level of competition
could lead to instability or even failure of banking system. Especially the collapse of one
universal bank could have serious impacts for the entire financial system. Hence, despite the
growing popularity of universal banks in a global context, the United States, Japan continue
to prevent commercial banks from engaging in securities transaction and underwriting
(Cheang, 2004, p.46).
3. The impact of regulations on competitive conditions in banking industry
Regulation has a significant impact on competitive conditions in banking industry. In the
1980s, many countries undertook the deregulation of their financial systems. White and
Vittas (1986) summarized that the barriers being eroded include: restrictions on capital
markets, credit ceiling and exchange controls; and restrictions on foreign banks entry and the
activities of foreign banks in domestic markets (Mullineux, 1987, p.4). Reduction of these
barriers increased degree of competition in banking sector. As BIS (2001, p.24) showed,
deregulation of financial services led to dramatic increase of presence of foreign banks in
emerging economic in second haft of the 1990s. For example, in Latin America, the market
share of foreign banks rose to 40% in 2000 from an average of 7% a decade ago. Such thing

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caused adverse selection and moral hazard problem due to unhealthy competition.
Consequently, it resulted in global banking crisis 2007/8 and left serious consequences to the
world economy. After the banking crisis, there are many suggestions to reform the regulatory
system for the purpose of making financial system healthier. One of them is Dodd-Frank
Wall Street Reform Act of 2010 which was passed by US Congress. It required banks to hold
more capital to cushion against large losses, included strategies to keep companies from
becoming too big to fail and required that derivatives be moved onto exchanges for better
monitoring (Amadeo, 2014). Besides, reform package like Basel III was also passed by Basel
Committee to improve the banking sector’s ability to absorb shocks arising from financial
and economic stress, thus reducing the risk of spillover from the financial sector to the real
economy (BIS, 2010, p.1). Nevertheless, the need to reform regulation in the wake of
financial crisis reduced competition among banks which in turn decreased operational
efficiency in banking sector.
To sum up, competition in banking industry varies from bank size to changes in regulations
across countries. It requires banks create more competitive advantages to compete with other
banks both on domestic and international levels. Competition helps banks operate more
efficient but it also caused financial loss when exist unhealthy competition among banks.
Hence, it is very hard to determine whether promoting competitiveness in banking industry is
bad or good for the economy, which in turn difficult for authorities to make right decisions
for economic growth.

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1. Amadeo, K. (2014) Deregulation. Available at:
http://useconomy.about.com/od/glossary/g/deregulation.htm (Accessed: 14 December
2. Bandt, D. and Davis, E. P. (2000) 'Competition, Contestability and Market Structure
of European Banking Structures in the European Banking Sectors on the Eve of
EMU', Journal of Banking and Finance, 24(6), pp. 1045-1066.
3. BIS (2001) The banking industry in the emerging market economies: competition,
consolidation and systemic stability. Switzerland: Bank for International Settlements
4. BIS (2010) Basel III: A global regulatory framework for more resilient banks and
banking systems. Switzerland: Bank for International Settlements.
5. Cheang, N. (2004) Practices of Universal Banks and Macao’s Banking Activities.
Monetary Authority of Macao, pp.45-61.
6. Citibank (2013) Web Cam. Available at:
(Accessed: 13 December 2014).
7. Croushore, D. (2007) Money and Banking: A Policy-Oriented Approach. United
States: Cengage Learning.
8. Fuhrmann, R.C. (2014) How Banks Set Interest Rates On Your Loans. Available at:
http://www.investopedia.com/articles/investing/080713/how-banks-set-interest-ratesyour-loans.asp (Accessed: 11 December 2014).
9. G20 (2008) Competition in the Financial Sector. Available at:
http://g20russia.ru/load/780983084 (Accessed: 13 December 2014).
10. HSBC (2014a) Fuel Surcharge Waiver. Available at:
http://www.hsbc.co.in/1/2/personal/credit-cards/fuel-surcharge (Accessed: 13
December 2014).
11. HSBC (2014b) Rewards Programme. Available at:
http://www.hsbc.co.in/1/2/personal/credit-cards/rewards-programme# (Accessed: 13
December 2014).
12. Ly, T. (2013) Deposit, lending rates inch ever closer. Available at:
(Accessed: 12 December 2014).
13. Mishkin, F. (2004) The economics of money, banking and financial markets. 7th edn.
The United States of America: Addision-Wesley.

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14. Mishkin, F. S. and Eakins, S, G. (2012) Financial Markets & Institutions. 7th edn.
The United States of America: Pearson Education International.
15. Mullineux, A.R. (1987) U.K. Banking After Deregulation. London: Croom Helm.
16. Suresh, P. and Paul, J. (2010) Management Of Banking And Financial Services. 2nd
edn. India: Dorling Kindersley Pvt. Ltd.
17. Wu, J., Jeon, B. N, and Luca, A. (2009) 'Foreign bank penetration, resource allocation
and economic growth: evidence from emerging economies', MPRA Paper, 34946
(22), p.7.

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