Principles of banking and finance M. 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.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. 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. University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom Website: www.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 your copyright material, please let us know. Contents Contents Chapter 1: Introduction. 1 General introduction to the subject.
4 Online study resources. 6 The structure of the subject guide. 7 How to use this subject guide. 8 Structure of each chapter.
11 Part I: Financial systems. 13 Chapter 2: Introduction to financial systems. 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. 37 A reminder of your learning outcomes. 37 Sample examination questions.
38 Chapter 3: Comparative financial systems. 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.
62 A reminder of your learning outcomes. 62 Sample examination questions. 62 i 24 Principles of banking and finance Part II: Principles of banking. 63 Chapter 4: Role of financial intermediation.
66 Some evidence on financial intermediation. 67 Why do financial intermediaries exist?. 72 Asymmetric information: adverse selection and moral hazard. 73 What is the future for financial intermediaries?.
87 A reminder of your learning outcomes. 87 Sample examination questions. 87 Chapter 5: Regulation of banks. 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.
112 A reminder of your learning outcomes. 112 Sample examination questions. 112 Chapter 6: Risk management in banking. 116 Taxonomy of risk.
116 Policies to reduce risk. 120 Credit risk management. 120 Interest rate risk management. 134 ii Contents A reminder of your learning outcomes.
135 Sample examination questions. 135 Part III: Principles of finance. 137 Chapter 7: Capital budgeting and valuation. 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). 155 A reminder of your learning outcomes.
155 Sample examination questions. 156 Chapter 8: Securities and portfolios – risk and return. 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).
181 A reminder of your learning outcomes. 181 Sample examination questions. 181 Chapter 9: Financial markets – transmission of information. 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. 197 iii 24 Principles of banking and finance 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. 202 Appendix 2: Sample examination paper.
203 iv Chapter 1: Introduction 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 1 24 Principles of banking and finance • 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.
Eakins Financial Markets and Institutions. 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. Gale Comparing Financial Systems.
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. Allen Principles of corporate finance. 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: 2 Chapter 1: Introduction Dow, S.
‘Why the banking system should be regulated’, Economic Journal 106 (436) 1996, pp. ‘The Case for Financial Laissez-Faire’, Economic Journal 106 (436) 1996, pp. ‘A comparative anatomy of credit risk models’, Journal of Banking and Finance 24 (1-2) 2000, pp. 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. The Economics of the Financial Systems.
Allen Principles of Corporate Finance. Thompson The UK Financial System. Shastri Financial Theory and Corporate Policy. Goetzmann Modern Portfolio Theory and Investment Analysis.
Rochet Microeconomics of Banking.: The MIT Press, 2008) [ISBN 9780262061933] Chapters 2, 8 and 9. Titman Financial Markets and Corporate Strategy (Boston, London: McGraw-Hill/Irwin, 2002) second edition [ISBN 9780072294330] Chapters 4, 5, 6, 9 and 10. Modern Banking in Theory and Practice. Cornett Financial Institutions Management: a Risk Management Approach.
Commercial Bank Financial Management in the Financial-Services Industry. (Upper Saddle River, NJ: Pearson Education Inc. Gitman Corporate Finance. 3 24 Principles of banking and finance 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.
