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Figure 3.6 Short run average total cost and marginal cost functions of a eurobank
The fixed costs function is of the traditional form. The average variable cost function exhibits indivisibilities but assumes constant cost of variable factors. The average total cost function shows the indivisibilities of the variable factor. The marginal cost function shows such cost being equal to the cost of the variable factor for the first unit produced and zero thereafter until the variable factor is fully utilised and a new unit of that factor is employed.
Long-run Cost Functions
Traditionally the long-run in economic analysis relates to the time period when all factors, particularly fixed factors, are variable. Again, traditionally, fixed factors include plant and buildings. In this analysis it is considered that buildings, information technology systems and professional staff, although treated as fixed assets, are not the major constraint on the size of the banking function. Here we ignore external constraints such as prudential regulation. The major constraint becomes the bank's standing in the market. This standing should be considered from two angles; one is the bank's standing as a taker of deposits. This in turn will be related to its financial condition. The second angle is the bank's standing as a lender. This
latter point has a considerable impact upon the economies of scale in lending w hich the bank can enjoy.
To explain this we must consider the economies of scale associated with a single loan transaction. The larger the loan, the lower will be the average total cost per currency unit loaned. However, a bank can only make large loans or take large participations in syndicated loans, and maintain the required degree of portfolio diversification, if it has a large balance sheet.
Furthermore, it is known that interest rate tiering exists in the interbank market (Ellis 1981). If large size means lower perceived risk, large banks will incur lower funding costs than small banks. Moreover, borrowers prefer to issue loan mandates to the larger banks because the borrower is more confident that a larger bank can underwrite the transaction. The members of the syndicate management group are well placed to take large shares of each loan, enjoying greater economies of scale in each transaction.
In addition, the larger the loan participation, the higher the proportion of front end fees (ref ch4 p i 71),thus a bank making large loans will not only enjoy lower average costs per transaction but also higher average revenue. This results in higher profitability, a better capital assets ratio and a better reputation in the market.
Clearly the ability of the bank to increase its scale of operation and the size of average transaction, assuming a constant degree of portfolio diversification, depends upon the market's perception of the bank. This perception in turn depends upon the bank's past performance.
It is considered by the writer that changing this perception has a longer time scale than changing any of the tangible fixed assets such as buildings, information technology systems or staff.
In order to increase the standing of the bank and thereby enjoy the economies of scale associated with large transactions, it is neces-
sary for the bank to grow and, in practice, to grow steadily and continuously. Thus the flow of new loans from a bank and their average size is positively related to that bank's existing stock of loans.
Therefore, although in the long run the banks may enjoy economies of scale associated with larger information technology systems, and a higher calibre of staff attracted to larger, and therefore assumed more prestigious institutions, they also enjoy substantial economies of scale due to increased transaction size. This increased transaction size is possible as the bank's balance sheet and reputation increase; this reputation itself being positively related to balance sheet size.
The result of this hypothesis is depicted in the following diagram of the long run cost functions:
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c. P & I A f Y f
Figure 3.7 Long run costs functions of a eurobank
The falling long run average cost results from economies of scale due to increasing average transaction size. As total balance sheet increases, the bank can supply more loans in larger average transactions and thus operate at successively lower sets of short run cost functions. Thus each successive scale of balance sheet results in a larger scale of transaction, each having a lower average cost per currency unit loaned. This includes lower marginal cost at the point
of hiring an additional indivisible unit of the variable factor. Moreover, although marginal cost is often z e r o , the positive point of marginal cost falls as average transaction size rises. Thus growth of the bank's balance sheet by allowing the bank to operate at lower average transactions cost allows the bank to operate at a point nearer to where MC = MR = 0.
Furthermore, where increased transaction size results in greater fee income or even higher spread, the bank's average and marginal revenue will shift to the right, again enhancing balance sheet size through retention of larger profits.
On page 109 above the importance of marketing in the growth of the eurocurrency market was noted. If we extend the role of marketing to the individual bank, we can see that the revenue curves are shifted to the right thus enhancing the growth of the bank. If marketing costs exhibit diminishing marginal productivity, they will militate against the falling positive marginal cost point. However, for cost per currency unit loaned to rise as a result of marketing effort, marketing costs per currency unit must outweigh the economies of scale in transactions costs resulting from larger average size of transactions possible from the increased size of the total banking operation.
Therefore, balance sheet growth and its attendant marketing and public relations exercises are important in the bank's utility function in that they allow for growing profits without the bank reaching the profit maximising condition which any way may be close to MC-MR—0. Incremental profits are important because these supplement the bank's capital base. A growing capital base is required in order to avoid being under-capitalised as the balance sheet grows.
This analysis of the short and long run cost functions does not by itself explain the quantity of loans supplied. For that it is necessary to analyse the bank's revenue functions as well.
The Revenue Functions
Because - each eurocurrency loan is individually negotiated, often with a considerable degree of confidentiality, and because the loan will incorporate some non price factors in its t e r m s , each bank or syndicate of banks can differentiate its product. As such it will face a negatively sloped demand curve for its product. However, this differentiation may only be slight and therefore the substitution between different banks' products is considerable.
This ability to choose between banks according to the terms of the loan is enhanced by the fact that the market is uncartelised. Moreover, because eurobanks, unlike domestic banks, often do not require an established banking relationship with the prospective borrower before lending, it is possible to approach many banks separately and compare the terms of loans. Therefore the price elasticity of demand for loans from any one syndicate will be highly elastic.
Accordingly, the revenue curves of a eurobank are characterised by the diagram below:
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The Complete Model
The barriers to entry into eurobanking are very low (as distinct from the barriers into banking generally) for institutions already engaged in domestic banking. In effect such a change requires only the establishment of a foreign currency bookkeeping system. Accordingly, the ability of firms to enter and leave the industry is considerable. It is therefore considered by the writer that the eurobanking can be characterised by an adaptation of the monopolistically competitive model suggested by Chamberlin (1950).
Chamberlin suggested that super profits would be competed away by firms entering the industry, thus shifting the demand curve downwards until the demand curve is tangential to the long run average cost curve. In the process the demand curve may become more elastic. In Chamberlin's model a unique profit maximising solution was possible because of the use of linear revenue curves and 'u' shape cost curves.
In the current analysis competition in the short run will shift the average revenue curve until it is tangential to the short run average cost curve. In the long run competition will ensure that the average revenue curve is tangential to. the cost curve of whichever scale of lending function is chosen. Thus the dashed line marked A R in figure 3.9 below represents a locus of points of long run equilibrium average revenue. The solid line marked LATC represents a locus of points of equilibrium long run average total cost. In both cases long run equilibrium is defined as tangency between average revenue and average total cost for whatever scale of lending function is chosen. The relevant marginal revenue curve will be that associated with the average revenue curve tangential to the chosen cost function.
Because each loan is individually negotiated, the terms can be related to the resource costs of producing that loan. If the price charged were above average cost, super profits would arise and be competed away (maybe instantaneously through competitive tendering for loan mandates). If a price less than average cost is charged, a loss
will ensue which the bank can avoid by not making the loan. Therefore, provided that the bank is aware of its cost functions when they
negotiate the terms of loans, they do not need to enter the market for any individual loan that will result in a loss. In effect the lending banker exhibits perfect mobility of resources in respect to any one loan analogous to that hypothesised in the perfect competition model.
Thus, with competition for loan mandates removing super profits and the ability to avoid losses by not entering into lending on unfavourable t e r m s , the banks will be able to achieve an average revenue equal to average cost.
If one bank had resource costs significantly above its competitors, it would be unable to lend competitively and would leave the market altogether. The deposit funds would then flow to the more efficient banks that can make a normal profit from loans priced at the then existing average revenue.
With the behaviour of the marginal cost function being a positive but declining series of points, or zero, due to the indivisibility of the variable labour input, it is always optimal for the banker to operate at a point where marginal cost is zero. Given the highly elastic demand function for the individual bank as postulated above, and the ability of marketing to shift the revenue functions to the right, the profit maximising criterion of MC = M R will not be an effective constraint upon bank operations even where profit growth is important in the b a n k 1s utility function provided that there is an additional positive constraint. The effective constraints upon bank balance sheet growth are the minimum acceptable return on total assets and a maximum acceptable perception of risk. The greatest of these two becomes the binding constraint.
The relationships between the revenue functions, marginal cost and long run average cost on one hand and the return on total assets and risk constraints on the other are shown below:
1 -I f i t i t r Ae>'TA * coWrAfiiM'T Ao-TA - X f r U r t A / * M -r v > 7 » A . jAtXtr-rj- *
Figure 3.9 The long run equilibrium of a eurobank
Of the two constraints suggested, it is considered by the writer that the risk constraint will be the most volatile in that perception of risk will depend upon the degree of diversification of the loan portfolio and the variability of the income stream from that portfolio. As the bank's portfolio increases, greater concentration of that portfolio may result, particularly if new lending is taken up by one particular group of borrowers, as happened with bank lending to developing countries during the 1970's. Alternatively, systematic elements of risk may affect all borrowers. Macro economic phenomena could be particularly influential in this respect.
On the other hand, the perception of depositors, shareholders and regulatory authorities of what is the minimum acceptable return on total assets is likely to change only slowly; at least in relation to the changing circumstances of certain groups of the bank's borrowers.
It can be seen from the diagram above that if perceived riskiness rises, then the quantity of loans provided will be reduced, while a reduction in perceived riskiness will result in increased lending. The
return on total assets constraint operates in an analogous manner. This reaction may be considered as credit rationing but it must be stressed that this analysis relates to a single bank. For credit rationing to be imposed by a whole market all banks will have to have similar per
ception of risk and similar degrees of risk aversity.
It may very well be that the perceived risk constraint as hypothesised here explains the slowdown in the growth of bank lending to developing countries observed in the last two years.
If banks do indeed behave as suggested in this chapter, it is more appropriate to consider growth to be the major factor in the bank's utility function.
The suggestion that the maximisation of profits may not be the only or even dominant element of a eurobank is supported by anecdotal evidence (Euromoney 1978, 1982) and responses to the writer's survey discussed in chapter seven of this thesis. This evidence suggests that market share or balance sheet size were important objectives in the late 1970's. Davis (1981) suggests that the balance sheet growth was only just giving way to profits as an important objective at the time that he was writing.
Further evidence that balance sheet size is an important corporate objective comes from the continued publication of rankings of banks by the quantity of eurocurrency loans written. These rankings are published in Euromoney and Institutional Investor. As these publications rely upon popular demand for their existence, the continued publication of these rankings indicates that they provide a form of knowledge required by readers - mostly practising bankers.
The importance of market share and balance sheet size may also be explained by the work of Marris (1964) and Baumol (1959) suggesting that executives' salaries are related to growth of the firm or sales revenue. For a bank,sales growth and balance sheet growth are identical.
Furthermore, balance sheet size may be an important determinant of depositor confidence, not least because a large portfolio allows greater diversification of the unsystematic element of risk. Moreover, balance sheet size may give borrowers confidence that loan requirements can be provided by the bank. This is important where the borrower may be wishing to expand its market share.
The bank's objectives need not be of equal dominance, indeed the dominant objective may change during the life of the organisation, but the market behaviour will be similar; this is suggested by Davis (1981) and Euromoney (1982b). It is in fact quite reasonable to expect new banks to concentrate on balance sheet growth until their presence is felt in the market and then to give profits more priority. This is particularly so given the advantages of depositor and borrower confidence that a large balance sheet confers upon a bank. Responses to the survey reported in chapter seven suggest that bank corporate objectives have indeed changed during the 1970's and early 1980's.
Conclusion
In conclusion, it is considered that the growth of the eurocurrency market is influenced by the portfolio preferences of depositors, borrowers and lenders. These preferences are influenced 'by several factors including price advantages of eurobank transactions, government controls on domestic markets, tastes and a learning process both enhanced by marketing efforts and the corporate objectives of the eurobanks. These corporate objectives manifest themselves in the portfolio preferences of the lenders.
The fixed coefficient multiplier approach is inappropriate to explain euromarket growth because of flexibility of the reserve base and the redeposit ratio, as well as inadequate measures of the reserve base and total euromarket lending. The fact that the multiplier approach is inappropriate does not of itself preclude multiple credit creation by
the eurobanks. In fact, the theoretical analysis of the influence of marketing and relative prices upon portfolio preferences suggests that,
as the market matures, the redeposit ratio and thus multiple credit creation could increase. The existence or otherwise of government controls will also influence the growth of the euromarkets.
This chapter has also shown that the corporate objectives of growth maximisation or long run profit maximisation are compatible with the cost and revenue functions of eurobank lending. Responses to a survey reported in more detail in chapter seven of this thesis confirm that asset growth was an important corporate objective of eurobanks during the 1970's. The fulfilment of this objective would have a considerable influence upon the growth rates of the euromarkets during that period.
The growth of the eurocurrency markets is of crucial importance to the developing countries because these markets have become such an important source of external finance. However, continued growth of the euromarkets does not guarantee an adequate supply of eurobank credit to developing countries. The portfolio preferences of the banks are of utmost importance. These preferences will be influenced by the expected rate of return and the perceived risk attached to such loans compared to those available on alternative assets. The ability to manifest these preferences will depend upon the constraints bearing upon the eurobanks
at any point in time.
The next chapter analyses the financial terms attached to eurocurrency loans and eurobonds in order to ascertain the determinants of the expected rate of return on such assets.
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