One fundamental difference in the application of the theory of the firm to international banking compared with domestic banking is that international banking more closely resembles a one product production system. This is because international banks use relatively more resources lending money and relatively less resources in attracting deposits compared with domestic banks.
The growing literature regarding the theory of the banking firm explains a bank's behaviour from several angles.
Baltenspergen (1980) divides the literature on the banking firm into two groups. One group he refers to as partial models, where the total size of the bank's portfolio is given, therefore the question at issue is the optimal allocation of this portfolio. The second group consist of " .... Complete models of the banking firm, ie models which attempt to explain the joint determination of not only the structure of assets and liabilities and their interaction, but also the total scale of the bank's operation and portfolio", (Baltenspergen, op cit, p 3 ) . It seems that from casual observation of the aggressive marketing policies of the eurobanks, both in relation to deposits and loans, that a theory of the banking firm which assumes the portfolio size to be exogenously given is inappropriate.
Of the complete models, Baltenspergen identifies three groups. Group one models assume that banks are monopolistic price setters in deposits and/or credit markets. These models are clearly inappropriate for the competitive euromarkets. Group two models assume banks are risk averse and that instead of maximising profits only, the utility function to be maximised has profits as a positive element, and risk, usually incorporated as variability in profits or income, as a negative element. The group three models emphasise the importance of the real resource or production aspects of banking. These models essentially represent pure production cost models of banking ie they explain size
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and structure of bank liabilities and assets purely in terms of the flows of real resource costs of generating those stocks (emphasising in particular the cost of deposit production). This production cost approach has been emphasised by Pesek (1970), Saving (1977), Towey
(1974) and Sealey & Lindley (1977).
Although such an approach seems a plausible starting point from which to describe eurobanking, they have two weaknesses. Firstly, they assume profit maximisation is the dominant element of the bank's utility function. Secondly, stemming directly from the profit maximising function, the deposit attracting function is assumed to exhibit rising marginal cost while revenue shows falling marginal revenue.
The literature cited above relates to the behaviour of "banks" taken to mean domestic banks. These banks differ from eurobanks in the view of the writer simply because the deposit attracting function of domestic banks exhibits rising marginal cost whereas that of eurobanks does not.
The suggestion that domestic banking exhibits rising marginal cost is supported, at least for US banks, by Benston, Hanweck and Humphrey (1982). They consider their work to be an improvement upon such work as Bell and Murphy (1968), and Benston (1965), because these earlier studies which generally found decreasing or constant marginal cost, related to the provision of one type of bank service, whereas the later work includes the total provision of all banking services by the firm.
Benston, Hanweck & Humphrey (op cit) use an output measure which incorporates deposit taking services and loan making services. This is only valid if the bank's objective function incorporates numbers of deposits or value of deposits positively in the function. This may be correct for a commercial bank that generates business from very intimate banker-customer relationships. However, it is c o n s i d e r e d
eurobanking. As such, eurobanks do not get any benefit from deposits except that they fund earning assets. Therefore, deposits are not considered to be an output of the eurobank but simply an input to the production process.
Frazer (1982) would suggest falling marginal costs even in domestic banking. Osborne (1982) also suggests falling marginal costs in attracting domestic deposits for banks situated in the USA. These last two studies have again concentrated on one product of the banking firm - cash transmission in the Frazer paper and deposits in the one by Osborne.
However, in eurobanking deposits are attracted not by a variety of labour intensive services but by the explicit interest rate paid on deposits. If eurobanks offer additional non loan services, these are generally fee earning services contributing to the total revenue of the bank and not conducted basically to attract deposits. Moreover, the eurobanks do not operate a cash transmission system.
It is important to note a distinction between the behaviour of average and marginal costs due to changes in the number of transactions and the changes in costs due to the size of each transaction. This distinction is important in the analysis of financial intermediation because in the production of, say a sparking plug, a given level of non raw material inputs is required to transform a given quantity of raw materials into a plug. In financial intermediation no such rigidity exists; the same quantity of non deposit resources can be used for a $100 loan or a $10,000 loan. As the loan size increases, so the transaction may become more complex, say a $1 million loan requiring more non deposit resources than the $10,000 loan but within each degree of complexity there will be a great range of loan sizes that can result from the same input of non deposit resources. This point is returned to below when we discuss the short and the long run in relation to the costs of intermediation.
One price which might rise as banks strive to increase the total value of their lending business is the cost of deposits, particularly from the interbank market. However, by the terms of the eurocurrency loan agreements, the interest rate costs of funding the loans are passed on to the borrower by charging a reference rate, eg LIBOR, plus a spread. Therefore the funding costs do not reckon as a cost of production to the eurobank although these costs do influence the price which the borrower pays for the service.
This analysis therefore proceeds to investigate the non deposit interest resource costs of financial intermediation.
Short-run Cost Functions
A bank's costs are assumed in this analysis to be dominated by fixed costs because the major constituents are the costs of maintaining premises, information technology systems and a highly trained professional labour force. By the nature of the conditions of
employment and expenses of training, the professional labour force exhibits considerable embodied capital and therefore the size of this labour force is not varied with short term fluctuations in output ie lending.
The variable costs consist of labour costs attributable to clerical staff, some of which, at least in London, will be of a temporary nature. There will also be the costs of the clerical systems
of the bank. These clerical costs are assumed to be a constant function of the quantity of total staff employed.
An important feature of this analysis is that the fixed factors and the variable labour factor exhibit considerable indivisibility. Amongst the fixed factors, indivisibilities are found in the information technology systems and in the labour force. The variable labour factor also exhibits indivisibility because of the discrete nature of the labour input. In this latter case the result is that
marginal cost is discontinuous and, in fact, zero for most of the quantity of output.
At this stage, it is important to define marginal product. In this analysis it is assumed to be only one loan ie the marginal loan and not a number of loans, say an additional ten or twenty. The reason for adopting such a definition here is that the output of one loan could be a simple process ie using little labour time, or a more complex process using more labour time. it is therefore difficult to determine how many loans an additional unit of labour will process or how many
currency units are involved with each loan (ref pl21 above) .
Furthermore, if the management took the view that an additional worker could process 1 0 0 loans within a given time, the marginal cost of labour would be the wage divided by 1 0 0; if 101 loans were processed, the marginal cost of the last loan would be zero. If, on the other hand, the management had a rule that workers only processed 100
loans, then the marginal cost of the one hundred and first loan would be equal to the wage of the additional worker. It is therefore considered that it is only valid to define marginal product as a group of units of output if • production is in discrete batches of a uniform size and that those batches are less than the full capacity of the worker.
The cost functions of the eurobank can thus be depicted as shown below:
C
VARIABLE COSTS