38426425 basics of banking

8/8/2019 38426425 Basics of Banking

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Financial Markets and Institutions

Dr. George AlexandrouOffice: R.744 Office Hours: Mon. 5:30-6:00p.m. and 9:00-9:30p.m.

E-mail: [email protected] [email protected]

Lecture 7

Commercial and Investment banking


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Learning outcomes

Understand the nature of commercial banking and itscontribution in the business and economic life.

Understand the basics of the operations of commercialbanking industry.

Understand the basic characteristics and activities of theinvestment banking.

Understand the nature of the major noncommercial banks and

their international role.


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Noncommercial banks

Noncommercial international banks are the banks that focus

on the development and economic coordination of a number of

countries.

The major noncommercial international banks are:

1. The bank for International Settlements

2. The International Monetary Fund

3. The World Bank


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BIS - Structure

BIS established as a commercial bank.

Original shareholders:

The central banks of: Belgium, France, Germany, the UK, Italy

(holding jointly more than 50%), Japan, a financial group from the US

(J.P. Morgan, First National Bank of the city of NY, First National

Bank of Chicago).

The US allocation of shares was sold to the public but

Citibank exercises their voting rights.

Federal Reserve System is not a shareholder but participate in

BIS committees.

BIS performs almost any financial service for central banks.

However, BIS must not create money like a conventional bank

BIS is not permitted to finance directly government operations.


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BIS - Operations

BIS dealings with the German government during the 2nd ww.

Gold from occupied countries 3,740kgr ($4.2 - $50m).

BIS is used by Treasuries of western governments and theircentral banks as the forum to resolve issues on International money supply; currency values and interest rates.

In their monthly meetings in Basle, the central bankers discusslocal and international problems.

The meetings are informal and undocumented. Gentlemens agreements are reached.

Central banks deposits are pooled and invested anonymously.


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International Monetary Fund (IMF)

IMF is an organisation established by the Treasuries of the US

and the UK during the 2nd ww.

Objectives: To assure free convertibility of currencies in trade.

To avoid currency devaluations and make exports more competitive.

To prevent international monetary crises. A pool of funds (gold and currencies) are available to countries

that experience deficits of their balance of payments.

Initial agreement in Bretton Woods (1944) 44 countries.

Now membership is 150 country-members.


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IMF Structure and quotas

IMF has two main departments: The General department (GD)

The Special Drawing Rights (SDR) department.

The SDR is the first reserve assets (money) to be created byinternational decision.

Within the GD each member has a General Resource Account(GRA).

Each member deposits in its GRA its quota. Quota (IMF) is the minimum subscription (contribution) of a

country in order to become a member of the IMF.


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IMF Structure and quotas 2

A country satisfies its quota subscription by depositing:

Freely usable currencies (at least 25% of the total quota) reserve

tranche on which interest is paid and

Its own currency. The total quota subscriptions is available to all members.

A country can freely use its reserve tranche to satisfy its

balance of payment deficit.

There is no need to reverse this transaction (buy its own

currency).

If the reserve tranche in insufficient credit tranches can be

obtained.

Subsequent tranches are called upper credit tranches and are

available subject to scrutiny and payment of interest.


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World Bank Group

The World Bank Group is comprised of four affiliates:

1. The International Bank for Reconstruction and Development (IBRD)

2. The International Development Association (IDA)

3. The International Finance Corporation (IFC)4. The Multilateral Investment Guarantee Agency (MIGA).

The IBRD (or WB) was created during the Bretton Woods

conference (1944).

WB concentrates on long-term development.

WB and IMF hold their annual meetings jointly and

membership in the IMF is a prerequisite for WB membership

WB must lend for productive purposes and stimulate

economic growth in developing countries.


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The International Finance Corporation (IFC)

The IFC was established in 1956 and makes private sector

investment.

It has 170 countries members.

IFC advises governments on the fiscal, legal and regulatory

frameworks.

IFC attracts international investors to the host country

security markets.

IFC relies on capital markets for its funding and is an active

participant in privatizations.


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The Multilateral Investment guarantee agency (MIGA)

MIGA is the newest member of the WB group (1988).

Formed by 42 WB member countries (now 160+ members).

MIGA provides insurance protection for foreign investors

against noncommercial risk in developing countries:

Currency transfer risk: risk that conditions for converting and

repatriating currency will deteriorate.

Expropriation risk: the risk of being unwillingly deprived thi

investment or the benefits from the investment.

Risk of war, revolution and civil disturbance.

MIGA may insure: For equity investments, up to 90% (+up to 450% of investm for earn)

For loans and loan guarantees 90% principal + 135% of principal for

accrued interest.


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The nature of the retail Banking in the UK

The distinction between Retail and Wholesale banking has recently become lessclear, since retail banks undertake wholesale activities.

Retail banking is more relevant term that retail banks, since also non-banks offer

retail banking services.

Banking involves taking deposits and repackage the funds and on-lent as loans.

Retail banking: Large-volume, low-value end of the industry.

Deposits from individuals and small business (and loans to the same group).

Wholesale banking: Low-volume, large-value end of the industry.Typical clients are the medium/large companies and large organisations.

To operate as a bank in the UK a business need authorisation by the FSA (98).


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The Balance Sheet of a bank

Liability refers to the money an individual or legal person has borrowed or has topay for a delivery of a good or service.

A borrower is liable to repay the loan in an agreed fashion at an agreed time or

over an agreed period.

The liabilities represent claims against the bank.

The liabilities part of a banks balance sheet has three main sources of money

coming in:

Deposits (the largest part)

Borrowings and

Shareholders equity and retained profits.


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The Balance Sheet of a bank (2)

The assets represent claims by the bank against others.

The assets part represents the uses of money and includes:

Lending (the largest part)

Notes and coins

Money market funds

Securities

Fixed assets (property).


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Table 1. A banks summary balance sheet

LIABILITIESWhere the money comes from ASSETSHow liabilities (money) has been used

Deposits CashBorrowings Money market fundsShareholders funds Other securities

Lending


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Table 2. A banks extended balance sheet

LIABILITIES ASSETS

Ordinary share capital Cash

Other share capital Balances at the Bank of EnglandReserves Money at call and short noticeRetained profits Bank and trade Bills of ExchangeProvisions against losses Treasury billsBond issues SecuritiesCustomers deposits Advances to customersOther borrowing Premises and equipmentTrade creditorsTax


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The UK Retail banks

English banks:- Barclays

- Lloyds-TSB

- HSBC

- Abbey National

Scottish banks:

- Royal Bank of Scotland

- Bank of Scotland (HBOS)

- Clydesdale

Northern Ireland banks:- Bank of Ireland

- Ulster Bank

- Northern Bank.


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The Balance Sheet of a Retail Bank

Table 3.1 The combined balance sheet of the UK retail banks at 31 Dec 1996.

Source:Bank of England Statistical Abstracts, 1997, table 3.4.

Liabilities bn Assets bn

Notes outstanding 2.7 Notes and coins 4.8Total sterling deposits

(of which, sight deposits)

467.8

(210.1)

Balances with the Bank of

England 1.7Foreign currency deposits 148.6 Market loans 102.1Items in suspense and transmissionplus capital and other funds 92.0

Total bills 12.2

Repo bills 13.6

Investments 50.7Advances 338.5Other currency and miscellaneousassets 186.5Banking Department lending tocentral government

0.9

Total liabilities 711.0 Total assets 711.0


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The Balance Sheet of a Retail Bank (2)

In the liabilities side of the balance sheet we can see:

1. The small item notes outstanding which refers to private bank notes.

2. The sterling deposits that constitute the majority of a banks liabilities.

This mainly comes from individuals and firms.

Around 45% of those deposits are sight deposits, i.e. payable in demand.

3. A fifth of a banks deposits are foreign currency deposits.

4. Finally, the other major part of bank liabilities is the items in suspense or

transmission (such as cheques drawn and in the course of collection) andcapital and other funds (such as issued share capital, long-term debt and

reserves).


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In the asset side of the retail banks balance sheet we have:1. Cash in form of notes and coins is a relatively small fraction of a banks

assets (around 0.7%).

2. Another small item is the cash balances with the BoE. This is mainly the

0.15%, non-interest-bearing, compulsory cash ratio required on all liabilitiesexceeding 400m.

3. Market loans provide additional liquidity.

These are mainly short-term loans made in money markets.

4. The bills are mainly Treasury bills or bank bills.5. The repo bills are claims refer to sale and repurchase agreements, where

banks acquire balances through the operation of a new system of monetary

control.

6. The investments of a retail bank are mainly in holding marketable securities.These are mainly government bonds or government guaranteed stocks and

therefore have the characteristics of low default risk and marketability.


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7. Sterling advances are the main asset of a retail bank, which is her around50% of the total assets. Major parts of these advances are:

Overdraft facilities to corporate clients

Term loans to business (increasingly since mid 70s)

Personal lending (increasingly since 80s):- Mortgages

- Unsecured lending.

8. Other currency and miscellaneous assets include

Advances in other currencies (20%)

Market loans and investments in other currencies (80%)

Miscellaneous assets include the banks physical assets (premises

and equipment)

9. The final item, Banking Department lending to Central Government, refers to

the Banking Department of the BoE, which is included in the retail banks

classification owing to its involvement in the clearing system.


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Recent changes in Retail Banking

ATMs

Telephone banking

First Direct (1989, Midland Bank)

Non-banking firms supplying retail banking services

Supermarkets (Tesco, Sainsburys, etc) Insurance companies (Prudential)

Internet banking


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Deconstruction of banking services

Separate provision of each component, via subcontracting.

For example mortgage loans can be deconstructed to:

Origination

Mortgage broker to customer.

Administration processing paperwork.

Risk analysis

assess creditworthiness of client.

Funding

Finance is raised - Assets held on balance sheet - capital allocated to the risk.


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Payment services

Transfer of ownership of certain assets are carried out in settlement of debt

incurred.

Need for an instrument that serves as:

Medium of exchange

Means of payment.

Temporary store of purchasing power (since payments and receipts are notsynchronised)

Original commodity satisfying these conditions was money.

Now financial innovation has permitted unbundling the functions of money: credit card cervices as medium of exchange.

Direct debit effects means of payment.

current accounts now pay interest.


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Risks in Retail Banking

Retail banks like all financial intermediaries have to manage the following risks:

1. Liquidity risk

Issued liabilities have shorter maturity (payable on demand) than theassets term to maturity.

2. Asset risk

The risk that the realisable (redeemable) asset value is less than their

book value, due to default risk, price risk or fire sale discount.

Two additional sources of instability:

1. From the nature of the payments system (committing funds before payment).

2. From undertaking contingent commitments (more related to wholesale

banking).


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Liquidity risk

Results from mismatching of maturity of assets and liabilities. Liabilities (deposits) can be withdrawn at call or very short notice, whereas

assets (advances) that make up to 70% of assets are relatively illiquid.

To deal with that banks should manage the inflow and outflow of their

funds. Overdraft commitments (on the asset side) are also uncertain, introducing

another element of liquidity risk.

Two aspects of bank operations ameliorate this risk:

1. The large scale of operations. Large number of net inflows from depositsvia small accounts makes the overall net inflow more

predictable.

2. Through a diversified deposit basis.

Two main strategies of managing liquidity risk:

1. Reserve asset management and

2. Liability management


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Liquidity risk - Reserve asset management

Figure 3.1 The reverse asset management approach to liquidity risk

(Liquid Assets) + (New deposits) + (Loan Repayments)

used to finance:(Deposit Withdrawals) + (New Loans)

Loan Repayments are the most predictable element of cash inflows.

Liquid assets provide a buffer stock against unexpectedly large outflows.

Liquid assets maturity is layered between: Cash - Overnight Deposits - Bills -

Certificates of Deposit (CDs), with increasing interest rates.

New deposits

Deposit withdrawals

Loan repayments

New loansLiquid

assets


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Liquidity risk - Liability management

The bank determines first the desired quantity of assets and then adjusts theinterest rates to attract the necessary amount of deposits (liabilities) to fund

this level of activity.

In Reserve Asset Management it is the opposite.

The interest rates are constant and the amount of assets is adjusted in line with

the quantity of the deposits attracted by these rates.

The marginal cost of raising additional retail deposit is high because the higher

rate has to be offered to all deposits.

The marginal cost of raising short-term (overnight) funds in the inter-bank

market is much lower since the bank is price-taker in this market.

That motivated the banks to move away from the Reserve Asset Management

and towards the Liability Management for managing Liquidity Risk.


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Asset Risk - cont.

2. Investment Risk.

This relates to capital-uncertain assets. A fall in price will reduce the value of

these assets.

Example: The value of government securities held by a bank will fall if interest

rates increase (even with no default risk)

This risk can be hedged by selling band futures contracts or buying bond put

options.

3. Fire sale Risk (or Forced-sale Risk).

The realisable value of an asset might be lower than its book value if it has tobe sold at short notice.

i k


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Payments Risk

The payment system provides for the transfer of funds between accounts atdifferent financial institutions.

In the UK every day: 16,000,000 transactions of Total value 160,000,000,000.

Two types of payment systems:

1. The Wholesale payments system, involves large-value, same-day, sterling

transfers. The main system is the CHAPS (Clearing House Automated

Payment System). In 94: 16 member banks >100bn daily.

2. The Retail payments systems:

- The cheques clearing systems (deals with cheques and paper items).- The credit clearing systems

Additionally, the Bankers Automated Clearing Services (BACS),

is an electronic clearing house for items like standing orders and direct debits.


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Payments Risk - cont.

CHAPS allows a bank to make a credit to other banks in the system (either onits own account or on behalf of a customer).

The final settlement is made at the end of the day for the final overall debit and

credit balances (through settlement accounts held at the Bank of England).

Receiver Risk: The problem arises when a member bank, following an

instruction from another member, provides the funds to its customer before

the final settlement. If the receiving customer initiate further transaction

during the day (involving more bank members) and one bank fails beforefinal settlement, many banks will be left exposed.

Solution to this problem: The Real-time Gross Settlement (RTGS).

For this, all the bank transactions are recorded in the accounts of the BoE asthey occur, and the settlement bank receives an instruction only after the

payment has been settled by the BoE.

Th f Wh l l b ki


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The nature of Wholesale banking

The non-retail banks are a heterogeneous group subdivided into: UK merchant banks (30)

members of the British Merchant Bankers and Security Houses Association.

Originally they financed trade and commerce by accepting bills.

Now they have expanded their activities to direct lending, underwriting, newissues, portfolio management, M&A advice, etc.

Other UK banks

Regional banks

finance houses

leasing companies

US banks

Japanese and Other overseas banks


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The nature of Wholesale banking (2)

Table 4.1 Sterling and foreign currency deposits (liabilities) of the non-retail

UK banks 31 December 1996 (in million) [BT, p71].

Source:Bank of England Statistical Abstract, 1997.

Sterling Foreign

currency

% of sight sterling

to total sterlingUK merchant banks 23,440 13,317 21Other UK banks 42,592 8,832 14Japanese banks 29,728 149,465 7US banks 26,234 121,450 26

Other overseas banks 159,623 533,958 14

Th f Wh l l b ki (3)


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Liabilities (deposits) of the wholesale banking:

The wholesale market is market for large-sized deposits (min 250,000)

and loans (min 500,000) with low proportion of sight deposits (7-26%,

which is much less than the 45% for the retail banks).

Around 22% of sterling wholesale deposits are inter-bank.

The remaining 78% is time deposits of UK and overseas companies.

Almost 90% of foreign currency business originates from overseas

customers and banks (only the remaining 10% from other UK banks).

70% of foreign currency deposits is interbank - 30% is company time-deposits

Overseas banks are more heavily engaged in foreign currency business.



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Table 4.2 Assets of non-retail banks operating in the UK at 31 December 1996(in million) [BT, p72].

Merchant

banks

Other

UK

banks

Japanese

banks

US

banks

Overseas

banks

STERLINGNotes and coins and balance atthe BoE

57 114 78 96 369

Market loans 8,194 9,561 11,758 8,819 64,646Bills 35 160 46 6 1,183Claims under repo agreements 5,079 230 2 1,333 9,277

Advances 7,988 38,702 15,932 12,478 66,187Investments 4,672 3,437 1,871 1,739 17,419Total sterling assets 26,025 52,204 29,687 24,471 159,081

FOREIGN CURRENCY

Market loans 5,811 6,778 105,210 70,567 311,900

Advances 4,706 1,789 34,237 41,884 136,650Bills, investments etc. 5,142 3,645 12,311 17,487 116,650Total Foreign currency 15,659 12,212 151,758 129,938 564,924


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Maturity analysis of sterling and foreign currency activities with non-bankingcustomers of retail and wholesale banks in the UK at 31 Jan 1987:

Considerable maturity mismatching of assets and liabilities. The bulk of

deposits is for less than 3 months to maturity and the assets greater than a year. Similarity of mismatching between sterling and foreign currency assets and

liabilities.

The mismatch is less for the wholesale banks than for the retail banks.

The UK banks have greater mismatching than the overseas banks. The wholesale banks, like the retail banks are not just liquidity distributors but

act to transform maturities.

Solution of the resulting liquidity risk:

Liability management via access to inter-bank borrowing as immediate source offunds to replace withdrawn deposits.

Securitisation of assets (packaging liquid assets into marketable instruments that

can be sold on to investor).

Asset-backed securities (ABS)


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Asset-backed securities (ABS)

Asset-backed security (ABS) is a tradable instrument supported by a pool of

loans. A banks removes some of its loans (assets) from its balance sheet and places

them in a Special-purpose Vehicle (SPV), which finances its holdings by

selling ABSs to investors. This process is also known as securitisation and

adds marketability to assets that have very little liquidity.The first issue of ABS in the US (1970s). In the UK 1985.

UK is the second largest market in the world (Total issues in 1996: 23bn)

almost 4% of the total bank and building societies lending (580bn).

In 1997, NatWest converted into bonds 1bn of housing loans and 3bn ofcorporate loans.

Benefits from ABSs:

The lender (bank) removes assets from its balance sheet (given that the

relevant risks are transferred to investors) and frees up capital for other uses.

Additionally, reduces the overexposure of the lender to a particular sector.

Off-balance-sheet business


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Off balance sheet business

Off-balance-sheet is business that generates a contingent commitment and

income to the bank without it appearing on the balance sheet under

conventional accounting procedures.

Examples:

Loan commitments (advance commitment by a bank to provide a credit) Revolving lines of credit (credit line commitment over several years)

Overdraft (a facility for customer borrowing but can be withdrawn)

Note issuance facilities (facility to issue commercial paper over a number of

years, which transforms short-term funds to long-term funds)

All these generate fee income for the bank.

Guarantees (a bank underwrites the obligations of a client, relieving the

counterparty from having to assess the creditworthiness of the client).

Acceptances (the bank guarantees payment of clients liability)

performance bonds (the bank support the good name of the client and its

ability to perform under a particular contract).

All these also generate a fee for the bank.

Off-balance-sheet business (2)


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Swap and hedging transactions (A number of financial

instruments/products can be used to hedge transaction risks, I.e. intsrument

that neutralise risk exposure)

Swaps (interest rates and currency)

Interest rate caps, floors and collars (options)

Forward rate agreements (forwards)

A transaction can be hedged (to neutralise risk) or unhedged (left open to

exposure).

Securities underwriting (a commercial of investment bank can guarantee

that the whole new issue of shares or bonds is taken up, by agreeing to buy

up to a set amount of securities).

For this the bank receives a fee.

Other financial services the provide by a bank generate fee but not recorded as

a balance sheet entry:

Loan origination - Trust and advice services - Brokerage and agency

services - payment services (credit card and cash management).

Off balance sheet business (3)


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Table 4.4 Fee or commission income as a percentage of net interest income

for Barclays Bank Group, 1980-96.

Source: Barclays Bank annual report and accounts.

The data in Table 4.4 above show the increasing importance of fee andcommission income over the interest income during the recent period (the

latter represents the difference between the borrowing and lending rates).

1980 1982 1984 1986 1988 1990 1994 1996

29 34 41 45 52 64 84 84



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Factors determining the growth of the off-balance sheet business:

1) From the banks point of view:

desire for fee income

diversify operations

expand into new business areas

Changes in the financial environment.

2) Greater volatility of interest rates and exchange rates since 1970s has

led to increased demand for hedging instruments (some - like options and

futures - traded in exchanges and some provided by banks over the

counter).

3) Greater perception of credit risk by banks has led to shift away from

bank intermediation (deposits and lending) to capital market instruments

as source of financing (generates underwriting and securitisation fees).



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( )

4) Arbitrage opportunities in capital markets as result of barriers such as

exchange rate controls, interest rate controls, reserve ratios, e.g. swaps

allow borrower to raise money in market with comparative advantage and

swap into currency in which he wants to borrow.

5) Changes in regulations and technology

6) Regulatory pressures have increased levels of capital in banking.

7) This led to banks pursuing off-balance-sheet business, which is not

subject to capital adequacy controls and hence increases returns on capital

employed.

8) Advances in computing, information processing and

telecommunications technology have enabled more complex instruments

to be designed and priced (financial engineering)



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Implications of the growth in off-balance-sheet business: 1) Banks have taken on risks which are not explicitly related to banks

capital.

2) Liquidity risk (insufficient funding to meet obligations immediately)

3) Credit risk (risk of default by the counter party). 4) Position risk (results from adverse movements in interest rates and

exchange rates)

5) Price risk (risk that market value of asset may be lower than book value).

As a result of these risks:

Banks may be underpricing new securities.

Regulators have responded to these risks by introducing new risk assets ratio

(bank has to have capital related to risk-adjusted value of its assets).

Off-balance-sheet instruments are converted to a credit equivalent and then

risk-weighted along with on-balance sheet instruments.

38426425 basics of banking

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