The Bank Analyst’sHandbook

Money, risk and conjuring tricks

Stephen M Frost

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The Bank Analyst’s Handbook

The Bank Analyst’sHandbook

Money, risk and conjuring tricks

Stephen M Frost

Copyright C© 2004 John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester,West Sussex PO19 8SQ, England

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Library of Congress Cataloging-in-Publication Data

Frost, Stephen M.The bank analyst’s handbook : money, risk, and conjuring tricks / Stephen M. Frost.

p. cm.Includes bibliographical references and index.ISBN 0-470-09118-5 (alk. paper)1. Banks and banking. I. Title.

HG1601.F76 2004332.1–dc22 2004002790

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

ISBN 0-470-09118-5

Typeset in 10/12pt Times by TechBooks, New Delhi, IndiaPrinted and bound in Great Britain by MPG Limited, Bodmin, CornwallThis book is printed on acid-free paper responsibly manufactured from sustainable forestryin which at least two trees are planted for each one used for paper production.

http://www.wiley.comhttp://www.wileyeurope.com

For my childrenNatasha, Thomas and Juliet

Contents

Foreword ixAcknowledgements xiiiPrologue xv

Part I Financial Systems 11 Securities Markets and Financial Intermediation 32 Introduction to Securities Valuations 273 Central Banks and the Creation of Money 47

Part II The Spread Business 694 Deposit Taking and Other Funding 715 Corporate Lending 836 Operational Services 997 Mortgage Lending 1078 Credit Cards and Other Retail Loans 117

Part III Risk Management 1299 The Controls Cycle 131

10 Managing Interest Rate and FX Risk 13911 Trading 15912 Managing Market Risk 18113 Managing Credit Risk 20114 Capital Management 227

Part IV Capital Markets 25315 Fund Management 25516 Stock and Bond Issuance and Brokerage 28517 Securitization 307

Part V Bank Valuations and Acquisitions 31918 Bank Valuations 32119 Bank Acquisitions 349

Part VI Problem Loans and Banking Crises 36720 Corporate Failures and Problem Loans 36921 Banking Crises 38722 Dealing with and Valuing Insolvent Banks 405

Part VII Supervision and Financial Statements 41723 Regulation, Supervision and Policing 41924 The Balance Sheet 43525 The Income Statement 451

vii

Contents

Primers 465Statistics for Finance 467Derivation of Duration and Convexity 479Financial Institutions 485Appendix I – The Basel Accord 501Appendix II – Glossary of Terms 523Sources and Further Reading 537

Index 539

viii

Foreword

I have put my sickle into other mens corne, and have laid my building upon other mens foundations.John Speed, sixteenth century mapmaker, from The Theatre of the Empire of Great Britaine

BRIDGING A GAP

Financial institutions have few friends. However, despite their poor image, they provide a rangeof services without which it is difficult to envisage how a modern economy could operate. Itis also true that banks attract some of the brightest and most highly qualified people of anyindustry. Money is one factor, banks pay well for top talent, but many are also attracted bythe intellectual challenges of the business. Banks are difficult to analyze but they also providefascinating and challenging problems to solve.

No single person could now write the definitive text on financial systems because the scopeof the subject matter is too broad, the level of detail too deep and it is in a state of constant flux.One can, for example, go to any large bookshop and buy a 600+ page ‘introductory text’ to valueat risk, techniques used in controlling trading risk. Books that focus on a particular, narrowlydefined subject tend to be very detailed and are usually written for specialist practitioners orfinance academics.

Books that aim to give a general introduction to banking, securities and financial marketsare often rather superficial and most suited to a high-school audience. They tend to be full ofrather boring tables showing such interesting things as international bank rankings by assetsand charts illustrating the growth in the nominal value of interest rate swap agreements. Thisbook represents an attempt to bridge the gap between the more superficial introductions andthe specialist tomes. In writing this book I have tried to follow these guiding principles:

� Scope and detail. That all important functions and subjects related to the financial servicesindustry be covered. That the key principles related to each subject are clearly identified andthat the level of detail is sufficient for the reader to understand their nature, rationale andshortcomings.

� Brevity. That explanations and subjects are covered in a clear and concise manner. Manyspecialist finance texts weigh in at an impressive 1000+ pages. The longer a book onprinciples is, the less likely it is to be concerned with principles. Einstein’s original paper onspecial relativity was a mere 80 pages long. Less is more.

� Universality. That the coverage is of universal applicability rather than country specific, andwill date only slowly. This is achieved by focusing on principles and the underlying economicreality of transactions. Where there are important differences in practices between countriesthese are identified.

� Motives. That the motives of people and organizations are clearly identified and conflicts ofinterest highlighted. Power, greed, fear and corruption all play their parts in financial dealings.

ix

Foreword

TARGET READERSHIP

In a very real sense, this is the book that I wish I had had when, fresh out of business school, Istarted out as a bank analyst. An important objective is to demystify a vital industry that manyfind to be baffling and impenetrable. People who will benefit most from reading this book includethe following:� Business school students and other graduates. MBA and finance students will find that

while the main courses are based on fundamental principles, they come with a pinch ofworldly cynicism. The book also highlights issues such as the failure of financial statementsto provide a true view of banks’ condition and the arbitrary nature of regulatory capitalrequirements. Several important areas, such as credit risk management and banking crises,are also covered that are rarely addressed in general financial works. Anyone who is seriouslyconsidering a career in financial services should find that reading this book helps them inmaking their decision.

� Finance professionals. Many front-office finance professionals are specialists working in anarrowly defined field. This book will help them to gain a wider perspective on other parts ofthe industry with which they are less familiar. Many other professionals work in back-office,systems and other support functions. In some cases they have only a limited understandingof the businesses they are supporting and frequently feel too intimidated to admit theirignorance. This book will help them to gain a better understanding of the businesses theysupport and improve their communications with other people working in the industry.

� Analysts and portfolio managers. Financial analysts and portfolio managers are likely tofind the chapters on bank valuation approaches of particular interest. Portfolio managersapply diversification techniques in the context of fund management but they will gain a newperspective from seeing how these techniques are also applied in trading, credit risk and inturn drive bank capital management and requirements.

� Consultants, accountants, auditors and legal practitioners. Many external profession-als provide a wide range of services to financial institutions. This book will help them tounderstand better their clients’ requirements. It will also help to break down the barriers tocommunication created by industry jargon.

� Financial journalists. Most financial journalists are journalists first and finance specialistssecond. This book will give them a solid grounding in theory and practices as they relateto the financial services industry and help them to understand and interpret bank results,new developments and regulatory changes better. As Warren Buffett put it “The smarter thejournalists are, the better off society is. People read the press to inform themselves, and thebetter the teacher, the better the student body.”

� Corporate management. “If you know the enemy and know yourself, you need not fear theresult of a hundred battles. If you know yourself but not the enemy, for every victory gainedyou will suffer a defeat. If you know neither the enemy nor yourself, you will succumb in everybattle” (from Sun Tzu’s The Art of War ). Corporate treasuries face many of the same riskmanagement issues as banks.

I have assumed a basic understanding of accounting and level of numeracy. Some parts of thiswork are rather technical but I have tried to keep the level of mathematics in the body of thetext itself relatively low and provided more formal derivations and proofs in stand-alone exhibitsand primers.

x

Foreword

BOOK STRUCTURE

The main body of this work is organized around seven relatively discrete parts:

� Part I – Financial systems. We start by painting a big picture showing the principal meanswhereby capital from investors is channeled to borrowers, and the roles played by commercialbanks, investment banks and fund managers and securities markets in that process. We laythe foundations for the approaches and methods used to value financial assets. We concludeby looking at how money is created, the functions of central banks and the tools they haveto influence the supply and price of money.

� Part II – The spread business. The main source of commercial banks’ income comes fromthe spread they generate between the returns they earn from loans and the costs of attractingdeposits to fund those loans. In the second part of this book we examine deposit taking andretail and corporate lending. We also cover the most common operational services theyprovide to their corporate clients.

� Part III – Risk management. Risk management lies at the heart of core bank competencies.In Part III we focus on interest rate, foreign exchange and credit risk management. We lookat how risk can be measured in terms of volatility of returns and losses and the way in whichportfolio diversification reduces risk. We also explore the fundamental basis for value-at-risk(VaR) methods for controlling market risk and how this can be used in the context of creditrisk assessment. We conclude by looking at why bank capital should be considered as abuffer to absorb a level of losses determined by management and how VaR approaches canbe used to define the level of capital that a bank should hold. The Basel Accord on regulatorycapital requirements, in its old and proposed form, is introduced and we take a hard look atits main features and arbitrary nature.

� Part IV – Capital markets. In this part we look at the roles played by fund managers andinvestment banks as capital markets intermediaries. We look at the different types of fundmanagers and investment products offered and examine the methods used to assess port-folio performance. We look at investment banks’ key capital markets’ intermediation role inthe primary and secondary markets and at their organization and other services offered. Wealso examine the nature of asset securitization and how asset backed securities are usedto redistribute risk and returns.

� Part V – Bank valuations and acquisitions. The subject of equity valuations is both broadand complex. We restrict ourselves to the methods used to value commercial banks usingthe dividend discount model as the primary tool and show how to approach valuations ofbanks with excess capital and how to accommodate short-term explicit earnings forecastsusing multiple-stage models. We look at the worldwide pressures for consolidation and thefundamental and management incentives for bank acquisitions. We look at the practicalconstraints on using cash to make acquisitions and the fundamental constraint imposed byminimum regulatory capital requirements.

� Part VI – Problem loans and banking crises. Under “normal” conditions credit lossescan simply be treated as a cost-of-doing-business. When credit quality starts to deteriorate,either at individual banks or on a system-wide level, the focus of attention becomes problemloans. We look at why corporates fail and how banks manage the resultant problem loans.Banking crises are relatively uncommon but when they do occur their impact is severe. Weexamine the major causes of banking crises and the methods most commonly used in theirresolution.

xi

Foreword

� Part VII – Supervision and financial statements. In the final part of this book we look athow the financial services industry is policed by regulators and supervisors and the functionsof accounting authorities and audit bodies. We also look at the most important balancesheet items and income statement lines and their related ratios. We show how to go aboutforecasting the balance sheet and income statement looking at loan growth forecasts andnet interest income in particular detail.

PRIMERS

There are also three self-contained primers at the back of this book.The first gives a relativelyconcise but formal introduction to the various statistical methods referred to in this book. Thesecond a formal derivation of duration and convexity. The third provides thumbnail sketches ofall of the various institutions that play a part in financial services.

There are very few formal sources in this book, these are well-travelled roads and the founda-tions of modern financial theory were laid more than a quarter of a century ago. I have includeda list of finance books currently on my bookshelves.

xii

Acknowledgments

The story behind this book differs from that of most financial texts and this is not the place to tell it in full.Nor do I have much time, however, for seemingly endless lists of people and platitudes. I met hundredsof people in my professional capacity, many of whom were very helpful. Two groups of commercial bankers do

stand out, HSBC country managers and ex-Citibankers. So very different and yet so alike. I will concentrateon those people who actually made a real difference to me. I hope they all know how grateful I am to them.

This book might never have seen the light of day save for an element of serendipity. I first met Chris

Matten when he was appointed CFO of a Singapore bank I covered. He is also the author of an excellent book

ìManaging Bank Capitalî that I had already read. It had given me much food for thought, not least because it

had been written by a practitioner rather than an academic. I donít know what he first thought when my rough

first draft arrived on his desk with a hastily scribbled plea for any feedback or suggestions. It was 18 monthssince we had last spoken. The draft (or manuscript as I now know it is called) was posted the day I flew tothe UK for a three-week holiday with my children. This was the first time anyone had had a look at any ofit so I awaited his response with a degree of trepidation.

Chris was very generous with his comments. By e-mail he effectively gave me a crash-course in how

publishers work. I hadnít done any of the things I was supposed to have done. No proposal. No defined

target audience and so on. Iím glad I didnít know what I was supposed to do, the book has life becauseI breathed it into it. I am not sure I could have done that if I had followed some tightly structured plan.

He made the critical introduction to Rachael Wilkie, a senior editor with John Wiley in the UK. I was ableto delay my return to Singapore and we met up for my first literary lunch. It was all going much faster than Iíd

planned. I hadnít intended approaching any publisher until the work was completed, still some months away. I

flew back to Singapore if not with a firm commitment then with at least good reason to hope. Other reviews hadto be sought and I had to put together all of those marketing related materials that I had avoided preparing.

Dr Alistair Milne of the Cass Business School in London reviewed the book for John Wiley at this relativelyadvanced stage and I took note of his insightful suggestions on book structure. Acting on them meant addingtwo new chapters and re-ordering the rest. It was well worth doing. He is not responsible for the rather

pragmatic approach Iíve taken to the application of text-book financial theory.

Rachael had the courage of her convictions and put the proposal forward to Wileyís commissioning committee.I sent off the completed manuscript a few months later and the contract followed. I thank the team at JohnWiley for their subsequent efforts.

Then there were my friends and family. Most of whom were in the UK and we kept in touch by phoneand email. Alan Spence made a very important contribution. He got me to send him back-ups of the work as

it progressed. As a result, when an incompetent computer repair shop wiped my hard disk it was painful butpossible to recover. He held my hand as the labor progressed and the book began to emerge, albeit from thedistance of 11,500 kilometers. He asks the right questions and that is often more important than having the right

answers. Alan has always been there when it mattered.Paul Hallas gamely agreed to be the lay guinea pig and made some useful suggestions. Anne Marie,

Mike, Amanda and Suzi in the UK demonstrated that oneís oldest friends are often also the best. My othergreat friend, Alan Stewart, died of a brain tumor around the time this book was started. He was so pleased

xiii

Acknowledgments

when, just months before he died, he was awarded his PhD. It is a tribute to his own spirit that he was ableto savor the moment even as he faced death. He does, however, appear in the book in the guise of one ofthree young men who bought a house on credit cards. I am sorry that I have not been in a position to give hiswidow Karen more support. We all miss him.

I was suffering from acute depression when I started this work. I had cut myself off from the world,

stayed at home with my cat, tuned in to the BBC World Service and thought and wrote. I might never havewritten this book if it had been otherwise. My friends and family in the UK were very supportive and veryfar away. Ed Manser, Damaris, Gary, Nick, Hugh and Gerry in Singapore defied the cynicís definition of afriend. Katya Watmore showed great strength of character and compassion when she reached out her hand tohelp me pull myself out of the very deep, dark hole into which I had fallen. I am not sure why Katya, inparticular, placed such faith in me but my family and I will be forever indebted.

This book is dedicated to my children, bound for New Zealand, who are far away but close to my heart.By the time this book is published I will have completed development of a course and workbook that areintended to complement this book. And after that, who knows. It is a big world out there.

I would welcome any feedback and can be contacted by e-mail at the address below. Please includethe word ìHandbookî in the subject line to avoid being filtered out as spam.

Stephen FrostFebruary 2004s m frost@hotmail.com

xiv

Prologue

The love of money is the root of all evil.The Bible, Timothy, Chapter 12

LANGUAGE, GENERAL RELATIVITY, TECHNOLOGY AND LIBERALIZATION

Language

It is not uncommon to meet professionals in financial services who have only a vague idea aboutwhat their colleagues actually do, even though they work on the same floor. The root cause isspecialization and the subsequent development of languages, or patois, that makes communi-cation between common specialists faster and more precise but are virtually impenetrable toeverybody else.

Some of the terms in these languages can be quite evocative (butterfly spread, fallen angels,chastity bonds, baked-in-the-cake, sinking funds, double witching day, bottom fishing, concertparty, dressing up, flip-flop notes, ever-greening, barefoot pilgrim) and sound quite fun. Otherterms (collateralized debt obligation, contingent immunization, continuous net settlement, non-cumulative preference stocks, death-backed bonds, disintermediation, correlation coefficients,dynamic asset diversification, subordinated limited irredeemable preference shares) are quiteintimidating and sound as though they should have come from a German-speaking lawyer.

Most lay people have no idea what most of these terms mean but assume quite reasonablythat people who work in finance do. This is like assuming that all Europeans speak the samelanguage. The terms that we meet in day-to-day life are usually the ones we would rather nothave to think about such as bounced check, over credit limit, minimum payment, bank charges,commission rates and, at ATMs, service suspended.

General Relativity

It is not necessary to understand Einstein’s theory of general relativity or be able to recallNewton’s laws to know that if you drop a brick onto your foot it is going to hurt. We only have toknow enough about the effects of gravity to avoid dropping a brick on our toes in the first place.One does not have to be able to derive the highly complex and very difficult Black–Scholesmodel for valuing financial options to be able to understand how they can be used, what factorsdetermine their price and how changes in these factors will affect a traded option’s price.

Richard Feynman (a jazz-playing, womanizing, fun-loving physicist who won the Nobel prize)believed that understanding what lies behind a natural phenomenon described by a set ofequations was more important than the ability to write them. He also argued that if one can’texplain a phenomenon without having to resort to equations, one doesn’t really understandwhat is going on. This is how it should be with financial theory.

xv

Prologue

Much of financial theory tries to formalize what we instinctively believe to be true. We knowthat if we back a winning long-shot the payout will be far higher than if it had been the clearfavorite. Risk and reward are inextricably linked. Many of us are experts in liquidity managementand recognize credit and settlement risks when we see them.

Significant advances have been made in finance theory over the past 40 years, particularlyin the areas of asset portfolio management and option valuation techniques. People still jokeabout weather forecasting but short-term forecasting is actually pretty good these days, madepossible by very powerful number-crunching computers. I doubt, however, that any progress hasbeen made in terms of predicting market behaviour reliably and profitably using mathematicalcomputer models. This lack of progress would be consistent with the fundamental premise thatsecurity price movements are inherently random. An awful lot of people are paid a great dealof money in the belief that this premise is false.

We also need to maintain a healthy level of skepticism about theories that rely on unrealisticsimplifying assumptions and those that cross the line between science and psychology. An at-tractive theory may be supported by historic data but fail the acid test of successfully forecastingfuture results.

Technology

Most of the academic papers on financial theory submitted to journals would lie gathering dustin various libraries around the world if it had not been for the huge advances in informationtechnology and data processing that have been made over the past 30 years or so. In 1666(the same year as the Great Fire of London) Isaac Newton was able to calculate the velocityrequired for a rocket to escape earth’s gravity but it took nearly 300 years before the technologywas developed to allow this to be achieved.

Computer hardware, databases, software applications and huge increases in cheap band-width and telecommunications capabilities have allowed financial institutions to apply theseadvances in financial theory. Academic financial journals are now full of articles seekingto support or disprove these theories by mining the rich vein of digital financial data nowavailable.

Few really understand that the world’s financial system has become entirely dependent ontechnology. It became fashionable, after the event, to dismiss the warnings of possible Y2Kdisasters as hysterical, self-serving hyperbole. If Captain Smith had reduced speed the Titanicmight have escaped from its appointment with destiny. On arrival in New York some would havecriticized him for being too cautious and for failing to meet the promised crossing time. Financialinstitutions make huge investments in technology where a successful outcome is one wherenothing happens.

Liberalization

It is difficult to gain a historical perspective of the times through which we live. Each newparadigm gains its supporters and has its 15 minutes of fame before being casually dis-carded. In the 1980s there were scores of books extolling the Japanese way of doing things.American politicians inflamed fears that the Japanese would end up owning most of theUSA. This hysteria reached a peak when Japanese investors bought the symbolic RockefellerCenter in New York. By the early 1990s most of these books had been remaindered andwere being used for landfill. Many so-called new paradigms are simply the same old ideas

xvi

Prologue

packaged in a different form whose time has come again, and are used to sell consultancyservices.

Liberalization, in all of its forms, has passed into and out of favor many times. The last 25years of the twentieth century are likely to be viewed by posterity as a period when it was inascendancy around the world (despite occasional set-backs). Most industries were affectedand financial services were no exception. A major inflexion point was the collapse in the early1970s of the fixed exchange rate system between major industrialized economies establishedat the end of the Second World War.

Commercial banking and financial brokerage were among the few industries where nationalprice controls, in the form of regulated deposit and lending rates and commission rates forbuying and selling stocks, still existed. The types of activities that financial institutions couldundertake were also highly restricted. Deposit-taking banks in many countries were prohibitedfrom stock exchange membership and from owning insurance companies or writing insurancepolicies. Significant regulatory barriers had been erected in countries around the world to pre-vent domestic financial systems falling into the hands of foreigners.

Banking cartels had become well entrenched in many countries. Banks and their regulatorsenjoyed a cozy co-existence with incumbents enjoying considerable shelter from the harsh lightof competition. This was at the expense of their customers of course. Liberalization occurred fora number of reasons. Financial institutions started to shift their international business to thoseregimes with the most laissez-faire attitude and lowest taxes and costs. Facing a continuingloss of jobs and revenues the more highly regulated centers were under relentless pressure toact to “create a level playing field”. Boundaries between different types of businesses becameincreasingly difficult to define. Companies could borrow from a commercial bank or raise fundsfrom the capital markets. Insurance companies and brokerages sold investment products thatcompeted head on with bank deposit products.

Progress on World Trade Organization (WTO) agreements on financial services has beenslow and is likely to remain so. Competition and market forces do not stand still, however.Financial crises have also forced some governments to relax maximum limits on the level offoreign ownership and lower barriers to entry in order to attract foreign capital.

PUBLIC IMAGE LIMITED

Historic Perspective

The most basic financial services, such as money lending, date back to the earliest use of moneyas a store of value and a means of exchange. Banks, however, have never enjoyed universalpopularity. In the Bible, we read about Jesus Christ throwing out the moneychangers from thetemple two thousand years ago. The Quran prohibits the payment of interest on loans anddeposits. Shakespeare mocked Shylock, a moneylender, in the play The Merchant of Venice.

Banks were blamed widely for the 1930s depression in the US when Gross Domestic Product(GDP) halved and millions lost their jobs. Thousands of banks failed and many retail depositorssaw their life savings vanish. People who had taken out mortgages to buy their homes, but wereunable to make the required monthly payments, found themselves homeless after banks actedto seize the property and evict the occupants.

xvii

Prologue

Retail Banking Blues

In more recent years banks around the world have taken action to dissuade low-income retailcustomers from using their services. This has been a three-pronged attack. The first pronginvolved the introduction of automated teller machines (ATMs) to try to coax retail customersaway from bank branches. The second prong was widespread closures of marginal branches.The third prong involved the introduction of account and transaction-based fees. In many casesthese fees are waived for customers who maintain a specified minimum balance in their depositaccount. Inevitably it has tended to be the people who can least afford these fees that haveended up paying them. This has left banks open to continuing political attack and in somecountries legislators have acted to force banks to provide a free basic banking service.

Banks have also been attacked by consumer advocacy groups for offering easy credit andcharging excessive rates of interest to consumers. Inevitably banks have been guilty of mis-leading advertising. Banks and finance companies may calculate, and highlight, the “interestrate” charged on installment loans by taking the total interest paid divided by the initial valueof the loan. As this takes no account of the loan’s reducing balance over its term this rate iswell below the effective rate being charged. In many countries lawmakers have had to resort tolegislation to prohibit such practices.

Many banks have also been guilty of selling investment products to ill-informed retail cus-tomers without explaining the nature of the underlying downside risks. On occasion when thingshave gone badly wrong banks refer complaining customers to the small print in the lengthyagreement that the customer signed. These “agreements” always seek to indemnify the bankagainst any claims or customer losses. As these agreements are usually written in an archaicform of financial legalese it is not surprising that few members of the general public understandtheir detail.

The Pig Trough

Best-selling books and box-office hits have shaped popular perception of investment banking.Michael Douglas, in his Oscar-winning portrayal of an investment banker in the 1984 movie WallStreet, caught the public eye with his battle cry that “Greed is good”. There are many books,both fiction and non-fiction, that have chronicled the excesses of investment bankers, “Mastersof the Universe”. One of the best of these books is Burrough’s Barbarians at the Gate whichgave a riveting account of the takeover of RJR Nabisco, at the time the largest ever such deal,warts and all.

Any doubts about whether such accounts exaggerated the level of avarice in the 1980s wereprobably dispelled by the closure of Drexel Burnham, a US investment bank that pioneeredthe issue of ( junk) bonds for companies with a low credit standing. The US District Attorneyprosecuted Michael Milken, its high profile CEO, for criminal and racketeering charges. Milkenpleaded guilty and was sentenced to two years in jail and “agreed” to pay a fine of $850m.

Most insurance companies seem to have been designed to avoid paying out on any claimsand on the rare occasions when they do they never seem to meet the claims in full. Claimson damage from minor auto accidents always seem to be finely balanced between the costsof the claim and losing the no-claims bonus. Life insurance policies always seem to cost morethan originally expected and to give worse returns than alternatives. The people selling suchinvestment products rarely understand how these actually work but follow a script and aretrained to give stock responses to frequently asked questions.

xviii

Prologue

Retail brokers push speculative stocks in order to persuade clients to place buy and sellorders and hence generate brokerage commission. Many so-called “independent” financialadvisors recommend those investment policies that generate the highest commission for theadvisor rather than those that are in their clients’ best interests. Investors who have boughtmutual funds find that if they try to sell those funds that the amount they actually receive is wellbelow the value of their investment due to high redemption charges. Nobody likes cold callingbut in many countries such practices are legal and used with high-pressure sales techniquesto persuade unsophisticated investors to buy investment funds that are totally inappropriate totheir needs. Money and morality are words that both start and end with the same letters buthave little else in common.

xix

PART I

Financial Systems

1

1

Securities Markets and Financial Intermediation

There is no such thing as absolute value in this world. You can only estimate what a thing is worthto you.

Charles Dudley Warner, US Journalist

RAISON D’ÊTRE

Pure capitalist economies are market-based. The allocation and prices of capital, labor, goodsand services are determined by market forces alone, based on supply and demand. Thisdiffers from that of command, or planned, economies where allocation is determined, andprices set, by a central authority. The former Soviet Union provides an example of a commandeconomy.

Developed economies today can be viewed as “mixed” economies where private enterpriseand market disciplines are the major determinants of capital allocation and the establishmentof prices but the state also plays a role. Even in those countries where market forces are givenmost freedom to act the state usually intervenes to correct the most egregious forms of marketfailures and in particular to protect groups, such as individual depositors and investors, fromabuses such as fraud.

Market-based economic systems need financial organizations and structures to facilitatepricing, market making and redistribution of money and financial risk in order to operate effi-ciently:

� Money. A fundamental requirement of efficient modern economies is that capital is trans-ferred from those parties with a surplus and allocated to those individuals, companies andsectors that can generate the highest economic returns. The main mechanism used to de-termine this allocation is the action of financial markets.

� Risk. All human activities involve a degree of risk. There is, however, a wide range of thelevel of risk associated with specific activities. Some institutions and individuals exposed toa particular form of risk may wish to reduce that exposure and will be prepared to pay to doso. Others are prepared to accept those risks at a certain price. As a result there is a marketfor risk. Financial service organizations help these markets to function by taking such risksonto their own account, acting in an intermediary role and providing products to redistributerisks.

In this first chapter we set the scene by painting a big picture showing the principal flows of moneyfrom investors to borrowers. An impressionist work is created with thousands of brushstrokesbut only makes sense when seen from a distance. Individual brushstrokes have little meaningin themselves. Readers may come across terms in this chapter with which they are unfamiliaror whose precise definition is unclear. My advice to readers is to gloss over any such terms.We will be looking at all of the areas covered here in more detail later.

3

The Bank Analyst’s Handbook

The glossary at the end of this book contains definitions of many of the more importantfinancial terms. The dictionary definition of a glossary, however, is “a detailed list of specificterms on a particular subject area that never contains the one you are looking for”.

PRINCIPAL CHANNELS

One of the most important functions of a financial system is to facilitate the flow of capital fromthose with excess (the providers of capital) to those with a financing need (the users of capital).I will tend to use the term investors rather than the unwieldy providers of capital and borrowersrather than users of capital. Members of the former group are also referred to as savers andmembers of the latter group as security issuers.

It is convenient to identify four distinct groups: individuals, private corporations, public sectorentities such as municipal authorities and governments. Members of each group may play eitherrole and at times will play both. There are three principal channels for flows of money betweeninvestors and borrowers:

� Direct investment. These are direct flows of money from individual investors to individualborrowers. Most of these flows are in the form of equity investments and dividends and capitalreturns on these investments. Direct investments suffer from a number of fundamental andpractical problems. These flows account for only a very small proportion of the total flowsbetween investors and borrowers.

� Bank intermediation. Banks take deposits from savers and pass these funds on to borrow-ers. They pay interest on the deposits and charge interest on the loans. Their profits comefrom the spread between the rate they pay for funds and the rate they charge. The poolingof individual deposits and banks’ ability to lend to many different borrowers eliminate manyof the problems associated with direct investments.

� Securities markets intermediation. Using securities markets provides a way to avoid bankintermediation by bringing together many individual investors to invest in securities, such asequities and bonds, issued by many different borrowers. Securities market intermediationalso eliminates many of the direct investment problems. By eliminating the banks’ spreadthis may provide better returns to investors and lower cost funds to borrowers.

A third type of intermediary exists, not identified explicitly above, that offers investment productsby packaging securities in a number of different ways and selling these to investors. The relativeimportance of bank versus securities market intermediation varies significantly from country tocountry but we can make these general observations:

� Level of development. Securities market intermediation becomes increasingly more impor-tant as the level of development of a country increases. In the most developed economiessecurities intermediation to meet corporate financing requirements has become much largerthan bank intermediation. In emerging markets the low level of income is reflected in a lim-ited demand for investment products and a lower level of domestic institutional investors.This is one factor in bank intermediation remaining more important than securities marketsintermediation in these countries.

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Securities Markets and Financial Intermediation

� Corporate versus retail. As the level of bank intermediation for corporate financing hasfallen in relative importance retail lending has become far more important. In the most de-veloped markets banks have increasingly looked to exploit their advantages in originatingretail loans and sell such loans on rather than fund these loans themselves. They have doneso by using the securities markets.

In this chapter we will look at the following:

� The demand side, and in particular the characteristics of the financing requirements ofcorporates, individuals and governments.

� The supply side in terms of the range of investors’ requirements.� The specific problems associated with direct investments.� The nature of bank intermediation in terms of the way in which it eliminates the problems

associated with direct investments and an outline of the range of credit products and depositsoffered.

� The nature of securities and the features of, and difference between, primary and secondarysecurities markets.

� The four main securities markets (money market, bond markets, asset backed securitiesand equity) and the main forms and characteristics of the securities issued in each market.

� The role and importance of fund managers (mutual funds, pension fund and life insurers)and how their functions add value to the investment process.

� Finally we will pull these all together to get a complete picture of the flows of funds and legalrights between investors and borrowers.

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The Bank Analyst’s Handbook

THE DEMAND SIDE – THE USERS OF CAPITAL

Corporate Financing Requirements

The characteristics of financial undertakings vary across two primary axes. First the risks in-volved in the undertaking and second the timing and value of the associated cashflows. To alarge extent these risk and timing characteristics dictate the nature of the financing required.Most corporate financing requirements fall into one of the following broad categories.

It is possible to meet a long-term financing requirement with short-term funds that are continuallyrolled over but this exposes the user of the funds to significant risks. If liquidity tightens, orinvestors become more risk averse, the borrower may find it difficult to raise short-term moneyand even if this is possible may have to pay through the nose to get it. The process of continually

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Securities Markets and Financial Intermediation

paying off old debt while raising new debt also incurs transaction costs that over the life of thefinancing requirement are likely to be significant.

There is a significant variation in the level of risk associated with different financial invest-ments. Short-term self-liquidating finance for trade is very low risk while medium- to long-termproject financing, where the project owner is completely dependent on the success of the projectto service its financing, is usually very high risk.

In general, the financing term should match the economic term of the undertaking beingfinanced, returns should reflect the risks associated with the undertaking and financing shouldbe provided by parties willing to accept such risks for such returns.

Retail Financing Requirements

The range of retail financing requirements is much narrower than for corporations:

� Homes. Many people, for a number of reasons, aspire to own their own home whether itbe a castle in the English countryside, a condo in New York or a semi-detached house insuburbia. Financing for such purchases is long term in nature and usually paid for from theincome of the occupier or occupiers.

� Automobiles. Automobiles are usually second only to property in terms of retail big-ticketacquisitions. These are depreciating assets and most owners look to pay off any financingthey obtain within three to five years.

� Seasonal. While an individual’s behavior may be impossible to predict with any certaintypeople as a whole still tend to act as a herd. Spending on many goods rises in winter aspeople go out to buy carefully chosen gifts for their loved ones and socks and chocolatesfor their other relatives. Spending on vacations peaks in the summer months as the masseshead for the beaches. During the rest of the year people either save for their next holiday orwork to pay off their last.

� Consumer goods. White goods such as washing machines and refrigerators have nowbecome so cheap that their cost relative to income has fallen sharply. Most men love toys,however, and there is always the next generation of mobile phone, personal digital assistant,plasma screen or home entertainment system to salivate over. Many women are fashionvictims and this may help to explain why the smaller bikinis become the more they seem tocost. These types of purchases are often made on a whim and have to be paid for either fromsavings or by borrowing. Real consumers would need a dictionary to find out the meaningof the word savings. And such people are easy prey for predators such as unscrupulousfinance companies and banks.

� Occasional. Certain events, weddings and medical emergencies are good examples, occurinfrequently but may require significant outlays. The timing of such events cannot usually bepredicted well in advance.

� Education. Most students have to pay for tertiary education. Financing is usually providedby a combination of parental contributions, income from part-time or summer jobs and long-term education loans.

Government Financing Requirements

The focus of this book is on financial markets and financial institutions. The subject of publicsector finance is fortunately well outside our scope other than to the extent that it impacts on

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The Bank Analyst’s Handbook

these markets and institutions. In brief, however:

� Income. Government income comes from taxes imposed on corporates and individuals. Thereceipt of these taxes is highly seasonal. The absolute level of taxes expected is based ongovernment economists’ forecasts for economic activity. The best economists are all bornwith two hands, thick skins and a good sense of humor. The actual level of tax receipts isoften very different from that expected.

� Expenditure. Certain parts of government expenditure are fixed but larger parts depend onthe level of economic activity and unemployment. Little, if any, provision is made for majorunexpected events, such as a war. The actual level of expenditure is usually very differentfrom that expected.

� Political pressures. Political pressures mean that forecasts for income have a bias towardsbeing too high while forecasts for expenditure are biased towards being too low.

The difference between income and expenditure has to be financed through borrowing and thisis usually achieved through the issue of bonds. The level of borrowing should also be affected bythe economic cycle. Deficits tend to be largest during recessions and smallest (or even becomesurpluses) at the peak of the cycle. It is difficult, however, to differentiate between deficits thatare due to cyclical factors and those that are structural in nature.

The overall result is that most governments are continually paying off debt from old bondissues while attracting new financing by issuing new bonds. These bonds are issued across arange of maturities varying anywhere between three months and 30 years. The level of govern-ment borrowing has a direct effect on the demand for, and hence price of, money. Excessivelevels of government borrowing make it harder and more expensive for the private sector toborrow and this is the phenomenon referred to as “crowding out” by economists. Just whatconstitutes excessive requires a political as much as an economic judgement.

THE SUPPLY SIDE – INVESTORS, SAVERS, PROVIDERS OF CAPITAL

Individuals, corporations and even governments and state institutions may have savings ormoney that is surplus to their current requirements. For convenience sake we will refer to themall as investors. Investors seek the following:

� Risks and returns. To get the highest level of return available for a given level of risk taken,or the lowest level of risk possible for a given level of return. These are not at all the samething. There is a wide range of tolerances to risk between investors.

� Economic term. To make investments whose economic term matches that of their liabilities.An individual seeking to invest in order to generate an ongoing income in their retirement willlook for investments that meet that objective rather than investments offering a short-termreturn only, for example.

� Liquidity. To match the liquidity of their investments with their own liquidity requirements.Some investors need to keep most of their funds in investments that are close to being cashequivalents and can be easily and quickly liquidated. Other investors may be willing to accepta much lower level of liquidity in return for higher long-term returns.

� Counterparty risk. To minimize counterparty specific risk.

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