Banking and Financial Institutions

Guy HargreavesACF-104

Wechat: Guyhargreaves

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Recap of yesterdayUnderstand commercial bank balance sheets

and general principles of bank balance sheet management

Compare off and on balance sheet products and structures

Understand key considerations for the practice of good banking

The business of commercial banking

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Goals of todayAppreciate the key drivers to the business of

commercial bankingReview how commercial banks generate

financial returnsDescribe the key metrics used in commercial

bank financial management

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Theory in practiceRecall commercial banks perform three basic

high level functions:1. Size transformation2. Maturity transformation3. Risk transformation

This is the theory – how in practice to commercial banks actually generate net profit?

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Size transformationFor a commercial bank this means:

Estimating market appetite for credit Underwriting and distributing syndicated loans in

size Using balance sheet to take on the liquidity risk of

making a loan larger than its deposit base

Customers want loans and other banking products and services tailored to their own size

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Maturity transformationFor a commercial bank this means:

Using its “Capital Structure” to manage maturity risk

Underwriting balance sheet maturity “Gaps”

Very long dated maturity demands can be challenging for commercial banks

Banks prefer 3-5 year maturities for loans

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Risk transformationSavers and depositors want to invest in

diversified portfolios of credit risk $100 invested in a single “A” rated corporate can

have very a different investment outcome compared with $1 invested in each of 100 “A” rated corporates

Bank portfolios are very diverse which means savers can have confidence in banks

Capital regulations and access to central bank liquidity also helps risk transformation

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So how do banks make money?Like all businesses, banks have capital

structures: Equity capital Hybrid capital Subordinated debt Long term bonds Medium term notes Short term deposits

Aim of commercial banks is to use this capital to invest in assets which generate sufficient return to provide an acceptable return on capital (RAROC)

Decreasing riskDecreasing maturity

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Recall: banking products and servicesCommercial banks offer a wide range of

products and services Current / chequing accounts - fees, liability raising Term deposits - liability raising Consumer loans / mortgages - asset raising Credit / Debit Cards - fees, asset raising Cash management services - fees, asset / liability

raising Corporate / SME loans - asset raising Trade Finance - fees, asset raising Financial market products - fees, trading, spread Online banking - access

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The cost of capitalThe cost of commercial bank capital is an

important input into the economics of the business of banking

Weighted Average Cost of Capital (WACC) is a closely managed metric for banks

Banks with high WACC need to invest in higher returning assets to generate acceptable returns

Higher returning assets are riskier Riskier assets require more regulatory capital to be

held=> can become circular

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WACC exampleCapital type % of Capital

StructureCost

Equity capital 6.0% 12.0%

Hybrid capital 2.0% 9.0%

Subordinated debt 2.0% 5.0%

Long term bonds 20.0% 4.0%

Medium term notes 10.0% 3.0%

Short term deposits 60.0% 1.0%

Total: 100.0% WACC: 2.7%

The bank will need its weighted average asset yield to be greater than 2.7% to generate operating profit

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RAROCRisk Adjusted Return on Capital (RAROC)Widely used metric in commercial banking to

measure the return generated from financial assets

Commercial banks fix minimum RAROC hurdles to assist in their decision making processes

RAROC = Revenue – Cost – Expected LossRequired Capital

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RAROC

RAROC = Revenue – Cost – Expected LossRequired Capital

Where: Revenue is NIM Cost is the fully loaded cost of taking on the asset Expected loss is the amount the bank must assume

it will lose from investing in the risky asset Required capital is the amount of regulatory capital

a bank must hold when investing in the risky asset

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Meeting return hurdlesAssume a bank sets its RAROC hurdle at 12%An exporter requests a $100m 3-year loan for

capital expenditure: The exporter is an “AA” rated company with a sound

balance sheet and good track record The bank has an overall cost/income ratio of 40% The bank needs to hold 8% capital against the loan The bank’s funding cost for the loan is 3%

=> What interest rate [I%] should the bank offer on this loan?

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Meeting return hurdles

RAROC = Revenue – Cost – Expected Loss Required Capital

Revenue $R = $100m * (I% – 3%) Cost $C = $R * 40% Expected loss = PD * LGD where Probability

of Default for “AA” rated company for 5-years is 0.2% with Loss Given Default of 20% (recovery rate 80%)

Required capital RC = $100m * 8% = $8m

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Meeting return hurdles 12% = $R – ($R * 40%) – $100m * 0.2% * 20%

$8m

= $R * 60% - $0.04m $8m

= ($100m * (I% - 3%) * 60% - $0.04m $8m

=>I% = (12% * $8m + $0.04m) + 3%

$60m= 4.6667% (“Credit margin”: 167 basis points)

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Meeting return hurdlesCharging a “AA” rated company a credit

margin of 167 basis points could be uncompetitive

If customer wanted to pay a 50 basis point margin the bank would have to accept RAROC of 3.25% or not do the deal

Banks often subsidise low RAROC lending in order to “X-sell” higher margin products

Take a whole of relationship view on the customer Aim to earn fees from derivative hedging income

perhaps

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Fee based incomeCommercial banks like fee-based revenue

because they do not have to set capital aside if there is no residual credit or market risk

Fees include: Syndicated loan underwriting fees Upfront derivative fees

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Derivative business incomeBanks generate derivative revenues from

trading and “market making”Trading: take “long” or “short” positions in

markets through derivatives, similar to securities trading

Market Making: provide prices to clients at any given time of their choice

Aim to buy low / sell high by having clients transaction on both sides of the “bid/offer” spread

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Foreign Exchange incomeBank FX divisions generate income from

trading and market makingFX markets are extremely efficient and

bid/offer spreads are very narrowVolumes are HUGE though!Complex FX derivatives are high margin

generators for banksFX market was first to embrace e-markets

platforms and many customers can plug directly into markets these days

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The retail banking businessThe principles behind making money in the

retail business are similar to wholesale banking

Retail bankers are allocated capital and look to make loans, funded by deposits, to generate acceptable RAROC

Portfolio diversification is easier given there are many smaller customers in the portfolio

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The mortgage businessBy far the largest retail commercial banking

business in many economiesMortgage NIM often in the range of 1-3%RAROC, cost/income, efficiency are key

driversMortgage product is very similar across many

banks

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Credit and debit cardsCredit cards offer the holder an unsecured

line of credit that can be drawn to pay for goods and services

Debit cards are accounts that must have positive fund balances before they can used to pay for goods and services

Retailers that accept credit cards charged fees of up to 3% for each transaction

Customers that don’t repay their cards monthly often subject to huge interest rates eg 16%

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Trade financeTrade finance products are typically short

term, uncommitted and secured RAROC is high because banks don’t have to set

aside capital against “undrawn commitments” Off-balance sheet products like Letters of Credit

(LCs) can have favourable capital treatment Secured against trade flows eg crude oil cargos

(LGD significantly reduced

Economics of trade finance often highly reliant on commodity prices

With crude prices halving, if volumes remain unchanged trade finance volumes will half

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Key bank financial metricsLoan / Deposit ratio – measure of how much of banks loan

book is being funded by depositsTier 1 ratio – ratio of permanent capital to “risk weighted

assets” (RWAs)Leverage Ratio – ratio of Tier 1 capital to total assetsLiquidity Coverage Ratio – ratio of outflows over a critical

timeframe (eg 30 days) to high quality liquid assetsNet Stable Funding Ratio – ratio of “stable funding” to long

term assetsEfficiency ratio – equivalent to the operating margin – ratio

of operating revenue (EBIT) to total revenueROE or ROA – traditional return metricsCredit quality – loan loss ratios