The Business of Banking Chapter 11

Hong Kong Banking Industry Three Tier Structure Link Fully Licensed Banks -21 Locally Incorporated -164 Foreign Incorporated Restricted License Banks: Securities Companies - 20 RLB’s Deposit Taking Corporations: Finance Companies - 23 DTC’s

Historical Origins Modern Local Banks: Pre-war banks. (HSBC, Bof EA,). International Banks –. (Citibank, StanChart, DBS) Chinese State Banks – Chinese government set up banks in HK in pre-war era. After the revolution, these were taken over by PRC. Due to the isolation of PRC, these banks were the main link between the mainland and the world financial system (Bank of China, Nanyang Commercial) Native Banks – Banks that serviced the rapidly growing retail markets for small deposits and loans during the immediate post-war migration of immigrants from the mainland (Hang Seng, Wing Lung, Dao Heng and many others)

Transactions Costs 1. Pooling Savings Debt serves a useful purpose in matching those who currently have greater income than consumption to those with greater consumption than income. However, matching buyers and sellers involves some costs. Institutions develop to reduce these costs. 1. Pooling Savings Take advantages of economies of scale Diversify Risks Safekeeping of Assets 2. Providing Liquidity Reduce transactions costs by allowing depositors to convert assets into cash. 3. Reduce Information Costs Ameliorate asymmetric information

Licensed Banks Aggregate Balance Sheets

Multiple Currency Deposits Hong Kong banks accept large amounts of foreign currency deposits. Small market for Foreign currency loans in Hong Kong. HK banks lend money to banks overseas, multinational banks lend money to firms overseas.

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Bank Assets Cash Items Primary Reserves (Vault cash + Clearing Balances), Current Balances at Other Banks. Loans Interbank Lending, Advances to Customers Securities Government Bonds, MBS, Corporate Debt, Large CD’s, Stocks. Other Assets Land, Buildings, etc.

Liabilities Checkable & Non Transactions Deposits: Checking accounts, current accounts, demand deposits,savings deposits, time deposits, certificates of deposit. Borrowings: Discount window borrowing, borrowing in interbank market. Other Liabilities: Subordinated debt, deferred tax liabilities

Hong Kong Interbank Market Hong Kong deposit market dominated by big branch networks many smaller banks raise funds by borrowing from big banks. Until 2001, HK limited branch networks of foreign banks. Foreign banks finance HK lending with loans from overseas parent. HK banks accept many foreign currency deposits. Lend that F.C. to banks overseas.

Bank Net Worth/Shareholder Funds: Funds put at risk by the owners of the bank. Share Capital: Money raised by selling equity shares in Primary Markets Retained Earnings : Profits not (yet) paid as dividends. Balance sheet typically includes some proposed dividend. For tax purposes, some retained earnings are classified as other reserves

Profits of Banking: Interest Income Banks collect retail deposits from savers and make loans to borrowers. Profits are earned by banks when they are able to make loans at higher interest rates than they pay depositors. Net Interest Income is the interest rate earned on assets (mainly loans) minus the average interest paid on liabilities (mainly deposits).

Net Interest Margin: Net Interest Income divided by Interest Earning Assets.

Investment Income, etc. Changes in Value of Subsidiaries etc.

Capital Adequacy Management Compared to non-financials, banks have low capitalization. Bank capital is the funds invested by the owners of banks in the bank. Three factors affect the decisions of bank owners to finance with equity capital: Bank capital prevents bank failure. Bank capitalization affects returns to shareholders Government regulations affect capitalization (next chapter)

Bank Failure Bank failure occurs when a bank cannot pay its depositors in full. Riskier and less liquid assets make bank failure more likely. Banks with high levels of capital can have some negative profits and still avoid failure. Bank owners need to invest their own funds to offset its own moral hazard issues.

How Bank Capital Prevents Bank Failure Consider two banks with identical balance sheets except that Bank A is well capitalized while bank B is poorly capitalized. Assets Liabilities Reserves $10 Deposits $90 Deposits $96 Loan $90 Capital $10 Capital $4

How Bank Capital Prevents Bank Failure Bad economic times cause borrowers to default on $5 million in loans. This wipes out the capital of the weakly capitalize bank but leave the highly capitalized bank in business. Assets Liabilities Reserves $10 Deposits $90 Deposits $96 Loan $85 Capital $5 Capital -$1

Equity Multiplier ROA/ROE This is assets relative to shareholders equity (i.e. net worth less loan capital) A measure of the returns earned on assets is Return on Assets Owners of equity are concerned with the pay-off they earn per each dollar originally invested in the bank: Return on Equity Equity returns are a positive function of ROA and leverage

Basil Capital Accords International Treaty sets minimum standards for bank regulation. Committee meets under the auspices of the Bank for International Settlements: the central bank of central bankers. Treaty defines Capital Adequacy Ratio: Basi requires HK banks to maintain a Capital Adequacy Ratio of at least 8%

A bank has n = 1, …, N assets. Asset n has a dollar value of Ln. Risk Adjusted Assets The risk adjusted assets of a bank are a weighted some of loans and other assets, with the weights being an increasing function of risk. A bank has n = 1, …, N assets. Asset n has a dollar value of Ln. Total assets = L1 + L2 + ….LN Regulators assign a weight to each asset, wn, that is increasing in the level of credit risk. Risk adjusted Assets = w1L1 + w2L2 +….wN L3

CAR Risk Adjusted Assets are weighted sum of assets with higher weights for higher risk. Original risk weight categories have become more complicated OECD Government. 0% Banking. 20% (weight = .2) Secured Residential Lending. 50% (weight = .5) Commercial and consumer loans, corporate bonds. 100%-150% (weight = 1-1.5)

Capital Adequacy Ratio of HK Banks

Basel II Banks are required to have some share of their operating income as capital. The new accord creates more sophisticated way of measuring credit risk. Banks must keep capital depending on assets and operating income increasing capital requirements. Banks to apply their own credit models (based on statistical analysis and valuation of collateral and hedging to their liabilities) This will likely reduce capital needed.

Credit Risk: Credit Risk: The risk arising from the possibility that the borrower will default. Financial Intermediaries in general and banks in particular exist because of their efficiency in dealing with credit risk. Much of credit risk in financial markets occurs due to asymmetric information and its associated phenomena, adverse selection and moral hazard.

Managing Banks: Balance Risks and Returns Banks must take risks as part of their business. Often most profitable activities of a bank will generate most risks for the banks. Bank managers must manage risk return trade-offs. Principles for Maximizing Returns while dealing with credit risk Diamonds in the rough Banks try to find borrowers who will pay high interest rates but who are unlikely to default. Borrowers who are well known to be good credit risks will have many sources of funds. Banks need to find information about certain borrowers not publicly available.

Strategies for Managing Credit Risk Credit-Risk Analysis – A loan officer manages banks relationship with borrowers and evaluate potential borrowers. Loan officers may have some specialization with certain industries or businesses. Loan officers also use credit scoring systems which use statistical data to measure default probabilities and charge interest rate commensurate with risk. Monitoring – Loan agreements may contain restrictions on borrower behavior or value of assets. Loan officers monitor behavior and may recall loans if covenants are violated.

Strategies for Managing Credit Risk (cont.) 3. Collateral – Loans identify physical assets which may be taken by the bank in case of default. 4. Long-term Relationships – Banks often have relationships with certain businesses which reduces information problems. elationships have value to businesses which they are loathe to jeopardize by engaging in moral hazard behavior.

Strategies for Managing Credit Risk (cont.) Credit Rationing - Borrowers must seek additional sources of finance for their projects including equity. Diversification – Banks can limit the likelihood of default by reducing exposure to a particular borrower or class of borrower. Sometimes there is a trade-off between diversification needs and strategies for finding diamonds in the rough, such as specialization or long-term relationships which may tend to reduce

Measures of Credit Risk Assessing a bank’s exposure to credit risk, we could ask 3 questions: What is the historical loss rates on loans and investments? What are the expected losses in the future? How is the bank prepared to weather the losses?

Expected Future Losses Historical Loss Rate Loan losses/charge-offs are the loans written off as uncollectible in any period. Releases & Recoveries refer to loans written off in the past but collected or collateral repossessed. Net loan losses are gross loan losses less recoveries. Expected Future Losses Measures Past Due Loans: Borrowers have not made a scheduled payment. Nonperforming Loans: Loans past due for 90 days are more.

Net Chargeoff Rates by Loan Type Source: FDIC Statistics on Banking

Net Charge-off Rates by Loan Type Source: USA FDIC Statistics on Banking Link

Protection Against Future Losses Loan Loss Reserve (Allowances for Loan Impairment): Quantity of gross value of loans that have been recognized as being likely to not be repaid. Net Loans (which appears as an asset on balance sheet) = Gross Loans – Loan Loss Reserve. When banks add to their loan loss reserve, they will deduct from profits. When banks charge-off bad loans, they deduct from gross loans and loan loss reserve and net assets are unchanged..

Credit Derivatives Risk Management Tools Used to transfer risk from one party to another. Credit Default Swaps (CDS) – A bank with credit risk exposure will pay X basis points per year and counter-party will make payment if there is a pre-determined credit “event” such as default or credit downgrade, etc.

Credit Default Swap Bank A Fee Payment Payment if negative credit event Bank B

Source: BIS Derivative Statistics

Liquidity Management Majority of Bank liabilities (deposits) are very Liquid. Banks provide payment mechanism to customers and are able to raise funds at low interest as a result. Liquidity advantage of depositors helps overcome asymmetric information advantage of bankers. Most profitable bank assets, loans, are illiquid. Banks particular expertise is in analyzing and monitoring long-term investment projects. Often expertise about a given project is specific to the bank itself and can’t be transferred. Banks loan portfolios are highly illiquid. Liquidity Risk: The possibility that depositors may collectively decide to withdraw more funds than the bank has on hand.

Liquidity Risk Most profitable bank assets, loans, are illiquid. Banks have a liquidity mismatch between assets and liabilities. Liquidity Risk: The possibility that depositors may collectively decide to withdraw more funds than the bank has on hand.

Maturity Mismatch No matter how well a bank is managed or how good the credit quality of their loans, if all liquid deposits are withdrawn at once, banks could not raise enough liquid funds to pay all obligations. Banks have very illiquid assets (loans) and obligations to repay their depositors in full at any time. If all of the depositors at a bank withdraw their funds at the same time, the bank will have to sell their loans at a discount, and they will not have enough funds to pay all of their depositors. If all of their depositors keep their money in the bank, most banks will be able to repay all of their depositors with interest. Thus, the payoff to any individual depositor depends on what other depositors decide to do.

Game Theory In many economic situations, agents returns depend on the actions of other agents. In such a situation, agents must think strategically. Economists use game theory to describe such situations. John (“A Beautiful Mind”) Nash developed a concept called the Nash equilibrium. A Nash equilibrium occurs when every player in a game is playing their best strategy given the strategy that the other players play. Economists believe that outcomes of strategic situations are likely to be well-described by Nash equilibrium. Since every individual in a Nash eq. is playing there best strategy given the actions of others, no one has any incentive to change their strategy individually.

Bank Run Game: Withdraw or Don’t Withdraw Depositors each deposit $1000 at 10% interest. They can choose to withdraw their funds before collecting interest or keep their funds with the bank. The right hand table shows pay-offs for each decision under two possible situations. All other depositors keep their funds in the bank and the bank survives. All other depositors withdraw funds and the bank must liquidate. Payoffs If an individual keeps their funds with the bank and everyone else does likewise, everyone gets their funds with interest. If an individual doesn’t withdraw, but everyone else does, the bank will have nothing left to pay the individual who gets nothing. If the individual depositor withdraws but no one else does, the depositor loses only interest. If an individual depositor withdraws and everyone else does, they have some chance of getting some funds (say $500) back. Individual Depositors Decision All Other Depositors Decision Withdraw Don’t Payoff: $500 $0 $1000 Payoff: 1100

Bank Runs The phenomenon in which all depositors compete to withdraw their funds at the same time is called a bank run or a bank panic. Depositors lack complete information about the value of banks assets. If depositors believe that there is a significant fraction of loans which will not be repaid, depositors may have an incentive to immediately withdraw funds. Bank deposits are first come, first serve. If you withdraw your funds before the bank declares losses you may not suffer at all. Further, even if you believe that banks assets are sound you may have an incentive to immediately withdraw, if you believe that other depositors will also withdraw their funds.

Panic of 1965 In 1964, there was a collapse in the property market. In January 1965, the Banking Commissioner closed Ming Tak bank which suffered losses in property investment. Two weeks later there was a run on deposits at Canton Trust which also had property holdings. Canton Trust suspended business on February 8. On February 9, there were runs on deposits at many native banks including Wing Lung, Dao Heng, and the strongest of the native banks Hang Seng. On April 9, Chinese newspapers published rumours that the head of Hang Seng was being interviewed by the police. By the end of the day, depositors had withdrawn half of the savings and checking deposits at Hang Seng. On April 10, Hongkong Bank took over Hang Seng.

Deposit Insurance Hong Kong Deposit Protection Board compensation limit is set at HK$500,000 per depositor per bank; secured deposits are protected; Hong Kong dollar, Renminbi and foreign currency deposits are protected; a DPS Fund with size of 0.25% of relevant deposits will be built up through the collection of contributions from Scheme members; and differential contributions will be assessed based on the supervisory ratings of individual Scheme members. Liquidity Crisis: Sudden deposit withdrawal requires liquidation of otherwise sound assets. Bank of East Asia, 2008 Link

Lender of Last Resort Banking system sufficiently important that gov’ts will usually protect depositors and prevent mass bankruptcies. Liquidity Crisis: Lend at penalty rates against good collateral. Walter Bagehot, 1840’s. Solvency Crisis: Recapitalize banks through gov’t purchase of equity, diluting or destroying shareholder value. Moral Hazard: Banks creditors and (sometimes owners) are protected from consequences of risky behavior. Link

Managing Liquidity A bank faces withdrawals of $5 million. This reduces liquidity. The bank can restore liquidity by managing assets or liabilities. Liquidity can be restored by converting secondary reserves (market securities) into primary reserves (cash). Assets Liabilities Cash - $5 Checkable Deposits -$5 Assets Liabilities Cash +$5 Securities -$5 The bank can also engage more short-term liabilities by increasing borrowings from other banks or central bank. Assets Liabilities Cash +$5 Borrowings+$5

Liquidity Requirements Liquidity Ratio Hong Kong licensed banks are required to keep a liquidity ratio of 25% or More Most banks are fairly liquid.

Core Deposits vs. Managed Liabilities Bank Liabilities can be divided into two parts. Core Deposits – Demand Deposits, Savings Accounts, Small Time Deposits (Retail Funds) Managed Liabilities – Borrowings from Other Banks, Commercial Paper, Large CD’s and Time Deposits (Wholesale Funds) Retail funds have lower interest costs and are thought to be more stable. They take much longer time to raise and have greater non-interest costs.

Measuring Liquidity Risk Loan to Deposit Ratio – Ratio of illiquid loans to liquid deposits. High measure of loan-to-deposit ratio indicates high liquidity risk.

Interest Rate Risk: Income Side Interest Rate Risk – The risk to an institution's income resulting from adverse movements in interest rates Many bank liabilities are of very short maturity (such as saving deposits) whose interest changes with market interest rates. Many bank assets are long-term and interest income may not change as market interest rate rises. When market interest rates rise, NIM will decline.

Interest Rate Risk: Balance Sheet Perspective An asset (or a liability) represents a set of payments that must be made at times in the future. Define PVT as the present value of a future payments made to an asset or a set of assets in T periods. Useful Approximation

Duration Measure of Interest Rate Risk Define market value, MV, of an asset or a set of assets as the sum of present values derived from payments made in each future period. Define the duration of an asset as d The % change of the market value of an asset to a change in the interest rate is approximately proportional to the duration of an asset.

Measuring Interest Exposure Calculate the duration of a banks assets, dA. Calculate the duration of a banks liabilities, dL. An increase in the interest rate will have the following effect on assets and liabilities. Calculate the GAP as a function of duration of assets and liabilities.

An increase in interest rates changes the value of a banks assets and liabilities.

Managing Interest Rate Risk A bank which has a large stock of assets which will pay a fixed interest rate may face losses if market interest rates rise. Since deposits must be redeemed at any time, the bank must offer market interest rates. If market interest rates rise, loan spreads will be cut. Banks may use asset and liability management to match the sensitivity of assets and liabilities to interest rates.

Floating Rate Loans Fixed payment loans have a constant payment based on a fixed interest rate. Floating rate loan payments are based on an interest rate that changes as some benchmark interest rate changes Floating rate loans protect NIM from interest rate margins.

Swaps Basic (plain vanilla) interest rate swap is agreement by two parties to exchange interest rate payments on a notional principal. One party pays a fixed interest rate for a pre-determined period of time. Another party pays a floating rate equivalent to some benchmark interest rate (LIBOR, etc.)

Swaps and Hedging If a bank has long-term fixed rate assets and short-term liabilities, they face interest rate risk. Solution: Swap income from fixed rate assets for floating rate from dealer. A pension fund with long-term obligations may like to lock in fixed income at a higher rate than LT treasuries. They may also swap income from floating rate assets for fixed income from a dealer.

Interest Rate Swaps are Quickly Growing in Importance Source: BIS International Financial Statistics http://www.bis.org/statistics/derstats.htm

Banks as Risk Taking Institutions Banks may specialize in ameliorating effects of asymmetric information. But there is still asymmetric information between banks and depositors. Banks info advantages are offset in at least 2 ways. Bank Capital – Owners of banks put some of their own funds into banks and these funds are at risk. Liquidity Advantage of Depositors – Depositors can withdraw funds very quickly from banks.