Banking and Financial Institutions Guy Hargreaves ACF-104 Wechat: Guyhargreaves

Recap of yesterday Understand 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

Goals of today Appreciate the key drivers to the business of commercial banking Review how commercial banks generate financial returns Describe the key metrics used in commercial bank financial management

Theory in practice Recall commercial banks perform three basic high level functions: Size transformation Maturity transformation Risk transformation This is the theory – how in practice to commercial banks actually generate net profit?

Size transformation For 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

Maturity transformation For 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

Risk transformation Savers 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

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 risk Decreasing maturity

Recall: banking products and services Commercial 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

The cost of capital The 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

WACC example Capital type % of Capital Structure Cost Equity capital 6.0% 12.0% Hybrid capital 2.0% 9.0% Subordinated debt 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

RAROC Risk 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 Loss Required Capital

RAROC RAROC = Revenue – Cost – Expected Loss Required 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

Meeting return hurdles Assume 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?

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

Meeting return hurdles 12% = $R – ($R * 40%) – $100m * 0.2% * 20% $8m = $R * 60% - $0.04m = ($100m * (I% - 3%) * 60% - $0.04m => I% = (12% * $8m + $0.04m) + 3% $60m = 4.6667% (“Credit margin”: 167 basis points)

Meeting return hurdles Charging 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

Fee based income Commercial 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

Derivative business income Banks 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

Foreign Exchange income Bank FX divisions generate income from trading and market making FX markets are extremely efficient and bid/offer spreads are very narrow Volumes are HUGE though! Complex FX derivatives are high margin generators for banks FX market was first to embrace e-markets platforms and many customers can plug directly into markets these days

The retail banking business The 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

The mortgage business By far the largest retail commercial banking business in many economies Mortgage NIM often in the range of 1-3% RAROC, cost/income, efficiency are key drivers Mortgage product is very similar across many banks

Credit and debit cards Credit 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%

Trade finance Trade 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

Key bank financial metrics Loan / Deposit ratio – measure of how much of banks loan book is being funded by deposits Tier 1 ratio – ratio of permanent capital to “risk weighted assets” (RWAs) Leverage Ratio – ratio of Tier 1 capital to total assets Liquidity Coverage Ratio – ratio of outflows over a critical timeframe (eg 30 days) to high quality liquid assets Net Stable Funding Ratio – ratio of “stable funding” to long term assets Efficiency ratio – equivalent to the operating margin – ratio of operating revenue (EBIT) to total revenue ROE or ROA – traditional return metrics Credit quality – loan loss ratios