THE BUSINESS OF BANKING Chapter 11

Transactions Costs 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. Intermediaries develop to reduce these costs. 1. Pooling SavingsTake advantages of economies of scale Diversify Risks Safekeeping of Assets 2. Providing LiquidityReduce transactions costs by allowing depositors to convert assets into cash. 3. Reduce Information Costs Ameliorate asymmetric information

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Hong Kong Banking Industry Three Tier Structure Fully Licensed Banks -22 Locally Incorporated -164 Foreign Incorporated Restricted License Banks: Securities Companies - 20 RLB’s Deposit Taking Corporations: Finance Companies - 23 DTC’s Link

+Bank of Communication 3

Historical Origins 1. Modern Local Banks: Pre-war banks. (HSBC, Bof EA,). 2. International Banks –. (Citibank, StanChart, DBS) 3. 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) 4. 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)

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 1. Cash Items Primary Reserves (Vault cash + Clearing Balances), Current Balances at Other Banks. 2. Loans Interbank Lending, Advances to Customers 3. Securities Government Bonds, MBS, Corporate Debt, Large CD ’ s, Stocks. 4. Other Assets Land, Buildings, etc. p. 31

1. Checkable & Non Transactions Deposits: Checking accounts, current accounts, demand deposits,savings deposits, time deposits, certificates of deposit. 2. Borrowings: Discount window borrowing, borrowing in interbank market. 3. 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

Investment Income, etc. Changes in Value of Subsidiaries etc. PROFIT = NII + NFI +PLL-OE + NOE -TAX

Profits of Banking: Interest Income 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 Margin: Net Interest Income divided by Interest Earning Assets. Net Fee Income

Fee Income

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: 1. Bank capital protects against bank failure. 2. Bank capitalization affects returns to shareholders 3. 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. AssetsLiabilitiesAssetsLiabilities Reserves $10Deposits $90Reserves $10Deposits $96 Loan $90Capital $10Loan $90Capital $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. AssetsLiabilitiesAssetsLiabilities Reserves $10Deposits $90Reserves $10Deposits $96 Loan $85Capital $5Loan $85Capital -$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

Capital Management Banks face a trade-off with leverage. If ROA is typically positive, leverage multiplies ROE. Leverage increases the volatility of ROE and increases probability of default risk or reaching regulatory boundaries. Capital constrained banks either raise new capital or slow lending growth, usually the latter.

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. 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. Principles for Maximizing Returns while dealing with credit risk

Strategies for Managing Credit Risk 1. 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. 2. 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.) 5. Credit Rationing - Borrowers must seek additional sources of finance for their projects including equity. 6. 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: 1. What is the historical loss rates on loans and investments? 2. What are the expected losses in the future? 3. How is the bank prepared to weather the 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 LinkLink

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..

Loan Provisions are a contra-asset (i.e. netted out on asset side of the balance sheet)

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 Bank B Fee Payment Payment if negative credit event

Source: BIS Derivative Statistics BIS Derivative Statistics

Liquidity Management Majority of Bank liabilities (deposits) are very Liquid. 1. Banks provide payment mechanism to customers and are able to raise funds at low interest as a result. 2. Liquidity advantage of depositors helps overcome asymmetric information advantage of bankers. Most profitable bank assets, loans, are illiquid. 1. 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 creditors may collectively decide to withdraw more funds than the bank has on hand.

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). AssetsLiabilities Cash - $5Checkable Deposits -$5 AssetsLiabilities Cash +$5 Securities -$5 The bank can also engage more short-term liabilities by increasing borrowings from other banks or central bank. AssetsLiabilities Cash +$5Borrowings+$5

Core Deposits vs. Managed Liabilities Bank Liabilities can be divided into two parts. 1. Core Deposits – Demand Deposits, Savings Accounts, Small Time Deposits (Retail Funds) 2. 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.

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.

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 PV T 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, d A. Calculate the duration of a banks liabilities, d L. 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.

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. Almost all mortgages in HK are floating rate.

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 Source: BIS International Financial Statistics

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. 1. Bank Capital – Owners of banks put some of their own funds into banks and these funds are at risk. 2. Liquidity Advantage of Depositors – Depositors can withdraw funds very quickly from banks.