1. Introduction to Banking and Finance
Guy Hargreaves
WeChat: Guyhargreaves
ACE-102

2. Central Banks, monetary policy and the lender of last resort

3. Central Banks
Central Banks play a critical role at the heart of every currency’s financial system
Responsible for oversight of monetary system underpinning the currency
Some Central Banks are also charged with oversight of the deposit-taking and non deposit-taking financial institutions in their financial system
Most common goal of a Central Bank is to manage monetary policy to foster growth without inflation

4. Central Banks Most common roles of a Central Bank are:
Control the issue of banknotes and coins
Control or influence the amount of credit creation within a financial system
Act as “lender of last resort”
The Government’s banker
Oversee FX, gold and other reserves
Effectively Central Banks control credit expansion, liquidity and money supply of an economy

5. Macroeconomic policy
Government policy focused on economic management can generally be viewed in five categories:
Monetary policy (influence supply and cost of money)
Fiscal policy (government taxation and spending)
Exchange rate policy (influence FX rates)
Prices / incomes policy (inflation and earnings)
National debt policy (government debt management)

6. Central Bank monetary policy
Monetary policy is the most important role of Central Banks
Governments tend to set objectives for monetary policy – Central Banks take independent actions to try and meet these objectives
Price Stability (low or no inflation, and not deflation)
Full employment (low unemployment)
Stable economic growth (not too hot and not too cold)
Financial market stability (FX, interest rates and the financial system itself)

7. Monetary policy tools The major tools of a Central Banker are:
Open Market Operations (OMOs)
The Discount window
Reserve requirements
Via these tools Central Banks can influence:
Short term interest rates
FX rates
Bank reserves

8. Open market operations
The Central Bank will buy or sell government securities in the open market to influence both interest rates and the overall money supply
eg the US Federal Reserve (Fed) announces to the market its target for the overnight Fed Funds rate
Fed Funds are interbank borrowings used to manage the reserves they are required to hold at the Fed
If Fed Funds is higher than the Fed’s target rate it will inject money into the banking system through “repo” lending transactions
As money is pushed into the system the Fed Funds rate falls to the level targeted by the Fed The opposite happens if Fed Funds is trading lower than the Fed’s target
Banks and financial markets use the Fed Funds rate as a base rate to set other interest rates from

9. Quantitative easing
Since the GFC the Fed and other Central Banks have been conducting a type of OMO called Quantitative Easing (QE)
Typical OMOs are very short term – often overnight – and therefore alter the money supply short term
With QE the Fed purchased longer term securities such as RMBS, in theory expanding the money supply more permanently
QE was designed to reduce long term interest rates and boost inflation at a time when deflation was a risk

10. The discount window
Eligible banks are able to access their Central Bank’s Discount Window
The discount window is a facility that allows banks to borrow from the Central Bank by discounting securities
Discount window rates are typically higher than rates targeted by Central Banks through their OMOs
Discount windows are generally considered to be used only in times of financial system stress

11. Reserve requirements
Banks are required to hold a certain % (reserve ratio) of their deposits in Reserve Assets, making these funds unavailable for on-lending
By increasing the reserve ratio Central Banks can force banks to reduce their existing lending or reduce future lending

12. Recall: theory of credit creation
Bank
$ Deposit taken
$ Loan made
$ Reserve held A
5.0000 B
4.5000 C
4.0500 D
3.6450 E
3.2805 …
Total
50.000
Under a 10% Reserve Ratio for each $1 deposit taken the banking system can create $10 in new deposits
Credit Multiplier = Change in Deposits / Change in Reserves = 500 / 50 = 10

13. Changing reserve requirements
Reserve Ratio
$ Deposit taken
$ Credit Created 5% 50
1,000
10%
500
15%
333.3
Reducing the reserve ratio from 10% to 5% allows the banking system to create more new deposits, whereas increasing it to 15% reduces the amount of new credit creation possible

14. Monetary policy
Of the five policy categories managed by Governments, monetary policy is the only area Central Banks can effectively manage:
Monetary policy – OMOs, discount and reserves
Fiscal policy – government decisions
Exchange rate policy – very open market
Prices / incomes policy – government decisions
National debt policy – government decisions

15. Monetary policy theory
Milton Friedman: “inflation is always and everywhere a monetary phenomenon” - prominent in the school of Monetarism
One of many theories on the underlying cause of inflation
The equation of exchange: MV = PY
M is the quantity of money
V is the velocity of money
P is the price level (or GDP deflator)
Y is real GDP
Quantity theory of money:
Assuming the velocity of money was constant then for a given real GDP, the price level P is directly related to the money supply M
Seems intuitive but empirical evidence is mixed

16. Exchange rate policy
Direct action in the FX markets to impact prices is extremely difficult for any party, including Central Banks – for fully floating currencies with little exchange restrictions
Many countries have fixed exchange rates (eg HKD, RMB) which are allowed to trade within a controlled band
FX rates can be set to be higher or lower than they would be if prices were allowed to float
Market truism: “you can control price, or you can control volume – but you can’t control both”

17. Central Bank independence
Independent Central Banks tend to meet their monetary policy objectives more often
Thinking about our policy mix what might governments see as quick fixes for their political fortunes?
Fiscal policy – highly political
Exchange rate policy – impractical
Prices / incomes policy – highly political
National debt policy – highly political
Monetary policy – tempting???

18. The lender of last resort
Central Banks through their discount window and supervisory responsibilities are considered by some as “lenders of last resort”
In a time of crises banks can access the discount window to stay afloat when there might be a “run” on
This function is really about providing liquidity and not solvency to a bank or group of banks
Solvency is the ability of a bank to ultimately meet all its liabilities from its asset base with an acceptable level of equity remaining
“Bank Liquidity” is the ability of a bank to reissue maturing liabilities as and when they become due

19. The lender of last resort
Many consider lender of last resort to introduce “moral hazard” into the banking system
Banks have a perverse incentive to take excessive risk if they feel their Central Bank will “bail them out”
Banks arguably occupy the most privileged position in the economy
Able to leverage their balance sheets (total assets / equity 10-30x)
Able to tap their Central Banks for liquidity if business becomes difficult
Many economists and others argue for less regulated “Free Banking” – this has its +ves and -ves

20. Supervision
Central banks around the globe have many and varied roles in supervision or many functions and features of their respective financial systems
Monetary analysis (data and statistics)
Oversee financial market stability
Promote market stability
Supervise banks (some CBs, not others)
Reserve portfolio management
Payment systems

21. What is bank supervision?
Banks occupy a highly privileged position in the economy, being highly leveraged but with “government guaranteed” liquidity!
To ensure banks do not fall to moral hazard and they are soundly run the regulators have established rules around bank capital, liquidity and other risks
Global standards for regulation have been set by the Bank for International Settlements (BIS), based in Basel, Switzerland

22. What is bank supervision?
The Basel capital accords, negotiated amongst its 60 members, are supposed to set a standardised global framework for sound bank management practices
Being non-binding, the BIS I, II and incoming III accords have not been adopted uniformly worldwide leading to effects from the “law of unintended consequences”

23. Regulatory “arbitrage”
Banking regulations are a significant driver for banks:
Business mix (eg mortgage versus High Yield corporate lending)
Capital management strategy
Transaction structures
Risk / reward and compensation policies
Banks have had great ability to react quickly to regulatory opportunities in the past
“Regulatory arbitrage” under BIS I was commonplace because of uneven treatment of risk weightings in that system

24. Regulatory “arbitrage”
Under BIS I corporate bonds were “risk weighted” at 100% for determining capital required to support them
Didn’t matter if the issuer was AAA or BB
Capital for $10m of corporate bonds = $10m * 100% * 8%
= $800k
But for the same corporate bonds sold to SPC which issues 364 day CP supported by the bank liquidity facility would be 0% risk weighted for the bank
=> Banks set up SPVs to fund their corporate bonds!

25. Goals of bank supervision
Bank supervision aims to:
Minimise regulatory arbitrage (reduce to zero!
Watch bank leverage and liquidity carefully
Maintain system stability to avoid the discount window being used
Create a stable financial system

26. Bank regulation and the future

27. Why do we need bank regulation?
Financial systems suffer periods of instability
Business cycle, fundamental changes, technology can all cause instability
The banking sector is vulnerable to this instability due to its in-built high leverage
An unstable banking system can cause “bank runs” when depositors lose confidence
Central bank regulation of banks and the banking system is vital to minimise the chances of banking system instability and to protect bank customers

28. Types of bank regulation
Bank regulations come in the form of either Systemic Regulation of Prudential Regulation
Systemic regulation is usually:
Government deposit insurance
Lender of last resort
Prudential regulation is usually:
Capital rules
Liquidity rules
Code of conduct

29. History of bank regulation
Each local financial system has its own history of bank regulation
Globally a number of major regulatory milestones have had widespread impact:
1933 Glass-Steagall – separation of Investment and Corporate Banking in the US (largely repealed in 1999)
1988 first Basel Capital Accord “BIS I”. Concept of Tier 1 (Equity) and Tier 2 (sub debt, hybrids, other) and Risk Weighted Assets (RWAs). Tier 1 + Tier 2 capital = 8% * RWA
1996 second Basel Capital Accord “BIS II”. Three “Pillars” – 1: capital, 2: supervisory review, 3: disclosure

30. BIS II
Currently the “global” banking system is supposed to be operating under BIS II
Pillar 1:
Risk Weightings aligned to actual expected credit risk
Credit risk calculation could be “Standardised” or “Internal Ratings Based”
Market and Operational risk also included
Pillar 2:
Boosting regulatory powers to review and supervise banks
Pillar 3:
More disclosure of risk, capital adequacy and risk management

31. Financial Crises There are many types of financial crises, including:
Banking crises
Currency crises
Speculative asset price bubbles
Economic crises
GFC was mostly a banking crisis but it came from a speculative asset bubble
Economic crises are usually deep recessions or depressions where GDP falls sharply

32. Banking Crises
Loss of confidence in a bank or number of banks leading to bank run where depositors withdraw funds rapidly
Often associated with periods of poor lending decisions leading to high loan portfolio loss provisions
High leverage in the banking system means confidence is fragile
Small loan losses can quickly turn into a banking crisis

33. Currency Crises
A large increase in country risk can cause foreign investors to lose confidence in the country
Country risk might come from a local economic crisis or perhaps political change
Foreign investors will sell a currency quickly if they lose confidence
25%+ fall on relevant FX rate
Often the Central Bank will try to support the currency by increasing local interest rates
1997 Asian Currency Crisis is classic example of currency crisis – began in Thailand and flowed across the region

34. Currency Crises - IDR
Indonesian Rupiah – USD FX rate:

35. Speculative Asset Price Bubbles
A speculative asset price bubble is a large increase in the price of an asset, often over longer periods, which leaves the asset valuation out of line with underlying fundamental valuations
Dutch tulip bubble of 1637
1929 Wall St crash
1980s Japan property bubble
Late 1990’s “dot-com” bubble
US housing price bubble
Bubbles usually end with a large price crash!

36. 2007-9 Global Financial Crisis
GFC had its roots in US property prices

37. 2007-9 Global Financial Crisis
US property prices from 1987:

38. Over-investment in property
Both US Agency lenders (Fannie Mae and Freddie Mac) lent aggressively to US home buyers in
Securitised lenders also lent aggressively over this time – Investment Banks arranged funding of their using securitisation
Loans for “sub-prime” borrowers were made at 100% LVR!
By 2006 the US property market was a bubble financed by lenders and investors all over the world, often using large amounts of leverage

39. The property bubble bursts
In 2006 the US property market bubble burst and mortgage borrowers started defaulting in large numbers
Banks had massive exposure to the mortgage loan business through loans and securitised products
By 2007 banks around the world were reporting huge losses and confidence in the global banking system had collapsed
Extraordinary measures were taken by 2009 to rescue the system
USD 700bn TARP recapitalised the US banking system
USD short term interest rates were lowered to near 0%
Banks and insurers were forced into mergers or government ownership
Etc etc!

40. Fed Funds
Fed Funds lowered to historic levels:

41. Impact on the “real economy”
US GDP growth collapses during the crisis:

42. Impact on the “real economy”
US unemployment rises sharply from 2008:

43. Impact on the “real economy”
US automobile industry goes bankrupt and needs government bailout
AIG – large international insurer - nationalised
Bank of America forced to buy Merrill Lynch
Property market collapse worsens
US government injects USD2 trillion+ into the economy through fiscal measures
Etc etc!

44. Conclusion: improve bank regulation
The wasn’t just a US crisis – Europe has had enormous problems as well
Result was fast track Basel / BIS III
US passed “Dodd Frank” law
Reduce bank trading
Increase derivative transparency through clearing
Allow for orderly bank closures
Rid system of “too big to fail”
Reform mortgage market
Toughen consumer finance protection laws

45. BIS III
Required Capital – increase required capital – Tier 1 up from 4% to 6%
Introduce Leverage Ratio – ratio of Tier 1 capital divided by “total exposure” to be a minimum of 3%
Introduce Liquidity Cover Ratio – High quality liquid assets divided by net cash outflow over the next 30 days >100%
Introduce Net Stable Funding Ratio – Long Term Stable Funding divided by Long Term Assets (> 1-year) > 100%

46. BIS III
Introduce counter-cyclical capital buffers – increase capital in good times so banks have more protection for bad times
Strengthen risk frameworks across a lot of areas of the banks eg:
Credit Valuation Adjustment (CVA) for swap counterparty risk management
OTC derivative clearing through centralised exchanges
BIS III is costly for banks and will be less efficient (ie a burden for the global economy) - but should strengthen the banking system
Timetable for introduction

47. Banking of the future?
Banking in the future may look nothing like the past!
Same basic functions of financial intermediation and direct finance will probably exist
“Fintech” or Financial Technology is changing the banking landscape dramatically
2000: 300M internet users mostly on dial-up
2015: 3,000M internet users mostly on 4G smartphones
Cryptocurrencies – what if Bitcoin is the future?
P2P decentralised “trustless” “currency”
No Central Bank can control supply of cryptocurrencies
The “Blockchain” may change banking forever!

48. Fintech at a glance

49. Fintech is the place to be!
Retail branch banking will die out with our parents!
Everyone has a smartphone and can use it to bank
Banking has been slow to change and adopt technology in the past 20 years
Disruption is the BIG economic theme of the 2010s and probably the next two decades
Think Uber, Paypal, iTunes Store, Amazon, Alibaba, Tencent

50. The business of banking

51. Theory in practice
Recall banks, like other financial intermediaries, perform three basic high level functions:
Size transformation
Maturity transformation
Risk transformation
The business of banking doesn’t focus on these functions per se, rather it creates practical products and services that solve customer problems and meet customer needs

52. Size transformation For a bank this means:
Estimating market appetite
Underwriting and distributing in size
Using balance sheet to take liquidity risk
Using information asymmetry fairly
Customers want loans and other banking products and services tailored to their own size

53. Maturity transformation
For a bank this means:
Using its “Capital Structure” to manage maturity risk
Underwriting balance sheet maturity “Gaps”
Using information asymmetry fairly
Very long dated maturity demands can be challenging for banks
Sweet spot 3-5 years for loans
Project Finance loans often years!

54. Risk transformation
Savers rationally want to invest in diversified portfolios of credit risk
$100 invested in a single “A” rated corporate can have very different investment outcomes compared with $100 invested across 100 “A” rated corporates
Bank portfolios are very diverse
Borrowers don’t care so much about this risk transformation
Government deposit guarantees also impact savers behaviour (not risk transformation)

55. 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 banks is to use this capital to invest in assets which generate sufficient return to provide an acceptable return on capital (RAROC)
Decreasing risk
and maturity
for financial
liability holders

56. The cost of capital
The cost of bank capital is a crucial 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

57. 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

58. RAROC Risk Adjusted Return on Capital (RAROC)
Widely used metric in the banking industry to measure the return generated from specific assets
Banks set minimum RAROC hurdles in their decision making processes
RAROC = Revenue – Cost – Expected Loss
Required Capital

59. RAROC RAROC = Revenue – Cost – Expected Loss Required Capital Where:
Revenue is earned from the “net margin” or the return from the asset less the cost of funding it
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 asset

60. Meeting return hurdles
Assume a bank sets its RAROC hurdle at 12%
An exporter requests a $100m 3-year loan for capex:
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 banks funding cost for the loan is 3%
=> What interest rate I% should the bank set on this loan?

61. 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

62. 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
= % (“Credit margin”: 167 basis points)

63. Meeting return hurdles
Charging a “AA” rated company a credit margin of 167 basis points would be “out of market”
If customer wanted to pay 50 basis points the bank would have to accept RAROC of 3.25% or pass on the deal
Banks often subsidise low RAROC lending in order to “Cross Sell” higher margin products
Take a whole of relationship view on the customer
Aim to earn fees from advisory or perhaps income from derivative hedging

64. Cross sell
Banks like other businesses are strongly focused on cross selling additional products to the same customer
Borrower takes out a floating rate loan for 5-years as funding for an acquisition
Bank provides tightly priced loan and is awarded Interest Rate swap which hedges the borrower against rising interest rates
Bank provides M&A advisory for a fee
=> combination of three transactions meet bank’s RAROC hurdle

65. Fee based income
Banks like fee based revenue because they do not have to set capital aside as there is no residual risk
Fees include:
M&A fees
Syndicated loan underwriting fees
Bond underwriting fees
Equity underwriting fees
Upfront derivative fees

66. Derivative business income
Derivative business are very complex!
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 liquidity to clients at any given time by quoting either buy or sell price
Aim to buy low / sell high by having clients transaction on both sides of the “bid/offer” spread

67. Securities business income
Bank Capital Markets divisions generate large revenues when markets are healthy
Equity, bond, syndicated loan and securitisation transactions flow through financial market dealing rooms
Banks trade and “market make” in the securities in the secondary market
In addition banks are paid fees for arranging, underwriting, and distributing new securities issues in the primary market

68. Foreign Exchange income
Bank FX divisions generate income from trading and market making
FX markets are extremely efficient and bid/offer spreads are almost non-existent
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

69. Dodd Frank and trading
Following the GFC new regulations called “Dodd Frank” were enacted
Under Dodd Frank banks’ ability to engage in trading will be severely reduced
Market making will still be possible – but only valuable in less efficient markets

70. The retail banking business
The principles behind making money in the retail business are broadly similar to wholesale banking
Retail bankers are allocated capital and look to make loans, funded by deposits, to generate acceptable RAROC
Portfolio diversification is possibly easier given there are many smaller customers in the portfolio
Being retail, banks have historically had extensive branch networks for coverage
The internet is changing the face of retail banking dramatically!

71. The mortgage business
By far the largest retail business in many economies
“Mum and Dad” borrowers taking out home loans
Typically “secured” by the property financed
Borrowers are asked for deposits ranging from 0% to 60% of the property
Margins often 1-3% for banks
Securitisation industry has been significant supplier of funding to mortgage business
“Prime” and “sub-Prime” borrowers

72. 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%
Fraud risk is very high in the credit card business

73. 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

74. Investment products
Banks have increasingly moved into many areas of investment products including:
Pension and mutual fund management
Trustee and custodial services
Private banking and advisory
Funds management is a “best efforts” fee based business and not financial intermediation
As saving pools grow funds under management grow driving fee growth

75. 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

76. The economics of diversification
Bank portfolios benefit from their scale and diversification
Significant efficiencies come from large scale because of the economics of fixed versus marginal or variable costs
Large scale alters the asymmetric information balance making banks more able to deliver efficient products
Portfolio diversification theory suggest more diversified portfolios will perform more closely to expectations
Less diversification leads to higher event risk which impacts on bank WACC

77. Asymmetric information
Financial market participants often have varying levels of information –> Information Asymmetry
Some players have differing information
Some players have Inside Information
All players have imperfect information
Asymmetric information can lead to Adverse Selection and Moral Hazard

78. Adverse selection
Adverse selection can become a big problem in banking due to information asymmetry
Better informed banks can tend to “exploit” less well informed customers
Extreme examples in GFC when investors were sold portfolios of mortgage loans where borrowers were adversely selected to be poor quality
In famous case of “Abacus” a bank created an adversely selected portfolio and profited from also arranging for another client to “bet against” the portfolio
The so-called “Market for Lemons” problem where “bad money drives out good”
Compliance and Risk Management functions are being heavily increased in banks today to prevent outcomes like this

79. Moral hazard
Moral hazard arises in a contract when one of the parties has an economic incentive to behave against the interests of the other
Classical example is a homeowner buying fire insurance just before their home burns down
Insurance industry is large target of this behaviour
Banks have a poor record of managing moral hazard given large incentives to behave poorly
Often arises in the Principal-Agent relationship where the agent has information asymmetry and can act in its own interests rather than the interests of its customer