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

2. Recap of yesterday
Central Bank roles and goals in monetary policy setting
Lender of last resort
Central Bank roles in supervision
The relationship between Central Banks and the banks they regulate

3. The business of banking

4. Today’s goals Understand how banks generate financial returns
Describe the key metrics used in bank financial management
Appreciate the advantages of economies of scale and diversification
Understand the problems of asymmetric information, adverse selection and moral hazard

5. 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

6. 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

7. 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!

8. 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)

9. 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

10. Recall: banking products and services
Retail and Corporate banks offer a wide range of products and services
Current and chequing accounts - fees, liability raising
Term deposits - liability raising
Consumer loans and mortgages - asset raising
Credit and Debit Cards - fees, asset raising
Cash management services - fees, asset / liability raising
Corporate and SME loans - asset raising
Trade Finance - fees, asset raising
Financial market products and services - fees, trading, “bid/offer” spread
Capital Market products and services - fees, underwriting
Securitised or asset backed lending - fees, asset /liability raising
Investment products and services - fees
Insurance - fees, risk income
Advisory services - fees
Online banking - access

11. 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

12. 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

13. 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

14. 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

15. 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?

16. 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

17. 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)

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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!

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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