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

2. 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

3. The business of commercial banking

4. 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

5. 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?

6. 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

7. 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

8. 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

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 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

10. 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

11. 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

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 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

14. 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

15. 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?

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 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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%

25. 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

26. 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