Revise Lecture 18. Basic Lending Principles Q: What is asset management banking?

Revise Lecture 18

•Basic Lending Principles

• Q: What is asset management banking?

• Asset management banking

Basic Lending Principles

Asset management banking• One of the main challenges to a bank is ensuring its

own liquidity under all reasonable conditions.• Commercial banks differ widely in how they manage

liquidity.• A small bank derives its funds primarily from

customer deposits. Its assets are mostly loans to small firms and households and it usually has more deposits than it can find creditworthy borrowers for.


Asset management banking• Excess funds are typically invested in assets

that will provide it with liquidity.

• The holding of assets that can readily be turned into cash when needed is known as asset management banking.

• Q: What is liability management banking?

• Liability management banking


Liability management banking

• In contrast, large banks generally lack sufficient deposits to fund their main business dealing with large companies, governments, other financial institutions and wealthy individuals.


Liability management banking• Most of these banks borrow the funds they

need from other major lenders in the form of short-term liabilities which must be continually rolled over.

• This is known as liability management,A much riskier method than asset management.



• A small bank will lose potential income if it gets its asset management wrong.

• A large bank may fail if it gets its liability management wrong.


Liability management banking • The key to liability management is the ability to

borrow always. • Therefore, a bank’s most vital asset is its

creditworthiness. If there is any doubt about its credit, lenders can easily switch to another bank.

• The rate a bank must pay to borrow will go up rapidly with the slightest suspicion of trouble.



• In recent years, large banks have been making increasing use of asset management in order to enhance liquidity, holding a larger part of their assets as securities as well as securitizing their loans to recycle borrowed funds.



• A ‘bank run’ is an overwhelming demand for cash by a bank’s depositors.

• A large depositor assumes a risk and needs to know something about the bank’s own balance sheet.

• However, a healthy balance sheet does not eliminate all risks.


Liability management banking• Even if the depositor knows the bank has

adequate liquidity.• Large depositors must, therefore, be

concerned about what others are likely to believe. A rumour a bank, even though unfounded, can trigger a run causes a solvent bank to fail.


• Profitability

• Q: What is profitability and profitability management?


Profitability• A bank generates profit from the differential

between the level of interest it pays for deposits and other sources of funds and the level of interest it changes in its lending activities.

• This difference is referred to as the SPREAD between the cost of funds and the loan interest rate.


Profitability• Historically. Profitability from lending activities

has been cyclic and dependent on the needs and strengths of loan customers.

• In recent history, investors have demanded a more stable revenue stream and banks have therefore, placed more emphasis on transaction fees, primarily loan fees, but also including services charges on an array deposit activities.


Profitability• However, lending activities still provide the

bulk of a commercial or retail bank’s income.• In the past few decades, banks have taken

many measures to ensure that they remain profitable while responding to ever-changing market conditions.


Profitability• The banking industry’s main obstacles to

increasing profits are existing regulatory burdens, new government regulations and increasing competition from non-traditional financial institutions.

• Profitability Management


Profitability Management• Profitability management is a total

management process, rather than just an accounting or analysis procedure.

• In contrast to asset and liability management, it places primary emphasis on the profit and loss account and secondary emphasis on the balance sheet.


Profitability Management• With profitability management, profitability is

not merely reported; it is planned, measured and interpreted.

• Planning ensures that efforts are directed toward the achievement of corporate objectives.


Profitability Management• Measurement checks and adjusts progress

against plan by matching revenue received with related expense

• Interpretation develops a valid picture of people and businesses, thereby serving as a basis for the next planning cycle.


Profitability Management• Profitability management involves the

monitoring of three distinct types of profitability statistics. The profits of bank can be measured in three ways;

• By organization• By product• By account


Profitability Management

• Organizational profitability is the most familiar type since all banks have some system for reporting the performance of their major organizational units.

• However, an effective profitability management system will also measure the performance of services and accounts.

Lecture 19


• Safety Issues


Safety Issues• The persistent failures of banks to lend

sensibly in Pakistan and in many other countries have brought the question of safety in lending to the fore;

• Why do banks persistently lend so imprudently and how should lending be done at minimum risk?


Safety Issues• One essential problem is the human and

managerial challenge of motivating employees of banks to cater to the interest of the owners (shareholders) of the bank.

• The history of banking is replete with episodes of employees favouring friends and relatives with loans.


Safety Issues• In some countries, there are well-defined

market rates for bribes for obtaining loans from banks.

• This problem is also present in Pakistan, though the record of Pakistan’s banking system in this aspect is much better than that of many other countries.


Safety Issues• Another aspect of the problems of banks

concerns prudent levels of leverage.• A bank is a financial intermediary with fairly

small equity capital, which borrows money from depositors and invest it into risky assets. This involves a high degree of leverage


Safety Issues• Leverage, at the level of the bank, is

dangerous regardless of the quality of credit analysis which has gone into each loan.

• High leverage generates high risk and high returns. If high returns are obtained, the bank takes the profits but it is protected from high losses by the government.


Safety Issues• Regulators have tried many policy initiatives aimed

at obtaining a banking system which has controlled leverage, high quality lending and thus, a reduced risk of failure.

• These include capital adequacy requirements based on clumsy measurement of risk, prohibition of lending against real estate, restrictions on lending against shares, rules governing collateral, etc.


Safety Issues• A riskless loan is one that is fully collateralised using

actively traded assets. • These assets should be traded objects so that a ‘market

to market’ can be done daily, to ensure that the collateral is always larger than the outstanding loan.

• The value of the asset that is measured when marking to market should be the liquidation value., thus taking into account the problems faced by the bank when selling off the assets.

• Diversification of Risk


Diversification of Risk• Diversification in banking has been a topic of

discussion in the literature for decades. • It effects on performance, risk, efficiency and

firm value have been examined extensively.• Diversification does have a significant impact

on a bank’s risk as well as its performance.


• Benefits of Diversification


Benefits of Diversification• One of the most common benefits associated

with respect to diversification is a lower cost of capital.

• Banks, with some level of global diversification have access to different capital markets which could lead to a lower cost of funds through a larger deposit base.


Benefits of Diversification• Furthermore, the potential for more efficient

internal capital markets is another of cited benefit to diversification.

• Another benefit associated with activity diversification is the ability to gain economies of scale / scope for the organization.


Benefits of Diversification• An example might be bank which collects

information credit information on potential borrowers. With this information, the bank may be able to offer these potential clients insurance products or underwriting services at a lower cost because much of the information needed has already been collected when evaluating the loan application.


Benefits of Diversification• Benefits associated with market power have also

been advanced. The argument suggests that banks may diversify their activities or their operations geographically to gain or maintain market share.

• Finally, an important benefit that has been proposed by some is the ability for organizations to reduce earnings volatility by spreading operations across areas with different economic environments.

Documents

Revise Lecture 18. Basic Lending Principles Q: What is asset management banking?