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 2
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Todays 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 4
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Theory in practice Recall banks, like other financial
intermediaries, perform three basic high level functions: 1. Size
transformation 2. Maturity transformation 3. Risk transformation
The business of banking doesnt focus on these functions per se,
rather it creates practical products and services that solve
customer problems and meet customer needs 5
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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 6
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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 10-20 years! 7
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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 dont care so much about this
risk transformation Government deposit guarantees also impact
savers behaviour (not risk transformation) 8
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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 9
Slide 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 10
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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 11
Slide 12
WACC example Capital type% of Capital StructureCost Equity
capital 6.0%12.0% Hybrid capital 2.0% 9.0% Subordinated debt 2.0%
5.0% Long term bonds20.0% 4.0% Medium term notes 10.0% 3.0% Short
term deposits60.0% 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 12
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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 13
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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 14
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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? 15
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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 16
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 18
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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 banks RAROC hurdle 19
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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
20
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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 21
Slide 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 22
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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 23
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Dodd Frank and trading Following the 2007-9 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 24
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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! 25
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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 26
Slide 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 dont repay their cards monthly
often subject to huge interest rates eg 16% Fraud risk is very high
in the credit card business 27
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Trade finance Trade finance products are typically short term,
uncommitted and secured RAROC is high because banks dont 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 28
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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 29
Slide 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 30
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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 31
Slide 32
Asymmetric information Financial market participants often have
varying levels of information > Information Asymmetry 1. Some
players have differing information 2. Some players have Inside
Information 3. All players have imperfect information Asymmetric
information can lead to Adverse Selection and Moral Hazard 32
Slide 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 2007-9
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
33
Slide 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 34