Commercial banking

MFIN 302 Bank financial management Lecture 2

Lecture preview
Banks play an important role in channeling funds to finance productive investment opportunities. They provide loans to businesses, allow us to purchase homes with mortgages etc.

Lecture preview
Today we will examine how banking is conducted to earn the highest profits possible. In the commercial banking setting, we look at loans, balance sheet management, and income determinants. Topics include: o The bank balance sheet o Basics of banking o General principles of bank management o Off-balance sheet activities o Measuring bank performance

The bank balance sheet

The Balance Sheet is a list of a banks assets and liabilities: Total assets = total liabilities + capital A banks balance sheet lists sources of bank funds (liabilities) and uses to which they are put (assets) Banks invest these liabilities into assets in order to create value for their capital providers The next slide shows the aggregate balance sheet for all commercial banks as of 2011, each of these items as a % of assets.

Bank assets
Item Cash

billion TL
13.1

% of assets
1.1%

Receivables from Central Bank Receivables from Banks Securities Held for Trading (Net)
Securities Available for Sale (Net) Required Reserves Securities Held to Maturity (Net) Loans Non-performing Loans (Net) Affiliates, Subsidiaries and Joint Ventures (Net) Assets to be Sold (Net) Premises and Equipment (Net) Other Assets TOTAL ASSETS

39.8 50.1 9.8

186.9 50.5 88.3 682.9 3.9 16.7 2.2 9.9 33.6 1217.7

3.3% 4.1% 0.8%

15.3% 4.1% 7.3% 56.1% 0.3% 1.4% 0.2% 0.8% 2.7% 100.0%

The Bank Balance Sheet: Assets (a)

Reserves: funds held in account with the Central Bank (vault cash as well). Required reserves represent what is required by law under current required reserve ratios. Any reserves beyond this area called excess reserves. Currently, the reserve requirement is 11% for shortterm TL and foreign currency based deposits.
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The Bank Balance Sheet: Assets (b)

Securities: these are either government debt, or other (non-equity) securities. These makeup about 23.4% of assets.

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The Bank Balance Sheet: Assets (c)

Loans: representing 56% of assets, these are a banks income-earning assets, such as business loans, auto loans, and mortgages. These are generally not very liquid. Some banks might specialize in either consumer loans or business loans, and even take that as far as loans to specific groups (such as a particular industry).

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The Bank Balance Sheet: Assets (d)

Other Assets: bank buildings, computer systems, and other equipment.

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Bank loan composition

Loan type Working Capital Loans billion TL 178.2 % of total 26.1%

Consumer Loans
Credit Cards Export Loans Directed Loans

168.4
58.5 40.6 39.2

24.7%
8.6% 5.9% 5.7%

Other Investment Loans

Discount Loans Loans of Funds Originated Import Loans Export Guaranteed Investment Loans Precious Metals Loans Receivables from Factoring Transactions Loans to Purchase Security for Customer Other Loans Total Loans

35.3
6.9 5.1 2 1.3 1.2 0.5 0.4 145.1 682.9

5.2%
1.0% 0.7% 0.3% 0.2% 0.2% 0.1% 0.1% 21.2% 100.0%

Bank liabilities
Item Deposit (Participation Funds) a) Demand Deposits (Participation Funds) b) Term Deposits (Participation Funds) Payables to the Central Bank Payables to Money Market billion TL 695.5 121.1 574.3 3.4 1.8 % of assets 57.1% 9.9% 47.2% 0.3% 0.1%

Payables to Banks
Funds from Repo Transactions Funds Securities Issued (Net) Taxes, Duties, Charges and Premiums Payable Subordinated Debt Other Liabilities

167.4
97.0 7.7 18.4 1.7 8.4 71.7

13.7%
8.0% 0.6% 1.5% 0.1% 0.7% 5.9%

TOTAL SHAREHOLDERS' EQUITY

TOTAL LIABILITIES

144.7
1217.7

11.9%
100.0%

The Bank Balance Sheet: Liabilities (a)

Demand Deposits: non-interest earning accounts Demand deposits are a banks lowest cost funds and they make up about 10% of bank liabilities. Time Deposits: are the overall primary source of bank liabilities (57%) and are interest bearing. The average maturity of time deposits is roughly 1 month
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Bank deposits by maturity

The Bank Balance Sheet: Liabilities (b)

Borrowings: banks obtain funds by borrowing from the Central Bank, other banks, and corporations; these borrowings are called: discount loans/advances (from the CB), interbank offshore dollar deposits (from other banks), repurchase agreements (a.k.a., repos from other banks and companies), commercial paper and notes (from companies and institutional investors)

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The Bank Balance Sheet: Liabilities (c)

Bank Capital: is the source of funds supplied by the bank owners, either directly through purchase of ownership shares or indirectly through retention of earnings (retained earnings being the portion of funds which are earned as profits but not paid out as ownership dividends). This is about 12% of assets (unadjusted for risk).
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The Bank Balance Sheet: Liabilities (c)

Since assets minus liabilities equals capital, capital is seen as protecting the liability suppliers from asset devaluations or write-offs (capital is also called the balance sheets shock absorber, thus capital levels are important).

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Basics of Banking
Before we explore the main role of banksthat is, asset transformationit is helpful to understand some of the simple accounting associated with the process of banking. But think beyond the debits/credit and try to see that banks engage in asset transformation.

Basics of Banking
Asset transformation is, for example, when a bank takes your savings deposits and uses the funds to make, say, a mortgage loan. Banks tend to borrow short and lend long (in terms of maturity).

Basics of Banking
T-account Analysis:
Deposit of $100 cash into First National Bank

Basics of Banking
Deposit of $100 check

Conclusion: When bank receives deposits, reserves by equal amount; when bank loses deposits, reserves by equal amount

Basics of Banking
This simple analysis gets more complicated when we add bank regulations to the picture. For example, if we return to the $100 deposit, recall that banks must maintain reserves, or vault cash. This changes how the $100 deposit is recorded.

Basics of Banking
T-account Analysis:
Deposit of $100 cash into First National Bank

Basics of Banking
As we can see, $10 of the deposit must remain with the bank to meeting government regulations. Now, the bank is free to work with the $90 in its asset transformation functions. In this case, the bank loans the $90 to its customers.

Basics of Banking
T-account Analysis:
Deposit of $100 cash into First National Bank

General Principles of Bank Management

Now lets look at how a bank manages its assets and liabilities. The bank has four primary concerns: 1. Liquidity management 2. Asset management
Managing credit risk Managing interest-rate risk

3. Liability management 4. Managing capital adequacy

General Principles of Bank Management

Although we will focus on these ideas, banks must also manage credit risk and interest-rate risk. An in-depth discussion of these topics will be presented later.

 Managing Capital Adequacy ratio

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Key Risks in Financial Institutions Management

Credit Risk

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Probability of default on any promised payments of interest or principal or both

Liquidity Risk
Probability of being unable to raise cash when needed at reasonable cost

Interest Rate Risk

Probability that changes in interest rates will adversely affect the value of net worth

Operational Risk
Probability of adverse affect of earnings due to failures in computer systems, management errors, etc.

Exchange Risk
Probability of loss due to fluctuating currency prices

Crime Risk
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Due to embezzlement, robbery, fraud, identity theft

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Defenses Against Risk

Quality Management Diversification
Geographic Portfolio

Deposit Insurance (increased from $100K to $250K in the Fall of 2008 through Dec 2009) Owners Capital
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Types of Capital
Common Stock Preferred Stock Surplus Undivided Profits Equity Reserves Subordinated Debentures Minority Interest in Consolidated Subsidiaries Equity Commitment Notes
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Tasks Performed By Capital

Provides a Cushion Against Risk of Failure Provides Funds to Help Institutions Get Started Promotes Public Confidence (credit crisis 2007-2009 showed importance) Provides Funds for Growth Regulator of Growth Role in Growth of Bank Mergers Regulatory Tool to Limit Risk Exposure Protects the Governments Deposit Insurance System
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Need of adequate capital fund

Confidence and strength of bank To cover hazards To finance growing industry and trade Obligatory for new branch Prevention of RBI losses

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Capital Adequacy Management

1. Bank capital is a cushion that prevents bank failure. For example, consider these two banks:

Capital Adequacy Management

What happens if these banks make loans or invest in securities (say, subprime mortgage loans, for example) that end up losing money? Lets assume both banks lose $5 million from bad loans.

Capital Adequacy Management

Impact of $5 million loan loss

Conclusion: A bank maintains reserves to lessen the chance that it will become insolvent.

Capital Adequacy Management

So, why dont banks hold want to hold a lot of capital? 2. Higher is bank capital, lower is return on equity
ROA = Net Profits/Assets ROE = Net Profits/Equity Capital EM = Assets/Equity Capital ROE = ROA EM Capital , EM , ROE

Capital Adequacy Management

3. Tradeoff between safety (high capital) and ROE 4. Banks also hold capital to meet capital requirements

Average bank capital ratio by year

Standards for measuring capital adequacy ratio

Ratio of aid up Capital to Reserve Capital Deposit Ratio Capital Asset Ratio- 1:5 Adjusted Bank Asset Ratio : 1:6 Primary Capital to Risk ratio

The Basel Agreement on International Capital Standards

Bankers for International Settlement (BIS) meet at Basel situated at Switzerland to address the common issues concerning bankers all over the world. The Basel Committee on Banking Supervision (BCBS) is a committee of banking supervisory authorities of G-10 countries and has been developing standards and establishment of a framework for bank supervision towards strengthening financial stability through out the world. In consultation with the supervisory authorities authorities of a few non-G-10 countries including India, core principles for effective banking supervision in the form of minimum requirements to strengthen current super-visory regime, were mooted.

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The Basel Agreement on International Capital Standards

An International Treaty Involving the U.S., Canada, Japan and the Nations of Western Europe to Impose Common Capital Requirements On All Banks Based in Those Countries

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Historically, the minimum capital requirements for banks were independent of the riskiness of the bank
Prior to 1990, banks were required to maintain:
a primary capital-to-asset ratio of at least 5% to 6%, and a minimum total capital-to-asset ratio of 6%

The Basel Agreement

The Basel Agreement of 1988 includes risk-based capital standards for banks in 12 industrialized nations; designed to:
Encourage banks to keep their capital positions strong Reduce inequalities in capital requirements between countries Promote fair competition Account for financial innovations (OBS, etc.)

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Historically, the minimum capital requirements for banks were independent of the riskiness of the bank
Prior to 1990, banks were required to maintain:
a primary capital-to-asset ratio of at least 5% to 6%, and a minimum total capital-to-asset ratio of 6%

The Basel Agreement

The Basel Agreement of 1988 includes risk-based capital standards for banks in 12 industrialized nations; designed to:
Encourage banks to keep their capital positions strong Reduce inequalities in capital requirements between countries Promote fair competition Account for financial innovations (OBS, etc.)

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The Basel Agreement

A Banks Minimum Capital Requirement is Linked to its Credit Risk
The greater the credit risk, the greater the required capital

Stockholders' equity is deemed to be the most valuable type of capital Minimum capital requirement increased to 8% total capital to risk-adjusted assets Capital requirements were approximately standardized between countries to level the playing field

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Tier 1 Capital
Common Stock and Surplus Undivided Profits Qualifying Noncumulative Preferred Stock Minority Interests in the Equity Accounts of Consolidated Subsidiaries Selected Identifiable Intangible Assets Less Goodwill and Other Intangible Assets

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Tier 2 Capital
Allowance for Loan and Lease Losses Subordinated Debt Capital Instruments Mandatory Convertible Debt Cumulative Perpetual Preferred Stock with Unpaid Dividends Equity Notes Other Long Term Capital Instruments that Combine Debt and Equity Features

Risk Weighted Assets

Capital Adequacy Ratio is calculated based on the assets of the bank. The values of bank's assets are not taken according to the book value but according to the risk factor involved. The value of each asset is assigned with a risk factor in percentage terms

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Basel Agreement Capital Requirements

Ratio of Core Capital (Tier 1) to Risk Weighted Assets Must Be At Least 4 Percent Ratio of Total Capital (Tier 1 and Tier 2) to Risk Weighted Assets Must Be At Least 8 Percent The Amount of Tier 2 Capital Limited to 100 Percent of Tier 1 Capital

 Suppose CRAR at 10% on Rs. 150 crores is to be maintained. This means the bank is expected to have a minimum capital of Rs. 15 crores which consists of Tier I and Tier II Capital items subject to a condition that Tier II value does not exceed 50% of Tier I Capital. Suppose the total value of items under Tier I Capital is Rs. 5 crores and total value of items under Tier II capital is Rs. 10 crores, the bank will not have requisite CRAR of Rs. 15 Crores. This is because a maximum of only Rs. 2.5 Crores under Tier II will be eligible for computation.

Subordinated Debt
These are bonds issued by banks for raising Tier II Capital. They are as follows :They should be fully paid up instruments. They should be unsecured debt. They should be subordinated to the claims of other creditors. This means that the bank's holder's claims for their money will be paid at last in order of preference as compared with the claims of other creditors of the bank. The bonds should not be redeemable at the option of the holders. This means the repayment of bond value will be decided only by the issuing bank.

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The Most Glaring Hole with the Original Basel Agreement is its Failure to Deal with Market Risk, Especially Problematic During the 2007-2009 Global Credit Crisis In 1995 the Basel Committee Announced New Market Risk Capital Requirements for Their Banks In the U.S. Banks Can Create Their Own In-House Models to Measure Their Market Risk Exposure, VaR, to Determine the Maximum Amount a Bank Might Lose Over a Specific Time Period Regulators Would Then Determine the Amount of Capital Required Based Upon Their Estimate Banks That Continuously Estimate Their Market Risk

What Was Left Out of the Original Basel Agreement

 The Third Pillar Market Discipline Market discipline imposes strong incentives to banks to conduct their business in a safe, sound and effective manner. It is proposed to be effected through a series of disclosure requirements on capital, risk exposure etc. so that market participants can assess a banks capital adequacy. These disclosures should be made at least semi-annually and more frequently if appropriate. Qualitative disclosures suchas risk management objectives and policies, definitions etc. may be published annually.

COMPUTATION OF CAPITAL REQUIREMENT

The Practicing Manager:

Strategies for Managing Capital: what should a bank manager do if she feels the bank is holding too much capital? Sell or retire stock Increase dividends to reduce retained earnings Increase asset growth via debt

The Practicing Manager:

Reversing these strategies will help a manager if she feels the bank is holding too little capital? Issue stock Decrease dividends to increase retained earnings Slow asset growth (retire debt)

How a Capital Crunch Caused a Credit Crunch in 2008

The slowdown in growth of credit triggered a crunch in 2007credit was hard to get. What caused the credit crunch? Housing boom and bust led to large bank losses, including losses on SIVs which had to be recognized on the balance sheet. The losses reduced bank capital.

How a Capital Crunch Caused a Credit Crunch in 2008

Banks were forced to either (1) raise new capital or (2) reduce lending. Guess which route they chose? Why would banks be hesitant to raise new capital (equity) during an economic downturn?

Off-Balance-Sheet Activities
1. Loan sales (secondary loan participation) 2. Fee income from
Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit

3. Trading Activities and Risk Management Techniques

Financial futures and options Foreign exchange trading Interest rate swaps

All these activities involve risk and potential conflicts

Rouge Traders
To highlight the problems that some of these off-balance sheet activities generate, we will briefly look at two incidences with devastating results. Barings: Nick Leeson engaged in speculative trades on the Nikkea, and personally generated $1.3 billion in losses over a 3-year period. Barings had to close!

Rogue Traders
Daiwa Bank: Toshihide Iguchi racked up $1.1 billion in losses in trading. When he fessed-up, the bank decided to hide this from regulators. The bank was eventually fined $340 million and barred from U.S. operations.

Measuring Bank Performance

Much like any business, measuring bank performance requires a look at the income statement. For banks, this is separated into three parts: Operating Income Operating Expenses Net Operating Income Note how this is different from, say, a manufacturing firms income statement.

Bank Income Statement

Item Interest income - Interest expense Net interest income - Special provisions for non-performing loans Net interest income after provisions Total non-interest income - Non interest expenses Profit (loss) before tax - Provision for taxes Net income billion TL % of equity 88.1 48.8 39.3 4.1 35.2 26.5 36.2 25.3 5.4 19.9 60.9% 33.7% 27.2% 2.8% 24.3% 18.3% 25.0% 17.5% 3.7% 13.8%

Measuring Bank Performance

As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows both calculations and historical averages for key bank performance measures.

Lecture Summary
The Bank Balance Sheet: we reviewed the basic assets, liabilities, and bank capital that make up the balance sheet Basics of Banking: we examined the accounting entries for a series of simple bank transactions

Lecture Summary (cont.)

General Principles of Bank Management: we discussed the roles of liability, reserves, asset, and capital adequacy management for a bank Off-Balance Sheet Activities: we briefly reviewed some of the (risky) activities that banks engage in that dont appear on the balance sheet or income statement

Lecture Summary (cont.)

Measuring Bank Performance: we reviewed the income statement for a banking organization and key ratios commonly used for measuring and comparing bank performance