Banking and Financial Institutions

Guy HargreavesACF-104

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Recap of yesterdayUnderstand banking systems within

developed economiesAppreciate the structure of a typical

commercial banking system Review payment systems and how they

operateDescribe the main products and services

offered by commercial banks Understand the commercial banking

customer base

The theoretical and practical roles of commercial banks

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Today’s goalsReview of maturity transformation,

aggregation and risk transformationReview of credit creation multiplierUnderstand how commercial banking

improves the efficiency of an economyAppreciate the role commercial banking has

in driving economic growthUnderstand the role commercial banks play

within financial markets

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The theory of bankingCommercial banks perform three basic theoretical

functions:1. Size transformation2. Maturity transformation3. Risk transformation

In addition, commercial banks provide products and services at the time of their customer’s choosing

Because of the positioning of commercial banks within the financial system, they improve system liquidity, reduce system cost and lower system risk

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Size transformationUnlikely a saver will deposit the exact amount

of funds with a retail bank that its borrower customer demands on any given day

Banks have multiple sources of liquidity to cover mismatches in financial transaction size:

Central bank liquidity windows Interbank markets Public money market or bond markets

Banks can take a “portfolio management” approach to size transformation as they have a broad base of saver and borrower customers

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Maturity transformationUnlikely a saver will deposit funds with a

commercial bank to mature on the exact date that a borrower customer wants its loan to mature

Banks manage “asset-liability” maturity mismatch risk as part of their capital and liquidity management framework

Banks also take a “portfolio management” approach to maturity transformation as with size

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Risk transformationUnlikely a saver will wish to deposit all its

funds with a single borrower, instead looking to diversify its credit risk across a broad range of borrowers

Banks lend to a broad range of borrowers, offering savers a diversified credit risk profile

In addition, banks have a regulated capital structure ensuring borrowers have a cushion against expected and unexpected losses in the portfolio

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Credit creationCommercial banks have very privileged

position in the economy: Usually the most leveraged sector in he economy

(15-30x leveraged!) Often the beneficiary of government deposit

insurance / guarantee schemes Guaranteed access to Central Bank pools of

liquidity at all times

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Recall: credit creationWhen a bank accepts a deposit it is required to

hold a certain amount (eg say 10%) in approved reserves (deposits with Central Bank or government securities)

The balance (90%) can be lent to new borrowers who purchase goods and services from another economic entity, who then might deposit the proceeds in another bank

That other bank will then retain the reserve requirement and further lend the funds to borrower

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Theory of credit creationBank $ Deposit

taken$ Loan made

$ Reserve held

A 50.0000 45.0000 5.0000

B 45.0000 40.5000 4.5000

C 40.5000 36.4500 4.0500

D 36.4500 32.8050 3.6450

E 32.8050 29.5245 3.2805

… … … …

Total 500.000 450.000 50.000

Under a 10% Reserve Ratio for each $1 deposit taken the banking system can create $10 in new deposits

Credit Multiplier = Change in Deposits / Change in Reserves = 500 / 50 = 10

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Theory, what about in practice?Retail banking

Size transformation Who deposits the exact $355, 450 you might need to buy your

apartment? – no-one! Maturity transformation

Who makes 30-year deposits? – no-one! Risk transformation

Who creates diversified portfolios backed by capital and supported by Central Banks? – well actually there are alternative investments which is why the deposit market is so competitive

Credit creation Who leverages the money supply so effectively to create

plentiful liquidity for retail borrowers? – no-one with any stability other than commercial banks

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Theory, what about in practice?Wholesale banking

Size transformation Who deposits the exact $325.21m a company needs

for its acquisition? – no-one! Maturity transformation

Who makes 5-year deposits to fund corporate loans? – no-one!

Risk transformation As for Retail Banking

Credit creation As for Retail Banking

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Lifting the efficiency of an economyBanks lend money and take deposits at the

time their customers demand This reduces risk for borrowers that need certainty

of funds on a specific day And reduces opportunity costs for savers who might

otherwise take time to find a borrower and while missing out on interest payments

Banks reduce transaction, information and search costs by exploiting their large size and reach

Larger turnover, larger fund flows reduces unit costs and increases economic efficiency

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Credit creation boosts growthCentral Bank policy impacts growth in an

economy through commercial banks Altering the money supply alters interest rates,

which flows through commercial banks to the real economy and impacts demand

Altering the Central Bank Reserve Ratio impacts on the supply of credit from the commercial banking system to the real economy

Commercial banks can choose to raise capital, which through the credit multiplier can lift the supply of credit to an economy

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Capital allocation in an economyCommercial banks are amongst the most

important institutions in an economy when it comes to capital allocation to different industries / sectors

Lending reduced to twilight industries Lending increased to new growing industries Lending into increasing productivity, away from

falling productivity Forced corporate restructurings

Market based capital allocation drives developed economies to become more efficient

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Commercial banks in financial marketsFinancial markets are not part of the banking

system, but are critical for commercial banksCommercial banks operate in a number of

financial markets and derivatives Money markets FX markets Commodity markets Syndicated loan markets

Commercial banks are mostly users of bond and equity (capital) markets

Investment banking businesses are more focused on arranging deals in the capital markets

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Recall: financial marketsA financial market is generally considered a

collection of individual markets made up of “fungible” products in which:

Capital (debt and equity) is raised Financial instruments are traded Financial (and physical) risks are managed

Markets can be focused on Primary activity or Secondary activity

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Recall: fungibility“Fungibility is the property of an asset whose

individual units are capable of mutual substitution”

one unit of an asset can be substituted for another Examples could be 1 ounce of gold, 1 USD

banknote, 1 barrel of crude oil Examples of non-fungibility could be two USD

bonds issued by the same company but with different maturities

Fungibility is critical in financial markets to provide standardisation - which creates certainty and liquidity

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Recall: liquidityLiquidity is the ability to buy or sell an asset

(financial or otherwise) without materially the asset’s price

Most liquid market in the world is foreign exchange, trades USD 5.3 trillion per day on average

Three days FX trade = annual global trade!

Low liquidity markets include unlisted shares, highly structured ABS, property

Important property of financial marketsCommercial banks are large suppliers of

liquidity to financial markets

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Money marketsShort term debt financing and investment marketsTerms usually less then 1-yearCommercial banks usually deal in:

Treasury bills (for liquidity and capital management) Commercial paper (CP) (corporate lending alternative) Bankers’ acceptances (guarantee for future customer

payment) Certificates of Deposit (marketable deposits) Repurchase agreements (short term securities funding) Federal Funds (reserve requirement management)

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Bond marketsFixed income instruments which are debt

securities where the borrower (issuer) is required to repay principal and interest based on a predetermined schedule or rate over a fixed term

Investment banks usually arrange bond issues for larger corporates (not a retail issuance product)

Commercial banks issue bonds as part of their liability management process

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Fixed income ratings (long term)Standard &

Poor’sMoody’s Fitch Default Risk profile

AAA Aaa AAA Investment Grade: extremely strong

AA+ | AA | AA- Aa1 | Aa2 | Aa3 AA+ | AA | AA- Investment Grade: very strong

A+ | A | A- A1 | A2 | A3 A+ | A | A- Investment Grade: strong

BBB+ | BBB | BBB- Baa1 | Baa2 | Baa3 BBB+ | BBB | BBB- Investment Grade: adequate

BB+ | BB | BB- Ba1 | Ba2 | Ba3 BB+ | BB | BB- High Yield : less vulnerable

B+ | B | B- B1 | B2 | B3 B+ | B | B- High Yield : more vulnerable

CCC Caa1 | Caa2 | Caa3 CCC High Yield : vulnerable

CC Ca CC High Yield : highly vulnerable

C C C High Yield : highly vulnerable +

SD Selective default

D D Default

NR NR Not rated

Credit ratings are a critical component of the efficient operation of the fixed income market

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Foreign exchange marketsThe exchange of an amount of money (or

deposit) in one currency for an amount of money (or deposit) in another currency

Commercial banks use the FX market: As a source of liquidity for customer hedging and

foreign currency payment transactions To manage their own asset/liability balance sheet

risks As a source of revenue from market making

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A foreign exchange transaction

Joe needs EUR to pay for a new book he is expecting shortlyThe USD-EUR exchange rate is trading in the FX market at 1.09Joe pays USD100 to Linda’s USD bank account in exchange for

Linda paying EUR109 to Joe’s EUR bank account

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10 days later…

10 days later Joe is given the book by a friend and wants to convert his EUR back to USD

USD has weakened and the USD-EUR exchange rate fallen to 1.00 Joe pays EUR109 to Linda’s EUR bank account in exchange for Linda paying

USD109 to Joe’s USD bank account Joe has made a USD9 profit in being “long” EUR when it “rallied”

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Futures and derivatives“Derivative” is a general term for a range of

financial instruments which includes FuturesDerivatives are contracts between two

parties that derive their value from the performance of an “underlying” instrument or index, or anything!

Generally derivatives are either forwards, swaps, options or futures

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Futures and derivativesCommercial banks deal mostly in:

Interest rate swaps FX forwards, swaps and options Bond, bill futures Commodity futures

Counterparty credit risk management and central clearing systems have become critical issues for commercial banks in their OTC derivatives businesses

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CommoditiesWholesale commercial banks have many

customers with exposure to commodity markets and prices

Energy commodities such as oil and gas big for commercial banks

Metals, agricultural products also popular Customer hedging almost all of the activity of

commercial banks in commodities Harsh capital treatment for banks that trade in

commodities for their own book

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Syndicated loansLoans where borrowers enter into a single

loan agreement with syndicates of banks - ranging from 5 banks to over 50 banks for very large deals

Very traditional business for commercial banks Helpful when customer borrowing requirements

become too large for a single commercial bank to handle

Banks earn additional income from underwriting and distributing syndicated loans