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Banking and Financial InstitutionsGuy HargreavesACF-104Wechat: Guyhargreaves1Basic principles of commercial bankingFinancial systemThe typical components of any financial system: Financial AssetsBorrowers and Savers of financial assetsFinancial IntermediariesCentral Bank regulators (set and manage the rules of the financial system)Financial systems exist within individual countries which have their own currencyCurrency blocks (eg Euro) can have common components (eg European Central Bank)

3Banking system4The Banking System is that part of a financial system in which regulated banks operateDoes not include Capital Markets which are part of the Financial MarketsIncludes payments, Central Bank operations, bank loans, deposits any activity which involves a regulated bankWhether the activity is regulated is an important distinctionUnregulated activity is conducted outside of the security and support provided by Central Bank regulated commercial banks

Financial marketsPlaces or platforms where financial assets are bought and soldElectronic or over-the-counter (OTC)Open outcry exchanges are almost things of the past (eg futures pits)Most significant financial markets conduct trade in:Securities (shares and bonds eg NYSE, Nasdaq)Futures and derivatives (eg Chicago Mercantile Exchange / Chicago Board of Trade)Foreign exchange (largest cash market of them all)Commodities (much of the physical trade is OTC)

5Financial assetsAn asset is any property of value held or owned by an individual or companyA Financial Asset can be thought of as financial property eg:Cash (money) in your walletDeposit with a bankCorporate bondCommon share of a company6Financial claimsFinancial Claims are contractual obligations created when a Borrower accepts money from a Saver (or Lender)Obligation to pay that money back at some time in the futureObligation to pay interest or a return on that moneyCan be Secured or Unsecured by other assetsHolder of financial claim has a Financial AssetGrantor of financial claim has a Financial Liability7Information asymmetryFinancial market participants often have varying levels of information >Information AsymmetrySome players have differing informationSome players have Inside InformationAll players have imperfect informationInside Information is usually gained from private sources and is usually illegal to trade from (insider trading)A key regulatory task is to prevent insider trading 8Adverse selectionAdverse selection can become a big problem in commercial banking due to information asymmetryBetter informed banks can tend to exploit less well informed customersCompliance and Risk Management functions are being heavily increased in banks today to prevent outcomes like this9Moral hazardMoral hazard arises in a contract when one of the parties has an economic incentive to behave against the interests of the otherClassical example is a homeowner buying fire insurance just before their home burns downInsurance industry is large target of this behaviourCommercial banks have a poor record of managing moral hazard given large incentives to behave poorlyOften arises in the Principal-Agent relationship where the agent has may act in its own interests rather than the interests of its customer10The theory of bankingCommercial banks perform three basic theoretical functions:Size transformationMaturity transformationRisk transformationIn addition, commercial banks provide products and services at the time of their customers choosingBecause of the positioning of commercial banks within the financial system, they improve system liquidity, reduce system cost and lower system risk11Size transformationUnlikely a saver will deposit the exact amount of funds with a retail bank that its borrower customer demands on any given dayBanks have multiple sources of liquidity to cover mismatches in financial transaction size:Central bank liquidity windowsInterbank marketsPublic money market or bond marketsBanks can take a portfolio management approach to size transformation as they have a broad base of saver and borrower customers 12Maturity transformationUnlikely a saver will deposit funds with a commercial bank to mature on the exact date that a borrower customer wants its loan to matureBanks manage asset-liability maturity mismatch risk as part of their capital and liquidity management frameworkBanks also take a portfolio management approach to maturity transformation as with size13Risk 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 borrowersBanks lend to a broad range of borrowers, offering savers a diversified credit risk profileIn addition, banks have a regulated capital structure ensuring borrowers have a cushion against expected and unexpected losses in the portfolio14Financial intermediationTwo fundamental parties to any financial system:Borrowers (deficit units)Savers (surplus units)Financial Intermediation is conducted by third parties who take deposits from Savers and make loans with those deposits to BorrowersFinancial intermediation increases economic efficiency by offering valuable transformative services to both Borrowers and Savers 15Direct versus indirect finance16

Retail / WholesaleCommercial BanksInvestment BanksShadow bankingThe term Shadow Banking has been used in the past 5-10 years to describe a banking-like system of financial intermediation conducted by NBFIsAs a result it is largely unregulated and is considered to have contributed significantly to the 2007-9 GFCPost 2007-9 GFC shadow banking closed down but in recent years it is re-emerging in the form of P2P lending, crowdfunding and private equity 17Types of financial intermediariesIntermediaries are usually either:Regulated commercial banks or building societies etcNon bank financial institutions (NBFIs)Regulated banks are typically:Retail Commercial BanksWholesale Commercial BanksDeposit-Taking Institutions eg banksNon-Deposit-Taking Institutions eg insurance companies18Commercial bank structureRetail commercial banksLimited liability corporate organisationsFocus at retail levelMortgage and savings productsMostly listedMedium sized balance sheetsLarge number of smaller customers20Wholesale commercial banksLimited liability corporate organisationsFocus at wholesale or corporate levelCorporate loansAll listedLarge sized balance sheetsSmaller number of larger customers21Investment banks Investment banks are not regulated commercial banks unless they are owned by a commercial bank (eg ANZ)Focus at wholesale / corporate levelCapital Markets productsListed and unlistedVolatile balance sheetsSmaller number of large customers22Commercial bank departmentsBoard of DirectorsManagement OfficeFinancial ControlRisk ManagementLegal and ComplianceOperationsHuman ResourcesInformation TechnologyFinancial MarketsWholesale BankingRetail Banking

23Board of DirectorsMade up of:Chairman non-operational, strategic roleCEO executive and board memberCFO - executive and board memberCRO - executive and board memberCTO - executive and board memberNon-Executive Director (NED) x 2?Approves strategy of the bankAppoints CEO, CRO, CFO, CTO etcApproves financial statements, compensation etc24Management OfficeUsually made up of:CEO heads up and runs the bankCFO heads up finance functionCRO heads up risk functionCTO heads up IT functionCOO heads up operations functionHead of MarketsHeads of Retail/Wholesale bankingDevelops bank strategy, and after Board approval executes this strategy25Financial ControlManagement reportingFinancial accounts (quarterly / semi / annual)Regulatory reportingTax and transfer pricingDaily P&L

26Risk ManagementCredit riskMarket riskLiquidity riskCountry riskOperational riskReputational riskSpecial Asset Management

27Legal and ComplianceGroup legalFront Office legalComplianceEnsures bank staff follow policy and proceduresProtects the bank against money laundering and other criminal activityPrevents insider trading and other crimes28OperationsCash settlementsSecurities settlementsMiddle OfficeFinancial MarketsCorporate loan managementProperty managementGeneral logistics

29Human ResourcesBank staff are commercial bankings most valuable assetHiring, firing, training, team buildingSome commercial banks have aggressive firing policiesCompensation policy critical for good banking30Information TechnologyFront Office, Middle Office, Back Office computer systemsCommercial banks traditionally have used technology to support operations rather than a competitive weaponMany banks in 2015 stuck with legacy, outdated systems big problem!

31Financial MarketsSalespeopleTradersStructurersQuants (so-called rocket scientists)Treasury management

32Wholesale BankingCorporate BankingProject FinanceTrade FinanceLeasingRelationship managementCash management

33Retail BankingDeposit productsMortgage departmentCardsConsumer loansBranches and infrastructure

34Commercial bank productsCommercial banking productsRetail and wholesale commercial banks offer a wide range of products and services including:Current and chequing accountsTerm depositsConsumer loans and mortgagesCredit and Debit CardsCash management servicesCorporate and SME loansTrade FinanceFinancial market products and servicesOnline banking

36Mortgage productsOne of the most fundamental banking productsA bank lends money to a borrower to purchase a house, apartment or other propertyOnly a portion of the property purchase price is lent (eg 50%) the balance is funded from savings of the borrowerThe borrower repays loan principal and interest over an agreed time frame (eg 30 years)The bank takes a mortgage over the property which entitles it to seize and sell the property to repay the loan if the borrower defaultsBanks are at the heart of retail property financing across the globe 37Credit and debit cardsA group of banks were responsible for the development of widely used credit cards such as Visa and MastercardCard products offer the great convenience of being cash-like and widely acceptedCredit cards offer the holder an unsecured line of credit that can be drawn to pay for goods and servicesDebit cards are accounts that must have positive fund balances before they can be used to pay for goods and services38Corporate banking productsCorporate banking customers range from SME to mid market to large listed multinational companies (MNCs)These customers have a range of commercial banking needs including:Lease and hire purchase financingInvoice and receivable discountingCorporate loans and commercial paper (CP)Project finance

39Cash management servicesCorporate customers have complex daily cash management requirements including:Multi currency cash accountsAccount sweeping and reconciliationLockbox facilitiesSubsidiary account managementForeign exchangeSophisticated online cash management solutions are now offered by many banks to help corporate customers manage their business flows40Trade financeCommercial banks are central to the financing of trade flows across the globe:Guaranteeing payments for exporters and importers through correspondent banking relationshipsFinancing shipments of commodities around the globeWorking capital finance for trading companiesInventory financing 41Financial market productsCommercial banks offer a range of financial market products and services including:Foreign exchange and forwardsMoney market productsSyndicated loansDerivative risk management productsRepo products

42Payment systemsA Payment System is any organised system established to allow participants to transfer financial assets between themselvesPayments take place for many reasons:In exchange for goods and servicesCreation or repayment of a financial liability/assetCommercial banks have historically played a key role in payments systems

43Payment systems - RTGSInterbank payment systems use Real Time Gross Settlement (RTGS) to transfer money between bank participantsRetail participants must hold some form of account with a commercial bank in the payments systemTo effect payment a participant will instruct its bank to transfer money from that participants account to the proper account of another participant at its own bankThe two banks settle the transaction through adjustment of their own accounts held with the relevant Central BankCentral Banks usually manage RTGS systems

44Payment systems - SWIFTInternational payment systems use Society for Worldwide Interbank Financial Telecommunication (SWIFT) to transfer money between participantsSWIFT is does not alter the underlying mechanics of individual domestic payment systemsSWIFT is simply a system that arranges domestic payments between international participantsUnless the banks handling a SWIFT transaction are primary deposit-taking institutions in the currency of the transaction, instructions will be handled through a correspondent banking arrangement

45Commercial bank payment productsCommercial banks offer many ways for their clients to instruct a payment:ChequesOnline transfersStanding ordersCredit cardsDebit cardsATMsSmartphonesSMS

46Correspondent bankingCommercial banks often hold accounts with other domestic or international commercial banksNostro account: our money held by youVostro account: your money held by usWhen a bank holds an account with another bank it is said to have a Correspondent Banking RelationshipIf a bank does not maintain an account with its Central Bank it needs to have a correspondent banking relationship with one that does47The role of commercial banksCredit 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 bankThat other bank will then retain the reserve requirement and further lend the funds to borrower49Theory of credit creationBank$ Deposit taken$ Loan made$ Reserve heldA50.000045.00005.0000B45.000040.50004.5000C40.500036.45004.0500D36.450032.80503.6450E32.805029.52453.2805Total500.000450.00050.000Under a 10% Reserve Ratio for each $1 deposit taken the banking system can create $10 in new depositsCredit Multiplier = Change in Deposits / Change in Reserves = 500 / 50 = 10

50Theory, what about in practice?Retail bankingSize transformationWho deposits the exact $355, 450 you might need to buy your apartment? no-one!Maturity transformationWho makes 30-year deposits? no-one!Risk transformationWho 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 competitiveCredit creationWho leverages the money supply so effectively to create plentiful liquidity for retail borrowers? no-one with any stability other than commercial banks51Theory, what about in practice?Wholesale bankingSize transformationWho deposits the exact $325.21m a company needs for its acquisition? no-one!Maturity transformationWho makes 5-year deposits to fund corporate loans? no-one!Risk transformationAs for Retail BankingCredit creationAs for Retail Banking52Credit creation boosts growthCentral Bank policy impacts growth in an economy through commercial banksAltering the money supply alters interest rates, which flows through commercial banks to the real economy and impacts demandAltering the Central Bank Reserve Ratio impacts on the supply of credit from the commercial banking system to the real economyCommercial banks can choose to raise capital, which through the credit multiplier can lift the supply of credit to an economy

53Capital allocation in an economyCommercial banks are amongst the most important institutions in an economy when it comes to capital allocation to different industries / sectorsLending reduced to twilight industriesLending increased to new growing industriesLending into increasing productivity, away from falling productivityForced corporate restructuringsMarket based capital allocation drives developed economies to become more efficient54The business of commercial bankingSize transformationFor a commercial bank this means:Estimating market appetite for creditUnderwriting and distributing syndicated loans in sizeUsing balance sheet to take on the liquidity risk of making a loan larger than its deposit baseCustomers want loans and other banking products and services tailored to their own size

56Maturity transformationFor a commercial bank this means:Using its Capital Structure to manage maturity riskUnderwriting balance sheet maturity Gaps Very long dated maturity demands can be challenging for commercial banksBanks prefer 3-5 year maturities for loans

57Risk transformationSavers 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 corporatesBank portfolios are very diverse which means savers can have confidence in banksCapital regulations and access to central bank liquidity also helps risk transformation58So how do banks make money?Like all businesses, banks have capital structures:Equity capitalHybrid capitalSubordinated debtLong term bondsMedium term notesShort term depositsAim 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 riskDecreasing maturity59The cost of capitalThe cost of commercial bank capital is an important input into the economics of the business of bankingWeighted Average Cost of Capital (WACC) is a closely managed metric for banksBanks with high WACC need to invest in higher returning assets to generate acceptable returnsHigher returning assets are riskierRiskier assets require more regulatory capital to be held=> can become circular 60WACC exampleCapital type% of Capital StructureCostEquity 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 profit61RAROCRisk Adjusted Return on Capital (RAROC)Widely used metric in commercial banking to measure the return generated from financial assetsCommercial banks fix minimum RAROC hurdles to assist in their decision making processes

RAROC = Revenue Cost Expected LossRequired Capital62RAROCRAROC = Revenue Cost Expected LossRequired Capital

Where:Revenue is NIMCost is the fully loaded cost of taking on the assetExpected loss is the amount the bank must assume it will lose from investing in the risky assetRequired capital is the amount of regulatory capital a bank must hold when investing in the risky asset63Meeting return hurdlesAssume 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 recordThe bank has an overall cost/income ratio of 40%The bank needs to hold 8% capital against the loanThe banks funding cost for the loan is 3%

=> What interest rate [I%] should the bank offer on this loan?64Meeting return hurdlesRAROC = 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% = $8m65Meeting return hurdles 12%= $R ($R * 40%) $100m * 0.2% * 20%$8m= $R * 60% - $0.04m $8m= ($100m * (I% - 3%) * 60% - $0.04m $8m=>I%= (12% * $8m + $0.04m) + 3% $60m= 4.6667% (Credit margin: 167 basis points)66Meeting return hurdlesCharging a AA rated company a credit margin of 167 basis points could be uncompetitiveIf customer wanted to pay a 50 basis point margin the bank would have to accept RAROC of 3.25% or not do the dealBanks often subsidise low RAROC lending in order to X-sell higher margin products Take a whole of relationship view on the customerAim to earn fees from derivative hedging income perhaps 67Fee based incomeCommercial banks like fee-based revenue because they do not have to set capital aside if there is no residual credit or market riskFees include:Syndicated loan underwriting feesUpfront derivative fees68Commercial bank risk managementGood commercial bankingGood commercial banking requires sound management practicesDiversify: risk, income, geographies, business lines and productsFinancial: focus on NIM, NPAT, regulatory capital, provisions (risk management), costsStrategy: invest in technology, focus on strengths, understand your business, enter/exit business prudentlyGood banking = healthy banking system = healthy financial system able to withstand crises/shocks

70Good commercial bankingSet long term incentives, remove short term incentivesEncourage longer term behaviour by staff, managementLeads to better decisions = stable bank = strong share price and high liquidity / access to capitalGood banking = healthy banking system = healthy financial system able to withstand crises/shocks

71Commercial bank management72Strategy: global, regional, local, products, retail / wholesale, technologyRisk management: credit, market, legal / reputational, operational, country, liquidity > diversificationFinancial: NIM, NPAT, ROE, RAROC, RoRWA, NIM Regulatory: CET1, RoRWA, LCR, NSFRCustomers: product mix, KYC, X-sellOperations: technology, costs, risk managementBalance sheet principlesAssets Liabilities = CapitalLiabilities:Defined maturity dateDefined coupon (interest rate)Must be repaid or default occursCapital:No maturity date (perpetual)No defined coupon (dividend may or may not be paid)No requirement for repayment - permanent73US commercial bank balance sheet

74On or off balance sheet?If the item appears in the balance sheet financial statement then it is on balance sheetRisks that do not appear in the balance sheet financial statement are off balance sheet egLetters of Credit (LCs)GuaranteesCounterparty credit risk on derivativesBanks need to hold regulatory capital against on and off balance sheets exposures under BIS II and BIS II

75Trading versus banking booksBanks use two broad accounting regimes:Banking book holds corporate and retail loans on an accruals basis; uses the loan provision model for potential losses from defaults; no market riskTrading book holds securities and marketable instruments on a mark-to-market basis; gains and losses in market value brought to P&L daily; all market riskWhether a financial instrument is held in a banking book or a trading book is critical to the way it is risk managed76Credit (default) riskLoans in the banking book and bonds in the trading book both have credit default riskThe issuer will fail to repay a coupon or principal, or will go into bankruptcyBanks have Special Asset Management units which do nothing but manage defaulted or near defaulted customers Once in default, banks will often take control of the company as senior creditors, sell all remaining company assets and use the proceeds to repay creditors in order of seniorityIf a bank receives less than it is owed following liquidation it has suffered a recovery rate of < 100%Banks may make provisions in their balance sheets for loans which they expect have a high chance of defaulting

77Market riskInterest rate risk:Exposure through a financial instrument to movements in interest ratesFixed rate bonds, interest rate swaps, bond futures anything with a long dated fixed cashflowDelta the change in the $ value of that instrument for a 0.01% change in interest ratesVAR Value at Risk how much the bank would lose if a significant move in interest rates occurred

78Market riskFX risk:Exposure through a financial instrument to movements in foreign exchange ratesSpot FX, foreign exchange swaps, FX futuresDelta the change in the $ value of that instrument for a certain change in FX ratesIncluded in firmwide VAR

79Liquidity (gap) riskThe ongoing ability of a commercial bank to refinance its short term liabilities like depositsBanks tend to lend long and borrow short borrowers want the certainty of funding for long periods whereas savers dont want to lock up their funds for long periodsLiquidity or gap risk is the risk savers will not redeposit their savings when they mature, leaving the bank repaying deposits whilst remaining invested in longer term loansReinvestment or refinancing risk is the risk that when a bank comes to refinance a deposit interest rates will be higher interest rate risk80Operational riskOperational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external eventsRegulators and banks are working towards a consistent and standardised way of measuring and holding capital against this riskCauses of operational risk include internal and external fraud, employment practices and work safety, illegal business practices (eg money laundering) and physical or system failures81Country riskGlobal commercial banks invest significant capital into many countries around the world to support their local operationsSome of these countries are risky emerging markets (eg Argentina) where there is a risk that the local government introduces foreign exchange controls or other measures that might be harmful to the bankSovereign risk is not country risk it is the risk a sovereign will default on its debt

82Reputational riskBanks have suffered scandals and bad media headlines throughout historyAs a result many banks have seen their reputations with customers, governments and other important stakeholders suffer badlyWhen a bank earns a poor reputation its WACC increases as savers become reluctant to deposit, and borrowers are less willing to do business with banks that have behaved badly

83Credit risk management toolsCredit default risk management is a critical element of commercial banking managementCredit Committees (CC) establish maximum exposure limits to individual, group and related borrowersLimits are set for loans, derivatives, settlement, FX and many other financial productsCC monitors total exposure to the borrower or groupBankers are forbidden to lend or trade in more volume with the borrower or group than the limit set by CCThis prevents the bank from becoming overexposed to any one borrower or group

84Portfolio diversificationCritical to bank credit default risk management is to lend to a broad diversified set of borrowersDiversification means investing in a broad range of borrowers so that risk can be reduced in the portfolioDont put all your eggs in one basket!Investing in $1 in each of 50 borrowers is far less risky than investing $50 in just one borrower

85Classical credit analysisEvery commercial bank has a slightly different way of performing credit analysisMany banks use the classical model of five CsCharacter is the borrower of good character eg have they defaulted before or ever committed fraud?Capital is the borrower too leveraged?Capacity - does the borrower have a strong capacity to repay the loan? What is the earnings volatility of the borrower?Conditions what is the loan going to be used for? Does this make sense?Collateral is the loan secured by specific assets or is it unsecured?

86Bank credit scoringOnce a credit analysis is performed many banks score or rate the loan or borrower87Standard & PoorsMoodysCommercial BankDefault Risk profileAAAAaaR0Investment Grade: extremely strongAA+ | AA | AA-Aa1 | Aa2 | Aa3R1 R2 R3Investment Grade: very strongA+ | A | A-A1 | A2 | A3R4 R5 R6Investment Grade: strongBBB+ | BBB | BBB-Baa1 | Baa2 | Baa3R7 R8 R9Investment Grade: adequateBB+ | BB | BB-Ba1 | Ba2 | Ba3R10 R11 R12High Yield : less vulnerableB+ | B | B-B1 | B2 | B3R13 R14 R15High Yield : more vulnerableCCCCaa1 | Caa2 | Caa3R16 R17 R18High Yield : vulnerableCCCaR19High Yield : highly vulnerableCCR20High Yield : highly vulnerable +SDSelective defaultDDDefaultNRNRNot ratedExpected lossFrom the credit default risk analysis banks estimate Probability of Default (PD), Loss Given Default (LGD)Expected Loss (EL) = PD x LGD x EADPD is the likelihood a borrower will defaultLGD is the loss a bank expects if a borrower does defaultEAD is Exposure at Default which is the loan amount plus unpaid interest at default EL then feeds into the RAROC model to determine whether the loan makes financial sense for the bank

88Credit provisioningWhen a commercial bank expects to take a loss on a loan it makes an individual credit provisionLarge banks routinely take collective provisions against their overall portfoliosA provision is the amount of a loan the banks expects to lose

89International commercial bankingInternational banking structureA series of locally regulated banks all owned by the same company located in countries all over the globeEach local bank is either a branch or a subsidiary of the Head Office bankEach branch the same legal entity as the head office but located at a different address ie another countryEach subsidiary is a separate company owned by the head office bank 91Branch versus subsidiaryBecause commercial bank branches are the same legal entity as the head office they dont need to be separately capitalisedEach branch shares the same capital and is exactly as strong as the head officeIf a customer deals with a branch it is legally the same as dealing with head officeSubsidiaries need to either have their own capital or they need to be fully guaranteed by the head officeBecause head office can let a subsidiary fail customers of a subsidiary require head office guarantees usually92International bank regulationUsually commercial banks are regulated by the Central Bank or banking regulator in the country of the head officeEg Citibank would have branches in China but is regulated by the Federal Reserve because it is a US based bankHowever local bank regulators want to also regulate each branch or subsidiary because they do not want failure of a bank in its head office country to impact on the local banking system=> very complicated regulation for International commercial banks93International paymentsSWIFT connects local payment systems which simply operate as normalWhen an international payment is instructed banks simply transfer funds between themselves in the local currencyIf an FX transaction is required banks will handle that as part of the overall paymentBecause international commercial banks can use their local branches to make payments they are generally more efficient at handling international payments

94International bank departmentsInternational banks have mostly the same departments as local or regional banksLikely to have specialists who coordinate multinational customer business across the globeCountry Risk and Operations departments are usually much largerLegal and regulatory functions are more complicated

95International bank riskInternational banks have the same credit and market risk functions as local banksHowever with more financial markets businesses and corporate bankers operating across the globe, international banks often take on a wider array of risksBecause international banks tend to be larger they need more capital and become systemically important banksThis means they require even more capital!

96Case study: ANZ BankSustainability important to ANZ

98Global bank, regional strategy

99Diversified income streams

100Diversified balance sheet

101Important numbers for ANZ102Provisions: write down of loan value which flows through P&L PBP: profit before provisionsROE: return on equityCET1: Common Equity Tier 1 - % equity versus total assets ie regulatory capitalAPRA: ANZs banking regulator

Net Interest MarginNIM closely watchedDifference between deposit rates and lending rates mainlyNIM defined for:Business AssetsRetail AssetsDepositsNIM falling = more competition in market usually

103Cost / Income closely watched104

Return on RWARWA: Risk Weighted AssetsRegulatory Capital = RWA * BIS III % ratiosBIS III % ratios set by Basel committees and managed by Bank RegulatorsReturn on RWA = NPAT/RWAGives properly adjusted sense of banks net earning margins adjusted for risk105

Risk: CreditProvisions are losses expected to be made on defaulted or near defaulted loansImpaired Assets are financial assets that are under significant risk of having provisions made against themANZs impairment trend is positive ie problem customers are being worked out of the bank

106X-Sell is vital in commercial bankingCustomer acquisition costs are mostly fixed (not variable)Once a Customer has passed KYC (Know your Customer) rules then an account can be establishedOnce an account is established ANZ wants to not just sell one product to the customer, but two or three or five!

107Digital investment criticalFrom zero in 2012 ANZ has grown mobile banking revenue massivelyFending off the challenge from Silicon Valley which is using technology aggressively to poach bank customersCommercial banks MUST invest in FINTECH or risk being left behind like the old taxi industry (UBER)

108Regulatory Capital important!

109Balance Sheet composition

110Wholesale Asia strategy

111ANZ in China

112Markets revenue customer drivenDodd Frank rules move financial markets towards customers and away from tradingCustomer revenues not reliant on market volatilityIncome variability lower when customer driven

113Diversified markets incomeFinancial markets income diversified across products:FXRatesCapital MarketsCommoditiesOther

114Market risk carefully managedBalance sheet usage lowMarket VAR $150-200kLow revenue volatility

115Provisions: collective and individual

116Historical losses lag corp leverage

117Mortgage data important!Mortgages are THE core product of retail banksANZs mortgage business is very healthy60% of all Australian lending is mortgagesLVR: Loan to Value Ratio ie the amount of mortgage outstanding / value of the property secured under the mortgageAverage mortgage size AUD 376,000118

Mortgage risk - low45% of ANZs mortgage portfolio is secured by property at LVR < 60%Some mortgage LVRs 95%+ which is a bit riskyusually requires a mortgage insurance policy 119

Mortgage losses very lowFor Australian mortgages ANZ losses (ie provisions that have turned into actual losses) 0.01%If mortgage NIM is 2% then losing 0.01% is very acceptableLosses are low because mortgages are secured by property at LVR of 60%-90% mainlyIf borrower defaults bank can sell the property and usually recover all loan payments due ie recovery of 100%120

Prudent lending processesANZ has very strong and prudent mortgage lending practicesFrom pre-application to fulfillment (paying out the loan money) the system checks and assesses all risks carefullyCredit assessment very important121