An Introduction to Banking

Liquidity Risk and Asset-Liability Management

Moorad Choudhry

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781119950240
• Edition: 1
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

"A great write-up on the art of banking. Essential reading for anyone working in finance."
Dan Cunningham, Senior Euro Cash & OBS Dealer, KBC Bank NV, London

"Focused and succinct review of the key issues in bank risk management."
Graeme Wolvaardt, Head of Market Risk Control, Europe Arab Bank plc, London

The importance of banks to the world's economic system cannot be overstated. The foundation of consistently successful banking practice remains efficient asset-liability management and liquidity risk management.

This book introduces the key concepts of banking, concentrating on the application of robust risk management principles from a practitioner viewpoint, and how to incorporate these principles into bank strategy.

Detailed coverage includes:

• Bank strategy and capital
• Understanding the yield curve
• Principles of asset-liability management
• Effective liquidity risk management
• The role of the bank ALM committee

Written in the author's trademark accessible style, this book is a succinct and focused analysis of the core principles of good banking practice.

Chapter 1

Bank Business and Capital

Banking has a long and honourable history. Today it encompasses a wide range of activities of varying degrees of complexity. Whatever the precise business, the common denominators of all banking activities are those of risk, return and the bringing together of the providers of capital. Return on capital is the focus of all banking activity. The co-ordination of all banking activity could be said to be the focus of asset–liability management (ALM), although some practitioners will give ALM a narrower focus. Either way, we need to be familiar with the wide-ranging nature of banking business and the importance of bank capital. This then acts as a guide for what follows.

In this introductory chapter we place ALM in context by describing the financial markets and the concept of bank capital. We begin with a look at the business of banking. We then consider the different types of revenue generated by a bank, the concept of the banking book and the trading book, financial statements and the concept of provisions.

BANKING BUSINESS

Banking operations encompass a wide range of activities, all of which contribute to the asset and liability profile of a bank. Table 1.1 shows selected banking activities and the type of risk exposure they represent. The terms used in the table, such as ‘market risk’, are explained elsewhere in this book. In another chapter we discuss the elementary aspects of financial analysis – using key financial ratios – that are used to examine the profitability and asset quality of a bank. We also discuss bank regulation and the concept of bank capital.

Table 1.1 Selected banking activities and services.

Service or function	Revenue generated	Risk
Lending
– Retail	Interest income, fees	Credit, market
– Commercial	Interest income, fees	Credit, market
– Mortgage	Interest income, fees	Credit, market
– Syndicated	Trading, interest income, fees	Credit, market
Credit cards	Interest income, fees	Credit, operational
Project finance	Interest income, fees	Credit
Trade finance	Interest income, fees	Credit, operational
Cash management
– Processing	Fees	Operational
– Payments	Fees	Credit, operational
Custodian	Fees	Credit, operational
Private banking	Commission income, interest income, fees	Operational
Asset management	Fees, performance	Credit, market, operationalpayments
Capital markets
– Investment banking	Fees	Credit, market
– Corporate finance	Fees	Credit, market
– Equities	Trading income, fees	Credit, market
– Bonds	Trading income, interest income, fees	Credit, market
– Foreign exchange	Trading income, fees	Credit, market
– Derivatives	Trading income, Credit, marketinterest income, fees

Before considering the concept of ALM, all readers should be familiar with the way a bank’s earnings and performance are reported in its financial statements. A bank’s income statement will break down earnings by type, as we have defined in Table 1.1. So we need to be familiar with interest income, trading income and so on. The other side of an income statement is costs, such as operating expenses and bad loan provisions.

That the universe of banks encompasses many different varieties of beasts is evident from the way they earn their money. Traditional banking institutions, perhaps typified by a regional bank in the United States (US) or a building society in the United Kingdom (UK), will generate a much greater share of their revenues through net interest income than trading income, and vice versa for a firm with an investment bank heritage such as Morgan Stanley. Such firms will earn a greater share of their revenues through fees and trading income. The breakdown varies widely across regions and banks.

Let us now consider the different types of income streams and costs.

Interest income

Interest income, or net interest income (NII), is the main source of revenue for the majority of banks worldwide. It can form upwards of 60% of operating income, and for smaller banks and building societies it reaches 80% or more.

NII is generated from lending activity and interest-bearing assets, ‘net’ return is this interest income minus the cost of funding loans. Funding, which is a cost to the bank, is obtained from a wide variety of sources. For many banks, deposits are a key source of funding, as well as one of the cheapest. They are generally short term, though, or available on demand, so must be supplemented by longer term funding. Other sources of funds include senior debt, in the form of bonds, securitized bonds and money market paper.

NII is sensitive to both credit risk and market risk. Market risk, which we look at later, is essentially interest rate risk for loans and deposits. Interest rate risk will be driven by the maturity structure of the loan book, as well as the match (or mismatch) between the maturity of loans against the maturity of funding. This is known as the interest rate gap.

Fees and commissions

Banks generate fee income as a result of providing services to customers. Fee income is very popular with bank senior management because it is less volatile and not susceptible to market risk like trading income or even NII. There is also no credit risk because fees are often paid upfront. There are other benefits as well, such as the opportunity to build up a diversified customer base for this additional range of services, but these are of less concern to a bank’s ALM desk.

Fee income uses less capital and also carries no market risk, but does carry other risks, such as operational risk.

Trading income

Banks generate trading income through trading activity in financial products such as equities (shares), bonds and derivative instruments. This includes acting as a dealer or market-maker in these products as well as taking proprietary positions for speculative purposes. Running positions in securities (as opposed to derivatives) in some cases generates interest income; some banks strip this out of the capital gain made when the security is traded to profit, while others include it as part of overall trading income.

Trading income is the most volatile income source for a bank. It also generates relatively high market risk, as well as not inconsiderable credit risk. Many banks, although by no means all, use the Value-at-Risk (VaR) methodology to measure the risk arising from trading activity, which gives a statistical measure of expected losses to the trading portfolio under certain market scenarios.

Costs

Bank operating costs comprise staff costs and operating costs, such as provision of premises, information technology and office equipment. Other significant elements of cost are provisions for loan losses, which are charges against the loan revenues of the bank. Provision is based on subjective measurement by management of how much of the loan portfolio can be expected to be repaid by the borrower.

CAPITAL MARKETS

A ‘capital market’ is the term used to describe the market for raising and investing finance. The economies of developed countries and a large number of developing countries are based on financial systems that encompass investors and borrowers, markets and trading arrangements. A market can be one in the traditional sense such as an exchange where financial instruments are bought and sold on a trading floor, or it may refer to one where participants deal with each other over the telephone or via electronic screens. The basic principles are the same in any type of market. There are two primary users of capital markets: lenders and borrowers. The source of lenders’ funds is, to a large extent, the personal sector made up of household savings and those acting as their investment managers such as life assurance companies and pension funds. The borrowers are made up of the government, local government and companies (called corporates). There is a basic conflict between the financial objectives of borrowers and lenders, in that those who are investing funds wish to remain liquid, which means having easy access to their investments. They also wish to maximize the return on their investment. A corporate, on the other hand, will wish to generate maximum net profit on its activities, which will require continuous investment in plant, equipment, human resources and so on. Such investment will therefore need to be as long term as possible. Government borrowing as well is often related to long-term projects such as the construction of schools, hospitals and roads. So while investors wish to have ready access to their cash and invest short, borrowers desire funding to be as long term as possible. One economist referred to this conflict as the ‘constitutional weakness’ of financial markets (Hicks, 1939), especially as there is no conduit through which to reconcile the needs of lenders and borrowers. To facilitate the efficient operation of financial markets and the price mechanism, intermediaries exist to bring together the needs of lenders and borrowers. A bank is the best example of this. Banks accept deposits from investors, which makes up the liability side of their balance sheet, and lend funds to borrowers, which forms the a...