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Part I
A Primer on Banking
Part I is a primer on banking, and sets the scene for newcomers, be they students or practitioners. It is essential to be familiar with the nature of banking business, as well as the types of instruments used in money market trading. We also need to be familiar with banking capital and financial statements, the former preparatory to a discussion on regulatory capital and the Basel rules, the latter simply for general knowledge purposes. So the first part of this book covers these areas.
We begin with a look at the fundamentals of banking business, and the different elements of bank capital. We also look at financial ratio analysis, used when reviewing metrics such as return on capital.
The remainder of Part I looks at regulatory capital, credit risk and credit limits, the use of securitisation and the yield curve.
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Chapter 1
A Primer on Bank Business and Balance Sheet Risk
This chapter is intended for newcomers to the market, junior bankers and finance students. Everyone else should read it as an essential refresher course. The purpose of this primer is to introduce all the essential basics of banking necessary to gain a strategic overview of what banks do and to manage what risk exposures they face. We begin with the concept of banking, and follow with a description of bank cash flows, calculation of return, the risks faced in banking, and organisation and strategy.
A summary of the bank product line is given in the Appendix at the end of the chapter.
An Introduction to Banking
Banking has a long and honourable history. 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 Chapter 2 we discuss 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.
| 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 payments | Credit, Market, Operational |
| 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, fees | Credit, Market |
Before considering the concept of asset and liability management (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 the 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 the costs, such as operating expenses and bad loan provisions.
That the universe of banks encompasses many different forms 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 bank such as Goldman Sachs or Morgan Stanley. The latter firms will earn a greater share of their revenues through fees and trading income.
During 2007 a regional European bank reported the following earnings breakdown, as shown in Table 1.2.
Table 1.2 European regional bank, earnings structure 2007.
Source: Author's notes.
| Net interest income | 62 |
| Fees and commissions | 27 |
| Trading income | 11 |
However, this breakdown varies widely across regions and banks, and in fact would be reversed at an “investment bank” whose core operating activity was market-making and proprietary trading.
Let us now consider the different types of income stream and costs.
Interest Income
Interest income, or net interest income (NII), is the main source of revenue for the majority of banks worldwide. As we saw from Table 1.2, 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, the “net” return is this interest income minus the cost of funding the loans. Funding, which is a cost to the bank, is obtained from a variety of sources. For many banks, retail 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 are often supplemented with longer term funding. Other sources of funds include senior debt, in the form of bonds, securitised bonds and money market paper.
NII is sensitive to both credit risk and market risk. Market risk, which we will 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 the loans against the maturity of the funding. This is known as the interest-rate gap.
Fees and Commissions
Banks generate fee income as a result of the provision of 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 NII. There is also no credit risk because the fees are often paid up front. There are other benefits as well, such as the opportunity to build up a diversified customer base for this additional range of services.
Fee income uses...
