An Introduction to Banking E-Book

Moorad Choudhry

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Securities and Investment Institute
• Sprache: Englisch

Seitenzahl: 923

Veröffentlichungsjahr: 2018

Beschreibung

A practical primer to the modern banking operation Introduction to Banking, Second Edition is a comprehensive and jargon-free guide to the banking operation. Written at the foundational level, this book provides a broad overview of banking to give you an all-around understanding that allows you to put your specialty work into context within the larger picture of your organization. With a specific focus on risk components, this second edition covers all key elements with new chapters on reputational risk, credit risk, stress testing and customer service, including an updated chapter on sustainability. Practical material includes important topics such as the yield curve, trading and hedging, asset liability management, loan origination, product marketing, reputational risk and regulatory capital. This book gives you the context you need to understand how modern banks are run, and the key points operation at all levels. * Learn the critical elements of a well-structured banking operation * Examine the risk components inherent in banking * Understand operational topics including sustainability and stress testing * Explore service-end areas including product marketing and customer service Banks continue to be the heart of the modern economy, despite the global financial crisis --they have however become more complex. Multiple layers and a myriad of functions contribute to the running of today's banks, and it's critical for new and aspiring bankers to understand the full breadth of the operation and where their work fits in. Introduction to Banking, Second Edition provides an accessible yet complete primer, with emphasis on the areas that have become central to sustainable banking operation.

Leseprobe

Table of Contents

COVER

TITLE PAGE

FOREWORD

PREFACE

LAYOUT OF THE BOOK

PREFACE TO THE FIRST EDITION

ACKNOWLEDGEMENTS

ABOUT THE AUTHOR

PART I: Bank Business and the Markets

Chapter 1: BANK BUSINESS AND CAPITAL

THE BASIC BANK BUSINESS MODEL

BANKING BUSINESS

SCOPE OF BANKING ACTIVITIES

BANKING PRODUCTS

CAPITAL MARKETS

FINANCIAL STATEMENTS AND RATIOS

BIBLIOGRAPHY

NOTES

Chapter 2: CUSTOMER SERVICES AND MARKETING FOR BANK PRODUCTS

MARKETING FINANCIAL SERVICES

CUSTOMER SERVICE

PRODUCT DEVELOPMENT

PRODUCT PRICING

CONCLUSION

NOTES

Chapter 3: CREDIT ASSESSMENT AND MANAGING CREDIT RISK

PART 1

CREDIT PROCESS

LOAN ORIGINATION PROCESS STANDARDS

QUALITATIVE FACTORS: RETAIL AND NON‐RETAIL EXPOSURES

INTERNAL RATINGS

COUNTERPARTY RISK PARAMETERS

DEFAULTS EVENTS AND MEASURES

PRODUCT CREDIT RISK MEASUREMENT

CREDIT RISK TERMINOLOGY

MODEL DEVELOPMENT

RISK MONITORING AND MODEL VALIDATION

TRADING BOOK CREDIT EXPOSURES

PART 2

CONCLUSIONS

NOTE

Chapter 4: THE MONEY MARKETS

INTRODUCTION

SECURITIES QUOTED ON A YIELD BASIS

SECURITIES QUOTED ON A DISCOUNT BASIS

COMMERCIAL PAPER

REPO

THE CLASSIC REPO

REPO COLLATERAL

LEGAL TREATMENT

MARGIN

FOREIGN EXCHANGE

FX BALANCE SHEET HEDGING

CURRENCIES USING MONEY MARKET YEAR BASE OF 365 DAYS

NOTES

Chapter 5: THE YIELD CURVE

IMPORTANCE OF THE YIELD CURVE

USING THE YIELD CURVE

YIELD‐TO‐MATURITY YIELD CURVE

ANALYSING AND INTERPRETING THE YIELD CURVE

THEORIES OF THE YIELD CURVE

THE ZERO‐COUPON YIELD CURVE

CONSTRUCTING THE BANK'S INTERNAL YIELD CURVE

CALCULATION ILLUSTRATIONS

UNDERSTANDING FORWARD RATES

SONIA YIELD CURVE

CONCLUSIONS

APPENDIX

REFERENCES

APPENDIX

BIBLIOGRAPHY

NOTES

Chapter 6: INTRODUCTION TO MONEY MARKET DEALING AND HEDGING

MONEY MARKET APPROACH

ALM IN A NEGATIVE YIELD CURVE ENVIRONMENT

CREDIT INTERMEDIATION BY THE REPO DESK

INTEREST‐RATE HEDGING TOOLS

BIBLIOGRAPHY

NOTES

PART II: Asset–Liability Management and Liquidity Risk

Chapter 7: BANK ASSET AND LIABILITY MANAGEMENT I

BASIC CONCEPTS

LIQUIDITY GAP

MANAGING LIQUIDITY

LIQUIDITY MANAGEMENT

THE ALM DESK

CRITIQUE OF THE TRADITIONAL APPROACH TO ALM

STRATEGIC ALM

CONCLUSIONS

BIBLIOGRAPHY

NOTES

Chapter 8: ASSET AND LIABILITY MANAGEMENT II: THE ALCO

TRADITIONAL ALCO MISSION

ALCO GOVERNANCE BEST‐PRACTICE PRINCIPLES

CONCLUSIONS

APPENDIX 8.1: ALCO RECOMMENDED TERMS OF REFERENCE

NOTES

Chapter 9: BANK LIQUIDITY RISK MANAGEMENT I

BEST‐PRACTICE LIQUIDITY RISK MANAGEMENT FRAMEWORK

THE LIQUIDITY POLICY STATEMENT

CONCLUSION

NOTE

Chapter 10: LIQUIDITY RISK MANAGEMENT II: BASEL III LIQUIDITY, LIABILITIES STRATEGY, STRESS TESTING, COLLATERAL MANAGEMENT AND THE HQLA

BASEL III LIQUIDITY METRICS

OPTIMUM LIABILITIES STRATEGY AND MANAGING THE HIGH‐QUALITY LIQUID ASSETS (HQLA) PORTFOLIO

THE LIQUID ASSET BUFFER

LIQUIDITY REPORTING, STRESS TESTING, ILAAP, AND ASSET ENCUMBRANCE POLICY

LIQUIDITY STRESS TESTING

INDIVIDUAL LIQUIDITY ADEQUACY ASSESSMENT PROCESS

INTRA‐DAY LIQUIDITY RISK

ASSET ENCUMBRANCE

COLLATERAL FUNDING MANAGEMENT, FVA, AND CENTRAL CLEARING FOR OTC DERIVATIVES

CONCLUSIONS

NOTES

Chapter 11: BUSINESS BEST‐PRACTICE BANK INTERNAL FUNDS TRANSFER PRICING POLICY

BACKGROUND

SETTING THE BANK POLICY STANDARD

THE TERM LIQUIDITY PREMIUM

TEMPLATE FTP REGIMES

CONCLUSIONS

Chapter 12: NET INTEREST INCOME (NII), NET INTEREST MARGIN (NIM) AND THE MANAGEMENT OF INTEREST‐RATE RISK IN THE BANKING BOOK

NET INTEREST INCOME

NET INTEREST MARGIN

INTEREST‐RATE RISK IN THE BANKING BOOK

SIMULATION ANALYSIS

THE MANAGEMENT OF GAP RISK

THE MANAGEMENT OF BASIS AND OPTION RISKS

THE MANAGEMENT OF PREPAYMENT RISK

THE MANAGEMENT OF PIPELINE RISK

THE MANAGEMENT OF CAP AND FLOOR RISK

BASEL COMMITTEE: HIGH‐LEVEL PRINCIPLES FOR INTEREST‐RATE RISK IN THE BANKING BOOK

CONCLUSIONS

NOTE

Chapter 13: SECURITISATION MECHANICS FOR BALANCE SHEET MANAGEMENT

THE PARTIES TO A SECURITISATION

STRUCTURAL FEATURES OF ABS

PRACTICAL ISSUES WITH ORIGINATING AN OWN‐ASSET SECURITISATION TRANSACTION

SUMMARY AND CONCLUSIONS

BIBLIOGRAPHY

NOTE

PART III: Strategy, Regulatory Capital and Case Studies

Chapter 14: STRATEGY SETTING

THE STRATEGIC PLANNING PROCESS

CONSIDERATIONS IN THE DEVELOPMENT OF STRATEGY

STRATEGY AND THE BANK BUSINESS MODEL

EVALUATION OF THE STRATEGIC PLAN

CONCLUSION

BIBLIOGRAPHY

Chapter 15: BANK REGULATORY CAPITAL, BASEL RULES AND ICAAP

THE BANKING MODEL AND CAPITAL

KEY CAPITAL CONSIDERATIONS

CAPITAL MANAGEMENT POLICY

CAPITAL ADEQUACY AND STRESS TESTING

ICAAP PROCESS – WORKED EXAMPLE OF PRESENTATION

STRESS TESTING

DIVIDEND POLICY

CASE STUDY: INTERNAL CAPITAL ASSESSMENT

CONCLUSIONS

BIBLIOGRAPHY

NOTES

Chapter 16: MANAGING OPERATIONAL RISK

OPERATIONAL RISK OVERVIEW

CONDUCT RISK

OPERATIONAL RISK MEASUREMENT

OPERATIONAL RISK MEASUREMENT CONCEPTS

BASEL OPERATIONAL RISK FRAMEWORK

STANDARDISED APPROACH

QUALITATIVE INPUT AND MODEL VALIDATION

OPERATIONAL RISK MANAGEMENT FRAMEWORK

CONCLUSIONS

Chapter 17: ADVICE AND PROBLEM SOLVING: CASE STUDIES

HOW TO STUDY THIS CHAPTER

Appendix A: FINANCIAL MARKETS ARITHMETIC

INTEREST: PRESENT AND FUTURE VALUE

MULTIPLE CASH FLOWS

CORPORATE FINANCE PROJECT APPRAISAL

INTERPOLATION AND EXTRAPOLATION

NOTE

Appendix B: ABBREVIATIONS AND ACRONYMS

INDEX

END USER LICENSE AGREEMENT

List of Tables

Chapter 1

Table 1.1 Selected banking activities and services

Table 1.2 Bank analysis ratios for capital strength

Table 1.3 Typical priorities of corporate bonds and loans of investment grade and sub‐investment‐grade borrowers

Table 1.4 Components of a bank balance sheet

Table 1.5 Components of bank income statement, typical structure for retail bank

Table 1.6 Bank cost–income ratios

Chapter 2

Table 2.1 Vanilla commercial banking products

Chapter 3

Table 3.1 Formulae and description for the key ratios mentioned above

Table 3.2 Comparison of RARoC vs EVA

Chapter 4

Table 4.1 Comparison of US CP and eurocommercial paper

Table 4.2 Terms of a classic repo trade

Chapter 6

Table 6.1 Hypothetical money market rates

Table 6.2 Description of LIFFE short sterling futures contract

Table 6.3 Impact of interest‐rate changes

Table 6.4 Vanilla swap example terms

Table 6.5 Swap quotes

Table 6.6 OIS cash flows

Chapter 7

Table 7.1 Simplified ALM profile for a regional European bank

Table 7.2 Funding the liquidity gap: two examples

Table 7.3 Market rates as at 2 June 2004

Table 7.4 Example gap profile

Chapter 8

Table 8.1 ALCO traditional mission

Chapter 14

Table 14.1 Strategic metrics and KPIs

Chapter 15

Table 15.1 Capital framework based on the Basel III framework: hypothetical bank start‐up

Table 15.2 AT1 and T2 instrument requirements

Table 15.3 Level 1 risk taxonomy

Table 15.4 Example risk indicator levels

Table 15.5 Sample incorporation of an institution's relevant risk types in the ICAAP

Table 15.6 ICAAP process

Table 15.7 Capital management risk taxonomy

Table 15.8 MIRA material risks

Table 15.9 SREP slide

Three types of stress testing are applied:

Table 15.10 Initial capital assessment

Table 15.11 Base case scenario projection

Table 15.12 Summary of management actions in stress

Chapter 17

Table 17.1 EAB deposit rates as at January 2009

Table 17.2 Regime implemented at the London subsidiary

Table 17.3 EAB deposit rates as at June 2009

Table 17.4 Final EAB FTP monthly curve

Table 17.5 Other arrangements

Table 17.6 UK commercial bank IRRBB reporting

Table 17.7 Potential net hedged between fixed‐rate assets and liabilities and floating‐rate assets and liabilities

Appendix A

Table A.1 The effect of more frequent compounding

Table A.2 Discount factor table

List of Illustrations

Chapter 1

Figure 1.1 Scope of banking activities

Figure 1.2 Composition of earnings

Chapter 3

Figure 3.1 Credit loss distribution

Figure 3.2 Applying credit loss distributions into capital calculation

Figure 3.3 Risky asset portfolio and capital structure

Figure 3.4 Summary of a risk‐weighted assets calculation for a retail and corporate customer commercial bank

Figure 3.5 Loan principal cash flow profile

Chapter 4

Figure 4.1 Bloomberg screen DCX used for a US dollar market, 3‐month loan taken out for value 18 November 2005

Figure 4.2 Bloomberg screen DCX for a Singapore dollar market, 3‐month loan taken out for value 18 November 2005

Figure 4.3 Libor screen on Bloomberg, 13 September 2016

Figure 4.4 Libor history 2011–2016

Figure 4.5 Sterling curves, 13 September 2016

Figure 4.6 Bloomberg screen GP showing fed funds rate for the period May–November 2005

Figure 4.7 Bloomberg screen GP showing USD overnight Libor rates for the period May–November 2005

Figure 4.8 Classic repo transaction

Figure 4.9 Classic repo trade example

Figure 4.10 FX balance sheet hedging- part (ii)

Figure 4.11 FX balance sheet hedging- part (iii)

Figure 4.12 FX balance sheet hedging- part (iv)

Figure 4.13 FX balance sheet hedging‐ part (i)

Chapter 5

Figure 5.1 Risk‐free and risky curves

Figure 5.2 Yield‐to‐maturity yield curves

Figure 5.3 Curve results when employing Nelson‐Siegel and OLS methods

Figure 5.4 GBP SONIA and GBP swap curves, 13 October 2016

Chapter 6

Figure 6.1 Positive yield curve funding

Figure 6.2 Negative yield curve funding

Figure 6.3 Eurozone AAA sovereign bond yield curve, 15 June 2017

Figure 6.4 Intermediation between stock loan and repo markets; an example using UK gilts

Figure 6.5 Position timeline

Figure 6.6 Key dates in an FRA trade

Figure 6.7 Rates used in FRA pricing

Figure 6.8 Illustration of interest basis mismatch hedging using the OIS instrument

Figure 6.9 Tullet US dollar depo rates, 10 November 2003

Figure 6.10 Garban ICAP OIS rates for USD, 10 November 2003

Chapter 7

Figure 7.1 Cornerstone of traditional ALM philosophy

Figure 7.2 A derivatives trading house's ALM profile

Figure 7.3 Commercial paper programme liability profile

Figure 7.4 Shows the graphical profile of the numbers in Table 7.1

Figure 7.5 Funding position on a daily basis

Figure 7.6 Gap limit report

Figure 7.7 Example of detailed gap profile

Figure 7.8 Gap maturity profile in graphical form

Figure 7.9 Gap maturity profile, bank with no short funding allowed

Figure 7.10 Gap maturity profile, UK high‐street bank

Figure 7.11 Liquidity analysis – example of UK bank profile of maturity of funding

Figure 7.12 Change in spread between 3‐month Prime rate and 3‐month Libor 2009–2010

Chapter 8

Figure 8.1 ALCO reporting input and output

Figure 8.2 ALCO governance organisation

Chapter 9

Figure 9A Template for Board risk appetite statement

Figure 9.1 UK banks' liquidity ratios 1968–2010

Figure 9.4 Liquidity policy statement: basic framework

Figure 9.5 Liquidity policy statement: basic framework

Figure 9.6 Liquidity policy statement: basic framework

Figure 9.7 Liquidity policy statement: basic framework

Figure 9.8 Liquidity policy statement: basic framework

Figure 9.9 Liquidity policy statement: basic framework

Figure 9.10 Bank liquidity report showing 8‐day and 1‐month liquidity ratios

Figure 9.12 Liquidity report and liquidity ratio calculation

Figure 9.13 Cumulative liquidity model

Figure 9.18 Summary liquidity snapshot

Chapter 10

Figure 10.1 Simplified overview of the LCR calculation

Figure 10.2 The US maturity mismatch add‐on

Figure 10.3 Simplified overview of the NSFR calculation

Figure 10.6 Liquidity value of liabilities

Figure 10.9 Deposit product analysis

Figure 10.11 Requirements for LAB (or HQLA) eligibility

Figure 10.12 Pros and cons of the different interest‐rate risk hedging instruments

Figure 10.13 Transition to COREP in the EU

Figure 10.14 End‐to‐end liquidity stress testing process

Figure 10.16 Specimen daily maximum liquidity requirement

Figure 10.17 The total liquidity requirement

Figure 10.18 Weighted average asset encumbrance by country

Figure 10.19 Interest‐rate simulations

Figure 10.20 IRS MtM PV simulations

Figure 10.21 Cross‐currency swap mark‐to‐market PV simulations

Figure 10.22 Comparing IRS and XCY expected exposures

Figure 10.23 Expected swap exposure through life

Figure 10.24 Derivatives funding curve as secured funding COF

Figure 10.25 Uncollateralised derivatives net position FTP pricing

Figure 10.26 Customer IRS and hedging IRS

Chapter 11

Figure 11.1 Bank internal funding arrangement

Figure 11.3 Bank FTP curve and other funding curves

Figure 11.4 Retail banking FTP regime

Figure 11.5 Retail banking asset–liability interconnection

Figure 11.7 Corporate banking FTP regime, asset example

Chapter 12

Figure 12.1 Components of bank P&L

Figure 12.2 NII as a percentage of Total Income – major UK banks, 2014 accounts

Figure 12.3 UK bank NIMs, 2012–2014

Figure 12.4A Bank products that influence NIM

Figure 12.4B WestChoud Bank starting balance sheet position, showing NII and NIM

Figure 12.4C WestChoud Bank, Scenario 1 potential impact on NII/NIM

Figure 12.4D WestChoud Bank, Scenario 2 potential impact on NII/NIM

Figure 12.4E WestChoud Bank, Scenario 3 potential impact on NII/NIM

Figure 12.4F WestChoud Bank, Scenario 4 potential impact on NII/NIM

Figure 12.4G WestChoud Bank, Scenario 5 potential impact on NII/NIM

Figure 12.6 Maturity schedule time buckets for EVE calculation

Figure 12.7 The volatility of UK interest rates over time

Figure 12.10 Interest rate swap schematic

Figure 12.12 A comparison between sterling 1‐month and 3‐month interbank lending rates

Figure 12.13 Period 1 – Amortising pay fixed swap hedge aligned to anticipated behavioural run‐off profile of a loan cohort

Figure 12.14 Period 2 – General level of interest rates falls so loans anticipated to repay quicker than original assumption

Figure 12.15 Period 2 – Balloon receive fixed swap is written to realign swap hedge to behavioural loan run‐off profile

Figure 12.16 Typical timeline for a fixed‐rate mortgage offer

Chapter 13

Figure 13.1 Vanilla securitisation structure

Figure 13.2 Originators and asset classes used for securitisation in Europe

Figure 13.3 Consumer loan vintage analysis

Figure 13.4 ABS vs traditional bond finance

Figure 13.5 Engagement across the organisation and transaction governance

Figure 13.7 Market conditions could adversely affect transaction launch

Chapter 14

Figure 14.1 Leadership commitment

Figure 14.2 Strategy‐setting cycle, pre‐crash

Figure 14.3 Strategy‐setting cycle, post‐crash

Figure 14.4 UK banks customer funding gap, 1997–2009

Figure 14.5 Formulation of capital management strategy

Chapter 15

Figure 15.1 Stylised representation of a typical commercial bank balance sheet

Figure 15.2 Expected and unexpected losses

Figure 15.3 Capital structure considerations under CRR/CRDIV

Figure 15.4 Combined buffer requirement for a bank under Basel III

Figure 15.5 RWA breakdown

Figure 15.6 Capital considerations

Figure 15.7 Hypothetical new bank capital structure minimum compliance with Basel III

Figure 15.8 Formulating capital management strategy

Figure 15.9 The three pillars of capital and risk management

Figure 15.10 Steps involved in the ICAAP production and approval process

Figure 15.11 Three‐level scenario

Figure 15.12 ICAAP governance process: the commonly observed process

Figure 15.13 All‐embracing ICAAP governance process

Figure 15.14 Summary of the ICAAP planning and implementation process, linking strategy and capital management

Figure 15.15 Point‐in‐time capital assessment (1‐year horizon) Pillar I and Pillar IIA

Figure 15.16 Capital surplus/deficit

Figure 15.17 Progress towards key strategic balance sheet objectives

Figure 15.18 Base case capital projection

Figure 15.19 Assessment of capital buffers mixed approach

Figure 15.20 Forward‐looking capital assessment: standard approach

Figure 15.21 Assessment of capital buffers: standard approach

Chapter 17

Figure 17.1 Northern Rock funding types 1998–2007

Figure 17.2 Northern Rock CDS price history April–September 2007

Figure 17.3 Proposed ALM report in table and graph formats

Figure 17.4 Business line funding usage

Figure 17.5 CBD ALCO governance

Figure 17.6 UK commercial bank IRRBB reporting

Figure 17.7 Bank IRRBB hedge structure

Appendix A

Figure A.1 Relationship between NPV and IRR

Figure A.2 A typical brokers' screen

Guide

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E1

AN INTRODUCTION TO BANKING

PRINCIPLES, STRATEGY AND RISK MANAGEMENT

SECOND EDITION

Moorad Choudhry

With contributions from Ed Bace, Polina Bardaeva, Kevin Liddy, Jamie Paris, Soumya Sarkar and Chris Westcott

First Edition published: April 2011

© 2018 John Wiley & Sons, Ltd and Moorad Choudhry

Registered office

John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom

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FOREWORD

Steen Blaafalk

I know Moorad Choudhry as an experienced professional and very strong personally, and it is with great pleasure that I accept to write a short foreword for the new edition of An Introduction to Banking.

A key role for a bank is to transform short‐term deposits from businesses and households into long‐term loans to businesses and households that want to borrow for investments or consumption. In this way, banks support growth and wealth in society – not only by creating jobs in the banking sector – but also by supporting growth in many sectors of the economy.

An integral part of banking is taking calculated risks. A professionally run bank will reserve enough capital to absorb expected as well as unexpected losses on the lending book to continue its business, even in a recession.

Another risk is maturity transformation – borrowing short and lending long. On the one hand, it is a source of income for the bank. On the other hand, it is a threat to the survival of the bank if it is funding itself too short or through unstable funding sources that disappear when a crisis occurs.

In the years leading up to the 2008 global financial crisis, banks had become significantly less consolidated as the capital rules allowed them to have a very high gearing of the balance sheet. Moreover, many banks had funded themselves very short in the capital markets since liquidity was ample and spreads were very low – building up huge customer funding gaps. At the same time, the banks had competed fearlessly on margins in order to attract new business. A cocktail that would be doomed to go wrong at some point in time.

When the global financial crisis culminated in September 2008 with the collapse of Lehman Brothers, all confidence in and among financial institutions disappeared. This resulted in liquidity drying out very fast, and institutions with a short/unstable funding profile found themselves unable to refinance their debt. Additionally to this, many banks found themselves too thinly capitalised to absorb the loss incurring during this next period.

The global financial crisis spilled over into the real economy since many banks were not able to fund the loan demand of their customers and they did not have the excess capital to grow their balance sheets. The authorities reacted to the situation by demanding significantly higher capital and liquidity ratios, which of course in the situation catalysed the crisis in the real economy.

An Introduction to Banking describes getting the right balance between running a safe bank and optimising the use of capital and liquidity to the benefit of the shareholders of the bank for the long run.

In the first part of the book, Moorad introduces the reader to the basic concepts of running a bank. I can recommend this part of the book to bankers who need a broader insight into the institutional setup and basic terms in banking. Understanding the basics of banking helps you to get the full benefit when it becomes more detailed, dealing with asset and liability management (ALM) as well as capital and liquidity management later in the book.

Asset & Liability Management is the very essence of banking. To be successful as a bank you need to have professional asset and liability management processes, starting from the top management and flowing down to the different business areas of the bank, including proper Funds Transfer Pricing (FTP) for capital and liquidity, to understand and make transparent the drivers for various banking products.

As a Group Chief Financial and Risk Officer, I have had great professional benefit from the description of the role of the Asset & Liability Committee, the risk policy, reporting, and stress testing, as well as the description of the day‐to‐day management in the risk and treasury departments. It was also rewarding for me to read the final chapters about best practice in capital and funding management and corporate governance, which we should not forget when we enter into the next period of bull markets.

Moorad manages to describe a comprehensive and complex area of banking in a lively and readable language.

I can highly recommend the book as a handy reference work for anyone who is involved in banking strategy, ALM, and liquidity risk management.

Steen Blaafalk

Group Chief Financial and Risk Officer

Saxo Bank A/S

Copenhagen

10 March 2015

PREFACE

Who among the world's population of authors would not love to write a timeless work? Ideally, a timeless work of fiction, but failing that, something factual that remains the undisputed benchmark for its subject. Somewhat paradoxically, I hold that the latter is actually harder to accomplish. Please don't get me wrong, only a very small minority of us (of which I am not one) have it in them to produce Hamlet, or Dune, or The Iliad, or The Assistant, or Crime and Punishment, or The Adventures of Sherlock Holmes, or The Crab With The Golden Claws, or Seven Pillars of Wisdom, or Peanuts, Featuring Good Ol' Charlie Brown, or countless other such immortal works. But once one has produced classic art, it lives forever. There is no need ever to update or modify it.

Practitioner textbooks, on the other hand, are rarely timeless. In almost every field of learning, society develops and adds to its knowledge base, such that a work of non‐fiction rapidly becomes out of date. To maintain currency requires constant updates and further editions, which means more work. An author ambitious of producing a literary masterpiece should avoid the factual learning genre.

But there is an apparent paradox when it comes to works of fact concerning banking: in theory, unlike in so many commercial disciplines, the main principles have not changed since the first modern banks came into being in the fifteenth century. Much of what held good for banks in 1808 and 1908 would have remained fine for banks in 2008, if certain senior bank executives had been competent enough to remember them (or even bothered to learn them in the first place).

The traditionally staid and “conservative” field of banking has experienced considerable development and change of late. However, if anything, this “development” has not been all positive. While lauding the introduction of tools and techniques that have enabled borrowers to reduce their risk and assist economic growth worldwide, most of us are now rightly wary of ever‐more sophistication and complexity in finance. It really is time for banks, and banking, to revert somewhat to the basics of finance and look to deliver genuine good customer service, and roll back the ever‐increasing complexity in the industry. Why? Because such sophistication often ended up doing more harm than good.

Finance is as much art as science anyway. So much of it is expectations based on assumptions, despite what the financial market “quants” would tell you. That this is not known universally is itself worrying, with bankers the world over convinced that the stated gross redemption yield of a bond purchased in the secondary market is actually what they will receive for holding said bond. The valuation of equities, the calculation of default probability, the expected life of a loan, the “risk weighting” of a loan asset, the “expected shortfall” risk exposure of a trading portfolio…these are all so much estimations based on assumptions. Which person in their right mind, trying to do the right thing for everyone, would wish to build sophistication on such a foundation?

In any case, in many countries banks have managed to transform their image from perceived bastions of stability and good social standing into seeming snake‐oil selling hucksters of low repute and lower intentions. This is a pity, because without banks performing their vital roles as secure stores of money and maturity transformation specialists, economic and social development would take place at a much slower pace. So while it is almost unarguable to state the importance of banks and the good they do for society, it is also unarguable to state that the work undertaken by banks must reflect sound risk management principles as well as scrupulous ethics and good intentions.

Hence, it becomes necessary to update the first edition of this “introductory” book about banking. The first edition isn't necessarily out of date, at least not all of it anyway – more that it doesn't emphasise the principles of banking as strongly as it should have. And of course it was never going to be timeless…works of fact so rarely are. But this second edition, requiring readers to shell out their hard‐earned cash for a second time, is needed so as to emphasise more of the principles of banking as well as update some of the technical content.

In any case, any author would do well to remember the words of Sir Arthur Conan Doyle from the preface to The Sherlock Holmes Stories (1903):

“…all forms of literature, however humble, are legitimate if the writer is satisfied that he has done them to the highest of his power. To take an analogy from a kindred art, the composer may range from the oratorio to the comic song and be ashamed of neither, so long as his work in each is as honest as he can make it. It is insincere work, scamped work, work which is consciously imitative, which a man should voluntarily suppress before time saves him the trouble.”

So that is the ultimate objective of this revised second edition: not to attempt to achieve timelessness and immortality, which would reflect only a monstrous and insufferable arrogance and egotism on my part, but rather simply to be viewed by readers as a work of honesty that was done to the best of the author's ability and that, if the market allows it, can remain of value on the bookshelf for many years to come. Irrespective of whether this last ambition is achieved, I hope at least that this book has served its purpose for today. And as Ian MacDonald so memorably said in the preface to his last update of the majestic Revolution In The Head, no further editions will be forthcoming.

LAYOUT OF THE BOOK

This book is comprised of 17 chapters, grouped in three parts. There is some rhyme and reason in the split: Part I may be considered a primer on the basics, not just of banking, but also the interest‐rate markets, customer service, and credit assessment – essentially, the basics of financial markets. Part II looks at the balance sheet in general, and asset–liability management in particular, while Part III covers strategy, regulatory capital, and operational risk.

For newcomers to the market there is a primer on financial market arithmetic in Appendix A at the back of the book.

New material in this second edition includes:

Case studies on problem solving involving several real‐world risk management issues (and solutions) the author has been involved with;

A chapter on liabilities strategy setting, as part of the balance sheet optimisation process;

A detailed look at the importance of understanding net interest margin (NIM);

Best‐practice ICAAP and ILAAP process principles;

Various reasonably important sundries such as strategy and operational risk management.

As ever, the intention is to remain accessible and practical throughout, and to provide information of value to the practitioner in banking – we hope sincerely that this aim has been achieved. Comments on the text are welcome and should be sent to the author care of John Wiley & Sons Ltd, Chichester, England.

PREFACE TO THE FIRST EDITION

Banking is a long‐established and honourable profession. The provision of efficient loan and deposit facilities is an essential ingredient in human development and prosperity. For this reason, it is important that all banks are managed prudently. The art of banking remains unchanged from when banks were first established. At its core are the two principles of asset–liability mismatch and liquidity risk management. The act of undertaking loans and deposits creates the mismatch, because while investors like to lend for as short a term as possible, borrowers prefer to borrow for as long a term as possible. In other words, the act of banking is the process of maturity transformation, whereby banks “lend long” and “fund short”. Banks do not “match‐fund”, because there would never be enough funds available to match a 25‐year maturity mortgage with a 25‐year fixed deposit. Thus, banking gives rise to liquidity risk, and bankers are therefore required to take steps to ensure that liquidity, the ability to roll over funding of long‐dated loans, is continuously available.

We define banking as the provision of loans and deposits; the former produce interest income for the bank, while the latter create interest expense for the bank. On the bank's balance sheet the loan is the asset and the deposit is the liability, and the bank acts as the intermediary between borrowers and lenders. The fact that all banks, irrespective of their size, approach, or strategy, must manage the two basic principles of asset–liability management (ALM) and liquidity management means that they are ultimately identical institutions. They deal within the same markets and with each other. That means that the bankruptcy of any one bank, while serious for its customers and creditors, can have a bigger impact still on the wider economy because of the risk this poses to other banks. It is this systemic risk which posed the danger for the world's economies in 2008, after Lehman Brothers collapsed, and which remains a challenge for financial regulators.

This book introduces the fundamental art of banking, which is ALM and liquidity risk management. It does not describe the different types of banks and their organisational structures that exist around the world. Neither does it describe the wide range of bank products that are available or the great variation in financial markets and instruments that can be observed. These topics are covered abundantly in existing textbooks. The object of this book is to present bank ALM and liquidity management at an introductory level, something that is not so common in textbooks on finance. These topics deserve to be understood and appreciated by everyone involved in banking, because it was unsound practices in these fields that helped to create the banking crisis in 2008, and made its impact so much worse than it need have been. Proper respect for the art of ALM will mitigate the impact on banks of the next financial crash.

ACKNOWLEDGEMENTS

Love, thanks, and respect, as always, to the Raynes Park Footy Boys and The Pink Tie Brigade. A Solid Bond in Your Heart. Thanks to Juan Carlos Sihuincha for the great photograph!

You know who your friends are when you're “UB40”. Very special thanks to Clax, KMan, Farooq Jaffrey, Zhuoshi Liu, Rich Lynn, Michael Nicoll, Stuart Turner, Colin Johnson, Abu Abdi, Mohamoud Dualeh, Mohammed Dualeh, Dan Cunningham, Ali Andani, Konstantin Nikolaev, Nathanael Yishak, Chris Westcott, Jamie Paris, Polina Bardaeva, Graeme Wolvaardt, Shahrukh Feroz Ahmed, Angel Alchin, A. Mehdi, Nik Slater, Milivoje Davidovic, Aleksandar Doric, David Fance, Barry Howard, David Castle, Nick Carpenter, Balamurali Radhakrishnan, Asif Abdul‐Razzaq, Rod Pienaar, Richard Pereira, Michael Widowitz, and Zumi Farooq.

At Wiley I'd like to thank Stephen Mullaly, Jeremy Chia, Syd Ganaden, the now departed Thomas Hyrkiel and the mighty Nick Wallwork, plus Emily Paul, Caroline Maria Vincent, and Aida Ferguson.

Thank you. I won't forget it.

Moorad Choudhry

Surrey, England

24 June 2017

ABOUT THE AUTHOR

Professor Moorad Choudhry lectures on the MSc Finance programme at the University of Kent Business School. He was latterly Treasurer, Corporate Banking Division, at the Royal Bank of Scotland, Head of Treasury at Europe Arab Bank, Head of Treasury at KBC Financial Products, and Vice‐President in structured finance at JPMorgan Chase Bank. He was a gilt‐edged market‐maker at ABN Amro Hoare Govett Securities Limited. He began his City career at the London Stock Exchange in 1989.

Moorad is a Fellow of the Chartered Institute for Securities & Investment, a Fellow of The London Institute of Banking & Finance, and a Fellow of the Institute of Directors. He is a member of the Editorial Boards of Journal of Structured Finance, Qualitative Research in Financial Markets, International Journal of Economics and Finance, and American Securitisation. He was born in Bangladesh and lives in Surrey, England.

I have a problem with psychometric testing: it is to my mind a spurious device used by large corporations to ensure that anyone with a semblance of wit or independent thought doesn't get anywhere near securing a job. If the entire country were subjected to psychometric testing and all those who failed it humanely put down, we'd be left with a rump of deathly, grey‐faced middle managers.

—Rod Liddle, The Sunday Times, 18 August 2013.

PART IBank Business and the Markets

Part I of this book introduces the subject of banking, with a look first at the main products, and then proceeds to discuss all the key aspects of a bank business: namely, customer service, credit assessment, trading and hedging techniques, the yield curve, regulatory capital, and the money and capital markets. This part is the “primer” on banking and is essential reading for all practitioners.

We begin with a look at the fundamentals of banking business, products and customer service, and the different elements of bank capital. This is essentially an introduction to the nature of banking. We then consider further elementary finance background, with a look at the basics of financial statements. The contents of this chapter may appear more at home in a textbook on accounting, but an understanding of ratio analysis is vital for the bank practitioner, who is concerned with issues such as return on capital as well as balance sheet sustainability.

This is followed with more detail on credit risk and credit assessment, and the basics of trading and hedging.

Chapter 1BANK 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 undertaken by specific individual banks, the common denominator of all banking activities is that of bringing together those who require funding with those who possess surplus funding, and acting as a transmission mechanism for the processing of payments. That is in essence all that banks do, and while it isn't a complex service provision, it is nevertheless an important one. Societal and economic development worldwide relies on efficient banking service provision.

In this introductory chapter we describe the financial markets, the basic banking business model, 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. We also introduce the different products offered by banks to their customers.

THE BASIC BANK BUSINESS MODEL

The basic bank business model has remained unchanged ever since banks became an integral part of modern society.1 Of course, as it is more of an art than a science, the model parameters themselves can be set to suit the specific strategy of the individual bank, depending on whether the strategy operates at a higher or lower risk–reward profile. However, the basic model is identical across all banks. In essence, banking involves taking risks, followed by effective management of that risk. This risk can be categorised as follows:

Managing the bank's capital;

Managing the liquidity mismatch – a fundamental ingredient of banking is “maturity transformation”, the recognition that loans (assets) generally have a longer tenor than deposits (liabilities).

If we wished to summarise the basic ingredients of the historical bank model, we might describe it in the following terms:

Leverage: A small capital base is levered up into an asset pool that can be 10 to 30 times greater (sometimes even higher);

The “gap”: Essentially, funding short to lend long is a function of the conventional positive‐sloping yield curve and is dictated by recognition of the asset–liability mismatch noted above;

Liquidity: An assumption that a bank will always be able to roll over funding as it falls due;

Risk management: An understanding of credit or default risk.

These fundamentals remain unchanged. The critical issue for bank management, however, is that some of the assumptions behind the application of these fundamentals have changed, as demonstrated by the crash of 2007–2008. The changed landscape in the wake of the crisis has resulted in some hitherto “safe” or profitable business lines being viewed as risky. Although favourable conditions for banking may well return in due course, for the foreseeable future the challenge for banks will be to set their strategy only after first arriving at a true and full understanding of economic conditions as they exist today. The first subject for discussion is to consider what a realistic, sustainable return on the capital target level should be and to ensure that it is commensurate with the level of risk aversion desired by the Board. The Board should also consider the bank's capital availability and what amount of business this could realistically support. These two issues need to be addressed before the remainder of the bank's strategy can be considered.

Strategy

The most important function that a bank's Board can undertake is to set the bank's strategy. This is not as obvious as it sounds. It is vital that banks have a coherent, articulated strategy in place that sets the tone for the entire business from the top down.

In the first instance, the Board must take into account the current regulatory environment. This includes the requirements of the Basel III rules. A bank cannot formulate strategy without a clear understanding of the environment in which it operates. Once this is achieved – before proceeding with a formal strategy – the bank needs to determine what markets it wishes to operate in, and establish what products and what class of customer it wants to service. All its individual business lines should be set up to operate within the main strategy, once markets and customers have been identified.

In other words, a bank cannot afford to operate by simply meandering along, noting its peer group market share and Return on Equity (RoE) and making up its strategy as it goes along. This approach, although it would never be admitted, is evidently what many banks do indeed follow – however inadvertently – and results in a senior management and Board that is not fully aware of what the bank's liabilities and risk exposures are.

The first task is to understand one's operating environment. The bank also needs to incorporate a specific target market and product suite as the basis of its strategy. Concurrent with this, the bank must set its RoE target, which drives much of the bank's culture and ethos. It is important to get this part of the process right at the start. Prior to the crash, it was common for banks to seek to increase revenue by adding to their risk exposure. Assets were added to the balance sheet, or higher risk assets were taken on. In the bull market environment of 2001–2007 – allied to low funding costs as a result of low base interest rates – this resulted in ever higher RoE figures, to the point where it was common for even Tier 2 banks to target levels of 22–25% RoE in their business appraisal. This process was of course not tenable in the long run.

The second task – following on immediately from the first – is to set a realistic RoE target and one that is sustainable over the entire business cycle. This cannot be done without educating Board directors as well as shareholders, who must appreciate new, lower RoE targets. Managing expectations will contribute to a more dispassionate review of strategy. Just as importantly, risk‐adjusted RoE should also be set at a realistic level and not be allowed to increase. Hence, the Board and shareholders must accept that lower RoE levels will become the standard. This should also be allied to lower leverage levels and higher capital ratios.

Concurrently with the above process, a bank must ask itself where its strengths lie and formulate its strategy around that. In other words, it is important to focus on core competencies. Again, the experience of the crash has served to demonstrate that many banks found themselves with risk exposures that they did not understand. This may simply have been the holding of assets (such as structured finance securities) whose credit exposures, valuation, and secondary market liquidity they did not understand, or embarking on investment strategies such as negative basis trading without being aware of all the measurement parameters of such strategies.2 To implement a coherent, articulate strategy properly, a bank needs to be aware of exactly what it does have (or does not have) expertise for undertaking, and not operate in products or markets in which it has no genuine knowledge base.

Allied to an understanding of core competence is a review of core and non‐core assets. Bank strategy is not a static process or document, but rather a dynamic one. Regular reviews of the balance sheet need to be undertaken to identify any non‐core assets, which can then be assessed to determine whether they remain compatible with the strategy. If they are not, then a realistic disposal process would need to be drawn up. In the long run, this is connected with an understanding of where the bank's real strengths lie. Long‐term core assets may well differ from core assets, but this needs to be articulated explicitly. The decision on whether an asset is core or non‐core, or short‐term core or long‐term core, is a function of the bank's overall strategy – based on its expertise – and what markets and customers it wishes to service. This will be embedded in the strategy and the bank's business model. This drives the choice of products and business lines to which the bank feels it can add value.

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

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, interest income, fees

Credit, market

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 commercial 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 (NII) than trading income, and vice versa for a firm with an investment bank heritage such as Morgan Stanley. In fact, the vast majority of the world's banks do not even run a “trading book”, which is a business activity with a specific accounting definition and treatment. Such firms will earn a greater share of their revenues through fees and loan interest 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 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, while “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, customer 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, securitised 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 asset‐liability management (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. In some cases, running positions in securities (as opposed to derivatives) generate 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 perhaps the most volatile income source for a bank. It also generates relatively high market risk, as well as not inconsiderable credit risk. In the era of Basel III, banks will be migrating from the use of Value‐at‐Risk (VaR) methodology to measure the risk arising from trading activity to the use of the Expected Shortfall (ES) method, which gives a statistical measure of expected losses to the trading portfolio under certain market scenarios. This is dictated by the Fundamental Review of the Trading Book (FRTB) rules implemented under Basel III. A discussion of this topic is outside the scope of this book but further detail can be obtained from the author's book Moorad Choudhry Anthology.

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.

SCOPE OF BANKING ACTIVITIES

The different aspects of banking business vary widely in nature. For our purposes we may group them together as shown in Figure 1.1. Put very simply, “retail” or “commercial” banking covers the more traditional lending and trust activities, while “investment” banking covers trading activity and fee‐based income such as stock exchange listing and mergers and acquisitions. The one common objective of all banking activity is return on capital. Depending on the degree of risk it represents, a particular activity will be required to achieve a specified return on the capital it uses. The issue of banking capital is vital to an appreciation of the banking business; entire new business lines (such as securitisation) have been devised in response to the need to make the use of capital more efficient.

Figure 1.1 Scope of banking activities

As we can see from Figure 1.1, the scope of banking business is wide. Activities range from essentially plain vanilla activity, such as corporate lending, to complex transactions, such as securitisation and hybrid product trading. There is vast literature on all these activities, so we do not need to cover them here. However, it is important to have a grounding in the basic products; subsequent chapters will introduce these.

ALM is the discipline in banking risk management that is concerned with the efficient management of the mismatch between assets (loans) and liabilities (deposits), and with management of the bank's capital. It therefore concerns itself with all banking operations, even if day‐to‐day contact between the ALM desk (or Treasury desk) and other parts of the bank is infrequent. The ALM desk will be responsible for the Treasury and money market activities of the entire bank. So, if we wish, we could draw a box with ALM in it around the whole of Figure 1.1. This is not to say that the ALM function does all these activities; rather, it is just to make clear that all the various activities represent assets and liabilities for the bank, and one central function is responsible for this side of these activities.

For capital management purposes, a bank's business is organised into a “banking book” and a “trading book”. We consider these next; first though, a word on bank capital.

Capital