7 commercial banking 1

Question 1

Three definitions of a bank

Answer 1

1) General definition - a financial provider or a deposit institution collecting free money and offering loans to different subjects as well as services
2) “EU“ definition - EU Directive 2006/48/EC defines a credit institution (which a bank is), as a) an undertaking whose business it is to receive deposits and other repayable funds from the public and to grant credits for its own account, or b) an electronic money institution within the meaning of Directive 2000/46/EC.
3) Czech Act on Banks“ definition (No. 21/1992 Coll.) - a bank is a joint-stock company accepting deposits from the public and granting loans, licensed by the Czech National Bank.

Question 2

What´s the aim of bank´s management?

Answer 2

▪ To manage a bank with the goal of maximising its value for shareholders under risk conditions
▪ Dealing with information asymmetry
▪ Appropriate risk management needed
▪ Corporate governance/principal-agent problem

Question 3

Banks´ financial statements and ratios

Answer 3

two main bank financial statements
1. balance sheet (sources and use of funds)
2. profit and loss statement (P&L)

ratios
▪ Book value of equity (BVE) = value of equity
▪ Market value of equity (MVE) = share market price x
number of shares
▪ Market-to-book ratio (MVE/BVE) – ratio greater >1?

Question 4

bank’s balance sheet (definition)

Answer 4

Balance sheet (a statement of condition or statement of resources) is a “snapshot” on a given day – very often December 31 – which indicates the composition of all asset and liabilities of the bank, including shareholders´ equity

1) Balance sheet: A = L+ NW
A = total assets, L = total liabilities,
NW =A-L = net worth = equity = capital

Question 5

bank’s P&L (definition)

Answer 5

▪ Profit and loss statement (“P&L” or income statement) can be viewed as an explanation as to how bank’s net earnings before dividend distributions were achieved, and why capital increased and decreased
▪ Profits are the lifeblood of any commercial firm

Profit and loss statement: P= R-C-T
P = after-tax profits, R = total revenues,
C = total costs, T = taxes

Question 6

Bank-oriented financial system

Answer 6

Germany, Japan, CZ
1. Liquidity transformation
* Via transformation of lots and terms
2.Risk transformation
* Banks offset risk
* Risk-offsetting tends to be inter-temporal
* Restricted to a few risk carriers
3. Information transformation
* Internalization of information by banks, leading to duplication
* Restricted information transparency
4. Corporate control
* Controlling orientation (relationship lending)
* Maximization of stakeholder value
5. Legislation/supervisory authorities protection
* Strong culture of creditor and depositor protection

Question 7

Capital-market-oriented financial system

Answer 7

USA, UK
1. Liquidity transformation
* Savings flow into the economic cycle directly via various investment instruments (bonds, stocks, funds, derivatives)
2.Risk transformation
* Investors offset risk
* Risk-offsetting tends to be inter-sectoral
* Investors assume risk in line with their readiness to take risks
3. Information transformation
* Externalization of information via brokers and media
* High information transparency
4. Corporate control
* Liquidity orientation/maximization of returns
* Maximization of shareholder value
5. Legislation/supervisory authorities protection
* Increased level of shareholder and investor protection

Question 8

Banking system

Answer 8

system of banks acting in a economy and their relation with the environment (other banks, companies, state/government, foreigners, …)

Question 9

One-Level vs.Two-Level System

Answer 9

▪ One-level: No central bank, banking activities just by commercial banks;
In centrally planned economies – micro and macro function jointly in a „monobank“
▪ Two-level: Separation of macroeconomic function (central bank) from microeconomic function (com.banks)

Question 10

Universal vs. separate banking system

Answer 10

▪ Universal banking
- classical products of commercial banking – savings, loans, payments
- products of investment banking – securities issuances, securities trades, depot trades, asset management, mergers and acquisitions
▪ Separate banking
- strict separation of investment and commercial banking
- Glass-Steagall Act (1933)
- The Gramm-Leach-Bliley Act (1999)
- The Dood-Frank Act (2010)

Question 11

Commercial vs investment banks in the US

Answer 11

commercial - deposits
investment - almost no deposits, mostly repurchase agreements

Question 12

The 2008 financial crisis

Answer 12

end of an era in investment banking
▪ Lehman Brothers’ bankruptcy
▪ Merrill Lynch taken over by Bank of America
▪ Morgan Stanley and Goldman Sachs applied to become regulated banks (broker-dealers became banks)

Question 13

recent trend in banking

Answer 13

separation of investment and commercial banking
❖ USA: Volcker rule: the restoration of Glass-Steagall Act
❖ EU: Liikanen report
❖ GB: Sir Vicker´s report (“ring-fencing“)

Question 14

volcker

Answer 14

institutional separation of comercial banking and certain investment activities

• engage in market-making
• perform underwriting business
• hold non-trading exposures to other financial intermediaries

Question 15

likanen

Answer 15

subsidiarisation: proprietary and higher-risk trading activity have to be placed in a separate legal entity

• perform underwriting business
• hold non-trading exposures to other financial intermediaries
• holding company with banking and trading subsidiaries

Question 16

vickers

Answer 16

ring-fencing: structural separation of activities via a ring fence for retail banks

• holding company with banking and trading subsidiaries
• geogrephical restrictions: limitations for ring-fenced banks in the UK to provide services outside the European Economic Area

Question 17

The functions of the banking system

Answer 17

1) Clear and settle payments
2) Aggregate and disaggregate wealth and flows of funds
3) Transfer funds
4) Process information
5) Manage uncertainty and control risk
6) Provide ways for dealing with agency problems that arise in financial contracting

Question 18

The key functions of a bank

Answer 18

1) Effective transformation of capital
2) Non-cash money supply
3) Providing non-cash payment services

Question 19

Maturity mismatching

Answer 19

long-term assets vs. short-term liabilities

Question 20

Effective transformation of capital

Answer 20

1) size (deposit aggregation),
2) information asymmetry of creditors and debtors (delegated monitoring of debt contracts, in case of default letting the debtor go bankrupt, minimal monitoring of deposits),
3) different risk of assets and liabilities (deposit insurance, effective selection and diversification of assets – efficient allocation),
4) maturity (different time structure of the assets and liabilities),
5) liquidity or marketability,
6) territory or currency.

Question 21

CAS (Czech Accounting Standards)

Answer 21

for the Czech National Bank (CNB) and tax purposes
▪ sources for bank accounting: The Act on Accounting + CNB
▪ data on the Czech banking sector are according to CAS
▪ no international comparison of banks performance

Question 22

IFRS (International Financial Reporting Standards)

Answer 22

for investors and analysts
▪ IAS (International Financial Reporting Standards) until 2002, now only IFRS
▪ IFRS enable international comparison of bank’s performance
▪ Since IFRS obligatory for the Czech banks (Czech companies with listed securities on public markets)

Question 23

Main differences CAS x IFRS

Answer 23

▪ historical costs (CAS – prudence rule) x fair value (IFRS – true and fair view)
▪ vague terms definitions in CAS but a form of financial statements is set (x IFRS)
▪ substance over the form in IFRS x CAS (e.g. leasing)

Question 24

scheme of crises

Answer 24

1. Boom in corporate and/or household lending
2. Bust in corporate and/or household lending
3. Bust in corporate and/or household lending leading to credit crunch
4. Bust in corporate household and/or lending leading to government recapitalisation of banks
5. Banks as source of weakness to sovereign
6. Sovereign as source of weakness to banks
7. Sovereign and banks as two-way sources of weakness
8. Sovereign and banks as two-way sources of weakness leading to credit crunch
9. Multi-sovereign backstop for sovereign and banks

Question 25

Active banking operations

Answer 25

Active banking operations are shown on the left-hand side of the balance sheet, reflecting the use of capital (credit operations, securities purchase), and reflecting operations in which a bank grants credits to third parties (the bank as a creditor) and this is also where income is generated (e.g. interest income).

Question 26

Passive banking operations

Answer 26

Passive banking operations, depicted on the right-hand side of the balance sheet, is when a bank is in a debtor position, an operation linked to acquiring new liabilities (collection of deposits, issuing bonds’, CDs and inter-bank loans), issuing shares (equity) and setting up reserve funds and other funds from the profit.

Question 27

OBS and derivatives

Answer 27

Off-balance sheet
Derivatives = swaps, forward, futures, options etc.

Question 28

CDS

Answer 28

credit default swap

Question 29

Gross notional value

Answer 29

is the sum of CDS contracts bought (or equivalently sold) across all counterparties, where each trade is counted once.

Question 30

Net notional value

Answer 30

is calculated as the sum of net protection bought (or equivalently sold) across all counterparties. Net protection bought is evaluated at the level of individual counterparties, where protection sold will be offset by protection bought for the same reference entity.

Question 31

Profit and loss statement (P&L)

Answer 31

▪ Profit and loss statement (“P&L” or income statement) can be viewed as an explanation as to how bank’s net earnings before dividend distributions were achieved, and why capital increased and decreased
▪ P&L measures a bank’s income
▪ Profits are the lifeblood of any commercial firm