Chapter 1: Overview of banking Flashcards
Main activities of a bank
LIFT WAR CD
Loans
Insurance
Foreign exchange
Transaction/payment facilitation + Trading
Wealth management
Advice (Acquisitions & Mergers)
Risk Management (e.g. swaps to hedge foreign exchange/interest rates, or securitisation)
Capital raising (equity + debt)
Deposits
Traditional bank
LORE P
- banking License required to accept retail deposits.
- Owned by shareholders.
- Regulated and supervised.
- Examples (includes):
1. Retail banks (individuals and small businesses)
2. Commercial banks (all sizes of companies). - Products:
1. Deposits
2. Current accounts
3. Lending facilities: Overdrafts, Loans, Credit Cards, Mortgages
Wholesale bank
FLOWER
* banks making greater use of wholesale Funding instead of retail deposits.
* focus on Loans to medium and large corporate customers.
* Operational effiiciency: lower costs due to simpler business model.
* Wholesale rates: lower net interest spreads due to:
1. Lower interest rates on corporate loans.
2. Higher rates on wholesale funding.
* Excellent credit quality: Lower credit losses due to high-quality borrowers.
* lower cost of Regulatory requirements due to lack of deposits
Investment bank
An investment bank is a financial institution that primarily serves large corporations and institutional investors.
Revenue often generated from fees and commissions, not just interest rates
They focus on capital market activities such as (TRUSS):
* Trading:
Support secondary markets through trading activities.
May engage in proprietary trading (taking positions in securities for their own account).
* specialised Risk management:
(e.g. derivative products)
* Underwriting securities:
Help companies raise equity and debt capital.
* Strategic advisory services:
(M&A, restructuring, etc)
* Specialised lending:
(e.g. trade finance, project finance, commodity finance)
Universal bank
- Combines traditional banking and investment banking.
- Often includes wealth management, fund management, and bancassurance.
- Industry concerns about potential risk to bank deposits from investment bank trading activities – Regulations (like Volcker Rule) in place to mitigate this concern
Challenger bank
CODE
- Challenge incumbent banks with innovative products and services, and competitive rates.
- new entrants enabled by the move to Online banking and reduced barriers to entry.
- open APIs allow Data sharing between banks and third-party providers, fostering innovation
- leverage technology for low-cost operations (no physical branches). Easy and Efficient.
Shadow bank
SHADOW
- offer banking Services without a banking license.
-
Higher leverage than regulated banks:
Might be limited in periods of stress where less
wholesale funding is Available. - cannot accept Deposits
- less Oversight (regulated)
- typically focus on providing credit, financed by Wholesale borrowing.
- Examples: asset managers, hedge funds, private equity funds, securitization companies, and money market funds.
Mutual bank
MUSE
* owned by Members
* Unable to raise equity capital for losses or new investment.
* Strong values and are commitment to members and communities
* Examples include building societies, credit unions, and rotating savings associations.
Development bank
DOPE
* provide credit and financial services to Developing countries.
* Owned and supported by developed countries.
* fill a critical role in Providing higher-risk loans and equity stakes
* Examples: World Bank, African Development Bank.
Central Bank
BIG MONEY PIG
* Banks to banks and governments (incl. managing banks’ reserves and foreign reserves)
* Issuing notes and coins
* Governing national payments systems
* Monetary Policy (to control inflation)
* Overseeing banks (regulation/supervision)
* No personal/corporate customers
* Ensuring financial stability in the economy (incl. setting capital buffers and supervising as above)
* Yield (interest rates) management to control inflation
* Purchasing/selling securities to maintain liquidity (Quantitative Easing)
* Intervention (when needed)
* Guidance (for the financial sector)
Twin Peaks
Structure:
1. Prudential Authority
Goal = Safety and Soundness of Financial Institutions
- Financial Sector Conduct Authority
Goal = Consumer protection
Benefits:
* Enhanced focus
* Improved accountability
* Better consumer protection
* Stronger financial stability
* Market confidence
Challenges:
* Coordination (especially where mandates overlap)
* Cost
* Complexity
* No-mans-land items slipping between
Economic Role of Banks
MAPS
-
Making Payments Easier
* Payment systems between banks enables easier sales in economies
* Encourage domestic business and international trade -
Accepting Deposits
* Accessible store of case assets with interest rates
* Encourages saving (key policy lever for monetarists) -
Providing Loans
* Allow entities to pay for large once-off expenses that would be unaffordable otherwise, and to spread the cost of new assets.
* Encourages consumption (key policy lever for monetarists) - Economies of Scale and Specialisation
* Efficient use of resources contributes to economic growth
* Surplus funds by some customers are used to provide loans to other customers which funds economic activities
* Credit vetting, pooling. managing risks and managing maturity transformations (so economy has ready access to funds needed)
Bank Feedback Loop into Economy
Economic cycle changes: (no inflation outlook)
* Periods of rapid growth → low rates to encourage growth
* Periods of recession → higher rates to combat inflation (except COVID)
The Positive (/Negative) Feedback Loops:
* Economic Growth (/Economic Decline)
* Means more (/less) people employed, and wages rise (/are restricted)
* This means Loans are more easily (/less easily) paid
* Lower (/higher) levels of credit loss expected
* More (/less) banking competition with lower (/higher) margins offers, and more relaxed (/stricter) lending policies because of economic sentiment
* Stimulates (/suppresses) demand for debt
* Feeds back into cycle by increasing economic growth (/decline)
Forms of Income on Financial Statement
1. Net interest income
* From banking book operations
* Positive spread expected between interest on deposits taken and loans made
* = [Gross interest income on loans+securities] - [Gross interest paid on funding instruments like deposits+wholesale loans] = Gross interest income - Cost of Funding
2. Non-interest income
* From banking book operations
* Income on fees charges
* Examples: Account fees, Commitment fees, Transaction fees, Asset management fees, Insurance fees
* Timing: Initial, Ongoing, Termination
3. Trading income
* From trading book operations
* Trading book is marked-to-market daily: Daily Gains/Losses must be included in the trading income
* Some cases, market price is not available and marked-to-model values used.
Forms of Expenses on Financial Statement
Operational expenses
* Categories: Fixed (e.g., head office, central functions, IT, treasury), Semi-fixed (e.g., product design, credit risk, marketing), and Variable (e.g., credit data, fees to intermediaries)
* Examples: Staff, Property, IT, Marketing,Outsource/Third-party costs, Depreciation
Cost of credit
* Cost of doing business
* Considerably higher in period of recession than economic growth
Impairments = Cost of credit:
* Line item in the income statement reflecting the changes in provisions
* Can also be used to reduce the value of the banks’ general assets (e.g., fixed assets, goodwill, and intangibles)
* Profits and losses on assets/liabilities in trading books are NOT included in impairments (they’re in trading income)
Provisions:
* Impact timing of the loss recognition, NOT the loss amount
* Reduce the carrying value of the loan assets on the balance sheet – based on forward-looking info (ECL models).
* Increase to 100% after default event
* Asset write-offs done against the provision after the collections process is exhausted
Need to be reasonable and supportable by forward-looking info
* Provisions made by allocating loans to stages:
Stage 1: Performing Loans
~ No significant increase in credit risk since origination
~ Typically 0 days in arrears
Provisions: 12-month expected credit losses
Stage 2: Underperforming Loans
~ Significant increase in credit risk since origination
~ Typically 30 days in arrears
Provisions: Lifetime expected credit losses
Stage 3: Non-performing Loans
~ Default event has occurred
~ Typically 90 days in arrears
Provisions: Lifetime expected credit losses
Tax
* Corporation tax on PBT (~28% in SA)
* May be a bank levy like in the UK
Cost of Capital
* Minimum return, which investors expect on their capital
* Two measures:
1. Weighted Average Cost of Capital (WACC)
…allows for mix of debt and equity capital
2. Cost of equity capital
…using Capital Asset Pricing Model (CAPM)
Key Financial Ratios
SPICE GRL
Stability of funding:
* Loan to Deposit Ratio
* Lower rate –> bank less reliant on wholesale funding (which is less stable than deposits)
Profitability:
* Net Interest Margin
* Increasing NIM can indicate improving profitability
OR a move to higher risk lending resulting in a bigger margin – possibly greater credit losses which may offset
Income stability:
* Net interest income to Total income ratio
* High ratio –> most of the bank’s income is net interest income (which is typically more stable than trading)
Capital strength:
* CET1 to Total RWA ratio
* Limited value: Different banks have different capital requirements. Banks may have different capital buffers to cover their risk
Efficiency:
* Cost to Income Ratio
* Possible loss in efficiency if cost per income is increasing
OR change in business mix
Growth:
* Earnings Per Share
* Growth in EPS YoY is important to investors
Rank of loan portfolio:
* Ratio of Stage 2 or 3 Loans to Total Loans
Liquidity strength
* LCR + NSFR
Sources of Funds
Deposit Taking
Advantages
* Low cost
* Long term
* Relatively Stable (especially with Deposit Insurance Schemes)
Wholesale market funding
Disadvantages
* Higher cost
* Less stable (more likely to be withdrawn – less ‘sticky’)
* Highly sensitive to bank risks (lenders more hardline in recessions/stress)
Central bank funding
Capital
Categories of Climate Risk
Physical Risk:
Direct impacts of weather events (floods, droughts, storms) and long-term changes (sea level rise, temperature shifts) on bank assets, infrastructure, and operations.
* Acute risks: Short-term, high-impact events like floods or wildfires.
* Chronic risks: Gradual, long-term changes like rising sea levels impacting coastal properties.
Transition Risk:
Indirect impacts arising from the shift towards a low-carbon economy.
* Market risk: Potential devaluation of assets linked to high-carbon activities.
* Technology risk: Disruption from emerging clean technologies rendering existing infrastructure obsolete.
* Policy/legal risk: Stringent regulations and carbon pricing impacting sectors banks invest in.
* Reputational risk: Negative public perception due to bank’s financing of unsustainable activities.
Impact of Climate Risk on
Banks’ Business Risk
Credit Risk
* Climate change can impact borrowers’ ability to repay loans, affecting probability of default (PD) and loss given default (LGD).
* Physical risks can impair borrowers’ assets and income, leading to higher default rates.
* Transition risks, such as policy changes or shifts in market preferences, can also affect borrowers’ financial health.
Market Risk
* Climate change can lead to significant fluctuations in asset prices.
* E.g. volatility in the valuations of energy sources that aren’t clean, which can impact the bank’s investments
Operational Risk
* Physical risks like extreme weather events can disrupt a bank’s operations, damaging infrastructure or affecting employee availability.
* Transition risks, such as the need to adapt to new technologies or regulations, can also pose operational challenges.
Liquidity Risk
* Climate change can impact a bank’s ability to raise and maintain funding.
* For example, increased costs due to climate change may reduce individuals’ ability to save, affecting retail deposits.
* Additionally, changes in investor sentiment and credit ratings due to climate concerns can impact wholesale funding availability and cost.
TCFD recommentations on firm disclosure for climate risk
Governance:
* Governance structures related to climate risk.
* This may include any committees set up to set policy, manage, and assess climate risk.
Strategy:
* Assessing how climate risks and opportunities have been incorporated into strategy and financial planning.
Risk management:
* Regarding how climate risks and opportunities are identified, assessed, and managed.
* The bank may outline which sectors or portfolios they are
concerned about with respect to climate risk.
Metrics and targets:
* These are used to assess and manage climate risk, including GHG emissions and their plan to reduce their emissions.
