The Principles of Banking

Moorad Choudhry

• Publisher: Wiley
• Year: 2012
• ISBN:
  9780470827024
• Edition: 1
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

The ultimate guide for bank management: how to survive and thrive throughout the business cycle

An essential guide for bankers and students of finance everywhere, The Principles of Banking reiterates that the primary requirement of banking—sound capital and liquidity risk management—had been forgotten in the years prior to the financial crash. Serving as a policy guide for market practitioners and regulators at all levels, the book explains the keys to success that bankers need to follow during good times in order to be prepared for the bad, providing in-depth guidance and technical analysis of exactly what constitutes good banking practice.

Accessible to professionals and students alike, The Principles of Banking covers issues of practical importance to bank practitioners, including asset-liability management, liquidity risk, internal transfer pricing, capital management, stress testing, and more. With an emphasis on viewing business cycles as patterns of stable and stressful market behavior, and rich with worked examples illustrating the key principles of bank asset-liability management, the book is an essential policy guide for today and tomorrow. It also offers readers access to an accompanying website holding policy templates and teaching aids.

• Illustrates how unsound banking practices that were evident in previous bank crashes were repeated during the creation of the 2007-2008 financial market crisis
• Provides a template that can be used to create a sound liquidity and asset-liability management framework at any bank
• An essential resource for the international banking community as it seeks to re-establish its credibility, as well as for students of finance
• Explains the original principles of banking, including sound lending policy and liquidity management, and why these need to be restated in order to avoid another bank crisis at the time of the next economic recession
• Covers topics of particular importance to students and academia, many of which are marginally—if ever—addressed in current text books on finance
• Offers readers access to a companion website featuring invaluable learning and teaching aids

Written by a banking practitioner with extensive professional and teaching experience in the field, The Principles of Banking explains exactly how to get back to basics in risk management in the banking community, essential if we are to maintain a sustainable banking industry.

"engaging and interesting and, more importantly, easily understood, allowing a clear picture to emerge of how the principle or concept under discussion is to be applied in the real world."
- GraemeWolvaardt, Head of Market & Liquidity Risk Control, Europe Arab Bank Plc

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.

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.

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 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.

Core operating income	% share
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...