An Introduction to Banking

Principles, Strategy and Risk Management

Moorad Choudhry

• Publisher: Wiley
• Year: 2018
• Print ISBN: 9781119115892
• eBook ISBN: 9781119115908
• Edition: 2
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

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.

PART I
Bank 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 1
BANK 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 custome...

Table of contents

• COVER
• TITLE PAGE
• TABLE OF CONTENTS
• FOREWORD
• PREFACE
• PREFACE TO THE FIRST EDITION
• ACKNOWLEDGEMENTS
• ABOUT THE AUTHOR
• PART I: Bank Business and the Markets
• PART II: Asset–Liability Management and Liquidity Risk
• PART III: Strategy, Regulatory Capital and Case Studies
• Appendix A: FINANCIAL MARKETS ARITHMETIC
• Appendix B: ABBREVIATIONS AND ACRONYMS
• INDEX
• END USER LICENSE AGREEMENT