Introduction to Banking & Issues in Bank

Management
Banking

The Nature of Financial Intermediation

● A bank is a financial intermediary that accepts deposits, offers loans and facilitates
payments — these are banks’ distinguishing features.
● The main role of financial intermediaries and markets is to provide a mechanism by which
funds are allocated to their most productive opportunities

● Direct finance is an alternative to intermediation where borrowers obtain funds directly

from lenders via financial markets, as depicted in the figure below.

Barriers to Direct Financing:

1. Difficulty in aligning individual borrowers and lender
2. Incompatibility of needs -
○ Lenders seek low risk, low cost, and liquidity.
○ Borrowers seek timely funds at minimal cost.

Financial intermediaries bridge this gap by reducing transaction costs and information
asymmetries, which are market failures that hinder financial market efficiency.

Financial markets and intermediaries co-exist in most economies; the flow of funds in the
context of direct and indirect finance is shown below.
  Financial intermediation creates a different set of costs for borrowers and lenders,
therefore, benefits must outweigh costs in order for this process to be viable.
 The role of financial intermediation has become progressively more complex with
activities such as brokerage services, leasing, factoring and securitisation.

 Shadow banking is a different way of moving money between lenders and

borrowers. It includes financial activities that happen outside of traditional banks
 The most important shadow banking activities for the economy and financial stability
are securitization (turning loans into tradable investments) and collateral
intermediation (using assets as security for borrowing).

The Role of Banks

 Fundamentally, banks transform small, low-risk, liquid deposits into large, higher-
risk, illiquid loans through three key functions:
1. Size — Banks pool small deposits to fund larger loans, benefitting from
economies of scale.
2. Maturity — Banks short-term deposits into medium- and long-term loans, which
results in asset-liability mismatches and liquidity risk.
3. Risk — Depositors/lenders want low-risk and certainty, while borrowers pose
high-risks and uncertainty.
 Banks minimise the risk of losses on loans through diversification, screening and
monitoring borrowers, and holding capital and reserves to buffer unexpected losses.
Information Economies
Banks reduce costs and increase profits by taking advantage of economies of scale and
scope.
a) Transaction costs – Banks offer safer, more flexible investments by diversifying risk
and using efficient transaction technologies.
b) Economies of scale – Handling more transactions lowers costs, standardizing
contracts helps growth, and specialized staff improve lending and risk management.
c) Economies of scope – Banks save money by using the same resources to offer
multiple financial products instead of creating each separately.

Asymmetric Information
 No party has perfect or equal information, and some have insider knowledge

 Regulation helps to reduce information asymmetries, but acquiring information is a

costly process in general, therefore it is impossible to remove all asymmetries.
 Adverse Selection — The better-informed economic agent has an incentive to
exploit their informational advantage, and hence their counterpart in a transaction
ex ante.
 Solutions like signalling and screening exist but are costly and imperfect.

 Moral Hazard — Superior information may enable one party to work against the
interests of another after a financial transaction. A partial solution here is
“monitoring”.
 Principal-Agent Problems — Agents may not act in the best interest of those they
represent. Monitoring and aligning the interests of the principals and agents can
address this issue.

 Establishing long-term relationships with clients can help banks manage adverse
selection, moral hazard, and agency problems. Another alternative is “transaction banking”
where loans are essentially securitised and banks act as brokers.

Basic Banking
It is instructive to consider the balance sheet of a bank to understand how banks work.
Below is a retail bank’s stylised balance sheet.
Bank Services
 Payment Services — Payment services facilitate value transfer between participants,
which is crucial for economic efficiency. They can be paper-based or electronic.
 Deposit & Lending Services — These include current accounts, time or savings
deposits, personal and asset loans, of which there are a variety of structuring
options.

Types of Banks
Commercial Banks – Large banks that serve both businesses and individuals, offering loans,
deposits, and other financial services.
 Example: JPMorgan Chase (USA)

Savings Banks – Focus on savings and mutual ownership, meaning they are often owned by
their depositors rather than shareholders.
 Example: Sparkassen (Germany)

Co-Operative Banks – Member-owned banks that provide banking services to individuals

and businesses.
 Example: Rabobank (Netherlands)

Building Societies – Similar to savings banks but mainly focus on retail banking, especially
home loans (mortgages).
 Example: Nationwide Building Society (UK)

Credit Unions – Non-profit, member-owned financial institutions that offer loans and
savings accounts, often serving local communities.
 Example: Navy Federal Credit Union (USA)

Finance Houses – non-deposit taking institutions that provide finance by raising funds in
capital markets.
 Example: Toyota Financial Services (Global)

Issues in Bank Management

Retail Banks’ Balance Sheet Structure

Bank Equity Capital

Banks’ Income Structure

 As with any company, profits are equal to revenues/income less costs.
 Costs are derived from the liabilities side of the balance sheet — operating costs,
interest on deposits, interest on debt, provision for loan losses, taxes and dividends.
 Revenues are generated from the asset side of the balance sheet — interest from
loans and investments, fees and commissions.
Investment Banks’ Financial Statements

 Revenues are mainly derived from:

(i) trading and principal investments
(ii) investment banking (corporate finance)
(iii) agency trading service fees
(iv) Investment management fees
(v) interest income.
 Costs are dominated by interest expenses followed by staffing costs, transaction
fees, insurance costs, depreciation, technology and marketing.

Bank Performance and Financial Ratio Analysis

CAMELS: blueprint to begin systematically analysing a bank’s overall performance
 assess the overall safety and soundness of individual banks.

Probability Ratios
Asset Quality

Shareholder Value Creation

A bank can create shareholder value by pursuing a strategy that maximises the return
on capital invested relative to the (opportunity) cost of capital (the cost of keeping equity
shareholders and bondholders happy) — generally determined via the CAPM.

Solvency Ratios

1. If a bank increases leverage (RLR):

o ROE increases, making shareholders happy.
o Risk also increases, as a smaller equity base means losses hit shareholders
harder.
2. If a bank reduces leverage:
o ROE falls, since it relies less on borrowed funds.
o Solvency improves, making the bank safer in downturns.

Bank Financial Management

 objective of a bank it to max shareholder value

In achieving this, the role of financial management is three-fold:

1. to undertake financing decisions (how to acquire finance);

2. to make investment decisions (how to allocate finance); and
3. to control resources (how to conserve finance).
 management needs to focus on the following

Asset-Liability Management (ALM)

 Aligns financing and investment decisions.
 Manages interest rate risk and liquidity.
 Balances risk, returns, and safety to maximize bank value.
 Overseen by ALCO (Asset and Liability Committee), led by the Treasurer and
CFO.
 A critical banking function, also involved in capital management.

Liquidity Management
 Ensures enough cash or liquid assets to meet withdrawals and loan demands.

Key trade-offs:
1. Liquidity vs. Profitability – Holding more liquid assets reduces returns.
2. Reserves as Insurance – Banks hold required and excess reserves to manage risks.

 If reserves are low, ALCO coordinates liquidity by:

1. Borrowing from other banks.
2. Selling securities.
3. Selling loan assets.
4. Borrowing from the central bank.

 Banks must act discreetly to avoid panic, as liquidity and solvency are closely linked.
Capital Adequacy Management
 Liquidity: Ability to meet short-term obligations.
 Solvency: Ability to repay in the long run.
 Trade-off: More capital improves stability but lowers ROE.
 Regulatory Capital: Set by regulators.
 Economic Capital: Based on internal risk assessment.

 Banks allocate economic capital to maximize risk-adjusted returns.

Banking Risks
 Credit Risk: Risk of borrower default or credit deterioration (rating downgrades,
credit spread changes).
 Interest Rate Risk: Risk from mismatches between rate-sensitive and fixed-rate
assets (refinancing & reinvestment risks).
 Liquidity Risk: Arises from asset-liability mismatches, affecting ability to meet
obligations (day-to-day and crisis withdrawals).
 Operational Risk: Losses from failed internal processes, people, systems, or external
events.
 Market Risk: Losses from price movements in assets, liabilities, or derivatives
(interest rates, exchange rates, asset prices).
 Risk Measurement:
- Large banks use Value-at-Risk (VaR) for trading portfolios.
- Small banks rely on sensitivity analysis to assess market risk.

Bank Risk Management

 Risk management is a comprehensive process involving culture, measurement,
monitoring, mitigation, and internal controls.
 Risk Measurement quantifies risk exposures, whereas Risk Management
encompasses defining strategy, identifying, quantifying, understanding, and
controlling risks.

Managing Interest Rate Risk

1. Gap analysis
At a given time t, the gap for a specific tenor τi is defined as

total gap may be computed as

Another way to express this is via an interest rate sensitivity ratio

For all tenors

2. Maturity gap
The utility of duration or delta comes from the following approximation

Managing Liquidity Risk