Finance & BankingFinancial Risk

Online Banking Course: An Introduction to Banking – Liquidity Risk and Asset-Liability Management

An Introduction to Banking - Liquidity Risk and Asset-Liability Management

Preface

Banking is a long-established and honourable profession. The provision of efficient loan and deposit facilities is an essential ingredient in human development and prosperity. For this reason, it is important that all banks are managed prudently. The art of banking remains unchanged from when banks were first established. At its core are the two principles of asset–liability mismatch and liquidity risk management.

The act of undertaking loans and deposits creates the mismatch, because while investors like to lend for as short a term as possible, borrowers prefer to borrow for as long a term as possible. In other words, the act of banking is the process of maturity transformation, whereby banks ‘lend long’ and ‘fund short’.

Banks do not ‘match-fund’, because there would never be enough funds available to match a 25-year maturity mortgage with a 25-year fixed deposit. Thus, banking gives rise to liquidity risk, and bankers are therefore required to take steps to ensure that liquidity, the ability to roll over funding of long-dated loans, is continuously available.

We define banking as the provision of loans and deposits; the former produce interest income for the bank, while the latter create interest expense for the bank. On the bank’s balance sheet the loan is the asset and the deposit is the liability, and the bank acts as the intermediary between borrowers and lenders. The fact that all banks irrespective of their size, approach or strategy must manage the two basic principles of asset–liability management (ALM) and liquidity management means that they are ultimately identical institutions.

They deal within the same markets and with each other. That means that the bankruptcy of any one bank, while serious for its customers and creditors, can have a bigger impact still on the wider economy because of the risk this poses to other banks. It is this systemic risk which posed the danger for the world’s economies in 2008, after Lehman Brothers collapsed, and which remains a challenge for financial regulators.

This book introduces the fundamental art of banking, which is ALM and liquidity risk management. It does not describe the different types of banks and their organizational structures that exist around the world. Neither does it describe the wide range of bank products that are available or the great variation in financial markets and instruments that can be observed.

These topics are covered abundantly in existing textbooks. The object of this book is to present bank ALM and liquidity management at an introductory level, some- thing that is not so common in textbooks on finance. These topics deserve to be understood and appreciated by everyone involved in banking, because it was unsound practices in these fields that helped to create the banking crisis in 2008, and made its impact so much worse than it need have been. A proper respect for the art of ALM will mitigate the impact on banks of the next financial crash.

Layout of the book

This book comprises 10 chapters. The first four provide a necessary background on bank capital, the money markets, the yield curve and market risk hedging. This is essential reading for all newcomers to the financial markets.

Chapters 5–7 discuss the asset–liability management (ALM) process for a bank – the essential art of banking – and the role of the ALM committee or ALCO, which is the most important executive management committee in a bank.

Chapter 8 takes a detailed look at liquidity risk management, while Chapter 9 focuses on bank strategy and return. The final chapter looks at regulatory capital, the availability and treatment of which drives bank strategy.

For newcomers to the market there is a primer on financial market arithmetic in Appendix B (p. 317).
Highlights of the book include:

  • an accessible look at the ALM function undertaken at banks and securities houses, including risk management and management reporting;
  • the role of the bank ALM committee (ALCO);
  • a review of liquidity risk management and the main liquidity
    metrics used in banks;
  • a discussion of bank strategy and why this should focus on sustainable returns over the business cycle;
  • an introduction to the Basel II and Basel III regulatory capital rules and their implications.

As always, the intention is to remain accessible and practical throughout, and we hope this aim has been achieved. Comments on the text are most welcome and should be sent to the author, care of John Wiley & Sons (UK) Ltd.

 

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, the common denominators of all banking activities are those of risk, return and the bringing together of the providers of capital. Return on capital is the focus of all banking activity.

The co-ordination of all banking activity could be said to be the focus of asset–liability management (ALM), although some practitioners will give ALM a narrower focus. Either way, we need to be familiar with the wide-ranging nature of banking business and the importance of bank capital. This then acts as a guide for what follows.

In this introductory chapter we place ALM in context by describing the financial markets 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.

 

BANKING BUSINESS

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 repre- sent. The terms used in the table, such as ‘market risk’, are explained elsewhere in this book. In another chapter we discuss the 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.

Before considering the concept of 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 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 costs, such as operating expenses and bad loan provisions.

That the universe of banks encompasses many different varieties of beasts 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 firm with an investment bank heritage such as Morgan Stanley. Such firms will earn a greater share of their revenues through fees and trading income. The breakdown varies widely across regions and banks.

Let us now consider the different types of income streams and costs.

An Introduction to Banking-Selected banking activities and services

 

Interest income

Interest income, or net interest income (NII), is the main source of revenue for the majority of banks worldwide. 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, ‘net’ return is this interest income minus the cost of funding loans. Funding, which is a cost to the bank, is obtained from a wide variety of sources. For many banks, 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 must be supplemented by longer term funding. Other sources of funds include senior debt, in the form of bonds, securitized bonds and money market paper.

NII is sensitive to both credit risk and market risk. Market risk, which we 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 loans against the maturity of funding. This is known as the interest rate gap.

 

Fees and commissions

Banks generate fee income as a result of providing services to customers. Fee income is very popular with bank senior manage- ment because it is less volatile and not susceptible to market risk like trading income or even NII. There is also no credit risk because fees are often paid upfront. There are other benefits as well, such as the opportunity to build up a diversified customer base for this additional range of services, but these are of less concern to a bank’s ALM desk.

Fee income uses less capital and also carries no market risk, but does carry other risks, such as operational risk.

 

Trading income

Banks generate trading income through trading activity in financial products such as equities (shares), bonds and derivative instruments. This includes acting as a dealer or market-maker in these products as well as taking proprietary positions for speculative purposes.

Running positions in securities (as opposed to derivatives) in some cases generates interest income; some banks strip this out of the capital gain made when the security is traded to profit, while others include it as part of overall trading income.

Trading income is the most volatile income source for a bank. It also generates relatively high market risk, as well as not inconsiderable credit risk. Many banks, although by no means all, use the Value-at-Risk (VaR) methodology to measure the risk arising from trading activity, which gives a statistical measure of expected losses to the trading portfolio under certain market scenarios.

 

Costs

Bank operating costs comprise staff costs and operating costs, such as provision of premises, information technology and office equipment. Other significant elements of cost are provisions for loan losses, which are charges against the loan revenues of the bank. Provision is based on subjective measurement by management of how much of the loan portfolio can be expected to be repaid by the borrower.

 

CAPITAL MARKETS

A ‘capital market’ is the term used to describe the market for raising and investing finance. The economies of developed countries and a large number of developing countries are based on financial systems that encompass investors and borrowers, markets and trading arrangements.

A market can be one in the traditional sense such as an exchange where financial instruments are bought and sold on a trading floor, or it may refer to one where participants deal with each other over the telephone or via electronic screens. The basic principles are the same in any type of market.

There are two primary users of capital markets: lenders and borrowers. The source of lenders’ funds is, to a large extent, the personal sector made up of household savings and those acting as their investment managers such as life assurance companies and pension funds. The borrowers are made up of the government, local government and companies (called corporates).

There is a basic conflict between the financial objectives of borrowers and lenders, in that those who are investing funds wish to remain liquid, which means having easy access to their investments. They also wish to maximize the return on their investment. A corporate, on the other hand, will wish to generate maximum net profit on its activities, which will require continuous investment in plant, equipment, human resources and so on.

Such investment will therefore need to be as long term as possible. Government borrowing as well is often related to long-term projects such as the construction of schools, hospitals and roads. So while investors wish to have ready access to their cash and invest short, borrowers desire funding to be as long term as possible.

One economist referred to this conflict as the ‘constitutional weakness’ of financial markets (Hicks, 1939), especially as there is no conduit through which to reconcile the needs of lenders and borrowers. To facilitate the efficient operation of financial markets and the price mechanism, intermediaries exist to bring together the needs of lenders and borrowers. A bank is the best example of this.

Banks accept deposits from investors, which makes up the liability side of their balance sheet, and lend funds to borrowers, which forms the assets on their balance sheet. If a bank builds up a sufficiently large asset and liability base, it will be able to meet the needs of both investors and borrowers, as it can maintain liquidity to meet investors requirements as well as create long-term assets to meet the needs of borrowers.

A bank is exposed to two primary risks in carrying out its operations: that a large number of investors decide to withdraw their funds at the same time (a ‘run’ on the bank) or that a large number of borrowers go bankrupt and default on their loans. The bank in acting as a financial intermediary reduces the risk it is exposed to by spreading and pooling risk across a wide asset and liability base.

Corporate borrowers wishing to finance long-term investment can raise capital in various ways. The main methods are:

  • continued re-investment of the profits generated by a company’s current operations;
  • selling shares in the company, known as equity capital, equity securities or equity, which confer on buyers a share in ownership of the company. Shareholders as owners have the right to vote at general meetings of the company, as well as the right to share in the company’s profits by receiving dividends;
  • borrowing money from a bank, via a bank loan. This can be a short-term loan such as an overdraft, or a longer term loan over two, three, five years or even longer. Bank loans can be at either a fixed or, more usually, variable rate of interest;
  • borrowing money by issuing debt securities, in the form of bills, commercial paper and bonds that subsequently trade in the debt capital market.

The first method may not generate sufficient funds, especially if a company is seeking to expand by growth or acquisition of other companies. In any case a proportion of annual after-tax profits will need to be paid out as dividends to shareholders.

Selling further shares is not always popular amongst existing shareholders as it dilutes the extent of their ownership; moreover, there are a host of other factors to consider including whether there is any appetite in the market for that company’s shares. A bank loan is often inflexible, and the interest rate charged by the bank may be comparatively high for all but the highest quality companies.

We say ‘comparatively’, because there is often a cheaper way for corporates to borrow money: by tapping the bond markets. An issue of bonds will fix the rate of interest payable by the company for a long-term period, and the chief characteristic of bonds – that they are tradeable – makes investors more willing to lend a company funds.

The bond and money markets play a vital and essential role in raising finance for both governments and corporations. In 2009 the market in dollar-denominated bonds alone was worth over $13 trillion, which gives some idea of its importance.

The basic bond instrument, which is a loan of funds by the buyer to the issuer of the bond, in return for regular interest payments up to the termination date of the loan, is still the most commonly issued instrument in debt markets. Nowadays there are a large variety of bond instruments, issued by a variety of institutions. An almost exclusively corporate instrument, the international bond or Eurobond, is a large and diverse market. In 2009 the size of the Eurobond market was over $2 trillion.

In every capital market the first financing instrument ever developed was the bill and then the bond; today, in certain developing economies the government short-dated bond market is often the only liquid market in existence. Over time – as financial systems develop and corporate debt and equity markets take shape – the money and bond markets retain their importance due to their flexibility and the ease with which transactions can be undertaken.

In advanced financial markets – such as those in place in developed countries today – the introduction of financial engineering techniques has greatly expanded the range of instruments that can be traded. These instruments include instruments used for hedging positions held in bonds and other cash products, as well as meeting the investment and risk management needs of a whole host of market participants.

Debt capital markets have been and continue to be tremendously important to the economic develop- ment of all countries, as they represent the means of intermediation for governments and corporates to finance their activities. In fact, it is difficult to imagine long-term capital-intensive projects – such as those undertaken by, say, petroleum, construction or aerospace companies – taking place without the existence of a debt capital market to allow the raising of vital finance.

 

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