Guy Hargreaves ACF-104 Wechat: Guyhargreaves. Recap of yesterday Appreciate the key drivers to the...
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Banking and Financial Institutions Guy Hargreaves ACF-104 Wechat: Guyhargreaves
Guy Hargreaves ACF-104 Wechat: Guyhargreaves. Recap of yesterday Appreciate the key drivers to the business of commercial banking Review how commercial
Slide 1Appreciate the key drivers to the business of commercial
banking
Review how commercial banks generate financial returns
Describe the key metrics used in commercial bank financial
management
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Bank asset and risk management and its context in the Basel
framework
Goals of today
Understand the tools used to manage the various balance sheet
risks
Understand the credit analysis and approval process within
commercial banks
Review of Central Bank roles and goals in commercial bank
regulation
Review the pros and cons of existing and new regulations around
balance sheet risk management
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Some players have differing information
Some players have Inside Information
All players have imperfect information
Asymmetric information can lead to Adverse Selection and Moral
Hazard
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Adverse selection
Adverse selection can become a big problem in commercial banking
due to information asymmetry
Better informed banks can tend to “exploit” less well informed
customers
Extreme examples in 2007-9 GFC when investors were sold portfolios
of mortgage loans where borrowers were adversely selected to be
poor quality
Compliance and Risk Management functions are being heavily
increased in banks today to prevent outcomes like this
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Moral hazard
Moral hazard arises in a contract when one of the parties has an
economic incentive to behave against the interests of the
other
Classical example is a homeowner buying fire insurance just before
their home burns down
Insurance industry is large target of this behaviour
Banks have a poor record of managing moral hazard given large
incentives to behave poorly
Often arises in the Principal-Agent relationship where the agent
has information asymmetry and can act in its own interests rather
than the interests of its customer
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Risk is everywhere in banking
Credit risk
Market risk
Liquidity risk
Operational risk
Country risk
Reputational risk
Banks and risk
The profitability of commercial banks is driven by how well they
manage risk “flows”:
Customers transfer their risk to banks
Banks take on risk for principal trading
=> Managing all these risk flows as an ongoing viable business
has risk
Some risk is unmanageable - banks need to avoid
All risk needs to be properly priced and managed
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Credit (default) risk
Loans in the banking book and bonds in the trading book both have
credit default risk
The issuer will fail to repay a coupon or principal, or will go
into bankruptcy
Banks have Special Asset Management units which do nothing but
manage defaulted or near defaulted customers
Once in default, banks will often take control of the company as
“senior creditors”, sell all remaining company assets and use the
proceeds to repay “creditors” in order of seniority
If a bank receives less than it is owed following liquidation it
has suffered a recovery rate of < 100%
Banks may make “provisions” in their balance sheets for loans which
they expect have a high chance of defaulting
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Exposure through a financial instrument to movements in interest
rates
Fixed rate bonds, interest rate swaps, bond futures – anything with
a long dated fixed cashflow
“Delta” – the change in the $ value of that instrument for a 0.01%
change in interest rates
VAR – “Value at Risk” how much the bank would lose if a significant
move in interest rates occurred
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FX risk:
Exposure through a financial instrument to movements in foreign
exchange rates
Spot FX, foreign exchange swaps, FX futures
“Delta” – the change in the $ value of that instrument for a
certain change in FX rates
Included in firmwide VAR
Exposure through a financial instrument to movements in credit
margins
Corporate bonds, credit swaps, credit indices
“Delta” – the change in the $ value of that instrument for a 0.01%
change in credit margins
Included in firmwide VAR
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Exposure through a financial instrument to movements in commodity
prices
Gold swaps, commodity futures
“Delta” – the change in the $ value of that instrument for a
certain change in commodity prices
Included in firmwide VAR
Banks use two broad accounting regimes:
Banking book – holds corporate and retail loans on an “accruals”
basis; uses the “loan provision” model for potential losses from
defaults; no market risk
Trading book – holds securities and marketable instruments on a
“mark-to-market” basis; gains and losses in market value brought to
P&L daily; all market risk
Whether a financial instrument is held in a banking book or a
trading book is critical to the way it is risk managed
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Liquidity (gap) risk
The ongoing ability of a commercial bank to refinance its short
term liabilities like deposits
Banks tend to “lend long” and “borrow short” – borrowers want the
certainty of funding for long periods whereas savers don’t want to
lock up their funds for long periods
Liquidity or gap risk is the risk savers will not redeposit their
savings when they mature, leaving the bank repaying deposits whilst
remaining invested in longer term loans
Reinvestment or refinancing risk is the risk that when a bank comes
to refinance a deposit interest rates will be higher – interest
rate risk
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Operational risk
Operational risk is defined as “the risk of loss resulting from
inadequate or failed internal processes, people and systems or from
external events”
Regulators and banks are working towards a consistent and
standardised way of measuring and holding capital against this
risk
Causes of operational risk include internal and external fraud,
employment practices and work safety, illegal business practices
(eg money laundering) and physical or system failures
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Global commercial banks invest significant capital into many
countries around the world to support their local operations
Some of these countries are risky emerging markets (eg Argentina)
where there is a risk that the local government introduces foreign
exchange controls or other measures that might be harmful to the
bank
Sovereign risk is not country risk – it is the risk a sovereign
will default on its debt
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Banks have suffered scandals and bad media headlines throughout
history
As a result many banks have seen their reputations with customers,
governments and other important stakeholders suffer badly
When a bank earns a poor reputation its WACC increases as savers
become reluctant to deposit, and borrowers are less willing to do
business with banks that have behaved badly
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Credit risk management tools
Credit default risk management is a critical element of commercial
banking management
“Credit Committees” (CC) establish maximum exposure limits to
individual, group and related borrowers
Limits are set for loans, derivatives, settlement, FX and many
other financial products
CC monitors total exposure to the borrower or group
Bankers are forbidden to lend or trade in more volume with the
borrower or group than the limit set by CC
This prevents the bank from becoming overexposed to any one
borrower or group
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Bank risk management tools
Critical to bank credit default risk management is to lend to a
broad diversified set of borrowers
Diversification means investing in a broad range of borrowers so
that risk can be reduced in the portfolio
“Don’t put all your eggs in one basket”!
Investing in $1 in each of 50 borrowers is far less risky than
investing $50 in just one borrower
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Classical credit analysis
Every commercial bank has a slightly different way of performing
credit analysis
Many banks use the classical model of five “C”s
Character – is the borrower of good character eg have they
defaulted before or ever committed fraud?
Capital– is the borrower too leveraged?
Capacity - does the borrower have a strong capacity to repay the
loan? What is the earnings volatility of the borrower?
Conditions – what is the loan going to be used for? Does this make
sense?
Collateral – is the loan secured by specific assets or is it
unsecured?
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Bank credit scoring
Once a credit analysis is performed many banks score or “rate” the
loan or borrower
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Not rated
Expected loss
From the credit default risk analysis banks estimate Probability of
Default (PD), Loss Given Default (LGD) ad Expected Loss
PD estimates are usually quite accurate but LGD is much harder to
calculate
Expected Loss (EL) = PD * LGD * EAD
EAD is Exposure at Default and can often be larger than the
facilities granted if interest is unpaid
Expected Loss then feeds into the RAROC model to determine whether
the loan makes financial sense for the bank
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Credit provisioning
When a commercial bank expects to take a loss on a loan it makes an
individual credit provision
Large banks routinely take collective provisions against their
overall portfolios
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Market risk -VAR
Value at Risk (VAR) – banks look at 2-3 years of price history and
use probability models to determine to a high degree of confidence
how far a market can move over say 1 or 5 days
Traders are then given $ amounts they can potentially gain or lose
based on VAR – this sets the total amount of a financial instrument
a trader can have exposure to in his/her trading book
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VAR example
Joe is an interest rate swaps trader and is given a $1m daily VAR
limit he can trade for the bank
Joe trades 3-year bonds which have a delta of $250 ie if Joe owns
$1m bonds and interest rates rise by 1 basis point (or o.o1%) Joe
will lose ~$250 on a market valuation
Joe’s Risk Management team tells him based on their VAR models the
3-year bond is assumed to move a maximum of 20 basis points or 0.2%
in a day
Joe is offered $30m of 3-year bonds by an investor – can he buy
them?
if Joe bought the bonds he would have a delta of $250 * 30 = $7,500
; at worst the bond yield will increase by 20 basis points in a day
and if so Joe would lose $7,500 * 20 = $150,000 => Joe can buy
the bonds as he has a daily VAR limit of $1m
Joe could buy a maximum of $200m bonds under that VAR limit
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VAR weaknesses
Weaknesses in the VAR method have been shown up since the 2007-9
GFC
Markets have a capacity to move in much more extreme ways than VAR
models predict
VAR models may underestimate “tail risks” – so-called “black swans”
championed by Nassim Taleb
Regulators and bankers became too comfortable with VAR – belief
that it is worst case loss potential makes risk managers overly
comfortable
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Business cycle, fundamental changes, technology can all cause
instability
The banking sector is vulnerable to this instability due to its
in-built high leverage
An unstable banking system can cause “bank runs” when depositors
lose confidence
Central bank regulation of banks and the banking system is vital to
minimise the chances of banking system instability and to protect
bank customers
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Types of bank regulation
Bank regulations come in the form of either Systemic Regulation of
Prudential Regulation
Systemic regulation is usually:
History of bank regulation
Each local financial system has its own history of bank
regulation
Globally a number of major regulatory milestones have had
widespread impact:
1933 Glass-Steagall – separation of Investment and Corporate
Banking in the US (largely repealed in 1999)
1988 first Basel Capital Accord “BIS I”. Concept of Tier 1 (Equity)
and Tier 2 (sub debt, hybrids, other) and Risk Weighted Assets
(RWAs). Tier 1 + Tier 2 capital = 8% * RWA
1996 second Basel Capital Accord “BIS II”. Three “Pillars” – 1:
capital, 2: supervisory review, 3: disclosure
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BIS II
Currently the “global” banking system is supposed to be operating
under BIS II
Pillar 1:
Credit risk calculation could be “Standardised” or “Internal
Ratings Based”
Market and Operational risk also included
Pillar 2:
Pillar 3:
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BIS III
Required Capital – increase required capital – Tier 1 up from 4% to
6%
Introduce Leverage Ratio – ratio of Tier 1 capital divided by
“total exposure” to be a minimum of 3%
Introduce Liquidity Cover Ratio – High quality liquid assets
divided by net cash outflow over the next 30 days >100%
Introduce Net Stable Funding Ratio – Long Term Stable Funding
divided by Long Term Assets (> 1-year) > 100%
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Introduce counter-cyclical capital buffers – increase capital in
good times so banks have more protection for bad times
Strengthen risk frameworks across a lot of areas of the banks
eg:
Credit Valuation Adjustment (CVA) for swap counterparty risk
management
OTC derivative clearing through centralised exchanges
BIS III is costly for banks and will be less efficient (ie a burden
for the global economy) - but should strengthen the banking
system
Timetable for introduction 2011-19
Banking crises
Currency crises
Economic crises
2007-9 GFC was mostly a banking crisis but it came from a
speculative asset bubble
Economic crises are usually deep recessions or depressions where
GDP falls sharply
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Banking Crises
Loss of confidence in a bank or number of banks leading to bank run
where depositors withdraw funds rapidly
Often associated with periods of poor lending decisions leading to
high loan portfolio loss provisions
High leverage in the banking system means confidence is
fragile
Small loan losses can quickly turn into a banking crisis
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Currency Crises
A large increase in country risk can cause foreign investors to
lose confidence in the country
Country risk might come from a local economic crisis or perhaps
political change
Foreign investors will sell a currency quickly if they lose
confidence
25%+ fall on relevant FX rate
Often the Central Bank will try to support the currency by
increasing local interest rates
1997 Asian Currency Crisis is classic example of currency crisis –
began in Thailand and flowed across the region
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Speculative Asset Price Bubbles
A speculative asset price bubble is a large increase in the price
of an asset, often over longer periods, which leaves the asset
valuation out of line with underlying fundamental valuations
Dutch tulip bubble of 1637
1929 Wall St crash
1980s Japan property bubble
Bubbles usually end with a large price crash!
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The 2007-9 wasn’t just a US crisis – Europe has had enormous
problems as well
Result was fast track Basel / BIS III
US passed “Dodd Frank” law
Reduce bank trading
Rid system of “too big to fail”
Reform mortgage market