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