guy hargreaves ace-102. recap of yesterday central bank roles and goals in monetary policy setting...

Guy Hargreaves ACE-102

Recap of yesterday Central Bank roles and goals in monetary policy setting Lender of last resort Central Bank roles in supervision The relationship between Central Banks and the banks they regulate 2

Todays goals Understand how banks generate financial returns Describe the key metrics used in bank financial management Appreciate the advantages of economies of scale and diversification Understand the problems of asymmetric information, adverse selection and moral hazard 4

Theory in practice Recall banks, like other financial intermediaries, perform three basic high level functions: 1. Size transformation 2. Maturity transformation 3. Risk transformation The business of banking doesnt focus on these functions per se, rather it creates practical products and services that solve customer problems and meet customer needs 5

Size transformation For a bank this means: Estimating market appetite Underwriting and distributing in size Using balance sheet to take liquidity risk Using information asymmetry fairly Customers want loans and other banking products and services tailored to their own size 6

Maturity transformation For a bank this means: Using its Capital Structure to manage maturity risk Underwriting balance sheet maturity Gaps Using information asymmetry fairly Very long dated maturity demands can be challenging for banks Sweet spot 3-5 years for loans Project Finance loans often 10-20 years! 7

Risk transformation Savers rationally want to invest in diversified portfolios of credit risk $100 invested in a single A rated corporate can have very different investment outcomes compared with $100 invested across 100 A rated corporates Bank portfolios are very diverse Borrowers dont care so much about this risk transformation Government deposit guarantees also impact savers behaviour (not risk transformation) 8

So how do banks make money? Like all businesses, banks have capital structures: Equity capital Hybrid capital Subordinated debt Long term bonds Medium term notes Short term deposits Aim of banks is to use this capital to invest in assets which generate sufficient return to provide an acceptable return on capital (RAROC) Decreasing risk and maturity for financial liability holders 9

Recall: banking products and services Retail and Corporate banks offer a wide range of products and services Current and chequing accounts- fees, liability raising Term deposits- liability raising Consumer loans and mortgages- asset raising Credit and Debit Cards- fees, asset raising Cash management services- fees, asset / liability raising Corporate and SME loans- asset raising Trade Finance- fees, asset raising Financial market products and services- fees, trading, bid/offer spread Capital Market products and services- fees, underwriting Securitised or asset backed lending- fees, asset /liability raising Investment products and services- fees Insurance- fees, risk income Advisory services- fees Online banking- access 10

The cost of capital The cost of bank capital is a crucial input into the economics of the business of banking Weighted Average Cost of Capital (WACC) is a closely managed metric for banks Banks with high WACC need to invest in higher returning assets to generate acceptable returns Higher returning assets are riskier Riskier assets require more regulatory capital to be held => can become circular 11

WACC example Capital type% of Capital StructureCost Equity capital 6.0%12.0% Hybrid capital 2.0% 9.0% Subordinated debt 2.0% 5.0% Long term bonds20.0% 4.0% Medium term notes 10.0% 3.0% Short term deposits60.0% 1.0% Total:100.0% WACC: 2.7% The bank will need its weighted average asset yield to be greater than 2.7% to generate operating profit 12

RAROC Risk Adjusted Return on Capital (RAROC) Widely used metric in the banking industry to measure the return generated from specific assets Banks set minimum RAROC hurdles in their decision making processes RAROC = Revenue Cost Expected Loss Required Capital 13

RAROC RAROC = Revenue Cost Expected Loss Required Capital Where: Revenue is earned from the net margin or the return from the asset less the cost of funding it Cost is the fully loaded cost of taking on the asset Expected loss is the amount the bank must assume it will lose from investing in the risky asset Required capital is the amount of regulatory capital a bank must hold when investing in the asset 14

Meeting return hurdles Assume a bank sets its RAROC hurdle at 12% An exporter requests a $100m 3-year loan for capex: The exporter is an AA rated company with a sound balance sheet and good track record The bank has an overall cost/income ratio of 40% The bank needs to hold 8% capital against the loan The banks funding cost for the loan is 3% => What interest rate I% should the bank set on this loan? 15

Meeting return hurdles RAROC = Revenue Cost Expected Loss Required Capital Revenue $R = $100m * (I% 3%) Cost $C= $R * 40% Expected loss = PD * LGD where Probability of Default for AA rated company for 5-years is 0.2% with Loss Given Default of 20% (recovery rate 80%) Required capital RC = $100m * 8% = $8m 16

Meeting return hurdles 12%= $R ($R * 40%) $100m * 0.2% * 20% $8m = $R * 60% - $0.04m $8m = ($100m * (I% - 3%) * 60% - $0.04m $8m => I%= (12% * $8m + $0.04m) + 3% $60m = 4.6667% (Credit margin: 167 basis points) 17

Meeting return hurdles Charging a AA rated company a credit margin of 167 basis points would be out of market If customer wanted to pay 50 basis points the bank would have to accept RAROC of 3.25% or pass on the deal Banks often subsidise low RAROC lending in order to Cross Sell higher margin products Take a whole of relationship view on the customer Aim to earn fees from advisory or perhaps income from derivative hedging 18

Cross sell Banks like other businesses are strongly focused on cross selling additional products to the same customer Borrower takes out a floating rate loan for 5-years as funding for an acquisition Bank provides tightly priced loan and is awarded Interest Rate swap which hedges the borrower against rising interest rates Bank provides M&A advisory for a fee => combination of three transactions meet banks RAROC hurdle 19

Fee based income Banks like fee based revenue because they do not have to set capital aside as there is no residual risk Fees include: M&A fees Syndicated loan underwriting fees Bond underwriting fees Equity underwriting fees Upfront derivative fees 20

Derivative business income Derivative business are very complex! Banks generate derivative revenues from trading and market making Trading: take long or short positions in markets through derivatives, similar to securities trading Market Making: provide liquidity to clients at any given time by quoting either buy or sell price Aim to buy low / sell high by having clients transaction on both sides of the bid/offer spread 21

Securities business income Bank Capital Markets divisions generate large revenues when markets are healthy Equity, bond, syndicated loan and securitisation transactions flow through financial market dealing rooms Banks trade and market make in the securities in the secondary market In addition banks are paid fees for arranging, underwriting, and distributing new securities issues in the primary market 22

Foreign Exchange income Bank FX divisions generate income from trading and market making FX markets are extremely efficient and bid/offer spreads are almost non-existent Volumes are HUGE though! Complex FX derivatives are high margin generators for banks FX market was first to embrace e-markets platforms and many customers can plug directly into markets these days 23

Dodd Frank and trading Following the 2007-9 GFC new regulations called Dodd Frank were enacted Under Dodd Frank banks ability to engage in trading will be severely reduced Market making will still be possible but only valuable in less efficient markets 24

The retail banking business The principles behind making money in the retail business are broadly similar to wholesale banking Retail bankers are allocated capital and look to make loans, funded by deposits, to generate acceptable RAROC Portfolio diversification is possibly easier given there are many smaller customers in the portfolio Being retail, banks have historically had extensive branch networks for coverage The internet is changing the face of retail banking dramatically! 25

The mortgage business By far the largest retail business in many economies Mum and Dad borrowers taking out home loans Typically secured by the property financed Borrowers are asked for deposits ranging from 0% to 60% of the property Margins often 1-3% for banks Securitisation industry has been significant supplier of funding to mortgage business Prime and sub-Prime borrowers 26

Credit and debit cards Credit cards offer the holder an unsecured line of credit that can be drawn to pay for goods and services Debit cards are accounts that must have positive fund balances before they can used to pay for goods and services Retailers that accept credit cards charged fees of up to 3% for each transaction Customers that dont repay their cards monthly often subject to huge interest rates eg 16% Fraud risk is very high in the credit card business 27

Trade finance Trade finance products are typically short term, uncommitted and secured RAROC is high because banks dont have to set aside capital against undrawn commitments Off-balance sheet products like Letters of Credit (LCs) can have favourable capital treatment Secured against trade flows eg crude oil cargos (LGD significantly reduced Economics of trade finance often highly reliant on commodity prices With crude prices halving, if volumes remain unchanged trade finance volumes will half 28

Investment products Banks have increasingly moved into many areas of investment products including: Pension and mutual fund management Trustee and custodial services Private banking and advisory Funds management is a best efforts fee based business and not financial intermediation As saving pools grow funds under management grow driving fee growth 29

Key bank financial metrics Loan / Deposit ratio measure of how much of banks loan book is being funded by deposits Tier 1 ratio ratio of permanent capital to risk weighted assets (RWAs) Leverage Ratio ratio of Tier 1 capital to total assets Liquidity Coverage Ratio ratio of outflows over a critical timeframe (eg 30 days) to high quality liquid assets Net Stable Funding Ratio ratio of stable funding to long term assets Efficiency ratio equivalent to the operating margin ratio of operating revenue (EBIT) to total revenue ROE or ROA traditional return metrics Credit quality loan loss ratios 30

The economics of diversification Bank portfolios benefit from their scale and diversification Significant efficiencies come from large scale because of the economics of fixed versus marginal or variable costs Large scale alters the asymmetric information balance making banks more able to deliver efficient products Portfolio diversification theory suggest more diversified portfolios will perform more closely to expectations Less diversification leads to higher event risk which impacts on bank WACC 31

Asymmetric information Financial market participants often have varying levels of information > Information Asymmetry 1. Some players have differing information 2. Some players have Inside Information 3. All players have imperfect information Asymmetric information can lead to Adverse Selection and Moral Hazard 32

Adverse selection Adverse selection can become a big problem in 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 In famous case of Abacus a bank created an adversely selected portfolio and profited from also arranging for another client to bet against the portfolio The so-called Market for Lemons problem where bad money drives out good Compliance and Risk Management functions are being heavily increased in banks today to prevent outcomes like this 33

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 34

guy hargreaves ace-102. recap of yesterday central bank roles and goals in monetary policy setting...

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