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RETAIL BANKING I

RETAIL BANKINGACADEMYCourse Code 102 - Retail Banking Overview

102.Retail Banking Overview

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RETAIL BANKINGACADEMYCourse Code 102 - Retail Banking Overview

Course Code 102

Retail Banking Overview

Introduction

“A bank is an institution whose current operations consist in granting loans and receiving deposits from the public.” *

Research shows that ancient Greek banks were performing complex operations, such as the transformation of deposits into loans.† Retail banks are examples of financial intermediaries. They mediate between suppliers and demanders of capital. Specifically, retail banks receive mainly individual deposits and corporate deposits and create personal loans and mortgages as well as loans to SMEs (small and medium-sized businesses). Furthermore, modern retail banking is characterised by multiple products, multiple channels and multiple customers.‡ The accelerated growth in internet and mobile banking is having a big impact on traditional branch banking§ and has created digital money substitutes (i.e., e-money, M-Pesa) that present exciting opportunities for retail bankers but also new security concerns.

This module presents an overview of the principles of modern retail banking. We consider the economic role of retail banks as financial intermediaries (among other roles) and provide a financial analysis of the retail bank’s balance sheet and income statement. We also consider important banking metrics that are based on data from the balance sheet and income statements. These include cost income ratio; loan-to-deposit ratio; spread margin and net interest margin.

* Frexias and Rochet, Microeconomics of Banking, 2nd Edition, (Cambridge: MIT Press, 2008).

† D. Cohen, Athenian economy and society: A banking perspective, (Princeton, NJ: Princeton University Press, 1992).

‡ Gopinath Shyamala, Deputy Governor of Reserve Bank of India, “Retail Banking Opportunities and Challenges”, Banking Frontiers International Conference on Retail Banking Directions: Opportunities and Challenges (2005).

§ The death of branch banking may be overstated; Virgin Money recently bought the failed British bank, Northern Rock, and created a modern, ergonomic branch environment.

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Course ContentThis module comprises four chapters as follows:

Chapter 1: Roles of a Bank in the Economy

Chapter 2: The Liability Side of the Balance Sheet of a Retail Bank

Chapter 3: The Asset Side of the Balance Sheet of a Retail Bank

Chapter 4: The Income Statement of a Retail Bank

The module concludes with a summary and review questions.

Course Code 102 - Retail Banking Overview

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Chapter 1: Roles of a Bank in the Economy

A bank performs three important economic functions. One function is:

a) Financial Intermediation

Where a bank borrows funds from consumers/corporations and lends to consumers and firms that require financing. In other words, banks channel funds from savers to investors.

The benefits to the economy can be rationalised on the basis of:

(i) Information Asymmetry

Suppose borrowers have more information than savers about their credit risk. If savers were to seek out borrowers in order to lend directly, they could make an incorrect choice in lending that may lead to higher-than-expected counterparty risk. For example, savers may incorrectly assess such factors as probability of default (PD), loss-given default (LGD) and exposure at default (EAD). These factors are borrower-specific and are more difficult to estimate with limited information. This problem is called adverse selection – or incorrect choice arising from hidden information. The obvious consequence of adverse selection is that lenders are likely to underestimate the expected loss associated with the loan. However lenders, knowing they could make bad choices, may ration the amount of loans they are willing to make and may even choose to make only short-term (i.e., less risky) loans. This potential for ‘market failure’ is a typical consequence of information asymmetry and is popularly known as the ‘lemons problem’.*

(ii) High Transaction Costs

Individual lenders (i.e., savers) may incur several types of costs in trying to lend directly. These include search costs that are incurred in finding a suitable borrower; risk-assessment and risk-monitoring costs in estimating the variables that determine the level of counterparty risk the lender is likely to bear; as well as the costs of monitoring the loan contract. Finally, there is also the cost of enforcing the loan contract should violations occur (i.e., payments are skipped). These

* George A, Akerlof, “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Quarterly Journal of Economics (The MIT Press), Vol 84 No 3, pp488-500 (1970).


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costs can be quite high, and borrowing costs for consumers and firms can become prohibitive. This can restrict the level of investment that takes place in the economy, and so limit economic growth. Financial intermediaries, via the law of large numbers,* can lower the average transaction cost to borrowers, leading to lower-cost loans. In doing so, financial intermediaries provide liquidity in the loan markets.

Another economic function that a bank provides is:

b) Asset Transformation

Where a bank collects short-term deposits that are typically liquid and creates loans of varying maturities, and loan amounts to meet the demand of borrowers. This process of asset transformation, i.e., the conversion of short-term liabilities into longer-term assets, creates several sources of risk for the bank. For example, the asset-liability mismatch of duration creates interest-rate risk on the bank’s balance sheet.† There are other sources of risk for the bank as it transforms deposits into loans. For example, if deposits are priced relative to a variable benchmark (i.e., interbank rate), deposit rates will also be variable. This rate of change in the deposit rate is called the tracking speed. But if the deposits are transformed into fixed-rate loans, these loans will be re-priced infrequently. This is called the re-pricing speed. Clearly, when the re-pricing speed is not equal to the tracking speed, margins will be relatively variable and hence risky.

The third role of banks in the economy is:

c) Creation of Money Supply Through Fractional-Reserve Banking

Fractional-reserve banking refers to the practice whereby banks receive deposits from customers and must keep a fraction of these deposits as reserves. The bank lends the excess above required reserves to consumers and corporations. To see how this lending process creates money supply, we provide a simple example. Assume that the Central Bank mandates a minimum reserve ratio of 10 percent. Consider a bank that receives $100 of deposits. This bank may lend a maximum of $90, holding reserves of 10 percent of $100, which is $10. The borrower then deposits the $90 in another (or the same bank). This is now considered new deposits. Hence the receiving bank will keep reserves of 10 percent of $90 (or $9) and lend up to $81. This process of continual lending and fractional-reserve banking leads to creation of deposits ad infinitum – at least in theory. The maximum amount of deposits created for a reserve ratio of 10 percent is 10 times the initial deposit, which amounts to $1,000. For a $1 deposit, the maximum amount of deposits created is given by the formula:

D= 1re

where D = maximum amount of deposits created, and re = reserve ratio. So, for a reserve ratio of 10 percent, each dollar of deposit leads to a maximum amount of deposits of $10.

The link to money supply is as follows: Money Supply (M) = CU +D where CU = coins and notes and D = deposits. With no change in CU, we see that Δ M= Δ D. Hence the lending process that creates deposits leads to an increase in money supply by the same amount.

102.1: Formula for maximum deposits

To facilitate its role of financial intermediary, a typical retail bank provides certain core services. We discuss these in some detail.

* The law of large numbers plays an important role in risk management. The module titled Credit Loss Management will deal with the law of large numbers and its relationship in differentiating between risk and uncertainty.

† Duration will be discussed later in this module. For now, we indicate that it is a measure of interest-rate risk (assuming no credit risk). That is, longer duration securities have, all else being equal, high interest-rate risk 6.


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d) Core Services of a Retail Bank

A characterisation of modern retail banking is one with multiple products (payment and savings accounts, loans, residential mortgages, investments), multiple channels (branches, internet, mobile) and multiple customers (individuals, SMEs).

The core services of a retail banks are:

1. Deposit taking

2. Payment services

3. Underwriting of loans

The customer can make deposits through savings accounts and transaction accounts. Savings accounts represent money lent to a financial institution (i.e., bank) where the lender (i.e., depositor) earns a relatively low rate of return but obtains certain privileges, such as withdrawal as desired. In several countries, savings accounts are insured to a maximum amount by government agencies against a bank’s inability to meet its obligations to depositors.* Savings accounts also include time deposits†, which have a specified time period (e.g., 60 days) and which typically pay a fixed interest rate. The funds cannot be withdrawn without penalty before the term of the deposit ends. Certificates of deposit (CDs) are examples of time deposits. CDs may be sold, prior to maturity, to other investors in an open market.

The second type of deposit is called a ‘transactional account’. These accounts are called ‘checking accounts’ in the US and ‘current accounts’ in the UK. As opposed to, for example, time deposits, funds in current accounts are available on demand, and hence are also known as ‘demand deposits’. These accounts usually do not earn any interest since they are intended to facilitate payment services. Banks provide several ways for the customer to conduct payments or money transfers. These include direct deposit (GIRO‡), standing orders (regular automatic transfer of funds), debit cards (direct cashless payment of merchandise purchases), credit cards, and international transfer of funds (SWIFT)§.

Underwriting of loans by banks involves a credit-risk evaluation of the potential customer/borrower. The customer may require a personal loan (without collateral) or a mortgage that is backed by the real estate asset that the borrowed funds will purchase or a credit card to facilitate payments. In each of these cases, a detailed review of the applicant’s financial health is assessed and a determination of the amount, term and conditions of the loan is made.

Apart from these core services, the retail bank also provides cash management, advisory services (such as, private banking) and investment-product offerings (e.g., mutual funds). We provide a brief description of these banking activities.

Cash management is a service offered by retail banks for its small and medium-sized enterprise (SME) customers that includes liquidity management where banks optimally balance cash requirements with investment of excess cash reserves. One popular method for conducting liquidity management is via a sweep account. A sweep account links a commercial checking account to an investment account which comprises money-market investments. In simple terms, excess cash (i.e., above a pre-determined target level) is automatically invested. The investment account is partially cashed-in when the company’s cash position falls below the target level. The bank earns a fee for providing this service.

* Deposit insurance is available for a savings limit that varies across countries. For example, there is an EU-wide limit of €100,000 and the UK limit is €85,000.

† Time deposits are also known as ‘term deposits’ in some countries (e.g., Canada), a ‘fixed deposit’ in India and a bond in the UK.

‡ GIRO is an acronym for General Interbank Recurring Order. For example, an employer directs its bank to transfer a salary to the employee’s bank. In the US, the automatic clearing house (ACH) provides an electronic version of the giro transfer.

§ SWIFT is an acronym for the Society for the Worldwide Interbank Financial Telecommunication.


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Another fee-business for banks is based on advisory wealth-management services provided for private banking clients. Some of the wealth-management services include savings, discretionary portfolio management, establishment of trusts, and inheritance as well as tax planning.

In offering wealth-management advice, banks may sell investment products such as mutual funds and ETFs (exchange traded funds) to customers, including private banking clients. The main reason is that the bank’s advisory role may create a demand for such investment products in order to achieve the aspirational goals of the customer’s retirement plan.

We now consider the balance sheet of a retail bank.


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Chapter 2: The Liability Side of the Balance Sheet of a Retail Bank

The financial-intermediary role of banks offers an opportunity to distinguish between assets and liabilities. A bank borrows funds from depositors (a liability) and lends to consumers and firms (an asset). While this chapter emphasises the liability side of the balance sheet, it is worthwhile considering the entire balance sheet in general terms.

The balance sheet is based on the formula;

Assets = Liabilities + Shareholder Equity

The International Accounting Standard Boards (IASB) states that an asset has an important attribute – it is owned by the enterprise (i.e., the bank) and is expected to produce future economic benefits. In this sense, the financial assets of a bank represent ownership of value that can be converted into cash.

The International Financial Reporting Standards (IFRS) states that, “A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.” * Examples for a retail bank are retail deposits, corporate deposits and other sources of funding.

The main construct of a retail bank’s balance sheet is as follows:

* Framework for the Preparation and Presentation of Financial Statements.


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ASSETS LIABILITIESCash and Cash Equivalents

Loan Products

(Loans, Mortgages...)

Investments

(Bonds, Listed Equities, Derivatives [MBS])

Goodwill

Fixed Assets

(Real Estate – such as branches – IT infrastructure)

Deposits

Interbank Funding

Wholesale Funding

Unsecured Debt

SHAREHOLDER EQUITY

Paid-in Capital Retained Earnings

102.2: Retail bank balance sheet

We now consider the liability side in detail.

The liabilities of a retail bank mainly comprise:

a) Deposits from individuals and small and medium-sized businesses(SMEs)

b) Interbank funding

c) Wholesale funding

We explain each of these categories in turn:

a) Deposits

We have presented a detailed explanation of transactional accounts and savings accounts in Chapter 1. An important component of deposits is called core deposits, which include savings accounts and checking accounts. These deposits are a source of stable funding* and also cost less relative to other types of deposits (e.g., time deposits). In addition, checking accounts typically pay no interest. Clearly, retail banks may leverage the stability of core deposits to cross-sell other products, thereby increasing the likelihood of fee income.†

b) Interbank Funding

Banks borrow from each other to meet liquidity requirements or to satisfy minimum reserve ratios set by the central bank. The latter concept was discussed in Chapter 1. These loans are typically short-term (e.g., maturity of one week) while most are overnight.

* The stickiness of core deposits is supported by academic research; see for example, Song and Thakor, Review of Financial Studies, 20(6): 2129-77 (2007).

† A related concept is the non-core dependence ratio which measures the degree to which the bank is funding long-term assets by non-core deposits. In the US, the Federal Financial Institutions Examination Council shows that this ratio rose steadily from about 12 percent in 2003 to more than 20 percent in 2008, when many banks suffered a liquidity crisis as non-core deposit funding dried up. More details on wholesale funding will follow later in this chapter.


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We present some information on the typical interbank rates.

Euribor = Euro InterBank Offered Rate is an average interest rate at which banks lend unsecured funds to other banks. In essence, Euribor is a euro-priced, bank-to-bank lending rate. Eonia = Euro OverNight Index Average is an average, overnight rate at which banks lend to other banks. In other words, Eonia = one-day Euribor rate.*

The LIBOR (London Interbank Offered Rate) is a daily reference rate based on rates that banks charge other banks for unsecured funds in the London wholesale market. Maturities range from overnight to one year for 10 major currencies. It is published by Reuters on behalf of the British Bankers Association (BBA) and published around 11am London time.

c) Wholesale Funding

Banks may augment their deposit base with short-term wholesale funding. Sources of wholesale funding include large-denomination certificates of deposit (CDs), repurchase agreements which are relatively short term and unsecured debt which is relatively longer term. We define each of these in turn.

Certificates of Deposit (CDs)

Unlike a time deposit, which cannot be bought or sold in an open market (i.e., not negotiable) and must be held to maturity, a certificate of deposit is a security issued by a bank to a depositor. A CD is negotiable and hence may be sold in an open market subject to current market-interest rates. A CD is usually interest-bearing (although they may be sometimes sold at a discount to par).

Here is an example:

Bank sells a $10 million CD for 30 days with a single coupon annual interest rate of three percent payable at maturity. The interest rate convention is Actual/360.† Hence at maturity, the bank pays the investor (i.e., the buyer of the CD) a total of:

$10 million + ($10 million * 0.03 * 30/360) = $10.025 million

Repurchase Agreement (Repo)

If a bank has short-term cash needs, it could sell assets in the open market. Alternatively, it could borrow in the money market with the asset (usually high-quality) serving as collateral. This action of managing liquidity is conducted through a repurchase agreement. From the perspective of a bank which is borrowing cash and is selling a high-quality collateral to the lender, a repurchase agreement is simply collateralised lending. However, this is just the first leg of the transaction. Simultaneously, the reverse transaction is agreed upon with respect to date and (repo) interest rate. That is, the lender will return the collateral to the borrower and obtain the cash plus interest due for the lending period. (See example below). This transaction is called a ‘repo’ when viewed from the borrower’s perspective (i.e., the party that sells the collateral) and a ‘reverse repo’ when considered from the lender’s perspective (i.e., the party that buys the collateral).

* For more details on the construction of the LIBOR, consult “BBA LIBOR Explained” on the BBA website.

† Interest payments are calculated according to the convention D/B where D = day count and B = annual basis. The convention Actual/360 means that D = the actual number of days and B = 360 days.


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A repo transaction is illustrated as follows:

Time: t0

Bank Sells Collateral Lender

Cash

Time: t1

Bank Cash + Interest Lender

Buys Collateral

Both legs of the transaction are completed at time 0.

102.3: Repo transaction

Here is an example:

At the start date the following repo deal is agreed:

Collateral (sovereign bond) price at par:

Repo principal: €10,000,000

Repo rate: 2%

Interest is calculated according to the convention, Actual/360

Repo term: 7 days

This means that the borrower (i.e., the bank) will sell a sovereign bond (the collateral) at par (100 percent of face value) and receive €10 million. The maturity is seven days and interest payment due is calculated for seven days on a 360-day year basis. Hence interest due at maturity is €10 million * 0.02*(7/360) = €3,888.89. So at the maturity date, the lender returns the collateral to the bank and the bank returns the repo principal + repo interest due = €10,003,888.89.

In some cases, depending on the term of the repo as well as the quality of the collateral, repo principal may be less than the current market value of the collateral. This difference is called a ‘haircut’. For example, if a haircut of two percent is deemed appropriate, then repo principal will be 98 percent of the current market value of the collateral. In our example, although the current market value of the bond is €10 million, the lender will exchange €9.8 million.

It is important to note that the bank can also take the side of the lender in the repurchase agreement described above. In this case, as indicated above, the bank is engaged in a reverse repo, where the bank lends the cash and buys the collateral. So a reverse repo is an asset. This is discussed in the next chapter.

It is worthwhile highlighting the risks associated with a bank’s overdependence on wholesale funding. First of all, intense bank competition for deposits may force banks to take on riskier


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wholesale funding.* The intuition is based on the hypothesis that when there is intense competition for deposits, the cost of deposits rises relative to wholesale funding and so the cost of retail funding rises compared to wholesale funding. This raises the demand for wholesale funding.

d) Unsecured Debt

When a bank raises secured debt, some form of collateral is pledged to the lender in the event that the borrower falls into bankruptcy. Hence, all else being equal, the bank incurs lower cost of debt. In this case, the lender has rights to the collateral that can be liquidated to pay the remaining debt obligation. But when a bank raises unsecured debt, it is essentially borrowing from lenders without providing any collateral. This type of debt is below collateralised (secured) debt in bankruptcy proceedings.

As such, apart from term risk and credit risk (existing for all corporate debt), unsecured debt is likely a better indicator of default risk for a bank. For this reason, some experts have suggested that regulators should monitor the risk premium on unsecured debt relative to similar term secured debt to get an indication of the market’s assessment of the bank’s default risk.

The potential benefits of market discipline are explicitly stated in Pillar III of the Basel Accords. “The monitoring and potential corrective actions by market participants and authorities have been labelled indirect market discipline. In particular, supervisors can use the (secondary) market signals as screening devices or inputs into early-warning models geared at identifying banks, which should be more closely scrutinised.” (Basel Committee on Banking Supervision, Working Paper 12)

This type of debt is different from covered bonds (to be covered in Chapter 3) which are considered to be particularly low risk since borrowers get a claim on both the issuing bank and the underlying covered pool of assets. As indicated above, unsecured debt is not backed by any pool of assets, although senior unsecured debt has a priority over junior unsecured debt in the event of bankruptcy.

A bank may issue unsecured subordinated debt to bolster its Tier 2 capital levels as specified in Basel III. For example, it was reported by Bloomberg on 8 March 2011 that “Commerzbank AG plans to improve its capital structure by selling subordinated bonds… unsecured 10-year notes denominated in euros… Today’s transactions are aimed at ‘a long-term optimisation’ of the bank’s Tier 2 capital structure before Basel III, the bank said.”

There is the distinct possibility that banks will continue to issue unsecured debt to diversify their sources of funding. But also the trend towards covered bonds will probably ease, since banks have a limited amount of assets to dedicate to the cover pool. Hence, more unsecured debt issuance is likely. As noted in the Dow Jones Newswires on 28 February 2011, “There’s a limit to how much covered debt banks can issue, as it depends on how much collateral they have,” said Jeremy Walsh, head of covered bond syndicate at Royal Bank of Scotland. “They need to look at other sources of funding.”

We now describe the main elements of the asset side of the balance of a retail bank.

* See Craig and Dinger, ‘Deposit Market Competition, Wholesale Funding and Bank Risk’ (2010), which states that “our results support the notion of a risk-enhancing effect of deposit market competition”.


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Chapter 3: The Asset Side of the Balance Sheet of a Retail Bank

An asset of the bank has two main attributes: the bank has control through ownership and an expectation of future economic benefits. The latter may be in the form of expected future cash flows from financial assets such as financial products (e.g., loans) and investments (e.g., listed equities). Specifically, the International Accounting Standards Board (IASB) defines an asset as follows:

“An asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise.” *

We now describe in detail the different classes of assets in a retail bank.

Cash and Cash Equivalents

Cash and cash equivalents are the most liquid assets of a bank, in the sense that they are already cash or are quickly converted into cash. The Financial Accounting Standards Board (FASB) defines cash equivalents as “highly liquid securities with maturity of three months or less”. The components of “cash and cash equivalents” are as follows:

1. Vault cash to meet daily customer demands that include cashing of cheques, withdrawals from ATMs etc.

2. Reserves held at the central bank to meet regulatory reserve requirements.† This policy of paying interest on reserves (IOR) was advocated by Milton Friedman more than 40 years ago, and many central banks currently have such a policy in place.‡ Reserves held at the central bank, as well as vault cash, count towards the minimum reserve requirement of the bank.

* Similarly, the Financial Accounting Standards Board (FASB) defines an asset as follows: “Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”

† In the US, the Federal Reserve, under authority granted by the Emergency Economic Stabilization Act of 2008, amended its Regulation D, Reserve Requirements of Depository Institutions to mandate that regional Federal Reserve banks pay interest to depository institutions on both their required and excess reserves. The implementation date was 1 October 2008.

‡ If a central bank raises its IOR, there could be a direct implication on banks’ willingness to lend to the public. For example, banks will probably weigh the risk-less IOR with the risky lending rate to the public and may decide in favour of holding excess reserves with the central bank.


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3. Cash equivalents are highly liquid, money-market instruments with a term to maturity of 30 days or less. These include short-term US treasury bills, reverse repos with other banks etc.

Loan Products

In a simple sense, banks are lenders in two main ways. First, they invest in bonds and other interest-earning assets through the capital markets. These bonds are typically issued by corporations and governments, which are borrowers. Banks also underwrite loans to consumers and businesses as part of their intermediary function. This type of lending (underwriting) is more customised and hence creates specific counterparty risks. Consequently, there is an expectation that some loan losses are part of normal business. We consider the case of products such as loans and mortgages. But before we do this, it is worth introducing the concept of trading and banking books. This will help to explain the categories we have created in this chapter: products versus investments.

In the trading book, the bank attempts to benefit from (ex-post) differences between the buying and selling prices of the instruments in which it has invested. Specifically, “the bank’s trading book contains instruments that are intended to be held for a short term and which are taken by the bank to benefit from actual or expected differences between their buying and selling prices” (Basel, 1996). Since these assets are labelled ‘held for trading’ (HfT), they are reported at fair value in the balance sheet and changes in the fair value or dividend and interest income earned are recorded in the income statement.

In the retail banking book (a subset of the banking book), the bank tries to profit from the margin between what is earned on assets and paid on liabilities. A closely related concept is when assets are deemed to be held to maturity (HTM). These are debt securities where the company has positive intent and ability to hold the security to maturity. HTM assets’ fluctuations in fair value are not included in the company’s financial statements. Of course, this cannot apply to equity such as investments in listed shares of other banks, since there is no set maturity date for share holdings. As we have indicated in Chapter 1, the retail banking book is a part of the banking book that focuses on private persons and small and medium enterprises (SMEs).

In the investment book, gains and losses from revaluation of ‘available for sale’ (AFS) assets are recorded in a reserve account in shareholder equity. They are not short-term marketable assets (HfT) or assets held to maturity.

Loans

Loans are contracts between the lender (i.e., the bank) and the customer who receives a principal amount in exchange for promised payments subject to agreed terms and conditions. As the underwriter, the bank assumes the risk of repayment. Hence it assesses the credit risk of the prospective borrower and designs the loan contract based on financial information provided by the customer. For a typical consumer, this information includes employment history, personal savings, credit scores etc. For a business customer, examination of the financial statements as well as debt ratings provided by rating agencies will help in the underwriting process.*

Assessment of the credit risk embedded in the loan contract is a predominant function of the bank.† There are two sources of uncertainty to evaluate in a loan contract. The first deals with expected loss on the loan contract. Algebraically, expected loss is given by the formula: E(L) = PD*LGD*EAD where PD = probability of default, LGD = loss given default, EAD = exposure at default. Default occurs when the customer fails to meet repayment obligations. The monetary value of existing obligations, should the customer default immediately, is called exposure at default (EAD). If the recovery rate is RR, then the actual loss upon default is (1-RR)*EAD. Loss given default (LGD) is the actual loss (in monetary value) the bank will incur should the customer default. Hence LGD = (1-RR)*EAD.

† Given asymmetric information between providers of bank funding and banks’ managers, credit-risk-sensitive funds providers may worry about the security of their funds under high levels of credit exposure.


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Here is an example of this:

A bank makes a loan to a customer and as of today, there is an outstanding repayment amount of $500,000 in principal and interest. The following information is assumed: EAD = $500,000; PD = 1%; ‘LGD = 5%’. What is the expected loss?

As we see, loan loss is a normal part of a bank’s lending business. To manage the effect of loan losses, banks create a loan loss provision (LLP) on the asset side of the balance sheet. It also has an income statement effect that we shall see in the next chapter.* Loan loss provision is an allowance for loan losses. It is netted against gross loan amounts on the balance sheet and serves to absorb actual and known loan losses.† In accounting jargon, LLP, similar to depreciation, is a contra-asset. At the end of each reporting period, (i.e., quarter), the LLP rises by positive additions to the loan loss provision in the income statement and falls by the level of net charge-offs.

Consider this example:

Assume that a bank lends €5 million to a business enterprise. The bank wants to make a specific provision for actual loan losses. It decides that a provision of €100,000 is appropriate based on the estimates provided by the risk-management group. Two accounting entries will occur. First, this loan loss provision of €100,000 will reduce net income by €100,000. Second, there will be an increase in the loan loss provision (LLP) on the balance sheet that will reduce the gross value of loans.

It is important to note that as the loan is deemed ‘non-performing’,‡ the continual additions to the LLP should be adequate to offset future charge-offs. For this reason, charge-offs should reduce LLP first. This being the case, there should be no impact on the bank’s equity. The key point is that as bank management builds up LLP over time as the loan is undergoing a process from performing to non-performing, the additions to LLP should be equal to the charge-off value of the loan.

A bank may also use a general provisions policy for loan loss provisions for its portfolio of loans rather than a provisioning policy for specific loans. When the business cycle is on the upswing, banks typically experience lower loan-default rates as customers benefit from higher consumer demand for their products and services. Banks may then build up loan loss provisions during this period – a policy called pro-cyclical provisioning. Hence, based on the ‘incurred loss’§ model, banks will probably require loan loss provisioning during worsening economic periods. But since additions to loan loss provisions will be charged to the profit and loss account this will reduce current earnings while future loan losses in the downturn will first of all reduce the LLP having a positive effect on reported earnings at that point. This has the effect of smoothing earnings.

* At this point, it is enough to know that banks set aside part of their earnings to cover actual loan loss. The line item is ‘additions to loan loss provisions’. All else being equal, this will reduce earnings.

† LLP serves to absorb actual loan losses while bank capital serves to absorb unexpected losses. The role of capital in banks is considered in Retail Banking II.

‡ Basel Committee (2004, page 92) states: “A default is considered to have occurred with regard to a particular obligor when either or both of the two following events have taken place: a) The bank considers that the obligor is unlikely to pay its credit obligations to the banking group in full, without recourse by the bank to actions such as realising security (if held) and b) The obligor is past due more than 90 days on any material credit obligation to the banking group”.

§ Under the incurred loss model, a bank can make a provision to reserves only if it can document that a loan loss has been incurred. This means that a loss is probable and can be reasonably estimated. But then, to reasonably estimate a loan loss, it is typical to rely on historical loan loss rates. Consequently, during an economic upturn when actual loan loss rates are below average, bankers would likely reduce provisions. This may make the level of LLR too low to deal with a downturn. John Dugan, US Comptroller of the Currency, stated in the Journal of Accountancy in 2009 that the incurred cost model should be changed to incorporate ‘expected loan loss’ so that LLR will be built up prior to a downturn.


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Mortgages

A mortgage is a loan supported by collateral where the loan repayments are periodic annuities (e.g., monthly). For a residential mortgage, the collateral is real estate. The annuities are calculated so that when payments are made on time and in full, the principal loan amount is completely repaid. This process is called ‘amortisation’.* Mortgage jargon identifies two special attributes – the interest term and the amortisation period.

The term of the mortgage is the period during which the interest rate on the loan is fixed. The amortisation period is the period over which the annuities are calculated. For example, a mortgage for $1 million at a fixed rate of four percent for five years that is amortised over 15 years, means that the loan interest rate is fixed for a five-year period and will be renegotiated for the next period. The loan amount of $1 million is amortised over 15 years. Typically, this means annuities are made, probably monthly, calculated for 180 months.

Variable rate mortgages are also available. In this case, mortgage rates are based on some benchmark market rate† and typically have an adjustment period, during which the rate is unchanged. The rate is reset at the end of the adjustment period and the monthly annuity is recalculated. These mortgages are known as adjustable rate mortgages (ARMs) in the US and are quite common internationally.‡ It is common for banks to originate both residential and commercial mortgages. The bank (i.e., the mortgagor) faces credit risk, as would be the case in all loans. However, this loan is secured by a real estate asset. One source of risk is that the market value of the collateral (i.e., real estate) may lose value, rendering a shortfall in collateral value. One possible outcome is foreclosure where the borrower exercises its put option – that is, to put the real estate back to the bank which forecloses the property. This possibility is more likely when the market value of the collateral is less than the debt value of the mortgage. In this case, the recovery rate may be relatively low so that the actual loss incurred by the lender (i.e., (1-RR) *EAD) is high.

For this reason, lenders impose caps on loan-to-value (LTV) ratios when funding mortgages. LTV is defined as the mortgage loan amount divided by the appraised market value of the property. For a LTV cap that is equal to 80 percent, the borrower must provide an unencumbered equity investment of 20 percent.§ This is equivalent to a haircut of 20 percent where the loan amount is 20 percent less than the current market value of the collateral. The link between credit risk and the LTV ratio is recognised in Basel III (more details in Asset Liability Management in Retail Banking II) where mortgage loans¶ secured on residential property have a risk weight of 35 percent for LTVs less than or equal to 60 percent; however, the risk weight rises to 50 percent for LTVs that are higher than 60 percent but less than or equal to 80 percent. Finally, the risk weight will be 100 percent for a Category 1 mortgage with a LTV that is higher than 80 percent.

Compared with other types of loans, mortgage loans embed a unique risk – prepayment risk – in addition to maturity (term) and default risks. In the case of residential mortgages, a homeowner may exercise either a call option (refinancing) to prepay the loan balance with or without paying any financial penalties if new mortgage rates are lower, or a put option to default – the homeowner is to ’put’ the house to the bank and let the bank foreclose the property – if the net worth is negative (i.e., if the market value of the property is less than the mortgage loan balance). This put to default risk is especially prevalent in the USA and was one of the main contributors to

* The word ‘mortgage’ is derived from the French word ‘mort’ which means ‘death’. The process of amortisation literally kills off the loan amount.

† In the US, the US Treasury rates for one-year maturity are a common benchmark. Other terms such as three years and five years are also used.

‡ Clearly, there may be a decreased preference for adjustable rate mortgages when interest rates are low. This is because borrowers may prefer to lock in low rates for a longer period by way of fixed-rate mortgages. Similarly, when interest rates are historically high, there is a presumption that future interest rates are likely to decline. Hence there is probably a higher demand for adjustable rate mortgages.

§ Kelly in the Journal of Housing Research, 2008, shows that “borrowers who provide down-payments from their own resources have significantly lower default propensities than borrowers whose down-payments come from relatives, government agencies, or non-profits”.

¶ These mortgages are described as Category 1, and include first mortgages where the loan cannot be a balloon payment.


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the housing crisis in the period 2007 to 2012.

Unlike conventional loans, banks that lend via mortgages may incur a specific risk – a prepayment risk that the borrower prepays (i.e., calls back) part or all of the mortgage when there is no contractual prepayment penalty. This event is likely to occur under a low interest-rate environment,* the lender faces a reinvestment problem. That is, the prepaid mortgage balance will be reinvested in new mortgages at lower interest rates. Prepayment risk is also called contraction risk. It can also result from the sale of the underlying real estate. Clearly, this additional risk requires a risk premium that is included in market mortgages rates. From a financial-engineering perspective, a mortgage with a prepayment option is similar to a call option embedded in a callable bond where the issuer has the right to call the bond from the owner.† Clearly, a mortgage is a callable bond issued by the homeowner with and/or without prepayment penalty.

Investments

We have already shown how a bank, as financial intermediary, channels funds from depositors to demanders of funds such as consumers and companies that require loans. The loans are customised to meet the customer’s requirements after due diligence and risk evaluation are conducted. However, companies and governments can also borrow funds via the capital markets in the form of debt securities. Debt securities, as opposed to loans, are contracts between lenders and borrowers that offer standardised features. This allows these contracts to be marketable so that one party to the contract can sell his/her obligation to the other party at the market price. Importantly, banks may lend to corporations and governments etc, via the debt markets.

We consider some of these debt securities in detail.

(1) Bonds

A bond is a security (i.e., a contract) sold by a corporation or a government in order to borrow money from lenders. The principal or loan amount is paid to the borrower at the time the contract is made. The contract stipulates the terms and conditions for promised repayment to the lender. After the terms and conditions are set by the borrower, only then is a loan amount calculated. This loan amount is called the price of the bond. A bond is called a sovereign‡ bond when the borrower is a government, and a corporate bond if the borrower is a corporation.

Here is an example of a bond:

A corporation sells a five-year bond that pays four percent coupon interest semi-annually. The buyer of the bond is a retail bank.

We provide some explanations of the terms and conditions of this deal.

• The term of the bond is five years. It is sometimes called the outstanding maturity. It is similar to a loan for five years.

• Bonds typically have a (notional) par value of 100. This permits the calculation of the interim interest or coupon payments.

• The coupon interest is four percent annually and is set by the borrower or issuer of the bond. This means that the corporation must pay the bank 4 percent per year in two semiannual interest payments of 2 percent * 100 = $2.

* There is also prepayment when the real estate is sold outright.

† The equivalent risk in callable bonds is called ‘call risk’. It occurs when interest rates are declining and proceeds are reinvested at lower rates.

‡ US Government Treasury coupon bonds are an example of sovereign bonds with original maturities of more than 10 years. The original maturity is the term of the bond when it was originally issued. When the original maturities range from one to 10 years, these securities are called Treasury Notes.


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• Finally, the par value is repaid to the bank at the end of five years – the maturity date.

The special case of a zero-coupon bond is when the bond pays no coupons so that the lender receives only the par value at maturity.

We now introduce an interesting valuation principle:

The price of a bond (i.e., the amount that the borrower receives) is equal to the present value of the cash flows that the borrower promised to pay to the lender.

We apply this valuation principle to zero-coupon bonds.

Example: What is the price of a five-year zero-coupon bond that is priced to yield 8 percent?

Solution: The price of this bond is the present value of a single payment of $100 made at maturity in five years.

This value is P= 100(1.08)5

= $68.06.

This means that the lender will pay the borrower $68.06 in return for $100 at the end of five years. The yield-to-maturity is a promised return of 8 percent per annum. Note that if these values multiply linearly, for example, if the borrower will pay the lender $10 million at the end of five years, the loan amount will be $6.806 million today for a promised rate of return of 8 percent per annum.

Note that if the yield to maturity was higher than 8 percent, the price of the bond will be lower than $68.06. This is an example of an important property of bonds.

Bond prices and bond yields move in opposite directions to each other.

Hence if the bank (i.e., the lender) chooses to sell the bond prior to maturity, the market price will be affected by the prevailing interest rates. Hence bonds are exposed to interest rate risk. If the lender chooses to sell the bond and the prevailing yield has declined, the bond price will increase and the lender will earn a higher rate of return. But the opposite is also true.

While interest rates have a profound effect on bond prices, the passage of time has meant that bond prices must converge to the par value. Hence the volatility of bond prices arising from interest rate changes is reduced as the bond approaches maturity.

We summarise interest rate sensitivity of a bond as follows:

Bonds with the highest interest rate risk have the following characteristics:

Long term to maturity and low interest rate yield.

So a bank, if it wants to de-risk its balance sheet in terms of interest rate risk, may consider selling long-term bonds that have low coupon yields. Clearly, long-term zero-coupon bonds have the potential for high interest rate sensitivity.

To illustrate, consider the following information reported for European sovereign bonds for 3 April 2011 (Financial Times).


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Ten-year Sovereign Bond Spreads

Country Latest Yield Spread over the Bund yield

Spread over the US T-Bond yield

Greece 12.98% 9.61 9.53

Italy 4.85% 1.47 1.40

Portugal 8.71% 5.33 5.25

Spain 5.38% 2.01 1.93

France 3.73% 0.35 0.28

102.4: Ten-year sovereign bond spreads

The indicated spreads (e.g., for Greece, 9.61 percent over the equivalent German 10-year bund yield and 9.53 percent over the similar US bond yield) for the various countries’ debt means that, relative to the German 10-year bund, there are high levels of risk premium for perceived default risk for Greek bonds compared to similar German and French bonds.

Rating agencies such as Moody’s and Standard & Poor’s have created bond-rating categories for credit risk. These apply to all bonds – sovereigns and corporates. Corporate bonds typically have varying degrees of credit risk – the risk of default in the sense that the bond’s cash flow is not known with certainty. It is important to note that the borrower has only promised to repay the lender the declared cash flows. But if there is a risk of default, for example, then the lender must estimate the probability of receiving the cash flows in full and on time. In the first case, the lender’s return is promised and is called yield to maturity (YTM); in the second case, the lender’s return is an expected rate of return.

The rating classification for Moody’s is as follows: in the top four categories, the bonds are rated as investment grade ranging from Aaa to Baa with Aaa being the highest quality debt and lowest default risk. Below Baa, the five categories are below investment grade and have high levels of probability of default. A rating downgrade can lead to a much higher cost of borrowing as investors such as banks seek higher expected rates of return.*

Moody’s Standard & Poor’s

Aaa AAA

Aa AA

A A

Baa BBB

Ba BB

B B

Caa CCC

Ca CC

C C,D

102.5: Rating classifications

These widened spreads have raised some concerns about the manner in which banks calculate risk-weighted assets (RWAs), especially if they are investors in sovereign bonds of countries such as Greece. The reason we indicate this point is that currently government debt is assumed to be free of default risk when held in trading books. That is, there is capital for credit risk but only to cover interest-rate risk. But bonds that are rated AA- or better (see S&P rating above) that are held in the banking book require no capital allocation. In fact, regulators also typically allow banks to hold zero capital against bonds issued by their own government, regardless of the rating.

* It is interesting to note that on 10 March 2011, Moody’s cut Greece’s credit rating by three notches, citing an increased default risk, to B1 from Ba1 – lower than Egypt – raising Greek bond spreads even further over German bunds.


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“It’s the banking book treatment that is more significant. Last year’s EU-wide bank stress tests found a huge disparity between the size of trading and banking book exposures – as examples, BNP Paribas had €91.3 billion of EU government bond exposure in its banking book, and only €4.6 billion in its trading book; UniCredit’s split was €58.8 billion and €23 billion; Barclays Capital’s was £35 billion and £7.4 billion.” Source: Risk.net 31 March 2011

In summary, banks may buy bonds – sovereign and corporates – as alternative form of lending via the capital markets. This being the case, lending positions can be terminated at the bank’s discretion by selling the bond before maturity. However, there is interest rate risk, especially for long-term bonds with low yield-to-maturity and low coupon yields – in which case, the degree of interest rate risk is high. There can also be considerable risk as manifested in debt ratings provided by rating agencies or by yield spreads relative to the US Treasury bond or to the German bund.

(2) Mortgage-Backed Securities (MBS)

The simplest form of a mortgage-backed security is a pass-through version. It is similar to a bond. Let’s see how this is the case. First, we define the concept of securitisation. This is the process by which a set of assets are pooled and securities representing financial interests in the pool are issued to investors. Typically, the owner of the assets (i.e., the originator) sells the assets to a special purpose vehicle (SPV) which is set up just for the purpose of facilitating the securitisation process. To pay for the assets it bought from the originator, the SPV borrows funds from investors (i.e., like a bond) who receive in return securities that promise future cash payments. So to be succinct, creating bonds with a pool of loans as collateral involves a process called securitisation. There is a key point here as well. The risk of payment to bondholders comes from the assets in the pool rather than from the bank that originated the assets.

Let us take the example of mortgage-backed securities (MBS).

A bank issues mortgages to homeowners. It then pools five-year mortgages that are insured by a government agency. It sells this pool of mortgages to an SPV that purchased them with funds obtained from investors. This is a true sale, which means that the originating bank can remove the mortgages from its balance sheet. The homeowners who obtained the mortgages from the originating bank promised to make monthly payments that comprise interest and principal repayment. Homeowners have an option to repay the full or partial principal outstanding, although above a certain percentage of voluntary repayment normally a prepayment penalty exists.

The originating bank will receive monthly payments from homeowners and will pass these payments – less a servicing fee – to the SPV. Monthly payments will be made to the holders of the MBS. Note that cash flows to investors may be unpredictable and variable since homeowners have the option to prepay their mortgages and so payments are accelerated to investors. This is a prepayment risk borne by investors.

There are two points of interest in this example. First, the originating bank has sold off its mortgage obligations to a SPV which now owns the assets on behalf of its investors. The mortgages are now off the balance sheet of the original bank, which still earns a servicing fee. From a regulatory perspective, the bank has less asset risk and hence less capital requirement.*

The second point is that banks may also be an investor in mortgage-backed securities and may incur several sources of risk. We know that prepayment risk probably occurs when market interest rates are relatively low, making the reinvestment of cash flows received by the investor

* As reported in the Financial Times (2 March 1011), US regulators have crafted the broad outlines of the new rule that will require mortgages to carry a (down-payment) of at least 20 percent before banks can fully securitise them. Banks will be forced to retain 5 percent of the credit risk on loans they originate with down-payments of less than 20 percent.


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unattractive. There is also the likelihood of credit risk. While some residential mortgage-backed securities (RMBS) may be guaranteed by a government agency, this is not always the case.* Hence, default risk may be present especially for those mortgages that are not guaranteed by the full faith of the government. To see this point, it is probably useful to note the categories of residential mortgages that are used in the origination process and hence affect the extent of credit risk faced by the investor.

Prime mortgages taken out by highly qualified borrowers with full documentation and strong financial background.

Alt. A (or Alternative A) mortgages, with highly qualified borrowers that do not conform to high standards in some particular way. They may have higher loan-to-value ratios or less than conforming documentation etc.

Subprime mortgages where borrowers have poor but unverifiable sources of income or wealth. There is a high probability that these borrowers will have difficulty meeting the repayment schedule.

Furthermore, banks may invest in MBS where the originating mortgages are on assets other than residential. These include commercial mortgage-backed securities (CMBS) where the underlying assets are office buildings, retail malls etc. CMBS also present a potential for high default risk determined mainly by economic conditions.

In summary, banks may originate MBS and thereby remove the initial mortgages from their balance sheets, rendering less capital requirement for risk. Banks may also invest in MBS for more frequent income receipts compared to traditional bonds. But there are risks of prepayment as well as default.

(3) Covered Bonds

A covered bond has similarities to a mortgage-backed security (MBS) which we discussed earlier. A covered bond is backed by cash flows from a pool of assets such as high-quality mortgages or sovereign loans that are dedicated to cover the bond. The pool of assets that cover the bond remains on the balance sheet of the issuing corporation. This is unlike an MBS where a true sale occurs. For the covered bond, the dedicated pool of assets remains on the balance sheet of the corporation. Should the corporation experience financial difficulties and go bankrupt, the covered pool is exempt from bankruptcy dissolution. Thus compared to conventional bonds, investors of a covered bond have an additional source of protection.

There is a key advantage to credit institutions. As stated by Avesani, Pascual and Ribakova†, “covered bonds help credit institutions gain access to an alternative stable and relatively cheap funding source in an environment of increasing reliance on wholesale funding as opposed to a core deposit base”.

Banks invest in covered bonds as a relatively low-risk investment since there is a double layer of protection: the issuing bank and the covered pool of assets. However, banks may also issue covered bonds to build up their funding base. This type of transaction would constitute a liability for the issuing bank. Recently, Reuters (24 March 2011) reported that draft legislation in Australia proposes that banks can issue up to eight percent of their assets in Australia in covered bonds. Data provider Dealogic shows that, for the first quarter of 2011, foreign banks sold almost $11

* An excerpt from the website of the US Securities and Exchange Commission states, “Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a US government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), US government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the US government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the US government, have special authority to borrow from the US Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitise mortgages, known as ‘private-label’ mortgage securities.”† “The Use of Mortgage Covered Bonds”, IMF Working Paper 07/20.


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billion of covered bonds backed by a covered pool of mortgages in the US.

Not unexpectedly, the yields on covered bonds have recently narrowed as the demand for these securities (especially in light of the recent European sovereign crisis) have accelerated. Yet, after deposits, covered bonds remain a relatively cheap source of funding for banks.

Finally, as we discuss in Retail Banking II, Basel III gives covered bonds preferential status in the liquidity-coverage ratio as the only bank asset eligible for the liquidity buffers, which is an essential safety net for investors concerned about future economic shocks.*

We conclude the discussion so far with a description of equity and its renewed importance under Basel II. Recall that Equity = Assets – Liabilities. This means that the book value of equity is the book value of assets less the book value of liabilities, even though these individually may be accounted for on market value. Clearly, the market value of a bank is the number of shares outstanding multiplied by the price per share in the stock market. The market value of the bank is called the market capitalisation, or market cap for short. For example, the market cap for Bank of America on 7 April 2011 was $137.75 billion, while the book value of equity is calculated as assets ($2,265 billion) less total liabilities ($2,037 billion) for a value of $228 billion. It’s worth noting that the market value of Bank of America is actually less than the book value of the company. This has implications for the expected future development of economic profit that will be discussed in the RB II module Asset and Liability Management.

Goodwill

Goodwill is an intangible asset on the bank’s balance sheet. An intangible asset is one that is an identifiable non-monetary asset without physical substance, a bank brand being an example. Goodwill arises only when it is externally purchased, and this happens only when it is part of the purchase price paid to acquire another company. Specifically,

Goodwill = Purchase Price of the Acquired Business – The Fair Market Value of Net Assets. The fair market value of net assets is the fair market value of assets less the fair market value of liabilities at the acquisition date.

In effect, Goodwill is the monetary value that the acquiring firm paid for the intangible characteristics of the acquired company or set of assets. For example, ING Bank purchases the branch network of another bank located in Brussels. The assets that are being considered include the physical branches, ATM network, information technology (including customer database) and information systems (IS). Valuation experts from the mergers and acquisition department of ING estimate that the assets are currently worth €10.5 million. ING Bank pay €10.8 million for the assets, all in cash. The accounting will show that assets on ING Bank’s balance sheet will reduce cash by €10.8 million, assets will increase by €10.5 million and goodwill will increase by €0.3 million.

Goodwill may be impaired,† in a similar way as tangible assets such as real estate may be subject to depreciation. An impairment test involves two steps. The first step is to identify potential impairments by comparing the fair value of a reporting unit to its carrying amount. Goodwill is not considered impaired as long as the fair value of the unit is greater than its carrying value. The second step is only required if an impairment to goodwill is identified in step one. So for example, if the bank currently reports the value of the business as €10.80 million but it is determined that the current fair value of the assets is €10.82 million, then there is no impairment of the goodwill and the process ends. But if the current fair value is determined to be €10.75 million, the goodwill is impaired.

* “Uncertainty in the sovereign market is having a direct spillover on covered bonds,” said Claus Tofte Nielsen, who helps oversee the equivalent of €430 billion at Norges Bank Investment Management in Oslo. In addition, “after retail deposits, covered bonds are considered as the cheapest funding source for banks despite the increase of yields in the last days,” said Frank Will, head of frequent borrower strategy at RBS in London. (Bloomberg, January 2011).

† According to IAS 36.6, an asset is impaired when its carrying amount exceeds its recoverable amount.


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The second step is to compare the implied fair value of goodwill to its carrying amount, where the implied fair value of goodwill is computed on a residual basis, that is, by subtracting the sum of the fair values of the individual asset categories (tangible and intangible) from the indicated fair value of the reporting unit as determined under step one. If the carrying amount of goodwill exceeds its implied fair value, an impairment loss is recognised. That loss is equal to the carrying amount of goodwill that is in excess of its implied fair value, and it is presented on the income statement as a deduction from income. Hence impairment not only reduces the asset value (and hence the equity value) but also reduces the net profit of the corporation.

Tests for goodwill impairment are typically conducted once annually, but may be done more frequently if it is deemed necessary by the chief financial officer (CFO).

Finally, we consider the category of tangible assets on the bank’s balance sheet.

Fixed Assets

For the bank, fixed (i.e., longer term) assets include owned real estate (e.g., bank branches, head office), IT, ATM network, computers and telecommunications equipment etc. Generally, these assets are recorded as net of depreciation. Depreciation is a non-cash expense that reduces taxable profit. Here is an example:

The book value of real property, at the beginning of the reporting period, is $10 million.

Depreciation is calculated on a straight-line basis for an expected economic life of 25 years. This means that 1/25 = 4 percent of the current value of the real property is depreciated. This value is 4 percent of $10 million = $0.4 million. At the end of the reporting period, the real property has a net value of $9.6 million on the asset side of the balance sheet. On the income statement, the taxable profit is reduced by $0.4 million. The net effect of depreciation is to reduce the taxes that would have been due. As a general formula, if the total amount of depreciation on all assets is $X, and the corporate tax rate is T, then taxes due are reduced by T*$X. In our example, if the corporate tax rate is 30 percent, then the reduction in taxes due to depreciation is 30%*$0.4 million = $0.12 million.

We now consider the income statement of a retail bank.


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Chapter 4: The Income Statement of a Retail Bank

The income statement documents the sources of revenue and expenses for the bank over a specific period (e.g., a quarter). The most important source of income for a retail bank is interest income. This is the income earned on interest-bearing assets. As discussed in Chapter 3, interest bearing assets include loan products (i.e., loans, mortgages) and investments (i.e., reverse repos, bonds, covered bonds, mortgage-backed securities). The net interest income is equal to income earned on interest-bearing assets less the interest paid to depositors and other sources of funding.

Sources of non-interest income for a retail bank are:

(i) Commission income arising from management fees, brokerage and advisory fees, and funds transfer.

(ii) Investment income arising from rental income, dividend income and realised gains/loss on equities/bonds. Value changes of assets in the trading book are recorded in the income statement.

The conventional wisdom in the banking industry is that earnings from fee-based products are more stable than interest-based earnings, and that fee-based activities reduce bank risk via diversification. However, there is evidence that this is not necessarily the case.* It is likely that non-interest income (especially for large banks) is less stable than interest income due to trading losses and write-downs.

The main sources of expenses are:

a) Operating expenses, which are dominated by staff expenses (not surprising since banking is a ‘people business’). But there are also other sources in operating expenses. These include IT costs to support the bank’s operations and operations depreciation as well as lease costs for real estate (including branches), computer equipment, software costs etc.

b) Additions to loan loss provisions

* Staikouras et al, “Bank Non-Interest Income: A Source of Stability?” (2000), finds evidence that non-interest income is less stable than interest income


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We have already discussed at length (see Chapter 3) loan loss provisioning as an expense in the income statement.

Based on these main categories of sources of income and expenses, we can create an income statement. A generic income statement is constructed as follows:

Interest result +

Commission Income +

Investment Income +

Other (e.g., trading income) =

Underlying Income (UI)

– Operating Expenses (OPEX)

= Gross Profit (i.e., GP=UI-OPEX)

– Additions to Loan Loss Provisions

= Underlying Profit Before Tax

– Taxes Due

= Net Profit After Tax

102.6: Generic income statement

We now derive some important banking ratios from the information found in the retail bank’s balance sheet and income statement.

Selected Retail-Banking Ratios

From the balance sheet and income statement, the following selected banking ratios may be calculated.

Cost Income Ratio (CIR)

A traditional non-financial institution considers operational margin as a measure of efficiency. In this case, operational margin is defined as the ratio of operating profit to operating revenues, and operating profit is the difference between operating revenues and operating costs. Hence an operating margin of, for example, 30 percent means that for every dollar of operating revenues, 70 cents of operating costs are incurred.

In a retail bank, a related measure of operational efficiency is cost income ratio (CIR). Whereas for a non-financial institution the higher the operating margin, the greater the efficiency of the institution, in the case of a bank, the lower the cost income ratio, the more efficient it is.

Specifically,

CIR= OPEX UI where UI = underlying income and OPEX = operating expenses.


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In other words, in the calculation of cost income ratio, only operating expenses are considered – meaning that additions to loan loss provisions are excluded. Underlying income is the sum of both net interest and non-interest income where the latter includes commission income, investment income and trading income.

Here is an example based on the public release of the third-quarter financial results (2010) of ING Bank.* All numerical entries are in millions of euro.

Interest result 3,404

Commission income 645

Dividend income 64

Other income (e.g., trading income) 228

Operating expenses 2,454

Gross Profit 1,887

Addition to loan loss provisions 374

Underlying Profit before tax 1,513

102.7: Financial results of ING Bank

Note that underlying income = 3,404 + 645 + 64 +228 = €4,341 million. Based on this data, it is clear that the cost-income ratio for ING Bank is operating expenses divided by underlying income = 2.454/ 4,341 = 56.5%. This means that it requires 56.5 cents to earn €1 of underlying income.

The relationship between gross profit and cost-income ratio is observed from the following algebraic calculation:

Gross Profit = Underlying Income (UI) minus Operating Expenses (OPEX) = UI*(1- CIR). Clearly, there is a negative relationship between cost-income ratio (CIR) and gross profit (GP). A lower value of cost income ratio leads to a higher gross profit. Academic research has provided evidence to support this relationship. For example, Mathuva† (as well as several references therein) found a negative relationship between CIR and a bank’s profitability.

It is interesting to note that a key determinant of CIR is interest result. This is not surprising since interest result is a predominant proportion of the retail bank’s total underlying income. For example, for ING Bank (Q3, 2010), we see that interest result at 3,404/4,341 is equal to 78 percent of total underlying income. Consequently, while research has found a negative relationship between CIR and a bank’s profitability, a plausible hypothesis is that there is a negative relationship between interest result and CIR. This hypothesis was tested for European banks by Burger and Boorman (2008).‡ They found a statistically significant negative relationship between interest result and CIR for banks in selected European countries between 2002 and 2007. This indicates that interest result is a strong component of CIR and, hence of bank profitability.

Finally, we note that CIR should be viewed with caution. This is because CIR may rise even if actions taken to reduce operational costs are successful. This is because underlying income may fall faster than operational costs. A low CIR may also be accompanied by high loan loss provisions which could result in a lower Underlying Profit before tax.

We now consider two closely related margins – net interest margin (NIM) and net interest spread (NIS).

* See ING Group website.

† D. M. Mathuva, “Capital Adequacy, Cost to Income Ratio and Performance of Commercial Banks: The Kenyan Scenario”, The International Journal of Applied Economics and Finance, 3(2): 35-47, (2009).

‡ A. Burger, and J. Boorman, “Productivity in Banks: Myths and Truths of the Cost-Income Ratio”, Banks and Bank Systems, Vol 3, Issue 2, 2008.


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Net Interest Margin (NIM) and Net Interest Spread (NIS)

We develop both margins and then discuss their relationships and their relative importance as indicators of bank profitability.

As we defined above and repeat here for reference, interest result = interest income – interest expense. Sources of interest income are derived from the asset side of the balance sheet and include cash equivalents (i.e., reverse repos); loan products (i.e., loans and mortgages); investments (i.e., bonds, mortgage-backed securities, listed equities). Clearly, this would exclude assets such as property, IT and IS. Interest expense would include payments on deposits and other forms of funding including wholesale funding and debt financing.

Next, we define net interest margin,

Net Interest Income Interest Income Interest Expense

Interest Earning Assets Interest Earning Assets Interest Earning AssetsNIM = = –

Note that NIM is not a measure of the bank’s total profitability since it excludes other sources of income such as fees and investment income and does not include operating expenses such as staff and IT costs etc.

To link NIM to net interest spread (NIS), we define:

NIS = Interest Income Interest Expense

Interest Earning Assets Interest Bearing Liabilities -

In other words, NIS is the difference between the bank’s asset yields and its funding costs. Retail banks rely mostly on deposits to fund interest earning assets and so would incur lower funding costs. But relying on a large number of retail clients would lead to a higher level of operating expense, probably leading to a relatively high CIR. Asset yield is interest income divided by the interest-earning assets on the balance sheet.

Consider the following information on NIM and NIS released by Deutsche Bank as part of its financial results for the full year, 2009.

Total interest income €26,953 million

Total interest expense €14,494 million

Average interest-earning assets €879,601 million

Average interest-bearing liabilities €853,303 million

Gross interest yield (i.e., asset yield) 3.06%

Gross interest rate paid (funding costs) 1.70%

NIS 1.36%

NIM 1.42%

102.8: Financial results of Deutsche Bank


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We present some calculations that would explain the data in the table and highlight the use of the formulae for NIM and NIS presented above.

1. Net interest result = €26,953 million - €14,494 million = €12,459 million. Hence, NIM = €12,459 million / €879,601 million = 1.42%

2. Gross interest rate paid (i.e., funding costs) = €14,494 million / €853,303 million = 1.70%

3. Gross interest yield (i.e., asset yield) = €26,953 million / €879,601 million = 3.06%. Hence, NIS = 3.06% –1 .70% = 1.36%

Since interest-bearing liabilities are less than interest-earning assets, we see that NIM is greater than NIS.

We now consider another ratio that measures the extent to which a bank depends on non-deposit funding that is normally more expensive and risky. This is the ‘loan-to-deposit’ ratio (LTD).

Loan-to-Deposit Ratio (LTD)

Loan-to-deposit ratio is defined as

LTD =

Loans($)

Deposits($)

Importantly, this ratio is a measure of risk since if the value of LTD is above the average of the industry, it may suggest that the bank is over-relying on the more risky (and more expensive) wholesale funding. This could lead to a higher level of funding uncertainty and if banks face liquidity problems in the future, they may react by substantially de-risking and de-leveraging their respective balance sheets. Indeed, it is found that “an increase in funding uncertainty induces highly extended banks with high loan-to-deposit ratios to essentially reverse their prior strategy: they now cut back on their loan commitments, while at the same time trying to attract a larger deposit base with higher interest rates.” * Ritz (2010) cites the example of the Royal Bank of Scotland that “had high loan-to-deposit ratios at the outset of the financial crisis and was heavily dependent on wholesale funding”. In response, they have now set themselves the aim of reducing their loan-to-deposit ratios to no more than 100 percent.†

Finally, we conclude this chapter with a popular metric – return on equity.

Return on Equity (ROE)

Return on (shareholder) equity is defined as

ROE = Net Profit After Tax

Equity

Clearly, ROE is a measure of shareholder profitability. For example, an ROE of 15 percent means that net profit after tax is 15 percent of the book value of shareholder equity. Obviously, there is an expectation of higher ROE for high-growth markets. As evidence of this, HSBC reported an ROE of 21.1 percent for the Asia region in 2010, which was twice the ROE for the bank as a whole.

An implication of Basel III (more analysis in Retail Banking II), which requires banks to hold more equity capital, is a negative effect on ROE in that the same net income will be spread over a larger equity base. Indeed, as reported in the Taipei Times on 1 March 2011, HSBC has cut its ROE targets substantially. “We’ve targeted 12 to 15 percent through the cycle for return on equity, principally

* Ritz , “How Do Banks Respond to Funding Uncertainty?”, Oxford University, 2010.

† ING Group has responded to the financial crisis with a new strategy of de-risking and de-leveraging called, ‘Back to Basics’.


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taking into consideration what we view as a somewhat unstable and uneven economic recovery over the coming years, as well as much higher capital requirements,” Iain Mackay (the finance director) said. HSBC’s decision to cut back its return on equity targets followed a similar move by rivals Barclays and Credit Suisse. Both those lenders scaled back their profitability expectations, saying that their returns would be held in check by regulatory requirements to hold more capital.

One of the main drawbacks of ROE is that, as a profitability measure, it does not account for the risk that was taken to earn the net profit on equity. This is an important limitation of ROE. Clearly, a high net profit could be earned by taking substantial risks to earn trading income. The ROE in this case could be very high, but on a risk-adjusted basis, it might represent a relatively poor performance.* There are other limitations.

When write-downs or impairments occur, the asset values are represented by their net values. This leads to a reduction in the book value of equity, and hence the ROE could experience an increase when in fact the profitability of the bank has not improved. A similar consequence is expected if a company engages in share-buybacks. The effect is to reduce the book value of equity.

Summary

This module covered an extensive overview of retail banking, from viewing banks as financial intermediaries to considering the roles that a retail bank serves in the real economy. We also considered the typical sources of funding (i.e., the liability side of balance sheet) that include retail deposits and wholesale funding. Later, we considered the asset side of the balance sheet that includes loan products (i.e., loans and mortgages) and the risks embedded in the banking book and trading book. Next, we presented an analysis of the income statement showing that the interest result is the main source of income for a retail bank. We also showed, as is typical for any people business, that staff costs dominate operating costs. Finally, the module concluded with the calculation of common retail banking metrics such as net interest margin (NIM), net interest spread (NIS), return on equity (ROE) and cost income ratio (CIR).

* For this reason, we will consider, among other metrics, risk-adjusted return on capital (RAROC) to incorporate risk through economic capital. Some banks also calculate return on Tier 1 capital as well as return on core Tier 1 capital. These metrics will be considered in Retail Banking II.


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Multiple Choice Questions

1. You are given the following statements.

a) Assets = Liabilities + Shareholder Equity.b) Deposits are part of a bank’s assets.c) Loan Loss Reserve is set aside to cover unexpected loan loss.

Which of the following options is correct?

I) Only a) is correctII) Only c) is correctIII) Statements a) and b) are correctIV) All statements are correct

2. You are given the information that probability of default on a loan is 1 percent and that the recovery rate is 95 percent for a loan with an outstanding value of $500,000. The expected loss is:

a) $300b) $250c) $500d) None of the above

3. Which is incorrect?

a) A high loan-to-deposit ratio may signal a bank’s over-reliance on wholesale funding.b) The banking book is exposed mainly to credit risk.c) A covered bond is an off-balance sheet item.d) A bond issued by a government is called a ‘sovereign’.

4. Which of the following statements is incorrect?

a) Goodwill is an intangible asset.b) Deposits are a bank liability.c) The Euribor is a euro-priced bank-to-bank lending rate.d) A bank that sells collateral in a repo transaction is a lender.

5. Suppose that cost decreases by 2 percent and income decreases by 1 percent , then the cost income ratio will:

a) Increase by 2 percentb) Decrease by 2 percentc) Increase by 1 percentd) Decrease by 1 percent


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6. A retail bank incurs a relatively high degree of leverage if

a) Loan to value ratio is high b) Assets to deposits ratio is high c) Net interest spread is lowd) Volatility of net earnings is low

7. A 3 percent coupon bond is priced to yield 3 percent. This bond is selling at:

a) Premium to parb) Discount to parc) Par

8. The income statement of a bank shows the following information with all monetary values stated in millions of euro.

Total sources of income =1000; total operating cost = 620 and addition to loan loss provisions = 80.The cost income ratio is:

a) 70 percentb) 62 percentc) 8 percentd) None of the above

9. Which statement is correct? One of the drawbacks of ROE as a financial metric is that:

a) it is not suitable for use at the bank level. b) it is not risk-adjusted.c) it only captures the profit earned from the banking book.d) it only captures the profit earned from the trading book.

10. Which statement is incorrect?

a) Goodwill may be subject to impairment.b) Net Interest Margin is higher than Net Interest Spread.c) Provision for loan losses is included in the cost income ratio.d) The recent financial crisis has shown that sovereign bonds are not risk-free.

Answers:

1 2 3 4 5 6 7 8 9 10

I b c d d b c b b c


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