THE BUSINESS OF BANKINGChapter 11

Transactions Costs• Debt serves a useful purpose in matching those who currently have

greater income than consumption to those with greater consumption than income.

• However, matching buyers and sellers involves some costs. Intermediaries develop to reduce these costs.

1. Pooling Savings •Take advantages of economies of scale

•Diversify Risks• Safekeeping of Assets

2. Providing Liquidity •Reduce transactions costs by allowing depositors to convert assets into cash.

3. Reduce Information Costs

•Ameliorate asymmetric information

Link

Hong Kong Banking Industry• Three Tier Structure

Fully Licensed Banks-22 Locally Incorporated

-164 Foreign Incorporated

Restricted License Banks: Securities Companies- 20 RLB’s

Deposit Taking Corporations: Finance Companies- 23 DTC’s

Link

Licensed banks incorporated in Hong Kong

At 17 October 2014

BANK OF EAST ASIA, LIMITED (THE) 1

HONGKONG & SHANGHAI BANKING CORPORATION LIMITED (THE) 1SHANGHAI COMMERCIAL BANK LIMITED 1

CITIBANK (HONG KONG) LIMITED 2

DBS BANK (HONG KONG) LIMITED 2

OCBC WING HANG BANK LIMITED 2

PUBLIC BANK (HONG KONG) LIMITED 2

STANDARD CHARTERED BANK (HONG KONG) LIMITED 2

BANK OF CHINA (HONG KONG) LIMITED 3

CHINA CITIC BANK INTERNATIONAL LIMITED 3

CHINA CONSTRUCTION BANK (ASIA) CORPORATION LIMITED 3

INDUSTRIAL AND COMMERCIAL BANK OF CHINA (ASIA) LIMITED 3

NANYANG COMMERCIAL BANK, LIMITED 3

CHIYU BANKING CORPORATION LIMITED 4CHONG HING BANK LIMITED 4DAH SING BANK LIMITED 4FUBON BANK (HONG KONG) LIMITED 4HANG SENG BANK, LIMITED 4TAI SANG BANK LIMITED 4TAI YAU BANK, LIMITED 4WING LUNG BANK LIMITED 4

1. Modern Local2. International3. China State4. Native

+Bank of Communication 3

Historical Origins1. Modern Local Banks: Pre-war banks. (HSBC, Bof

EA,).2. International Banks –. (Citibank, StanChart, DBS)3. Chinese State Banks – Chinese government set up

banks in HK in pre-war era. After the revolution, these were taken over by PRC. Due to the isolation of PRC, these banks were the main link between the mainland and the world financial system (Bank of China, Nanyang Commercial)

4. Native Banks – Banks that serviced the rapidly growing retail markets for small deposits and loans during the immediate post-war migration of immigrants from the mainland (Hang Seng, Wing Lung, Dao Heng and many others)

Licensed Banks Aggregate Balance Sheets

Sep-15HKD Million HKD Million

Assets (AS) $19,064,516 Liabilities (LB) $19,064,516Notes and Coins $31,730 Amount Due to Authorized Institutions in HK $1,039,478Amount Due from Authorized Inst in HK $879,642 Amount Due to Banks Abroad $3,786,284Amount Due from Banks Abroad $4,233,518 Deposits from Customers $10,659,279Loans and Advances to Customers $7,560,040 NCD Outstanding $729,320NCD Held $369,791 Other Debt Instruments Outstanding $300,271Negotiable Debt Instruments (NDI) $3,699,709 Capital, Reserves and Other Liabilities $2,549,885Investments in Shareholdings $163,743Interest in Land and Buildings $200,183Other Assets $1,926,161

Multiple Currency Deposits• Hong Kong banks accept large amounts of foreign currency deposits.

• Small market for Foreign currency loans in Hong Kong.

• HK banks lend money to banks overseas, multinational banks lend money to firms overseas.

01-J

an-9

1

01-O

ct-9

2

01-J

ul-94

01-A

pr-9

6

01-J

an-9

8

01-O

ct-9

9

01-J

ul-01

01-A

pr-0

3

01-J

an-0

5

01-O

ct-0

6

01-J

ul-08

01-A

pr-1

0

01-J

an-1

2

01-O

ct-1

3

01-J

ul-15

0

1000

2000

3000

4000

5000

6000

HK$: LB: Deposits from Customers

HK$: Loans and Advances to Customers

FC: Loans and Advances to Customers

FC: LB: Deposits from Customers

HK

D B

illi

on

Link

Bank Assets1. Cash Items Primary Reserves (Vault cash + Clearing Balances), Current

Balances at Other Banks.2. Loans Interbank Lending, Advances to Customers3. Securities Government Bonds, MBS, Corporate Debt, Large CD’s, Stocks. 4. Other Assets Land, Buildings, etc.

p. 31

1. Checkable & Non Transactions

Deposits: Checking accounts,

current accounts, demand

deposits,savings deposits, time

deposits, certificates of deposit.

2. Borrowings: Discount window borrowing,

borrowing in interbank market.

3. Other Liabilities: Subordinated debt,

deferred tax liabilities

Hong Kong Interbank Market• Hong Kong deposit market dominated by big branch

networks many smaller banks raise funds by borrowing from big banks.

• Until 2001, HK limited branch networks of foreign banks. Foreign banks finance HK lending with loans from overseas parent.

• HK banks accept many foreign currency deposits. Lend that F.C. to banks overseas.

Bank Net Worth/Shareholder Funds: Funds put at risk by the owners of the bank.

• Share Capital: Money raised by selling equity shares in Primary Markets

• Retained Earnings : Profits not (yet) paid as dividends. • Balance sheet typically includes some proposed dividend.• For tax purposes, some retained earnings are classified as other

reserves

Investment Income, etc.

Changes in Value of Subsidiaries etc.

PROFIT =NII + NFI +PLL-OE + NOE -TAX

Profits of Banking:

Interest Income

• Net Interest Income is the

interest rate earned on assets (mainly loans) minus the average interest paid on liabilities (mainly deposits).

• Net Interest Margin Net Interest Margin: Net Interest Income divided by Interest Earning Assets.

Net Fee Income

Mar

, 199

7

Sep, 1

997

Mar

, 199

8

Sep, 1

998

Mar

, 199

9

Sep, 1

999

Mar

, 200

0

Sep, 2

000

Mar

, 200

1

Sep, 2

001

Mar

, 200

2

Sep, 2

002

Mar

, 200

3

Sep, 2

003

Mar

, 200

4

Sep, 2

004

Mar

, 200

5

Sep, 2

005

Mar

, 200

6

Sep, 2

006

Mar

, 200

7

Sep, 2

007

Mar

, 200

8

Sep, 2

008

Mar

, 200

9

Sep, 2

009

Mar

, 201

0

Sep, 2

010

Mar

, 201

1

Sep, 2

011

Mar

, 201

2

Sep, 2

012

Mar

, 201

3

Sep, 2

013

Mar

, 201

40

0.5

1

1.5

2

2.5

Net Interest Margin: Local & Foreign Retail Bank

Fee Income

Capital Adequacy Management

• Compared to non-financials, banks have low capitalization.

• Bank capital is the funds invested by the owners of banks in the bank.

• Three factors affect the decisions of bank owners to finance with equity capital:

1. Bank capital protects against bank failure.2. Bank capitalization affects returns to shareholders3. Government regulations affect capitalization (next chapter)

Bank Failure

• Bank failure occurs when a bank cannot pay its depositors in full.

• Riskier and less liquid assets make bank failure more likely.

• Banks with high levels of capital can have some negative profits and still avoid failure.

• Bank owners need to invest their own funds to offset its own moral hazard issues.

How Bank Capital Prevents Bank Failure

• Consider two banks with identical balance sheets except that Bank A is well capitalized while bank B is poorly capitalized.

Assets Liabilities Assets LiabilitiesReserves $10 Deposits $90 Reserves $10 Deposits $96

Loan $90 Capital $10 Loan $90 Capital $4

How Bank Capital Prevents Bank Failure

• Bad economic times cause borrowers to default on $5 million in loans. This wipes out the capital of the weakly capitalize bank but leave the highly capitalized bank in business.

Assets Liabilities Assets LiabilitiesReserves $10

Deposits $90 Reserves $10 Deposits $96

Loan $85 Capital $5 Loan $85 Capital -$1

Equity to Asset Ratio Commercial Banks

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Jan-

05

Jan-

06

Jan-

07

Jan-

08

Jan-

09

Jan-

10

Jan-

11

Jan-

12

Jan-

13

Jan-

14

USA HK

Equity Multiplier ROA/ROE• This is assets relative to

shareholders equity (i.e. net worth less loan capital)

• A measure of the returns earned on assets is Return on Assets

• Owners of equity are concerned with the pay-off they earn per each dollar originally invested in the bank: Return on Equity

• Equity returns are a positive function of ROA and leverage

ASSETSEM

EQUITY CAPITAL

PROFITSROA

TOTAL ASSETS

PROFITSROE ROA EM

EQUITY CAPITAL

Assets 1,263,990 EM 9.0808

Liabilities 1,124,797 ROA 0.0120Net Worth 139,193 ROE 0.1087Profits 15,131

Capital Management

• Banks face a trade-off with leverage.

• If ROA is typically positive, leverage multiplies ROE.

• Leverage increases the volatility of ROE and increases probability of default risk or reaching regulatory boundaries.

• Capital constrained banks either raise new capital or slow lending growth, usually the latter.

Credit Risk:• Credit Risk: The risk arising from the possibility that the

borrower will default. • Financial Intermediaries in general and banks in

particular exist because of their efficiency in dealing with credit risk.

• Much of credit risk in financial markets occurs due to asymmetric information and its associated phenomena, adverse selection and moral hazard.

Managing Banks: Balance Risks and Returns

• Banks must take risks as part of their business. • Often most profitable activities of a bank will generate

most risks for the banks. • Bank managers must manage risk return trade-offs.

Diamonds in the rough • Banks try to find borrowers who will pay high interest rates but

who are unlikely to default.• Borrowers who are well known to be good credit risks will have

many sources of funds.• Banks need to find information about certain borrowers not

publicly available.

Principles for Maximizing Returns while dealing with credit risk

Strategies for Managing Credit Risk

1. Credit-Risk Analysis – A loan officer manages banks relationship with borrowers and evaluate potential borrowers.

• Loan officers may have some specialization with certain industries or businesses.

• Loan officers also use credit scoring systems which use statistical data to measure default probabilities and charge interest rate commensurate with risk.

2. Monitoring – Loan agreements may contain restrictions on borrower behavior or value of assets. Loan officers monitor behavior and may recall loans if covenants are violated.

Strategies for Managing Credit Risk (cont.)

3. Collateral – Loans identify physical assets which may be taken by the bank in case of default.

4. Long-term Relationships – Banks often have relationships with certain businesses which reduces information problems. elationships have value to businesses which they are loathe to jeopardize by engaging in moral hazard behavior.

Strategies for Managing Credit Risk (cont.)

5. Credit Rationing - Borrowers must seek additional sources of finance for their projects including equity.

6. Diversification – Banks can limit the likelihood of default by reducing exposure to a particular borrower or class of borrower.

• Sometimes there is a trade-off between diversification needs and strategies for finding diamonds in the rough, such as specialization or long-term relationships which may tend to reduce

Measures of Credit Risk• Assessing a bank’s exposure to credit risk, we could

ask 3 questions:

1. What is the historical loss rates on loans and investments?

2. What are the expected losses in the future?

3. How is the bank prepared to weather the losses?

Historical Loss Rate• Loan losses/charge-offs are the loans written off as

uncollectible in any period.• Releases & Recoveries refer to loans written off in the

past but collected or collateral repossessed.• Net loan losses are gross loan losses less recoveries.

Expected Future LossesMeasures• Past Due Loans: Borrowers have not made a scheduled

payment.• Nonperforming Loans: Loans past due for 90 days are

more.

Mar

, 199

7

Sep, 1

997

Mar

, 199

8

Sep, 1

998

Mar

, 199

9

Sep, 1

999

Mar

, 200

0

Sep, 2

000

Mar

, 200

1

Sep, 2

001

Mar

, 200

2

Sep, 2

002

Mar

, 200

3

Sep, 2

003

Mar

, 200

4

Sep, 2

004

Mar

, 200

5

Sep, 2

005

Mar

, 200

6

Sep, 2

006

Mar

, 200

7

Sep, 2

007

Mar

, 200

8

Sep, 2

008

Mar

, 200

9

Sep, 2

009

Mar

, 201

0

Sep, 2

010

Mar

, 201

1

Sep, 2

011

Mar

, 201

2

Sep, 2

012

Mar

, 201

3

Sep, 2

013

Mar

, 201

4

-2

0

2

4

6

8

10

Hong Kong Credit Performance

Overdue > 3 month & Rescheduled Loan: Local & Foreign Retail Bk(LF)

Bad Debt Charge to Average Total Assets: Local & Foreign Retail Bank

Net Chargeoff Rates by Loan TypeSource: FDIC Statistics on Banking

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

Total loans &leases

Total real estateloans

Commercial &industrial loans

Loans toindividuals

All other loans& leases

(including farm)

2004

2003

2002

2001

2013 2011 2009 20070.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Net Chargeoff Rates

Net loans and leases All real estate loans Commercial and industrial loans Loans to individuals

Net Charge-off Rates by Loan TypeSource: USA FDIC Statistics on Banking Link

Dec, 1

990

Nov, 1

991

Oct, 1

992

Sep, 1

993

Aug, 1

994

Jul,

1995

Jun,

199

6

May

, 199

7

Apr, 1

998

Mar

, 199

9

Feb, 2

000

Jan,

200

1

Dec, 2

001

Nov, 2

002

Oct, 2

003

Sep, 2

004

Aug, 2

005

Jul,

2006

Jun,

200

7

May

, 200

8

Apr, 2

009

Mar

, 201

0

Feb, 2

011

Jan,

201

2

Dec, 2

012

Nov, 2

013

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Loans in HK by Type

Financial Concerns

Other Individual

Individual Residential

Construction&Development

Commercial&Industrial

Protection Against Future Losses• Loan Loss Reserve (Allowances for Loan Impairment): Quantity of gross value of loans that have been recognized as being likely to not be repaid.

• Net Loans (which appears as an asset on balance sheet) = Gross Loans – Loan Loss Reserve.

• When banks add to their loan loss reserve, they will deduct from profits.

• When banks charge-off bad loans, they deduct from gross loans and loan loss reserve and net assets are unchanged..

Loan Provisions are a contra-asset (i.e. netted out on asset side of the balance sheet)

Credit Derivatives

Risk Management Tools Used to transfer risk from one party to another.

• Credit Default Swaps (CDS) – A bank with credit risk exposure will pay X basis points per year and counter-party will make payment if there is a pre-determined credit “event” such as default or credit downgrade, etc.

Credit Default Swap

Bank A

Bank B

Fee Payment

Payment if negative credit event

Source: BIS Derivative Statistics

2004-H2

2005-H1

2005-H2

2006-H1

2006-H2

2007-H1

2007-H2

2008-H1

2008-H2

2009-H1

2009-H2

2010-H1

2010-H2

2011-H1

2011-H2

2012-H1

2012-H2

2013-H1

2013-H2

0

5000000

10000000

15000000

20000000

25000000

30000000

35000000

40000000

45000000

50000000

All counterparties (gross)

Liquidity Management• Majority of Bank liabilities (deposits) are very Liquid.

1. Banks provide payment mechanism to customers and are able to raise funds at low interest as a result.

2. Liquidity advantage of depositors helps overcome asymmetric information advantage of bankers.

• Most profitable bank assets, loans, are illiquid. 1. Banks particular expertise is in analyzing and monitoring

long-term investment projects. Often expertise about a given project is specific to the bank itself and can’t be transferred. Banks loan portfolios are highly illiquid.

Liquidity Risk: The possibility that creditors may collectively decide to withdraw more funds than the bank has on hand.

Managing Liquidity• A bank faces withdrawals of $5 million.

• This reduces liquidity. The bank can restore liquidity by managing assets or liabilities. Liquidity can be restored by converting secondary reserves (market securities) into primary reserves (cash).

Assets Liabilities

Cash - $5 Checkable Deposits -$5

Assets Liabilities

Cash +$5Securities -$5

• The bank can also engage more short-term liabilities by increasing borrowings from other banks or central bank.

Assets Liabilities

Cash +$5 Borrowings+$5

Core Deposits vs. Managed Liabilities• Bank Liabilities can be divided into two parts.

1. Core Deposits – Demand Deposits, Savings Accounts, Small Time Deposits (Retail Funds)

2. Managed Liabilities – Borrowings from Other Banks, Commercial Paper, Large CD’s and Time Deposits (Wholesale Funds)

• Retail funds have lower interest costs and are thought to be more stable. They take much longer time to raise and have greater non-interest costs.

Measuring Liquidity Risk

Loan to Deposit Ratio – Ratio of illiquid loans to liquid deposits. High measure of loan-to-deposit ratio indicates high liquidity risk.

Interest Rate Risk: Income Side

• Interest Rate Risk – The risk to an institution's income resulting from adverse movements in interest rates

• Many bank liabilities are of very short maturity (such as saving deposits) whose interest changes with market interest rates.

• Many bank assets are long-term and interest income may not change as market interest rate rises.

• When market interest rates rise, NIM will decline.

Managing Interest Rate Risk

• A bank which has a large stock of assets which will pay a fixed interest rate may face losses if market interest rates rise.

• Since deposits must be redeemed at any time, the bank must offer market interest rates. If market interest rates rise, loan spreads will be cut.

• Banks may use asset and liability management to match the sensitivity of assets and liabilities to interest rates.

Interest Rate Risk: Balance Sheet Perspective• An asset (or a liability) represents a set of payments that

must be made at times in the future. • Define PVT as the present value of a future payments made

to an asset or a set of assets in T periods.

• Useful Approximation

(1 ) 1T

FACE PV iPV T

i PV i

PVFACE T i= .1 I = .11 Δi/(1+i) ΔPV ΔPV/PV ΔPV/PV/Δi/(1+i)

100 1 90.90909 90.09009 0.009091 -0.819 -0.00901 -0.99099100 2 82.64463 81.16224 0.009091 -1.48238 -0.01794 -1.97305100 3 75.13148 73.11914 0.009091 -2.01234 -0.02678 -2.94627100 4 68.30135 65.8731 0.009091 -2.42825 -0.03555 -3.91072100 5 62.09213 59.34513 0.009091 -2.747 -0.04424 -4.86648

Duration Measure of Interest Rate Risk

• Define market value, MV, of an asset or a set of assets as the sum of present values derived from payments made in each future period.

• Define the duration of an asset as d

• The % change of the market value of an asset to a change in the interest rate is approximately proportional to the duration of an asset.

T

ttPVMV

1

T

t

t

MV

PVtd

1

i

id

MV

MV

1

Measuring Interest Exposure

• Calculate the duration of a banks assets, dA. Calculate the duration of a banks liabilities, dL.

• An increase in the interest rate will have the following effect on assets and liabilities.

• Calculate the GAP as a function of duration of assets and liabilities.

i

id

A

AA

1

i

id

L

LL

1

A L

LD GAP d d

A

An increase in interest rates changes the value of a banks assets and liabilities.

i

i

A

Ldd

A

L

i

id

i

id

A

L

L

L

A

A

A

L

A

A

A

NW

LALA

111

1

1

NW NW NW iGAP

A NW A iNW i

EM GAPNW i

Floating Rate Loans

• Fixed payment loans have a constant payment based on a fixed interest rate.

• Floating rate loan payments are based on an interest rate that changes as some benchmark interest rate changes

• Floating rate loans protect NIM from interest rate margins.• Almost all mortgages in HK are floating rate.

Swaps• Basic (plain vanilla) interest rate swap is agreement by

two parties to exchange interest rate payments on a notional principal.

• One party pays a fixed interest rate for a pre-determined period of time. Another party pays a floating rate equivalent to some benchmark interest rate (LIBOR, etc.)

Swaps and Hedging• If a bank has long-term fixed rate assets and short-term

liabilities, they face interest rate risk. Solution: Swap income from fixed rate assets for floating rate from dealer.

• A pension fund with long-term obligations may like to lock in fixed income at a higher rate than LT treasuries. They may also swap income from floating rate assets for fixed income from a dealer.

Interest Rate Swaps

Source: BIS International Financial Statistics http://www.bis.org/statistics/derstats.htm

Jun.

98

Dec.9

8

Jun.

99

Dec.9

9

Jun.

00

Dec.0

0

Jun.

01

Dec.0

1

Jun.

02

Dec.0

2

Jun.

03

Dec.0

3

Jun.

04

Dec.0

4

Jun.

05

Dec.0

5

Jun.

06

Dec.0

6

Jun.

07

Dec.0

7

Jun.

08

Dec.0

8

Jun.

09

Dec.0

9

Jun.

10

Dec.1

0

Jun.

11

Dec.1

1

Jun.

12

Dec.1

2

Jun.

13

Dec.1

3

Jun.

140

100000

200000

300000

400000

500000

600000

700000

Total contracts Billions US$

Banks as Risk Taking Institutions• Banks may specialize in ameliorating effects of

asymmetric information.• But there is still asymmetric information

between banks and depositors.Banks info advantages are offset in at least 2

ways.1. Bank Capital – Owners of banks put some of

their own funds into banks and these funds are at risk.

2. Liquidity Advantage of Depositors – Depositors can withdraw funds very quickly from banks.