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Banking Systems

Securitisation

Note: Any profit-maximising business, including banks, must deal with macroeconomic risks, such as the effects of inflation or recession and microeconomics risks like new competitive threats. Banks confront a number of risks atypical of non-financial firms, and it is these risks which are the subject here.

Note: The core product of a bank is intermediation between those with surplus liquidity, who make deposits, and those in need of liquidity, who borrow from the banks. The payments system facilitates the intermediary role of banks

Note: Global financial system deregulation reforms took place in the 1980's, breaking down international barriers and increasing competition among banks. Because of these deregulation reforms banks faced new risks to manage.

Note: Banks moved into off-balance sheet banking, such as switch from interest income generating sources to non-interest income activities. This lead to bank risk management expanding to include not just ALM, but management of risk arising from off-balance sheet activity.

Risk Management involves spotting the key risks, deciding where risk exposure should be increased or reduced, and identifying methods for monitoring and managing bank's risk position in real time. Inadequate risk management may threaten solvency of a bank. Insolvency is a negative net worth, Liabilities in excess of assets

VaR is one of the new models used to manage not only market risk but, in some banks, credit risk as well.

Credit Risk, the risk that a borrower defaults on a bank loan, is the risk usually associated with banks, because of the lending side of the intermediary function. It continues to be central to good risk management because most bank failure are linked to a high ratio of non performing loans to total loans.

Note: Risk Management is central to a banks objective which is maximising shareholders value (Excess minimum return) by maximising profits. The minimum return maximised is the risk-free rate plus the risk premium for the bank. ROA and ROE are used by shareholders as an indication of performance and can influence share prices

Risk is defined as the volatility or standard deviation of net cash flows of the firm. Banks objective is to add value to its equity by maximising the risk-adjusted returns of shareholders.

RISKS SPECIFIC TO BANKING

Credit Risk and Counterparty risk: Counterparty risk is the risk that one of the parties in an agreement will renege on the terms of a contract. Credit Risk is the risk than an asset or a loan becomes irrevocable in the case of outright default, or the risk of unexpected delay in the servicing of a loan. Banks are in the business to take credit risk. Banks choose portfolios of assets with varying degrees of risk, taking into account that a higher default risk is accompanied by higher returns

Liquidity or Funding Risk: This is the risk of insufficient liquidity for normal operating requirements, that is, the ability of the bank to meet its liabilities when they fall due. Public fear of banks liquidity issues may lead to a bank run. Liquidity of an asset if the ease with which it can be converted to cash. Excess liquidity will lead to lower returns. Banks make money by funding short and lending long. Maturity Matching will guarantee sufficient liquidity and eliminate liquidity risk because all deposits are invested in assets of identical maturities. Not ideal because banks are in the business of asset transformation

Settlement/Payment Risk: This is created if one party to a deal pays money or delivers assets before receiving its own cash or assets, thereby exposing it to potential loss. This can include credit risk and liquidity risk

Market Risk: Associated with instruments traded on well defined markets. If a bank is holding instruments on account, then it is exposed to market risk, the risk that price of the instrument will be volatile. Systemic Risk is caused by movement in the prices of all instruments in the market. Two major types of market risks are Currency and Interest Rate Risks.

Other Types of Risks:

Interest Rate Risk

Gearing Risk

Operational Risk

Political Risks

Approaches To Management Of Risk

Gap Analysis is a method of ALM that can be used to assess interest rate risk or liquidity risk excluding credit risk. Gap analysis is a simple IRR measurement method that conveys the difference between rate sensitive assets and rate sensitive liabilities over a given period of time. This type of analysis works well if assets and liabilities are compromised of fixed cash flows. Because of this a significant shortcoming of gap analysis is that it cannot handle options, as options have uncertain cash flows.

Duration Gap Analysis is an alternative method for measuring interest-rate and liquidity risk. It examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates. It measures the average lifetime of a security’s stream of payments.

Duration is a useful concept, because it provides a good approximation, particularly when interest-rate changes are small, of the sensitivity of a security’s market value to a change in its interest rate.

Financial Derivatives are instruments which allow financial risks to be traded direct because they are a part of the banks toolkit for risk management. They can help to protect against market risks, such as currency and interest rate risks that may affect a bank negatively.

VaR is used to measure a banks market risk and credit risk. It is used to estimated the likely or expected maximum amount that could be lost on a banks portfolio as a result of changes in risk factors. Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. The risk manager's job is to ensure that risks are not taken beyond the level at which the firm can absorb the losses of a probable worst outcome. It is measured in three variables: the amount of potential loss, the probability of that amount of loss, and the time frame.

Minimising Credit Risk:

Accurate Loan Pricing - Price of loan should exceed risk-adjusted rate. and include any administration costs

Credit Limits - Due to adverse selection, availability of loan should be restricted to a selected class of borrowers that meet requirements

Use of Collateral

Loan Diversification

Securitisation / Credit Derivatives - Method of reducing credit risk exposure by passing on risk to third party. Credit derivatives can be used to insure against default (CDS)

Financial Derivative is a contingent instrument whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterised by high leverage.

Note: It gives one party a claim of an underlying asset or cash value of the asset, at some fixed date in the future. The other party is bound by the contract to meet the corresponding liability.

Banks Use Derivatives To:

Hedge against risk arising from proprietary trading

Speculate on their trading books

Generate business related to transferring risks between different parties

Use them on behalf of clients

Manage market and credit risk arising from on and off balance sheet activities

A Future is a contract obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underlying asset; they are standardised to facilitate trading on a futures exchange.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset.

A Forward is a customised contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. Unlike standard futures contracts, a forward contract can be customised to any commodity, amount and delivery date.

Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customise terms, the lack of a centralised clearinghouse also gives rise to a higher degree of default risk.

An Option is a contract that allows the holder to buy or sell an underlying security at a given price, known as the strike price. The two most common types of options contracts are put and call options, which give the holder-buyer the right to sell or buy respectively, the underlying at the strike if the price of the underlying crosses the strike. Typically each options contract is written on 100 shares of the underlying. With options, the agent pays for more flexibility because they are not obliged to exercise it.

European Option can only be exercised at the end of its life, at its maturity.

American Option can be exercised anytime during its life. American options allow option holders to exercise the option at any time prior to and including its maturity date.

A Swap is a contract to exchange a cash flow related to the debt obligation of two counterparties. The main instruments are interest rate, currency, commodity and equity swaps. They are OTC agreements.

Money Supply is defined as currency in circulation outside the banking system plus deposits held at banks.

Note: Banks and Central Bank play an important role in creating money. Banks create money by lending out deposits, hence their activities can be affected by the central bank

Instruments of Monetary Policy:

These methods target money supply growth rate...

Open market operations: Achieved by buying and selling government treasury bills. Gilt repos are also used, a gilt sale and repurchase agreement.

Buying and selling securities in the financial market: This affects the monetary base (quantity of notes and coins in circulation). If government prints new money to purchase securities, then monetary base will increase

Reserve ratios: In some countries , banks are required to hold a certain fraction of their deposits as cash reserves, and central bank can influence money supply. If reserve ratio is raised, then banks reduce their lending, so money supply is reduced.

Discount rate: The rate charged to commercial banks when they want to borrow money from the central bank. Raising discount rate above general market interest rate, means it becomes more expensive for commercial banks to borrow.

Most of these methods have been abandoned by countries in the developed world. Now most central banks have committees that meet regularly to decide what interest rates should be set at to ensure country's inflation rate meets government target. Any changes in interest rate should affect demand, which will in turn keep inflation in check. Now focused on Interest rates to control demand as opposed to focus on money supply growth rate.

Note: A Central bank can stabilise the price level by the exercise of monetary policy, through the control of money supply/and or use of interest rates. Many governments singled out price stability as the key objective of the central bank.

Monetary Policy: Making

sure the supply and cost of money and credit from the financial system

contribute to the nation’s economic goals.

Monetary Policy Goals:

•Stable Prices

•Sustainable GDP growth

•High Employment

•Satisfactory external balance

There's an inverse relationship between inflation and unemployment

The

lower the unemployment, the greater the inflation

The higher the unemployment, the lower the inflation

When inflation is high, tight money policy is considered.Tradeoff is higher unemployment

When unemployment is high, loose-money policy is considered. Tradeoff is higher inflation

Indicators Monitored:

A. Indicators of Economic Growth

1.) GDP

2.)

Industrial production index

3.)

Unemployment rate

4.)

Consumer confidence surveys

B. Index

of Leading, Coincident, and Lagging

Indicators

C. Indicators of Inflation

1.Producer

and Consumer Price Indexes

2.Other

Indicators

The most important principle is Operational efficiency. It can be defined as the capacity of the operational

framework to enable monetary policy decisions to feed through as precisely and

as fast as possible to short-term money market rates. These in turn, through

the monetary policy transmission mechanism, affect the price level.

Monetary policy impacts on banking:

Liquidity/treasury management of

banks

Intermediate volumes

Interest rates spread between

deposits and loans

Opportunity to have a safety net in

case of crises

The Basel Agreement is an international treaty that imposed on banks in the participating countries a common capital requirements. G10 countries

Note: At the outset, its main purpose

was to assure that international banks did not escape the supervisory authority which typically is

restricted to a particular country, and to ensure that foreign branches and subisidiaries where adequately regulated

Basel I was established in 1988 but came into effect in 1993. It established a single system of capital adequacy standards for the

international banks of the participating countries.

The main principle was that banks should have to set aside reserves based on the Basel risk assets

ratio (Cooke Ration). Only Credit Risk is considered in Basel I.

capital weighted / risk assets

Types of Capital Under Basel I:

Tier 1 or core capital consists of equity, disclosed reserves, retained earnings, less goodwill and

other deductions, and

Tier 2 or supplementary capital are loan loss allowances, undisclosed reserves, gnereal loss

reserves etc.

Risk Weighted Assets are found by sorting the assets by credit type and assigning lower weights

to more creditworthy assets:

0% cash, gold, bonds issued by OECD governments

20% bonds issued by agencies of OECD governments (as e.g. export credit guarantee agencies), Local (municipal) governments and insured mortgages

50% uninsured mortgages

100% all corporate loans and claims by non-OECD banks or government debts,equity and property.

Off-balance items (as letters of credit, futures, swaps, forex agreements) were converted into credit risk equivalents (a method later abandoned) and weighted by the type of counterparty.

Capital Requirements:

8% total capital (Tier 1 and Tier 2)

4% for core capital (Tier 1)

Criticisms of Basel I:

The rules did not account for the many differences

among banks in different countries, where the way of measuring capital might differ quite substan-

tially. This also holds for the determination of tier 1 and tier 2 capital where the rules in one country

may result in another classification than those of another country.

The off-balance items were con-

sidered in a too simplistic way when translated to ordinary assets, since this translation did not take

into account the risk in market price, concentrating on default risk.

The weighting used in

Basel I are simplistic, since corporate loans with rating AAA still count as 100% while loans to Ital-

ian banks can be weighted 20% even though the rating of these banks vary from A+ to AA−

The 1996-amendment:

Introduction of Mark Risk. Risk involved in movements in market prices.

Introduction of Tier 3 Capital to include trading book activities

Banks enabled to us Internal Risk Models

Introduced limitations on the total concentration of risk:

if the risky asset exceeds 10% of the bank’s total capital, the regulator must be informed, and advance

permission must be obtained for any risk exceeding 25% of the capital.

Topics

Risk Management

Derivatives

Monetary Policy

Basel I