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Topic 2 Financia System and Commerical Bank Management

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Topic : Financial System and

Commercial operation and


management (Chap2 &9)
WEEK 3
Financial System
• Institutional perspective:

• the financial system encompasses the Financial markets,


intermediaries, instruments, clients etc.; and

• Functional perspective:

• the financial system facilitates the allocation and deployment of


economic resources, across time and space and in uncertain
environment.
Financial System
• Composed of

• Financial Institutions

• Markets

• Instruments
Clients of Financial System
• Surplus Spending Unit
 Income >
• Household Sector consumption +
investment on real
• Business Sector assets
• Deficit Spending Unit
• Government  Income <
consumption +
Sector
investment on real
assets
Flow of Funds

Funds

Surplus Deficit
Spending Unit Spending
Unit
Borrower/
Saver / Lender/ Seller of
Assets
Buyer of Financial Assets /
Financial Assets/ Demander of
Supplier of Funds
Funds

Financial Assets = Financial Claims


How financial institutions are organized
• Reserve Bank (central bank)
• Universal bank
• Large bank
• Investment banks
• Commercial bank
• Credit union
• Building society
Reserve bank (central Bank)
• The Federal Reserve System (or the Fed) is the central bank and monetary authority of the
United States. .
• The Fed's main duties include:
• conducting national monetary policy,
• supervising and regulating banks,
• maintaining financial stability,
• and providing banking services.

• Saudi Central Bank:


Saudi central BANK
Universal banks (all services bank)
• These banks offer a wide range of services including credit Cards, retail and
commercial loan, Wealth Management & Investment services.
• Retails services bank /commercial banking services/ investment banking service
• E.g Citi group in US
• HSBC in Asia (Hong Kong based)
• Deutche Bank (Europe)
• ICBC bank of China (largest)
Large banks

Focus on both retails and commercial banking services

WellFargo (RETAIL BANK)

Bank of America (commercial Bank)

Also serve as Investment Banks, focus on raise capital (London, NY, Singapore)

Eg Goldman Sach, BARCLAYS, Credit Suisse


A community bank is a depository or
lending institution that primarily
serves businesses and individuals in a
small geographic area.
COMMUNIT
Y BANKS
Focus on retails banking and small
business banking

Community There about 18,000 bank with more


thank 100b assets in US.
bank
Investment Banks

• What do they do ?
• How do they add value ?
• Think about M&A, how Investment play
roles.
Non-Bank Financial Institutions

• Investment Banks
• Help businesses to raise capital by selling financial
securities to the public
• Manage public issues of stocks and bonds
• Cost effective service
• Certification (credit worthiness)
• Charges service fees
• Serve as underwriters
• Help in Merger and Acquisition (combining firms)
Investment Banks

• Investment Banks

• Help businesses to raise capital by selling financial securities to the


public
• Manage public issues of Stocks and Bonds
• Cost effective service
• Charges service fees

Example: JPMorgan, Morgan Stanley and HSBC


Investment Bank
• Facilitator of external financing

• Process of issuing securities:


• Deal Origination
• Analyzing and advising function

• Deal Execution
• making market aware, compliance with legal documents
Non-Bank Financial institutions: Building Societies

• Building societies are Authorized deposit taking institutions (ADIs)


and they are an alternative to banks
• Attract deposits and tailor loans of different types.

• Credit Union
• Credit unions are ADIs and regulated primarily by regulatory
authority. They tend to focus on consumer lending.

• Finance companies
• Finance companies provide a variety of financial services such as
consumer finance, business loans, purchasing business
• They are not ADIs
Contractual saving institutions
• Contractual savings institutions include national provident funds, life insurance
companies, private pension funds.
• They have long-term liabilities and stable cash flows and are therefore ideal
providers of term finance, not only to government and industry, but the
housing sector.
• Insurance companies: general vs life insurance
Commercial
Bank
Management
Background about commercial bank
• What is a commercial bank? How does it is different
from other financial institutions?
• They are different in term of: income source, structure
and funding sources.
• Commercial banks: definition
• Commercial banks work by accepting deposits from
customers and using those deposits to make loans.
Source of income
• Banks get their money from customer deposits, which allows them to then
offer these as loans.
• They make a profit on the interest they charge for mortgages, vehicle loans,
company loans, and personal loans. Customers with checking or savings
accounts will also receive interest on their deposits.
• Commercial banks often provide other services such as financial advice or
basic investment services.
The functions of commercial banks

• Commercial banks' primary function is to serve the financial needs of their


customers. The main functions of a commercial bank include:
• Ensuring that the money of its customers is safe.
• Providing consumers interest on their deposits to hedge against inflation.
• Offering loans to individuals, businesses, and homeowners.
• Providing financial advice to relevant parties and other financial services such as
insurance and fund management
Interest on deposit and inflation hedge
• Deposits in commercial banks are rewarded with interest.
• Savings accounts may earn substantial interest rates whereas current accounts earn just a tiny fraction of
that.
• Interest earned on deposits is significant at times of inflation to keep the actual worth of your money intact.
• However, this depends entirely on the rate of interest you earn on your saving deposits and the inflation
rate.
• If you are earning an interest of 3% in your earnings and inflation increases to 4%, then you would be losing
money in real terms. If instead, you receive an interest of 5% on your deposit, then you would have the real
value of your savings increase.
• Real rate = Nominal rate - inflation
Offering Loan
• Loans are one of the main sources of income for commercial banks. They use a portion of the
deposits made by other individuals to offer loans to other customers and businesses.
• However, for them to maximize their profits, they must made a positive spread between
lending and borrowing rate.

• Commercial banking becomes more profitable when banks lend money to businesses and
individuals and there’s a wide difference between the interest charges on loans and deposits.
• The main issue a bank has to worry about is making sure it has enough cash on hand to
accommodate client withdrawal requests.
The balance sheet of commercial banks
Typical Balance Sheet

• Typical Balance Sheet


• A typical balance sheet consists of the core accounting equation, assets equal
liabilities plus equity.
• A = L+E
• Under these accounts, non-banking companies may have other large classes
such as PP&E, intangible assets, current assets, accounts receivables,
accounts payables, and such.
Commercial Bank balance sheet
• A bank, however, has unique classes of balance sheet line items that other companies won’t. The typical
structure of a balance sheet for a bank is:
• Assets
• Property
• Trading assets
• Loans to customers
• Deposits to the central bank
• Liabilities
• Loans from the central bank
• Deposits from customers
• Trading Liability (short position: example forward rate agreement)
• Equity
• Common and preferred shares
Trading assets for banks

Treasuries, mortgage-backed
Trading assets are securities Trading assets are
securities, foreign exchange
held by a firm for the considered current assets as
contracts, and other
purpose of reselling to make they are intended to be sold
securities can be considered
a profit. quickly.
trading assets.

The value of trading assets


need to be updated on the
balance sheet and recorded
as a profit or loss on the
income statement when sold.
Commercial Bank balance sheet
Income statement

These bad pieces of credit are written off


in the income statement as a provision
for credit loss.
A bank run occurs when many customers withdraw all their
money simultaneously from their deposit accounts with a
banking institution for fear that the institution is, or might
become, insolvent.

The situation takes place in fractional reserve banking systems


where banks only maintain a small portion of their assets as
What is a bank cash.

run?
As more customers withdraw their money, there is a likelihood
of default, and this will trigger more withdrawals to a point
where the bank runs out of cash.

An uncontrolled bank run can lead to bankruptcy, and when


multiple banks are involved, it creates an industry-wide panic
that can lead to an economic recession.
Style of commercial Bank Management
• Asset Management:
• In highly regulated banking sector, asset management was dominant practices. Because of regulation, banks were
restricted their loan activities to match the available amount of deposits they received from the customers,
• Liabilities management:
• With the removal of restrictive regulation, commercial banks now actively manage their sources of funds
(liabilities) in order to ensure they have sufficient funds available to meet loan demand and other commitment.
• If the loan demand is to increase, banks enter capital markets and borrow necessary funds required to meet their
forecast loan demand.
• Therefore banks are no longer dependent on their deposit base for lending.
• Bank with a higher credit rating, are able to borrow substantial amount from international capital markets.
Bank-off-balance sheet business
• Bank also undertake a substantial volume of business transaction that is not
recorded either asset or liabilities.
• For example, commercial banks have developed expertise on the provision of
risk management products, using a range of over the counter and exchanged
traded derivative instrument including forward contract, forward rate
agreement, swap contract, future and option contract.
Commercial bank’s Off-balance sheet
• Types:
• Direct credit substitute: are provided by commercial bank to support a client
financial obligations. Example: stand by letter of credit
• Trade- and performance related items: guarantee made by banks on behalf of its
clients for non-financial obligation. These include
• Documentary letter of credit: bank on behalf of its clients, will authorize
payment to the name party against the delivery.
• Performance guarantee: banks agree to provide financial compensation to their
third party if a client does not complete term and condition of the contract.
• Commitment: make comment to extend the loan which are yet to delivered.
• Foreign exchange contract, interest rate contract and ,other market related
Where does the bank obtain the funds that it lends?

• The source of funds appears on a bank balance sheet either as a liability that bank
eventually repay or equity funds provided by the shareholders.
• The sources of funds include
• Current account deposit
• Call and on demand deposit
• Term deposit
• Negotiable certificate of deposits
• Debt liabilities
• Foreign currencies liabilities:
Valuation for Bank certificate of deposit
• The price of the Certificate of Deposit is the present value
of Face value received on the maturity period based on
appropriate discount rate adjusted for days to maturity.
Example
• For example, if the Face Value OF A 180-Day to maturity CD is $100,000, the
buyer ma pay 96,755.38 to issuing bank. On maturity of the CD, the holder
of the CD received $100,000 on presentation CD to issuing bank.
• Price of CD:

• For example, a Bank issues a 180-days CD with a face value of $100,000,


yielding 8.75% per annum. What should be price of the CD?
• =$95,863.43
Source of funds
• Borrowing from the Federal Reserve Bank

Federal Reserve District banks regulate certain activities of banks and also provide short-term
loans to banks. This form of borrowing by banks is often referred to as borrowing at the Discount
Window.
• The interest rate charged on these loans is known as the discount rate.
• Loans from the discount windows are short term, commonly from one day to a few weeks.
• the discount window is mainly used to resolve a temporary shortage of funds.
• The federal funds rate (based on excess reserve) is more volatile than the discount rate because it
is market determined, as it adjusts to demand and supply conditions on a daily basis.
• Conversely, the discount rate is set by Federal Reserve and adjusted only periodically to keep it
inline with other market rates.
Source of funds
• Debt liabilities:
• As part of bank’s liabilities management, bank issue debt iinstrument into money
markets and capital markets.
• The principal domestic money market instrument include: Negotiable certificate of
deposit.
• Medium to long term instrument issued by the bank include debentures (security
attached) , unsecured notes (without any security attached or collateral) are bonds issued
by both corporation and banks.
• The bonds pays a regular coupon interest payment and principal on maturity.
Source of funds
• Foreign currency liabilities: debt instrument issued into international capital
markets that are denominated in in another currencies.

• Loan capital and shareholder equity:


• Loan capital: bank issue subordinated notes.
• Like big companies, commercial bank also issue equity securities such as
ordinary share that are quoted on stock exchanges.
Source of funds
• Bank Capital generally represents funds obtained through the issuance of
stock or through retaining earnings.
• Primary capital results from issuing common or preferred stock or retaining
earnings, while secondary capital results from issuing subordinated notes
and debentures.
• A bank’s capital provides a cushion to absorb losses, therefore, a bank must
maintain a specific minimum capital required by law.
Source of funds
• Eurodollar Borrowings:
If a U.S bank needs short term funds, it may borrow from those banks outside the
United States that accept dollar dominated deposits, or Euro dollars. Bonds Issued
by the Bank:

• Like other corporations, banks own some fixed assets such as land, buildings, and
equipment.
• These assets often have an expected life of 20 years or more and are usually
financed with long term sources of funds, such as through the issuance of bonds.
Use of funds
• Personal and housing finance:
• Commercial lending: bank bill held , overdraft facilities
• Lending to government
Use of funds
• Bank Loans Types : business loan vs term loan
• A common type of business loan is the working capital loan designed to support on going
business operations.
• A working capital loan can support the business until sufficient cash inflows are generated.
These loans are typically short term, yet they may be needed by businesses on a frequent
basis.
• Banks also offer term loans, primarily to finance the purchase of fixed assets such as
machinery.
• A term loan involves a specified amount of funds to be loaned out, for a specified period of
time, and for a specified purpose.
Use of funds
• Revolving credit loan obligates the bank to offer up to some specified maximum
amount of fund over a specified period of time typically less than 5 years.
• Bank is committed to provide funds when requested; it charges a commitment
fee on unused funds.
• The interest rate charged by banks on loans to their most creditworthy
customers is known as the prime rate.

• 17
CALCULATING FOR INSTALLMENT PAYMENT or annuity payment
If you borrow $10,000, with an interest rate of 10%, how much would you need to make annual
payment over the next 4 years?

PV of loan = 10,000, 𝑃𝑉
𝐶=
i= 10% 1 1
[ − ]
N =4 𝑟 𝑟 ( 1 + 𝑟 ¿ ¿¿ 𝑇 )
C = annual payment =?
=$3154.7
1 1
𝑃𝑉 𝑜𝑓 𝐿𝑜𝑎𝑛= 𝐶 [ − ]
𝑟 𝑟 ( 1+𝑟 ¿ ¿¿ 𝑇 )

year Beginning Year-end Total-year Amortizatio End-year


of Laon interest on end n of loan loan balance
balance balance payment
(C)

1
10000 1000 $3,154.71 $2,154.71 $7,845.29
2
$7,845.29 784.5291963 3154.71 $2,370.18 $5,475.11
3
$5,475.11 547.5113122 3154.71 $2,607.20 $2,867.92
4
$2,867.92 286.7916397 3154.71 $2,867.92 $0.00
Commercial Bank Credit Policy
• Banks make loans different entities including personal, household, business and government. Each loan posits
different level of risks.
• However, banks employ certain measures to reduce the probability of defaults (loss loans provision or bad
debt).

• When conducting credit analysis, banks may use a variety of tools such as ratio analysis, cash flow analysis,
and trend analysis to determine the default risk of a loan.
• Sometimes, credit analysts may conduct a review of the collateral provided, credit history, and the
management’s ability.
• The analysts aim to predict the probability that the borrower will default on their financial obligations and
the level of losses that the lender will suffer in the event of default.
Commercial Bank Credit Policy
• The main ratio used to measure the repayment ability of the borrower is the
debt service coverage ratio (DSCR)
• DCRS = Total cash / Total debt obligation
• The debt obligation include both interest payment and principal payment which
are due.
• A DSCR of 1.5 is preferred, and it means that the entity generates enough cash
flows to pay all the debt payments and an additional 50% cash flow above what
is required to service its debt.
5 Cs for credit analysis
• The 5 C’s of credit analysis is a basic framework that guides the lender in
assessing the creditworthiness of a borrower. The 5 C’s are as follows:
• Character, capacity, capital, collateral and conditions
• Character is an important element of credit analysis, and it looks at the
borrower’s reputation for paying debts. The lender is interested in lending to
people who are responsible and needs to be confident that they have the right
experience, education background, and industry knowledge to generate income
5 Cs for credit analysis
• Capacity evaluates the borrower’s ability to service the loan using the cash flows
generated by individual / the business.
• The lender wants the assurance that individual / household or business generates
enough cash flows to able able to make principal and interest payments in full.
• Capital is the amount of money that the business owner or executive team has invested
in the business. Or individual or household invest in share markets those can be sold to
meet the obligation
• Lenders are willing to extend credit to borrowers who have invested their own money
into the business, which serves as proof of the borrower’s commitment to the business.
5 Cs for credit analysis
• Collateral is the security that the borrower provides as a guarantee for the loan,
and it acts as a backup in the event that the borrower defaults on the loan.
• Most often, the collateral provided for the loan is the asset that the borrower is
borrowing money to finance.
• For example, a home acts as collateral for a mortgage loan, and auto loans are
secured by vehicles. The collateral can also be accounts receivable or inventory
for the business, real estate or real property, factory equipment, and working
capital.
5 Cs for credit analysis
• The condition of the loan refers to the purpose of the loan, as well as the conditions of
the business and the broader economy.
• The loan’s purpose can be to purchase factory equipment, finance real estate
development, or serve as working capital. Loans with a specific purpose are easier to
approve than signature loans that can be used for any purpose.
• The lender also considers the condition of the environment in which the business
operates. The conditions can be the state of the economy.
• For example consumer sentiment survey suggests that there will be an optimistic
prospect of the economy.
Regulatory requirement for commercial banks
• Capital requirements are standardized regulations in place for banks and other
depository institutions that determine how much liquid capital (that is, easily sold
securities) must be held viv-a-vis a certain level of their assets.
• Express as a ratio the capital requirements are based on the weighted risk of the banks'
different assets.
• In the U.S. adequately capitalized banks have a tier 1 capital-to-risk-weighted assets
ratio of at least 4%.
• Capital requirements are often tightened after an economic recession, stock market
crash, or another type of financial crisis.
Capital adequacy requirement
• The Capital Adequacy Ratio set standards for banks by looking at a bank’s ability to pay
liabilities, and respond to credit risks and operational risks. A bank that has a good CAR has
enough capital to absorb potential losses. Thus, it has less risk of becoming insolvent and
losing depositors’ money. After the financial crisis in 2008, the
Bank of International Settlements (BIS) began setting stricter CAR requirements to protect
depositors.

 The Capital Adequacy Ratio (CAR) helps make sure banks have enough capital to
protect depositors’ money.

 The formula for CAR is: (Tier 1 Capital + Tier 2 Capital) / Risk-Weighted Assets

• Capital requirements set by the BIS have become more strict in recent years.
Capital adequacy requirement

• The Bank of International Settlements separates capital into Tier 1 and


Tier 2 based on the function and quality of the capital. Tier 1 capital is
the primary way to measure a bank’s financial health. It includes
shareholder’s equity and retained earnings, which are disclosed on
financial statements.
• As it is the core capital held in reserves, Tier 1 capital is capable of
absorbing losses without impacting business operations. On the other
hand, Tier 2 capital includes revalued reserves, undisclosed reserves,
and hybrid securities. Since this type of capital has lower quality, is less
liquid, and is more difficult to measure, it is known as supplementary
capital.
Capital adequacy requirement
• The bottom half of the equation is risk-weighted assets. Risk-weighted assets are the sum
of a bank’s assets, weighted by risk. Banks usually have different classes of assets, such as
cash, loans, debentures, and bonds, and each class of asset is associated with a different
level of risk. Risk weighting is decided based on the likelihood of an asset to decrease in
value.

• Asset classes that are safe, such as government debt, have a risk weighting close to 0%.
Other assets backed by little or no collateral, such as a debenture, have a higher risk
weighting. This is because there is a higher likelihood the bank may not be able to collect
the loan. Different risk weighting can also be applied to the same asset class. For
example, if a bank has lent money to three different companies, the loans can have
different risk weighting based on the ability of each company to pay back its loan.
Capital adequacy requirement
• Calculating the Capital Adequacy Ratio (CAR) – Worked Example

• Let us look at an example of Bank A. Below is the information of Bank A’s Tier 1 and 2 Capital, and
the risks associated with their assets.

• Bank A has three types of assets: Debenture, Mortgage, and Loan to the Government. To calculate
the risk-weighted assets, the first step is to multiply the amount of each asset by the
corresponding risk weighting:
Capital adequacy requirement
 Debenture: $9,000 * 90% = $8,100

 Mortgage: $45,000 * 75% = $33,750

 Loan to Government: $4,000 * 0% = $0

• As the loan to the government carries no risk, it contributes $0 to the risk-weighted assets.

• The second step is to add the risk-weighted assets to arrive at the total:

 Risk-Weighted Assets: $8,100 + $33,750 + $0 = $41,850


The Capital Adequacy Ratio of Bank A is as follows :

• Where:

 CAR : $4,000 / $41,850 = 10%

• As Bank A has a CAR of 10%, it has enough capital to cushion potential losses and protect depositors’
money.

• What are the Requirements?

• Under Basel III, all banks are required to have a Capital Adequacy Ratio of at least 8%. Since Tier 1 Capital
is more important, banks are also required to have a minimum amount of this type of capital. Under
Basel III, Tier 1 Capital divided by Risk-Weighted Assets needs to be at least 6%.
Liquidity Coverage Ratio
• Liquidity Coverage Ratio: −Stock of high-quality liquid assets/ Total net cash
outflows over the next 30 calendar days
• − Minimum requirement = 100% −Ensures that the bank has adequate level of
assets to meet liquidity needs over the next 30 days
Basel III and bank liquidity
• The objective of the liquidity coverage ratio( LCR) is to promote the short-term
resilience of the liquidity risk profile of banks. It does this by ensuring that
banks have an adequate stock of unencumbered high-quality liquid assets
(HQLA) that can be converted easily and immediately in private markets into
cash to meet their liquidity needs for a 30 calendar day liquidity stress scenario.

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