1. Revise Lecture 18

2. Basic Lending Principles

3. Q: What is asset management banking?

4. Asset management banking

5. Basic Lending Principles
Asset management banking
One of the main challenges to a bank is ensuring its own liquidity under all reasonable conditions.
Commercial banks differ widely in how they manage liquidity.
A small bank derives its funds primarily from customer deposits. Its assets are mostly loans to small firms and households and it usually has more deposits than it can find creditworthy borrowers for.

6. Basic Lending Principles
Asset management banking
Excess funds are typically invested in assets that will provide it with liquidity.
The holding of assets that can readily be turned into cash when needed is known as asset management banking.

7. Q: What is liability management banking?

8. Liability management banking

9. Basic Lending Principles
Liability management banking
In contrast, large banks generally lack sufficient deposits to fund their main business dealing with large companies, governments, other financial institutions and wealthy individuals.

10. Basic Lending Principles
Liability management banking
Most of these banks borrow the funds they need from other major lenders in the form of short-term liabilities which must be continually rolled over.
This is known as liability management,
A much riskier method than asset management.

11. Basic Lending Principles
Liability management banking
A small bank will lose potential income if it gets its asset management wrong.
A large bank may fail if it gets its liability management wrong.

12. Basic Lending Principles
Liability management banking
The key to liability management is the ability to borrow always.
Therefore, a bank’s most vital asset is its creditworthiness. If there is any doubt about its credit, lenders can easily switch to another bank.
The rate a bank must pay to borrow will go up rapidly with the slightest suspicion of trouble.

13. Basic Lending Principles
Liability management banking
In recent years, large banks have been making increasing use of asset management in order to enhance liquidity, holding a larger part of their assets as securities as well as securitizing their loans to recycle borrowed funds.

14. Basic Lending Principles
Liability management banking
A ‘bank run’ is an overwhelming demand for cash by a bank’s depositors.
A large depositor assumes a risk and needs to know something about the bank’s own balance sheet.
However, a healthy balance sheet does not eliminate all risks.

15. Basic Lending Principles
Liability management banking
Even if the depositor knows the bank has adequate liquidity.
Large depositors must, therefore, be concerned about what others are likely to believe. A rumour a bank, even though unfounded, can trigger a run causes a solvent bank to fail.

16. Basic Lending Principles
Profitability

17. Q: What is profitability and profitability management?

18. Basic Lending Principles
Profitability
A bank generates profit from the differential between the level of interest it pays for deposits and other sources of funds and the level of interest it changes in its lending activities.
This difference is referred to as the SPREAD between the cost of funds and the loan interest rate.

19. Basic Lending Principles
Profitability
Historically. Profitability from lending activities has been cyclic and dependent on the needs and strengths of loan customers.
In recent history, investors have demanded a more stable revenue stream and banks have therefore, placed more emphasis on transaction fees, primarily loan fees, but also including services charges on an array deposit activities.

20. Basic Lending Principles
Profitability
However, lending activities still provide the bulk of a commercial or retail bank’s income.
In the past few decades, banks have taken many measures to ensure that they remain profitable while responding to ever-changing market conditions.

21. Basic Lending Principles
Profitability
The banking industry’s main obstacles to increasing profits are existing regulatory burdens, new government regulations and increasing competition from non-traditional financial institutions.

22. Profitability Management

23. Basic Lending Principles
Profitability Management
Profitability management is a total management process, rather than just an accounting or analysis procedure.
In contrast to asset and liability management, it places primary emphasis on the profit and loss account and secondary emphasis on the balance sheet.

24. Basic Lending Principles
Profitability Management
With profitability management, profitability is not merely reported; it is planned, measured and interpreted.
Planning ensures that efforts are directed toward the achievement of corporate objectives.

25. Basic Lending Principles
Profitability Management
Measurement checks and adjusts progress against plan by matching revenue received with related expense
Interpretation develops a valid picture of people and businesses, thereby serving as a basis for the next planning cycle.

26. Basic Lending Principles
Profitability Management
Profitability management involves the monitoring of three distinct types of profitability statistics. The profits of bank can be measured in three ways;
By organization
By product
By account

27. Basic Lending Principles
Profitability Management
Organizational profitability is the most familiar type since all banks have some system for reporting the performance of their major organizational units.
However, an effective profitability management system will also measure the performance of services and accounts.

28. Lecture 19

29. Basic Lending Principles
Safety Issues

30. Basic Lending Principles
Safety Issues
The persistent failures of banks to lend sensibly in Pakistan and in many other countries have brought the question of safety in lending to the fore;
Why do banks persistently lend so imprudently and how should lending be done at minimum risk?

31. Basic Lending Principles
Safety Issues
One essential problem is the human and managerial challenge of motivating employees of banks to cater to the interest of the owners (shareholders) of the bank.
The history of banking is replete with episodes of employees favouring friends and relatives with loans.

32. Basic Lending Principles
Safety Issues
In some countries, there are well-defined market rates for bribes for obtaining loans from banks.
This problem is also present in Pakistan, though the record of Pakistan’s banking system in this aspect is much better than that of many other countries.

33. Basic Lending Principles
Safety Issues
Another aspect of the problems of banks concerns prudent levels of leverage.
A bank is a financial intermediary with fairly small equity capital, which borrows money from depositors and invest it into risky assets. This involves a high degree of leverage

34. Basic Lending Principles
Safety Issues
Leverage, at the level of the bank, is dangerous regardless of the quality of credit analysis which has gone into each loan.
High leverage generates high risk and high returns. If high returns are obtained, the bank takes the profits but it is protected from high losses by the government.

35. Basic Lending Principles
Safety Issues
Regulators have tried many policy initiatives aimed at obtaining a banking system which has controlled leverage, high quality lending and thus, a reduced risk of failure.
These include capital adequacy requirements based on clumsy measurement of risk, prohibition of lending against real estate, restrictions on lending against shares, rules governing collateral, etc.

36. Basic Lending Principles
Safety Issues
A riskless loan is one that is fully collateralised using actively traded assets.
These assets should be traded objects so that a ‘market to market’ can be done daily, to ensure that the collateral is always larger than the outstanding loan.
The value of the asset that is measured when marking to market should be the liquidation value., thus taking into account the problems faced by the bank when selling off the assets.

37. Diversification of Risk

38. Basic Lending Principles
Diversification of Risk
Diversification in banking has been a topic of discussion in the literature for decades.
It effects on performance, risk, efficiency and firm value have been examined extensively.
Diversification does have a significant impact on a bank’s risk as well as its performance.

39. Basic Lending Principles
Benefits of Diversification

40. Basic Lending Principles
Benefits of Diversification
One of the most common benefits associated with respect to diversification is a lower cost of capital.
Banks, with some level of global diversification have access to different capital markets which could lead to a lower cost of funds through a larger deposit base.

41. Basic Lending Principles
Benefits of Diversification
Furthermore, the potential for more efficient internal capital markets is another of cited benefit to diversification.
Another benefit associated with activity diversification is the ability to gain economies of scale / scope for the organization.

42. Basic Lending Principles
Benefits of Diversification
An example might be bank which collects information credit information on potential borrowers. With this information, the bank may be able to offer these potential clients insurance products or underwriting services at a lower cost because much of the information needed has already been collected when evaluating the loan application.

43. Basic Lending Principles
Benefits of Diversification
Benefits associated with market power have also been advanced. The argument suggests that banks may diversify their activities or their operations geographically to gain or maintain market share.
Finally, an important benefit that has been proposed by some is the ability for organizations to reduce earnings volatility by spreading operations across areas with different economic environments.