1. Guy Hargreaves ACF-104

2. Recap of yesterday Understand banking systems within developed economies Appreciate the structure of a typical commercial banking system Review payment systems and how they operate Describe the main products and services offered by commercial banks Understand the commercial banking customer base 2

4. Today’s goals Review of maturity transformation, aggregation and risk transformation Review of credit creation multiplier Understand how commercial banking improves the efficiency of an economy Appreciate the role commercial banking has in driving economic growth Understand the role commercial banks play within financial markets 4

5. The theory of banking Commercial banks perform three basic theoretical functions: 1. Size transformation 2. Maturity transformation 3. Risk transformation In addition, commercial banks provide products and services at the time of their customer’s choosing Because of the positioning of commercial banks within the financial system, they improve system liquidity, reduce system cost and lower system risk 5

6. Size transformation Unlikely a saver will deposit the exact amount of funds with a retail bank that its borrower customer demands on any given day Banks have multiple sources of liquidity to cover mismatches in financial transaction size: Central bank liquidity windows Interbank markets Public money market or bond markets Banks can take a “portfolio management” approach to size transformation as they have a broad base of saver and borrower customers 6

7. Maturity transformation Unlikely a saver will deposit funds with a commercial bank to mature on the exact date that a borrower customer wants its loan to mature Banks manage “asset-liability” maturity mismatch risk as part of their capital and liquidity management framework Banks also take a “portfolio management” approach to maturity transformation as with size 7

8. Risk transformation Unlikely a saver will wish to deposit all its funds with a single borrower, instead looking to diversify its credit risk across a broad range of borrowers Banks lend to a broad range of borrowers, offering savers a diversified credit risk profile In addition, banks have a regulated capital structure ensuring borrowers have a cushion against expected and unexpected losses in the portfolio 8

9. Credit creation Commercial banks have very privileged position in the economy: Usually the most leveraged sector in he economy (15-30x leveraged!) Often the beneficiary of government deposit insurance / guarantee schemes Guaranteed access to Central Bank pools of liquidity at all times 9

10. Recall: credit creation When a bank accepts a deposit it is required to hold a certain amount (eg say 10%) in approved reserves (deposits with Central Bank or government securities) The balance (90%) can be lent to new borrowers who purchase goods and services from another economic entity, who then might deposit the proceeds in another bank That other bank will then retain the reserve requirement and further lend the funds to borrower 10

11. Theory of credit creation Bank$ Deposit taken $ Loan made $ Reserve held A 50.000045.00005.0000 B 45.000040.50004.5000 C 40.500036.45004.0500 D 36.450032.80503.6450 E 32.805029.52453.2805 … ……… Total 500.000450.00050.000 Under a 10% Reserve Ratio for each $1 deposit taken the banking system can create $10 in new deposits Credit Multiplier = Change in Deposits / Change in Reserves = 500 / 50 = 10 11

12. Theory, what about in practice? Retail banking Size transformation Who deposits the exact $355, 450 you might need to buy your apartment? – no-one! Maturity transformation Who makes 30-year deposits? – no-one! Risk transformation Who creates diversified portfolios backed by capital and supported by Central Banks? – well actually there are alternative investments which is why the deposit market is so competitive Credit creation Who leverages the money supply so effectively to create plentiful liquidity for retail borrowers? – no-one with any stability other than commercial banks 12

13. Theory, what about in practice? Wholesale banking Size transformation Who deposits the exact $325.21m a company needs for its acquisition? – no-one! Maturity transformation Who makes 5-year deposits to fund corporate loans? – no-one! Risk transformation As for Retail Banking Credit creation As for Retail Banking 13

14. Lifting the efficiency of an economy Banks lend money and take deposits at the time their customers demand This reduces risk for borrowers that need certainty of funds on a specific day And reduces opportunity costs for savers who might otherwise take time to find a borrower and while missing out on interest payments Banks reduce transaction, information and search costs by exploiting their large size and reach Larger turnover, larger fund flows reduces unit costs and increases economic efficiency 14

15. Credit creation boosts growth Central Bank policy impacts growth in an economy through commercial banks Altering the money supply alters interest rates, which flows through commercial banks to the real economy and impacts demand Altering the Central Bank Reserve Ratio impacts on the supply of credit from the commercial banking system to the real economy Commercial banks can choose to raise capital, which through the credit multiplier can lift the supply of credit to an economy 15

16. Capital allocation in an economy Commercial banks are amongst the most important institutions in an economy when it comes to capital allocation to different industries / sectors Lending reduced to twilight industries Lending increased to new growing industries Lending into increasing productivity, away from falling productivity Forced corporate restructurings Market based capital allocation drives developed economies to become more efficient 16

17. Commercial banks in financial markets Financial markets are not part of the banking system, but are critical for commercial banks Commercial banks operate in a number of financial markets and derivatives Money markets FX markets Commodity markets Syndicated loan markets Commercial banks are mostly users of bond and equity (capital) markets Investment banking businesses are more focused on arranging deals in the capital markets 17

18. Recall: financial markets A financial market is generally considered a collection of individual markets made up of “fungible” products in which: Capital (debt and equity) is raised Financial instruments are traded Financial (and physical) risks are managed Markets can be focused on Primary activity or Secondary activity 18

19. Recall: fungibility “Fungibility is the property of an asset whose individual units are capable of mutual substitution” one unit of an asset can be substituted for another Examples could be 1 ounce of gold, 1 USD banknote, 1 barrel of crude oil Examples of non-fungibility could be two USD bonds issued by the same company but with different maturities Fungibility is critical in financial markets to provide standardisation - which creates certainty and liquidity 19

20. Recall: liquidity Liquidity is the ability to buy or sell an asset (financial or otherwise) without materially the asset’s price Most liquid market in the world is foreign exchange, trades USD 5.3 trillion per day on average Three days FX trade = annual global trade! Low liquidity markets include unlisted shares, highly structured ABS, property Important property of financial markets Commercial banks are large suppliers of liquidity to financial markets 20

21. Money markets Short term debt financing and investment markets Terms usually less then 1-year Commercial banks usually deal in: Treasury bills (for liquidity and capital management) Commercial paper (CP) (corporate lending alternative) Bankers’ acceptances (guarantee for future customer payment) Certificates of Deposit (marketable deposits) Repurchase agreements (short term securities funding) Federal Funds (reserve requirement management) 21

22. Bond markets Fixed income instruments which are debt securities where the borrower (issuer) is required to repay principal and interest based on a predetermined schedule or rate over a fixed term Investment banks usually arrange bond issues for larger corporates (not a retail issuance product) Commercial banks issue bonds as part of their liability management process 22

23. Fixed income ratings (long term) Standard & Poor’sMoody’sFitchDefault Risk profile AAAAaaAAAInvestment Grade: extremely strong AA+ | AA | AA-Aa1 | Aa2 | Aa3AA+ | AA | AA-Investment Grade: very strong A+ | A | A-A1 | A2 | A3A+ | A | A-Investment Grade: strong BBB+ | BBB | BBB-Baa1 | Baa2 | Baa3BBB+ | BBB | BBB-Investment Grade: adequate BB+ | BB | BB-Ba1 | Ba2 | Ba3BB+ | BB | BB-High Yield : less vulnerable B+ | B | B-B1 | B2 | B3B+ | B | B-High Yield : more vulnerable CCCCaa1 | Caa2 | Caa3CCCHigh Yield : vulnerable CCCaCCHigh Yield : highly vulnerable CCCHigh Yield : highly vulnerable + SDSelective default DDDefault NR Not rated Credit ratings are a critical component of the efficient operation of the fixed income market 23

24. Foreign exchange markets The exchange of an amount of money (or deposit) in one currency for an amount of money (or deposit) in another currency Commercial banks use the FX market: As a source of liquidity for customer hedging and foreign currency payment transactions To manage their own asset/liability balance sheet risks As a source of revenue from market making 24

25. A foreign exchange transaction Joe USD100 Linda Linda EUR109 Joe Joe needs EUR to pay for a new book he is expecting shortly The USD-EUR exchange rate is trading in the FX market at 1.09 Joe pays USD100 to Linda’s USD bank account in exchange for Linda paying EUR109 to Joe’s EUR bank account 25

26. 10 days later… Linda USD109 Joe Joe EUR109 Linda 10 days later Joe is given the book by a friend and wants to convert his EUR back to USD USD has weakened and the USD-EUR exchange rate fallen to 1.00 Joe pays EUR109 to Linda’s EUR bank account in exchange for Linda paying USD109 to Joe’s USD bank account Joe has made a USD9 profit in being “long” EUR when it “rallied” 26

27. Futures and derivatives “Derivative” is a general term for a range of financial instruments which includes Futures Derivatives are contracts between two parties that derive their value from the performance of an “underlying” instrument or index, or anything! Generally derivatives are either forwards, swaps, options or futures 27

28. Futures and derivatives Commercial banks deal mostly in: Interest rate swaps FX forwards, swaps and options Bond, bill futures Commodity futures Counterparty credit risk management and central clearing systems have become critical issues for commercial banks in their OTC derivatives businesses 28

29. Commodities Wholesale commercial banks have many customers with exposure to commodity markets and prices Energy commodities such as oil and gas big for commercial banks Metals, agricultural products also popular Customer hedging almost all of the activity of commercial banks in commodities Harsh capital treatment for banks that trade in commodities for their own book 29

30. Syndicated loans Loans where borrowers enter into a single loan agreement with syndicates of banks - ranging from 5 banks to over 50 banks for very large deals Very traditional business for commercial banks Helpful when customer borrowing requirements become too large for a single commercial bank to handle Banks earn additional income from underwriting and distributing syndicated loans 30