Banks

After completing this reading, you should be able to:

• Identify the major risks faced by a bank and how these risks can arise.
• Distinguish between economic capital and regulatory capital.
• Summarize Basel Committee regulations for regulatory capital and their motivations.
• Explain how deposit insurance gives rise to a moral hazard problem.
• Describe investment banking financing arrangements, including private placement, public offering, best efforts, firm commitment, and Dutch auction approaches.
• Describe the potential conflicts of interest among commercial banking, securities services, and investment banking divisions of a bank and recommend solutions to the conflict of interest problems.
• Describe the distinctions between the “banking book” and the “trading book” of a bank.
• Explain the originate-to-distribute model of a bank and discuss its benefits and drawbacks.

The Major Risks Faced by a Bank

a. Identify the major risks faced by banks and explain ways in which these risks can arise

Credit Risk

This is the risk that borrowers will fail to meet their obligations in line with agreed terms. 

Credit risk arises when:

• A borrower defaults
• Some bank contracts that trade on derivatives may also give rise to credit risk. If the counterparty to a derivatives transaction defaults, the bank has a positive value, implying a negative value to the counterparty.

To hedge against credit risk, a bank builds expected losses into the interest charged on loans. Assuming a bank’s cost of funds is 1.3%, the bank may charge 4.2% as the interest rate on loans. The difference (2.9%) is known as the net interest margin. If a bank predicts a loss of 1% of what it lends, the bank will remain with 1.9% to cover its other costs, for example, administration costs.

Market Risk

This is the risk of losses in a bank’s trading book due to exposures to market variables. These market variables are also called risk factors, and they include changes in stock prices, interest rates, foreign exchange rates, commodity prices, and credit spreads.

Banks can use any of the three options below to hedge against market risk:

1. Spot transactions: A currency, say the USD, is bought or sold for immediate delivery.
2. Forward contracts: The price and amount of a commodity traded on a specified future date are agreed upon.
3. Options: The buyer/holder has a right but not an obligation to buy the underlying asset in the case of a call option, and a right but not an obligation to sell in the case of a put option.

Operational Risk 

This is the possibility of loss resulting from failed internal processes, systems, people, or external events.

The following are some of the categories of operational risk identified by regulators:

• Internal fraud – e.g employees stealing from a bank.
• External fraud – which includes cyberattacks, bank robberies, etc.
• Clients, products, and business practices e.g. money laundering.
• Damage to physical assets such as computers and ATM machines
• System failures and business disruptions.
• Problems in execution, delivery, and management of business processes, e.g. data entry errors.

Liquidity Risk 

This describes the risk resulting from the lack of a ready market for an asset, which in turn raises the specter of being unable to meet day-to-day funding needs.

Reputational Risk

Reputational risk refers to the potential for adverse public perception, negative publicity, or uncontrollable events to have a negative impact on a company’s reputation, thereby affecting its revenue.

Economic Capital vs. Regulatory Capital

b. Distinguish between economic capital and regulatory capital.

Banks need capital to fund their operations. Some of the capital is raised in the form of equity with the rest of it raised as debt.

Equity capital is sometimes referred to as going concern capital because it absorbs losses while the bank is a going concern. Providers of debt capital enjoy some protection because the bank has an obligation to meet contractual demands even when the bank is not doing well. Debt capital is therefore referred to as gone concern capital because holders only incur losses once the bank has been declared a failure or wound up.

To ensure that its activities proceed uninterrupted, a bank has to ensure that it maintains enough capital at all times. Although banks are allowed to use their internal models to estimate the amount of capital they need, regulators also have their capital requirements that must be met. This brings us to economic capital and regulatory capital.

Economic capital is a bank’s own capital estimate of the amount needed to remain solvent and maintain its day-to-day operations. One of the main motivations for calculating economic capital is to obtain and maintain a high credit rating. This way, the bank will stir up confidence among both depositors and investors.

Regulatory capital is the minimum amount of capital a bank is required to hold by the bank regulators. Regulatory capital for credit risk is designed to sufficiently cover a loss expected to be exceeded only once every 1000 years. Capital requirements have evolved in recent years and are now enforced more strictly than they were in the past. If a bank’s equity capital is USD 5 billion and there is a 1% chance that the bank will incur a loss higher than USD 5 billion over a year, both regulators and the bank itself will consider the equity capital insufficient.

Basel Committee Regulations for Regulatory Capital

c. Summarize the Basel Committee regulations for regulatory capital and their motivations.

The Basel Committee was established in 1974. It is the primary global standard-setter for the prudential regulation of banks and provides a forum for banks and regulators worldwide to exchange ideas.  

The motivations for Basel Committee regulations include:

Different capital requirements: Prior to 1988, capital calculation differed from country to country. This made cross-country comparisons and cross-country implementation of risk management tools impossible. In 1974, Basel regulations were introduced in an attempt to harmonize the calculation of capital across countries.

Evolution of bank activities: Initially, Basel regulations were designed to help banks cover losses arising from credit risk, particularly from defaults on loans and derivatives contracts. But with time, bank trading activities significantly increased, bringing about market risk. In response, the Basel committee in 1998 introduced modifications in the existing regulation, and banks were now required to keep capital for both credit and market risk. Later on, in 1999, operational risk was added into the portfolio of risks for which risk capital was required.

The 2007-2008 financial crisis: After several large banks went down during the crisis, the Basel committee pointed an accusing finger at the existing market risk capital requirements. The market risk capital framework was deemed insufficient. This led to yet another update of the regulations.

It’s important to note that Basel Committee regulations are always being reviewed to reflect the changing needs of the banking sector. In fact, some of the latest proposals in Basel III are not expected to have been implemented in full before 2027.

In a nutshell, here’s how different versions of the Basel Committee guidelines impacted the financial sector:

Basel I: All signatory countries pledged to calculate credit risk capital in the same manner.

Basel II: – Capital requirements for operational risk were introduced.

Basel 2.5– Capital requirements for calculating market risk were introduced.

Basel III – Equity capital was significantly increased.

The Link Between Deposit Insurance and Moral Hazard

d. Explain how deposit insurance gives rise to a moral hazard problem.

When a bank becomes insolvent, depositors may end up losing a percentage of their money. However, in most developed countries, the government guarantees that if a bank fails, the bank’s depositors will be in line for compensation. This is known as deposit insurance. Usually, depositors are able to receive a percentage of their deposit subject to a predetermined upper limit. For example, the U.K. government provides deposit insurance to most banks up to a limit of £85,000.

Moral hazard describes the fact that by being insured, customers will take little or no interest at all in the way a bank handles their money. After all, the depositors are assured of getting their money back even if the bank fails. In turn, the bank may relax its lending standards and its general policy on how it uses customer deposits.

In the absence of deposit insurance, depositors would maintain a keen eye on the bank’s actions so that it does not engage in activities that may endanger their money. For instance, a depositor will be keen to scrutinize the loans being offered, the conditions required for credit, and the capital set aside to serve as a buffer against economic losses. However, in a system with deposit insurance, a lack of scrutiny means that banks are free to lend as much as they want to whomever they wish, besides investing in other income-generating assets of their choice.

Investment Banking Financing 

e. Describe investment banking financing arrangements including private placement, public offering, best efforts, firm commitment, and Dutch auction approaches.

Investment banking mainly deals with the raising of debt and equity financing for corporations or governments. A typical arrangement starts with a corporation approaching an investment bank with a request for help in raising a specified amount of money. The two entities then agree on the form of finance desired – debt or equity – and the investment bank underwrites the issue. This means that the bank agrees to approach investors and ask them to subscribe to the issue. The bank sells the securities to investors. For example, an IPO would involve the sale of shares to investors.

The arrangement to sell the securities can take one of several forms:

1. Private Placement: The securities are sold to a small number of chosen investors. In other words, the sale is closed to the general public. Private placements are considered relatively cost-effective because they do not involve “going public” together with the associated costs, such as roadshows and ads. “Series A” Funding Rounds or “Series B” investments are examples of private placements.
   A price for the offering is determined by assessing the value of the issuer, then dividing this value by the number of securities to be offered. However, the offer price is usually less than the fair value of the issuer to increase the chances of a full subscription (all securities getting sold successfully).
2. Public Offering: A public offering involves the sale of equity shares or some other financial instruments to the public. In the U.S., this type of arrangement is subject to approval by the Securities and Exchange Commission. A public offering can take the form of a best effort or a firm commitment. On a best-efforts basis, the bank does as much as it can to place the securities with investors. The bank receives a fee that, in part, depends on the success of the placement. On a firm commitment basis, the investment bank buys the securities from the issuer and attempts to place them with investors. This type of arrangement is riskier for the bank because if it fails to resell all the securities, it will be forced to hold them itself or sell them at a lower price resulting in losses. The profit made on a firm commitment basis is the difference between the subscription price and the price paid to the issuer.
3. Dutch Auction: In a dutch auction, the price of the offering is set after taking into consideration all bids to determine the highest price at which the offering can be sold. In their bids, investors indicate the number of securities they are prepared to buy, and the price they are willing to pay for each. Securities are allotted to investors in order of bid prices, where the highest bid is considered first, then the next highest, until all the securities have been allotted. However, it’s important to note that all investors pay the same price – the bid price. This is usually the lowest bid acceptable. A Dutch auction is meant to balance supply and demand in the market, therefore the price before and after an IPO (Initial Price Offer should be the same).

Apart from investment banking, banks engage in other income-generating activities. These include:

• Advisory Services: This entails giving advice to companies on mergers and acquisitions, restructuring, and divestments. The client could be the target or even the acquirer.
• Securities Trading: A majority of banks involve themselves in securities trading through the brokerage of both equity and debt instruments. Most investments are, however, short-term to ensure the bank has enough liquidity.

Initial Public Offering (IPO)

An IPO is the first time offering of a company’s shares to the public. Before an IPO, a company’s shares are held by its founders, venture capitalists, and those who provided early-stage funding.

Before the IPO, the shares of the company do not trade on any official exchange, and so it is difficult to estimate just what the share price will be after the IPO. To get a good estimate of the share price, the company must divide the estimated value of the company after the IPO (including the money raised) by the total number of shares it wishes to create. Most banks typically set the offering price slightly below their best estimate to increase the chances of success for the offering. After an IPO, the share price typically increases. The indication is that the issuer could probably have raised even more money by setting a slightly higher offer price. However, too high an offer price, and possibly flawed investor expectations, can result in a drastic stock price fall.

IPOs are a good investment but unaffordable to small investors.

Conflicts of Interest in Banking

f. Describe the potential conflicts of interest among commercial banking, securities services,
and investment banking divisions of a bank, and recommend solutions to these conflict of
interest problems.

1. When giving investment advice, a bank might be tempted to recommend the securities being sold by its investment banking wing, even if such securities do not fit the profile of the customer.
2. The research division may mark a share as “buy” just to impress the management and create business for the investment banking division. This often happens when the research team is under pressure from management.
3. The commercial banking arm of a certain bank has a large loan outstanding to a client, where there is a considerable risk of incurring losses. To mitigate this high-risk loan, the bank may suggest that the client consider replacing it with a bond issue managed by the investment banking arm. If the investment banking arm agrees to this arrangement, then the debt instrument can be taken over by investors who are less informed than the commercial bankers.
4. During the appraisal process for credit, banks oft obtain lots of information about the borrower. A bank may be tempted to pass that information to the investment banking division to help it provide advice to a potential acquirer.

In an attempt to avoid conflict of interest, some banks have Introduced formal information barriers where members of the investment banking division are barred from communicating directly with their research division counterparts. Some companies have gone as far as requiring any communication between the two divisions to happen only through the compliance department.

Banking Book vs Trading Book

g. Describe the distinctions between the banking book and the trading book of a bank.

The banking book consists of assets on the bank’s balance sheet that are expected to be held until maturity. In other words, the bank cannot sell them. Items in the banking book are subject to credit risk capital calculations. The VaR for assets in the banking book is measured at 99.9% confidence on a 1-year time horizon.

The trading book consists of assets available for sale, meaning that they are eligible for day-to-day trading. Under Basel II and III, the trading book has to be marked to market on a daily basis. In addition, the VaR for all assets making up the trading book has to be measured at 99% confidence on a 10-day time horizon. Items in the trading book are subject to market risk capital calculations.

If a bank has a desk for trading an instrument, that instrument falls under a trading book. Otherwise, it falls under a banking book.

The Originate-to-Distribute Model

h. Explain the originate-to-distribute banking model and discuss its benefits and drawbacks.

Historically, banks used to originate loans and then keep them on their balance until maturity. That was the originate-to-hold model. With time, however, banks gradually and increasingly began to distribute the loans by selling them as securities to investors. By so doing, the banks were able to limit the growth of their balance sheet by creating a somewhat autonomous investment vehicle to distribute the loans they originated.

Advantages of the Model:

• It introduces specialization in the lending process.  Functions initially designated for a single firm are now split among several firms.
• It reduces the banks’ reliance on the traditional sources of capital, such as deposits and rights issues.
• It introduces flexibility into the banks’ financial statements and helps them diversify some risks.

Disadvantages of the Model

• Allowing banks to hive off part of their liabilities can result in the relaxation of lending standards and contribute to riskier lending. This implies that borrowers who previously would be turned away – possibly because of poor credit history – are now able to access credit.
• By splitting functions among multiple firms, the model can make it difficult for borrowers to renegotiate terms.
• The assets (loans) retained in the balance sheet become increasingly less representative of the role they play in the process of extending credit. In other words, the role and impact of banks as lenders in an economy are obscured.

Questions

Question 1

ABC Corp wishes to sell 10 million shares using a Dutch auction. The underwriter starts the auction by offering a price of $50 per share. The following bids are received:

$$
\begin{array}{c|c|c}
\textbf{Price} & \textbf{Bids} & \textbf{Shares} \\ \hline
$50 & 1 & 2,000,000 \\ \hline
$48 & 2 & 1,000,000 \\ \hline
$47 & 1 & 2,000,000 \\ \hline
$45 & 2 & 2,000,000 \\ \hline
$44 & 3 & 1,000,000 \\ \hline
$42 & 5 & 3,000,000 \\ 
\end{array}
$$

Determine the price that will be paid by all the successful bidders.

A. $50

B. $45

C. $42

D. $44

The correct answer is B.

After the auction closes, the underwriter will calculate the highest price at which all shares could possibly be sold. Here, the auction wound up with bids for 28 million shares. However, the highest bids adding up to 10 million shares will be the winning bids. The price will be set equal to the lowest winning price bid on the 10 million shares.

At $50/share, 1 bid comes in for 2,000,000 shares. The underwriter will lower the price to $48/share, where 2 more bids come in for another 2,000,000 shares. The underwriter will yet again lower the price to $47/share, where 1 bid comes in for 2,000,000 shares. And after lowering the price to $45, 2 more bids come in for 4,000,000 shares. This makes a total of 10,000,000 shares. Thus, $45 is the lowest winning price bid, and all successful bidders will pay $45/share.

Question 2

Which of the following options best describes the link between deposit insurance and moral hazard?

A. The possibility of a surge in deposits at a bank due to increased trust and confidence among depositors

B. An increase in the deposit of funds with questionable sources, i.e., laundered cash

C. Relaxed lending standards at a bank in the knowledge that customers are well protected from incurring losses

D. Increased supervision and monitoring of banks resulting from pledges, by the government, to compensate depositors if the bank fails

The correct answer is C.

Moral hazard describes the fact that by being insured, customers will take little or no interest at all in the way a bank handles their money. After all, the depositors are assured of getting their money back even if the bank fails. In turn, the bank may relax its lending standards and its general policy on how it uses customer deposits.

A is incorrect. While deposit insurance may indeed lead to increased trust and a surge in deposits, this doesn’t directly describe the moral hazard issue. Moral hazard is about taking on additional risk because someone else bears the cost, not merely about increased trust.

B is incorrect. A potential increase in illegal activities like money laundering doesn’t connect directly to the moral hazard created by deposit insurance. While deposit insurance might make a bank more attractive for depositors, it doesn’t inherently encourage or facilitate illegal activities like laundering money.

D is incorrect.It doesn’t describe the moral hazard problem, which is about the increased risk-taking that might result from deposit insurance. In fact, increased supervision would likely be a measure to counteract the moral hazard, not an example of it.

Things to Remember

• Deposit insurance is meant to build confidence among depositors, but it can indirectly lead to misbehavior by banks, knowing that their actions have limited consequences on the depositors.
• Efforts to address the moral hazard associated with deposit insurance may include regulations, supervision, and monitoring of lending practices to ensure that risk is being managed responsibly.