Banks

After completing this reading, you should be able to:

  • Distinguish between the two major types of banking.
  • Identify the major risks faced by a bank and how to hedge against those risks.
  • Distinguish between economic capital and regulatory capital.
  • Summarize Basel Committee regulations for regulatory capital and their motivations.
  • Differentiate between standardized and internal models of calculating capital.
  • 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.
  • Understand Initial Public Offering and how to estimate share prices.
  • 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.

Types of Banking

  • Commercial Banking: involves the trading activities of receiving deposits and making loans. Commercial banking can either be retail (dealing with private individuals and small businesses) or wholesale ( dealing with large corporations)
  • Investment Banking: involves raising capital for companies, advising companies on mergers and acquisitions and acting as broker deals to trade securities.

The Major Risks Faced by a Bank

Credit risk

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

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 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 of the below three options to hedge against market risk:

  1. Spot transactions: that allows the sell or purchase of a foreign currency instantly to allow an almost immediate recovery.
  2. Forward contracts: The amount to be traded on a commodity at a future date is agreed on now.
  3. Options: One side of the option is given the right to trade at a pre-arranged price.

Operational risk 

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

Liquidity risk 

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

Reputational risk

This is a potential loss in reputational capital based on either real or perceived losses in reputational capital.

Economic Capital vs. 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.

Regulatory capital is the minimum amount of capital a bank is required to hold in accordance with the bank regulators. Regulatory capital for credit risk is designed to sufficiently cover a loss expected to be exceeded only once every 1000 years. Even a 1% chance of a bank incurring losses in a year is now allowed.

The Basel Committee

The Basel Committee was established to provide a forum for bank regulators to exchange ideas.

Basel I – It required regulators to calculate capital requirements in the same manner. A modification that allowed banks to keep capital for market and credit risk was implemented in 1998 and was called Market Risk Amendment.

Basel II – Basel II introduced capital requirements for operational risk.

Basel II.5 – Revised the rules for calculating market risk capital.

Basel III – Increased the amount of equity capital to be held by a bank.

Standardized Versus Internal Models

To determine the amount of capital to be held by a bank, models are used.

Standardized models are developed by the Basel Committee. Any two banks with the same portfolio should get the same capital requirements by using the standardized model.

Internal models can only be used upon approval by regulators. They should, however, not reduce capital below a minimum level set equal to a percentage of capital given by the standardized approach. The value for 2027 has been set as 72.5%. Mathematically:

$$ \text{Required capital}= \text{max(Capital given by internal model; 0.725×Capital given by standardized model)\text{ $$

The Link between Deposit Insurance and Moral Hazard

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.

Different Investment Banking Financing Arrangements

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 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 road shows 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 well 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 a 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.

If a company wishes to raise, say $50M, an investment bank should divide the target capital needed ($50M) by the number of shares available after an IPO so as to assess the share price. The bank then sets the share price below its best estimate to ensure it sells at the offering price.

After an IPO, share price may increase meaning that the company has raised enough money.

IPOs are a good investment but unaffordable to small investors.

Potential Conflicts of Interest in Banking

  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. If a bank obtains confidential information that suggests one of its corporate borrowers may default in the near future, the bank may be tempted to push for floatation of a bond by the borrower, sometimes very aggressively. The bank would then use the proceeds to pay off the loan.
  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 interests, some banks have Introduced formal information barriers where members of the investment banking division may 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.

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 that are 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 trading book, otherwise it falls under banking book.

The originate-to-distribute model

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 banks’ reliance on the traditional sources of capital, such as deposits and rights issues.
  • It introduces flexibility into banks’ financial statements and helps them diversify some risks.

Disadvantages:

  • Allowing banks to hive off part of their liabilities can result in 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 is 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:

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

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

  1. $50
  2. $45
  3. $42
  4. $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?

  1. The possibility of a surge in deposits at a bank due to increased trust and confidence among depositors
  2. An increase in the deposit of funds with questionable sources, i.e., laundered cash
  3. Relaxed lending standards at a bank in the knowledge that customers are well protected from incurring losses
  4. 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.


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