Banks

After completing this reading, you should be able to:

  • Identify the major risks faced by a bank.
  • Distinguish between economic capital and regulatory 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.
  • 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

  • Credit risk: This is the risk that borrowers will fail to meet their obligations in accordance with agreed terms
  • Market risk: This is the risk of losses in a bank’s trading book due to changes in stock prices, interest rates, foreign exchange rates, commodity prices, and credit spreads.
  • 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 the amount of capital that a bank needs in order to remain solvent and maintain its day-to-day operations. Also known as risk capital, it’s the amount of capital required to absorb the impact of unexpected losses during a specified time horizon, at a given level of confidence.

Regulatory capital is the amount of capital a bank is required to hold in accordance with laid down regulations, rules, and guidance. For instance, according to Basel II, regulatory capital can be divided into three tiers:

  • Tier I capital – core capital
  • Tier II capital – supplementary capital, e.g., general loan reserves
  • Tier III capital, e.g., short-term subordinated debt

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. The investment bank makes a profit equal to 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.

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.

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. The bank does not mark such assets to market, nor is it required to record them at fair value. Historical cost accounting is used. 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.

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 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.

Evaluating the capital requirement for banks

Equity capital is categorized as “Tier 1 capital” while subordinated long-term debt is categorized as “Tier 2 capital.”To be in a position to absorb losses resulting from risks such as market risks, credit risk, and operational risk, a bank must have sufficient capital. The million dollar question: just how much capital is required?

The secret lies in evaluating the bank’s risk exposure and using statistical models to predict possible losses in the future. It’s important for banks to have a significant amount of its capital in form of equity. That’s because equity provides the best protection against adverse events. Debt does not provide as good a cushion as equity because it cannot prevent insolvency.

Consider the following financial statements from a small commercial bank.

Summary balance sheet for ABC bank at end of 2019:

$$ \begin{array}{|l|l|l|l|} \hline {\bf Assets} & {} & {\bf Liabilities\quad and\quad Net\quad worth} & {} \\ \hline Cash & 5 & Deposits & 80 \\ \hline Marketable \quad securities & 5 & Subordinated\quad long-term\quad debt & 10 \\ \hline Loans & 80 & Equity\quad capital & 10 \\ \hline Total & 100 & {} & 100 \\ \hline Fixed\quad assets & 10 & {} & {} \\ \hline {\bf Total} & {\bf 100} & {} & {\bf 100} \\ \hline \end{array} $$

Summary income statement for ABC bank at end of 2019 (Items shown as a percentage of total assets)

$$ \begin{array}{|l|l|} \hline Net\quad interest\quad income & 4.00 \\ \hline Loan\quad losses & (0.7) \\ \hline Non-interest\quad income & 0.9 \\ \hline Non-interest\quad expense & (3.0) \\ \hline Pre-tax\quad operating\quad income & 1.2 \\ \hline \end{array} $$

How much equity capital does ABC need? This question can be answered by assuming the worst; hypothesizing an extremely adverse scenario and considering whether the bank would survive. Suppose that a severe recession strikes increasing loan losses rise by 5% of assets to 5.7% next year. (For convenience, let’s assume that other items on the income statement are unaffected.) There will be a pre-tax net operating loss of 2.1% of assets \( \left( 1.2-5=-3.8 \right) \). If the corporate tax rate is 30%, this would result in an after-tax loss of about 2.7% of assets \(\left[ =\left( 1-0.3 \right) 3.8 \right] \).

Since the bank’s equity capital is 10% of assets, it can comfortably absorb a loss of 2.7%. In fact, it would still be able to withstand a second consecutive bad year similar to the first. However, if the bank had just 5% of equity capital, all of its equity capital would be wiped out after just two years of losses, and it would be far less likely to survive. Even a single year where losses are, say, 6% would trigger serious financial turmoil. Therefore, maintaining equity capital equal to 10% of assets would be more reasonable.

The above example illustrates just how important it is to evaluate a bank’s preparedness for potentially disastrous events.

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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