Fundamentals of Banking

Fundamentals of Banking

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1 Opening :
Banking business is one of the oldest, traced back to the 3rd century. The famous bank Medici bank was established at the14th century in Italy. This historical fact teaches us two things. First, banking business is simple, simple enough to be established in the medieval time. Second, banking business is lucrative, lucrative enough to bring a politician power, even nowadays.
The question here is why it is so lucrative? And why banks are often protected by tax payer’s money? This presentation aims to answer these questions through understanding the fundamentals of Banking.

2 Agenda:
This presentation consists of two parts, Money Supply and asset liability management (ALM). Re. Money Supply, it is all about understanding where dose Money come from. Re. ALM, there are a set of techniques to improve banks’ balance sheet and achieve sustainability of bank business, normally operated by treasury department.

3 Money Creation (Seigniorage):
A customer deposits $100 in a bank, and the bank lends out $100 to a third-party. The actual money $100 is no more left in the bank. However, the customer can use the deposited money for settlement as long as the transaction takes place as an account transfer within the same bank. Therefore, to the customer perspective, the money $100 is still available in the bank, as long as it is in the form of account transfer.

The key observation here is, money has been doubled by the bank. The money $100 deposited by the customer has increased to $200 by the bank’s lending activity. This process called “Money Creation” or “Credit Expansion”, and the right to create money is called ‘Seigniorage’.

4 Money Creation (Multiple Effects):
The $100 of loan will become the deposit of $100 in another bank eventually, unless the money is withdrawn to coins and note. And again, the same process can take place to increase the $100 to be $200 by the second bank’s lending activity. And the second bank’s lending can be deposited back to the first bank, creating a loop structure. All we need is just two banks to inflate money supply, by circulating money between the two banks. The key point here is, money is linking one another and sourcing from the same money.

5 Money Creation (Minimum Reserve requirement):
With the discussion so far, theoretically, single dollar could be multiplied to the infinite amount of money because of the loop structure. This is not the case in real world, because central bank sets up minimum reserve requirement called deposit reserve requirement ratio (RRR) for the total amount of deposit, in order to control Money Supply. As the slide shows, money available for lending keeps shrinking, so that the looping of money cannot continue forever.

6 High Powered Money:
As we have observed, money supply is expanded by banks’ lending activity. We have not discussed the starting point which will be a base of the expansion. To expand, we need a base. This base portion is called monetary base, supplied by the central bank. This is also called as high-powered money orM0.

7 Money Supply:
Based on the level of expansion and availability for settlement, the degree of liquidity, there is a classification of money supply. As discussed, the base money is called M0, supplied by central bank. M0 expanded is, called M1. M1 expanded by money market is M2, so on. This classification is different from country to country.

8 Singapore (as of Feb 2010):
Here is money supply statistics I took from MAS webpage. The key observation here is, Monetary Authority of Singapore provides money only $21 billion, but net deposit amount (M3) is $380 billion, more than18 times bigger than M0.

9 Banking / Shadow Banking:
The story of banking accounts for only half portion of Money Supply. The other half is shadow banking, such as investment banking, hedge fund. One example of shadow banking is, say a bank has $100 first and buy $100 of a security. Then lend out the security to obtain $100 again. Then buy $100 of a security so on. As a result, this bank spent $200, based on the original $100. This is called leverage. Also you can do the same. Buying a property and put it as collateral to raise money and buy another property again. In both banking and shadow banking, the principle is the same, stretching out credit to create Money.

10 When a Bank goes into Bankrupt?:
Please look at the number. 4000. This is number of commercial banks’ failures in 1933 U.S. alone. Last year, 140 banks failed. This number is excluding the number of banks saved by mergers and acquisition.　Yes, banks do fail. To understand the necessity of ALM, we need to understand when a bank goes into bankrupt. First, cash flow problem. This is applicable to all companies, even to individuals. When a company cannot fulfill payment obligation, the company’s asset is seized and liquidated.

Second, capital adequacy requirement, this is specific to banks. This a preventive measure to avoid banks’ bankruptcy. Banks are taking a vital role of money supply. Once a bank is gone, it has a huge impact on economy. In addition, all money is connected via lending activities among banks. One bank’s failure can trigger off a chained effect, affecting other banks as well, called systemic risk or domino effect. This is reason why banks are regulated by authorities.

11 Balance Sheet:
When we start a company business, we need money. One way to raise money is to invest our money called equity. The other way is to borrow money, called debt. Equity has no maturity. The company does not need to return equity money. Debt has a maturity and the amount the company has to return is fixed. That is why it is called fixed income as well.

Equity and debt, both are money, but we have to make sure, equity is used for a long term asset. Take a bakery business. We bought an oven with debt money, say the maturity is one month later. Obviously, we have to return the money in one month time, but selling the oven means closing our bakery business, no way to sell it within one month time. So that we should use equity for the oven, and use debt to buy raw materials such as wheat, sugars. Wheat and sugars can turn into bread within one day, and can be sold in the same day. We can have money back to repay debt.

12 Asset Liability Management:
The same principle applies to the bank for the sake of sustainability. And there are some specific techniques applied to bank’s balance sheet, called asset liability management. The items we cover here is only “passive” techniques, primarily monitoring on market risk, interest risk. “Active” means being active to maximize profit and minimize cost. This could be a big topic such as trading strategy so on, so we will not cover this in this presentation.

13 Maturity Ladder:
Constructing maturity ladder, a bank has to summaries cash inflow and cash outflow by dates, starting from the next day, based on different scenarios of interest rates change. Since we are creating different scenario to observe cash flow impact of the interest change, this may be called a simulation. Once mismatch between cash inflow and cash outflow is identified in the simulation, bank should take an action to change their balance sheet in advance as preventive measure. However, generally speaking, it is difficult. First, short term rate, such as overnight rate, is lower compared to long term rate. So banks are often tempted to borrow in a short term and invest in a long term in order to earn a profit. This is one of the cause, triggered the 1997 Asian financial crisis. Second, some banks business model is limited by a regulation. Say, S&L (Saving and Loan Association) in U.S. S&L’s business model is primarily focused on term deposit and mortgage loan. Since term deposit tenure is shorter than the period of mortgage loan, and the deposit rate was set to be very low by a regulation so called regulation Q, when interest goes up, money flies away from deposit upon maturity, although there are still outstanding mortgage lending. Again, this caused S&L crisis

14 Basis Value Point:
This is price elasticity of fixed income against interest change. Bond price goes down, when interest goes up. Take an example, say, there is exiting government bond, matured in one year. The price is $100 and the coupon rate is 5%. That means it gives $105 in one year. At the same time, the government issued a new bond, again matured in one year, the price is $100 but the coupon rate is 10% this time. So it gives $110 in one year. When you want to sell the exiting bond, which is the coupon rate 5%, you have to price down to $95 to realize 10% interest with $105 upon maturity, otherwise who buys the 5% coupon bond?

Price goes down further when year to maturity is longer, say two years. In this case, total cash inflow of 5% is $110 and $120 for 10%. In order to sell the 5% coupon bond, we have to price down to $90 to realize the same profit. In summary, price is more sensitive when the year to maturity is longer, because the interest portions which we have to cover up by pricing down is getting bigger. This is why bond price sensitivity is also called “duration”.

15 Value At Risk:
This is a portfolio value simulation based on historical data. Using certain period of historical market data, calculate the exiting portfolio value, and see how the value fluctuates. When VaR indicates portfolio value can drop significantly, we should change the portfolio to be more stable, or shorten the holding period of the portfolio. The problems of VaR are 1) it requires lots of computation. Once portfolio changes, we need to recalculate again. 2) Market data. The choice of market data could be arbitrary. If too old, underlying market condition could be different.

16 ALM Continued:
Again, ALM is to achieve sustainability of banks. If we lend out to terrorist group, it will cause reputation damage. If lawsuit, we need to raise contingency liability. With credit risk, we need to raise provision. So on. Some banks have an ALM committee to review Asset and liability regularly from top management point of views.