Basics of Banking and Derivatives

Finance Advanced Session


What is a Bank?
A bank is a financial institution whose traditional role
had been to accept deposits and give loans. Banking
operations have become more and more complex
nowadays
Commercial Banking
Commercial banking involves, among other things,
the deposit-taking and lending activities we have just
mentioned. Large banks are also often involved in
securities trading (e.g., by providing
brokerage services)
Investment Banking
Investment banking is concerned with
assisting companies in raising debt and equity, and
providing advice on mergers
and acquisitions, major corporate restructurings,
and other corporate finance decisions.
Large banks are also often involved in securities
trading (e.g., by providing
brokerage services)
Introduction to Banking
Classification of Banking System Retails vs Wholesale
Banking • Both loans and deposits are much larger in
wholesale banking than in retail banking
• Typically the spread between the cost of funds
and the lending rate is smaller for wholesale
banking than for retail banking
Commercial Investment • However, this tends to be offset by lower costs
(When a certain dollar amount of wholesale
lending is compared to the same dollar amount
of retail lending, the expected loan losses and
Wholesale
Retail Banking administrative costs are usually much less)
Banking
Retail Banking Why are banks so important?
Retail banking, as its name implies, involves taking • Banking sector forms the backbone of any
relatively small deposits from economy
private individuals or small businesses and making • Banks form the dominant part of the financial
relatively small loans to them. system of any country
• Failure of banks leads to a contagion effect in
the entire economy( also called the spillover
Wholesale Banking effect)
• Public savings and deposits are entrusted with
Wholesale banking involves the provision of banking
the bank and hence, it is imperative that banks
services to medium and large
are prevented from failures
corporate clients, fund managers, and other financial
• Great examples in history to substantiate these
institutions. Sometimes
points. E.g. The Financial Crisis of 2008
banks fund their lending by borrowing in financial
This is why banks are highly regulated
markets themselves.
institutions
 Analyzing a Bank’s Balance Sheet

Skeleton of a Bank’s Balance Sheet

Loans given out to customers Deposits made by customers
are assets as they represent are a liability for the bank as
claim to future cash flows (in whenever a depositor wants to
the form of principal borrow a certain amount of
repayment and interest money, the bank has to oblige;
payments); Loans are of Deposits are a cheap source
different types- short-term, of funds for bank, Deposits
long term, revolving credit consist of both Demand
facility etc. Deposits and Time Deposits

Banks can also borrow from

other banks in case it runs
Linkage with the Provision for short on funds and immediate
loan losses in the income funding is not possible by
statement increasing deposits or capital
infusion
The assets of the bank held by
the Central Bank; in Indian
This is the equity brought in
Context, it’s CRR (Cash
by the shareholders of the
Reserve Ratio)
bank

These items that we see are called On Balance Sheet items (that appear on the balance sheet). However, there are many such
transactions/investments/dealings which a bank does and are not reported on the balance sheet. These are called Off Balance Sheet items and
include mainly trading in derivatives.
In fact, nowadays, the amount of Off Balance Sheet items far exceeds that total value of On Balance Sheet items for a bank
 Analyzing a Bank’s Income Statement

Skeleton of a Bank’s Income Statement Meaning of the line items

This is the revenue source of a bank i.e. the interest it receives from the loans that it has
given out and the returns from the investments made by bank

This is the main expense channel of a bank i.e. the interest payment on the deposits
made by the customers that the bank has to make

Difference between interest income and interest expense; also called net interest
income; most crucial part of management of a bank

Will be dealt with in the upcoming slides; linkage with Allowance for Loan Losses in B/S

Includes the income from other services and investments that a bank makes; includes
fee-based income from services provided to customers (like ATM facility, net banking
and credit/debit card charges)

Includes the operating expenses of a bank like employee salary, administrative

expenses, expenses borne by the bank for providing specialized services to customers
etc.
 Provision for Loan Losses
What is the guarantee that a loan given by the bank will be duly
repaid?
There is no absolute certainty that repayment will be made. The
cases where a person fails to repay back the loan is called a default
scenario. Banks have to prepare themselves against these defaults
by keeping aside a capital buffer that can absorb the shock in case
of a default. This provisioning that is done in order to help a bank
protect itself from losses in case of defaults on the loans is called
Provisioning for Loan Losses
Calculation of Provision for Loan Losses
Provision for loan losses is usually calculated by considering the
ratio of net charge-off (or write off) to total loans and averaging it for
six years. This average ratio is then multiplied with the current loans
outstanding to get PLL. PLL is a non-cash expense as it is just a
provisioning made by the bank and not a real expense
Note: Calculation of PLL is just for the sake of understanding and
not mandatory to delve deep into
Allowance for Loan Losses
Allowance for loan losses is a contra-account to the loans
outstanding section of a balance sheet and it shows the cumulative
provisioning that has been made for loan losses.
If any loan is written off (charged off), then the amount is reduced
from the ALL account. Similarly, if a part of any loan that had been
written off is unexpectedly recovered, it is added back to the ALL
account
Writing Off/ Charging Off a Loan
Writing off /Charging off a loan means that in case of a loan that has
no scope of being recovered, the value of the loan as recorded on
the balance sheet is removed. It is considered as a loss, but
because provisioning is made in the ALL account, the amount of
loan charged off is reduced from that account and the income
statement remains unaffected
Non Performing Assets (NPA)
NPA is different from a write-off/charge-off. A Non Performing Asset
is defined as a loan whose repayment has not been done for the
past 90 days.
 Measures of Performance for Banks

Ratios(Metric) Formula Interpretation

Net Interest Margin 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 − 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆 NIM measures how large a spread between interest revenues and interest
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔(𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝑨𝒔𝒔𝒆𝒕𝒔) costs management has been able to achieve by close control over earning
assets and pursuit of cheaper sources of funding

Return On Assets 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 RoA is a measure of managerial efficiency. It indicates how capable
𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 management has been in converting assets into net earnings

Return on Equity Capital 𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆 RoE is a measure of rate of return flowing to shareholders. It indicates the
𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 net benefit shareholders have received from investing their funds in the firm

Earnings Spread 𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
𝑻𝒐𝒕𝒂𝒍 𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝑨𝒔𝒔𝒆𝒕𝒔
𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒙𝒑𝒆𝒏𝒔𝒆
−
𝑻𝒐𝒕𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑩𝒆𝒂𝒓𝒊𝒏𝒈 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
The spread measures the effectiveness of a financial firm’s intermediation
function in borrowing and lending money and also the intensity of
competition in the firm’s market area

What is a Derivative?
A formal definition of a derivative
contract is that it is a contract that
derives its value from the
underlying asset
Conclusion
Therefore, for a derivative contract
to be developed, there must be
two parties with opposing views
about the movement of prices of
the underlying asset. In the potato
example, the underlying asset of
the derivative contract is the
quantity of potato.
The party who is supposed to
buy the underlying asset is said
to be long on the forward
contract.
The party who is supposed to
sell the underlying asset is
called is said be short on the
forward contract.
Introduction to Derivatives
Example Types of Derivatives
Let us assume that the owner of a
French Fries restaurant expects
that potatoes will become costly in Derivatives
the near future. If the price of
potatoes goes up, then the cost of
raw materials increases which in
turn diminishes the profit margin
Forwards Futures Options Swaps
for the owner. Therefore, he wants
to enter a contract where he can
negotiate with a potato seller to Why are Derivatives important?
buy the potatoes in the future at a
certain predetermined price which Derivatives have been a very popular instrument for risk management
they will negotiate and lock in teams nowadays. Every division faces potential financial risk in some form
today. and hence, it becomes important for departments to engage in derivative
transactions in order to hedge the potential risks. For example, banks deal
Why will the potato seller agree in a huge amount of derivative transactions in order to hedge the interest
to sell the potatoes at a rate risk (which was discussed in banking), credit risk etc. Not only do
predetermined price in the institutions want to hedge their risk, they also want to make some gains, if
future? possible, from the derivative transactions. Hence, something that was
developed in order to hedge the risk became a major source of risk itself.
He must have an opposing view Biggest example- The financial crisis of 2008
about the movement of potato
prices in the future (he believes
that the potato price might go
down in the future)
 Forward Contracts and Future Contracts
What is a Forward Contract?
A forward contract is an agreement between
two parties to buy/sell a certain underlying
asset in the future at a certain price locked in
today.
The price which has been locked in is called
the Forward Price.
Features of Forward Contract
Forward contracts are OTC (over the counter)
products; they are not traded on the exchange
In a forward contract, there is a great amount of
counterparty risk involved as there is no
guarantee or anything at stake for the parties if
they don’t honor the terms of the contract.
Forward contracts are customized as per the
specific needs of the buyer and the seller. Thus,
they are also known as tailored contracts.
No upfront payment is required in order to go
into a forward contract
How does a forward contract work
Suppose that you estimate that you’ll need a
certain quantity of crude oil in the future. You go
into a forward contract with a counterparty who
is willing to sell crude oil in the future at a
predetermined price today. Let’s consider three
scenarios-
Forward Price > Price of asset in the future -
If you wouldn’t have gone into the contract, you
could have bought the asset at a lower price.
Thus, if the price of the asset in the future is
less than the forward price, the net effect is a
loss.
Forward Price < Price of the asset in the
future – It is beneficial for you as you can now
buy the asset at a lower price. Therefore, in this
case, the net effect is a gain.
Futures Contract
Futures are similar to forward contracts, though
there are certain differences-
Futures are traded on the exchange
Futures are standardized; they are not subject
to the specific demands or the needs of the
buyer/seller
In case of future contract, the counterparty risk
is very low as both the parties (buyer and
seller) have to deposit a certain amount of
money with the exchange as a form of
guarantee. This is called margin money. This
amount is settled on a day to day basis
based on the relative positions of the buyer
and the seller.

Options Contract
So far we have seen that in principle, in
forwards and futures contract, both the parties
are expected to oblige the terms of the
contract.
In case of options, the game is somewhat
different.
An option contract gives the buyer of the
contract the right (but not the obligation) to
buy/sell the asset. On the other hand, the
seller of the option (called the option writer)
is obliged to buy/sell the asset as per the
wishes of the buyer.
Types of Option Contracts
Option contracts are of two types- call option
and put option.
A call option gives the buyer of the option the
right (but not the obligation) to buy an asset at a
predetermined price. The seller of the option
has, therefore, the obligation to sell the asset.
Similarly, the put option gives the buyer of the
option the right (but not the obligation) to sell
the asset at a pre-determined price and the
seller of the put option (option writer) has the
obligation to buy the asset at that price.
Option Contracts
But why will the option writer take a risk? Option Combinations
This is because unlike forwards (where there is The person who buys the option is said to be
no upfront payment required) or futures (where long on the option. The person who sells the
both the parties have to maintain an amount option is said to be short on the option.
with the exchange), in case of options, the Therefore, in options we can have four sets of
buyer has to make an upfront payment to the combinations-
seller of the option. This upfront payment is Long Call- The right to buy an asset at a
called an option premium (the value of the certain price
option). Short Call- The obligation to sell an asset at a
certain price
How does an option payoff happen? Long Put- The right to sell an asset at a certain
price
Call Option Short Put- The obligation to buy an asset at a
Exercise price > Price in the future – In this case, certain price
the buyer of the option will choose not to exercise the
option as because the person can buy the asset in the The predetermined price is called the exercise
spot market at a cheaper rate. price or strike price (similar to the forward
Exercise price < Price in the future- In this case, the price in case of forward contract).
buyer of the option will choose to exercise the option
as because the person can buy the asset at the
exercise price which is less than the price prevailing in
the spot market.
Put Option
Exercise price > Price in the future – In this case,
the buyer of the option will choose to exercise the
option as because the person can sell the asset at a
higher rate than the spot rate
Exercise price < Price in the future- In this case, the
buyer of the option will choose not to exercise the
option as because the person can sell the asset at the
spot which is greater than the exercise price.