FIN3103B/3703B

Financial Markets
02: Financial Institutions II: Banks

Dr. YUE Ling

1 Sem2 AY2020/21
Financial Institutions II: Banks
I. Financial Intermediaries

II. Risk and risk management in Banking

1. Interest rate risk
2. Liquidity risk
3. Other risks

III. Central Banks

IV. Basel Committee on Bank Supervision

1. Basel I (July 1988)
2. Basel II (June 2004)
3. Basel III (2019)

2 Sem2 AY2020/21
I. Financial intermediaries
Financial intermediation: Intermediate between suppliers and
demanders of funds

• Maturity intermediation
• Denomination intermediation
• Risk intermediation

3 Financial Intermediaries
II. Risks and risk management in banking
Different sources of risk:
1. Interest rate risk
2. Liquidity risk
3. Other risks
• Credit risk
• Foreign exchange (FX) risk
• Trading risk or market risk
• Operational risk

Three steps in risk management:

• Identify risk
• Measure risk
• Manage risk

4 Risks and Risk Management in Banking
S&L crisis in the 1980s
• Maturity gap
• Short term deposits
• Long term fixed mortgage loans

• Fluctuation of interest rates

• Lifting of deposit rate ceiling (Regulation Q)

• Increase risk of loan portfolio

• Decrease in real estate prices => default

5 Interest Rate Risk
1. Interest rate risk
• Due to maturity mismatch, banks suffers from interest rate risks.

• Interest income and expense

• Interest income received from assets (e.g., loans)
• Interest expense incurred from liabilities (e.g., deposits)

• Interest rate sensitive assets and liabilities

• Remaining maturity
• Repricing

• Gap analysis: interest rate fluctuation & net interest income

• For a given horizon (e.g., 1 day, 1 week, etc):
• Gap = rate sensitive assets – rate sensitive liabilities

7 Interest Rate Risk
Gap report
1 Day 1 Wk 1 Mth 3 Mths 1 Yr > 1 Yr Total
($’m)

Assets:
SGS 0 30 60 20 100 0 210
Other MM 2 1 3 5 0 0 11
Fixed Rate Loans: 0
Corporate 5 20 50 200 100 100 475
Housing 5 10 30 50 200 1,000 1,295
Vehicle 1 2 3 5 10 30 51
Floating Rate Loans: 0
Corporate 300 0 0 0 0 0 300
Housing 1,000 0 0 0 0 0 1,000
Total Assets Repricing 1,313 63 146 280 410 1,130 3,342

Liabilities:
Interbank Borrowings 200 20 0 0 0 0 220
Saving Account 600 0 0 0 0 0 600
1-mth FD 20 30 50 0 0 0 100
3-mth FD 50 70 60 50 0 0 230
6-mth FD 20 120 150 140 0 0 430
1-Yr FD 120 20 15 20 30 0 205
Total Liabilities Repricing 1,010 260 275 210 30 0 1,785

Gap Position 303 (197) (129) 70 380 1,130

8 Interest Rate Risk
Gap report
Which is better: positive or negative gap position?

• Positive gap position:

• Benefit when interest rates _________
• Suffers when interest rates _________

• Negative gap position:

• Benefit when interest rates _________
• Suffers when interest rates _________

• Does a matched gap position mean no interest rate risk?

10 Interest Rate Risk
Gap report: shortcoming
• Time value of money is not taken into account
• Does not give a comprehensive view of how the net value of the
bank (assets and liabilities positions of the bank) will be affected
by a change in interest rate

Solution = Duration (Macaulay’s duration)

13 Interest Rate Risk
Duration
• Duration is a cash-flow-weighted average of the time-to-maturity.
• Duration (Macaulay’s duration):
𝐶 𝐶 𝐶
1∗ 2∗ ⋯ 𝑇∗
1 𝑖 1 𝑖 1 𝑖
𝐷
𝐶 𝐶 𝐶
⋯
1 𝑖 1 𝑖 1 𝑖 Present value 
of cash flows
𝑡𝐶
∑
1 𝑖
𝐷
𝐶
∑
1 𝑖

14 Interest Rate Risk
Duration
• Duration (Macaulay’s duration):
𝑡𝐶
∑
1 𝑖
𝐷
𝐶
∑
1 𝑖
• Example: 3-year coupon bond, face value = $1,000, coupon rate =
10%, annual coupon payment
Years Cash flow (CF) Present Value of CF t x PVCF
(i = 10%)
1 100
2 100
3 1100
Total

• Duration = _______________________

15 Interest Rate Risk
Duration

• Duration (Macaulay’s duration): 𝐷 ∑ ∑

• The longer the duration, all else constant, the more vulnerable the
portfolio is to changes in interest rates.
• Penalizes later cash-flows more. Hence, portfolios with more cash
flows earlier, all things constant, will have a shorter duration than
portfolios with more cash flows later.
• Portfolios with all cash flow at termination will have duration =
______________.

19 Interest Rate Risk
Duration
• Macaulay’s duration:
𝑡𝐶 𝐶
𝐷
1 𝑖 1 𝑖

• Percent price change: Modified Duration

𝐷𝑢𝑟𝑎𝑡𝑖𝑜𝑛
𝑀𝑜𝑑𝐷
1 𝑖

Δ𝑃 𝑀𝑜𝑑𝐷 ∗ Δ𝑖 ∗ 𝑃

21 Interest Rate Risk
Duration
• Example: 3-year coupon bond, face value = $1,000, coupon rate =
10%, annual coupon payment.
i0
Years Cash flow (CF) Present Value of CF t x PVCF
(i = 10%)
1 100 90.91 90.91
2 100 82.64 165.29
3 1100 826.45 2479.34
Total 1000 2735.54

• Duration = _______________________ P0
• If 𝑖 ↑ 1% (that is Δ𝑖=_____):

𝑀𝑜𝑑𝐷 _________

Δ𝑃 ______________
23 Interest Rate Risk
Duration gap
𝑀𝑉
𝐷 𝐷 ∗𝐷
𝑀𝑉

Δ𝑖
Δ𝑀𝑉 𝐷 ∗ ∗ 𝑀𝑉
1 𝑖

Δ𝑖
%Δ𝑀𝑉 𝐷 ·
1 𝑖

25 Interest Rate Risk
Duration gap: example
Base on following information, determine the duration gap for Bank A:
• DAssets = 2.70
• DLiabilities = 1.03
• MVAssets = 100
• MVLiabilities = 95

• Answer: 𝐷𝐺𝑎𝑝 __________________

• What is the change in market value of net worth as a percentage of

assets if interest rate rise from 10% to 11%?
Δ𝑖
%Δ𝑀𝑉 𝐷 ·
• Answer: 1 𝑖
• ∆𝑖 _________________
• 𝑖0 _________________
• Thus,%Δ𝑀𝑉 _________________

26 Interest Rate Risk
Duration gap
𝑀𝑉
𝐷 𝐷 ∗𝐷
𝑀𝑉
Δ𝑖
Δ𝑀𝑉 𝐷 ∗ ∗ 𝑀𝑉
1 𝑖

• Positive duration gap benefits (suffers) from decreases (increases) in

interest rates
• Negative duration gap benefits (suffers) from increases (decreases)
in interest rates
• So which is better?

• Immunization: achieving zero duration gap to immunize against

shifts in interest rate

• Does matched gap, a zero gap, a zero duration gap means no

interest rate risk?
29 Interest Rate Risk
(1) Basis risk
Interest rates in different instruments do not always move together
and in the same magnitude.

30 Interest Rate Risk
(2) Embedded option risk
• Pre-withdrawal
• When interest rate _______
• Depositors exercise option and withdrawal on fixed deposits
before maturity and re-deposit at higher rate

• Prepayment
• When interest rate _______
• Borrowers exercise option and prepay loan and refinance at
lower rates

• In either case, interest margin _______

• Solutions: Penalty for pre-mature withdrawal and prepayment

31 Interest Rate Risk
Managing interest rate risks
• Decision based on the gap analysis: target is 0 gap (matched gap)
• Decision based on the duration gap analysis: target is 0 duration gap
(immunization)

Balance Sheet Strategies

• Positive gap: get rid of assets and increase liabilities
• Decrease assets: sell or securitize
• Increase liabilities: borrow more funds
• Negative gap: increase assets and get rid of liabilities
• Increase assets: buy or issue more loan
• Decrease liabilities: reduce debt

• Weigh between the probability, direction, and magnitude of the

change of the interest rates with the cost involved
• There are easier ways to manage interest rate risk…

33 Interest Rate Risk
Off balance sheet strategies: (1) Futures
• Example: bank expects
• Interest rate falls by 100 basis points (1%) in 6 months time
• Bank net interest income (NII) falls by $100,000

• Strategy:
• Buy 6-month futures contracts of a short-term Treasury
security, e.g., 3-month T-bill
• F = Par×[1 – i (t/360)]
• F = futures price
• Par = face value = $1m
• i = discount yield = 5%
• t = term of T-bill = 90
• F = __________________

34 Interest Rate Risk
Off balance sheet strategies: (1) Futures
• Futures:
6 month later, i = 4% …………….
F = ___________________
Gain in futures trading = ___________
If the bank buys contracts = gap will be hedged

Problem:
• when interest rate does not move as expected, although
position is still hedged
• cross-hedge may not be perfect (hedging loans, eg. prime
peg loans, with another instrument, T-bills in this case)

37 Interest Rate Risk
Off balance sheet strategies: (1) Futures
• If T-bills futures are not available, other interest rate futures can be
used. Example: Eurodollar futures (LIBOR)
• Replace discount yield of T-bills by the respective interest rates
• Some times, International Monetary Market (IMM) price is used
instead of yields
• IMM = 100 – yield
• When IMM increases, prices of futures increases

• Example: What is the futures trading profit when a long CME 3-month
Eurodollar futures contract increases from $97.8725 to $97.8800

Yield = ________________________
Yield = ________________________
Yield has fallen by 0.75 bps

Profit = $ 1m * ________________________
= $ _________

40 Interest Rate Risk
Off balance sheet strategies: (2) Swaps
• Interest rate swap: transaction hedge
• Use interest rate swaps for (1) transaction hedge: for example,
client wants fixed rate loans but bank wants floating assets

Pay 5 yr 3% fixed (swap rate)
Swap 
Bank
Counterparty
Pay 5 yr SIBOR (floating)

Pay 5 yr 5% fixed

Client

43 Interest Rate Risk
Off balance sheet strategies: (2) Swaps
• Interest rate swap: transaction hedge
• Use interest rate swaps for (1) transaction hedge: for example,
client wants fixed rate loans but bank wants floating assets

Pay 5 yr 3% fixed (swap rate)
Swap 
Bank
Counterparty
Pay 5 yr SIBOR (floating)

Pay 5 yr 5% fixed No principal is exchanged between the bank 

and the swap counter party. Only the interest 
payments.
Client
Problem: 
• Client _____________
• Swap counter party: __________

44 Interest Rate Risk
Off balance sheet strategies: (2) Swaps
• Interest rate swap: balance sheet hedge
• Use interest rate swaps for (2) balance sheet hedge: for example,
if bank expects a fall of 100 basis points in interest rate in 6
months time and therefore a fall of $100,000 in net interest income
(NII)

• Strategy:
• Swap $10m: pay SIBOR (3%) and receive fixed (3%)
• Interest rate decrease 100 basis points (i = 2%)
• Swap income = ________

46 Interest Rate Risk
Managing interest rate risks
Asset Liability Management (ALM):
• The ALM function of the financial institution manages the interest
rate risk.

• The Asset and Liability Committee (ALCO) is a senior

management committee that oversees the function.

• A good ALM system will go a long way in providing timely and

useful information for decision making
• Comprehensive: include full portfolio of assets and liabilities
• Flexible: simulate different interest rate scenarios
• Clear and simple: reports, tables, and charts that top
management can understand

48 Interest Rate Risk
2. Liquidity Risks
• Banks must have sufficient liquidity to meet obligations (especially
withdrawal) failure of which will lead to bank runs. Banks cannot
have cash flow problems!!!

49 Liquidity Risk
Reserves requirement

• Reserves requirement = 10%, Excess reserves = $0 million

• Deposit outflow of $10 million. How much reserve to top up?

Source: Financial Markets and Institutions, 9e, Mishkin and Eakins. Pearson Education, 2018.

50 Liquidity Risk
 Sources of liquidity

After Selling Loans

Source: Mishkin and Eakins. Pearson Education, 2018.

51 Liquidity Risk
Liquidity risks
• Sources of liquidity: sell securities, borrow, Central bank’s
discount window (borrower of last resort).

• Liquidity needed:
• Short-term requirement
• Seasonal requirement
• Structure changes in liquidity requirement

• Liquidity regulation:
• Minimum Cash Balance (MCB)
• Minimum Liquid Assets (MLA)
• Liquidity Coverage Ratio (LCR)
• Net Stable Funding Ratio (NSFR)
• MAS Notices 758, 613 (formerly), 649, 652
52 Liquidity Risk
Liquidity regulation
• MAS Notice 758: Minimum cash balance (MCB) to be kept with MAS =
3% (used to be 6%) of liability base
• [Formerly] MAS Notice 613: Minimum liquid assets (MLA) to be kept with
MAS = 16% of liability base (cancelled and replaced)
• MAS Notice 649: Minimum liquid assets (MLA) and liquidity coverage
ratio (LCR) requirements: Combining Basel III liquidity requirements with
requirements in Notice 613
• SGD MLA requirement: liquid assets in SGD ≥ 16% of all SGD
qualifying liabilities
• All other currencies MLA requirement: liquid assets in any currencies
≥ 16% of qualifying liabilities in all currencies
• SGD and all other currency Liquidity Coverage Ratio (LCR)
requirement (short term)
• MAS Notice 652: Net Stable Funding Ratio under Basel III

54 Liquidity Risk
Price of liquidity
• Liquidity for loans and investments
• The price of liquidity: funds transfer pricing
• Funds are not free
• What is the appropriate cost of funds?
• The rate the bank has to pay to source for outside funds
• Instill loan pricing discipline (e.g., liquidity premium table)
• Evaluating corporate loan division

55 Liquidity Risk
3. Other Risks
Credit risks: Default risk
• Risk of default of any counterparty:
• Retail borrowers (e.g. residential, hire purchase, share
financing, personal loans, credit cards)
• Corporate borrowers (eg. loans to SMEs)
• Issuers of securities (eg. bonds and commercial paper
issuers)
• Swap counterparties

• How do we measure credit risks?

• PD (probability of default)
• LGD (loss given default)

• Central focus of the Basel Accords

56 Other Risks
3. Other Risks
Forex risks:
• Risk due to fluctuations of foreign currencies
• Commonly managed by derivatives
• For example: An US exporter exports 1000 TVs to Singapore,
the payment will be made 3 months from today. To lock the
exchange rate, buy a futures / forward contract of selling S$
(or say buy US$) with the delivery date is 3 months from
today.

57 Other Risks
3. Other Risks
Trading risk or market risk:
• Market risk due to trading activities of the treasury desk

• Tools:
• VaR (value at risk)
• EaR (earnings at risk)
• EVE (Economic Value of Equity)
• RiskMetrics
• Mark-to-Market

58 Other Risks
Exercise: Duration and Bank Value
Part I:
• Bank ABC has the following 2 bond-like loans:
• Loan 1: $1m loan fixed for 3 years at 10%
• Loan 2: $1m loan fixed for 5 years at 12%
• The market interest rate is now at 5%. What is the duration of the
bank’s loan portfolio? If the market interest rate increases by 1%
now, what will be the percentage change of the present value of
the portfolio?

Part II:
• ABC has $1.5m of liabilities (at market value) with a duration of
2.68 years. How much will the value of the bank change due to the
change in interest rate.

60 Duration
Financial Institutions II: Banks
I. Financial Intermediaries

II. Risk and risk management in Banking

1. Interest rate risk
2. Liquidity risk
3. Other risks

III. Central Banks

IV. Basel Committee on Bank Supervision

1. Basel I (July 1988)
2. Basel II (June 2004)
3. Basel III (2019)

64 Sem2 AY2020/21
III. Central banks
• A central bank, reserve bank, or monetary authority is an
(supposedly) independent entity responsible for the monetary
policy of its country or of a group of member states (e.g. EU)
• Primary/core responsibility: to maintain the stability of the
national currency and money supply
• Supervisory powers, to ensure that banks and other financial
institutions do not behave recklessly or fraudulently
• Examples
• Federal Reserve System (Fed) in the USA
• European Central Bank (ECB) in the European Union
• Monetary Authority of Singapore (MAS)

65 Central Banks
Central bank independence

Government ‐ Treasury  Central bank

department or Ministry of 
Finance

66 Central Banks
Functions of a central bank
Functions of a central bank (not all functions carried out by all
banks):
• Issuance of currency
• Implementation of monetary policy
• Controlling of money supply
• Act as a Lender of Last Resort
• Setting of official interest rate
• Managing foreign exchange and gold reserves
• Managing foreign exchange rate
• Regulation and supervision of the banking industry

• Note: Not all functions are carried out by all central banks.

69 Central Banks
Monetary policy instruments
The main monetary policy instruments available to central banks
includes:
• Bank reserve requirement: e.g. the minimum reserves each bank
must hold to satisfy withdrawal demands

• Interest-rate policy

• Open market operation: buying and selling government securities,

or other instruments

71 Central Banks
Regulation of the banking industry
• Permissible financial activities:
• Commercial banking activities: e.g. full banks, qualifying full
banks, finance companies, etc
• Investment banking activities: e.g. Glass Steagall Act, Gramm-
Leach-Billey Act
• Interest rate ceiling on deposit/loan
• Geographic restrictions on branches
• Capital requirement
• Liquidity requirement
• Deposit insurance:
• US$250,000 per depositor (FDIC)
• €100,000 per depositor (EDIC)
• S$75,000 per depositor (SDIC)
• Others
72 Central Banks
Financial Institutions II: Banks
I. Financial Intermediaries

II. Risk and risk management in Banking

1. Interest rate risk
2. Liquidity risk
3. Other risks

III. Central Banks

IV. Basel Committee on Bank Supervision

1. Basel I (July 1988)
2. Basel II (June 2004)
3. Basel III (2019)

76 Sem2 AY2020/21
IV. Basel Committee on Bank Supervision
• Three series of banking regulations (Basel I, II and III) set by the
Basel Committee on Bank Supervision (BCBS)

• BCBS is an international committee formed to develop standards

for banking regulation, founded in 1974 by central banks from the
G10 countries.

• Purpose:
• Ensure banks have enough capital to meet obligations and
absorb unexpected losses
• Promote financial stability

78 Basel
1. Basel I (July 1988)
• “International Convergence of Capital Measurement and Capital
Standards”, BCBS, 15th July 1988

• Definition of capital: two-tiers

• Structure of risk weights

79 Basel
Basel I (1988) definition of capital
• Two-tier capital:
• Tier 1:
• Common shareholders’ equity
• Disclosed reserves
• Minority interest in common shareholders’ equity of
consolidated subsidiaries

• Tier2:
• Undisclosed reserves
• Asset revaluation reserves
• General provisions/general loan loss reserves
• Hybrid (debt or equity) capital instruments: eg. preference
stocks and convertibles
• Subordinated debt
80 Basel
Basel I (1988) definition of capital
• Deductions from Tier 1 and 2:
• Investments in unconsolidated banking and financial
subsidiary companies
• Investments in the capital of other banks and financial
institutions (discretion of national authorities)

• Maximum of tier 2 = 100% of tier 1

81 Basel
Basel I (1988) risk weights of assets
Examples:
• On Balance Sheet items:
• 0%:
• Cash
• Claims on central banks
• Claims on Organization for Economic Co-Operation and
Development (OECD) governments or central banks
• 50%:
• Fully secured mortgage loans
• 100%:
• Claims on non-OECD governments and banks
• Premises, plant and equipment and other fixed assets
• All other assets

• Off-balance-sheet items are also assigned to risk categories via conversion

factor

Standard: to reach capital to weighted risk assets of 8% by end 1992

82 Basel
Basel I (1988)
• Standard: the ratio of capital to risk-weighted assets is at least 8%
(compliance by end of 1992)
• Example:
Assets $’m
Cash  100
Claims on OECD governments 150
Secured mortgage loans 500
Claims on non‐OECD governments 50
Other assets 200

Risk‐weighted assets: 
$100m x 0% + $150m x 0% + $500m x 50% + $50m x 100% + $200m x 
100% = $500m
Required capital: 
$500m x 8% = $40m
83 Basel
2. Basel II (June 2004)
• What was wrong with Basel I?

• Summary of revision:
• 3-pillar system
• Pay due regard to particular features of the present
supervisory and accounting systems in individual member
countries
• Maintain the 8% capital to risk-weighted assets (1st pillar)
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
𝐶𝑟𝑒𝑑𝑖𝑡 𝑅𝑖𝑠𝑘 12.5 ∗ 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑅𝑖𝑠𝑘

84 Basel
Basel II
(2004)

85
Basel II (2004)
Greater use of assessments of risk provided by banks’ internal
systems as inputs to capital calculations

• Credit risk: the standardized approach (for many banks)

• Similar to the 1988 method

• Credit risk: the Internal-Rating-Based (IRB) approach (allowed for

sophisticated banks)
• Rely on internal estimates of risk components:
• PD (probability of default)
• LGD (loss given default)
• EAD (exposure at default)
• M (effective maturity)
• Complex rules and risk-weighted functions
86 Basel
Basel II (2004)
• Operational risk: risk of loss resulting from inadequate or failed
internal processes, people and systems or from external events.
• Basic indicator approach
• Standardized approach
• Advanced measurement approach

• Market risk: risk resulting from trading activities

• Standardized measurement method
• Internal models approach

87 Basel
Basel II (2004)
• More national discretions. Too much?

• Two addition pillars:

• 2nd pillar: Supervisory review process
• 3rd pillar: Market discipline

• To be achieved by end-2007 by G-10

• MAS implemented Basel II at the same time as the G-10 countries
(The Group of Ten is made up of eleven industrial countries: Belgium,
Canada, France, Germany, Italy, Japan, the Netherlands, Sweden,
Switzerland, the United Kingdom and the United States)

88 Basel
3. Basel III (2019)
• BCBS agreed on Basel III in November 2010. Implementation was
originally planned for 2013-2015 and later extended to 2019-2022.

• BCBS summary:
https://www.bis.org/bcbs/basel3/b3_bank_sup_reforms.pdf

• Major changes
• Higher capital requirement
• Countercyclical buffer
• Systemically important banks (G-SIBs, D-SIBs)
• Liquidity requirement

• How much capital is enough?

89 Basel