05) Commercial Banks 27sept23 With Summary

FINA 1303
THE SELL-SIDE: COMMERCIAL BANKS
Veronique Lafon-Vinais
Associate Professor of Business Education - Department of Finance
© Prof Veronique Lafon-Vinais – All Rights Reserved

Course Map If time allows
Overview
Financial Pricing of Financial

Foundations of Institutions
Institutions Financial Regulations
Interest Rates (II)
(I) Assets
Stock Banking
DCF Sell Side Buy Side
Valuation Regulation
Traditional
Basics of Commercial Monetary
Institutional
Interest Rates Banking Policy
Investors
Investment Alternative
Banking Investors
2
© Prof Veronique Lafon-Vinais – All Rights Reserved
Course map
Overview
Financial Institutions
1. What are Commercial Banks?

Sell Side
2. Bank Management
3. Types of Risk in Banking

Commercial
Banking
4. Measuring Bank Performance
5. Current Issues
© Prof Veronique Lafon-Vinais – All Rights Reserved 3

Banks as financial intermediaries
$ $
Saver/ Bank Borrower
Lender
Deposit Loan
Account Contract
Asset transformation
What4are Commercial Banks?

Commercial Banks
Financial Intermediaries
Depository Institutions
Commercial Banks
Retail
Banking Corporate &
Investment
Bank
Consumer Retail/Consumer Wholesale
Finance Banking Banking
Trading,
Treasury &
Credit
Private Banking/ Markets
Cards
Asset Management
What are Commercial Banks?
Commercial Banking
Retail banking Wholesale banking
 Clients = Retail (individuals)  Clients = Corporates and
 Provide residential and consumer Institutionals (large size →
loans wholesale)
 Accepting small deposits  Provide commercial and

industrial loans
 Funded with deposits and

purchased funds

Mortgages in HK: what types of mortgages do
banks offer? What are typical terms? Could we
have a subprime crisis in HK?
 Group 1
 Video
 https://www.youtube.com/watch?v=cP7IjoeMcZw
 Article
 https://www.scmp.com/business/article/3227210/hong-kong-mortgage-
changes-attract-interest-property-experts-foresee-limited-impact-home-
prices
Forces shaping International Banking
Changes in the
New entrants
structure of banking
Globalization Reduction
in profit Disintermediation
margins
Technological
changes
Ongoing product
Increased & process
Innovation innovation
competition
Regulation/ Transformation
Deregulation of regulatory
framework
Commercial Banks
Traditional products and services: New products and services
 Deposit accounts  Investment banking services
 Credit services  Consulting services
 Payment and collection services  Risk management services
 Trade services  Broker/dealer services
 FX services  Insurance services
 Credit enhancement or payment  Asset management

guaranty
 Agent or fiduciary services

Banks in the old days
Fall 09 Foundations of Financial Institutions

Banks today
Foundations of Financial Institutions

Multiple Role of Banks
Borrower
Liquidity
Lender
Providers
Payment Credit
Banks
Channel Enhancement
Conduit for
Custody Agents
Monetary Policy
Trustees

The very special role of banks: money creation

Money creation: how it works
The loan is an asset The deposit is a
for the bank liability for the bank
The bank
The bank deposits the
makes a loan money from
to the the loan into a
business deposit
account for
the business
Bank deposits are part of the money supply

Banks in Hong Kong: digital banking
developments and implications
 Group 2
 Video
 https://www.youtube.com/watch?v=6R2uUk84g-I
 Article
 https://www.hkma.gov.hk/media/eng/doc/key-information/guidelines-
and-circular/2020/20200618e1a1.pdf

Source: Mox FCCIHK presentation 2 Feb 21

Source: Mox FCCIHK presentation 2 Feb 21

Banks in China: will digital banking replace
traditional banking?
 Group 3
 Video
 https://www.youtube.com/watch?v=_OQ9TNvFHc4&t=10s
 Article
 https://www.bain.com/insights/how-retail-banks-in-china-can-elevate-
digital-banking/

SUMMARY (KLOs)
 What are commercial banks
 What they do (basic business models)
 Competitors
 Money creation
Summary: Commercial Banks

Course map
Overview

Sell Side
2. Bank Management

Commercial
Banking
5. Current Issues
Bank Management
Class discussion
 Imagine that you are the CEO of a large bank

– (pick one and name it)
 What keeps you awake at night and why?
Commercial Banks – Class discussion

Bank Management
4 primary concerns of bank managers: Aspects of bank management:

• Make sure bank has enough cash
• Liquidity management
to pay deposit outflows
• Pursue an acceptably low level of
risk by acquiring assets with low
• Asset management
default rate and diversifying asset ALM
holdings
• Acquire funds at low cost • Liability management
• Decide the amount of capital the
bank should maintain and acquire • Capital management
this capital
Bank Management
Liquidity Management
Scenario 1
Bank A (Reserve Requirement = 10% of Deposits)

Assets Liabilities Reserve req.
Reserves $20 mil Deposits $100 mil = $10 mil
Loans $80 mil Capital $10 mil Excess reserves
Securities $10 mil = $10 mil
Deposit outflow of $10 mil
Bank A (Reserve Requirement = 10% of Deposits)

Bank Management
Scenario 2
Bank B (Reserve Requirement = 10% of Deposits)

Securities $10 mil = none
Deposit outflow of $10 mil
Bank B (Reserve Requirement = 10% of Deposits)

Loans $90 mil Capital $10 mil Shortfall of res.
Bank Management
4 Possible actions for Bank B
1. Borrow from other banks or corporations

Assets Liabilities
Reserves $9 mil Deposits $90 mil
Loans $90 mil Capital $10 mil
Securities $10 mil Borrowings $9 mil
2. Sell securities
Assets Liabilities
Securities $1 mil
Source: Mishkin/Eakins
Bank Management
4 Possible actions for Bank B (Cont)
3. Borrow from the FED

Assets Liabilities
Securities $10 mil Discount loans $9 mil
4. Call in or sell off loans

Assets Liabilities
Securities $10 mil
Bank Management
ALM: Asset and Liability Management
 Asset Management
– Get borrowers with low default risk, paying high interest rates
– Buy securities with high return, low risk
– Diversify portfolio
– Manage liquidity by holding liquid assets and managing reserves
 Liability Management
– No longer primarily depend on deposits
– When see loan opportunities, borrow or issue CDs to acquire funds
Bank Management
Off-Balance-Sheet Activities
 Fee income from:
– Foreign exchange trades for customers Off-balance sheet
– Servicing mortgage-backed securities activities involve trading
financial instruments and
– Guarantees of debt Contingent generating income from
– Backup lines of credit liabilities fees and loan sales,
activities that affect bank
 Trading in and of: profits but do not appear
on bank balance sheets
– Financial futures and options (source: Mishkin)
– Foreign exchange
– Interest rate swaps
 Loan sales
All these activities involve RISK
Bank Management
Global Banking Revenues 2014-2021
Bank Management Source: McKinsey - Global Banking Report 2021

Capital Adequacy Management
 Tradeoff between safety (high capital) and return (ROE)
 Banks also hold capital to meet capital requirements
 Strategies for Managing Capital

– Sell or retire stock
– Change dividends to change retained earnings
– Change asset growth (increase or shrink balance sheet by acquiring or selling

off assets)
Bank Management
Test Your Understanding
 What is the theoretical

background for capital adequacy
requirements
– More capital increases cushion
for losses
– More capital provides incentive

for shareholders to monitor
management
– All of the above
– None of the above

Bank Management
SUMMARY (KLOs)
 Understand the key aspects of bank management
 Liquidity risk and how to manage it
 Role of off-balance sheet activities
Summary: Bank Management

Course map
Overview

Sell Side
2. Bank Management

Commercial
Banking
5. Current Issues
Types of Risk in Banking
Risk Management Basics
Identify
1) Eliminate
2) Keep
Quantify 3) Mitigate
4) Increase
Manage
1) Probability
2) Severity
Verify
Risk Management
 Credit
 Liquidity
 Market
 Operational
 Legal & Reputational

Credit risk
 The ability and willingness of a borrower to pay when due
 Components: default risk and recovery risk

– Within a given level of default risk, recovery risk can vary widely
– Recovery highly dependent on position in capital structure e.g. higher

recovery for secured debt and on type of issue e.g. recovery higher for loans
than bonds
 Remedy: liquidate or work-out?

Credit Risk
Types Mitigation
 Borrower  Credit policy
 Counterparty  Credit limits
 Country  Concentration limits
 Industry  Credit scoring
 Consumer  Netting
 Settlement risk  Credit bureau
 Ratings

Credit risk in Asia: what is the level of NPLs
(non performing loans) for banks in Asia? How
has it evolved over time? Implications?
 Group 4
 Video
 https://www.youtube.com/watch?v=Elv5XsDwg4o
 Article
Market risk
Types Mitigation
 Interest Rate risk  ALM policy
 FX risk  Hedging
 Equity risk  Risk management policy and
 Commodity risk limits

Liquidity Risk
Types Mitigation
 Funding liquidity risk  ALM policy
 Market liquidity risk  Conservative funding policy
 Conservative ratios
“Liquidity is an illusion. It’s always here

when you don’t need it, and rarely there
when you do”
Michael Milken

Operational Risk
Types Mitigation
 Inadequate information systems  Risk management policy
 Operational breakdown  Back up and recovery plans
 Breaches in internal control  Segregation of duties
 IT security breakdown  Outsourcing
 Unforeseen catastrophes  Audits
 Fraud “West LB’s equity trading loss soars; trading investigation launched”
FT 31 August 07
“Jail for ex-NAB rogue forex dealers”

FT 5 July 06

Operational risks in banks in Asia: find recent
incidents, what happened, consequences
 Group 6
 Video link
 https://www.cnbc.com/video/2022/12/22/asias-emerging-markets-face-
two-evolving-risks-in-2023-mizuho-bank.html
 Article
 https://asia.nikkei.com/Business/Finance/ASEAN-banks-squeezed-
between-credit-risks-and-interest-dynamics
Legal & Reputational Risks
Types Mitigation
 Regulatory risk  Implement SOX and related
 Money Laundering corporate governance policies
 Conflicts of Interest  KYC Policies
 Non-enforceability of contracts  Legal & Compliance Dpts
 Non-compliance with corporate reporting to CEO
governance laws  Audits
 ESG issues  ESG audits (environmental and

corporate governance)
Reputational Risk for Financial Institutions: do
we care? Examples in Asia
 Group 7
 Video
 https://www.youtube.com/watch?v=7c4I3fdX8Js
 Article
 https://www.spglobal.com/marketintelligence/en/news-insights/latest-
news-headlines/hsbc-s-support-for-china-bill-risks-tarnishing-reputation-
among-some-clients-59001826
Test Your Understanding
 What is recovery risk?

– The risk of the borrower not paying
– The risk of how much the lender can

recover in a case of default
 How do banks help prevent money

laundering (which type of policy?)
– ALM policy
– KYC policy
– Credit policy

SUMMARY (KLOs)
 Basics of Risk Management
 Credit risk dimensions and mitigation
 Understanding market risk
 Market risk mitigation strategies
 Understanding operational risk
 Operational risk mitigation strategies
 Understanding legal & reputational risk and mitigation strategies
Summary
Course map
Overview

Sell Side
2. Bank Management

Commercial
Banking
5. Current Issues
Measuring Bank Performance
Income statement
 Operating Income: the income that comes from a bank’s ongoing operations =
– Interest income = interest on the bank’s assets
– Non-interest income = service charges and fees, plus revenues from off-balance
sheet activities
 Operating Expenses : expenses incurred in conducting the bank’s ongoing

operations =
– Interest expense = interest on bank’s liabilities
– Non-Interest expense = operational costs e.g. wages
– Provision for loan losses
 Net Operating Income (NOI)


Key Indicators
Size & Market

Profitability Other Financial Other
Share
Operating income Total Assets VAR Awards
Net income Market Cap Share Price Customer
EPS Funds under Ratings satisfaction
ROA management Employee turnover
ROE League Tables Lawsuits
ROEC Volume estimations
RAROC
Customer
profitability

Key Constituencies
Rating Agencies
Regulators Suppliers
Management
Shareholders Creditors
Employees
Competitors Customers

Bank Organization
 Matrix management
 Lines of business/lines of products
 CRM and implications
 Shifting strategies
 Impact of bank mergers
 Impact of bank regulation/deregulation

Matrix Management
Markets
US EMEA ASPAC LATAM

FX
MM
DCM
ECM
Derivatives
M&A
LOB

Derivatives in Asia: what is the level of
development of derivatives market (on
exchange and OTC) across Asia? What about
China? What are the issues? Implications?
 Group 5
 Video
 https://www.youtube.com/watch?v=gh6S8-lOR8E
 Article
 https://www.cmegroup.com/openmarkets/interest-
rates/2022/Derivatives-Trading-Growing-in-Asia.html
SUMMARY (KLOs)
 Understanding the various types of performance indicators
 Understanding matrix management
Summary
Course map
Overview

Sell Side
2. Bank Management

Commercial
Banking
5. Current Issues
Current Issues
Current issues in banking
 Regulatory pressure
 ESG/Sustainability
 Technology/FinTech
 Shadow banking
 New entrants
 …..
Current Issues

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FINA 1303

THE SELL-SIDE: COMMERCIAL BANKS

Associate Professor of Business Education - Department of Finance

© Prof Veronique Lafon-Vinais – All Rights Reserved

Financial Pricing of Financial

1. What are Commercial Banks?

3. Types of Risk in Banking

© Prof Veronique Lafon-Vinais – All Rights Reserved 3

What4are Commercial Banks?

Retail banking Wholesale banking

 Clients = Retail (individuals)  Clients = Corporates and

 Provide residential and consumer Institutionals (large size →

 Accepting small deposits  Provide commercial and

 Funded with deposits and

What are Commercial Banks?

Traditional products and services: New products and services

 Deposit accounts  Investment banking services

 Credit services  Consulting services

 Payment and collection services  Risk management services

 Trade services  Broker/dealer services

 FX services  Insurance services

 Credit enhancement or payment  Asset management

 Agent or fiduciary services

What are Commercial Banks?

Fall 09 Foundations of Financial Institutions

Foundations of Financial Institutions

What are Commercial Banks?

What are Commercial Banks?

Bank deposits are part of the money supply

What are Commercial Banks?

What are Commercial Banks?

What are Commercial Banks?

What are Commercial Banks?

What are Commercial Banks?

 What are commercial banks

 What they do (basic business models)

Summary: Commercial Banks

1. What are Commercial Banks?

3. Types of Risk in Banking

 Imagine that you are the CEO of a large bank

 What keeps you awake at night and why?

Commercial Banks – Class discussion

4 primary concerns of bank managers: Aspects of bank management:

Bank A (Reserve Requirement = 10% of Deposits)

Deposit outflow of $10 mil

Bank A (Reserve Requirement = 10% of Deposits)

Bank B (Reserve Requirement = 10% of Deposits)

Deposit outflow of $10 mil

Bank B (Reserve Requirement = 10% of Deposits)

1. Borrow from other banks or corporations

3. Borrow from the FED

4. Call in or sell off loans

– Buy securities with high return, low risk

– Manage liquidity by holding liquid assets and managing reserves

– When see loan opportunities, borrow or issue CDs to acquire funds

Bank Management Source: McKinsey - Global Banking Report 2021

© Prof Veronique Lafon-Vinais – All Rights Reserved 29

 Tradeoff between safety (high capital) and return (ROE)

 Banks also hold capital to meet capital requirements

 Strategies for Managing Capital

– Change dividends to change retained earnings

– Change asset growth (increase or shrink balance sheet by acquiring or selling