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The Banking System

Chapter 2

Risk Management and Financial Institutions 2e, Chapter 2, Copyright © John C. Hull 2009 1
1. Financial System
 Financial System is composed of the products and services
provided by financial institutions, which includes banks, insurance
companies, pension funds, organized exchanges, and the many
other companies that serve to facilitate economic transactions.
Virtually all economic transactions are effected by one or more of
these financial institutions. They create financial instruments, such
as stocks and bonds, pay interest on deposits, lend money to
creditworthy borrowers, and create and maintain the payment
systems of modern economies.

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1. Financial System
These financial products and services are based on the following fundamental
objectives of any modern financial system:

-To provide a payment system,

-To give money time value,

-To offer products and services to reduce financial risk or to compensate risk-
taking for desirable objectives,

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1. Financial System
- To collect and disperse information that allows the most efficient allocation of
economic resources,

- To create and maintain financial markets that provide prices, which indicates
how well investments are performing, which also determines the
subsequent allocation of resources, and to maintain economic stability.

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1. Financial System
Most people use the word Bank to describe a Depository Institution.

There are Depository and Non-Depository Institutions that differ by their


primary source of funds.

- Non-Depository Institutions, which are financial intermediaries that


cannot accept deposits but do pool the payments in the form of premiums or
contributions of many people and either invest it or provide credit to others.
Hence, Non-depository institutions form an important part of the economy.

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1. Financial System
- These Non-depository institutions are sometimes referred to as the
Shadow Banking System, because they resemble banks as financial
intermediaries, but they cannot legally accept deposits.
Consequently, their regulation is less stringent, which allows some
Non-depository institutions, such as hedge funds, to take greater
risks for a chance to earn higher returns.

- These institutions receive the public's money because they offer


other services than just the payment of interest. They can spread
the financial risk of individuals over a large group, or provide
investment services for greater returns or for a future income.

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1. Financial System
- Depository Institutions—banks that accept deposits—
contribute to the economy by lending much of the money
saved by depositors. However, deposits do not provide
all of an economy's funding, since only the wealthy save
a significant amount of money and most of it is not in
low-interest paying deposits which are taxable as
ordinary income.

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2. Banking System
 Banks play a central role in the money creation process and the
payment system. Bank credit is an important factor in financing of
investment and growth. Therefore, regulators have a special interest
in keeping banking system stable and efficient.

 Banks are corporations usually listed on the stock exchange and are
owned by shareholders. Banks fund themselves from both retail as
well as wholesale sources. Generally, banks rely on deposits as well
as funding from private markets.

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2. Banking System (Cont..)
 Banks are engaged in a wide range of activities to increase their capital and
profits.

 Retail Bank or Consumer Bank is the provision of services by a bank to


individual consumers, rather than to companies, corporations or other
banks. Services offered include savings and transactional accounts,
mortgages, personal loans, debit cards, and credit cards.

 Commercial Bank is a type of bank that provides services such as


accepting deposits, making business loans, and offering basic investment
products.

 Investment Bank is a type of bank that assists individuals, corporations,


and governments in raising financial capital by underwriting or acting as the
client's agent in the issuance of securities (or both).

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2. Banking System (Cont..)

 Islamic Bank: refers to a system of banking or banking


activity that is consistent with Islamic law (Shariah)
principles and guided by Islamic economics. The
contemporary movement of Islamic finance is based on
the belief that "all forms of interest are riba and hence
prohibited".

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2. Banking System (Cont..)
 Central Banks: to monitor financial Institutions and stabilize the economy.

- Central bank is the monitory authority and bank supervision aims to make the
financial system stable.

- Central banks control the availability of money and credit to ensure low
inflation, high growth and stability of financial system.

- Today’s policymakers strive for transparency in their operations.

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2. Banking System (Cont..)

-Example of Simple Bank Balance Sheet

Assets Liabilities
Cash 5 Deposits 90
Marketable Securities 10 Debt 5
Loans 80 Equity Capital 5
Fixed Assets 5
Total 100 Total 100

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2. Banking System

-Example of Simple Bank Income Statement

Net Interest Income 3.00


Provision for Loan Losses (0.80)
Non-Interest Income 0.90
Non-Interest Expense (2.50)

Pre-Tax Operating Income 0.60

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3. Bank Capital and Profitability
 Remember that net worth equals assets minus
liabilities.
 Net worth is referred to as Bank Capital, or
Equity Capital.
 We can think of capital as the owners’ stake in
the bank.
 Capital is the cushion banks have against a
sudden drop in the value of their assets or an
unexpected withdrawal of liabilities.
 It provides some insurance against insolvency.

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3. Bank Capital and Profitability
 An important component of bank capital is Loan
Loss Reserves:

 Loan loss reserves are an amount the bank sets


aside to cover potential losses from defaulted
loans.
 At some point the bank gives up hope a loan will
be repaid and erased from the bank’s balance
sheet.

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3. Bank Capital and Profitability
- There are several measures of Bank Profitability.

1. Return on Assets (ROA)

- ROA is the bank’s profit left after taxes divided by the


bank’s total assets.

[Profit left after taxes / Total Assets]

- It is a measure of how efficiently a particular banks uses


its assets.

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3. Bank Capital and Profitability
2 .The bank’s return to its owners is measured by
the Return on Equity (ROE).

- This is the bank’s profit after taxes divide by the bank’s


capital. [Profit after taxes / Capital]
- ROA and ROE are related to leverage (the use of various
financial instruments or borrowed capital, such as margin,
to increase the potential return of an investment).
- One measure of leverage is the ratio of banks assets to
bank capital.

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3. Bank Capital and Profitability
3. The final measure of bank profitability is Net
Interest Income.

- This is related to the fact that banks pay interest on


their liabilities and receive interest on their assets.
- Deposits and bank borrowing rate interest expenses;
securities and loans generate interest income.
- The difference between the two is net interest
income.

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3. Bank Capital and Profitability

 Off-Balance-Sheet: an asset or debt that does


not appear on a company's balance sheet. Items
that are considered off balance sheet are
generally ones in which the company does not
have legal claim or responsibility for. For
example, loans issued by a bank are typically
kept on the bank's books.

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3. Bank Capital and Profitability
To generate fees, banks engage in numerous off-
balance-sheet activities.

1. Lines of Credit - similar to limits on credit cards.

- The firm pays a bank a fee in return for the ability to


borrow whenever necessary.
- The payment is made when the agreement is signed
and firm receives a loan commitment.
- When the firm has drawn down the line of credit, the
transaction appears on the bank’s balance sheet.

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3. Bank Capital and Profitability
2. Letters of Credit

- These guarantee that a customer of the bank will


be able to make a promised payment.
- Customer might request that the bank send a
commercial letter of credit to an exporter in
another country guaranteeing payment for the
goods on receipt.
- In return for taking this risk, the bank receives a
fee.

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3. Bank Capital and Profitability
3. Standby Letter of Credit
- Is a guarantee of payment issued by a bank on
behalf of a client that is used as "payment of last
resort" should the client fail to fulfill a contractual
commitment with a third party. Standby letters of credit
are created as a sign of good faith in business
transactions, and are proof of a buyer's credit quality
and repayment abilities.

- These off-balance-sheet activities expose a bank to


risk that is not readily apparent on their balance sheet.

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4. Preventing Bank Failure
 There are many types of risks affect banks such as
Credit Risk and Liquidity Risk which may lead to
Systemic Risk [Discussed in Ch 1].

 The Basel Accords are principles and recommendations


on banking laws and regulations published by the Basel
Committee on Banking Supervision (BCBS). The
committee aims to improve the co-operation on
international regulatory issues by establishing principles
and recommendations for effective regulatory and
supervision of the international banking sector.

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4. Preventing Bank Failure (Cont..)
 In 1988, Basel I contains three main elements. Firstly, the BCBS
published the minimum capital ratios for banks. Banks were required
to have effective regulatory Capital Adequacy Ratio (CAR) of at
least 8% of the total assets on a risk adjusted basis.

 CAR: a measure of a bank's capital. It is expressed as a percentage


of a bank's risk weighted credit exposures.

 In response to the banking crises of the 1990s, the Basel Committee


developed a more comprehensive capital adequacy system to be
known as the Basel II Accord. It included new methods to deal with
credit risk and, adapt to the securitisation of the assets of the banks.
It also includes market, operational as well as interest rate risks, and
incorporates market based control and regulation.
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4. Preventing Bank Failure (Cont..)
 In November 2010, the Basel III was confirmed. It added
new principles relating to the responsibilities, structures
and processes of risk management; the responsibility of
Board with regard to its own activities and processes;
and the responsibilities and arrangements of Board in
group structures. The Basel III aims to enhance the
stability and soundness of the banking system, by
increasing the bank capital’s quantity and quality as well
as liquidity efficiency and mitigate systemic risk.

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