FFIRS 04/04/2012 9:55:35 Page 8 FFIRS 04/04/2012 9:55:35 Page 1

Praise for The Principles of Banking

Moorad Choudhry’s The Principles of Banking opens up a portal into the world of sophisticated, dynamic, capital markets-based commercial banking. He gives us the big picture, the precise details and a framework for analyzing the enormous risks facing these firms. The book is an invaluable resource. Jean Helwege J. Henry Fellers Professor of Business Administration, Department of Finance, University of South Carolina

This book is a ‘‘must read’’ for all senior bankers. There is no writer better than Moorad Choudhry for communicating the vital principles of liquidity, capital and asset-liability management and bank corporate governance. Professor Carol Alexander Chair of Financial Risk Management, ICMA Centre, University of Reading Chair of the Board, Professional Risk Manager’s International Association

The Principles of Banking is ideal reading for anyone planning or developing a career in banking. Professor Choudhry’s coverage is fully integrated, clear, and authoritative. There is no better practitioner’s guide to this subject. Darrell Duffie Dean Witter Distinguished Professor of Finance Graduate School of Business, Stanford University

The failure of the US banking system in 2007–2008 can be effectively described by failing to apply the principles and strategies discussed by Moorad Choudhry. Indeed, banks should understand the dynamic interaction of the economy, credit losses and interest rates, and utilize the strategies within to balance the extremes, and prioritize strategies based upon return of capital and return on capital. Joe Jennings CFA Former Managing Director, Sterne Agee & Leach, Inc., Memphis, TN

Asset and liability management (ALM) is at the heart of any bank. Among many of its functions, keeping the bank liquid and fixing the ‘‘value’’ of money (for the bank) are key to a bank’s survival and success. Moorad Choudhry has a wealth of experience in this area. The Principles of Banking is an invaluable practical guide on how banks can lift their conduct to meet the challenges of the post-crash era. Abhijit Patharkar Senior Business Manager, Asset and Liability Management, Standard Chartered Bank, Singapore

Moorad continues to make a substantial contribution both to academia and the finance profession. His latest book, The Principles of Banking, is a comprehensive coverage of best-practice concepts and his own recommended strategies which are set out in a very lucid manner. Moorad, who is a Visiting Professor at CARISMA, makes us proud; well done Moorad! Gautam Mitra Professor of Computational Optimisation and Modelling & Emeritus Professor, Brunel University Director of CARISMA: The Centre for the Analysis of Risk and Optimisation Modelling Applications FFIRS 04/04/2012 9:55:35 Page 2

Yet again, a work of excellence. Rafael Hurtado Vice-President Risk Management, Banco de Credito, Lima

Professor Choudhry puts financial instruments and their derivatives within the context of banks’ asset and liability management, constituting a masterful and unique reference work in the field. This book covers bank liquidity risk analysis and management, as well as stress testing. On these topics Professor Choudhry’s book is indispensable reading and is set to become the principal reference. Nuno Cassola e Barata Adviser, Market Operations, European Central Bank, Frankfurt

The Principles of Banking is a timely reminder and update, incorporating lessons from the crisis and offering practical insights from that rare person – someone who combines working in the market with the dispassionate analysis of an academic. This book provides theory and practice in an easy-to- follow manner, an ideal reference for seasoned professionals. Irving Henry Director, Prudential Capital and Risk, British Bankers’ Association, London

As a banker and bank regulator, asset and liability management has remained a high priority area for me. Professor Choudhry’s inclusive and incisive book on the nitty-gritty and nuances of this extremely important subject will help both practitioners and researchers better understand and analyse new tools and models for measuring and managing risk, as well as to keep up with the innovation challenges. Dr. K C Chakrabarty Deputy Governor, Reserve Bank of India, Mumbai

Professor Choudhry has been recommending for years what bank regulatory authorities only started writing about after the crash. The Principles of Banking is the last word on the subject, the definitive rulebook on bank governance and risk management for senior directors, board members and supervisors. Martin Barber Global Head of ITO Delivery, Hewlett-Packard Corporation, EMEA

A really comprehensive and approachable text – an invaluable companion for any financial market practitioner. Mark Miller Global Economist, Lloyds TSB Corporate Markets, London

A very highly rated book in the Group CFO performance management office! The office ALM bible, our main reference point on ALM matters. Vasilis Kosmas Head of Structured Finance, National Bank of Greece, Athens

Asset and liability management is without doubt a priority in banking; it is essential that proper controls are in place to ensure the best returns on, and also efficient use of, capital. This book covers all essential topics in a straightforward manner and builds, from basic to complex, a very useful tool for everyone in this environment. Tom O’Connor Head of Treasury, KBC Bank NV, London FFIRS 04/04/2012 9:55:35 Page 3

The Principles of Banking FFIRS 04/04/2012 9:55:35 Page 4

Dictum Meum Pactum

—The motto of the London Stock Exchange FFIRS 04/04/2012 9:55:35 Page 5

The Principles of Banking

MOORAD CHOUDHRY

John Wiley & Sons Singapore Pte. Ltd. FFIRS 04/04/2012 9:55:35 Page 6

Copyright # 2012 Moorad Choudhry Published in 2012 by John Wiley & Sons Singapore Pte. Ltd. 1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628

All rights reserved.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons Singapore Pte. Ltd., 1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628, tel: 65–6643–8000, fax: 65–6643–8008, e-mail: [email protected].

This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought.

The views expressed in this book are an expression of the author’s personal views only and do not necessarily reflect the views or policies of The Royal Bank of Scotland Group plc, its subsidiaries or affiliated companies, or its Board of Directors. RBS does not guarantee the accuracy of the data included in this book and accepts no responsibility for any consequence of their use. This book does not constitute an offer or a solicitation of an offer with respect to any particular investment.

While every attempt has been made to ensure accuracy, neither the author nor the publisher will accept any liability for any errors or omissions herein. This book does not constitute investment advice and its contents should not be construed as such. The contents should not be considered as a recommendation to deal in any financial market or instrument, and the author, publisher, employer, any named entity, affiliated body or academic institution will not accept liability for the impact of any actions resulting from a reading of any material in The Principles of Banking.

This Disclaimer in its entirety applies to the supplementary material accompanying this book, which appears on the Wiley website (see Chapter 19 for details).

Other Wiley Editorial Offices

John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United Kingdom John Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, Canada John Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany

Library of Congress Cataloging-in-Publication Data ISBN 978–0–470–82521–1 (Hardback) ISBN 978–0–470–82701–7 (ePDF) ISBN 978–0–470–82700–0 (Mobi) ISBN 978–0–470–82702–4 (ePub)

Typeset in 10/12pt, Sabon Roman by Thomson Digital, India Printed in Singapore by Markono Print Media Pte. Ltd. 10987654321 FFIRS 04/04/2012 9:55:35 Page 7

For my wife, Mrs. Lindsay Choudhry FFIRS 04/04/2012 9:55:35 Page 8 FTOC 04/05/2012 13:57:41 Page 9

Contents

Forewords xiii Preface xvii

Acknowledgements xxiii

About the Author xxv

PART I A PRIMER ON BANKING 1

CHAPTER 1 A primer on bank business and balance sheet risk 3

CHAPTER 2 Bank regulatory capital 75

CHAPTER 3 Banking and credit risk 131

CHAPTER 4 A primer on securitisation 179

CHAPTER 5 The yield curve 221

PART II BANK ASSET AND LIABILITY MANAGEMENT 351

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x Contents

CHAPTER 6 Asset–liability management I 353

CHAPTER 7 Asset–liability management II 385

CHAPTER 8 Asset–liability management III: Trading and hedging principles 445

CHAPTER 9 Asset–liability management IV: The ALCO 493

CHAPTER 10 The ALCO: Terms of reference and treasury operating model 503

CHAPTER 11 Risk reporting, risk policy and stress testing 531

PART III BANK LIQUIDITY RISK MANAGEMENT 587

CHAPTER 12 Principles of bank liquidity management 589

CHAPTER 13 Liquidity risk metrics 653

CHAPTER 14 Liquidity risk reporting and stress testing 687

CHAPTER 15 Internal funds pricing policy 715

PART IV BANK STRATEGY AND GOVERNANCE 759

CHAPTER 16 Bank strategy I: Formulating strategy and direction 761 FTOC 04/05/2012 13:57:41 Page 11

Contents xi

CHAPTER 17 Bank strategy II: Capital and funding management 801

CHAPTER 18 Principles of corporate governance 831

PART V APPLICATIONS SOFTWARE, POLICY TEMPLATES AND TEACHING AIDS 861

CHAPTER 19 Applications software, policy templates and spreadsheet models 863

Afterword 867 List of terms and their abbreviations 869

Index 875 FTOC 04/05/2012 13:57:41 Page 12 FBETW 04/04/2012 1:29:55 Page 13

Foreword

John Cummins

have been a colleague of Moorad Choudhry for a short time only but Ihave known his academic work for a longer period. It is unusual for one individual to have such a mixture of practical knowledge in the field of risk and treasury management allied to such a painstaking, rigorous academic approach to the subject. This is a very timely book. The global banking industry is going through a period of profound change, driven by the after-effects of the global financial crisis and bank failures, which were led in large part by the failure to observe sound, old-fashioned risk management principles. Liquidity management and funding mismatches are integral to the safety and soundness of the global banking system; the recent global financial crisis tested many widely held assumptions to destruction. This volume is a serious attempt to collate, record, demonstrate and recommend best risk management practices across all the disciplines, as a real primer for students as well as experienced practitioners in the different specialist areas of banking. Asset and liability practices form a distinct and separate field of Treasury risk management; their metrics and precepts can often be cloaked in a multivariate jargon that obfuscates the real, simple, ever-lasting precepts of banks’ risks and associated metrics. Moorad’s book distils many of the over-complicated explanations of ALM into plain English and simple concepts. The global financial crisis has forced many banks to return to the basics of banking and liquidity management. In an environment where treasury risk and bank balance sheet management have never been more critical to the sound functioning of the banking system, this book is a real addition to an understanding of the major steps required to run an efficient and well- controlled bank.

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xiv Foreword

The Principles of Banking provides a comprehensive survey of capital markets, the asset and liability process, bank corporate governance, funding and risk management that will give insights to those who are studying in this field and act as a handbook for business best-practice. In a world where over-specialisation can be a curse, this is one book that brings together many disciplines and sound principles that can assist all experts and students of risk management to add to their expertise and look to improve. Moorad highlights the importance of the new world post-crash assumptions; for example, the need for high-quality liquidity buffers of cash and highly-rated government bond holdings as part of core liquidity portfolios is discussed in Chapter 12, which emphasises that this is really a return to best practices from an earlier age. These moves are happening with the full support of the global regulatory authorities, with the UK as a leader in the drive for safer and stronger, more liquid banks. His chapters on these topics are well developed and full of incisive and informative research. The return to focus on customer deposits and prudent loan-to- deposit ratios are maxims that the RBS Group is following in its own return to standalone strength and improved balance sheet stability. Moorad’s book is excellent at bringing out the lessons of 2008 and providing a road map and guide to best practice for the future. It is important if banks are to avoid these issues in the future that all students entering the profession learn the lessons from the crisis, and that senior management inculcate the best practices which are outlined in this volume. I recommend this work to all interested in the banking world and risk management.

John Cummins Group Treasurer The Royal Bank of Scotland 29 September 2011 FBETW 04/04/2012 1:29:56 Page 15

Foreword

Ian Plenderleith

ll sorts of causes can be adduced for the financial crisis of 2007–2008, Afrom which the world is still recuperating. The globalisation of finance, as of other areas of business activity; deregulation and heightened competition; the concentration of banking groups following successive waves of mergers; the application of advanced quantitative techniques to risk control, with imperfect recognition of their limitations; innovation in the design of financial instruments and trading strategies; increased reliance on active liability management in wholesale markets; and the conjuncture of cyclical downturn in the global economy with continuing underlying imbalances between major economies – the list is long and will provide fertile soil for doctoral theses for years to come. But one pervasive faultline is that in the process many banks somehow lost sight of the basic principles of banking. So the primer that Moorad Choudhry provides in this book is both timely and salutary. In clear, concise and uncompromising terms, he has provided a comprehensive compendium of good practice, starting with an overview of the essential elements of banking business, then drilling down into the critical areas of asset–liability management, liquidity and risk management, and then surveying the over- arching issues of strategy and governance. Not all bankers are renowned for an interest in literature, but this book is required reading. If there is one area where this book will be most valuable in helping the present generation of bankers rebuild their business on the rubble of the financial crisis, it is in its treatment of liquidity – which Moorad Choudhry aptly describes as “the water of life” of banking. As he notes, ‘‘the crisis of 2007 and 2008 was as much a crisis of bank liquidity as it was of capital erosion’’. The huge expansion of wholesale markets over the past half century allowed banks to economise on the quantum and quality of liquidity they hold on the balance sheet as a cushion against unforeseen funding needs. But the result, as we have seen, has been severe exposure to

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xvi Foreword

liquidity strains if, as happened, wholesale market funding suddenly evaporates. The result has been much more substantial liquidity requirements set by bank supervisors, which, as Moorad Choudhry rightly remarks, are not new, but rather “a turning of the clock back to earlier times, when conservative principles in liquidity management were actually quite common place”. Our forefathers could not have put it better. It is not easy, in a book on the principles of banking, to bring the narrative to a thrilling climax. But Moorad Choudhry delivers a remarkable denouement with his chapter on corporate governance principles, which concludes with a clinical dissection of the weaknesses that undermined banks, large and small, in the recent crisis. This spine-chilling post mortem of what went wrong brings the principles of banking blazingly alive. If reading it keeps bankers awake at night, this admirable book will have served its purpose.

Ian Plenderleith Former Executive Director Bank of England 31 March 2011 FPREF 04/04/2012 1:16:56 Page 17

Preface

ficionados of science fiction will be familiar with Dune, a seminal work Ain that genre written by the late Frank Herbert. A complex, interwoven tale of imperial rivalry, medieval mysticism, clan fighting and religious hero worship, as well as an old-fashioned story of good guys versus bad guys, it is set on the desert planet Arrakis. Among a range of peculiar geophysical features, this planet suffers from an almost complete lack of water. The native inhabitants of Arrakis, the Fremen, appreciated this lack so much that they took great pains to preserve and recycle every drop of moisture, even to the extent of recycling water from the bodies of their dead. Water was life. Anything that was vital to the maintenance of life itself was known by the Fremen as ‘‘the water of life’’.1 And so to banking. Banks have always been a part of recorded history. Latin texts describe a form of borrowing and lending activity in Roman times, and before that the ancient Babylonians practised an elementary form of banking. In his excellent and thought-provoking book Zero (London: Souvenir Press, 2000), Charles Seife tells us ‘‘before Arabic numerals came around, money [lenders] had to make do with an abacus or counting board. The Germans called the counting board a Rechenbank, which is why we call moneylenders banks’’. So now we know. Banks are the lifeblood of society, because without them nothing would get done. By that I mean nothing productive. Nothing would be built, nothing would be traded, and very little would be consumed. This would result in all of us being much worse off than we are now. As Simon Johnson and James Kwak note in their book 13 Bankers (New York: Pantheon, 2010), because an advancing society in the process of industrialisation requires ‘‘investments in new technology, it also [requires] credit . . . long-run prosperity requires

1 Actually, it turns out that my own initial interpretation of this elegant expression was entirely erroneous. The story in fact refers to a powerful narcotic drug that is taken by the Bene Gesserit, a female order of exceptionally clever thinkers, as part of a developmental ritual, which ends either in death or in enhanced prescient powers on the part of the user. Reading Dune for the first time as a 15-year-old, I understood it as a general expression for the importance of water to life. And first impressions last . . .

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xviii Preface

large-scale commerce and industry, both of which require banks’’. Banks are vital to societal development and civilisation. And right from the start, banks have always had to rely on the availability of continuous funding, or liquidity. This is a definition of banking. For banks, liquidity is the water of life. Because they are such an important part of society and human development, it is apparent that banks must be managed properly. This is not as obvious as one might think. During the global financial crisis of 2007–2009, a number of small and large banks around the world failed, some of them quite spectacularly. Many of these banks were shown to have been managed with monumental incompetence by people who had seemingly been at the top of their game. People boasting MBAs, feted around the world with invitations to dine at prime ministerial and presidential levels. People who had in many cases never actually bothered to obtain any professional qualifications in banking, but who would have us believe their self-generated hype that they were the Masters of the Universe. Many of them thought that they could beat the market, that as long as the music was playing they should still be in the game, even as all the indications suggested that a recession was already enveloping them. In the end it was a case of the emperor’s new clothes, because it became apparent that many of these star bankers had done what any literate teenager could do: they’d made money in a bull market. Or, as Quentin Letts writes in his brilliant polemic 50 People Who Buggered Up Britain (London: Constable, 2009), ‘‘They were bull-market innocents caught short by change’’. Come the crash, they were shown to be naked. These people, through a combina- tion of hubris, arrogance, conceit, perverse empire-building obsession, greed, herd mentality, monstrous egotism, poor understanding of finance, simple ineptitude, and a lack of appreciation of the basic principles of banking, inadvertently conspired to bring about the worst banking crisis since the Great Depression, if not of all time. This book is for them. It is not for beginners, it is for senior staff. Of course, it is also for junior staff who may or may not aspire to reach the heights of the Board, but who want to understand before they get there what they don’t teach you at business school: the practical but vital principles of bank liquidity, capital and asset–liability management. This book is also about the principles of bank strategy and corporate governance. These principles are, in the main, not new (although some of them are). But they deserve to be renewed and never forgotten, especially during the next bull market run. Being about basic principles, The Principles of Banking omits a lot of product detail and complex mathematics on the more technical aspects of finance, much of which was covered to considerable depth in my book Bank Asset and Liability FPREF 04/04/2012 1:16:56 Page 19

Preface xix

Management (John Wiley & Sons, 2007). That book discussed such issues as analysing the yield curve, bank capital, securitisation, Basel II, value- at-risk (VaR) methodology, interest-rate risk hedging, derivatives pricing, determinants of the swap spread, and money markets trading. It also included detailed coverage of all the various products, both cash products such as bonds and floating-rate notes and derivatives such as credit default swaps (CDS) and caps/floors. We do not repeat that material here (and, as that book was over 1,400 pages long, that’s just as well!), although we do repeat the material that remains very relevant, and more important than ever in the light of recent events: the four chapters on bank asset–liability management (ALM) and the asset–liability committee (ALCO). But otherwise in this book we focus on key issues in bank strategy and liquidity management. So if you require detailed product technical knowledge, please consult the earlier book. Where we do get detailed and technical is in the field of liquidity risk management and management reporting. The 2007–2009 financial crisis highlighted the need for banks to ‘‘get back’’ to the roots of banking and concentrate on liquidity management, which is the essence of banking. In my earlier book I devoted four chapters to ALM and liquidity risk management, but clearly that wasn’t enough! In this book we dedicate a lot more page space to this essential topic. Liquidity is a key focus of bank regulators in the post-crisis age, so it is important to be up to speed with this subject at a detailed level. We also get very detailed and technical in Chapter 5. This chapter covers the yield curve, which is a very important topic. All senior management should be familiar with the yield curve, with the no-arbitrage principles of finance that drive its use, and how to analyse and interpret it. Why? Quite simply, because the curve drives everything. A bank sets the price of its assets and the cost of its liabilities from what its own internal risky yield curve implies. An understanding and appreciation of what the correct valuation of balance sheet items should be, requires an understanding of what drives the yield curve. It is worth taking the time and effort to become thoroughly au fait with Chapter 5. It has been kept deliberately technical, although still accessible, for the specific enjoyment of senior management and board members. This book looks at the high-level principles of finance. The first principle of banking is common sense. Being cautious and sensible is an essential prerequisite for sound and efficient bank management. Beyond this we cover further basic principles in the following chapters, but here is a flavour of them to start with:

1. Secure your funding base – that is, your liquidity – for all contingencies, before you start lending beyond your deposit base. FPREF 04/04/2012 1:16:56 Page 20

xx Preface

2. Establish a sound base of customer deposits, and ensure that a majority of lending is funded from core, stable deposits. 3. Lend prudently, and with sound judgement (that is, not following the herd), and if necessary across a diverse range of customers (but not to customers or sectors outside your area of expertise: know your risk). 4. Maintain a strong capital base of equity, sufficient to absorb all losses and unexpected losses, and still continue as a going concern. 5. See (1).

The essential message for bankers and regulators is one of conservatism. Liquidity crises are rare events, and it is possible for a person to spend his or her entire time in a senior managerial position at a bank and never experience one. The temptationtorelaxsomeoftheconservative principles recommended in this book is strong. However, because of the importance of banks to the world’s economic system, it is imperative that when a liquidity crisis does occur, a bank is able to survive it without support from the taxpayer. This is harder to do if one adopts a less-than- strict view about the liquidity and ALM risks involved in banking. Traditionally, we describe a bank as a financial institution that is in the business of taking deposits and advancing loans, and which makes money from the difference in interest rates paid and received on these two products (the ‘‘net interest income’’). This picture is still true today; even for the most complex banks with operations across multiple jurisdictions and product lines, it all still boils down to managing funding costs and running a sensible funding policy. While today even small banks deal in a variety of cash and derivative instruments across time zones, reflecting the high product sophistication in the finance industry, and the sources of revenue for banks are now quite diverse, the basic principles of running both a simple and a complex bank are unchanged, and identical. So while the modern banking institution is a complex beast, basic management objectives have remained unchanged. Or at least, they should have. In the lead-up to the financial crash, some senior bank management forgot this fact. Or quite possibly they were never aware of it in the first place. So to reiterate, this book covers essential principles of banking that will guide senior management towards a more sustainable business model for their banks, and regulators towards a more stable banking system. It is something of a handbook for competent management. Incidentally, The Principles of Banking does not review the causes of the financial crash of 2007–2009. Also, it does not offer macro-level prescriptions for the economy as a whole. These subjects are discussed in my book The Future of Finance (John Wiley & Sons, 2010). FPREF 04/04/2012 1:16:56 Page 21

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We must remember that at the core of all capital markets activity lies the need to bring together the suppliers of capital with the borrowers of capital. This was the original business logic behind the very first banks, and in that respect very little has changed. There is much other activity surrounding this basic function in the markets, but this function is paramount. As Mr. Letts goes on to say, ‘‘The first duty of the high street bank, surely, is stability. To be entrusted with the savings of small-time customers is a heavy responsibility’’. And the key ingredient in discharging this responsibility is the management of the bank’s assets and liabilities. It is this that we focus on in this book, high-level ALM and its twin siblings, capital and liquidity management. On the ALM desk in a bank, the cash assets and liabilities are king and must be managed prudently. Liquidity and disciplined ALM are the water of life in banking. That’s something the Fremen would have understood.

LAYOUT OF THE BOOK

The book is divided into five parts, covering the various different but relevant aspects of banking principles. These are:

Part I – A primer on banking Part II – Bank asset–liability management Part III – Bank liquidity risk management Part IV – Bank strategy and governance Part V – Application software, spreadsheets and teaching aids.

For newcomers to the market, junior bankers and students, we include a primer on banking basics in Chapter 1. A detailed background on financial instruments, a summary of financial market arithmetic, and a comprehensive glossary of banking and finance terms are included in the author’s earlier book Bank Asset and Liability Management. Highlights of The Principles of Banking include:

& a detailed look at the ALM function as undertaken by banks and securities houses, including risk management and management reporting; & comprehensive coverage of liquidity risk management, including liquidity metrics, reporting, contingency planning and the liquid asset buffer; & the role and function of the bank ALM committee (ALCO); including the organisation of the Group ALCO (GALCO) function in a multinational or multi-entity banking group; & a detailed technical analysis of internal funds pricing, and how it should be set up in a bank; FPREF 04/04/2012 1:16:56 Page 22

xxii Preface

& capital and liquidity risk reporting and stress testing; & strategy formulation, and capital and funding management; & recommended best-practice on effective bank corporate governance.

Files on t he Wiley w ebsite, www.wiley.com/go/principlesofbanking, accompany this book. They hold policy document templates, risk report samples, teaching aids, applications software and Excel spreadsheets. These are discussed in Chapter 19, and hopefully should be of some use to practitioners. Note that we do not discuss operational risk in this book. The principles of operational risk are not unique to banks, and would be applicable in any corporate environment. That said, bank management will need to be aware of the operational risk charge element in their regulatory capital requirement. As always, the aim is to remain accessible and practical throughout; we hope this has been achieved. Comments on the text are most welcome and should be sent to the author care of John Wiley & Sons Singapore Pte. Ltd. FLAST01 04/04/2012 1:33:36 Page 23

Acknowledgements

ove and affection to my wife Linzi, the most fantastically gorgeous Lwoman in the world, for inspiring this book, title and all, during a visit to the Bank of England Museum in February 2009. And for Arabella. Thank you to my Father, Mr A.K.M.S. Choudhry, for everything. If it wasn’t for you Da, I wouldn’t be in England, in Surrey, in the City, in banking and in academia. I owe everything to you, thank you for inspiring me to work hard towards my goals, and for inspiring those goals. Thank you to my Mum for always making sure I know right from wrong. Thank you to Anika, Millie and Leela, an exotic and unbeatable combination. Thanks to Clax, Khurram, the Raynes Park Footy Boys (Abukar Ali, Abubakar, Rod Pienaar, Richard Pereira, Mohamoud Dualeh, Zhuoshi Liu, Harry Cross and Farooq Jaffrey), Shareef C, Dave Beech, Nik Slater, Phil Broadhurst, the JP Morgan Chase ITS Footy Boys (Alan Fulling, Rich Lynn, Neil Lewis, Michael Nicoll, Jonathan Rossington, Stuart Medlen, Tony Fulling, Matthew Neville and Michael Beddow), Mike Brand, Didier Joannas, Martin Barber, Melvin Chan, Professor Carol Alexander, Andrew Benson, Suleman Baig, Stuart Turner, Mark Burgess, and Suraj Gohil. A Solid Bond In Your Heart. Thanks to Mr. Tim Leonard, Professor Darrell Duffie, Brian Eales, Professor Gautam Mitra, Professor Christine Oughton, Rob Lynn, Gino Landuyt, Zena Deane, Ee Sing Wong and everyone at CNBC Europe, Naomi Kerbel, Camy Boey, Jim Harrison, Tom O’Connor, Maira Chatziperou, Balamurali Radhakrishnan, Mike Hellmuth, Professor Radu Tunaru, David Lemmon and his Kiwi colleagues, Jaffar Hussain, Stafford Bent, Jas Singh Ghag, Jim Croke, Libon Fung, Professor Roman Matousek, Remi Bola, Wei Lei Goh, Emma and Maureen at Traveltime, Lamiaa Mohammed, Tony Holloway, Dr. James Berriman, Andre Stander, David Wileman, Sean Baguley, Professor Jean Helwege, Arno Kratky, Irving Henry, Eric Burg, Mark Miller, Len Harwood, Jim Byrne, Colin Johnson, Vikki Spooner, Nayan Sthanakiya, Eric Scotto di Rinaldi, Ghislain Lafont, David Moskovic, Chris Ko, Nicola Conway, Paul Bennett, Michelle Warner, Alun Oldreive, Lisa Sheehy, Gaynor Mullane, Cathryn Warner, Matt Foss, Gareth Walters,

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xxiv Acknowledgements

David Connolly, Phil Smith, Damon Mahon, Stephen Fox, Tieu Pham, Anita Berthier, Sarah Small, Jenny Organ, Eleanor Lavan and everyone who has helped, guided or inspired me through the years. Respect. For their help when I really needed it, I’d like to thank Dan Cunningham at KBC Bank, Adam Lawson at Beltane Ventures, Abhijit Patharkar at Standard Chartered Bank, Frank Spiteri at Peel Hunt, Sharad Samy at Aladdin Capital, Graeme Wolvaardt at Europe Arab Bank, Tope Fasua and Syed Ahmed at Global Analytics Consulting, Richard Mitchell at the CISI, Lisa Hughes at Coutts, Ravi Biant, Roger Drayton at UK ALMA, and Bill Rickard, Martyn Hoccom and Ani Lassus at The Royal Bank of Scotland. I won’t forget it. Thanks to the team at Wiley Asia, easily the best publishers in the world, especially Janis Soo, Joel Balbin, Cynthia Mak, Sharifah Sharomsah, Jules Yap, Nick Wallwork and the rest of the gang, and to the fantastic Edward Caruso, for every step of the way from commissioning to publication. Thank you to you – my readers. This time, it really is my last ever book. I’d like to sign off with two of the best from Derek Taylor at King & Shaxson Limited, a gentleman who’s looked after me right from the start when I joined Hoare Govett Securities back in 1992. The first one below is from my days at ABN Amro Hoare Govett, and the second from my time at KBC Financial Products:

Moorad: I like the long gilt right now, I’ve just bought 50 lots . . . Derek [shouting to the rest of the floor]: Sell 1,000 gilt! I don’t care what it costs, just get it done!

Moorad: I’m looking to diversify our funding sources, do you know any counterparties who might be long cash and looking to lend? Derek: Try Mervyn King at the Bank of England, I hear he’s a lender of last resort!

Goodbye! Stay handsome.

Goodbye . . .

Moorad Choudhry Surrey, England New Year’s Day, 2012 FLAST02 03/26/2012 22:38:21 Page 25

About the Author

Moorad Choudhry is Treasurer, Corporate Banking Division at The Royal Bank of Scotland. He was previously Head of Treasury at Europe Arab Bank, Head of Treasury at KBC Financial Products, and Vice President in Structured Finance Services at JPMorgan Chase Bank. He began his career at the London Stock Exchange in 1989. He is Visiting Professor at the Department of Economics, London Metropolitan University, and Chair of the University’s Centre for EMEA Banking, Finance and Economics. He is also Visiting Professor at the Department of Mathematical Sciences, Brunel University; Visiting Research Fellow at the ICMA Centre, University of Reading; and Visiting Teaching Fellow at the Department of Management, Birkbeck, University of London. Moorad is a Fellow of the Chartered Institute for Securities & Investment, a Fellow of the ifs-School of Finance, a Fellow of the Global Association of Risk Professionals, and a Fellow of the Institute of Sales and Marketing Management. He is Managing Editor of the International Journal of Monetary Economics and Finance, a member of the Education Advisory Board of the Association of Corporate Treasurers, and a member of the Editorial Boards of Qualitative Research in Financial Markets, Securities and Investment Review, the Journal of Structured Finance,and American Securitization.

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How does one define leadership? Simple. Look at the people sitting around you at the Boardroom table, your senior leadership team. How many of them would follow you to your next job for a cut in pay? If the answer is none of them, then you’re not a leader. A true leader commands respect and loyalty in equal measure, and that goes far beyond a wage packet.

— Sherif Choudhry, Vice President, CapGemini PART01 02/17/2012 12:9:47 Page 1

PART I A Primer on Banking

art I is a primer on banking, and sets the scene for newcomers, be they Pstudents or practitioners. It is essential to be familiar with the nature of banking business, as well as the types of instruments used in money market trading. We also need to be familiar with banking capital and financial statements, the former preparatory to a discussion on regulatory capital and the Basel rules, the latter simply for general knowledge purposes. So the first part of this book covers these areas. We begin with a look at the fundamentals of banking business, and the different elements of bank capital. We also look at financial ratio analysis, used when reviewing metrics such as return on capital. The remainder of Part I looks at regulatory capital, credit risk and credit limits, the use of securitisation and the yield curve.

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