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An Introduction to Banking

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An Introduction to Banking Thispageintentionallyleftblank AN INTRODUCTION TO BANKING LIQUIDITY RISK AND ASSET–LIABILITY MANAGEMENT The Chartered Institute for Securities & Investment Mission Statement: To set standards of professional excellence and integrity for the investment and securities industry, providing qualifica- tions and promoting the highest level of competence to our members, other individuals and firms. Formerly the Securities & Investment Institute (SII), and originally founded by members of the London Stock Exchange in 1992, the Institute is the leading examining, membership and awarding body for the securities and investment industry. We were awarded a royal charter in October 2009, becoming the Chartered Institute for Securities & Investment. We currently have around 40,000 members who benefit from a programme of professional and social events, with continuing professional development (CPD) and the promotion of integrity, very much at the heart of everything we do. Additionally, more than 40,000 examinations are taken annually in more than 50 countries throughout the world. The CISI also currently works with a number of academic institutions offering qualifications, membership and exemptions as well as information on careers in financial services. We have over 40 schools and colleges offering our introductory qualifications and have 7 University Centres of Excellence recognised by the CISI as offering leadership in academic education on financial markets. You can contact us through our website www.cisi.org Our membership believes that keeping up to date is central to professional development. We are delighted to endorse the Wiley/ CISI publishing partnership and recommend this series of books to our members and all those who work in the industry. As part of the CISI CPD Scheme, reading relevant financial publications earns members of the Chartered Institute for Securities & Investment the appropriate number of CPD hours under the Self- Directed learning category. For further information, please visit www.cisi.org/cpdscheme Ruth Martin Managing Director AN INTRODUCTION TO BANKING LIQUIDITY RISK AND ASSET–LIABILITY MANAGEMENT Moorad Choudhry A John Wiley and Sons, Ltd, Publication This edition first published 2011 # 2011 Moorad Choudhry Registered office John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, United Kingdom For details of our global editorial offices, for customer services and for information about how to apply for permission to reuse the copyright material in this book please see our website at www.wiley.com. The right of the author to be identified as the author of this work has been asserted in accordance with the Copyright, Designs and Patents Act 1988. 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 or otherwise, except as permitted by the UK Copyright, Designs and Patents Act 1988, without the prior permission of the publisher. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. Designations used by companies to distinguish their products are often claimed as trademarks. All brand names and product names used in this book are trade names, service marks, trademarks or registered trademarks of their respective owners. The publisher is not associated with any product or vendor mentioned in this book. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold on 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 should be sought. The views, thoughts and opinions expressed in this book represent those of the author in his individual private capacity, and should not in any way be attributed to The Royal Bank of Scotland plc or to Royal Bank of Scotland Group, or to Moorad Choudhry as a representative, officer, or employee of The Royal Bank of Scotland plc or Royal Bank of Scotland Group. This book does not constitute investment advice and its contents should not be construed as such. Any opinion expressed does not constitute a recommendation to any reader. The contents should not be considered as a recommendation to deal in any financial market or instrument and the author does not accept liability for any actions resulting from a reading of any material in this book. Whilst every effort has been made to ensure accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of reading any material presented in this book can be accepted by the author, publisher or any named person or corporate entity. A catalogue record for this book is available from the British Library. ISBN 978-0-470-68725-3 Set in 10/12pt Trump Medieval by OPS Ltd, Great Yarmouth, Norfolk, UK Printed in Great Britain by TJ International Ltd, Padstow, Cornwall, UK For Mrs. Lindsay Choudhry Ultimate yummy mummy Thispageintentionallyleftblank CONTENTS Foreword xiii Preface xix About the author xxiii 1 BANK BUSINESS AND CAPITAL 1 Banking business 2 Interest income 4 Fees and commissions 4 Trading income 4 Costs 5 Capital markets 5 Scope of banking activities 8 Capital 9 Banking and trading books 10 Financial statements and ratios 13 The balance sheet 13 Profit and loss report 14 References 21 viii CONTENTS 2 THE MONEY MARKETS 23 Introduction 25 Securities quoted on a yield basis 27 Money market deposits 27 Certificates of deposit 29 CD yields 30 Securities quoted on a discount basis 34 Treasury bills 36 Banker’s acceptances 37 Eligible banker’s acceptance 38 Commercial paper 39 Commercial paper programmes 40 Commercial paper yields 42 Asset-backed commercial paper 43 Repo 48 Definition 49 The classic repo 50 Examples of classic repo 52 The sell/buyback 56 Examples of sell/buyback 58 Repo collateral 60 Legal treatment 62 Margin 62 Variation margin 64 Currencies using money market year base of 365 days 65 3 THE YIELD CURVE 67 Importance of the yield curve 68 Using the yield curve 69 Yield-to-maturity yield curve 71 CONTENTS ix Analysing and interpreting the yield curve 72 Theories of the yield curve 73 The zero-coupon yield curve 83 Example calculation illustrations 88 Forward rate calculation for money market term 91 Understanding forward rates 92 Bibliography 93 4 INTRODUCTION TO TRADING AND HEDGING 95 Trading approach 96 The yield curve and interest rate expectations 96 Credit intermediation by the repo desk 98 Specials trading 100 Matched book trading 102 Interest-rate-hedging tools 103 Interest rate futures 103 Forward rate agreements 110 FRA mechanics 112 Overnight interest rate swaps 123 Credit risk hedging 129 Understanding credit risk 130 Credit rating rationale 133 Credit limit setting and rationale 135 Loan origination process standards 139 Bibliography 141 5 ASSET AND LIABILITY MANAGEMENT I 143 Basic concepts 144 Liquidity gap 147 Managing liquidity 153 x CONTENTS The liquidity ratio 156 The liquidity portfolio 157 6 ASSET AND LIABILITY MANAGEMENT II 167 Introduction 168 Basic concepts 169 Interest rate risk and source 174 The banking book 180 The ALM desk 181 Traditional ALM 182 Developments in ALM 184 Liquidity and interest rate risk 185 The liquidity gap 185 Gap risk and limits 186 Liquidity management 192 Interest rate gap 194 Portfolio-modified duration gap 197 Critique of the traditional approach 198 The cost of funding 199 Securitization 202 The securitization process 204 Benefits of securitization 206 Generic ALM policy for different-sized banks 212 NPV and value-at-risk 219 Bibliography 220 7 ASSET AND LIABILITY MANAGEMENT III: THE ALCO 223 ALCO policy 224 ALCO reporting 227 CONTENTS xi 8 BANK LIQUIDITY RISK MANAGEMENT 233 The liquidity policy statement 234 Principles of bank liquidity risk management 241 Measuring bank liquidity risk: key metrics 244 Internal funding rate policy 252 Conclusion 259 9 A SUSTAINABLE BANK BUSINESS MODEL: CAPITAL, LIQUIDITY AND LEVERAGE 261 The new bank business model 262 Liquidity risk management 271 The liquid asset buffer 276 Conclusions and recommendations 278 References 279 10 BANK REGULATORY CAPITAL 281 Banking regulatory capital requirements 282 Capital adequacy requirements 284 A primer on Basel II 285 Impact on specific sectors 289 Basel III 304 Bibliography 306 Appendix A Summary of bank product line 307 Appendix B Financial markets arithmetic 317 Appendix C List of abbreviations and acronyms 339 Index 343 Thispageintentionallyleftblank FOREWORD In many ways, a handbook that helps to contextualize the banking business as a portfolio of risk management activities could not be more welcome or timely. It should be no surprise that the global- ization of the financial system has dramatically expanded the scope of risks a bank naturally accumulates in its day-to-day operations. Accordingly, the difficulty of valuing and administering these aggregate risks continues to broaden. Whilst computer technology has at least provided the processing faculty against this increasing challenge, the banking industry is continually pressed to develop the analytical theory and hedging tools necessary to cope with risk management’s increasing complexity. The advent and rapid growth of markets such as asset securitization and credit derivatives, for instance, evidence such progress. Hence, any practical study of banking without a proper perspective on the fundamental liquidity, capital, interest rate, ..., and credit risk management techniques in practice today would be incomplete. With that said, the recent financial crisis has raised many questions around the merits of the so-called ‘advances’ made in valuation and risk theory over the past several decades. I would argue that ‘finan- cial engineering’, as it has so dubiously been labelled, has taken a disproportionate share of the blame as the catalyst for the crisis. As above, the genesis of these new tools and approaches has been born out of necessity and are a natural consequence of the increasingly complex risk landscape for the financial system.
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