The Business of Banking

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The Business of Banking

• Chapter 11

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Hong Kong Banking Industry

• Three Tier Structure

Link
Fully Licensed Banks -21 Locally
Incorporated -164 Foreign Incorporated
Restricted License Banks Securities Companies -
20 RLBs
Deposit Taking Corporations Finance Companies -
23 DTCs
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Historical Origins

• Modern Local Banks Pre-war banks. (HSBC, Bof
  EA,).
• International Banks . (Citibank, StanChart, DBS)
• Chinese State Banks Chinese government set up
  banks in HK in pre-war era. After the revolution,
  these were taken over by PRC. Due to the
  isolation of PRC, these banks were the main link
  between the mainland and the world financial
  system (Bank of China, Nanyang Commercial)
• Native Banks Banks that serviced the rapidly
  growing retail markets for small deposits and
  loans during the immediate post-war migration of
  immigrants from the mainland (Hang Seng, Wing
  Lung, Dao Heng and many others)

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Transactions Costs

• Debt serves a useful purpose in matching those
  who currently have greater income than
  consumption to those with greater consumption
  than income.
• However, matching buyers and sellers involves
  some costs. Institutions develop to reduce these
  costs.

1. Pooling Savings Take advantages of economies of scale
Diversify Risks
Safekeeping of Assets
2. Providing Liquidity Reduce transactions costs by allowing depositors to convert assets into cash.
3. Reduce Information Costs Ameliorate asymmetric information
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Licensed Banks Aggregate Balance Sheets
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Multiple Currency Deposits

• Hong Kong banks accept large amounts of foreign
  currency deposits.
• Small market for Foreign currency loans in Hong
  Kong.
• HK banks lend money to banks overseas,
  multinational banks lend money to firms overseas.

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Link
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Bank Assets

• Cash Items Primary Reserves (Vault cash
  Clearing Balances), Current Balances at Other
  Banks.
• Loans Interbank Lending, Advances to Customers
• Securities Government Bonds, MBS, Corporate Debt,
  Large CDs, Stocks.
• Other Assets Land, Buildings, etc.

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Liabilities

• Checkable Non Transactions Deposits Checking
  accounts, current accounts, demand
  deposits,savings deposits, time deposits,
  certificates of deposit.
• Borrowings Discount window borrowing, borrowing
  in interbank market.
• Other Liabilities Subordinated debt, deferred
  tax liabilities

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Hong Kong Interbank Market

• Hong Kong deposit market dominated by big branch
  networks many smaller banks raise funds by
  borrowing from big banks.
• Until 2001, HK limited branch networks of foreign
  banks. Foreign banks finance HK lending with
  loans from overseas parent.
• HK banks accept many foreign currency deposits.
  Lend that F.C. to banks overseas.

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Bank Net Worth/Shareholder Funds Funds put at
risk by the owners of the bank.

• Share Capital Money raised by selling equity
  shares in Primary Markets
• Retained Earnings Profits not (yet) paid as
  dividends.
• Balance sheet typically includes some proposed
  dividend.
• For tax purposes, some retained earnings are
  classified as other reserves

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Profits of BankingInterest Income

• Banks collect retail deposits from savers and
  make loans to borrowers.
• Profits are earned by banks when they are able to
  make loans at higher interest rates than they pay
  depositors.
• Net Interest Income is the interest rate earned
  on assets (mainly loans) minus the average
  interest paid on liabilities (mainly deposits).

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Net Interest Margin Net Interest Income divided
by Interest Earning Assets.
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Investment Income, etc.
Changes in Value of Subsidiaries etc.
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Capital Adequacy Management

• Compared to non-financials, banks have low
  capitalization.
• Bank capital is the funds invested by the owners
  of banks in the bank.
• Three factors affect the decisions of bank owners
  to finance with equity capital
• Bank capital prevents bank failure.
• Bank capitalization affects returns to
  shareholders
• Government regulations affect capitalization
  (next chapter)

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Bank Failure

• Bank failure occurs when a bank cannot pay its
  depositors in full.
• Riskier and less liquid assets make bank failure
  more likely.
• Banks with high levels of capital can have some
  negative profits and still avoid failure.
• Bank owners need to invest their own funds to
  offset its own moral hazard issues.

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How Bank Capital Prevents Bank Failure

• Consider two banks with identical balance sheets
  except that Bank A is well capitalized while
  bank B is poorly capitalized.

Assets Liabilities Assets Liabilities
Reserves 10 Deposits 90 Reserves 10 Deposits 96
Loan 90 Capital 10 Loan 90 Capital 4
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How Bank Capital Prevents Bank Failure

• Bad economic times cause borrowers to default on
  5 million in loans. This wipes out the capital
  of the weakly capitalize bank but leave the
  highly capitalized bank in business.

Assets Liabilities Assets Liabilities
Reserves 10 Deposits 90 Reserves 10 Deposits 96
Loan 85 Capital 5 Loan 85 Capital -1
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Equity Multiplier ROA/ROE

• This is assets relative to shareholders equity
  (i.e. net worth less loan capital)
• A measure of the returns earned on assets is
  Return on Assets
• Owners of equity are concerned with the pay-off
  they earn per each dollar originally invested in
  the bank Return on Equity
• Equity returns are a positive function of ROA
  and leverage

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Basil Capital Accords

• International Treaty sets minimum standards for
  bank regulation. Committee meets under the
  auspices of the Bank for International
  Settlements the central bank of central bankers.
  
• Treaty defines Capital Adequacy Ratio
• Basi requires HK banks to maintain a Capital
  Adequacy Ratio of at least 8

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Risk Adjusted Assets

• The risk adjusted assets of a bank are a weighted
  some of loans and other assets, with the weights
  being an increasing function of risk.
• A bank has n 1, , N assets. Asset n has a
  dollar value of Ln.
• Total assets L1 L2 .LN
• Regulators assign a weight to each asset, wn,
  that is increasing in the level of credit risk.
• Risk adjusted Assets w1L1 w2L2 .wN L3

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CAR

• Risk Adjusted Assets are weighted sum of assets
  with higher weights for higher risk.
• Original risk weight categories have become more
  complicated
• OECD Government. 0
• Banking. 20 (weight .2)
• Secured Residential Lending. 50 (weight .5)
• Commercial and consumer loans, corporate bonds.
• 100-150 (weight 1-1.5)

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Capital Adequacy Ratio of HK Banks
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Basel II

• Banks are required to have some share of their
  operating income as capital.
• The new accord creates more sophisticated way of
  measuring credit risk.
• Banks must keep capital depending on assets and
  operating income increasing capital requirements.
  
• Banks to apply their own credit models (based on
  statistical analysis and valuation of collateral
  and hedging to their liabilities) This will
  likely reduce capital needed.

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Credit Risk

• Credit Risk The risk arising from the
  possibility that the borrower will default.
• Financial Intermediaries in general and banks in
  particular exist because of their efficiency in
  dealing with credit risk.
• Much of credit risk in financial markets occurs
  due to asymmetric information and its associated
  phenomena, adverse selection and moral hazard.

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Managing Banks Balance Risks and Returns

• Banks must take risks as part of their business.
• Often most profitable activities of a bank will
  generate most risks for the banks.
• Bank managers must manage risk return trade-offs.

Principles for Maximizing Returns while dealing
with credit risk

• Diamonds in the rough
• Banks try to find borrowers who will pay high
  interest rates but who are unlikely to default.
• Borrowers who are well known to be good credit
  risks will have many sources of funds.
• Banks need to find information about certain
  borrowers not publicly available.

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Strategies for Managing Credit Risk

• Credit-Risk Analysis A loan officer manages
  banks relationship with borrowers and evaluate
  potential borrowers.
• Loan officers may have some specialization with
  certain industries or businesses.
• Loan officers also use credit scoring systems
  which use statistical data to measure default
  probabilities and charge interest rate
  commensurate with risk.

• Monitoring Loan agreements may contain
  restrictions on borrower behavior or value of
  assets. Loan officers monitor behavior and may
  recall loans if covenants are violated.

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Strategies for Managing Credit Risk (cont.)

• 3. Collateral Loans identify physical assets
  which may be taken by the bank in case of
  default.
• 4. Long-term Relationships Banks often have
  relationships with certain businesses which
  reduces information problems. elationships have
  value to businesses which they are loathe to
  jeopardize by engaging in moral hazard behavior.

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Strategies for Managing Credit Risk (cont.)

• Credit Rationing - Borrowers must seek
  additional sources of finance for their projects
  including equity.
• Diversification Banks can limit the likelihood
  of default by reducing exposure to a particular
  borrower or class of borrower.
• Sometimes there is a trade-off between
  diversification needs and strategies for finding
  diamonds in the rough, such as specialization or
  long-term relationships which may tend to reduce

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Measures of Credit Risk

• Assessing a banks exposure to credit risk, we
  could ask 3 questions
• What is the historical loss rates on loans and
  investments?
• What are the expected losses in the future?
• How is the bank prepared to weather the losses?

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Historical Loss Rate

• Loan losses/charge-offs are the loans written off
  as uncollectible in any period.
• Releases Recoveries refer to loans written off
  in the past but collected or collateral
  repossessed.
• Net loan losses are gross loan losses less
  recoveries.

Expected Future Losses

• Measures
• Past Due Loans Borrowers have not made a
  scheduled payment.
• Nonperforming Loans Loans past due for 90 days
  are more.

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Net Chargeoff Rates by Loan TypeSource FDIC
Statistics on Banking
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Net Charge-off Rates by Loan TypeSource USA
FDIC Statistics on Banking Link
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Protection Against Future Losses

• Loan Loss Reserve (Allowances for Loan
  Impairment) Quantity of gross value of loans
  that have been recognized as being likely to not
  be repaid.
• Net Loans (which appears as an asset on balance
  sheet) Gross Loans Loan Loss Reserve.
• When banks add to their loan loss reserve, they
  will deduct from profits.
• When banks charge-off bad loans, they deduct from
  gross loans and loan loss reserve and net assets
  are unchanged..

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Credit Derivatives

• Risk Management Tools Used to transfer risk from
  one party to another.
• Credit Default Swaps (CDS) A bank with credit
  risk exposure will pay X basis points per year
  and counter-party will make payment if there is a
  pre-determined credit event such as default or
  credit downgrade, etc.

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Credit Default Swap
Bank A
Fee Payment
Payment if negative credit event
Bank B
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Source BIS Derivative Statistics
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Liquidity Management

• Majority of Bank liabilities (deposits) are very
  Liquid.
• Banks provide payment mechanism to customers and
  are able to raise funds at low interest as a
  result.
• Liquidity advantage of depositors helps overcome
  asymmetric information advantage of bankers.
• Most profitable bank assets, loans, are illiquid.
  
• Banks particular expertise is in analyzing and
  monitoring long-term investment projects. Often
  expertise about a given project is specific to
  the bank itself and cant be transferred. Banks
  loan portfolios are highly illiquid.
• Liquidity Risk The possibility that depositors
  may collectively decide to withdraw more funds
  than the bank has on hand.

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Liquidity Risk

• Most profitable bank assets, loans, are illiquid.
  
• Banks have a liquidity mismatch between assets
  and liabilities.
• Liquidity Risk The possibility that depositors
  may collectively decide to withdraw more funds
  than the bank has on hand.

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Maturity Mismatch

• No matter how well a bank is managed or how good
  the credit quality of their loans, if all liquid
  deposits are withdrawn at once, banks could not
  raise enough liquid funds to pay all obligations.
  
• Banks have very illiquid assets (loans) and
  obligations to repay their depositors in full at
  any time.
• If all of the depositors at a bank withdraw their
  funds at the same time, the bank will have to
  sell their loans at a discount, and they will not
  have enough funds to pay all of their depositors.
  
• If all of their depositors keep their money in
  the bank, most banks will be able to repay all of
  their depositors with interest.
• Thus, the payoff to any individual depositor
  depends on what other depositors decide to do.

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Game Theory

• In many economic situations, agents returns
  depend on the actions of other agents. In such a
  situation, agents must think strategically.
  Economists use game theory to describe such
  situations.
• John (A Beautiful Mind) Nash developed a
  concept called the Nash equilibrium. A Nash
  equilibrium occurs when every player in a game is
  playing their best strategy given the strategy
  that the other players play.
• Economists believe that outcomes of strategic
  situations are likely to be well-described by
  Nash equilibrium. Since every individual in a
  Nash eq. is playing there best strategy given the
  actions of others, no one has any incentive to
  change their strategy individually.

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Bank Run Game Withdraw or Dont Withdraw

• Depositors each deposit 1000 at 10 interest.
• They can choose to withdraw their funds before
  collecting interest or keep their funds with the
  bank.
• The right hand table shows pay-offs for each
  decision under two possible situations.
• All other depositors keep their funds in the bank
  and the bank survives.
• All other depositors withdraw funds and the bank
  must liquidate.
• Payoffs
• If an individual keeps their funds with the bank
  and everyone else does likewise, everyone gets
  their funds with interest.
• If an individual doesnt withdraw, but everyone
  else does, the bank will have nothing left to pay
  the individual who gets nothing.
• If the individual depositor withdraws but no one
  else does, the depositor loses only interest.
• If an individual depositor withdraws and everyone
  else does, they have some chance of getting some
  funds (say 500) back.

Individual Depositors Decision Individual Depositors Decision Individual Depositors Decision
All Other Depositors Decision Withdraw Dont Withdraw
All Other Depositors Decision Withdraw Payoff 500 Payoff 0
All Other Depositors Decision Dont Withdraw Payoff 1000 Payoff 1100
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Bank Runs

• The phenomenon in which all depositors compete to
  withdraw their funds at the same time is called a
  bank run or a bank panic.
• Depositors lack complete information about the
  value of banks assets.
• If depositors believe that there is a significant
  fraction of loans which will not be repaid,
  depositors may have an incentive to immediately
  withdraw funds.
• Bank deposits are first come, first serve. If you
  withdraw your funds before the bank declares
  losses you may not suffer at all.
• Further, even if you believe that banks assets
  are sound you may have an incentive to
  immediately withdraw, if you believe that other
  depositors will also withdraw their funds.

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Panic of 1965

• In 1964, there was a collapse in the property
  market.
• In January 1965, the Banking Commissioner closed
  Ming Tak bank which suffered losses in property
  investment.
• Two weeks later there was a run on deposits at
  Canton Trust which also had property holdings.
  Canton Trust suspended business on February 8.
• On February 9, there were runs on deposits at
  many native banks including Wing Lung, Dao Heng,
  and the strongest of the native banks Hang Seng.
• On April 9, Chinese newspapers published rumours
  that the head of Hang Seng was being interviewed
  by the police.
• By the end of the day, depositors had withdrawn
  half of the savings and checking deposits at
  Hang Seng.
• On April 10, Hongkong Bank took over Hang Seng.

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Deposit Insurance

• Hong Kong Deposit Protection Board
• compensation limit is set at HK500,000 per
  depositor per bank
• secured deposits are protected
• Hong Kong dollar, Renminbi and foreign currency
  deposits are protected
• a DPS Fund with size of 0.25 of relevant
  deposits will be built up through the collection
  of contributions from Scheme members and
• differential contributions will be assessed based
  on the supervisory ratings of individual Scheme
  members.

• Liquidity Crisis Sudden deposit withdrawal
  requires liquidation of otherwise sound assets.
• Bank of East Asia, 2008 Link

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Lender of Last Resort

• Banking system sufficiently important that govts
  will usually protect depositors and prevent mass
  bankruptcies.
• Liquidity Crisis Lend at penalty rates against
  good collateral. Walter Bagehot, 1840s.
• Solvency Crisis Recapitalize banks through govt
  purchase of equity, diluting or destroying
  shareholder value.
• Moral Hazard Banks creditors and (sometimes
  owners) are protected from consequences of risky
  behavior.

Link
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Managing Liquidity

• A bank faces withdrawals of 5 million.
• This reduces liquidity. The bank can restore
  liquidity by managing assets or liabilities.
  Liquidity can be restored by converting secondary
  reserves (market securities) into primary
  reserves (cash).

Assets Liabilities
Cash - 5 Checkable Deposits -5
Assets Liabilities
Cash 5 Securities -5

• The bank can also engage more short-term
  liabilities by increasing borrowings from other
  banks or central bank.

Assets Liabilities
Cash 5 Borrowings5
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Liquidity Requirements Liquidity Ratio

• Hong Kong licensed banks are required to keep a
  liquidity ratio of 25 or More
• Most banks are fairly liquid.

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Core Deposits vs. Managed Liabilities

• Bank Liabilities can be divided into two parts.
• Core Deposits Demand Deposits, Savings
  Accounts, Small Time Deposits (Retail Funds)
• Managed Liabilities Borrowings from Other
  Banks, Commercial Paper, Large CDs and Time
  Deposits (Wholesale Funds)
• Retail funds have lower interest costs and are
  thought to be more stable. They take much longer
  time to raise and have greater non-interest
  costs.

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Measuring Liquidity Risk

• Loan to Deposit Ratio Ratio of illiquid loans
  to liquid deposits. High measure of
  loan-to-deposit ratio indicates high liquidity
  risk.

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Interest Rate Risk Income Side

• Interest Rate Risk The risk to an institution's
  income resulting from adverse movements in
  interest rates
• Many bank liabilities are of very short maturity
  (such as saving deposits) whose interest changes
  with market interest rates.
• Many bank assets are long-term and interest
  income may not change as market interest rate
  rises.
• When market interest rates rise, NIM will
  decline.

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Interest Rate Risk Balance Sheet Perspective

• An asset (or a liability) represents a set of
  payments that must be made at times in the
  future.
• Define PVT as the present value of a future
  payments made to an asset or a set of assets in T
  periods.

• Useful Approximation

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Duration Measure of Interest Rate Risk

• Define market value, MV, of an asset or a set of
  assets as the sum of present values derived from
  payments made in each future period.
• Define the duration of an asset as d
• The change of the market value of an asset to
  a change in the interest rate is approximately
  proportional to the duration of an asset.

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Measuring Interest Exposure

• Calculate the duration of a banks assets, dA.
  Calculate the duration of a banks liabilities,
  dL.
• An increase in the interest rate will have the
  following effect on assets and liabilities.
• Calculate the GAP as a function of duration of
  assets and liabilities.

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An increase in interest rates changes the value
of a banks assets and liabilities.
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Managing Interest Rate Risk

• A bank which has a large stock of assets which
  will pay a fixed interest rate may face losses if
  market interest rates rise.
• Since deposits must be redeemed at any time, the
  bank must offer market interest rates. If market
  interest rates rise, loan spreads will be cut.
• Banks may use asset and liability management to
  match the sensitivity of assets and liabilities
  to interest rates.

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Floating Rate Loans

• Fixed payment loans have a constant payment based
  on a fixed interest rate.
• Floating rate loan payments are based on an
  interest rate that changes as some benchmark
  interest rate changes
• Floating rate loans protect NIM from interest
  rate margins.

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Swaps

• Basic (plain vanilla) interest rate swap is
  agreement by two parties to exchange interest
  rate payments on a notional principal.
• One party pays a fixed interest rate for a
  pre-determined period of time. Another party pays
  a floating rate equivalent to some benchmark
  interest rate (LIBOR, etc.)

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Swaps and Hedging

• If a bank has long-term fixed rate assets and
  short-term liabilities, they face interest rate
  risk. Solution Swap income from fixed rate
  assets for floating rate from dealer.
• A pension fund with long-term obligations may
  like to lock in fixed income at a higher rate
  than LT treasuries. They may also swap income
  from floating rate assets for fixed income from a
  dealer.

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Interest Rate Swaps are Quickly Growing in
Importance
Source BIS International Financial Statistics
http//www.bis.org/statistics/derstats.htm
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Banks as Risk Taking Institutions

• Banks may specialize in ameliorating effects of
  asymmetric information.
• But there is still asymmetric information between
  banks and depositors.
• Banks info advantages are offset in at least 2
  ways.
• Bank Capital Owners of banks put some of their
  own funds into banks and these funds are at risk.
• Liquidity Advantage of Depositors Depositors
  can withdraw funds very quickly from banks.