Topics covered with me:
• Topic 1: Commercial and investment banks:
Activities and challenges (2 classes)
• Topic 2: Financial risks (2 classes)
• Topic 3: Liquidity and systemic risk (2 classes)
• Topic 8: Climate Finance (2 classes)
+ 2 exercise classes
1
International Banking - 30178
Academic year 2023-2024
Topic 1
Commercial and investment banks:
activities and challenges
Objectives of Topic 1
• Focus on commercial and investment banks
• Their activities and sources of profitability
– Balance sheet
– Income statement
– Financial ratio analysis
Chap. 2 – SC Textbook *Appendix 2B
Chap. 4 – SC Textbook
3
What are banks for?
What are banks for?
Saver (surplus of funds)
Borrower (shortage of funds)
Financial markets
(direct finance)
What are banks for?
Saver (surplus of funds)
Borrower (shortage of funds)
Financial institutions
(indirect finance)
Why do we need financial intermediaries (such
as banks)?
The two primary functions of FI (such as banks) are
1. Lower Transaction Costs
2. Reduce Asymmetric Info (ex ante: adverse selection; ex post: moral
hazard)
FI are better equipped than financial markets (direct finance) to solve these
problems.
What are Banks?
There are two “types” of banks:
1. commercial banks
2. investment banks
The Glass-Steagall Act (1933) separated investment and commercial banking
activities in response to the commercial bank involvement in stock market
investment.
What are Banks?
- Commercial Banks are institutions that accept deposits (liabilities) and make
loans (assets). They are traditionally the largest Financial Intermediary (FI) by
asset size.
- Investment Banks are not depository institutions. Mostly they:
1. underwrite the initial sale of stocks and bonds
2. are deal maker in mergers, acquisitions, and
spin-offs
3. are private broker/bank to the very wealthy
Investment banks ‘‘research’’ companies (provide analysts’ forecasts)
Direct credit
Investors
capital
Firms &
Sovereign
10
Intermediate credit (Commercial Banks)
Firms &
Sovereign
Investors
deposits
CB
Families
11
Intermediate credit (Investment Banks)
IB
Investors
capital
Firms &
Sovereign
12
Commercial banks
13
Commercial banks
• Major financial intermediaries in the economy
• Main providers of credit to household (mortgages) and corporate
sectors (typically to the SMEs)
• Different size classes
– Smaller banks are more specialized in lending to households
and real estate than larger banks
– Smaller banks collect deposits (retail customers) while large banks
use wholesale sources of liquidity
• Typically joint stock companies
– Publicly listed on the stock exchange
– Privately owned
14
The two financial statements
• Balance sheet: it captures the wealth of a bank,
that is the sources and uses of funds at one specific
date (end of the year)
• Income statement: it captures the performance of
a bank between two dates (two ends of the year)
• Appendix: Off Balance Sheet activities
15
Consider the (simplified) balance sheet of a company (not a FI):
where can you find LOANS and DEPOSITS?
Consider the (simplified) balance sheet of a company:
You can find
DEPOSITS here:
the company
keeps some of
its money in a
bank account
You can find
LOANS here: the
company
borrows funds
What about a commercial bank’s balance sheet?
What about a commercial bank’s balance sheet?
You can find
LOANS here: the
bank lends
money to SME,
households, etc
You can find
DEPOSITS here:
the bank always
owes them to
depositors
Balance sheet (b/s)
It lists sources and uses of banks’ funds
(usually, at the end of the financial year)
• Crucial to understand
– Asset quality and credit risk
– Capital Adequacy and Leverage Funding
20
The sources of funds (= liabilities)
• The funds come from:
a) general public (retail deposits)
b) companies (small, medium, and large corporate deposits)
c) other banks (interbank deposits)
d) debt issues (bond issues and loans)
e) equity issues (share issues, conferring ownership rights to
holders)
f) saving past profits (retained earnings)
21
The uses of funds (=assets)
• Funds are transformed into financial and, to a lesser
extent, real assets:
a) cash;
b) liquid assets: typically short-term instruments such as
Treasury bills;
c) loans (to SMEs and mortgages);
d) other investments;
e) fixed assets (branch network, computers, premises)
22
Simplified Balance sheet of a commercial bank
Assets
- Cash
-
Liquid assets
Loans
Other investments
Fixed Assets
Liabilities & Equity
- Retail deposits (households and
SMEs)
- Wholesale deposits (large firms/
FIs)
- Debt (senior/subordinated bonds)
- Equity
- Other capital terms
Total Assets
Total Liabilities & Equity
23
Simplified Balance sheet (b/s)
Assets
-
Cash
Liquid assets
Loans
Other investments
Fixed Assets
Total
Assets PCs
Branches,
Government and
Liabilities
corporate bonds,
etc. & Equity
1. Deposits (retails)
2. Deposits
Commercial
and (wholesale)
industrial (C&I),
mortgage loans
3. Equity
4. Other capital terms
All longer term
securities (bonds and
other debt Total
instruments)
Liabilities & Equity
24
What is special about banks’ (b/s)?
• Banks’(b/ s) are mirror image of non-financial
corporations
– Deposits appear on the liability side
– Loans appear on the asset side
The opposite is true for non-financial corporations
• The debt/equity ratio (leverage) is much higher than the
ratio of other kinds of firms (i.e. debt >>equity)
25
What is the consequence of high leverage?
• Any firm is solvent as long as its capital is non-negative.
But we just said that banks have less capital!
• When is a manufacturing firm insolvent?
– Assets need to decline by a large percentage
• When is the bank insolvent?
– Assets need to decline only by a small percentage
The bank is much riskier as it has a smaller loss
absorption capacity!
(we will go back to this in details later in the course) 16
Income statement (i/s)
It reports costs and revenues, thus bank profitability
(between two year-end balance sheets)
• Crucial to understand
– Banks’ profits
– Banks’ costs and revenues
27
What is an income statement? (i/s)
• It measures bank performance between two year-end
balance sheets, and thus bank profitability
• That is, the i/s reports costs and revenues and
Profits = revenues – costs
• Notice the difference:
– balance sheet reports stocks (e.g., amount of outstanding loans)
– income statement represents the cash flow values for a particular year
(e.g., interest received on outstanding loans)
28
Income statement
a
(b)
c =a-b
(d)
e =c-d
f
(g)
h =f-g
i =e+h
l
m =i+l
(n)
p =m-n
(q)
r =p-q
Interest income
Interest expense
Net interest income (or “spread”)
Provision for loan losses (PLL)
Net interest income after PLL
Non-interest income
Non-interest expense
Net non-interest income
Pre-tax net operating income
Securities gains (losses)
Income before taxes
Taxes
Net income
Cash dividends
Retained profit
19
How the b/s links with the i/s -1
Assets
1.
2.
3.
4.
5.
6.
7.
Loans
(Loan LossReserves)
Other Earning Assets
Total Earning Assets (1+2+3)
Fixed Assets
Non-Earning Assets
Total Assets
1.
2.
3.
4.
5.
6.
7.
Liabilities & Equity
Deposits
Other interest bearing liabilities
Other non-interest bearing liabilities
Total Liabilities (1+2+3)
Retained Earnings
Equity
Total Liabilities & Equity (4+5+6)
Income Statement
Interest income
Interest expense
Net interest income (or “spread”)
Provision for loan losses (PLL)
Net interest income after PLL
Non-interest income
Non-interest expense
Net non-interest income
Pre-tax net operating income
Securities gains (losses)
Net income before taxes
Taxes
Net income
Cash dividends
Retained profit
20
How the b/s links with the i/s -2
Net income (NI):
N
M
NI = Σ r n A n − Σ
n=1
r n L m − PLL + NiI − NiE − T
n=1
A = Assets (n)
L = Liabilities (m)
PLL = Provisions for loan
losses
NiI = Non-interest Income
NiE = Non-interest Expenses
T= Taxes
31
What drives interest income?
Yield on Each
Asset
Volume on
Earning Assets
Composition of
Assets
Interest Income
(income on all bank
assets such as loans,
securities and deposits
lent out to other
institutions,
households and other
borrowers)
32
What drives interest expense?
Interest Cost of
Each Liability
Volume of
Interest-Bearing
Liabilities
Interest Expense
(expenses on all
interest-bearing
liabilities such as
deposits, ST
borrowing and LT
debt)
Composition of
Liabilities
33
What drives non-interest income?
Fee Income
Service Charges
N on-interest
Income
Other Income
34
What drives non-interest expense?
Salaries &
Employee
Benefits
Property and
Equipment
Expenses
N on-interest
Expense
Other Operating
Expenses
35
How the b/s links with the i/s -3
Assets
1.
Loans
2.
(Loan Loss Reserves)
3.
4.
5.
6.
7.
Other Earning Assets
Total Earning Assets (1+2+3)
Fixed Assets
Non-Earning Assets
Total Assets
Liabilities & Equity
1.
2.
3.
4.
5.
6.
7.
8.
9.
Deposits
Other interest bearing liabilities
Derivatives & trading liabilities
Long-term funding
Other non-interest bearing liabilities
Total Liabilities (1+2+3)
Retained Earnings
Equity
Total Liabilities & Equity (4+5+6)
Income Statement
Interest income
Interest expense
Net interest income (or “spread”)
Provision for loan losses (PLL)
Net interest income after PLL
Non-interest income
Non-interest expense
Net non-interest income
Pre-tax net operating income
Securities gains (losses)
Net income before taxes
Taxes
Net income
Cash dividends
Retained profit
26
What drives provisions for loan losses?
Yield on each
loan
Volumes of
Loans
Provision for loan
losses
(amount charged
against earnings to
establish a reserve
sufficient to absorb
expected loan losses)
Composition of
Loans
27
Transition from a current loan to charge-off
Note: a NPL does not necessarily lead to losses.
If there is adequate collateral, losses might not occur
Loan is current and accruing interests
Once payment is 30 days late loan is classified as 30-90 days past due
Once payment is 90 days late loan is classified as 90 days past due
If full repayment of loan is uncertain loan is classified as non accrual
Loan is charged off once deemed uncollectible
Cash collection on previously charged-off loans are recorded as recoveries
NPL
Loan deterioration and equity
Reserves
reserves
reserves
reserves
- initial situation
Loan deterioration (cntd.)
Reserves
Equity falls
Reserves
Reserves
Management estimates that additional 5k won’t be paid as promised
Loan deterioration (cntd.)
Reserves
Equity falls
Reserves
Reserves
Management feels there is no chance for recovering those 5k.
Loan deterioration (cntd.)
It’s the gross loan value now that decreases, as reserves for loan losses
are established back at the initial level.
Reserves
Equity falls
Reserves
Reserves
Loan deterioration (cntd.)
Reserves
Reserves
Reserves
Off-Balance-Sheet (OBS) Activities
• (b/s) and (i/s) do not reflect the total scope of
bank activities
• OBS asset is an asset which moves onto the asset
side of a (b/s) or an income item of a (i/s) only
after a contingent event occurs
• OBS liability….
• What are they?
44
Major OBS Activities
– Loan commitment
– Credit facility with a maximum size and maximum period of time
when the borrower can use funds
– Standby letters of credit
– Guarantees issued to cover contingencies that may occur to a
borrower
– Futures, forwards, options, and swaps
– Derivate instruments – agreements to do something
– E.g. Forward: agreement to exchange assets for cash at a future
date at a pre-specified price
45
Why do banks engage in OBS activities?
1. Additional income in the form of fees
2. “Avoid” regulatory costs or “taxes”
– Example: reserve requirements and deposit insurance
premiums are not levied on OBS activities
3. Risk control - hedging
46
Largest banks as
of Nov. 2022
(G-SIFIs)
Source: Financial Stability
Board
Investment banks
48
Main activities of Investment Banks
– Underwrite securities
– Advising (Mergers and Acquisitions)
– Syndicated loans
IBs deal mainly with corporations and other large
institutions
IBs intermediate between fund suppliers and users,
while CBs transform funds into more attractive assets
49
Underwriting securities
• Helping customers in issuing new securities (debt and
equity) and distributing them
– Primary issues - IPO (Initial Public Offering)
– Secondary issues of seasoned firms
50
Underwriting securities
• In a private placement, the IB acts as an agent for a fee
• In a public placement, the IB can underwrite
– On a best-effort basis
• IB acts as an agent for a fee related to the placing success
– On a firm commitment basis
• IB acts as a principal, purchasing the securities from the issuer
at one price and seeking to place them with public investors
at a higher price: it gains a profit from the intermediation
51
Best effort vs. firm commitment
An IB agrees to underwrite an issue of 15 million shares of
the stock of TheBest Corp.
• On a best-efforts basis, it manages to sell 13.6 million
shares for $12.50 per share, and it charges TheBest Corp.
$0.275 per share sold.
– TheBest Corp. receives
($12.50 - $0.275) x 13,600,000 shares = $166,260,000
– The IB profit is:
$0.275 x 13,600,000 shares = $3,740,000
52
Best effort vs. firm commitment
An IB agrees to underwrite an issue of 15 million shares of
the stock of TheBest Corp.
• On a firm commitment basis, it agrees to pay $12.50 per
share and then sell the shares to the public for $13.25 per
share.
– TheBest Corp. receives:
$12.50 x 15,000,000 shares = $187,500,000
– The IB profit is:
($13.25 - $12.50) x 15,000,000 shares = $11,250,000
53
Mergers and Acquisitions (M&As)
• IBs provide advice or assist in M&As:
– Assist in finding merger partners
– Underwrite new securities issued by the merged firms
– Assess the value of the target firm
– Recommend terms of the merger agreement
– Etc.
54
Syndicated loans
• A syndicated loan is provided by a group of
financial intermediaries instead of a single lender
• It is structured by the lead FI and the borrower
• Once the terms (rates, fees, covenants, etc) are set,
pieces of the loan are sold to other FIs
55
Largest IBs by product group (2021)
Source: Financial Times
56
To sum up
• Investment banking is very different from
commercial banking
– Most activities such as securities trading and
underwriting, and M&A advice require no investment
in asset or liability funding
• Very different from loan issuance funded through deposits
– Thus, asset value is not a measure of the size of a firm
in this industry
– Rather, equity is used as the most common benchmark
of relative size
57
Simplified B/S of an Investment Bank
Assets
-
Liabilities & Equity
Cash & other non-earning assets Trading assets
Securities financing transactionsInvestment securities
Loans, notes and mortgages
Other investment
Fixed assets
Other assets
-
Commercial paper and other ST
borrowing
Trading liabilities
Securities financing transactions
LT borrowing
Deposits
Equity
- Other capital terms
Total Assets
Total Liabilities & Equity58
Simplified i/s of an Investment Bank
Revenues
- Trading and principal investments
- Investment banking
- Asset management, portfolio
service fees and commissions
- Interest income
Costs
-
Interest expenses
Operating expenses (staff costs)
Communication and technology
Occupancy and related depreciation
Professional fees
Marketing
Other expenses
59
What is “special” about IBs?
• There were five major investment banks in the US
prior to 2008…
– Bears Stearns
– Lehman Brothers
– Merrill Lynch
– Goldman Sachs
– Morgan Stanley
60
What happened to them?
• After 2008…
• The end of an era for US investment banks!
61
Bank performance
and
Financial ratio analysis
62
Recall: How to understand bank
performance?
• Balance sheets are crucial to understand
– Asset quality and credit risk
– Capital adequacy and leverage funding
• Income statements (profits and loss account) are
crucial to understand
– Banks’ profits
– Banks’ costs and revenues
63
Financial Ratio Analysis (FRA)
• How to construct measures to calculate different
aspects of performance?
• Different ratios measuring
– Profitability
– Asset quality
– Liquidity
64
Profitability ratios
• ROE = return on equity = net income/total equity
– Rate of return to the shareholders or
– The % return on each $ of equity
Often interpreted as a measure of profitability, but…
65
Profitability ratios
• ROE = return on equity = net income/total equity
– Rate of return to the shareholders or
– The % return on each $ of equity
Often interpreted as a measure of profitability, but…it
depends crucially on leverage!
If total equity is low (bank much indebted, high leverage)
 ROE high by construction (ceteris paribus)
66
Profitability ratios (cont.)
• ROA = return on assets = net income/total assets
– Measure average profit generated relative to the bank’s
assets
– Overall measure of efficiency and operational
performance
67
Profitability ratios (cont.)
• NIM = net interest margin (or “spread”)
= net interest income / total assets
– It measures the bank’s spread per unit of assets
– High NIM means that the difference between loan (and
other interest earning assets) and deposit rates is high
– What does it mean if one bank has a higher ratio than
another bank? (Assume the same loan quality)
68
NIM over time – until 2013…
69
Main challenges of the banking sector pre-Covid:






Low profitability and low market valuation
Low interest rate environment (LIRE)
Deleveraging/Legacy assets from the crisis
Increased regulation and compliance requirements
Damaged reputation
Digital disruption
Bank profitability varies across jurisdictions

Bank profitability has been
much higher in US than in the
Euro area or UK after the
financial crisis

Why?
Sovereign crisis (2011-13) in
addition to financial crisis
Lower interest rates
Higher non-performing loans
Higher regulatory burden
Different market structure





Price-to-book Ratio: US versus EU banks
•
Euro area banks have lower
valuation than US banks
•
IT and ES perform slightly better
than FR and DE
Price-to-book Ratio: US versus EU banks
•
Euro area banks have lower
valuation than US banks
•
IT and ES perform slightly better
than FR and DE
market value / book value
= share price X number of outstanding shares / net
assets
Price-to-book ratio: Individual banks (pre-Covid)
Source: Author’s calculations based on Bloomberg data
•
•
US banks have price-to-book ratios above 1
European banks have much lower ones
75
Low/negative interest rates (cont.)
• Pressure on bank profitability because of pressure on NIM
− Difficult to charge negative rates on deposits, in particular retail deposits (legal or
reputation impediments)
− More emphasis on fee income, but difficult to fully compensate
− Potential risk of increased risk taking (i.e., search for yield)
Still strong resilience with signs of deterioration
Bank
BEAT/
MISS
NII
YoY
Costs
YoY
CET1
Fully Loaded
CET1
YoY
BNP Paribas
BEAT
+13%
+7.2%
12.2%
-0.48%
Deutsche Bank
BEAT
+ 7.7%
+2.1%
13%
-0.23%
Credit Suisse
MISS
+4.9%
+1.6%
13.5%
-0.23%
BBVA
BEAT
+12.8%
+14.6%
12.5%
-0.44%
Credit Agricole
BEAT
+4.8%
+5.1%
11.1%
-1.26%
ING
BEAT
+0.6%
+3%
14.7%
-1.01%
Santander
MISS
+2.5%
+12.2%
12.1%
-0.05%
Societe Generale
BEAT
+1.1%
+6.9%
12.8%
-0.48%
UBS
MISS
-10.7%
-3.4%
14.2%
-0.33%
Unicredit
BEAT
+6.6%
-3.8%
15.7%
+0.21%
78
Source: Morgan Stanley Research, August 2022
Asset Quality ratios
• Reserves on Loan Losses/Gross Loans
– How much of the total loan portfolio has been provided
for, but not charged off
– Given a similar charge-off policy, the higher the ratio the
poorer the quality of the loan portfolio
• Non-Performing Loans (NPL)/Gross Loans
– The lower the ratio, the higher the quality of the loan
portfolio
• Non-Performing Loans (NPL)/Equity
– The higher the ratio, the greater the concern about the
bank’s solvency
80
Liquidity ratios
• Cash ratio: cash and due from other banks/total assets
• Liquidity securities ratio: Government securities/total
assets
• Loans/deposits
– How much of the bank’s loan portfolio is funded bydeposits
81
Some considerations on financial ratios
1. One-year’s figures are normally insufficient
–
Analysts look at least at five years
2. Comparison across banks may be difficult
–
Peer analysis among banks of similar size, operating in similar
geographical markets and perform similar activities
3. Ratios refer to a particular point in time
–
–
–
Seasonal effects can distort them
“Window dressing”: financial statements are made up to look
better than they really are
Possible manipulation and not compliance with recognized
accounting standards
82
The ROE framework
83
ROE decomposition
• Amount of capital is a measure of safety of the bank but
also of the return to shareholder through ROE
• Important decomposition:
ROE = ROA x EM
with EM (= equity multiplier) = Total assets/Total
equity capital.
ROE = Net income /Total equitycapital
ROA = Net income / Total assets
• EM measures the extent to which a bank’s assets are funded
with equity relative to debt
84
Trade-off between profitability and safety
Bank
Total assets
(a)
Total
capital (b)
EM= ROA
a/b
ROE=ROAxEM
Alpha
50.000.000 €
5.000.000€
10
1.5%
15%
Beta
50.000.000 €
2.500.000€
20
1.5%
30%
• The two banks have equal total assets and equal ROA,
but Alpha has more capital and lower EM and ROE
Which bank is safer?
Which bank is more desirable for shareholders?
85
The ROE framework
65
Trends post Covid19
• Change in supervision  softer supervision on capital
and liquidity regulation to avoid credit crunch (with Elena
Carletti)
• Rise in NPLs  are banks equipped to face new defaults?
• Digitalization  the lock down has accelerated the
digital revolution. What will happen to over-extended
branch networks? New IT and cyber risks (more on
operative risk in Topic 2)
66