Intro to Banking 3

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Guy Hargreaves
ACE-102
Recap of yesterday
 The role of maturity transformation, aggregation and
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risk transformation in financial intermediation
Credit creation via the credit multiplier
The critical payment system
Main banking products and services
Banking customer base
The banking industry within the global financial
system
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Today’s goals
 Understand concepts of market liquidity and product
fungibility
 List the major instruments traded in global financial
markets
 Understand some of the broad trends that have led to
today’s financial instruments
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Financial markets
 Definitions vary – but a financial market is generally
considered a collection of individual markets made up
of “fungible” products in which:
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Capital (debt and equity) is raised
Financial instruments are traded
Financial (and physical) risks are managed
 Markets can be focused on Primary activity or
Secondary activity, or both!
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What is fungibility?
 “Fungibility is the property of an asset whose
individual units are capable of mutual substitution”
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one unit of an asset can be substituted for another
Examples could be 1 ounce of gold, 1 USD banknote, 1 barrel of
crude oil
Examples of non-fungibility could be two USD bonds issued
by the same company but with different maturities
 Fungibility is critical in financial markets to provide
standardisation - which creates certainty and liquidity
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What is liquidity?
 Liquidity is the ability to buy or sell an asset (financial
or otherwise) without materially the asset’s price
 Most liquid market in the world is foreign exchange,
trades USD 5.3 trillion per day on average
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Three days FX trade = annual global trade!
 Low liquidity markets include unlisted shares, highly
structured ABS, property
 Important property of financial markets
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Financial markets have many pieces:
Money
Markets
Futures and
Derivatives
Securitisation
Fixed Income
Commodities
Equities
Foreign
Exchange
Syndicated
Loans
E-markets
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Money market instruments
 Short term debt financing and investment markets
 Terms usually less then 1-year
 Typical instruments include:
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Treasury bills
Commercial paper (CP)
Bankers’ acceptances
Deposits
Certificates of Deposit
Repurchase agreements
Federal Funds
Short dated bonds, ABS
 Question: which of the above are the most marketable?
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Money market instruments
 Question: which of the above are the most marketable?
 Typical instruments include:
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Treasury bills
Commercial paper (CP)
Bankers’ acceptances
Deposits
Certificates of Deposit (CD)
Repurchase agreements
Federal Funds
Short dated bonds, ABS
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Role of money markets
 Financing trade – provision of working capital and other
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short term instruments to finance global trade flows
Finance corporates – smooth short term financing flows
Investment – provide secure short term investments for
money market and other short term funds that require high
liquidity
Interbank liquidity – help banks fully fund their balance
sheets every day
Central bank policy – CBs can influence monetary policy
through money market operations
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Fixed income instruments
 Fixed income instruments are debt securities where
the borrower (issuer) is required to repay based on a
predetermined schedule or rate over a fixed term
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Public instruments purchased by wholesale or retail investors
Coupons (interest) generally either “fixed” or “floating” rate
Vast majority are “rated” by a major rating agency such as
Standard & Poor’s, Moody’s or Fitch
Ratings either “Investment Grade” or “High Yield” (so-called
junk bonds)
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Fixed income instruments
 Bonds are issued by a wide range of borrowers
(issuers)
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Governments (sovereign or municipal)
Agencies (government ownership)
Corporates
Special Purpose Vehicles (companies) – most commonly in
ABS
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Fixed income ratings (long term)
Standard & Poor’s
Moody’s
Fitch
Default Risk profile
AAA
Aaa
AAA
Investment Grade: extremely strong
AA+ | AA | AA-
Aa1 | Aa2 | Aa3
AA+ | AA | AA-
Investment Grade: very strong
A+ | A | A-
A1 | A2 | A3
A+ | A | A-
Investment Grade: strong
BBB+ | BBB | BBB-
Baa1 | Baa2 | Baa3
BBB+ | BBB | BBB-
Investment Grade: adequate
BB+ | BB | BB-
Ba1 | Ba2 | Ba3
BB+ | BB | BB-
High Yield : less vulnerable
B+ | B | B-
B1 | B2 | B3
B+ | B | B-
High Yield : more vulnerable
CCC
Caa1 | Caa2 | Caa3
CCC
High Yield : vulnerable
CC
Ca
CC
High Yield : highly vulnerable
C
C
C
High Yield : highly vulnerable +
SD
Selective default
D
D
Default
NR
NR
Not rated
 Credit ratings are a critical component of the efficient
operation of the fixed income market
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Foreign exchange
 Foreign Exchange (FX) is not a tradable security like
Fixed Income
 An FX transaction is simply the exchange of an
amount of money in one currency for money in
another!
 In a globalised economy with multiple currencies and
trade almost everyone has exposure to FX rates
 FX is traded in the market 24/7 and FX rates can move
significantly for many reasons
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A foreign exchange transaction
Joe
USD100
Linda
Joe
Linda
EUR109
 Joe needs EUR to pay for a new book he is expecting shortly
 The USD-EUR exchange rate is trading in the FX market at 1.09
 Joe pays USD100 to Linda’s USD bank account in exchange for
Linda paying EUR109 to Joe’s EUR bank account
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10 days later…
Linda
USD109
Joe
Linda
Joe
EUR109
 10 days later Joe is given the book by a friend and wants to convert his EUR back to USD
 USD has weakened and the USD-EUR exchange rate fallen to 1.00
 Joe pays EUR109 to Linda’s EUR bank account in exchange for Linda paying USD109 to
Joe’s USD bank account
 Joe has made a USD9 profit in being “long” EUR when it “rallied”
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Futures and derivatives
 Derivatives is a general term for a range of financial
instruments which included Futures
 Derivatives are contracts between two parties that
derive their value from the performance of an
“underlying”
 Underlyings can be almost anything, but more often
are assets, indices or rates
 Generally derivatives are either forwards, swaps,
options or futures
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Futures and derivatives
 The most common derivatives are:
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Interest rate swaps
FX forwards, swaps and options
Bond, bill futures
Commodity futures
Equity index futures
 Futures are traded on regulated exchanges such as
CBOT, HKEx and Euronext
 Most non-futures products are traded “Over-the
counter” (OTC)
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Swaps
 Derivative contracts between two parties where one
agrees to “pay” an agreed cashflow linked to an
underlying in exchange for “receiving” an agreed
cashflow linked to another underlying
 The “present value” of the expected swap cashflows is
calculated using market discount factors to arrive at
the market value of the swap
 Swap market values are dynamic and vary with
changing underlying market variables
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Futures
 Futures are standardised contracts, traded on a futures
exchange, to buy or sell a fixed amount of an asset at
an agreed price on a fixed date in the future
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eg under the CME US Treasury Bond future the participant
delivers or receives USD100k of a US government bond on a
specific day in one of the contract months of March, June,
September or December
 Because futures are standardised they can be highly
liquid, but the standardisation can also introduce
“basis risks” for participants using them for hedging
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Options
 Options are contracts under which the buyer has the
“right but not the obligation” to buy or sell an
underlying asset at an agreed price in the future
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eg an option to sell USD100 and buy EUR109 in 10 days time
 The power of options lie in the ability of the owner to
abandon them should the market move adversely
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eg if in 10 days the USD-EUR was 1.20 the option owner would
not “exercise” the option, instead selling USD100 to receive
EUR120
 The “option not to exercise” is like insurance and
requires the option buyer to pay a non-refundable
premium to the seller
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Commodities
 In recent years banks have built significant commodity
divisions which trade in both physical and derivative
contracts
 Energy commodities such as oil and gas are significant
markets for banks
 Metals, agricultural products also popular
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Syndicated loans
 In the traditional banking model most corporate loans
were “bilateral”
 As corporates grew the size of their loans grew aw well,
becoming too large for single banks to fund on their
own
 Syndicated loans were a solution – borrowers would
enter into a single loan agreement with syndicates of
banks - ranging from 5 banks to over 50 banks for very
large deals
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Syndicated loans
 Banks could earn additional income from
underwriting and distributing syndicated loans
 The loan agreements incorporated “transfer language”
which allowed banks in a syndicate to sell their loans
to other banks or investors easily
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Securitisation
 Securitisation is a financial structuring technique
which transforms pools of assets into Asset Backed
Securities (ABS) which can be sold to fixed income
investors
 Banks developed the securitisation business initially to
allow them to transform their own portfolios of
relatively illiquid assets into liquid securities that
could be sold for balance sheet management
 The securitisation business took on a life of its own in
the 1990s when banks applied the technique to
customer portfolios to generate additional fees
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Securitisation
 Mortgages are the most common securitised asset,
generating Residential Mortgage Backed Securities
(RMBS)
 Corporate loans, in particular High Yield loans, are
also a popular asset class generating Collateralised
Loan Obligations (CLOs)
 Trade Receivable securitisation is a popular product in
the post 2007-9 GFC era. Corporates with large
portfolios of trade receivables can use securitisation to
obtain very cheap funding
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Securitisation
 Motivations behind securitisation can vary:
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Banks might use securitisation to sell off illiquid portfolios
and achieve “regulatory capital relief”
Corporates might use securitisation to achieve cheaper
funding rates
CLO managers engage in “arbitrage” in that they are able to
purchase portfolios of loans and fund them cheaply with CLO
ABS
NBFIs might use securitisation as their primary funding tool
for their “originate to distribute” business models
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Securitisation
 Securitisation has been accused as being a primary
cause of the 2007-9 GFC
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It is true that originators of “sub-prime” mortgages use
securitisation to rapidly on-sell poor quality mortgage loans to
RMBS ABS investors
Confidence in securitisation was very negatively affected
during the crisis
“Sound” RMBS backed by prime borrowers actually performed
quite well
 New banking regulations and increased risk aversion
are a greater hindrance to the recovery of the
securitisation industry than anything else
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Equities
 The banking industry had played little or no role in
equities markets since the 1930s
 Investment banks and old style stockbroker/securities
firms dominated Initial Public Offering (IPO) and
associated equity primary and secondary markets
 In the late 1990s deregulation of securities laws
allowed commercial banks to establish or purchase
securities firms and participate in equity sales and
trading
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Equities
 Equity products offered in financial markets included:
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IPO underwriting
Secondary placements
Common or preferred shares
Equity derivatives (futures, index futures, swaps, options)
Secondary trading
Research
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E-markets
 The age of the internet has seen explosive growth in
electronic trading and associated e-markets
 Banks offer platforms and portals through which their
customers can place transaction orders directly into
markets
 Banks offer “market-making” services to clients via
these platforms to profit by intermediating buyers and
sellers
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E-markets
 E-market platforms offer access to:
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FX (“spot”, forwards, swaps, options etc)
Equities and equity indices
Fixed income and money market products
Derivatives
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