Guy Hargreaves
ACF-104
Wechat: Guyhargreaves
Recap of yesterday
 Understand commercial bank balance sheets and
general principles of bank balance sheet management
 Compare off and on balance sheet products and
structures
 Understand key considerations for the practice of good
banking
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Goals of today
 Appreciate the key drivers to the business of
commercial banking
 Review how commercial banks generate financial
returns
 Describe the key metrics used in commercial bank
financial management
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Theory in practice
 Recall commercial banks perform three basic high
level functions:
Size transformation
2. Maturity transformation
3. Risk transformation
1.
 This is the theory – how in practice to commercial
banks actually generate net profit?
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Size transformation
 For a commercial bank this means:
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Estimating market appetite for credit
Underwriting and distributing syndicated loans in size
Using balance sheet to take on the liquidity risk of making a
loan larger than its deposit base
 Customers want loans and other banking products and
services tailored to their own size
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Maturity transformation
 For a commercial bank this means:
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Using its “Capital Structure” to manage maturity risk
Underwriting balance sheet maturity “Gaps”
 Very long dated maturity demands can be challenging
for commercial banks
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Banks prefer 3-5 year maturities for loans
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Risk transformation
 Savers and depositors want to invest in diversified
portfolios of credit risk
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$100 invested in a single “A” rated corporate can have very a
different investment outcome compared with $1 invested in
each of 100 “A” rated corporates
Bank portfolios are very diverse which means savers can have
confidence in banks
Capital regulations and access to central bank liquidity also
helps risk transformation
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So how do banks make money?
 Like all businesses, banks have capital structures:
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Equity capital
Hybrid capital
Subordinated debt
Long term bonds
Medium term notes
Short term deposits
Decreasing risk
Decreasing maturity
 Aim of commercial banks is to use this capital to invest
in assets which generate sufficient return to provide an
acceptable return on capital (RAROC)
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Recall: banking products and services
 Commercial banks offer a wide range of products and
services
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Current / chequing accounts
Term deposits
Consumer loans / mortgages
Credit / Debit Cards
Cash management services
Corporate / SME loans
Trade Finance
Financial market products
Online banking
- fees, liability raising
- liability raising
- asset raising
- fees, asset raising
- fees, asset / liability raising
- asset raising
- fees, asset raising
- fees, trading, spread
- access
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The cost of capital
 The cost of commercial bank capital is an important
input into the economics of the business of banking
 Weighted Average Cost of Capital (WACC) is a closely
managed metric for banks
Banks with high WACC need to invest in higher returning
assets to generate acceptable returns
 Higher returning assets are riskier
 Riskier assets require more regulatory capital to be held
=> can become circular
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WACC example
Capital type
% of Capital Structure
Cost
Equity capital
6.0%
12.0%
Hybrid capital
2.0%
9.0%
Subordinated debt
2.0%
5.0%
Long term bonds
20.0%
4.0%
Medium term notes
10.0%
3.0%
Short term deposits
60.0%
1.0%
100.0%
WACC: 2.7%
Total:
 The bank will need its weighted average asset yield to
be greater than 2.7% to generate operating profit
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RAROC
 Risk Adjusted Return on Capital (RAROC)
 Widely used metric in commercial banking to measure
the return generated from financial assets
 Commercial banks fix minimum RAROC hurdles to
assist in their decision making processes
RAROC = Revenue – Cost – Expected Loss
Required Capital
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RAROC
RAROC =
Revenue – Cost – Expected Loss
Required Capital
 Where:
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Revenue is NIM
Cost is the fully loaded cost of taking on the asset
Expected loss is the amount the bank must assume it will lose
from investing in the risky asset
Required capital is the amount of regulatory capital a bank
must hold when investing in the risky asset
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Meeting return hurdles
 Assume a bank sets its RAROC hurdle at 12%
 An exporter requests a $100m 3-year loan for capital
expenditure:
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The exporter is an “AA” rated company with a sound balance
sheet and good track record
The bank has an overall cost/income ratio of 40%
The bank needs to hold 8% capital against the loan
The bank’s funding cost for the loan is 3%
=> What interest rate [I%] should the bank offer on this loan?
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Meeting return hurdles
RAROC =
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Revenue – Cost – Expected Loss
Required Capital
Revenue $R
= $100m * (I% – 3%)
Cost $C
= $R * 40%
Expected loss = PD * LGD where Probability of Default for
“AA” rated company for 5-years is 0.2% with Loss Given
Default of 20% (recovery rate 80%)
Required capital RC = $100m * 8% = $8m
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Meeting return hurdles
12%
= $R – ($R * 40%) – $100m * 0.2% * 20%
$8m
= $R * 60% - $0.04m
$8m
= ($100m * (I% - 3%) * 60% - $0.04m
$8m
=>
I%
=
=
(12% * $8m + $0.04m) + 3%
$60m
4.6667% (“Credit margin”: 167 basis points)
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Meeting return hurdles
 Charging a “AA” rated company a credit margin of 167
basis points could be uncompetitive
 If customer wanted to pay a 50 basis point margin the
bank would have to accept RAROC of 3.25% or not do
the deal
 Banks often subsidise low RAROC lending in order to
“X-sell” higher margin products
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Take a whole of relationship view on the customer
Aim to earn fees from derivative hedging income perhaps
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Fee based income
 Commercial banks like fee-based revenue because
they do not have to set capital aside if there is no
residual credit or market risk
 Fees include:
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Syndicated loan underwriting fees
Upfront derivative fees
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Derivative business income
 Banks generate derivative revenues from trading and
“market making”
 Trading: take “long” or “short” positions in markets
through derivatives, similar to securities trading
 Market Making: provide prices to clients at any given
time of their choice
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Aim to buy low / sell high by having clients transaction on
both sides of the “bid/offer” spread
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Foreign Exchange income
 Bank FX divisions generate income from trading and
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market making
FX markets are extremely efficient and bid/offer
spreads are very narrow
Volumes are HUGE though!
Complex FX derivatives are high margin generators for
banks
FX market was first to embrace e-markets platforms
and many customers can plug directly into markets
these days
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The retail banking business
 The principles behind making money in the retail
business are similar to wholesale banking
 Retail bankers are allocated capital and look to make
loans, funded by deposits, to generate acceptable
RAROC
 Portfolio diversification is easier given there are many
smaller customers in the portfolio
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The mortgage business
 By far the largest retail commercial banking business
in many economies
 Mortgage NIM often in the range of 1-3%
 RAROC, cost/income, efficiency are key drivers
 Mortgage product is very similar across many banks
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Credit and debit cards
 Credit cards offer the holder an unsecured line of
credit that can be drawn to pay for goods and services
 Debit cards are accounts that must have positive fund
balances before they can used to pay for goods and
services
 Retailers that accept credit cards charged fees of up to
3% for each transaction
 Customers that don’t repay their cards monthly often
subject to huge interest rates eg 16%
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Trade finance
 Trade finance products are typically short term,
uncommitted and secured
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RAROC is high because banks don’t have to set aside capital
against “undrawn commitments”
Off-balance sheet products like Letters of Credit (LCs) can
have favourable capital treatment
Secured against trade flows eg crude oil cargos (LGD
significantly reduced
 Economics of trade finance often highly reliant on
commodity prices
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With crude prices halving, if volumes remain unchanged
trade finance volumes will half
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Key bank financial metrics
 Loan / Deposit ratio – measure of how much of banks loan book
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is being funded by deposits
Tier 1 ratio – ratio of permanent capital to “risk weighted assets”
(RWAs)
Leverage Ratio – ratio of Tier 1 capital to total assets
Liquidity Coverage Ratio – ratio of outflows over a critical
timeframe (eg 30 days) to high quality liquid assets
Net Stable Funding Ratio – ratio of “stable funding” to long term
assets
Efficiency ratio – equivalent to the operating margin – ratio of
operating revenue (EBIT) to total revenue
ROE or ROA – traditional return metrics
Credit quality – loan loss ratios
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