INTRODUCTION TO BANK MANAGEMENT

1. 2. 3. 4.

Functions of banks ................................................................................... 3 Balance sheet............................................................................................ 6 Profit and loss account ............................................................................ 8 Banking products ................................................................................... 10
4.1. 4.2. 4.3. 4.4. Products on the assets side of the balance sheet ................................ 10 Products on the liabilities side of the balance sheet: ........................... 12 Derivative products (off-balance-sheet products)................................. 13 Service products ...................................................................................... 14

5. 6.

The principle of total bank management .............................................. 15 The legal framework ............................................................................... 17
6.1. 6.2. 6.3. Legal Provisions - Credit Risk ................................................................ 17 Legal Provisions - Liquidity Risk ............................................................ 22 Legal Provisions - Market Risk ............................................................... 22

7.

Ratios in bank management .................................................................. 24

FINANCE TRAINER International

Introduction to Bank Management / Page 1 of 25

INTRODUCTION TO BANK MANAGEMENT

Learning objectives You gain insight into the historical development of the banking business. You know the most significant banking transactions. You know the structure and the most important items of the balance sheet and the profit and loss account. You gain an overview of the most important banking products You understand the principle of total bank management. You know about the legal provisions concerning credit risk, market risk and liquidity risk.

FINANCE TRAINER International

Introduction to Bank Management / Page 2 of 25

1.

Functions of banks

The origins of the banking business are closely connected to the history of money. Priests organised the first banking transactions in ancient times, as they were known as trustworthy and the temples were good places for safekeeping. Beside the custody of money, their main business was the exchange of money.

In the Middle Ages the techniques of banking improved considerably. The center of new developments was northern Italy. There, the first giro banks opened in the 16th century. Their main task was money transfer.

Towards the end of the Middle Ages it became more important for banks to grant loans using the deposits of their customers. Moreover, banknotes were developed and became the statutory means of payment.

The first borrowers in the Middle Ages were sovereigns. In the 19th century, with the beginning of the Industrial Revolution, private businesses had a high demand for credit.

First, stock investments raised the big capital amounts which were necessary during industrialisation. Over the years the basic principle was developed which is still valid today: financing the granting of credits through customer deposits. From 1950 a seller's market prevailed in banking. There was hardly any competition between banks. The debit and credit interest agreement regulated the prices. Banks' main source of income - interest income was stable. From the 1980s onwards the interest margin (= interest income interest expense in % of the balance sheet total) steadily decreased with growing competition.

Extensive changes in the banking sector are currently in progress in order to preserve the banks profitability and will not be completed for a long time. More and more new products are being developed to increase income and customer orientation is becoming increasingly important. Radical economisation measures are being implemented to solve the problem of steadily increasing expenses, especially staff costs. Through the application of data processing banks are trying to increase their potential for economisation. Driven by higher profitability targets and economisation requirements, a consolidation process is in progress which is still not completed and which is leading to increasingly large-scale mergers.

FINANCE TRAINER International

Introduction to Bank Management / Page 3 of 25

The financial system serves as an inter-temporal swap system. This means that the capital provider allocates cash benefit to the capital seeker today and in return receives the promise of a cash benefit in the future. This future cash benefit is insecure; therefore risk allocation is one of the most important functions in banking.

Banks serve as financial middlemen in this inter-temporal exchange by taking funds from customers on the one hand and lending these funds to other customers on the other. In other words, banks refinance themselves using sight deposits and savings deposits, by means of which they grant loans to companies, individuals and other borrowers.

This risk transformation applies to different risks. These are the typical banking risks such as interest risk, liquidity risk and credit risk. The objective of risk management in the bank is to generate optimum returns in relation to the risk taken.

Beside risk transfer, the banks' main task is the provision of services. Banks advise customers. They provide funds for their customers by means of loans and assess customer funds. Banks process payment transactions, provide safes, exchange foreign currencies. Customers pay fees for these services. These fees include, firstly, regular fees such as regular margins for interest products or regular commissions and charges (e.g. deposit fees, account maintenance charges), and, secondly, one-off service fees such as administrative charges and exchange commissions.

Overview of the banking business Payment transactions: cash transactions credit transfer encashment cheques bills of exchange debit notes documents foreign currencies credit operations

FINANCE TRAINER International

Introduction to Bank Management / Page 4 of 25

Securities business: securities transactions on commission custody business issuing business own business

Lending business short and medium-term credits overdraft credit consumer credit long-term credits capital investment loans mortgage credit municipal loan

Borrowing business deposit business sight deposits time deposits savings deposits borrowing from the money market issue of bonds

FINANCE TRAINER International

Introduction to Bank Management / Page 5 of 25

2.

Balance sheet

The balance sheet compares the ASSETS and LIABILITIES of a bank.

Banks balance sheet

BALANCE SHEET ASSETS Volume in in mio. Euro LIABILITIES Volume in in Euro m

Cash and balances with central banks Trading assets Loans, advances to and placements with banks Loans and advances to customers
minus loan loss provisions

1,824 Amounts owed to banks 18,954 Amounts owed to customers 29,558 76,354 -3,622 17,976 1,177 1,162 4,586
Liabilities evidenced by certificates Trading liabilities Provisions Other liabilities Subordinated capital Minority interests Shareholders equity

41,033 56,562 19,992 10,504 3,49 4,673 6,455 650 4,61 147,968

Investments Property and equipment Intangible assets Other assets

TOTAL ASSETS

147,968 TOTAL LIABILITIES

Assets are receivables for a bank. The balance sheet classifies receivables according to two criteria: liquidity and customers

The most liquid receivables are cash reserves and balances with central banks. The objective of the short-term trading assets is to generate returns from short-term price fluctuations.

Loans due from banks are claims against other commercial banks and are mostly of a shortterm nature (no longer than 12 months).

Loans due from non-bank customers are the most important receivables of a bank. Receivables can be against companies (business operating loan, investment loans), individuals (overdraft credits, mortgage credits) or public authorities (federal government, countries, municipalities). The maturity varies from short-term (1 month) to long-term (up to 25 years).

FINANCE TRAINER International

Introduction to Bank Management / Page 6 of 25

The item investments covers the securities investments of the banks, i.e. their own investments. Securities are purchased either as working assets or as capital assets. If they belong to the capital assets the bank intends long-term holding of the securities, usually until the end of maturity.

The Liabilities are the debts of the bank. The classification according to maturity profiles (= liquidity) applies to liabilities too. Amounts owed to banks are debts with other commercial banks and are mainly of a shortterm nature (no longer than 12 months). They are especially useful for short-term refinancing of the bank. Amounts owed to customers are the main source of refinancing for most universal banks, whose main business purpose is the retail business. Private customers in particular invest their money in savings deposits. Liabilities evidenced by certificates are a bank's own issues. These constitute a long-term source of refinancing. This market is only open to banks of a certain size: a single issue needs a certain lot size as it has to be placed on the stock market. Such securities issues are bank bonds with a maturity of up to 20 years. Maturities from 3 to 10 years are standard. The return on these bonds is either a floating money market rate or a fixed interest rate.

An essential liability item in any organisation is shareholders' equity. Banks also need equity, therefore equity regulations are a key component of banking law. Off-balance-sheet transactions have no influence on the balance sheet, the reason being the principle that pending transactions are not to be entered on the balance sheet. Off-balancesheet transactions are mainly derivative financial instruments (financial swaps, options, futures).

FINANCE TRAINER International

Introduction to Bank Management / Page 7 of 25

3.

Profit and loss account

Income and expense are entered in the profit and loss account, the objective of which is to calculate the bank's annual result.

Profit and Loss account in EUR m Net interest income Losses on loans and advances Net interest income after losses on loans and advances Net fee and commission income Net trading result General administrative expenses Balance of other operating income and expenses Operating profit Net income before taxes Net income 2,307 (537) 1,770 1,076 231 (2,503) (1) 573 504 393

The most important item is the net interest income. It order to calculate the results you compare interest income and interest expenses. The bank receives interest on its claims. The customers have to pay interest on their loan. These payments are the interest income. The principle of an accrual return calculation applies. This means that it is not the amount of interest the bank has already received that is decisive, but the total amount of interest for one business period. This regulation requires an accrual calculation of interest income and expenses.

Interest expenses result from payments a bank has to make to its customers for its debts. At the end of the year the customers receives interest on their deposits. Again, accrual calculation of expenses is used.

The second source of income is the net fee and commission income. Account maintenance charges and deposit fees are examples of such items.

The bank generates its trading result from trading activities which focus on short-term profit making. The trading result includes profit and loss realised from trading activities on the one hand and trading assets valued at the current market price on the other.
FINANCE TRAINER International Introduction to Bank Management / Page 8 of 25

The losses on loans are listed after the interest income and represent the net allocation for loan loss provisioning. Net means that allocation of loan loss provisioning is set off against withdrawals. Losses on loans are the actual risk expenses of the lending business.

The administrative expenses show the resources needed for the provision of services. The main input factor is human resources, staff costs being the major item of expense in the bank's profit and loss account. Approximately 70 % of a banks administrative expenses stem from staff costs. The remaining 30 % are material expenses (rent, IT expenses, etc.).

FINANCE TRAINER International

Introduction to Bank Management / Page 9 of 25

4. 4.1.

Banking products Products on the assets side of the balance sheet

The most important products on the assets side of the bank's balance sheet are loans. These loans are placed with companies, public authorities and individuals.

There are two types of loans in corporate financing: business operating loans investment loans

Financing for public authorities covers loans to governments, federal states and municipalities.

In the personal loans business standardised products are used wherever possible. Products are standardised with regard to credit decision credit conditions IT support repayment and with respect to risk components these loans are placed quickly and cost-efficiently. In contrast to the traditional loans business, a scoring procedure is used instead of extensive credit rating and standard contracts are used instead of individual credit agreements.

Consumer loans are basically available to all citizens who have reached the age of majority, have a regular income and can be expected to pay back the stipulated instalments. The minimum credit amount which can be financed with a consumer loan is EUR 4,000. With a lower amount it is not even possible to earn the unit costs. The maximum amount of credit depends on the respective customer rating.

The maturity mainly depends on the purpose of the loan: for "consumer financing it ranges from 6 to 180 months for "financing of housing it ranges from 6 to 300 months

FINANCE TRAINER International

Introduction to Bank Management / Page 10 of 25

Consumer credits can basically be divided into 2 different types: one-time cash loan with fixed repayments overdraft credit

One-time cash loan This is a payback loan with monthly flat instalments. With each monthly instalment the borrower pays back shares of the capital and interests. Changes in the interest rate affect the flat instalments in such a way that capital as well as interests are totally redeemed upon maturity. Due to standardisation, loan repayments are made on a fixed date within the maturity period.

Overdraft An overdraft is the utilisation of a credit line. Liquidity is available on private accounts. The basis for calculating the amount of the overdraft is a multiple of the average volume on the credit side over a certain period. Additionally, there is a fixed upper limit in terms of an absolute amount. The time of granting and the maturity of the overdraft are regulated individually. In principle an overdraft is offered only to those customers who have had regular movements on their bank account over a certain period (normally 6 months).

An overdraft provides short-term liquidity. If there are no problems with the respective account (regular receipt of agreed amount) an extension can be granted automatically.

Mortgage loan A mortgage loan is intended for the financing of the purchase of a flat the building of a house the purchase of a house the purchase of real estate renovation and rebuilding

The maturity can be up to 30 years. A financing plan can be developed on the basis of a fixed interest agreement for 3, 5, 7 or 10 years.

FINANCE TRAINER International

Introduction to Bank Management / Page 11 of 25

4.2.

Products on the liabilities side of the balance sheet:

The most important refinancing products (liabilities) of a bank are sight, term and savings deposits.

Sight deposits are used for payment transactions. They pay low interest.

Term deposits are normally fixed deposits. They are payable on a fixed date. The maturity is usually 1, 3 or 6 months. The interests are payable at the end of maturity. Of course, the amount of interest depends on the current short-term interest rates on the money market, but mainly on the amount of the invested capital.

Savings deposits are credits on savings accounts. Money used for payment transactions is not considered to be a savings deposit. For interest calculation the cancellation period is decisive and not the period of capital allocation. Normally, accumulated interest income is credited annually to savings accounts.

Interbank money is also suitable for short-term refinancing of a bank as well as for the investment of a liquidity surplus.

Maturities:

Maturities of 1 month, 3 months, 6 months and 1 year are standard. Longer maturities are also possible.

Interest calculation:

Interest calculation depends on the current money market interest rates (1 month, 3 months, 6 months and 1 year) and on the in-vested volume. With a normal yield curve (interest rates for long-term maturities are higher than for short-term maturities) higher in-terests can be realised on long-term maturities. However, this higher return comes with lower flexibility.

Maturity profile:

Fixed-term deposits are due at the end of a stipulated term. As far as callable money is concerned, the maturity period is extended if the investor does not recall the money.

FINANCE TRAINER International

Introduction to Bank Management / Page 12 of 25

4.3.

Derivative products (off-balance-sheet products)

Derivative products have been growing dynamically over the last 15 years. Derivative products also known as off-balance-sheet products were mainly developed in banks and have become the instruments par excellence for managing banking risks and trading positions.

Derivative products are also called forward transactions. The buyer buys the underlying value at a stipulated price upon conclusion of the business transaction. The seller sells the respective value at a stipulated price. The advantage of the purchase of a forward contract is that there is no flow of liquidity, which means one can speculate on rising prices without initial investment. When someone sells a forward contract, he/she can speculate on falling prices. This is a major advantage of the sold forward contract.

The valuation of these products is based on the market value of an underlying instrument. This is an essential characteristic of these products.

Classification criteria delivery time spot transaction forward transaction

subject matter of contract unconditional transaction (both parties are obliged to deliver) conditional transaction (options)

place of contract conclusion on the stock exchange not on the stock exchange

underlying interest fx shares commodities prices

FINANCE TRAINER International

Introduction to Bank Management / Page 13 of 25

4.4.

Service products

Carrying out payment transactions is one of the most important services a bank provides. The goal is to encourage bank transfer and reduce cash transfer, as costs for cash transfer are very high.

Investment advisory is one banking service that is strongly increasing. Good advice on risk/return management improves the return on investment for customers. Banks are now selling more and more products which are not typical banking products, especially funds. The "fund industry is a growth market within the financial business. Even a price slump (like that of the past three years) will not stop this trend. The bank profits from the sale of these products and from the collection of the deposit fee. Fund shares have to be deposited in a securities account and these accounts are provided by banks.

FINANCE TRAINER International

Introduction to Bank Management / Page 14 of 25

5.

The principle of total bank management

All banks are trying to find a suitable system which helps them to manage the bank from a single transaction through the business units right up to the total bank result with one single concept.

The most important goal is increasing profitability, which serves as a basis for optimising the cost/income ratio optimising the risk/return ratio

Fierce competition and the growing diversity of products and markets is putting increased pressure on profits and increasing the demands made on bank management. As a result, a higher standard is required of the controlling and management methods and the instruments applied. In order to steer a bank in "the right direction", we must define the targets to be achieved. Most target-based concepts are geared towards profitability in all decision-making areas. Profitability is considered to be the most important parameter in the hierarchy of banking results.

The most important step in modern bank management is to install the transfer pricing method (which started its triumphant advance in the 1980s) in order to achieve a result measurement that works. Result measurement is a complex procedure, as many different divisions of a bank are involved.

Loan Customer interest rate: 8 % + 1 % handling fee (one-time) In a calculation determined by the transfer pricing method the 8% are divided as follows: 3% 1% 2% for interest rate risk management for standard risk costs for unit costs

0.5% for liquidity costs 0.5% for equity costs

FINANCE TRAINER International

Introduction to Bank Management / Page 15 of 25

The transfer pricing method requires two important preconditions in order to clearly allocate and calculate returns: Separation of riskless customer business, which earns its profit from contribution margins, and risk business, which makes its profit from taking targeted market and credit risks. Consistent reference parameters, so-called transfer prices, which enable this separation and permit comparison of different transactions.

In the above example we assume a risk share of 3 % (= transfer price) for a loan with a customer interest rate of 8 %. Chapter 3 will explain the details. The remaining margin of 5 % covers all other costs mentioned above. A contribution margin of 1 % remains, which covers the costs not yet directly calculated (mainly overhead costs) and includes the profit from the customer business as such.

Total bank management in line with the transfer pricing method has the following advantages: It allows transparent calculation of results. It provides valuable management information. Results can be assigned to the individual divisions. The divisions down to the individual account managers take responsibility for their own results. The objectives of the total bank can be more easily broken down to the single division and can also be consolidated in calculatory terms for the entire bank. It generates a consistent understanding of the profitability of a transaction. It facilitates risk/return-adequate pricing.

FINANCE TRAINER International

Introduction to Bank Management / Page 16 of 25

6.

The legal framework

The whole banking business is embedded in a legal framework. Unexpected bank collapses may quickly take on a political dimension, which is the reason why banking is subject to special legislation. The primary concern of modern banking legislation is to ensure that the typical risks of banks stay within certain limits.

The legal framework must be adhered to, and the banks management must take it into account when planning and defining goals for the individual business segments. Thus, while the legal framework restricts the scope of the bank's management in terms of management of the bank as a whole, it does not necessarily have to be built into the control tools used by the individual business divisions.

6.1.
Principle

Legal Provisions - Credit Risk

The minimum equity requirement aims to ensure that the existence of a bank is not jeopardised, even in the event of unexpected loan losses. Eligible Equity Minimum Capital Requirement = Risk-Weighted Assets

8%

Risk-Weighted assets = Volume * Instrument Risk Weighting * Counterparty Risk Weighting

FINANCE TRAINER International

Introduction to Bank Management / Page 17 of 25

Instrument risk weighting The instrument risk weighting, also called credit conversion factor, is applied to translate the volume of off-balance sheet positions into the volume of a credit-risk equivalent on-balance sheet position. In other words, the on-balance credit risk equivalent should represent the maximum possible loss on the position caused by a credit event. loan: 100% (on-balance!) derivatives dependent on maturities: 0.5 % - 29 %

Original maturity

Interest contracts

Other price risks (foreign exchange, gold)

Up to 1 year Up to 2 years For each further year

0.5 % 1% 1%

2% 5% 3%

To give an example, the instrument weighting for an interest swap with a maturity of 5 years is 4 %.

Counterparty risk weighting: Once the volumes of all positions are translated into default exposures (= credit-risk equivalent on-balance sheet position), risk-weightings are assigned to the positions depending on the nature and/or the rating of the counterparty and/or instrument. The following table shows standard risk-weights as they are applied under the Basel II Standard approach for Sovereigns, Banks, Corporates and Retail.

FINANCE TRAINER International

Introduction to Bank Management / Page 18 of 25

Rating

Sovereigns

Banks Option 1

Corporates

Retail

Mortgage residential property

AAA AA+ AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC and lower no rating

0% 0% 0% 20 % 20 % 20 % 50 % 50 % 50 % 100 % 100 % 100 % 100 % 100 % 100 % 150 % 100 %

20 % 20 % 20 % 50 % 50 % 50 % 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 % 100 % 150 % 100 %

20 % 20 % 20 % 50 % 50 % 50 % 100 % 100 % 100 % 100 % 100 % 100 % 150 % 150 % 150 % 150 % 100 %

75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 % 75 %

35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 % 35 %

EUR 2m loan to a Corporate with an A+ Rating. The counterparty risk-weight is 50%. The capital requirement is calculated as EUR 2m (Volume) * 100% (instrument risk weighting) * 50% (counterparty risk weight) * 8% (minimum capital requirement) = EUR 80,000.

FINANCE TRAINER International

Introduction to Bank Management / Page 19 of 25

Eligible Equity is defined as follows: paid-up capital disclosed reserve general banking risks fund supplementary capital (up to a maximum of 3 years remaining time to maturity) and participatory capital with an obligation to dividend back payments subordinate capital "re-valuation reserves", i.e. disclosed non-realised reserves amounting to 45% of the following differences (re-evaluation reserves are only used in the calculation of equity):
book value and current market value of land and buildings book value and current market value of securities

liability premium (resulting from the obligation to pay supplementary contributions, in cooperatives only)

What are the consequences of equity capital legislation for banks? Costs of equity capital "Equity capital is venture capital. For this reason, shareholders expect a premium on top of the risk-free market rate. This equity capital premium shall be allocated to the transactions on the asset side which give rise to the need for equity capital." These costs of equity capital which followed from the banking legislation have already had a lasting impact on the banking world. Corporate banking, which accounts for the major part of a bank's equity capital requirement, came under considerable pressure. Retail banking and treasury business were given a strong boost. Today, there is more of a focus on new approaches to calculating the costs of equity capital which are not always geared towards the equity capital requirements of legislators. These are internal approaches that go be-yond the legal requirements.

Securitisation Relatively undifferentiated equity backing requirements under Basel I (100% of all loans, regardless of the credit rating) limited the competitiveness of banks in corporate banking with top-rated counterparties. For this reason, good credit used to be securitized to reduce the cost of equity. Under Basel II, securitization patterns have changed. Securitisation is used for lending transactions and deposit positions. It involves the selling of financial instruments which are backed by the cash flow or value of the underlying as-sets. This allows banks to remove and add funds to their balance sheets more easily
FINANCE TRAINER International Introduction to Bank Management / Page 20 of 25

Booming derivatives Using derivatives, banks can trade market risks without taking on significant credit risks. For this reason, on-balance-sheet trade was largely reduced and derivative transactions were boosted. However, the increase in derivative transactions caused a commensurate rise in market risks, which prompted legislators to adopt the Capital Adequacy Directive.

Basel II has dramatically reduced the mismatch between economic (credit) risk of a bank and regulatory capital requirements. A few weaknesses still remain, however: Insufficient differentiation of credit risk and/or the risk weightings of the individual risk categories especially under the standard approach. Diversification effects in a credit portfolio are not accounted for. Little to no differentiation of risk weightings for loans with different maturities.

Basel II The final Basel II document (International Convergence of Capital Measurement and Capital Standards A Revised Framework) was published in June 2004 and its provisions replaced the previous capital requirement regulations from the Basel Accord of 1988. These provisions were translated into a separate EU directive which was transposed into national law and will took effect at national level in the beginning of 2007.

The introduction of capital requirements for operational risk, credit risk measurement based on credit ratings and new disclosure requirements were some of the most substantial changes that were implemented under Basel II.

The Basel II provisions concerning credit risk are dealt with separately in Chapter 6.

FINANCE TRAINER International

Introduction to Bank Management / Page 21 of 25

6.2.

Legal Provisions - Liquidity Risk

In its most extreme form, liquidity risk is the danger of a bank not being able to honour its payment obligations in a timely and unrestricted manner. It can also be defined as refinancing risk, which represents the risk of follow-up financing being more expensive than originally planned because of a sudden tightness of the market or a downgrading of the bank's own credit rating. different regulations in the individual countries

The principle: A minimum level of liquid assets aims to ensure short-term solvency when a sudden loss of liabilities occurs.

6.3.

Legal Provisions - Market Risk

The market risk is defined as the risk of the bank's result deteriorating due to fluctuations in interest rates, foreign exchange or other markets (e.g. stocks).

So far, legislators have only limited the market risk via the volume of open positions which must not exceed a fixed percentage of equity capital.

This deficit was removed with the introduction of the Capital Adequacy Directive (which has been in force in Germany and Austria since 1998). Now both market exposure and credit exposure consume equity capital. For example, the assumed loss potential on the open position in foreign currency transactions is 8 %.

In respect of interest-rate and other market risks, the Capital Adequacy Directive differentiates between the trading book and the bank book. The trading book contains all transactions involving financial instruments geared towards trading profits. The Capital Adequacy Directive (which provides the legal framework) contains a detailed evaluation of risks and requires the equity backing of market risks. Banks define their trading books in an internal process the main purpose is the intention to make a profit from short-term market fluctuations. The bank book encompasses all transactions conducted by the bank other than trading. The bank book does not contain any evaluation of market risks and thus does not entail any equity backing requirements.

FINANCE TRAINER International

Introduction to Bank Management / Page 22 of 25

The reason why the distinction between bank book and trading book was introduced is that interest rate and maturity profiles in customer business were not clear enough to be used in a legislative determination of market risks across borders.

The consequences of the Capital Adequacy Directive for banks are as follows: Legislation requires risk management of all banks based on loss exposure. The required distinction between bank book and trading book leads to a precise definition of trading activities. Equity capital will only be consumed by foreign currency risks, credit exposure and the risks in the trading books. No legislation has yet been adopted for equity backing to cover the interest-rate risk in the bank book. However, a tendency towards an integrated evaluation of market risks can be identified.

The following diagram provides an overview of the system underlying the assessment of risks on the basis of banking legislation in EU/OECD member states:

Eligible equity

Volume limits

Equity capital consumption

Trading book

Bank book

FX-risk

Market risk

Credit risk

Credit risk

Interest rate risk

Share risk

Other market risk

Counterparty risk

Recovery risk

Settlement risk

Counterparty risk

Instrument risk

Table 1: Risk assessment system based on EU and OECD legislation FINANCE TRAINER International Introduction to Bank Management / Page 23 of 25

7.

Ratios in bank management

Due to economic globalisation and the growing importance of raising equity via the stock exchange the standardisation of accounting rules is becoming more and more important. Banks quoted on the stock exchange publish their annual reports in line with the IAS (International Accounting Standards). As a result of this reorganisation the balance sheets and the profit and loss accounts have been newly classified. Below you will find examples of the most important key indicators and ratios in bank management.

Balance sheet indicators The most important balance sheet indicators from the model balance sheet) are as follows: in EUR m Balance sheet total Loans and advances to customers after loan loss provisions Primary funds Shareholders' equity 147,969 72,732 83,009 4,610

Primary funds are the total of amounts owed to customers; liabilities evidenced by certificates and subordinated capital.

Profitability indicators Profitability indicators are identical with the components of the profit and loss account.

Crucial figures are: net interest income after losses on loans and advances, operating result and profit before tax.

Cost-Income Ratio (CIR) This ratio establishes costs in per cent of gross earnings.

general administrative expenditure (net interest income + net fees and commissions income + trading result)

The cost-income ratio of the model bank is 69.3 %).

FINANCE TRAINER International

Introduction to Bank Management / Page 24 of 25

ROE (Return on equity) This ratio is the return on equity before tax.

Profit before tax equity

This is the most important management ratio. The ROE of the model bank is 10.93 %.

Return on risk-adjusted capital (RORAC) Profit before tax Equity to cover risks in banking operations

As already mentioned above, RORAC is a ratio combining profit and risk. RORAC thus stands for a method of integrating risk considerations, which are not taken into account when return on shareholders' equity is calculated and assessed. Return is measured in relation to the part of equity used to cover risks in banking operations. RORAC indicates the quality of the bank's risk/return ratio.

By using the RORAC concept in bank management, low-risk strategies are no longer systematically disadvantaged against high-risk strategies. That way, a bank focusing on (savings) deposits and investing its funds, as far as possible, in government and municipal bonds at matching maturities can be compared with a bank whose mainstay is the financial earnings of its trading departments.

FINANCE TRAINER International

Introduction to Bank Management / Page 25 of 25