Economics of

Banking /
Commercial
Banking
Week 10

Commercial Banking
Basics.
SMEs are the lifeblood of economies.

The life blood of SMEs is easy access to credit.

The most easiest way to get credit is through Banks.
Balance Sheet of Banks analysis indicates:

Liabilities: Deposits + Borrowings + Other liabilities.

Equity: Bank Capital or Banks NW.
Assets: Reserves + Cash Assets + Securities + Loans + Other
Assets.

Source of Funds = primarily deposits.

Use of Funds = primarily lending / loans.

Bank Liabilities.

Advantages of deposits: safety against theft; are liquid;

convenient way to make payments.
Types of deposits:

Checkable Deposits. Clients can write checks against available

balances. Also known as transaction deposits.
Depends can give returns / markup/ interest NOW (negotiable
order of withdrawal) deposits. In our terminology P&L deposits.
No returns Demand deposits. Usually held by businesses.
Important that all demand deposits are repayable on demand.
Non-Transaction Deposits. Term deposits.
Savings deposits notice for withdrawal usually 30 days. Also
used to be known as pass book accounts.
Money Market Deposit Accounts hybrid. Allow returns but
clients are allowed to write checks usually 2 or 3 in say a month.
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Bank Liabilities Contd

Certificate of Deposits specific maturities. Money back on the

term completion. Can be few months or several years.
Usually depositors are penalized if they break or encash the CoD.
Small denomination CoDs not tradeable; smaller amounts.
Large denomination CoDs tradeable / negotiable; larger
amounts.
Small deposits and checking accounts are covered against deposit
insurance schemes in some mature and deep markets. In
Pakistan, this is a rising trend.

Borrowings another source. Includes:

Loans from the funds or interbank market.

Loans from subsidiaries or foreign branches or affiliates.
Repos. Low risk due to counter parties being banks / large corp.
Discount loans from the Central Bank.
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Popularity of Checking
Were very popular.
Accounts.

Yet with time, the %age of these accounts have reduced.

Reason being that despite increase in convenience and
services, the returns are still low.
Other alternatives like time deposits, CoDs, etc. have
higher returns with slight difference in convenience.
Also generally as wealth in most developed countries
have increased, households can manage to hold other
alternatives.
However in bad times or signs of recessions, they are
considered to be relatively safe; especially if the deposits
have been insured.
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Bank Assets.

Assets are the uses of funds.

Assets are made through portfolios with the following key
aspects in mind:

Have to be matched with the deposits mix / demand for funds.

Have to be managed from risk perspective.
Have to be liquid enough to avoid any contingencies.

Types of Assets:

Reserves and other Cash Assets: includes vault cash, in ATMs, bank
deposits with the CB, deposits with other banks. Can be held as part of
requirements (SLR and CRR) and excess reserves.
Is a source of liquidity as discussed.
Another asset is the float money i.e. funds in process of being
collected.
Use of correspondent banking reduced this need, however this is still
prevalent in other forms.
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Securities. (Bank Assets

Marketable securities used for trading in financial
Contd)
markets. Sometimes called secondary reserves as they are

cash convertibles. Banks in the US were allowed to invest

in hybrid securities like MBS, however as a move towards
caution, banks are not preferring this nowadays.
Loans largest category. Also known as risk assets.
Subject to information costs and relative high default risks.
Common Types of Loans:

Working Capital.
Commodity or Seasonal loans.
Consumer Loans.
Agricultural Loans.
Real Estate Loans. Against residential are residential mortgages;
against commercial are commercial mortgages.
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Bank Capital.

Money provided by shareholders of the bank. Sometimes

invested by the management as well as previous earnings.
In Pakistan, there is a minimum requirement of Equity or
Bank Capital that an entity should have.
Also, from a portfolio perspective banks are also interested
in calculating the Minimum Capital Required or MCR
which is done through the Capital Adequacy Ratio (CAR).
The CAR is a ratio of a banks capital to its weighted
average risk assets. Through this the basic purpose of the
regulators is to check whether the bank can sustain losses
as well as honor withdrawals.
Internationally the acceptable ratio is in the range of 10%
to 12%.
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Basic Operations of a
Bank will take the deposits of a depositor and
Comm.
Bank
liabilities.

record their

They will then keep some portion of it as reserve requirements

with the CB.
The balance amount will be invested in assets. In order to earn
better on their assets, they will invest in risk assets or lending
products.
The income is earned from the assets invested in. This is ideally
over and above the costs incurred including the interest paid on
deposits.
The difference or spread is the banks income.
They will then take out their admin. Expenses and record their net
income.
Of course prudent lending and investments is to be done to earn
positive spreads.

Bank profits and Loan

Bank will write off loans in case they are likely to default.
Losses.

As discussed the bank maintains part of their capital as a

loan loss reserve. This is anticipation of future losses if
any. The bank calculates CAR as part of this procedure.
The bank creates the reserves also so that their capital
is not reduced. The loss reserve is created from current
profits. A reversal of the loan reserve or provisions would
increase the profits of that year.
An over-reporting of the reserves would be considered
as an incorrect procedure because at times when these
are needed the banks might even the reported profits
thereby doing something known as earnings
management.
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Bank Capital and Bank

Two important measures as far as profitability is concerned.
Profits.
NRFF. Net Revenues from Funds and; NIF. Net Interest Margin.

Net Interest Margin is interest recvd from assets less paid to

depositors.
NRFF is the total income including commissions, fees and
other related income.
Return on Assets is also important to assess what the bank is
earning on its assets employed.
ROE is more of a measure of banks management performance
as they are responsible to the shareholders for the profitability
and earnings.
Because ROE = ROA * Assets/Equity. Most managers have an
incentive to maintain high assets to equity ratio.

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Bank Capital and Profits

The Assets to Capital ratio or the Equity Multiplier as the Dupont
Contd
Analysis puts it is known as the Banks leverage. Is the inverse of the

leverage ratio (Capital / Assets).

This is an indirect way to assess how exposed the bank is. Because
there are large multiples involved, the leverage is a good measure to
see how even a small %age of profit or loss can bring changes in the
banks capital.
Moral Hazard can contribute to high bank leverage. How?

Bank managers are compensated partly on basis of their ability to get a high ROE
for their shareholders.
If part of the deposits are insured then there is less vigilance on part of the
depositors.
Thirdly in todays environments, banking companies are conglomerates. They
have investment banking and other divisions where the regulations are not as
stringent as for commercial banks.
The ultimate result is that bank managers might take on more risk then the
shareholders would prefer.
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Managing Bank Risks.

In addition to bank facing inadequate capital relative to their

assets. Other types of risks and their management include:
Liquidity Risks: comes from matching deposits with assets.
Any mismatch exposes bank to liquidity risks or the risk that
bank might not be able to raise funds by selling assets or
through loans or other sources.
Two techniques to manage liquidity risks are:

Asset Management utilizing the funds market / inter bank market or

conducting reverse repo transactions.
Liability Management determining the funds needed by borrowings to
meet the requirements. Borrow from other banks, CB or use repos.

Credit Risks: default of loans by clients. Either because of

adverse selection or moral hazard.

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Managing Bank Risks

Techniques for managing Credit Risks:
Contd

Diversification.
Credit Risk Analysis. Before and ideally during the life of the loan. Usually
banks have an obligor risk rating methodology or credit scoring techniques.
Also, prime rates were used (or rates allowed to high quality borrowers); rates
to high risks were premiums over the prime rate. Nowadays it is more of a
mark to market rate.
Collateral. Can be in the form of margins or compensating balances. Or can
be other form of collateral to meet the requirements so that the bank can have
the comfort in case of default. This is to gauge a measure of both the owners
stake in the transaction as well as to have a comfort in case of contingencies.
Credit Rationing. In the way to allow loans less than their demand. This can
happen before the credit is granted and in some cases after or during the
course of the relationship. A second type not commonly used is to charge high
rates altogether. This is risky but in some cases covers the higher risk of
defaults. In some cases, rationing is used oppositely that is to keep the rates
low and maintaining stringent conditions so that not all can get the access to
loans.

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Managing Bank Risks

Contd

Monitoring and Restrictive Covenants. To minimize risks that borrowers can do

moral hazards. Either business activities are restricted or additional
borrowings are so that the banks already allowing loans have some
safeguards as to return of their money.
LT business relationships. Assessing risks on the basis of private info on
borrowers. So banks intend to have long term relationships so that they can
monitor client activities over a period of time. This if used correctly is beneficial
to both.

Managing Interest Rate Risks. Depends on whether the banks

assets and liabilities are variable rates or fixed rates.
Measuring of interest rate risks are done as follows:

Gap Analysis. How much of assets and liabilities are on variable rates. If
assets are lower as in most cases, then gap would be negative.
Duration Analysis. Duration means that how early will the asset in number of
years be equal to the present value. If interest rate increases then duration of
assets reduces however the gap is still larger because most liabilities are on
demand. This will tend to reduce the banks capital, because the difference will
then have to be borne by the bank.
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Managing Bank Risks

Managing interest rate risks are done as follows:
Contd
Provide more adjustable or floating rate loans.

Also have market disruption clauses nowadays.

Utilize Interest Rate Swaps. Swap the interests on notional amounts so
that in case a bank has more variable rate liabilities (and fixed rate
assets) they can swap their liabilities to fixed rates or their assets to
variable rates. Both are just as good and work in the market usually.
Use interest rate hedges. Future and options derivatives. This is a
complete discussion for later.

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Transition of Banking.

Started with small banks.

The run on the banks and bank panics created the need for a CB which was
strong and independent.
Deposit insurances led to lesser of runs but increased the risk that banks
take on their balance sheets.
Then came the era of nation wide banking to reduce costs through
economies of scale. However, led to the argument that banks were
becoming too big to fail.
Simultaneously, banks expanded their boundaries by entering into fields
which made the lines hazy between banking companies of different natures.
Nowadays focus is on fee income from off balance sheet items. These
include items like focusing on FX transactions, issuing Stand by LCs, Loan
commitments, Loan Sales or securitization, trading in swaps, options and
derivatives, etc.+
Banks now needed to be regulated on these off balance sheet activities as
well.

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Transition of Banking
Then came the era of Electronic Banking. The advent and high
Contd
usage of ATMs and debit cards. Increased presence for banks, while

convenience for users. Are also considered low costs from an admin
point of view.
Then came virtual branches. All online methodology with physical
drops at places of convenience.
The crisis of 2007-2008 led to a lot of things. Banks and investors
realized that investments can lead to higher risks in assets and can
lead to collapses on a wider scale. Also markets for such assets like
the MBS stopped which made it difficult to value, hence the
terminology of toxic assets were used. With this came the problem
to assess how much of it will affect the banks capital. On the assets
side, this led to a credit crunch whereby bank refused to loan money
and tightened their criteria. This especially hits the SMEs which are
low on access to capital and generally more susceptible to losses as
they rely more on borrowed capital to operate their businesses.
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