1 Banks operations. Bank business models. Current Trends in Banking Oleg Deev 2 Contents 1. Functions of banks. 2. Why banks exist? 3. Types of bank operations. 4. Bank business models. 5. Current trends in banking. 3 What is a Bank? ̶ Banking operations may be varied and complex, but a simple operational definition of a bank is available (usually used by regulators): A bank is an institution whose current operations consist in granting loans and receiving deposits from the public. ̶ combination of lending and borrowing, ̶ a public good? Main functions of banks: ̶ Offering liquidity and payment services ̶ Transforming assets ̶ Managing risks ̶ Processing information and monitoring borrowers 4 Liquidity and Payment Services ̶ Management of fiat money: ̶ money change (exchange between different currencies issued by distinct institutions) ̶ provision of payment services – management of clients’ accounts – the finality of payments - the guarantee by the bank that the debt of the payer (who has received the goods or services involved in the transaction) has been settled to the payee through a transfer of money Checking accounts, credit cards, electronic banking or wire transfers (CHIPS or Clearing House Interbank Payments System, TARGET or Trans-European Automated Real-Time Gross Settlement Express Transfer), international payments (SWIFT or Society for Worldwide Interbank Financial Tele-communication), etc. Basic Operations of a Bank T-account is an accounting tool used to show changes in balance sheet items. Example: You open a bank account with 100 at XYZ Bank. Assets Blank Liabilities Blank Vault cash +100 Demand deposits +100 Blank Blank Blank Blank Assets Blank Liabilities Blank Required reserves +10 Demand deposits +100 Excess reserves +90 Blank Blank Blank Blank Blank Assets Blank Liabilities Blank Reserves +10 Demand deposits +100 Securities +30 Blank Blank Loans +60 Blank Blank ABC Bank uses its excess reserves to buy bonds worth 30 and make a loan worth 60. 6 What is a Bank? Illiquid Loans Liquid deposits Liquid assets Capital Assets Liabilities Bank Illiquid Machines, Products, Real estate Debt (mainly from banks) Liquid assets Capital Assets Liabilities Corporate Assets Liabilities Typical bank balance sheet Cash + Reserves at CB Equity Loans Deposits Financial instruments (long) Short-term liabilities Fixed assets Long-term debt Off-balance sheet (receivables) Off-balance sheet (liabilities) 7 What is a Bank? Capital (to absorb losses from IR-, FX-, credit mismatches) Assets Liabilities 3M EUR term deposit, 0.01 mln 1) Interest rate maturity mismatch 3 months10 years 2) Liquidity maturity mismatch 3 months10 years 3) FX mismatchEURCZK 4) Credit mismatch1 € paid in => 1 € paid backDefaultable (PD=1%, LGD=50%) Amount mismatch0.01 mln1 mln 10Y CZK term loan, 1 mln Mismatches Bank1 manages mismatch risks 1-4 Liquidity reserve (to cover unexpected outflows from sudden deposit withdrawals) 1) More precisely, the Treasury unit within the bank manages these asset-liability mismatches (= ALM risks) 8 Asset Transformation 1. Convenience of denomination - bank chooses the unit size (denomination) of its products (deposits and loans) in a way that is convenient for its clients. 2. Quality transformation - occurs when bank deposits offer better risk-return characteristics than direct investments (due to impossibility of diversification or asymmetric information situation). 3. Maturity transformation - banks transforms securities with short maturities, offered to depositors, into securities with long maturities, desired by borrowers. → liquidity risk 9 Asset Transformation 10 Risk Management ̶ Credit risk ̶ Default risk (borrower defaults) and migration risk (borrower’s credit worthiness deteriorates, but borrower still does not default) EL (expected loss) = PD (probability of default) × × LGD (loss given default) × EaD (exposure at default) ̶ Credit portfolio models: describe portfolio loss distribution, while taking into account diversification ̶ Liquidity risks ̶ Funding/ Roll-over risk: risk of not being able to roll-over funding ̶ Market liquidity risk: unable to quickly sell an instrument without large discount 11 Risk Management ̶ Market risk ̶ Potential losses resulting from movements of market prices like interest rates, credit spreads, FX-rates, stock prices, and commodity prices. ̶ Reinvestment risk: payments before investor’s horizon such that proceeds need to be (re-)invested => rate unknown => risk ̶ Pre-payment risk: unexpected early (partial or full) repayments of mortgages ̶ Model risk: arises if (i) instruments are priced with a model (if nonobservable market prices) or (ii) risk is measured. Model risk increases with complexity, number of assumptions, shortage of data ̶ Off-Balance-Sheet Operations ̶ loan commitments, credit lines and guarantees ̶ swaps, hedging contracts, and securities underwriting ̶ Operational risk ̶ Potential losses arising from ‘running the bank’: from internal or external fraud, system failure, breaking law, selling wrong product to customers, accidents, ethics, discrimination. 12 Monitoring and Information Processing ̶ Imperfect information on borrowers ̶ Banks invest in the technologies that allow them to screen loan applicants and to monitor their projects. → Firms and financial intermediaries develop long-term relationships, thus mitigating the effects of moral hazard. ̶ Compared to security investments, the value of a bank loan results from this long-term relationship and is a priori unknown, both to the market and to the regulator. ̶ This enhances economic efficiency and welfare ... but at the cost of inherently unstable banks (bank run). 13 Where do banks sit in the macro economy? 14 Bank business Banking book Banking book Liquid assets Capital Assets Liabilities Bank Trading book Trading book • Comercial banking products (loans, deposits, bonds that are held to maturity (hedges/ strategic investm.) • Valued at (initial cost) plus accrued interest (not valued at market prices, even if instrument had market prices) • IFRS: „Held to maturity“ • Main source of the asset-liability mismatch risks • Items that banks want (have) to trade (buy and sell) => often „churn“ rule: to be sold ≤ 180 days) • Result from market making, proprietary trading, flow trading (for customers) • Daily valued at market-(mark-to-market) (or model prices (markto-model) if market prices are unavailable or not credible because very illiquid instrument) • Often derivative instruments • Note: banking- and trading book exist on both balance sheet sides! 15 Banking Book vs. Trading Book 16 Service or function Balance sheet Revenue generated Risk Lending Retail, commercial, mortgage, project finance Assets Interest income, fees Credit, Market Trade finance, credit cards Assets Interest income, fees Credit, Market, Operat. Lending, Syndicated Assets Trading, interest incoem, fees Credit, Market Cash Management Processing Asset [balance <0], Liabilities [balance >0] Fees Operational Payments Fees Credit, Operational Custodians --------- Fees Credit, Operational Private banking --------- Commission income, interest income, fees Operational Asset management ---------- Fees, Performance payments Credit, Market, Operational Capital markets M&A ---------- Fees Corporate finance Aseets (if banks lends), Fees, Interest income (if bank lends) Trading (Equities, Foreign exchange, Derivatives) Assets (long, MV > 0) Liabilities (short, MV<0) Trading income, fees Credit, Market, Operational Trading (Bonds) Assets (long), Liabilities (short) Trading income, interest income, fees Depositing (Retail, Corporate, Public sector, Interbank) Liabilities Interest income Liquidity risk 17 From products to balance sheet 1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions Borrowing (client’s view) Payment Investment (client’s view) Services & Extras Government SecuritiesSaving DepositsCurrent account (-)Loans\Overdraft Facility Certificates of deposits (CDs) Investment funds Saving PlanLoans\Car Wealth ManagementLoans\CreditCard CustodyMortgages\Fixed-rate Mortgages\Variable-rate Mortgages\Rate Locker Mortgages\Securitisation Blocker Mortgages\Pre-payment Option Unsecured Deposits from customers Securitised Liabilities Mortgages (property- secured loans) Other Claims Investment fundsTerm DepositsLoans\Consumption Current account (+) Assets Liabilities 18 From products to balance sheet 1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions Payment Services & Extras Capital market financingMoney market depositsCorporate account (-)Bank financing (loans, leases) Certificates Payment servicesExport and trade finance Cash pooling Treasury management Advisory servicesTerm depositsPromissory note bonds Corporate account (+) Financing Cash Management Asset Management Risk ManagementInternational Business Information management Assets Liabilities Money market funds Third party securities Custody Company Pension Scheme Bank’s own debt issuances Equity Payment services Currencies Promissory note loans Trading assets Trading liabilities Derivatives Bank’s own equity issuances Unsecured Deposits from customers Securitised Liabilities Mortgages (property- secured loans) Other Claims Borrowing (client’s view) Investment (client’s view) 19 From products to balance sheet Repo (spot purchase) 1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions Payment Services & Extras Investment fundsPfandbriefFinance leases (real estate) Public sector PfandbriefReal estate loans Ship PfandbriefOperating leases Asset Mgt & Leasing Real Estate Finance Ship Finance Public Finance Assets Liabilities Other assets Ship loans Unsecured loans RE/ infrastructure loans Repo (spot sale) Secured deposits from customers Equity Promissory note loans Unsecured Deposits from customers Securitised Liabilities Mortgages (property- secured loans) Other Claims Trading assets Trading liabilities Borrowing (client’s view) Investment (client’s view) 20 From products to balance sheet 1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions Payment Services & Extras Advisory servicesRepo (spot sale)Correspondent banks (-)Trade loans Cash pooling Payment servicesCorrespondent banks (+) Currencies Repo (spot purchase) Assets Liabilities Other assets Secured deposits from customers Equity Promissory note loans Trading assets Trading liabilities Unsecured Deposits from customers Securitised Liabilities Mortgages (property- secured loans) Other Claims UD from banks SD from banks Claims on banks Money market trading UD from other banks Deposits to other banks Liquidity management Cash reserve Liquidity reserve Funding liquidity reserve Borrowing (client’s view) Investment (client’s view) 21 22 Wholesale banking ̶ Large value, low volume part of banking business ̶ Mix of domestic and foreign currency business ̶ Large size of deposits and loans ̶ Tailor made loans ̶ Dependence on inter-bank market ̶ Greater importance of off-balance-sheet facilities ̶ Small proportion of demand deposits 23 Universal banking ̶ Keeps customers in one stop shop ̶ Economies of scale exhausted quickly and constant returns to scale ̶ Economies of scope ̶ Size allows for risks to be spread and internally diversified ̶ Size also creates danger of Too Big to Fail 24 Islamic banking ̶ Risk sharing – each participant must share in the same risk-return distribution (removes asymmetric information problem) ̶ Materiality – all financial transactions must be backed by a tangible asset (no options). ̶ Non-exploitation – neither party can be exploited ̶ No sinful activity – alcohol, gambling, etc ̶ Widely practiced model is 2-tier Mudaraba ̶ Depositors enter into a contract with the bank to share profit ̶ Bank enters into a contract with the borrower to split the profit ̶ Fast rate of growth ̶ Islamic banking assets only constitute up to 2% of global banking assets 25 Shadow banking ̶ Financial Stability Board definition – ‘credit intermediation involving entities and activities outside the regular banking system’ ̶ Hedge Funds – more aggressive investment strategies than life assurance & pension funds. ̶ Special Purpose Vehicles – vehicle for securitisation ̶ Money Market Funds – short term high quality securities ̶ Private Equity – investment in private companies Process takes between 3 and 7 steps: 1. Loan originated by Bank or other FI 2. Loan warehousing financed by ABCP 3. Pooling & structuring loans by broker/dealers 4. ABS warehousing via trading book financed by REPOs 5. Pooling & structuring of ABS into CDOs done by broker dealers. 6. ABS intermediation is carried out by SIVs & hedge funds 7. All steps funded in the wholesale market 26 International banking ̶ Decision to locate depends on a number of factors ̶ Home Country Characteristics ̶ Home country regulations ̶ Resource costs ̶ Host Country Characteristics ̶ Absence or lack of regulation ̶ Monopolistic characteristics ̶ Information exploitation ̶ Phase 1 – home production, export bank services abroad ACF>ARF>ACD ̶ Phase 2 – bank in home country establishes foreign facilities ARF> ACF>ACD ̶ Phase 3 – foreign production is cheaper than at home (greater foreign share of business) ARF>ACD> ACF ̶ Phase 4 – home country bank produces banks services abroad and import to domestic country ACD>ARF>ACF 27 Bank Business Models 28 Bank Business Models 29 Bank Business Models Cluster analysis for European banks Ayadi and de Groen (2016) define BBMs distinguishes primarily between the key banking activities and the funding strategy, which broadly builds on asset-liability approach. Analysis covers 147 banking groups in Europe (80% of EU bank assets) in years 2006-2013. Financial crisis affected BBMs – banks received state aid have reoriented towards focused retail. 30 Bank Business Models Model transition matrix 31 EU bank’ adjustment to new business models 32 Competition Financial services D S P1 S1 P2 Price of financial services D1 S Pb1 Pb2 D2 Competition from NBFIs increases supply of financial services Increased substitution leads to fall in demand for bank services 33 34 35 Bank branches per million inhabitants (EU15) Bank employees per million inhabitants (EU15) Source: ECB Statistical Data Warehouse 36 Core business area IT systems used Lending IS from external vendors (i.e., SAP ‘‘Commercial Banking Operations’’ Module) Taking/managing deposits Branch and ATM network In-house-developed IS (online and mobile banking) SAP software modules Payments processing and infrastructure ATM networks In-house-developed IS (online and mobile banking) Card and digital payment networks SEPA Compliance with regulations Manual labour RegTech systems Marketing and sales CRM technology Salesforce automation technology 37 AI in Banking ̶ More accurate default predictions can be made with previously unused data types ̶ A greater variety of algorithms in credit risk estimation ̶ Safer payment networks (detection of fraud and money laundering) ̶ Managing the scale of the business infrastructure (predicting the amount of cash withdrawals, payments, etc.) ̶ Detection of non-compliance with regulations (analysis of phone conversations between employees and clients and between employees in real-time, natural language processing to read and interpret regulatory documents) ̶ Prediction of financial product purchases ̶ Churn prediction 45 Bank Runs and Crises: 1800-2023 Source: Jamilov et al. (2024). Note: The figures plot the frequencies of bank runs. The annual frequency of runs and crises is visualized as a moving average, using a tenyear time window. The frequency in each individual year is calculated as the total number of runs/crises divided by the number of countries for which the authors have data coverage in that specific year. 46 Literature ̶ Choudhry M. (2022). The Principles of Banking, 2nd ed. – Chapter 1 ̶ Matthews and Thompson (2015). The Economics of Banking. – Chapters 1, 3-5. ̶ Ayadi, R. (2019). Bank business models. – Chapters 3-4, 7. 47 Policy Consultancy Case You work as a policy consultant for Bank Consultancy Services (BCS), a firm that specializes in lobbying European and national parliaments for banks and financial institutions that want to protect their economic interests. President and C.E.O. of BCS asked you to prepare a brief for one of their major clients, an international bank headquartered in Germany, on the major issues that central banks and parliaments will address this following year. For the first part of your brief, review the following sources of information concerning banking issues that are available on the internet, mainly ̶ Bundesbank ̶ European Central Bank ̶ Bank for International Settlements 48 Policy Consultancy Case Based on these and other sources, determine the following: 1. What are the current major issues facing domestic banks and their regulators? 2. Because the client is an international bank, what are the current major issues facing international banks and their regulators? 3. How might these issues affect the client? 4. If new regulation is passed, what impact will it have on international bank customer? Choose one major issue and present its pros and cons for the client.