Chapter 1

Bank Business and Capital

Banking has a long and honourable history. Today it encompasses a wide range of activities of varying degrees of complexity. Whatever the precise business, the common denominators of all banking activities are those of risk, return and the bringing together of the providers of capital. Return on capital is the focus of all banking activity. The co-ordination of all banking activity could be said to be the focus of asset–liability management (ALM), although some practitioners will give ALM a narrower focus. Either way, we need to be familiar with the wide-ranging nature of banking business and the importance of bank capital. This then acts as a guide for what follows.

In this introductory chapter we place ALM in context by describing the financial markets and the concept of bank capital. We begin with a look at the business of banking. We then consider the different types of revenue generated by a bank, the concept of the banking book and the trading book, financial statements and the concept of provisions.

BANKING BUSINESS

Banking operations encompass a wide range of activities, all of which contribute to the asset and liability profile of a bank. Table 1.1 shows selected banking activities and the type of risk exposure they represent. The terms used in the table, such as ‘market risk’, are explained elsewhere in this book. In another chapter we discuss the elementary aspects of financial analysis – using key financial ratios – that are used to examine the profitability and asset quality of a bank. We also discuss bank regulation and the concept of bank capital.

Table 1.1 Selected banking activities and services.

Service or function	Revenue generated	Risk
Lending
– Retail	Interest income, fees	Credit, market
– Commercial	Interest income, fees	Credit, market
– Mortgage	Interest income, fees	Credit, market
– Syndicated	Trading, interest income, fees	Credit, market
Credit cards	Interest income, fees	Credit, operational
Project finance	Interest income, fees	Credit
Trade finance	Interest income, fees	Credit, operational
Cash management
– Processing	Fees	Operational
– Payments	Fees	Credit, operational
Custodian	Fees	Credit, operational
Private banking	Commission income, interest income, fees	Operational
Asset management	Fees, performance	Credit, market, operationalpayments
Capital markets
– Investment banking	Fees	Credit, market
– Corporate finance	Fees	Credit, market
– Equities	Trading income, fees	Credit, market
– Bonds	Trading income, interest income, fees	Credit, market
– Foreign exchange	Trading income, fees	Credit, market
– Derivatives	Trading income, Credit, marketinterest income, fees

Before considering the concept of ALM, all readers should be familiar with the way a bank’s earnings and performance are reported in its financial statements. A bank’s income statement will break down earnings by type, as we have defined in Table 1.1. So we need to be familiar with interest income, trading income and so on. The other side of an income statement is costs, such as operating expenses and bad loan provisions.

That the universe of banks encompasses many different varieties of beasts is evident from the way they earn their money. Traditional banking institutions, perhaps typified by a regional bank in the United States (US) or a building society in the United Kingdom (UK), will generate a much greater share of their revenues through net interest income than trading income, and vice versa for a firm with an investment bank heritage such as Morgan Stanley. Such firms will earn a greater share of their revenues through fees and trading income. The breakdown varies widely across regions and banks.

Let us now consider the different types of income streams and costs.

Interest income

Interest income, or net interest income (NII), is the main source of revenue for the majority of banks worldwide. It can form upwards of 60% of operating income, and for smaller banks and building societies it reaches 80% or more.

NII is generated from lending activity and interest-bearing assets, ‘net’ return is this interest income minus the cost of funding loans. Funding, which is a cost to the bank, is obtained from a wide variety of sources. For many banks, deposits are a key source of funding, as well as one of the cheapest. They are generally short term, though, or available on demand, so must be supplemented by longer term funding. Other sources of funds include senior debt, in the form of bonds, securitized bonds and money market paper.

NII is sensitive to both credit risk and market risk. Market risk, which we look at later, is essentially interest rate risk for loans and deposits. Interest rate risk will be driven by the maturity structure of the loan book, as well as the match (or mismatch) between the maturity of loans against the maturity of funding. This is known as the interest rate gap.

Fees and commissions

Banks generate fee income as a result of providing services to customers. Fee income is very popular with bank senior management because it is less volatile and not susceptible to market risk like trading income or even NII. There is also no credit risk because fees are often paid upfront. There are other benefits as well, such as the opportunity to build up a diversified customer base for this additional range of services, but these are of less concern to a bank’s ALM desk.

Fee income uses less capital and also carries no market risk, but does carry other risks, such as operational risk.

Trading income

Banks generate trading income through trading activity in financial products such as equities (shares), bonds and derivative instruments. This includes acting as a dealer or market-maker in these products as well as taking proprietary positions for speculative purposes. Running positions in securities (as opposed to derivatives) in some cases generates interest income; some banks strip this out of the capital gain made when the security is traded to profit, while others include it as part of overall trading income.

Trading income is the most volatile income source for a bank. It also generates relatively high market risk, as well as not inconsiderable credit risk. Many banks, although by no means all, use the Value-at-Risk (VaR) methodology to measure the risk arising from trading activity, which gives a statistical measure of expected losses to the trading portfolio under certain market scenarios.

Costs

Bank operating costs comprise staff costs and operating costs, such as provision of premises, information technology and office equipment. Other significant elements of cost are provisions for loan losses, which are charges against the loan revenues of the bank. Provision is based on subjective measurement by management of how much of the loan portfolio can be expected to be repaid by the borrower.

CAPITAL MARKETS

A ‘capital market’ is the term used to describe the market for raising and investing finance. The economies of developed countries and a large number of developing countries are based on financial systems that encompass investors and borrowers, markets and trading arrangements. A market can be one in the traditional sense such as an exchange where financial instruments are bought and sold on a trading floor, or it may refer to one where participants deal with each other over the telephone or via electronic screens. The basic principles are the same in any type of market. There are two primary users of capital markets: lenders and borrowers. The source of lenders’ funds is, to a large extent, the personal sector made up of household savings and those acting as their investment managers such as life assurance companies and pension funds. The borrowers are made up of the government, local government and companies (called corporates). There is a basic conflict between the financial objectives of borrowers and lenders, in that those who are investing funds wish to remain liquid, which means having easy access to their investments. They also wish to maximize the return on their investment. A corporate, on the other hand, will wish to generate maximum net profit on its activities, which will require continuous investment in plant, equipment, human resources and so on. Such investment will therefore need to be as long term as possible. Government borrowing as well is often related to long-term projects such as the construction of schools, hospitals and roads. So while investors wish to have ready access to their cash and invest short, borrowers desire funding to be as long term as possible. One economist referred to this conflict as the ‘constitutional weakness’ of financial markets (Hicks, 1939), especially as there is no conduit through which to reconcile the needs of lenders and borrowers. To facilitate the efficient operation of financial markets and the price mechanism, intermediaries exist to bring together the needs of lenders and borrowers. A bank is the best example of this. Banks accept deposits from investors, which makes up the liability side of their balance sheet, and lend funds to borrowers, which forms the assets on their balance sheet. If a bank builds up a sufficiently large asset and liability base, it will be able to meet the needs of both investors and borrowers, as it can maintain liquidity to meet investors requirements as well as create long-term assets to meet the needs of borrowers. A bank is exposed to two primary risks in carrying out its operations: that a large number of investors decide to withdraw their funds at the same time (a ‘run’ on the bank) or that a large number of borrowers go bankrupt and default on their loans. The bank in acting as a financial intermediary reduces the risk it is exposed to by spreading and pooling risk across a wide asset and liability base.

Corporate borrowers wishing to finance long-term investment can raise capital in various ways. The main methods are

• continued re-investment of the profits generated by a company’s current operations;
• selling shares in the company, known as equity capital, equity securities or equity, which confer on buyers a share in ownership of the company. Shareholders as owners have the right to vote at general meetings of the company, as well as the right to share in the company’s profits by receiving dividends;
• borrowing money from a bank, via a bank loan. This can be a short-term loan such as an overdraft, or a longer term loan over two, three, five years or even longer. Bank loans can be at either a fixed or, more usually, variable rate of interest;
• borrowing money by issuing debt securities, in the form of bills, commercial paper and bonds that subsequently trade in the debt capital market.

The first method may not generate sufficient funds, especially if a company is seeking to expand by growth or acquisition of other companies. In any case a proportion of annual after-tax profits will need to be paid out as dividends to shareholders. Selling further shares is not always popular amongst existing shareholders as it dilutes the extent of their ownership; moreover, there are a host of other factors to consider including whether there is any appetite in the market for that company’s shares. A bank loan is often inflexible, and the interest rate charged by the bank may be comparatively high for all but the highest quality companies. We say ‘comparatively’, because there is often a cheaper way for corporates to borrow money: by tapping the bond markets. An issue of bonds will fix the rate of interest payable by the company for a long-term period, and the chief characteristic of bonds – that they are tradeable – makes investors more willing to lend a company funds.

The bond and money markets play a vital and essential role in raising finance for both governments and corporations. In 2009 the market in dollar-denominated bonds alone was worth over $13 trillion, which gives some idea of its importance. The basic bond instrument, which is a loan of funds by the buyer to the issuer of the bond, in return for regular interest payments up to the termination date of the loan, is still the most commonly issued instrument in debt markets. Nowadays there are a large variety of bond instruments, issued by a variety of institutions. An almost exclusively corporate instrument, the international bond or Eurobond, is a large and diverse market. In 2009 the size of the Eurobond market was over $2 trillion.

In every capital market the first financing instrument ever developed was the bill and then the bond; today, in certain developing economies the government short-dated bond market is often the only liquid market in existence. Over time – as financial systems develop and corporate debt and equity markets take shape – the money and bond markets retain their importance due to their flexibility and the ease with which transactions can be undertaken. In advanced financial markets – such as those in place in developed countries today – the introduction of financial engineering techniques has greatly expanded the range of instruments that can be traded. These instruments include instruments used for hedging positions held in bonds and other cash products, as well as meeting the investment and risk management needs of a whole host of market participants. Debt capital markets have been and continue to be tremendously important to the economic development of all countries, as they represent the means of intermediation for governments and corporates to finance their activities. In fact, it is difficult to imagine long-term capital-intensive projects – such as those undertaken by, say, petroleum, construction or aerospace companies – taking place without the existence of a debt capital market to allow the raising of vital finance.

SCOPE OF BANKING ACTIVITIES

We have introduced the different aspects of banking business. For the largest banks these aspects vary widely in nature. For our purposes we may group them together as shown at Figure 1.1. Put very simply, ‘retail’ or ‘commercial’ banking covers the more traditional lending and trust activities while ‘investment’ banking covers trading activity and fee-based income such as stock exchange listing and mergers and acquisitions. The one common objective of all banking activity is return on capital. Depending on the degree of risk it represents, a particular activity will be required to achieve a specified return on the capital it uses. The issue of banking capital is vital to an appreciation of the banking business; entire new business lines (such as securitization) have been devised in response to the need to make the use of capital more efficient.

As we can see from Figure 1.1, the scope of banking business is wide. Activities range from essentially plain vanilla activity, such as corporate lending, to complex transactions such as securitization and hybrid product trading. There is a vast literature on all these activities, so we do not need to cover them here. However, it is important to have a grounding in the basic products; subsequent chapters will introduce these.

ALM is concerned with the efficient management of banking capital among other things. It therefore concerns itself with all banking operations, even if day-to-day contact between the ALM desk (or Treasury desk) and other parts of the bank is remote. The ALM desk will be responsible for the Treasury and money market activities of the entire bank. So, if we wish, we could draw a box with ALM in it around the whole of Figure 1.1. This is not to say that the ALM function does all these activities; rather, it is just to make clear that all the various activities represent assets and liabilities for the bank, and one central function is responsible for this side of these activities.

For capital management purposes a bank’s business is organized into a ‘banking book’ and a ‘trading book’. We consider them next; first though, a word on bank capital.

Capital

Bank capital is the equity of the bank. It is important as it is the cushion that absorbs any unreserved losses that the bank incurs. By acting as this cushion, it enables the bank to continue operating and thus avoid insolvency or bankruptcy during periods of market correction or economic downturn. When the bank suffers a loss or writes off a loss-making or otherwise economically untenable activity, the capital is used to absorb the loss. This can be done by eating into reserves, freezing dividend payments or (in more extreme scenarios) a writedown of equity capital. In the capital structure, the rights of capital creditors including equity holders are subordinated to senior creditors and deposit holders.

Banks occupy a vital and pivotal position in any economy, as the suppliers of credit and financial liquidity, so bank capital is important. As such, banks are heavily regulated by central monetary authorities, and their capital is subject to regulatory rules compiled by the Bank for International Settlements (BIS), based in Basel, Switzerland. For this reason its regulatory capital rules are often called the ‘Basel rules’. Under the original Basel rules (Basel I) a banking institution was required to hold a minimum capital level of 8% against the assets on its book.1 Total capital is comprised of

• equity capital;
• reserves;
• retained earnings;
• preference share issue proceeds;
• hybrid capital instruments;
• subordinated debt.

Capital is split into Tier 1 capital and Tier 2 capital. The first three items in the bullet list comprise Tier 1 capital while the remaining items are Tier 2 capital.

The quality of the capital in a bank reflects its mix of Tier 1 and Tier 2 capital. Tier 1 or ‘core capital’ is the highest quality capital, as it is not obliged to be repaid; moreover, there is no impact on the bank’s reputation if it is not repaid. Tier 2 is considered lower quality as it is not ‘loss absorbing’; it is repayable and also of shorter term than equity capital. Assessing the financial strength and quality of a particular banking institution often requires calculating key capital ratios for the bank and comparing them with market averages and other benchmarks.

Analysts use a number of ratios to assess bank capital strength. Some of the more common ones are shown in Table 1.2.

Table 1.2 Bank analysis ratios for capital strength.

Ratio	Calculation	Notes
Core capital ratio	Tier 1 capital/Risk-weighted assets	A key ratio monitored, in particular, by rating agencies as a measure of high-quality non-repayable capital, available to absorb losses incurred by the bank
Tier 1 capital ratio	Eligible Tier 1 capital/Risk-weighted assets	Another important ratio monitored by investors and rating agencies. Represents the amount of high-quality, non-repayable capital available to the bank
Total capital ratio	Total capital/Risk-weighted assets	Represents total capital available to the bank
Off-balance-sheet risk to total capital	Off-balance-sheet and continent risk/Total capital	Measure of adequacy of capital against off-balance sheet risk including derivatives exposure and committed, undrawn credit lines
Source: Higson (1995)

Banking and trading books

Banks and financial institutions make a distinction between their activities for capital management purposes, including regulatory capital. Activities are split between the ‘banking book’ and the ‘trading book’. Put simply, the banking book holds the more traditional banking activities such as commercial banking, loans and deposits. This would cover lending to individuals as well as corporates and other banks, and so will interact with investment banking business.2 The trading book records wholesale market transactions, such as market-making and proprietary trading in bonds and derivatives. Again, speaking simply, the primary difference between the two books is that the overriding principle of the banking book is one of ‘buy and hold’–-that is, a long-term acquisition. Assets may be held on the book for up to 30 years or longer. The trading book is just that, it employs a trading philosophy so that assets may be held for very short terms, less than one day in some cases. The regulatory capital and accounting treatment of each book differs. The primary difference here is that the trading book employs the ‘mark-to-market’ approach to record profit and loss (P&L), which is the daily ‘marking’ of an asset to its market value. An increase or decrease in the mark on the previous day’s mark is recorded as an unrealized profit or loss on the book: on disposal of the asset, the realized profit or loss is the change in the mark at disposal compared with its mark at purchase.

The banking book

Traditional banking activity – such as deposits and loans – is recorded in the banking book. The accounting treatment for the banking book follows the accrual concept, which accrues interest cashflows as they occur. There is no mark to market. The banking book holds assets for which both corporate and retail counterparties as well as banking counterparties are represented. So it is the type of business activity that dictates whether it is placed in the banking book, not the type of counterparty or which department of the bank is conducting it. Assets and liabilities on the banking book generate interest rate and credit risk exposure for the bank. They also create liquidity and term mismatch (‘gap’) risks. Liquidity refers to the ease with which an asset can be transformed into cash and to the ease with which funds can be raised in the market. So we see that ‘liquidity risk’ actually refers to two related but separate issues.

All these risks form part of ALM. Interest rate risk management is a critical part of Treasury policy and ALM, while credit risk policy will be set and dictated by the credit policy of the bank. Gap risk creates an excess or shortgage of cash, which must be managed. This is the cash management part of ALM. There is also a mismatch risk associated with fixed rate and floating rate interest liabilities. The central role of financial markets is to enable cash management and interest rate management to be undertaken efficiently. ALM of the banking book will centre on interest rate risk management and hedging as well as liquidity management. Note how there is no ‘market risk’ for the banking book in principle, because there is no marking to market. However, the interest rate exposure of the book creates an exposure that is subject to market movements in interest rates, so in reality the banking book is exposed to market risk.

Trading book

Wholesale market activity including market-making and proprietary trading is recorded in the trading book. Assets on the trading book can be expected to have a high turnover, although not necessarily so, and are marked to market daily. Counterparties to this trading activity can include other banks and financial institutions such as hedge funds, corporates and central banks. Trading book activity generates the same risk exposure as that on the banking book, including market risk, credit risk and liquidity risk. It also creates a need for cash management. Much trading book activity involves derivative instruments, as opposed to ‘cash’ products. Derivatives include futures, swaps and options. These can be equity, interest rate, credit, commodity, foreign exchange (FX), weather and other derivatives. Derivatives are known as ‘off-balance-sheet’ instruments because they are recorded ‘off’ the (cash) balance sheet. Their widespread use and acceptance has greatly improved the efficiency of the process behind risk exposure hedging for banks and other institutions alike.

Off-balance-sheet transactions refer to ‘contingent liabilities’, which are so called because they refer to future exposure contracted now. These are not only derivatives contracts such as interest rate swaps or writing an option, but also include guarantees such as a credit line to a third-party customer or a group subsidiary company. These represent a liability for the bank that may be required to be honoured at some future date. In most cases they do not generate cash inflow or outflow at inception – unlike a cash transaction – but represent future exposure. If a credit line is drawn on, it represents a cash outflow and that transaction is then recorded on the balance sheet.

FINANCIAL STATEMENTS AND RATIOS

A key information tool for bank analysis is the financial statement, which comprises the balance sheet and the P&L account. Assets on the balance sheet should equal the assets on a bank’s ALM report, while receipt of revenue (such as interest and fees income) and payout of costs during a specified period is recorded in the P&L report or income statement.

The balance sheet

The balance sheet is a statement of a company’s assets and liabilities as determined by accounting rules. It is a snapshot of a particular point in time, and so by the time it is produced it is already out of date. However, it is an important information statement. A number of management information ratios are used when analysing the balance sheet; they are considered in the next chapter.

In Chapter 2 we use a hypothetical example to illustrate balance sheets. For a bank, there are usually five parts to a balance sheet, split up in such a way to show separately

• lending and deposits, or traditional bank business;
• trading assets;
• Treasury and interbank assets;
• off-balance-sheet assets;
• long-term assets, including fixed assets, shares in subsidiary companies, together with equity and Tier 2 capital.

This is illustrated in Table 1.3. The actual balance sheet of a retail or commercial bank will differ significantly from that of an investment bank, due to the relative importance of their various business lines, but the basic layout will be similar.

Table 1.3 Components of a bank balance sheet.

Cash	Short-term liabilities
Loans	Deposits
Financial instruments (long)	Financial instruments (short)
Fixed assets	Long-dated debt
Off balance sheet (receivables)	Equity
	Off balance sheet (liabilities)

Profit and loss report

The income statement for a bank is the P&L report, which records all income and losses during a specified period of time. A bank income statement will show revenues that can be accounted for as net interest income, fees and commissions, and trading income. The precise mix of these sources will reflect the type of banking institution and the business lines it operates in. Revenue is offset by operating (non-interest) expenses, loan loss provisions, trading losses and tax expense.

A more ‘traditional’ commercial bank will have a much higher dependence on interest revenues than an investment bank that engages in large-scale wholesale capital market business. Investment banks have a higher share of revenue comprising trading and fee income. Table 1.4 shows the components of a UK retail bank’s income statement.

Table 1.4 Components of bank income statement, typical structure for retail bank.

The composition of earnings varies widely among different institutions. Figure 1.2 shows the breakdown for a UK building society and the UK branch of a US investment bank in 2005, as reported in their financial accounts for that year.

Net interest income

The traditional source of revenue for retail banks – net interest income (NII) – remains as such today (see Figure 1.2). NII is driven by lending, interest-earning asset volumes and the net yield available on these assets after taking into account the cost of funding. While the main focus is on the loan book, the ALM desk will also concentrate on the bank’s investment portfolio. The latter will include coupon receipts from money market and bond market assets, as well as dividends received from any equity holdings.

The cost of funding is a key variable in generating overall NII. For a retail bank the cheapest source of funds is deposits, especially non-interest-bearing deposits such as cheque accounts.3 Even in an era of high-street competition, the interest payable on short-term liabilities such as instant access deposits is far below the wholesale market interest rate. This is a funding advantage for retail banks when compared with investment banks, which generally do not have a retail deposit base. Other funding sources include capital markets (senior debt), wholesale markets (the interbank money market), securitized markets and covered bonds. The overall composition of funding significantly affects net interest margin and, if constrained, can reduce the activities of the bank.

The risk profile of asset classes that generate yields for the bank should lead to a range of net interest margins being reported across the sector, such that a bank with a strong unsecured lending franchise should seek significantly higher yields than one investing in secured mortgage loans; this reflects the different risk profiles of assets. The proportion of non-interest-bearing liabilities will also have a significant impact on the net interest margin of the institution. While a high net interest margin is desirable, it should also be adequate return for the risk incurred in holding the assets.

Bank NII is sensitive to both credit risk and market risk. Interest income is sensitive to changes in interest rates and the maturity profile of the balance sheet. Banks that have assets that mature earlier than their funding liabilities will gain from an environment of rising interest rates. The opposite applies where the asset book has a maturity profile that is longer dated than the liability book. Note that in a declining or low-interest-rate environment, banks may suffer from negative net interest income irrespective of their asset–liability maturity profile, as it becomes more and more difficult to pass on interest rate cuts to depositors.

While investment banks are less sensitive to changes in overall NII expectations due to their lower reliance on NII itself, their trading book will also be sensitive to changes in interest rates.

Fee and commission income

Fee revenue is generated from the sale and provision of financial services to customers. The level of fees and commission are communicated in advance to customers. Fee income known as non-interest income is separate from trading income and is desirable for banks because it represents a stable source of revenue that is not exposed to market risk. It is also attractive because it provides an opportunity for the bank to cross-sell new products and services to existing customers, and provision of these services does not expose the bank to additional credit or market risk. Fee income represents diversification in a bank’s revenue base.

Note, though, that although fee-based business may not expose the bank to market risk directly, it does bring with it other risks, and these can include indirect exposure to market risk.4 In addition, an ability to provide fee-based financial services may require significant investment in infrastructure and human resources.

Trading income

Trading income arises from the capital gain earned from buying and selling financial instruments. These instruments include both cash and derivative (off-balance-sheet) instruments and can arise from undertaking market-making, which in theory is undertaken to meet client demands and the proprietary business needs of the bank’s own trading book. Note that interest income earned while holding assets on the trading book should really be considered NII and not trading income, but sometimes it is not stripped out from overall trading book P&L. There is no uniformity of approach among banks in this regard.

Trading income is the most volatile form of bank revenue. Even a record of consistent profit in trading over a long period is no guarantee against future losses arising out of market corrections or simply making the wrong bet on financial markets. Trading activity was the first type of banking activity whose risk exposure was measured using the Value-at-Risk methodology, which replaced duration-based risk measures in the 1990s.

Operating expenses

Banking operating costs typically contain human resources costs (remuneration and other personnel-related expenses) together with other operating costs such as premises and infrastructure costs, depreciation charges and goodwill.5 Cost is generally measured as a proportion of revenue. A number of cost/income ratios are used by analysts, some of which are given in Table 1.5.

Table 1.5 Bank cost/income ratios.

The return on equity (ROE) measure is probably the most commonly encountered and is usually part of bank strategy, with a target ROE level stated explicitly in management objectives. Note that there is a difference between accounting ROE and market ROE; the latter is calculated as a price return, rather like a standard P&L calculation, taken as the difference between market prices between two dates. During the 1990s, and certainly into 2005, average required ROE was in the order of 15% or higher – with investment banks usually set a higher target of 20%, 22% or even higher for certain higher risk business. The ROE target needs to reflect the relative risks of different business activities.

Return on assets (ROA) is another common measure of performance. It is calculated as follows:

Current income (Interest income + Fees) × Asset value

Both financial statement P&L reports and measures such as ROE and ROA are bland calculations of absolute values; that is, they do not make any adjustment for relative risk exposure so cannot stand too much comparison with equivalent figures from another institution. This is because risk exposure – not to mention the specific type of business activity – will differ from one bank to another. However, there are general approximate values that serve as benchmarks for certain sectors, such as the 15% ROE level we state above. Banks also calculate risk-adjusted ratios.

Provisions

Banks expect a percentage of loan assets, and other assets, to suffer loss or become unrecoverable completely. Provisions are set aside out of reserves to cover for these losses each year; they are a charge against the loan revenues of the bank. The size of the provision taken is a function of what writeoffs may be required against the loan portfolio in the current period and in the future, and the size and adequacy of loan loss reserves currently available. In some jurisdictions there are regulatory requirements that dictate the minimum size of loss provision.

Provisions fund the bank’s loan loss reserve, and the reserve will grow in size when the bank provides more for expected credit losses than the actual amount that is written off. If the bank believes subsequently that the size of the reserve built up is in excess of what is currently required, it may write back a percentage of it.

The amount of provisioning will vary with the business cycle. During a boom period in the cycle, corporate and retail default rates are at historically lower levels, and so a bank can afford to lower the level of its provisioning. However, prudent management dictates that senior managers are familiar with their markets and are able to judge when provision levels should increase. In other words, banks should ‘know their market’.

REFERENCES

Hicks, J.R. (1939) Value and Capital, Oxford: Clarendon Press.

Higson, C. (1995) Business Finance, Oxford: Blackwell.

1 There is more to this than just this simple statement, and we consider this in Chapter 10.

2 For a start, there will be a commonality of clients. A corporate client will borrow from a bank and may also retain the bank’s underwriting or structured finance departments to arrange a share issue or securitization on its behalf.

3 These are referred to as NIBLs (non-interest-bearing liabilities).

4 For example, a strategy pursued by banks in the 1990s was to merge with or acquire insurance companies, creating so-called bancassurance groups. Although much insurance business is fee-based, the acquisition of insurance portfolios brought with it added market risk for banks.

5 These are accounting terms common to all corporate entities and are not used just to describe bank operating costs.