Preface

Banking is a long-established and honourable profession. The provision of efficient loan and deposit facilities is an essential ingredient in human development and prosperity. For this reason, it is important that all banks are managed prudently. The art of banking remains unchanged from when banks were first established. At its core are the two principles of asset–liability mismatch and liquidity risk management. The act of undertaking loans and deposits creates the mismatch, because while investors like to lend for as short a term as possible, borrowers prefer to borrow for as long a term as possible. In other words, the act of banking is the process of maturity transformation, whereby banks ‘lend long’ and ‘fund short’. Banks do not ‘match-fund’, because there would never be enough funds available to match a 25-year maturity mortgage with a 25-year fixed deposit. Thus, banking gives rise to liquidity risk, and bankers are therefore required to take steps to ensure that liquidity, the ability to roll over funding of long-dated loans, is continuously available.

We define banking as the provision of loans and deposits; the former produce interest income for the bank, while the latter create interest expense for the bank. On the bank’s balance sheet the loan is the asset and the deposit is the liability, and the bank acts as the intermediary between borrowers and lenders. The fact that all banks irrespective of their size, approach or strategy must manage the two basic principles of asset–liability management (ALM) and liquidity management means that they are ultimately identical institutions. They deal within the same markets and with each other. That means that the bankruptcy of any one bank, while serious for its customers and creditors, can have a bigger impact still on the wider economy because of the risk this poses to other banks. It is this systemic risk which posed the danger for the world’s economies in 2008, after Lehman Brothers collapsed, and which remains a challenge for financial regulators.

This book introduces the fundamental art of banking, which is ALM and liquidity risk management. It does not describe the different types of banks and their organizational structures that exist around the world. Neither does it describe the wide range of bank products that are available or the great variation in financial markets and instruments that can be observed. These topics are covered abundantly in existing textbooks. The object of this book is to present bank ALM and liquidity management at an introductory level, something that is not so common in textbooks on finance. These topics deserve to be understood and appreciated by everyone involved in banking, because it was unsound practices in these fields that helped to create the banking crisis in 2008, and made its impact so much worse than it need have been. A proper respect for the art of ALM will mitigate the impact on banks of the next financial crash.

Layout of the book

This book comprises 10 chapters. The first four provide a necessary background on bank capital, the money markets, the yield curve and market risk hedging. This is essential reading for all newcomers to the financial markets. Chapters 5–7 discuss the asset–liability management (ALM) process for a bank – the essential art of banking – and the role of the ALM committee or ALCO, which is the most important executive management committee in a bank.

Chapter 8 takes a detailed look at liquidity risk management, while Chapter 9 focuses on bank strategy and return. The final chapter looks at regulatory capital, the availability and treatment of which drives bank strategy.

For newcomers to the market there is a primer on financial market arithmetic in Appendix B (p. 317).

Highlights of the book include

• an accessible look at the ALM function undertaken at banks and securities houses, including risk management and management reporting;
• the role of the bank ALM committee (ALCO);
• a review of liquidity risk management and the main liquidity metrics used in banks;
• a discussion of bank strategy and why this should focus on sustainable returns over the business cycle;
• an introduction to the Basel II and Basel III regulatory capital rules and their implications.

As always, the intention is to remain accessible and practical throughout, and we hope this aim has been achieved. Comments on the text are most welcome and should be sent to the author, care of John Wiley & Sons (UK) Ltd.

Acknowledgements

Thanks to Adrian Buckley, Khurram Butt, George Evans, Sean Jayasekara, Grant Jenkinson, Gino Landuyt, Sharon Mandeville, Neil McDougall, Ekaterina Mihova, Lamiaa Mohammed, Frank Stoltz, Stuart Turner, Dianne Weston, the chaps in the Post Room, and Graeme Wolvaardt for their help during the time I was at Europe Arab Bank; and to Roger Drayton, Tope Fasua, Martyn Hoccom, Adam Lawson, Stuart Medlen, Abhijit Patharkar, Bill Rickard and Frank Spiteri for their help after I left there.

Thanks to The Raynes Park Footy Boys. A Solid Bond in Your Heart.

Moorad Choudhry
Surrey, England
2 October 2010