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Overview
Overview
Multiplier effect
Money transmission
Lend 100
Spend 100
Deposit 100
Lend 90
Investment capital
Maturity transformation
Cashflow management
Zooming in:
Maturity transformation
Each of our current accounts cant do much on their own
Balance is very volatile can change daily
Zooming in:
Multiplier effect
100
Deposit
90
90
Loan
Purchase
90
81
Deposit
Loan
They borrow less (so money supply falls, money is just an IOU)
They spend less (so less is produced and employment falls)
This means that the multiplier effect we saw above can actually start to go into reverse
Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession / depression. (Bank money is IOUs, so as IOUs falls so does money).
Overview
Asset
(deposits)
(loans)
Lots of Short
term deposits
margin
Long term
mortgages
Short term cards
Liability
Asset
12
10
(deposits)
(loans)
8
6
2%
5%
Margin 3%
2
0
1
25
49
73
97
121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
margin
3%
Savings Rate
Loan Rate
[todays focus]
Credit risk:
Expected and unexpected losses
We allow for expected losses when setting lending rates and fees but losses will
vary over time
Peak losses dont occur every year, but when they do, they can be large
Like insurance companies probability of ruin
Figure 1
Loss rate
Unexpected
loss (UL)
Expected
loss (EL)
Tim e
Probability of default
Risk score
Banks make money by taking risk and lending
The more accurately risk and expected loss can be predicted the easier it is to manage
Normally bad debts dont arise until a few years after a loan is written (seasoning)
We may not know we have mispriced risks until later
PD
value
15% Break even score
15% rate
5% rate
PD
Borrowers:
Savers
Loans
Bank:
~ 90%
Mortgages
Cards
Corporate
Overdrafts
Bank capital
~ 10%
Bank lends funds borrowed from savers and wholesale & its own capital
Banks hold capital to protect savers from unexpected losses
Bank A
Bank B
Cash
10%
10%
Mortgages
0%
90%
Loans
90%
0%
PD (Probability
of Default)
EAD (Exposure
at Default)
LGD (Loss
Given Default)
How much of the loan you owe that you cant pay back.
If you owe 1,000 and pay back 300 the LGD is 70%
Credit Loss
Normal
Downturn
PD (lifetime)
4%
12%
EAD
1,000
1,000
LGD
70%
80%
Loss
28
96
68
30%
25%
20%
15%
10%
5%
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
48%
52%
56%
60%
64%
68%
72%
76%
80%
84%
88%
92%
96%
100%
0%
Loan to Value
25%
20%
15%
10%
5%
0%
1
5
9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
101
30%
Loan to value
Normal
Downturn
PD (lifetime)
4%
12%
EAD
1,000
1,000
LGD
0.82%
13.2%
Loss
0.33
13.2
15.8
68
Mortgages
15
Bank A
Bank B
Cash
10%
10%
Mortgages
0%
90%
Loans
90%
0%
In the 1970s bank risks soared after a benign post war period:
Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
Japan banks were on a capital light fuelled take over of the financial
arena.
RWA
Cash
0%
Mortgage
50%
Corporate loan
100%
Personal loan
100%
Tier 1 capital.
The banks own money.
Initial share issues
Rights issues (additional shares issued)
Retained profits
Very loss absorbing
Tier 2 capital.
Like subordinated debt
Not be repaid until depositors get their money back.
Only used if a bank fails. This became a problem with too big to fail
Flash bank
Capital
1bn
Capital ratio 8.0%
Steady bank
Capital
1bn
Capital ratio 12.5%
Assume:
Flash bank
Steady bank
Capital
1bn
Capital ratio 8.0%
Capital
1bn
Capital ratio 12.5%
Flash bank
Steady bank
Profit
125m
Kept
62.5m
Extra assets 781m
Profit growth 6.25%
Profit
83m
Kept
41.5m
Extra assets 346m
Profit growth 4.16%
Basel I ~ 1992
Simple rules focused on credit risk - no other risks included
RWA risk weightings defined for each type of loan
Not specific enough
Implications
Helped standardise capital
RWA do not reflect lending risk Shell Oil needs same capital as a corner
shop
Tends to move banks up risk curve where they can get higher margin for
same RWAs
Danger of going up the risk curve like this may repeat with the proposed
leverage ratio
Implications
Banks were starting to outgrow Basel Is simplicity.
Securitisation allowed credit risk to move off balance sheet. This distorted
business models to exploit capital arbitrage. Eg Northern Rock :
from 1997 to 2006 Assets grew 13 - 87bn (x 6.6)
Standard Weightings
Loans
Loans
Calculate:
PD
EAD
LGD
By portfolios
Bank specific
RWAs
Loan
RWA
Property
35%
AAA AA-
20%
A+ - A-
50%
BBB BB-
100%
< BB-
150%
More granular
look up
RWAs
K is a correlation factor.
It depends on the type of lending, corporate, mortgages, credit cards
The maths was neat but rather missed a more fundamental flaw.
Higher ROE
Number of studies show lower capital for IRB
Design what is best for your bank
Its expected
Regulator expects / demands
Shareholders expect banks to know their own business
Shows confidence in data
To differentiate
between this risk
Bank A
1.5
Bank B
1
0.5
1
25
49
73
97
121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
-0.5
-1
-1.5
In a boom RWAs
and capital shrink
Bank A
1.5
Bank B
1
0.5
1
25
49
73
97
121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
-0.5
-1
-1.5
Bank A
1.5
Bank B
1
0.5
1
25
49
73
97
121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673
-0.5
-1
-1.5
Great moderation
Implications
Central Bankers have started to look at a range of new measures:
Ring fencing retail and investment banking plus living wills
Margins falling as
credit expands.
Banks max out on
credit just in time for
major losses!
Sources: Berger, A, Herring, R and Szeg, G (1995), The role of capital in financial institutions, Journal of Banking and Finance, pages 393430; United Kingdom:
Billings, M and Capie, F (2007), Capital in British banking 19201970, Business History, Vol. 49(2), pages 13962;
British Bankers Association; and published accounts.
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets). UK data show
riskweighted Tier 1 capital ratios for a sample of the largest banks.
(b) National Banking Act 1863.
(c) Creation of Federal Reserve 1914.
(d) Creation of Federal Deposit Insurance Corporation 1933.
(e) Implementation of Basel risk-based capital requirements 1990.
(f) From Billings and Capie (2007).
(g) BBA and Bank calculations. This series is not on exactly the same basis as 192070, so comparison of levels is merely indicative.
Liquidity issues
Liquidity Coverage Ratio (LCR)
Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)
To protect against too great term mismatch to profit from normal yield curve.
Leverage Ratio
IFRS9