Fundamentals of Financial Markets and Institutions Lecture 5 PDF

**Fundamentals of Financial Markets and Institutions** **22.01.2025 -- Lecture 5** [Banks balance sheets:] 1. Sources of funds - Liabilities - Core deposits - Managed liabilities (purchased funds) - More volatile and rate-sensitive, gathered in national or...

**Fundamentals of Financial Markets and Institutions** **22.01.2025 -- Lecture 5** [Banks balance sheets:] 1. Sources of funds - Liabilities - Core deposits - Managed liabilities (purchased funds) - More volatile and rate-sensitive, gathered in national or international bond/money markets. - Equity - Equity capital (book value): Net Worth = Assets -- Liabilities - Regulatory capital: Leverage ratios/Equity ratio = E/A - Typically, low. 2. Use of funds - Interest earning assets - *Loans and leases, investment securities.* - Fee-generating assets - *Management fees, advisory fees* - Non-earning assets - *Buildings, real assets* - Largest asset is typically net interest and net commission income. - Largest liabilities are typically personnel costs and IT expenses. - These are usually fixed, allowing for companies to exploit economies of scale if they manage to increase net assets and the number of investors. - But it also means companies can experience diseconomies of scale.  - Net commission income is typically relatively stable as the management fee is annually charged. - Only increases as number of investors increases. A graph of a company\'s financial report AI-generated content may be incorrect. - The largest total asset is typically lending. - Notably equities are a very small amount, with the amount varying depending on the company -\> different requirements. - *For example, for Aktia equity is only about 10% of total assets and liabilities.* [Bank Performance ] - Bank performance is assessed via ratio analysis of profitability (*cost-to-income, ROA, ROE)* and solvency (*core tier 1 capital ratio).* - Other meaningful comparisons include: - Time-series analysis: comparing banks performance over time. - Peer-group or cross-sectional analysis: comparing banks performance across similar banks in the same industry, region, or market segment. - Using control variables: ensuring fair comparisons considering factors like bank size, location, organizational structure, which may influence performance. Cost-to-income ratio: a company's costs in relation to its income. = operating costs (administrative and fixed costs -- no including bad debt as they are written off) / operating income. - Gives information to investors on how efficiently a firm is being run. - The lower the cost-to-income ratio the more profitable the bank is.  - The cost-to-income ratio of firms can vary by a lot. - Typically, it is around 40-60%. - Aktia has been struggling to achieve its target cost-to-income ratio. - To increase it Aktia has closed off some of its branches. - This indicates a larger shift in consumer behaviour, with some, particularly young customers, preferring digital services over physical -\> developing digital offerings. - This is more cost effective for banks, as they do not need to pay as much on renting spaces. - For banks customer retention is important. - The high switching costs associated with switching banks, means that it is hard for traditional banking to grow its customer base. - Comparatively, this is easier to do in asset management -\> some banks switching from traditional banking to focus on asset management. - *An example of this is Evli.* Regulatory capital: A measure of the bank's common equity capital as a percentage of the risk-weighted assets. - Common Equity Tier 1 capital (CET1): a bank's shareholder equity and retained earnings (disclosed reserves and sometimes non-redeemable, non-cumulative preferred stock). - Tier 2 capital: a bank's revaluation reserves, hybrid capital instruments, subordinated term debt, general loan-loss reserves, and undisclosed reserves. Capital adequacy ratio= Risk assets ration (RaR) = (Tier 1 Capital + Tier 2 Capital)/Risk-weighted Assets  - Aktia's capital adequacy ratio improved and has an additional buffer of around 3%. [Calculating risk-weighted assets] Capital adequacy: Basel Regulation - Basel Committee on Bank Supervision is a global incentive for financial stability. - Implement regulations known as accords. A screenshot of a computer AI-generated content may be incorrect. [Basel I:] - Focused on RaR, with a tier 1 capital requirement of 4% of risk-weighted assets and tier 1+2 requirement of 8% risk-weighted assets for all banks. - The value of an asset is adjusted by the risk class it is allocated to. - *For example, gold and cash have 0%, while mortgages are 50% and corporate loans are 100%.* - The riskier assets an institution holds the more capital it must have. How can institutions increase their capital ratio? 1. Increase capital -\> issue new shares or not pay dividends to retain profits. - Given they don't increase risk-weighted assets. 2. Reduce risk-weighted assets -\> cut back lending, sell loan portfolios, make less risky loans and investments. - After a few years of stress tests total risk-weighted assets were down by 20%. - However, this meant risky customers stopped receiving loans as banks focused on strengthening their balance sheet, leading to the growth of shadow banking. [Basel II]  - Introduced more complex weighting scheme, with many types of loans now depending on credit rating rather than simple percentage. - *Corporate debt would be rated on credit rating of the company it is issued to instead of all corporate debt being 100% risk*. [Basel III:] - it is gradually being adopted, but it is an evolving framework and pace varies by country. - EU has adopted the rules, but some elements are still under discussion in the US. - Aktia's intermit report, underlined at the risk weight, risk-weighted assets and the capital requirement. - Here the risk-weighted amount is what the CET1 is divided by to get the capital adequacy ratio. [Internal rating-based approach (IRBA):] - Big banks are allowed to use their own risk models, with the requirement that they are approved by the supervisor. - Must demonstrate the sophistication of their risk management through implementation of a robust, comprehensive framework across the credit lifecycle. - IRB models estimate the probability of default for each rating class and loss given default. - Aktia was given permission to use IRB model. - IRB approach reduced average risk weight of retail collateral decreased significantly, from 35% to 1%, improving Aktia's CET1 capital ratio.  - Large improvements in banks CET1 ratios. - Growing concerns over whether the banks are using IRB models to reduce the risk, to have lower equity required. - Are the lower risks because they are tinkering the risk of the holdings, or do they just know more about the riskiness? Leverage ratio = tier 1 capital/average total consolidated assets - Basel III introduced a minimum of 3%, as simple non-risk based, backstop measure. A screenshot of a report AI-generated content may be incorrect. - Aktia managed to be well over this limit, with 4.5%. - Basel III is 77 pages, highlighting the complexity of the frameworks, there are many different buffer requirements at different levels. Why are bank's balance sheets, performance and risks hard to evaluate? 1. There is no market assessment and large information asymmetries about many bank's assets, especially loans. - *Who are the borrowers? What exactly are the risks and how are they measured?* - We do not know a bank's customers to we rely on their assessments. 2. Banks may have incentive to hide risks. - Something stress tests and AQR aims to reduce, by increasing transparency. [Basel IV:] - Decided that banks are given too much freedom in their assessment of risk. - Idea to give floors on risk levels, to avoid banks being able to undervalue risk to a certain extent. [Banking and Lobbying:] - Banks however oppose these new rules, not wanting to increase their equity, and delay the adaption. - The commercial is an example of the lobbyists using all possible tactics to get this regulation removed. - Even though the rules would be regulation on banking not on customers. - European banks argue they should have a level playing field with US banks, so if Basel III is postponed in US, will it be as well in Europe?