Advanced Banking PDF

Lecture 1: Functions of the financial system ============================================ Structure of the course: Today we start with financial system in the first three weeks about banking sector and the last three weeks more about the practice of individual bank. Financial structure ----------...

Lecture 1: Functions of the financial system ============================================ Structure of the course: Today we start with financial system in the first three weeks about banking sector and the last three weeks more about the practice of individual bank. Financial structure -------------------  Financial systems produce information ex ante about investments and allocate capital. They then rely on the financial system to monitor investments. Financial systems also facilitate trading, diversification, and management of risk. Fourthly it is also about connecting people with credit and people with a demand for credit (mobilize and pooling savings). Lastly ease the exchange of goods and services. A distinction is made between: - Direct finance: sector in need of funds borrows from another sector via a financial market (market-based) - Indirect finance: a financial intermediary obtains funds from savers and uses these savings to make loans to a sector in need of finance (bank-based) In indirect finance an institution is the intermediate person, does not have to be a bank. Financial structure: = The set of institutions that channel resources from its savers to its investors, allocate them across alternative uses and enable investors to share risks and diversify their portfolios. Langfield and Pagano (2016) discuss: 1. differences 2. determinants 3. effects on the real economy Key points: 'the real world is characterized by transactions costs owing to asymmetric information between users and providers of funds and to limited enforcement of contracts. In the presence of these frictions, comparative advantages can emerge. Asymmetric information ---------------------- We had to assess [probability of default (PD)] 1. It may be the case that you know the person sitting next to you fairly well 2. You have the best information about your level of 'credit risk' In general: One party of a transaction has a better information position than the other party. In a loan transaction: the borrower knows more than the lender. How do banks help here? 1\. Manage ex ante and ex post information asymmetries (screening, monitoring) 2\. Reduce transactions costs, as banks are able to generate economies of scale 3. Delegated monitoring ----------------------- Why do investors first lend to banks who then lend to borrowers, instead of lending directly?' - Delegated monitoring (Diamond, 1986) Explains benefits of intermediaries - Some costs are lower when assets are held by intermediary rather than large number of individuals One borrower, one lender = Delegated monitoring pays when: K ≤ S (1) - K: cost of monitoring: will be expensive. - S: savings from monitoring: avoid some kind of bankruptcy which is very costly One borrower, more lenders = Two options - Either all m lenders monitor, at a total cost m ∗ K - Alternative is delegate the monitoring, at a total cost D (per borrower), delegated to an intermediary. There is a situation where the cost of a bank is lower then the alternative, which is S (no monitoring) or m\*K (where all of the lenders are monitoring) Insights from Diamond (1986): - Banks can avoid the duplication of effort of the monitoring of borrowers by small investors. - Banks monitor debt (loan) contracts, and issue unmonitored debt (deposit) contracts. - If the bank gets sufficiently [diversified] across independent loans \[\...\] then the chance that it will default on its deposits gets arbitrarily close to zero. Banks have comparative advantage in monitoring if 1. Many projects are involved (diversification) 2. Capacity of individual lenders is small (m is large) 3. Cost of delegating monitoring is small. 4. Bank-based & market-based systems ------------------------------------ Financial structure: Determinants: [Langfield and Pagano (2016)] Observation: 'Europe's already bank-based financial structure became even more dependent on banks, while the USA became slightly more market-based.' Relevant factors: [1. Comparative advantage in mitigating financial frictions ] [2. Public policy ] Comparative advantage. When are banks important? Public policy: 1\. Promotion of 'national champions'. does a country need to have a national bank? 2\. Leniency of supervision (week 2) 3\. Inadequate regulation. 4\. Promotion of 'regional champions'. They also point out steps 'in the right direction' Financial structure: Real effects --------------------------------- Do differences in financial structure have implications for growth or stability? Initially: no effect of financial structure on economic growth (Levine, 2002) Recent evidence suggests 1. Capital-based systems can boost economic growth. Benefits of direct finance are there. a. Improves total-factor productivity b. Boosts firms' investments 2. Bank-based systems associated with more volatility. if there is no funding available at the bank there is no alternative. c. Higher leverage d. More exposed to house prices Tutorial week 1 =============== Two main sources of income for ta bank - Net interest income (main source of income) - Fee-based business: for example large wealth clients or services Net interest margin of us banks = difference between interest income and interest expense. Term spread = the difference between assets of a bank and liabilities of a bank. Is related to the yield curve, if we were to plot interest rates at different maturities, we could make a picture of this. The term spread is the difference between the maturity of interest. Term spread slopes in gereal upwards. It is generally positive. Sometimes it is negative, then we have downward sloping term spread: A negative term spread can indicate a recession. Dependend variabels: net interest margins, return on assets, Group assignment: You use a measure of profitability as a dependent variable and you can use macroeconomic factors as independent variables. You run the regression. Pitch 5 min max Assignments week 1: Information asymmetry 1 ex ante information asymmetry 2 moral hazard and adverse selection 3 screening/monitoring Delegated monitoring:  1: cost of deposits = 3% + cost of monitoring 0.04% 3.04%. On the income side we have 0.6 \* F + 0.4\*1 = 3.04%. F = 3.04% / 0.6 = 0.0506 = 5.06% = 5.1%. **B. empirical perspective** 1 risk perspective: farmers cannot pay loans. But also more important, table 4 has banks in it. There are also banks that give the economy credit and help. The sentence: "More eroded counties..." (Hornbeck et al. 2012). 2 to get the picture, you need to download data, use the code of the author. Then you collapse the average deposits per year and plot it in a graph. During the great depression loan deposits were very low. The great stock market crash 1929. Lecture 2 financial (in)stability and crises: ============================================= Placing lecture in context: **Financial (in)stability** Instability: A sense among the clients that something is not right, bank run. For example, great depression and silicon valley bank. Bank stability: Key question: [Can the financial system continue to support the real economy? ] Analytical focus on 1. Shocks 2. Financial vulnerabilities 3. Resilience Systemic risk, in the context of banking: Systemic risk refers to the risk that an event will trigger a loss of economic value or confidence in a substantial part of the financial system that is serious enough to have significant adverse effects on the real economy Cyclical perspective: buildup of imbalances, bubbles (housing market) and Structural perspective: interconnections Financial instability can take on many forms:  Banking crisis over the years: The period after 1950 was different, no banking crisis for a long period. We thought we had control and we forgot that these crisis's could occur. **Why worry** Pressure on government finances: 1 Depositor insurance - Depositor insurance - Recapitalization - GDP shortfall: you will have to spend money on financial institutions that cannot go to healthcare for example. Origins of banking crises: (Source: Caprio and Honohan (2019).) if we go back in history, we roughly can identify three categories of banking crisis causes: 1. Shortcoming in management, fraud. 2. Government policies (directed credit) = very much involvement in direct credit of the government. Government is taking up monitoring that the banking must do and where to invest, for example because there was a political motive. 3. Macroeconomic booms and busts. = link with macro economy, how do cycles in housing/economy influence banking crisis's. **Vulnerabilities** (if we had this in 2008 we could avoid crisis) I Boom in U.S. housing market I Banks repackaged mortgages ('originate to distribute') I Complex products (securitization): where is the risk? I Shortcoming in credit ratings agencies I Credit booms in E.U. countries I Interconnected financial system **Resilience: in this case not so much.** There was not much to fall back on: I Mortgage defaults. I Loan losses for banks I Quick spread through international financial system I Too big to save (Iceland, Cyprus, Ireland) I Liquidity crisis, everyone wanted cash. I Credit crunch. Two views on banking crisis --------------------------- 1. Panic view: crises are random events. Random crisis, random bank run, random house crisis etc. 2. Banking crises are natural outgrowth of the business cycle **Panic view Diamond/Dybvig (1983)** Model is about the panic view of banking crisis it makes three points: 1. Banks are helpful, they provide better risk sharing then competitive markets. 2. But there is inherent vulnerability = The demand deposit contract has one undesirable equilibrium in which all depositors prefer to withdraw liquidity immediately (bank run). If one person gets their money, all of them go. 3. And bank runs matter as healthy banks can fail with adverse implications for investments. Classic policy implication drawn from this perspective would be to say that the government would guarantee a certain amount of money to prevent bank run. **Business cycle view: (Gorton (1988)** 1\. Empirical analysis of banking panics in the U.S. 2\. Panics are not random 3\. Rather, consumption smoothing by cash-constrained people 4\. [As a reaction to perceived higher economic risks] [Model of business cycle view: Allen/Gale (1998) ] 1\. Model with three periods 2\. Consumption can be early (period 1) or late (2). 3\. Bank invests in risky asset with return R at t = 0 4. Runs occur depending on R by a fraction of early-withdrawing late consumers = People that would get their money back in a few periods, take it out more early at the same time. **A third view of crises: Minsky** Credit boom-bust starts with a 'displacement', invention, or policy change that excites investors. Five stages: 1\. credit expansion, characterized by rising assets prices 2\. euphoria, characterized by overtrading 4\. discredit, characterized by liquidation. Banks not lending money anymore. 5\. panic, characterized by the desire for cash Lecture 3 Bank lending, the real economy, and monetary policy ============================================================= Explaining macroeconomic fluctations Do banks' actions matter much? - Money view No. It's all about money supply. - Credit view Yes. Bank loans also matter  Recent contribution on credit view 'Our key finding is that all forms of the model show that a credit boom over the previous five years is indicative of a heightened risk of a financial crisis.' Monetary policy has an effect via: - Loan supply: bank lending channel - Loan demand: balance sheet channel **Example**: monetary policy tightens Lecture 5 Regulation and supervision ==================================== **Bank capital over time:**  There is less solvency. Loss term assets are smaller than long term liabilities Regulation and supervision 1\. The case for regulation 2\. Microprudential versus macroprudential supervision 3\. Basel / Banking Union 4\. Solvency and liquidity Today most about macroprudential, Friday more on macroprudential supervision **Capital stack**: how much capital does a bank needs to hold from a solvency perspective. \ Micro is at the individual bank From a microperspective banks should hold 4.5% of something on their liability side a similar discussion as last weak. It is no longer total assets something different later in lecture Minimum requirement = pillar 1 something that banks must have as a minimum on their balance sheet. At the end there is 8%? Basically it is build up from the bottom. Idk CHAT GTP: **Left Column (Capital Buffers and Requirements)** - **Pillar 1 (Minimum Requirements)**: The fundamental capital requirement that all banks must meet. This includes a minimum level of Common Equity Tier 1 (CET1), which is the highest quality of regulatory capital. - **Pillar 2 (Requirements and Guidance)**: Additional capital requirements that may be imposed on banks based on their specific risk profile, including supervisory assessments. Pillar 2 has two layers: - **Pillar 2 Requirements**: Specific capital requirements set by supervisors for each bank. - **Pillar 2 Guidance**: Additional capital levels that regulators suggest banks should maintain above the minimum requirements. - **Capital Conservation Buffer**: Extra capital that banks must hold to absorb losses in times of financial stress. - **Counter-cyclical Capital Buffer**: Adjusted according to economic conditions to counteract excessive lending and risk-taking in good times and provide a buffer in downturns. - **Systemic Buffer**: Applied to banks that are deemed systemically important (e.g., SRB for Systemic Risk Buffer, G-SII for Global Systemically Important Institutions, O-SII for Other Systemically Important Institutions). **Middle Section (Capital Composition and Ratios)** - **Capital Tiers**: - **CET1 (Common Equity Tier 1)**: Highest quality of capital, primarily consisting of common shares and retained earnings. - **AT1 (Additional Tier 1)**: Secondary capital layer, often in the form of perpetual bonds. - **Tier 2**: Further layer of capital, used to absorb losses in case of bank insolvency. - **Required Ratios**: - **4.5%**: Minimum CET1 ratio. - **6%**: Minimum for CET1 plus AT1. - **8%**: Total minimum requirement including CET1, AT1, and Tier 2 capital. **Right Column (Microprudential and Macroprudential Distinctions)** - **Microprudential**: Refers to individual institution oversight, focusing on the stability of each bank to protect its customers and ensure its resilience. - **Macroprudential**: Focuses on systemic risk and the broader financial system, with tools like the counter-cyclical buffer and systemic buffer, aimed at managing economic cycles and preventing system-wide crises. **Summary** This regulatory structure ensures banks have layers of capital to protect against various risks, including bank-specific risks (microprudential) and system-wide financial risks (macroprudential). How much capital is held by banks in different jurisdictions.  Different type of banks/institutions hold different amount of capital. G-SIBS hold the lowest, these are big banks. **Regulation** Why? Bank failures have severe negative consequences for 1\. Borrowers (credit crunch) 2\. The rest of the financial sector (contagion) (think of leemans bankruptcy has lots of effect on financial stability) 3\. The real economy (growth) (what happens to growth?) a year after financial crisis decline in growth) Market failures \> we are not confident that the market solves problems on its own. A role for the government to regulate. Government intervention to address various market failures, i.e. a situation where market outcome would be sub-optimal. [Market failures:] 1\. Vulnerability to runs (deposit insurance) 2\. Moral hazard and excess risk (improve transparency, capital, liquidity) 3\. Systemic risk (macroprudential) Types of regulations 1\. Microprudential: ensure soundness and safety of individual financial institutions 2\. Macroprudential: preserve financial stability 3\. Competition policy: to protect consumers against abuse of market power 4\. Conduct-of business: focuses on how banks conduct business with customers and how they behave in markets **Basel:** Global standard setter for prudential regulation of banks Basel I: 1988 Basel II 2004 Basel III: 2011 Basel III (final): 2017 Currently Basel 3. We start in 2011 with Basel 3 a reaction to the global financial crisis. The reaction:  Leverage ratio: very intuitive more than 3%. Two metrics capital stack and leverage ratio, another restriction to what banks can do. Reaction to the global financial crisis Basel 3 updated (2017) - Risk weight floors. - Rebalancing away from internal models & complexity. Liquidity/solvency. Two new metrics LCR and NSFR. **In Europe: Banking Union** I Break vicious cycle between banks and sovereigns I Reduce costs to taxpayers of banking distress I Harmonize rules and standards to improve quality and efficiency of supervisory and regulatory frameworks **Financial trilemma** Tradeoff between 1. Financial stability 2. Financial integration 3. National financial policies If we want stability there are two outcomes: 1. We try it at the national level 2. We try it at the supra-national level  **Elements of the banking union** 1. [Single rulebook ] 2. [Single supervisory mechanism (SSM)] 3. [Single resolution mechanism (SRM)] 4. [Financing regime for exceptional circumstances] (also think of the deposit guarantee schemes) **CRD-IV** Two types of requirements in CRD-IV - Risk-weighted - Unweighted (leverage ratio) Risk weighted pilar one for example:  This is sort of what we are doing in the assignment. Deferent risks that contribute to REA. Most is credit risk. Unweighted (pillar I):  Liquidity coverage ratios: Simple version. Metrics for liquidity: - Liquidity coverage ratio (LCR) - Net stable funding ratio (NSFR) Bank needs to hold sufficient liquidity to withstand 30-day stress [LCR ≥ 100%] **NSFR** I Available stable funding relative to required stable funding I NSFR ≥ 100% I Reduce vulnerability to runs (microprudential) Lecture 6 - Macroprudential policies and stress testing ======================================================= Macroprudential policies and stress testing 1. Lender-based and borrower-based measurers 2. Stress testing, illustrated using flood risk Capital stack: buffer to withstand shocks. **Macroprudential tools** Aimed to ensure stability of the system as a whole: - Structural tools = build resilience irrespective of business cycle: (e.g. G-SII buffers, loan-to-v alue (LTV) limits). - Cyclical tools: build resilience in anticipation of downturn (e.g. CCyB) Countercyclical capital buffer - Ensure credit supply can continue in economic downturn - Dampen financial cycle - Build-up in good times - Release during adversity Key concepts for financial stability Can the financial system continue to support the real economy? I Shocks (hard to predict) I Financial vulnerabilities (we can monitor those) I Resilience (macroprudential tools) Formal definition: I Shocks: events that may lead to disruption or failure in part of the financial system I Financial vulnerabilities: a property of the financial system that: (i) reflects the accumulation of imbalances, (ii) may increase the likelihood of a shock, and (iii) when acted upon by a shock, may lead to systemic disruption. I Resilience: the capacity of a financial system to absorb shocks and prevent them from leading to an unravelling of the accumulated imbalances.  Loan to value (LTV) Real estate exposure per postal code. What balance sheet will be affected (4,5 6 or 7?)  scenario specific and portfolio specific  LTV goes up because there is damage, value goes down. **LGS = loss given default** We also use the historical correlation between LTVs and PDs:  I y: Default status of the counterparty i I Z: GDP growth, LTV and interest rate (risk-drivers) I X: borrower, collateral and loan characteristics **Capital depletion**  **Decomposition (EL vs RWA)**  **Would floods impair financial stability?** 1\. Property damages would cause a drop in system-wide capital of between 30 and 50 basis points 2\. Depletion due to flood specificities and starting-point loan-to-value ratios 3\. Compared to current levels of bank capital, such levels of depletion seem small [Resilience due to] 1\. High level of flood protection---very low probabilities of floods 2\. Floods mostly local---only part of real estate would be affected 3\. Flood protection is highest where most of real estate is concentrated 4\. Floods sometimes affect areas where starting-point LTVs are relatively low Lecture 7 - Introduction to part II / Tour d\'Horizon ===================================================== Economic function it performs: - Transferring funds from savers to borrowers - Services it offers to its customers, however changing profile - Legal basis for its existence: A bank is any business offering deposits subject to withdrawal on demand and making loans of a commercial or business nature. Bank landscape:  Three building blocks: 3 regulation. 2 the credit function: it is about the three questions (next lecture on Friday) three questions on when to give loan. 1 asset and liability management: ALM what is on the balance sheet of a bank. Start a... company: slide 16 Start a... bank slide 17: nothing special here Grow your bank go to people that provide money, pension funds, then we get some saving accounts. Getting saving accounts changes everything; it will change your business model Because we then got **the watchdog** Regulators have to guarantee saving accounts that is why they are so strict Slide 20: important Basic balance sheet of the bank. On the liability side we got the deposits that need to be protected. Regulator looks at banks trough five different lenses: solid banks, solid financial systems, properly managed, customer protection, protection for society (don't want financing Russia or money laundering). This might be exam question above, tell something about one of the lenses. Important \> The business model concerns maturity and risk transformation, distribution and management What is the revenue model: slide 23. Loan loss expense: provision for customers that don't pay. Fee income: example Arrangement fee, commitment fee (company wants to invests but because bank guarantees money in some time for example three months then they charge commitment fee), waiver fee(a company has no collateral, but in good held it can make arrangements about risk profile (ratios etc.) the re-negotiations are then covered in a waiver fee. Non interest expense: housing, people etc. it infrastructure is very constly for banks these days. **Capital (banks use capital, companies call it equity...)** Function of capital See slides: 1. Cushion against risk 2. Promote public confidence 3. Funds for development (skin in the game) 4. Regulator for growth (requires capital, basel thing) 5. Limit how much risk exposure a financial firm can accept. **Building blocks of capital** Different types of capital: - This one is important: core equity 1 ratio (tier 1 ratio) What is the difference between tier 1 and tier 2? - Tier 1 capita: - - Tier 2 capital:  We have these tiers because o fregulatory policy. What counts as capital? Banks play with the amount of capital they have to have on their balance sheet. The tiers allow them to differentiate capital. How much capital do you need (besides basel) Depends on your assets. What is your risk weighted balance sheet.  This above is the Basel thing. The regulatory capital ratio is different then the capital ratio. From basel 2 into 3 we also want some liquidity risk, not only credit risk. Also more prudent supervision on risk model and also balance sheet ratio. Basel 4: they said we just build in floors, for this portfolio we calculated the risk weighted assets. There is a floor for assets, no floor based on a risk model. Difference with basel 3 is that the floor is more strict. Sweet and Simple:  Example business risk: having a lot of assets in Russia on the balance sheet. Or young competitors hat have better it department Credit risk: related to quality of lenders Operational risks: everyone has operational risks. "The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events" Reputational risks. **Three lines of defense / responsibility** First line of defense: (business owns and manages risk) - Front-office - Back-office - Support Second line of defense: - Risk management - Compliance (there need to be rules) also challenges the first line of defense. Third line of defense - Internal audit  **First line of defense** **Second and line of defense** PPT slides 36 to 39 **Next parts read the slides from 39, however not the most important.** **Liquidity risk slide 42 is key** Cash is king. You have to make a payment. If you cannot pay something you're out. Operational risk: people, process or system think about that **Compliance risk:** most important question is: who are you? KYC important. Think of the different lenses. Everything is on the slides. **Sustainability is also important** In the exam it will be about one of these three types of risk  Strategic framework with specialists. Have we covered it all? In a bank you have different people, some think about credit risk and others thing about ALM, it only comes together at the management board. [Strategic framework] you have just the basic things look at slide 48. [Risk framework look at slides] Strategic framework tells you what to do and the risk framework tells you: under what conditions! Slide 50 also important Slide 51 how do we organize it? Not very important, linked to risk appetite and concentration risk Concentration risk, where is your risk concentrated?? Where are you exposed (think of Russia) Slide 53 monitorign: risk appetite statements by the board of directors, this is the balance sheet and how much we can take and that is diversified over the different risk categories. They devide it in categories because they need specialists because it is complicated. MT LPQ ALCO : asset liability committee OPSCO Chatgtp on slide 53 how to run bank! we skip a few slides and continue on slid 59! Banks play a much bigger role in the European model, but we know this already. Size of bnaking sector also much bigger. Slide 61 trends: mckinsey report see slides **Slide 66: how do we measure succes?** Income: Net interest margin Cost: the costs Capital = equity Impariments = ? Investors view slide 67 **Players slide 68 important** How are banks compared on success? Quiet clear on the slides - ROE - ROA - NIM - Profitability, how efficient are you running the show - LCR liquid. - Resilience how safe is your bank - Loan to deposit ratio: the less it is the better it is. Because it is cheap - Non-performing-loans = important they don't generate any cash, because we don't have capital for it and maybe a writeoff. - Solvency ratio You can rate them, slide 78 and 79. Lecture 8 - Credit risk management (i) ====================================== You are corporate with sales above 50 million   Security: is there collateral yes or no? Example: A business comes to the bank and your aim as a bank is that you get repaid. Three questions 1. Who are you? (do you already have loans?, which business are you in?, are you on a list?) 2. What are you going to use it for? (usage?, some banks only finance certain sectors?, strategy of the bank?) 3. Repayment. How are you going to repay? Suppose you finance a windmill park, where do you get the money from 1. Operations, cash from operations 2. Collateral. Sell the collateral. It is also a little bit of end of relationship. Not the preferred way. 3. Someone else takes over our loan, can be an equity investor or another bank. This is also end of relationship, also not preferred. Business risk: do you have sufficient cash for the coming years. [Projections] are key. You get the management case from a business but you need adjust it for the overoptimism of entrepreneurs (base-case) and you must make the downside case, what if it goes wrong and when does it go wrong, how much does it go down? How does it work when the ebitda turn out to be low? The case is transferred from the RM/Credit Analyst to the SEM (special department), they can help out with some consultancy. It can also be that the consultancy does not work out and then you get into the recovery fase. Banks start thinking from their own view point, it is not recovery for the client, but recovery of the loan. Do we want to transfer collateral to cash?  Business risk ------------- Four M's and 2 C's: - Macro: which country are you? (from which country is the cash coming) - Market: which market are we in? (mobile phones or production or farming etc.) - Manufacturing: how is the production facility (visit the client, you get a feeling when you visit it) - Management: education, experience etc. - Concentration Risk: if the company only has one off taker or supplier then that is a risk. (for example a company that only delivers to McDonalds, if McDonalds leaves them they have a problem, the contract is important with McDonalds) - Contingency: sales/contracts/guarantees. Reputation. Natural disaster risk. Management is important because they can influence all other factors. There is an order in the questions you ask because you look for the no, and hopefully it is a yes. If we see that business risk is okey, we go to the financial risk (Profitability, liquidity, solvency) Financial risk -------------- Key question is reliability of your data. Where is the data coming from? (big companies are probably analyzed by rating agencies) If there is distrust in the reliability of the numbers, don't proceed further. Fixed assets is related to depreciation. If fixed assets go down, because of depreciation, you want debt also to go down because that is your collateral. If the proceeds are not used for debt reduction, the D/E ratio changes. - The growth in revenue is more important than the actual number - Also the comparison with competitors is important. - As long as you can repay the loan it is fine If you see that the production is outdated and the cost is going up than that should be an alert Debt/EBITDA (because from ebitda you pay the debt) A D/ebitda of 3 is a bit of the turning point. The lower it is the better. [Solvency] - If a company wants to get financing, what did they put in? who bears the risk? How much capital/equity is put in. (skin in the game) **Liquidity** Five things that determine if there will be cash or no cash 1. P &L: what is net profit? 2. Asset conversion cycle: if I buy goods, the cash is going out later, before the money comes in it might be even later. Working capital, we need financing for working capital. 3. CAPEX: how much are your fixed asset returns? More than the interest? 4. Equity: who is behind the company's equity? 5. Debt: interest and repayment. Structured risk --------------- Who is getting the money (who gets it first) - Other loans? - Is there sufficient EBITDA if there are other banks involved? - Debt priority - Equal terms - Covenants How does the cash move through the entire entity of the organization, what does it look like, who am I financing? **Holding company risk** Example. Another company below the holding gets an [intercompany loan.] A subcompany can loan something to another subcompany. **Transfer pricing risk** Lecture 9 - Credit risk management (ii) from slide 63 ===================================================== Recapp: -------  When looking at the financial risk the [projections] are most important Also the reliability of data is important. But what if you are going to finance [some startup], is it reliable? (you can include covenants, for example on the amount of cash) liquidity covenant. (at least do all the payments trough the financial system of the bank, then you can monitor if there is sufficient cash) Structure risk: is there evidence of having a proper capital structure that produces money. If there is cash, who will get the cash? [Structured approach] Step 1 = creating a chart of the organizational structure. Are there other banks? Or are there intercompany loans? The powerpoint is not structured well. Group structure risk: 1. Holding company risk 2. Intercompany loans 3. Transfer pricing = one company is buying the stuff and selling it to another entity within the company. Mostly for tax reasons, or a producer is in Poland and it is sold in England. Avoidance of paying tax is not a good signal for a bank or to get a bank loan, because the may avoid paying interest. **Holding company risk** Important: Holding company risk: If we look at the company structure and we finance as a bank the holding company. And the debt goes to entity 3 (sales office) holding company risk is that the holding itself gets all its money from the sub companies (trough dividends!), however the other bank is paid from a sub entity then they have earlier access to cash, but we have the advantage that we have the possibility to get profit from all entities! (slide 50) does not always have to be problematic. **Intercompany loans:** it is better (as a bank that has a loan outstanding with the holding company) because if the holding company has an intercompany loan with a sub entity, then they have equal rights to the profits as another bank that is financing the subsidiary. **Transfer Pricing:**  In the starting point we see that we end up with the production sub receiving 7.5 million. However, suddenly you only get 2.5 million. You already have financed the production facility (this makes sense because they need the money), but suddenly there is a new bank coming up, that is looking where are the sales coming in, they are going to finance where the cash comes in. If we do our analysis and this phenomenon takes place, there are interrelated transactions, then if there are interrelated deliveries (which all makes sense) there is a risk that we cannot control the price of the goods that are soldinterrelated. Arm's length basis is important here, which means something like selling the goods between subsidiaries at market price. The best mitigant is to make contracts that everyone is equally liable. **Structure risk**: change of ownership. You can make an ownership clause or something FORMALIZATION -- THE CREDIT APPLICATION  3 risk analysis: tailored focused answers (also for the case) 4 control: collateral or covenants, business model does not work, what is plan b 5 information: what is the information need in the coming five years 6 conclusion: what is conclusion? Also when you enter new paragraphs. 2 phases: before and after drawdown Key question, can the structure be implemented? CAN THE DEAL STRUCTURE BE IMPLEMENTED? Think about the operational risk: the more covenants etc. the more administration. Can it handle your administration? The aim is to: minimize operational risk by not booking an operationally difficult transaction avoid reputational risk and lender liability make sure the structure works in the stress scenario **Collateral** Type of collateral, e.g. receivables, inventory, financial collateral. The type of collateral matters. As a bank you will have difficulty selling a factory because everyone will think why do you sell it? How fast can you transfer collateral in cash Valuation Marketability / Liquidity in default situation Stability Transferability **Covenants** Definition ‒Covenants are an agreement between the customer and the bank ‒It is no collateral ‒Covenants are ['tailor-made'] Three types of covenants: 1. Restrictive Covenants 2. Event Covenants 3. Financial Covenants , mostly based on ratio's (right to renegotiate) If you brake a covenant, it can happen that the bank restructures the company, but it can also be that the loan needs to be repaid immediately. The bank wants to step in before it is too late. There will be an agreement, if the covenant looks like it is going to be broken, then the bank has already made agreements with the client when it will step in. Covenants are only for special clients because it is a lot of work. **Pari passu** Key issues With whom are we Pari passu? Often only with other unsecured creditors Exactly how is the clause defined? If a company experiences problems another bank might notice it sooner and take the money, that is why you have pari passu. Another problem, which assets are considered under the pari passu, also new ones Negative Pletch = if we don't have it you also don't have it (pari passu) **No owner ship clause** only relevant if you think about succession **Material adverse clause** terms and conditions of the bank. If something material happens we renegotiate the loan, but issue is what is material? **Cross default**: ### Apply non-financial covenants important  Financial covenants ------------------- This is more about ratios, always ask some follow up questions. e.g. D/E ratio: What is equity? What is debt? Furthermore: Important that you be serious on the covenant. Monitor the client and act! Think of the house rules. Be firm on what you agreed on. 1. You need to understand it 2. You need to follow up Lecture 10 -- Regulation (Tour d\'horizon Regulatory Landscape) =============================================================== Very costly Banks are amongst the leading repositories of the public\'s savings. Especially the savings of individuals and families. Also think about retirement accounts. All these individuals lack the financial expertise or depth of information needed to correctly evaluate the riskiness of a bank. Trend is that it becomes more and more. [Integrity] is what you do when no one is watching... (reputation risk) Five senses: **Organization:** treating customers fairly, Relates to the way the organisation interacts with society, including clients, as reflected in the strategy, activities and decisions. **Employee:** Fraud, Conflict of itnreest, corrupt. Regulation of employees. **Client:** banks are gatekeepers. KYC, CDD, money laundering, terrorism financing etc. Relates to the activities and behaviour of clients that could potentially pose a compliance risk to the bank. **Market:** inefficiency and misconduct. Relates to supporting the efficient and effective working of the financial markets and avoiding market distortion. Market manipulation and abuse of inside information ; market transparency and transaction reporting. **Data privacy:** a big thing in banks, what do we do with data. Banks have gatekeeper role and afterwards monitoring role. Slide 7 to 9.  Highlights on slide 10 of sanctions etc. top ten threats, not that important. PEP-risk? Slide 15. How are we doing this: Slide 18 the items that you look out for to know a client. Sources of funds are also interesting Slide 20 important. Crypto ------ [MiCAR] = the Markets in Crypto-Assets Regulation, is a comprehensive regulatory framework developed by the EU to oversee crypto-assets and their service providers. It aims to provide legal certainty for crypto-asset issuers and service providers, foster innovation while ensuring consumer protection, and safeguard financial stability in the growing crypto market.  AMLA = anti monely laundering authority. Slide 27 to 30. Single rule book. AMLD 6. Regulation on money laundering. **Regulation put in perspective** Different lenses: - Solid banks (capital/liquidity/risks etc.) - Solid financial system (macro prudential measures, interconnectedness) - Properly managed banks (fit and proper testing (of management board in Frankfurt)) - Customer protection (privacy protection) - Protection of society (anti money laundering, CDD etc.) See slides 30 to 34.  Banks take sanctions serious because it harms reputation. Slide 37 G-SIBs and D-SIBs. See slide 39&40 and 44. 41 not important 42 bit important **European supervision** SSM and SRM purpose is to have financially stable banks. Key Items to Remember (slide47 and 48) Single Supervisory Mechanism (SSM) Single Resolution Mechanism (SRM) Single Rulebook How does ECB work? 1. Going and gone concepts 2. Single rule book 3. Pillar1 Capital requirements 4. Pillar 2 risk management and supervision. Risk appetite and more the qualitative part 5. Pillar 3 is market discipline you need to make public what your are doing. Skip slide 49 Slide 50 going and gone concern, important **Ssm** There is a distinction between the important banks and the not important banks. Joint supervisory teams.  We used to have supervising from own country, but now we have European supervision on significant institution.  Important Joint supervisory teams JST there is a team in Frankfurt and in Amsterdam. For Rabobank. Every bank has a team in Frankfurt and a local team. Look at the different pillers. Important. Ratios on slide 58. SREP test, must be passed otherwise you must get extra capital Pillar 3 you need to be consistent we need to compare year on year. Slide 63 examples of what needs to be disclosed Slide 66  [Guidelines] on recovery plan slide 68 recovery plan of SRM. It includes (slide 69) - ► Information on governance ► A description of how the plan was developed ► A description of the policies and procedures governing the approval of the recovery plan Slide 70 not important **Examples of recovery options** Slide 71 If your really in stress reduce Risk Weighted Assets it takes time, you cannot demant that clients repay loan before the agreement. You cant change overnight, but sometimes you have to. Got less than 24 hours to react. **BRRD** Bank Resolution and Recovery Directive Can be in the exam. Slide 73 important 3 Priorities 2023 - 2025 ------------------------ See slides. DORA. [Digital] operation resilience act. You need to be operational resilient, Five items to look at see slide 82. ICT needs to be protected. **BCBS 239** Slide 85 most important Lecture 11 The Green Regulatory Landscape & ALM =============================================== ESG:  [Key risks on commitments:]  NGO's are looking at banks for the publicity. European green deal: Not only banks, but every company must provide information on governance, strategy, impact risk and opportunity management, metrics and targets (slide 11) CSRD structures reporting in a business cycle - Double materiality assessment (double M) - And see slide 12 Slide 13 limited assurance. Regulators set a date in five years, but regulators and banks have to disclose now and make a plan.e a plan. [CSRD slide 15!] Green deal: we need to finance the transition (this means business for banks) and leave no one behind. This forms the sustainable Europe investment plan.  For the funding we can put in a [greenium]. A bank can give some capital relieve, if you are really green. (slide 20) Key messages on slide 21. Green premium, brown penalty. (see below at non-regulatory application) We are going to slide 25: CSRD covers everything, because it shows how are you running your bank. The background slides are not mandatory continue on slide 29. [Double M] - The impact of own operations, clients, value chain on the planet and society - External factors resulting from climate change influencing the Bank's / Firm position, development and performance Under CSRD I need to disclose how much co2 my product costs. Banks don't make products, but they finance products, we have financed emissions how much did we finance? We have different scopes: see slide 32 important. Second one is maybe you buy stuff or you need imput. Third scope is which emissions you are indirectly responsible for. As a bank, how much do you finance, indirect: In the case of small companies you can look sector wise, small companies don't calculate emissions. Slide 35 and 38, quick look. It is key to know double M and to know the various scopes of emissions. **Bank balance sheet** A bank has savings accounts on the balance sheet, that makes it different and introduces the watchdogs. Micar will not be in the exam, but will be in the resit.  Also loan loss expense is distinctive for banks. In normal companies it is called impairments You think your client is not going to pay, provision. How do we structure the price of mortgages. [Slide 49:] also important asset and liability management.  [Non-maturing deposits] is a fixed based and this is long term funding. ([slide 52]) (NMD) Transferring of long term loan to short term (tranfer something??) look at this later. NMD Treasury function. Asset and liability management: What is the right transfer price. How do we know how much is then non-maturing? Treasury department makes analysis [Managing the risks] We have the risk appetite, consisting of various kinds of risks. ALCO has dashboard. See slide 63 Liquidity metrics: slide 64 various metrics that are specific for a bank. 1\. The Bank is an intermediate / manager between the money lender and money supplier. 2\. The business model concerns maturity and risk transformation, distribution and management 3\. Retail Funding, Wholesale Funding and Capital are attracted and deposited in mortgages and investments Last picture of various risk types: slide 71. Various types of risks. Operational risk (people process and systems) Reputational risks Lecture 12 (left overs, Recap and exam prep) last lecture. ========================================================== Summary (see slides, know the concepts) Slide 10: Know what is typical of a bank balance sheet and bank income statement. Typical is loan loss expense and having saving accounts on the balance sheet (customer deposits) Slide 13: Fit and proper test, assessment of CFO etc in Frankfurt. Slide 14: most of the times everything only comes together very high up the firm. Reputational risk is important. Slide 16: know the different lenses. Genai: we still need people at the bank. Know something about deep learning etc, it is not free it cost a lot of energy and we pay with the data we provide. Slide 26: Slide 27: different scopes, explained on the slides. Slide 28: double M. what happens outside that can impact the balance sheet and what are we doing that impacts the outside world **Exam** 45 points each lecturer, total 90 points. Preferably split the answers over two different papers Individual assignment:  Example questions: Slide 33: the six stages and the three quest CCC, business risk, structure risk, financial risk, risk appetite? Slide 36 important. Going and gone concept. If client comes into difficulty we transfer client from the nice stuff (credit analysis) to the financial restructuring department. SREP is an exam for a bank. Each year banks are examined: all banks need to apply to the same European rules. Slide 38: Structure risk = who gets the money first? Holding company risk, transfer pricing etc. Start with organization chart Slide 39: sometimes a question on your opinion, like 8c on this slide. Slide 41: difficult question. Slide 42: question about the five lenses. About regulation.  **The next slides from slide 45 there is one or more questions that have been sent in and will be on the exam, including the answer.** Slide 45 not good. Slide 46 is a good question, could be in the exam. Slide 47 is key but simple. Slide 48 it was not really discussed probably not in the exam (client becomes too big so we need to attract other banks and that can be done trough syndicated loan. Slide 49 different chips, start with small clients and computer look at this (scorecard model), it is a volume game because it is not very profitable. The bigger amounts are done by a human. Slide 50 probably not in exam, but is useful to learn. Slide 51 was not really covered probably not in exam, but still something to read. Slide 53 asset conversion cycle was discussed and might be in exam so learn that fully. Slide 54 and 55 negative pledge clause (probably not in exam). Slide 56 (easy). Slide 57 is important, but no question on this.