Credit & Depositary Institutions PDF

ICADE International Financial Markets Credit & Depositary Institutions October 2024  What Have we Done so Far Function of Financial Markets and financial intermediaries Lesson 1. Financial Market instruments Introduction U...

ICADE International Financial Markets Credit & Depositary Institutions October 2024  What Have we Done so Far Function of Financial Markets and financial intermediaries Lesson 1. Financial Market instruments Introduction Understanding financial markets through the Financial Crisis Spanish financial (Subprime) Evolution of the financial system sector An overview of Financial Risks Central Banks: origins, structures and functions Lesson 2. The European Central Bank (ECB) and the Monetary policy EMU and The creation of money: What is money? monetary policy Supply and demand: monetary base Monetary policy Concepts and classes What is the interest rate? Lesson 3. - EURIBOR / LIBOR Understanding interest rates - Yield Curve Interest rate risk The yield curve (risk and term structure) - Central bank interest rate and money Interbank market markets Commercial paper and repos Interest rates  Banking Background - History The origins of capitalism (as known today) lie in the operations of Italian merchanting and banking groups in the 13th, 14th and 15th centuries Merchants had trading links across borders and used their cash resources for banking purposes Scenario – bankers sat at formal benches (banco), open in the air If a bank went into liquidation, the bench would be solemnly broke - giving us the word for bancarrotta (i.e. bankrupt) Early associations were partnerships, as shareholding companies did not began until the 16th century It is the Italians that claim the oldest bank in the world – Monte Paschi di Siena, founded in 1472 What´s going on today at the Monte Paschi di Siena? – will talk about it later First Banking crisis! Italian bankers had a long standing relationship with the British crown – bakers lent money to Edward I, Edward II and Edward III to finance their European wars Edward II however defaulted on the loan in 1345, and the Bardi and Peruzzi families in Florence crashed into liquidation  Banking Background – History (contd.) First instruments – bill of exchange, fx conversion, etc. In 1463…. The Medici bank helped an Italian firm in Venice to sell goods to a firm in Lndn, using a bill of exchange The Medici bank in Lndn would collect the money, and the bank would take care of the foreign exchange conversion and bear the risk The goods were invoiced at 97.18s4d (in old pounds, shillings and pence). This was equivalent to c. 535 ducats. The Medici branch in Venice paid the local firm 500 ducats on the bill of exchange, making 7% on the money it would not receive for 6 months (i.e. about 14% per annum) The bill represented a service to trade and exchange foreign money – i.e. it could not appear to involve the lending of money and it was certainly not “discounted” (i.e. brought to PV) in the modern sense as charging interest on money was forbidden by the Roman Catholic Church On the deposit side, depositors could not be paid formal interest, and would receive a share of profits paid at discretion Islamic banks today face similar issues due to the Koran´s rejection of the concept of interest as such  Banking Background – History (contd.) Banknotes We do not look to Italians for banknotes, but to goldsmiths in the UK In the UK merchants would hold money for safekeeping in the Royal Mint. However Charles I had many arguments with Parliament about money, and solved one of them in 1640 by marching down to the Royal Mint and stealing 130,000 pounds. Although money was replaced later, confidence in the Royal Mint was gone This was good news for goldsmiths who had secure vaults for gold and silver coins – and so the era of goldsmiths as bankers started (and lasted for 150 years). Coutts bank (still going today) began in 1692 as a goldsmith bank Goldsmiths gave out receipts for a deposit of gold coins made out to “the bearer” and to issue 10 receipts for a deposit of 10 coins If the bearer owed someone else 3 gold coins, he could pass on 3 bearer receipts. If someone wanted to borrow 5 gold coins, the goldsmiths could lend him 5 receipts and not give gold coins These are already modern banking traditions…with the exception that today notes are not backed by gold (as you well know…)  Banks – Definition & Type of Banks What is a bank? – a licensed financial institutions that is allowed to take deposits from clients, and perform lending activities Types of banks: By incorporation Public bank Private bank Central bank Multinational bank Cooperative bank Savings bank By business type Universal bank Commercial bank Investment bank Private bank Custodian bank  Banks – Definition & Type of Banks (contd.) Let´s look in further detail into some of them: Commercial banks – into the classic business of taking deposits and lending money Retail banking – involve high street branches which deal with the general public, shops and small businesses. High volume & low value Wholesale banking – involves low volume & high value, as it covers dealing with other banks, large corporates, etc Private banking – involves advising high-net-worth individuals on how to invest their wealth Historically it is a key Swiss specialty, and the most selected independent banks are based in Geneva In the US the oldest private bank is Brown Brothers Merchant/ Investment banks – “merchant” is the classic UK term, whilst “investment” is the US equivalent which is now dominant If commercial banking is about lending money, investment banking can be summarized as helping people to find the money  Banks – Definition & Type of Banks (contd.) Main activities of Investment Banking: Corporate finance – advising companies, public institutions, etc in their strategy, and helping them to implement it through raising capital (debt or equity), acquiring companies or assets (M&A), managing risks (interest rate or fx risk), researching stocks, etc Securities trading (secondary market activity on both equities and fixed income…as well as any type of related security) Investment management (both, the bank´s own funds as well as “other people´s money” (corporates, pension funds, mutual funds, etc) Savings banks – banks that do not have “outside” shareholders, but are mutually owned. These are savings (and cooperative banks) We have to differentiate the historical/ traditional role of these banks, with their modern role today (which is much closer to that of a commercial bank) Cooperative banks – owned by their members, with membership usually deriving from a trade or profession ((i.e. agriculture for example), and with a main objective which may not be to optimize profits  Banks – Definition & Type of Banks (contd.) Islamic banks – financial institutions that manage money in accordance with sharia law (i.e. are sharia compliant). Paying or receiving interest is not allowed, but depositors are paid a share of profit on a range of permitted investment in companies (excluding those involved with gambling, liquor or tobacco) State banks – banks owned by the state that are not central banks, but carry out some public sector activity. State owned post offices or national savings banks are an example  Shadow Banking Shadow Banking refers to an institution that looks like a bank and acts like a bank…but is not a bank Initially it referred mainly to nonbank financial institutions that engaged in what economists call maturity transformation (commercial banks engage in maturity transformation when they use deposits, which are normally short term, to fund loans that are longer term) Shadow banks raise (that is, mostly borrow) short-term funds in the money markets and use those funds to buy assets with longer-term maturities But because they are not subject to traditional bank regulation, they cannot—as banks can— borrow in an emergency from the Central Bank and do not have traditional depositors whose funds are covered by insurance A broader definition of shadow banks includes all entities outside the regulated banking system that perform the core banking function, credit intermediation (that is, taking money from savers and lending it to borrowers). The four key aspects of intermediation are Maturity transformation: obtaining short-term funds to invest in longer-term assets  Shadow Banking (contd.) Liquidity transformation: a concept similar to maturity transformation that entails using cash-like liabilities to buy harder-to-sell assets such as loans; Leverage: employing techniques such as borrowing money to buy fixed assets to magnify the potential gains (or losses) on an investment; Credit risk transfer: taking the risk of a borrower’s default and transferring it from the originator of the loan (or the issuer of a bond) to another party. Who´s included? Broker-dealers that fund their assets using repurchase agreements (repos) Money market mutual funds that pool investors’ funds to purchase commercial paper (corporate IOUs) or mortgage-backed securities are also considered shadow banks Financial entities that sell commercial paper (or other short-term obligations) and use the proceeds to extend credit to households (called finance companies in many countries)  Shadow Banking (contd.) Why would they represent a problem? As long as investors understand what is going on and such activities do not pose undue risk to the financial system, there is nothing inherently shadowy about obtaining funds from various investors who might want their money back within a short period and investing those funds in assets with longer-term maturities. Problems arose during the global financial crisis, however, when investors became skittish about what those longer-term assets were really worth and many decided to withdraw their funds at once. To repay these investors, shadow banks had to sell assets. These “fire sales” generally reduced the value of those assets, forcing other shadow banking entities (and some banks) with similar assets to reduce the value of those assets on their books to reflect the lower market price, creating further uncertainty about their health. At the peak of the crisis, so many investors withdrew or would not roll over (reinvest) their funds that many financial institutions—banks and nonbanks—ran into serious difficulty.  Shadow Banking (contd.) Had this taken place outside the banking system, it could possibly have been isolated and those entities could have been closed in an orderly manner. But real banks were caught – i.e. some shadow banks were controlled by commercial banks and for reputational reasons were salvaged by their stronger bank parent In other cases, the connections were at arm’s length, but because shadow banks had to withdraw from other markets—including those in which banks sold commercial paper and other short-term debt—these sources of funding to banks were also impaired. And because there was so little transparency, it often was unclear who owed (or would owe later) what to whom. In short, the shadow banking entities were characterized by a lack of disclosure and information about the value of their assets (or sometimes even what the assets were); opaque governance and ownership structures between banks and shadow banks; little regulatory or supervisory oversight of the type associated with traditional banks; virtually no loss-absorbing capital or cash for redemptions; and a lack of access to formal liquidity (for example, central bank funds) support to help prevent fire sales.  Shadow Banking (contd.) Estimating the size of the shadow banking system is particularly difficult because many of its entities do not report to government regulators In the run-up to the global financial crisis, the shadow banking system appeared to be largest in the United States, but nonbank credit intermediation was present in other countries—and is growing again—particularly in China The global shadow system peaked at $62 trillion in 2007, declined to $59 trillion during the crisis, and rebounded to $92 trillion by the end of 2015 The euro area shadow banking system is now the largest globally, comprising 33 percent of the total, whereas the US shadow banking system has declined from 33 percent to 28 percent  What do Banks do? – Creation of Credit Remember – a bank is a licensed Financial Institutions that is allowed to take deposits from clients, and perform lending activities I.e. they collect deposits from the public and channel these resources towards investment projects, lending to companies and individuals It is based upon the fact that only a small proportion of deposits are drawn in cash The creation of credit has some implications It is a reminder that banking depends on confidence Gvmnts and central banks will want to control it, given the implications for inflation Banks will need to measure the risks and set internal controls An external control by bank supervisors is required How banks/Financial institutions obtain benefits through lending money? The main source of revenues is the difference between the cost it pays to obtain funding and the income it gets from its lending activities – i.e. the Net Interest Income (NII) The same lending transaction could generate different income to different institutions depending on their capacity to obtain cheap funding  How does a Bank Balance Sheet look like? Off-Balance Sheet products - Bank endorsements - Letters of Credit Assets Liabilities - Cash - Customer deposits on demand - Central Bank deposits - Customer saving deposits - High liquidly products (ej: gob. bonds) - Central bank loans Securitizations - Credit - i.e. Loans (secured –mortages– or - Interbank market funding unsecured –consumer loans –) - Issued bond and debt certificates - Other Investment products Equity - Social capital & reserves What risks do you see? Banking services Payment services: bank transfers, credit and debit How to control the risk? cards, etc. “Universal banking”: distribution and even manufacturing of non-lending products: mutual funds, pension funds, insurance products, etc.  What risks do Banks have to Manage? Liquidity risk – caused by the bank’s inability to meet all its due obligations Credit risk – caused by borrower’s default on its obligations to the bank Market risk Interest rate risk– changes in interest rates Foreign exchange risk – caused by changes in exchange rates Reputational risk is the risk of loss caused by a negative impact on the market positioning of the bank Exposure risks – bank’s exposure to a single entity or to a group of related entities Operational risk – caused by negligence of employees, inadequate internal procedures and processes, inadequate management of information and other systems, and unforeseeable external events Investment risks – bank’s investment in non-financial sector entities, fixed assets and real estate Country risk – includes political and economic risk, and transfer risk Legal risk from court disputes due to breach of contractual and legal obligations, and penalties and sanctions pronounced by a regulatory body Strategic risk is the risk of loss caused by a lack of a long-term development component in the bank’s managing team.  What risks do Banks have to manage? – Introduction to Capital and Basel The basic concept of Capital Ratio has been around for years – i.e. bankers lend money, and some people Will default. Does this mean that Banks cannot repay depositors? The buffer, the money the bank can rely on is its capital There shd therefore be a prudent relationship between capital and lending – that is the capital ratio The idea of relating capital to lending has to be extended to capital to assets However all of assets are not the same for this purpose – what is the default risk of cash? Surely none. This is called Risk Weighted Assets (RWA) – i.e. the weight each of the asset shd have when measuring the capital needs Each lending activity generates a capital demand and the way to calculate it is through the issue of risk weighted assets - the capital ratio is determined by applying the risk weighting to the notional lent Basel Each central bank had different rules as to how to weight each asset, and therefore as to how to calculate the capital required In 1974 the G10 nations set up the Basel Committee to draw up uniform rules  What risks do Banks have to manage? – Introduction to Capital and Basel (contd.) In 1988 the Committee announced an agreement on uniform rules for capital ratio Definition of “capital” – the “best” capital is called “Tier 1”, and it consisted of Shareholders equity Retained profits Non-cumulative perpetual preference shares “Tier 2” capital was the remainder and included Cumulative perpetual preference shares Revaluation Reserves Undisclosed Reserves Subordinated term debt with maturity beyond 5 years The risk-weighting figures were agreed as well, and were applied not only to on-balance sheet items, but also to off-balance sheet items that involved risk (loan guarantees, standby letters of credit, derivative products –options, futures, swaps, etc) Being aware of the capital rules, banks have become more disciplined when awarding credit, being conscious of the impact on its operating profit. Every transaction must meet the bank´s target for profit on capital employed  Regulation of Credit Institutions – Overview of Basel And other central banks… Who controls Central Banks? They control themselves through the BIS Federal Federal Federal Federal reserve Formerly, the Basel Committee consisted of representatives from central banks reserve reserve reserve and regulatory authorities of several countries. The committee does not have the authority to enforce recommendations. A summary of its recent recommendations: Bank for Basell I (Publish in 1988) Minimal capital requirements International Settlements depending on the risk exposure. Capital = 8% assets weighted (5 categories with different weights: 0%, 10%, 20%, 50%, 100% -) European Central Basel II international regulation (Basel II framework agreement Bank (ECB) approved by the Basel Committee on Banking Supervision on June 26th 2004) La Banque Basel III framework agreement, approved by the Basel de France National Bank Committee on Banking Supervision in December 2010 and partly of Belgium reflected into Spanish law through RD 2/2011. Basel III is Banco de España completely reflected into European Law through REGULATION (EU) Nº 575/2013, issued on June 26th 2013  Regulation of Credit Institutions – Basel I 1988 - Why Basel I was needed? The reason was to create a level playing field for “internationally active banks” Banks from different countries competing for the same loans would have to set aside roughly the same amount of capital on the loans. (Became effective at the end of 1992). Capital was set at 8% and was adjusted by a loan’s credit risk weight. Credit risk was divided into 5 categories: 0%, 10%, 20%, 50%, and 100%. 0% Risk Weight: Cash, Claims on central governments and central banks denominated in national currency and funded in that currency Other claims on OECD countries, central governments and central banks Claims collateralized by cash of OECD government securities or guaranteed by OECD Governments 20% Risk Weight Claims on multilateral development banks and claims guaranteed or collateralized by securities issued by such banks Claims on, or guaranteed by, banks incorporated in the OECD Claims on, or guaranteed by, banks incorporated in countries outside the OECD with residual maturity of up to one year Claims on non-domestic OECD public-sector entities, excluding central government, and claims on guaranteed securities issued by such entities Cash items in the process of collection  Regulation of Credit Institutions – Basel I (contd.) 50 % Risk Weight Loans fully securitized by mortgage on residential property that is or will be occupied by the borrower or that is rented. 100% Risk Weight Claims on the private sector Claims on banks incorporated outside the OECD with residual maturity of over one year Claims on central governments outside the OECD (unless denominated and funded in national currency) Claims on commercial companies owned by the public sector Premises, plant and equipment, and other fixed assets Real estate and other investments Capital instruments issued by other banks (unless deducted from capital) All other assets At National Discretion (0,10,20 or 50%) Claims on domestic public sector entities, excluding central governments, and loans guaranteed by securities issued by such entities The approach in setting credit risk weights was too simplistic as it ignored other types of risk  Regulation of Credit Institutions – Basel II Implementation of the Basel II Framework took place between 2007 and 2009. Basel-II consisted of three pillars: Minimum capital requirements for credit risk, market risk and operational risk—expanding the 1988 Accord (Pillar I) Supervisory review of an institution’s capital adequacy and internal assessment process (Pillar II) Effective use of market discipline as a lever to strengthen disclosure and encourage safe and sound banking practices (Pillar III) PILLAR I: Minimum Capital Requirement PILLAR 2: Supervisory Review Process PILLAR 3: Market Discipline 1) Capital Measurement: New Methods 1) Banks are advised to develop an Aims to reinforce market discipline 2) Market Risk: In Line with 1993 & 1996 internal capital assessment process through enhanced disclosure by 3) Operational Risk: Working on new methods and set targets for capital to banks. It is an indirect approach, that commensurate with the bank’s risk assumes sufficient competition profile within the banking sector. Capital 2) Supervisory authority is responsible MCR = ³ 8% Credit Risk + Market Risk + Operational Risk for evaluating how well banks are assessing their capital adequacy Regulation of Credit Institutions – Basel III  Regulation of Credit Institutions – Basel III (contd.) Capital Given the basic equation: ³ 8% Credit Risk Basel III modifies the definition of three concepts. (Capital, credit risk and the minimum level of capital) New definition of capital (quality) Total capital = Tier 1 + Tier 2 Tier 1 Capital = Common equity Tier 1 + Additional Tier 1 Common equity Tier 1: common shares, retained earnings, disclosed reserves Additional Tier 1: includes unsecured perpetual hybrid instruments, junior to subordinated debt Tier 2: unsecured subordinated debt, minimum maturity of 5 years Tier 1 Tier 2 Total Common Equity Tier 1 Capital Capital Capital Credit risk 4.5 6.0 2.0 8.0 Enhanced coverage for: Minimum level of capital (within parentheses Basel II requirements) (2.0) (4.0) (4.0) (8.0) Securitisation. Trading book. Conservation buffer: 2.5% composed of common equity. To smooth banks’ Counterparty credit risk idiosyncratic pro-cyclicality: banks are not obliged to raise new capital but they re-build the buffer by limiting distribution of earnings Countercyclical buffer: 0% – 2.5% of fully loss absorbing capital instruments. To smooth system-wide pro-cyclicality  Other Relevant Regulation Single Banking License at the European Union: The single license authorizes a bank established in a Member State to open branches without any other formalities or to propose its services in the partner countries. Banking Union process in the UE (Day 4) 1) The Single Supervisory Mechanism (SSM), based in Frankfurt. 2) The Single Resolution Mechanism (SRM) 3) The Single Rulebook. One single regulation as regards capital requirements and bank insolvency procedures to be implemented throughout all member states. Deposit Guarantee Fund The aim of the Deposit Guarantee Fund is to protect account holders The Fund is a legal entity managed by a Comisión Gestora, whose members are appointed by the Bank of Spain and the member banks Member banks contribute annually to the Fund with a percentage of their total deposits The 2009 EU Directive unified the minimum coverage level of guaranteed deposits. Therefore, at present, all national funds must guarantee minimum deposits of €100,000 per saver and bank  First steps with accounting How is the balance sheet of a Credit Institution (banks and equivalents)? Assets - Cash - Central Bank deposits - High liquidly products (ej: gob. bonds) - Loans (secured –eg: mortages– or unsecured –consumer loans –) - Other Investment products A liability for a company is an asset for the creditor bank. Margin = X – Y % Liabilities - Customer deposits on demand - Customer saving deposits - Central bank loans - Interbank market funding - Issued bond and debt certificates Equity - Social capital & reserves Return = X% Cost = Y%  What are the risk Banks have to manage? – Introduction to Capital and Basel Basel III – Dec 2010 Liquidity and credit risk. Requirements for common equity and Tier 1 capital will be 4.5% and 6%, respectively. The liquidity coverage ratio(LCR) will require banks to hold a buffer of high quality liquid assets sufficient to deal with situations like "Bank Run". Leverage Ratio > 3%:The leverage ratio was calculated by dividing Tier 1 capital by the bank's average total consolidated assets;. Just an introduction, we will see it with more detail. Source: Asymptotix (The Riksbank: Basel III - tougher rules for banks)  Stress Tests The objective of the EU-wide stress test is to provide supervisors, banks and market participants with a common analytical framework to consistently compare and assess the resilience of large EU banks and the EU banking system to adverse economic shocks. The 2016 EU-wide stress test does not contain a pass fail threshold and is designed to be used as a crucial input into the SREP (Supervisory review and evaluation) in 2016, with the primary aim of setting Pillar 2 capital guidance although no supervisory actions are precluded. The stress test exercise is based on a common methodology and scenarios, and is accompanied by uniform data templates that capture starting point data and stress test results to allow a rigorous and comparable assessment of the banks in the sample. The EBA was responsible for coordinating the exercise and for the final dissemination of the results in line with its commitment to enhancing the transparency of the EU banking sector. Competent authorities were responsible for assuring the quality of the results and are responsible for any necessary supervisory follow-up measures as part of the SREP. Recovering the confidence in the system The adverse scenario implies EU real GDP growth rates over the three years of the exercise of -1.2%, -1.3% and 0.7% respectively –a deviation of 7.1% from its baseline level in 2018. It assesses 51 banks from 15 EU and EEA countries – 37 from SSM countries and 14 from Denmark, Hungary, Norway, Poland, Sweden and the UK. (29 of July 2016)  What´s Next on Regulation Regulation will continue to broaden and deepen Why? – to prevent another GFC similar to the one happened in 2008 Technology and advanced analytics are evolving (Big Data, machine learning, crowdsourcing…) And new risks are emerging… as example (from McKinsey&Company): Model risk. Banks’ increasing dependence on business modeling requires that risk managers understand and manage model risk better. Although losses often go unreported, the consequences of errors in the model can be extreme. For instance, a large Asia–Pacific bank lost $4 billion when it applied interest-rate models that contained incorrect assumptions and data-entry errors. Risk mitigation will entail rigorous guidelines and processes for developing and validating models, as well as the constant monitoring and improvement of them. Cybersecurity risk. Most banks have already made protection against cyberattacks a top strategic priority, but cybersecurity will only increase in importance and require ever greater resources. As banks store an increasing amount of data about their customers, the exposure to cyberattacks is likely to further grow. Contagion risk. Banks are more vulnerable to financial contagion in a global market. Negative market developments can quickly spread to other parts of a bank, other markets, and other involved parties. Banks need to measure and track their exposure to contagion and its potential impact on performance  General view of the sector: Spain Types of credit institutions: – Banks – Savings banks (have almost disappeared following the 2008-2013 crisis) – CECA. Confederación Española de Cajas de Ahorro – Now Asociación Bancaria) – Credit Co-operatives. are linked either to the rural or professional environments: “Cajas Rurales”, Caja Laboral, etc. – ICO. is a Public entity whose aim is to finance selected projects and business sectors at a cost below market. ICO cannot fund itself with deposits – Establecimientos Financieros de Crédito (EFC) Bailouts he Spanish to the Spanish banking system banking system Bailouts to the Spanish banking system (Total bailout = Eur 61.3 billion approximately) Popular 181.641 Total Assets Bankia 226.457 (Consolidated data) 31% M€- June 2016 36% Bankia Sabadell 231.342 36% Bankia Catalunya Banc Catalunya Banc Caixabank 392.942 NCG Banco NCG Banco Other BBVA 830.197 Other Santander 1.494.390 13% 20% 20%  General view of the sector: Europe Total assets, US$b Rank Bank Country (June 30, 2016) 1 HSBC Holdings UK 2,608.15 2 BNP Paribas France 2,417.00 3 Deutsche Bank Germany 2,006.71 4 Credit Agricole Group France 1,970.40 5 Barclays PLC UK 1,819.61 6 Societe Generale France 1,624.97 7 Banco Santander Spain 1,494.39 8 Groupe BPCE France 1,357.34 9 Royal Bank of Scotland UK 1,214.11 10 Lloyds Banking Group UK 1,142.22 11 UBS Group AG Switzerland 1,010.34 Market cap, 12 UniCredit S.p.A. Italy 992.040 Rank Company Country EUR billion 13 ING Group Netherlands 985.566 14 Credit Suisse Group Switzerland 838.547 1 HSBC Holdings UK 117.06 2 Banco Santander Spain 63.22 15 BBVA Spain 830.197 3 Lloyds Banking Group UK 62.11 4 BNP Paribas France 58.14 5 UBS Switzerland 56.85 6 ING Group Netherlands 43.94 7 BBVA Spain 41.19 Thank you