MFI Partial 1 PDF

lOMoARcPSD|16455129 MFI Partial 1 Management Of Financial Institutions (Università Commerciale Luigi Bocconi) Studocu non è sponsorizzato o supportato da nessuna università o ateneo. Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 Management of Financial Instituti...

lOMoARcPSD|16455129 MFI Partial 1 Management Of Financial Institutions (Università Commerciale Luigi Bocconi) Studocu non è sponsorizzato o supportato da nessuna università o ateneo. Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 Management of Financial Institutions PARTIAL ONE FUNDING PART1: Deposit services Funding Structure​: ​Why structure is important? Commercial banks form their BS in layers from most stable to most volatile. Equity related instruments (common & preferred stocks and RE, subordinated debt and LT senior debt) - Customer deposits (retail funding): most circumstances stable - Borrowed, purchases or wholesale funding: ST liabilities (Fed funds, Repos, Large CDs, Commercial Papers) - Flexibility VS stability Why is retail funding more stable than wholesale funding? - Low IR sensitivity: depositors loyal to bank (especially for small amounts) - Low sensitivity to changes in the bank credit risk (deposits are insured) - Pooled and managed according to law of large numbers Why is wholesale funding more volatile than core deposits? - Commonly short or very short maturity (overnight) - Funds “Purchased” at market IR - Commonly unsecured ⇒ Large banks buy “​ Funding at the margin”, meaning that they pay market rates on a greater proportion, with less customer loyalty and greater sensitivity to changes in mkt IR and the borrower’s credit worthiness. ​Wholesale funding based banks are more exposed to liquidity and IR risks but relatively more flexible. MANAGING DEPOSITS Transaction deposits​: non-interest bearing (checking account: demand deposits) // interest bearing (negotiable order of withdrawal -NOW- accounts, money market deposits accounts -MMDA) Non-transaction savings deposits​: Passbook savings deposits, time deposits (eg. certificate of deposits) ⇒ Longer term, higher IR than transaction deposits, less costly to manage PRICING DEPOSITS - Relatively low cost source of funding (limited interest expenses), - May entail operational costs (check processing, maintenance costs) - Can generate fees associated with payment services Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 ⇒ Important because of marketing mix ⇒ different pricing strategies - Cost-plus profit margin (​how to set fees?​) Deregulation has brought more frequent use of unbundled service pricing as greater competition has raised the average real cost of a deposit for deposit-service providers. - Marginal cost (​how to set IR?​) In order to know what IR should the bank offer to its customers, we need to know: ​the marginal cost ​of moving the deposit rate from one level to another and the ​marginal cost rate ​as a % of the volume of additional funds coming into the bank. - Conditional and relationship pricing, ​Segment-based Deposit → Type of customer each depository institutions plans to serve → Cost of serving different type of depositors Deposit pricing require detailed client segmentation in order to protect:target high quality customer relationship ⇒ CONDITIONAL & RELATIONSHIP pricing Conditional pricing:​ depositary sets up a schedule of fees in which the customer pays a low fee or no fee if the deposit balance remains above a min level, but faces higher fee if the average balance falls below that min. Technique may vary based on 1 or more factors: number of transactions passing through the account, average balance help in the account over a period (month), maturity of the deposits Relationship pricing:​ targeting best customers for special treatment: pricing deposits according to the number of services the customers uses. ⇒ promotes greater loyalty and makes customers less sensitive to the porches postes on services offered by competitors. Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 PART2: Non deposits Liabilities What does management do to find new money when deposits volume is inadequate to support all loans and investments they would like to make? The Customer Relationship Doctrine - First priority of lending institutions is to make loans to all customers from whom lender expects to receive positive net earnings - Lending decisions often precede funding decisions: all loans and investments whose returns exceed their cost and whose quality meets the lending instituion’s credit standards should be made LIABILITY MANAGEMENT - Strategy in which bank buys funds in order to satisfy loan requests and reserve requirements - Interest-sensitive approach to raising bank funds - Flexible: bank decide exactly how much it needs and how long ALTERNATIVE NONDEPOSIT SOURCES OF FUNDS FACTS: The usage of non deposit funds has risen esp for large institutions over time → trend has reverted since global financial crisis 1) Federal Funds Market (US) Borrowing from Federal Reserve Banks: immediately available reserves are tarded btw financial institutions and usually returned within 24h. Types of Fed Funds Loan Agreements: - Overnight loans: negotiated via FedWire or phone, returned next day, usually not secured by collateral - Term Loans: longer term Fed Funds contracts - Continuing contracts: automatically renewed each day, normally btw smaller institutions and their larger correspondents 2) Eurosystem - EU equivalent of Federal Funds Market TARGET2: European FedWire, owned and operated by Eurosystem. Leading EU platform for processing large value payments and used by both Central banks and commercial banks to process payments in euro in real time. 3) Repurchase Agreements (RPs) With RPs, the purchaser of Fed funds provides collateral in the form of marketable securities, reducing credit risk. Most domestic RPs transacted across Fedwire RP transactions often overnight funds Cost of RP: Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 4) Borrowing from CB (US) Fed makes the loan through its discount window by crediting the borrowing institution’s reserve account. Each loan made by the Fed Reserve must be backed by collateral acceptable to the Fed. 3 lending programs available from Fed’s discount window - Primary credit: rate slightly higher than fed funds rate (for ins in safe financial condition) - Secondary credit: available very St at a higher rate and haircuts on collateral. Made to institutions not qualifying for primary credit - Seasonal credit: longer periods than primary credit. For small and medium inst (<$500M) experiencing seasonal swings in deposit and loans. Lowest IR among 3 lending programs. 5) Borrowing from ECB (EU) Main lending program: European “Primary Credit” → Borrowing for one week at the “main refinancing operations” (MRO) rate. Collateral always required. → Borrowing overnight at the “marginal lending facility” (MLF) rate, which costs banks relatively more than if they borrow for one week (collateral also required) 6) Development and Sale of Large Negotiable CDs (certificate of deposits) Interest bearing receipt evidencing the deposit of funds in the bank for a specified period of time for specific IR. Hybrid because legally a deposit. Interest rates on fixed-rate CDs are quoted on an interest-bearing basis and the rate is computed assuming 360day days. ⇒ Rpz majority of negotiable CDs issued. How much will the depositor receive at maturity? 7) Long-Term Non Deposits Funds Sources More common in European banks, it includes subordinated debt and covered bonds (medium to lt debt “backed by a special pool of collateral on chich investors have a priority claim” Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 **Factors to consider when using non deposit funding sources: relative cost of each source, risk, maturity x which funds are needed, size of borrowing bank, regulations LENDING Relevance, Policies and Products Why is lending important? Banks: High profitable asset (interests and fees → NI and Op income) + loans make deposit Economic function: support growth of new businesses + financial intermediation: banks’ specialness: information provider Banks’ specialness:​ reducing information asymmetry between suppliers and users of funds → Ex ante: adverse selection → lender that sets one price for all borrowers runs risks of being adversely selected by low quality clients → Ex post: moral hazard → the borrower may have incentive to act inappropriately if his and and lenders’ interest are not aligned Banks as information providers:​ SME: opaque borrowers, large firms borrow from banks too. Credit Risk: ​main source of risk in lending → borrower is does not fulfill terms of loan agreement How banks manage credit risk? -​Individual level: ​evaluate borrower’s ability and willingness to repay loan ⇒ CREDIT PROCESS 1) Ex ante: Credit Analysis 2) Ex post: Credit Review (monitoring) 3) Credit Workout NPLs: how to handle problems loans: modification of the terms of the loans agreements, obtain additional guarantee, call the loan, loan recovery through different procedures (legal enforcement, asset sale etc..)* -Portfolio level: Aims/decisions: size/ growth rate How: originating new loans, replacing old loans with new ones, active loans portfolio management through Credit Risk Transfer (CTR) tools. Credit Analysis (the screening phase) Consist of assessing borrower’s creditworthiness in order to avoid loans errors → making loan to customer who will default, denying loan to customer who would ve repay debt Procedure: collect information, evaluate company/management/industry in which it operates, project borrower’s cash flow ​(first source of repayment​), evaluate collateral (​secondary source of repayment​), analysis x risk classification, draft loan agreement Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 Risk classification: ​system comprises series of rating grades that differentiate levels of credit risk. A bank’s loan classification system varies according to the bank’s size, sophistication and complexity, and the nature of its lending activities. Rating grades may be startifies into broad risk bands :* - Performing loans: range form undoubted loans to other loans that are fully performing but at consecutively higher levels of risk - Potential problem loans: loans developing early warnings signs of problems, early stages of delinquency prior to being recognized as impared and loans having other issues that need closer monitoring - Non performing loans: loans require specific provisions Parts of typical loan agreement: The Promissory Note, Loan Commitment Agreement, Collateral, Covenants (affirmative, negative), Borrower Guaranties or Warranties, Events of Default ⇒ Common pitfall: to focus too much on collateral rather on borrower”s ability to generate cash flows Collateral: → Assets: several possible types, both “physical” and financial (uncollected receivables, plant, marketable inventory, equipment …) → Personal guarantees: the bank needs to assess the guarantor standard → Main features of assets as collateral - Value: in principle market value should always exceed the outstanding principal on a loan ⇒ the lower the loan-to-value (LTV) ration, the more likely the lender can sell the collateral for more than the balance for its sale - Marketability: have a ready market for its sale - Legal Structure: lender should be able to easily take possession of the collateral ⇒ Collateral secondary source of repayment because cash is preferred and it’s costly and lengthy Covenants​: Arrangements aims to protect against changes in the borrower’s operating environment that damages bank’ interests → Positive: indicate specific provisions to which the borrower must adhere → Negative: Indicate financial limitations and prohibited events Monitoring Monitoring performance of existing loans: loans repayment schedule (payments delayed?), covenants (violated?), quality and condition of collateral (kept in good conditions? Mkt price reduced?), evaluation of borrower’s financial conditions (any major event in industry/ company) Loan workouts:​ Process of recovering funds from a problem loan situation Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 What steps should a lender take when a loan is in trouble? ​Goal: maximize full recovery of funds Downgrading, modification of terms of the agreement, call of the loans (immediate payment required), procedures for loan recovery → Restructuring the loan: deferring interest and principal payments, length in maturities liquidating unnecessary assets, providing new funds → Judicial enforcement → Extra-judicial proceedings: negotiation between debtor and creditor → Market solutions, by selling/securitizing the stock of NPLs ISSUES with Credit Process → Credit process accuracy varies across banks, depending on loan officer’s experience, loans amount and type, bank loan policy, credit philosophy/culture, qualite of data provided → Case of highly opaque borrowers: too much focus on collateral (subprime) → When credit process is poor: potential inefficiencies in credit market: - Credit rationing: lower loan amount, higher IR, larger collateral than necessary → allocation mechanism inefficient - Zombie lending: when banks do not recognize troubled loans as NOP, but try to keep them alive to avoid coser supervisory scrutiny BUSINESS LOANS Short- Term Business Loans - Self-Liquidating Inventory Loans​: loans used to finance purchase of inventory and repaid by assets it is used to purchase → quick & reliable to generate cash ⇒ take advantage of ​normal cash cycle of business - Working Capital Loans:​ can last for few days to 1 year, secured by accounts receivable or by pledges of inventory, floating IR, commitment fee is charged on the unused portion of the credit line and sometimes on whole loan available - Revolving Credit Finance: ​allows customer to borrow up to a pre specified limit, repay all or a portion of the borrowing, and reborow as necessary → one of the most flexible unsecured loan (can be ST or LT up to 5years) LT Business Loans Term Business Loans​: LT business inv such as purchase of equipment for construction of physical facilities ⇒ period >1y, commonly collateralized, repaid through installments BANK’S CAPITAL Equity capital is a “cushion” that protects liability holders from unexpected losses affecting bank’ assets. Why worry about bank capital? Banks take risks, but they are “fragile” and risks taken affect profitability and net worth. Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 Moral Hazard drives banks to hold low level of capital ( Toobigtofail) - Limits losses arising from deposit insurance claims - Long term source of funds - Promotes public confidence: reassure debt holders - Reduces the conflict of interest btw shareholders and liability holders How much capital to hold? AC: available capital EC: economic capital Regulators prefer more capital, but banks prefer to operate with lower levels of capital than socially optimal because because lower capital increases ROE Basel Agreements: ​ensure that financial institutions have enough capital to meet obligations and absorb unexpected losses with respect to 3 main category of risk: Credit Risk, Market Risk, Operational Risk TOTAL RISK BASED CAPITAL RATIO: Regulatory Capital= Tier1 + Tier 2 Tier1 Capital (CET1 + AT1)⇒ Capable of absorbing losses under going-concern conditions - Common Equity Tier1 (CET1): sum of common equity Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 - Additional Tier 1 (AT1): capital instruments with no fixed maturity and no incentives to redeem, may be callable at the initiative of the issier only after a min of 5y, coupon payments no mandatory Tier 2 (T2, supplementary capital) ⇒ capable of absorbing losses in the event of a crisis - Long term subordinated debts - No incentives to redeem - May be callable at the initiative of the issuer only after a min of 5 years RWA - Credit Risk Credit Risk: ratings Each bank can choose method to measure risk exposure: → The standard method: simplest approach. External rating given by credit agencies → Method base on internal ratings “IRB” approach: allows banks to assign a rating to each counterparty resulting from an internal process of measuring the borrower’s creditworthiness (allows more adequate measurement// needs approval bc possibility to cheat) RWA- Market Risk Market RIsk: risk of changes in the mkt value of an instrument or portfolio of financial instruments, connected with unexpected changes in market conditions. ⇒ Amount of capital required to cover unexpected losses due to market risk measured with VAR models RWA - Operational Risk → Risk of loss resulting from inadequate or dysfunction of human resources or failures of processes and systems, or from external events. Second most important risk after credit risk (eg. fraud, aging, natural disaster …) Capital required to protect again op risk determined by Basic Indicator Approach: capital is equal to a fixed % of gross income) Basel III: Objectives - Strengthen global capital and liquidity rules with the goal of promoting a more resilient banking sector - Improve banking sector ability to absorb shocks from economic stress (reduce risk of spillover form financial sector to real economy) - improve risk management and governance as well as strengthen bank’s transparency and disclosures (market discipline) - Strengthen the resolution of systemically significant cross-border banks Main measures: - Considerably increase the quality of banks’ capital - Significantly increase the required level of their capital as well as stricter and common guidance on RWAs Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 - - Reduce systemic risk (​systemic risk is a risk that an event will trigger a loss of confidence in a substantial portion of the financial system that is serious enough to have adverse consequences for the real economy) Increase risk coverage Introduce liquidity requirements Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 BANKS’ ASSET QUALITY Part1 Classification and Measures Bad loans: exposures to insolvent debtors (even if insolvency has been yet declared by court) Unlikely to pay: exposure other than bad loans, where according to the bank the debtor is unlikely to pay its credit obligation in full, without embarking on actions such as realization of collateral Past Due: exposures other than Bad loans and Unlikely to pay, which at the reference date are more than 90 days past du and exceed a given material threshold ⇒ NPL Asset quality assessment → loan loss provisions → impact on net income/ loss → impact on capital Part 2 Current Banking sector challenges: Low IR environment and high competition on commission income penalize banks’ core profitability.​ ⇒ Interest income revenue is constantly decreasing, for commercial banks net interest income represents at least 50/60% of total revenue. Still heavy cost structures​: high fixed costs, with a widespread branch presence in the territory// new technologies and more sophisticated clients requiring massive IT investment, new digital platform, employees Asset quality:​ most relevant issue affecting EU banks in the past few years. Provisions on bad loans have wiped out banks’ core profitability. Coverage levels of non-performing loans have reached ~46%. Solving the asset quality issue could restore confidence in the banks and lead to a re-rating of the entire sector. Covid19 → New NPE formation + delay in collections of existing NPE Capital:​ Capital ratios improved in the last few years following a series of extraordinary actions undertaken by EU banks. However much stricter requirements are and will be applied to banks. Asset quality and capital are interconnected. Regulatory uncertainty and “cost of regulation​”: rapid evolving environment → increasing regulatory costs// National/ Cross border M&A could be a way to solve some of the issues identified. ⇒ Banking sector stock re-rating cannot happen without first solving the asset quality and profitability issues Key relationship: Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 Asset quality → profitability: ROE → P/ TBV (tangible book value) Market trading and stock Re-rating ROE - P/TBV ​Relationship Methodology A Where: TBV per Share = tangible book value / nb of shares EPS = earning per share → NI/ nb of shares Positive Correlation between ROE and P/BV (TBV), the higher the ORE the higher the P/BV multiple This relationship is studied by hedge funds, portfolio managers in the stock selection ROE - P/TBV Relationship Methodology B → Price of a stock can be expressed using the stable growth dividend discount model PBV ratio is an increasing function of: ROE, long term/stable growth rate, payout ratio PBV ratio is a decreasing function of the risk of the firm Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 Bottom line consideration: if a company is able to outperform its cost of equity (ROE > Ke), it should be trade above BV It is therefore not surprising that stocks of banks with poor ROE (below Ke) are trading at multiples P/BV < 1 Simplified Economic Impact from Selling Non-Performing Loans Removing non-performing exposures from banks’ balance sheet has several benefits including: RWAs release, Improvement of capital ratios (depending on sale price), improvement of asset quality indicators/ market perception, remove the risk of further credit deterioration/ increase of coverage → potentially less loan loss provisions and consequently higher profirst and ROE What if banks are not selling NPE portfolios at carrying value? Carrying Value = Gross NPL * (1- Cash Coverage)= Net Non Performing Exposure IF Sale Price < Carrying Value → P&L Losses for the bank arise Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 The Investment Functions in Financial Services Management Investment Function, why is it important? → Buy and sell bonds/ investment instruments is not primary function of most banks → So why are banks not allocating their funds only to loans? ⇒ Liquidity // risk // diversification // tax efficiency // stabilize income etc…. → in general ⅕ up to ⅓ of all assets of a bank are allocated to investments in securities that are under the management of investment officers: Government bonds and notes, corporate bonds, ABS, etc.. Crossboards accounts: investments held by depository institutions stand between cash, loans, and deposits Available investment instruments Money Market instruments - Reach maturity within 1 year - Low risk - Ready marketable/ liquid Popular instruments: Treasury Bills: → T-bills, ST gov bonds (in IT: BOT), ST maturity since inception, high degree of safety, liquidity, could be used for collateral borrowing, issued at discount to par ST Treasury Notes and Bonds → Have relatively long original maturities: notes 1 to 10 yrs, Bonds > 10 yrs. However when these securities come within 1 year of maturity → MM instruments Coupon instruments, could be used for collateral borrowing, (in IT: BTP) Federal Agency Securities → Marketable notes and bonds sold by agencies owned by or sponsored by the federal government Explicit gov guarantee? Not always, although investors believe congress would rescue an agency in trouble → which are the implications? Agency yields in line with those treasury securities + high liquidity Could be used for collateral borrowing, ( in IT Cassa depositi e Prestiti) Also certificates of deposits, eurocurrency deposits, banker’s acceptances, commercial paper, ST muni obligations Capital market instruments - Reach maturity beyond 1 year Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 - Expected high return Liquidity vs Market volatility Popular market instruments Corporate Notes and Bonds → Corporate notes → maturity within 5 years → Corporate bonds → mat > 5 years Higher pre-tax yields vs govies // Ability to sustain banks’ interest income, especially during low interest rates periods // Taxable income Investment Maturity Strategies Once the investment officer chooses the type of securities he or she believes a financial firm should hold, it remains the question on how to distribute those securities over time: what maturities of securities should the investing institution hold? STRATEGIES: 1) The Ladder or Spaced Maturity Policy Choose a maximum acceptable maturity Advantages: simple/ reduce investment income fluctuations/ flexibility, take advantage of other investment opportunities 2) The Front- End Load Maturity Policy strategy” Short term strategy Mainly a “liquidity - Advantages: simple, strong liquidity, limited exposure to IR fluctuations Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 3) The Back End Load Maturity Policy → Long term strategy → Investment portfolio as a “source of income” Adv: maximize income potential Important: availability of other source of funding to satisfy short term liquidity assets 4) The Barbell Strategy → Combination of long term and short term strategy → No holdings at intermediate maturities Advantages: be covered in case short term liquidity needs arise, be exposed to some income potential 5) The rate Expectation Approach - Decide and adapt investment strategy based on expectations / forecasts on IR movements Advantages: Maximize returns / opportunity Points of attention: high risk/ reliance of forecasts and complex strategy High transactions costs to switch the investment portfolio Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 LIQUIDITY AND RESERVES MANAGEMENT: STRATEGIES & POLICIES LIQUIDITY POSITION Financial institutions' Treasury function, know firm net liquidity position → Regulatory framework ⇒ to prevent liquidity risk → Remain a profit oriented institution ⇒ Plan for a liquidity rescue plan Supplies of liquidity flowing into the financial firm - Positive changes if liabilities: incoming deposits, bonds issuance etc.. - Negative changes of financial assets: customer loan repayments, sale of securities, etc.. - Sale of real assets: sale of real estate - Borrowings from the money market/ paid capital increases - Revenues from the sale of nondeposit services: commissions, dividends etc.. Demand on the financial firm for liquidity - Negative changes of liabilities: deposits withdrawals, bonds repayment, etc… - Positive changes of financial assets: granting of loan, acquisition of securities, etc.. - Acquisition of real assets: acquisition of real estate - Financial costs: dividend payments to stockholders, interest expenses - Non financial costs/ operating expenses: salaries, rent, etc.. - taxes ⇒ These various sources of liquidity demand and supply come together to determine each financial firm’s net liquidity position at any moment in time That net liquidity position (L) at time t is: Liquidity deficit is Lt<0 and Liquidity Surplus is Lt > 0 LIQUIDITY MANAGEMENT STRATEGIES 1) Asset Liquidity Management ( or Asset Conversion Store liquidity in assets, predominantly in cash and marketable securities. When liquidity is needed, selected assets are converted into cash until all demands for cash are met. Needed features: ready market, stable price (deep mkt), reversible (limited risk of loss) ⇒ Simple strategy, with limited risk BUT transaction costs, low returns, once assets are sold they're gone Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 2) Borrowed Liquidity (Liability) Management Borrow immediately spendable funds to cover all anticipated demands for liquidity Easy strat, advs: borrow when you need, no need to change asset composition, flexible However very risky bc IR are volatile and credit availability can change 3) Balanced Liquidity Management Mix of strategy 1 & 2. Part holding liquid assets, part borrowing Unexpected liquidity needs → addressed by ST borrowing Expected/ longer-term liquidity needs → planned / forecasted and specifically addressed Which are the most common methods for estimating financial institutions’ liquidity needs? 1) Sources and Uses of Funds Approach → Loans demand and deposits availability Understanding the concept of liquidity gap first: <0 or >0? STEP 1​: loans and deposit must be forecasted for a given time period Common practices is to break down forecasts into three components: - Trend - Seasonality - Cyclicality STEP 2​: the estimated change in loans and deposits must be calculated WHat should our liquidity manager do? Raise new funds in weeks 2,3,4 and 6 from the cheapest and most reliable funds sources and profitably invest the expected surplus in week 5 2) Structure of Funds Approach STEP 1:​ Classification of the banks’ liability based on liquidity criteria Eg. liability of bank divided into 3 categories based on liquidity STEP 2:​ Set up liquidity reserves against them Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 What if a good customer asks for a new loan? 3) Liquidity Indicator Approach → Estimating liquidity needs base on experience and industry average Adoption of certain liquidity indicators such as - Cash position indicator: Cash/tot A - Liquid securities indicator: cash and cash like securities/ Tot A ⇒ Business industry might be misleading Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 ANALYSIS OF BANKS’ FINANCIAL STATEMENTS PART 1 Who is interested in analysing banks’ financial statements? → Regulators, investors, auditors, equity research analysts, corporate finance advisors/ IB, competitors.. et Income ROE: N SH. Equity One on most synthetic measures to assess performances/ returns for banks’ shareholders Limits: - Bank’s riskiness is not part of equation - Might include extraordinary and non-recurring positive/negative items - Depends on banks’ assessment of credit quality - Limited time horizon VS sustainable profitability Which Financial Statements need to be analyzed? Consolidated or parent company accounts? → Depends on the objectives on the analysis: generally to gather comprehensive understanding of financial performance consolidated accounts need to be used as a base for analysis KEY PRINCIPLES for FI: IFRS/ IAS In Italy IFRS/ IAS needs to be adopted by - Publicly traded companies - Company issuing financial instruments osl to public - Banks and intermediaries - Insurance companies ANALYSIS OF BANK 4 main step should be followed; 1) Understand the bank's business model (commercial bank? IB? Universal bank?) 2) Based on their business modem, analyze main items (loan book, commission income etc..) + historical trend 3) KPIs analysis (profitability, capital asset quality, etc..) 4) Benchmarking analysis vs. peers BALANCE SHEET Assets: uses of funds Liabilities + Equity: sources of funds *** not all items are included (limitation) → In order to have better understanding divide each line of A by tot A and same for Lia Reclassification Methodology Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 ⇒ Interest Earning Assets (IEA) and Interest Bearing Liabilities (IBL) You separate assets that generate income from other and liabilities that have a cost from the others ( most common method of reclassification) IEA - IBL spread is a key components for bank’s income generation capacity IEA key element: LOANS (analysis of loan book important) IBL key component: Due to customers → most important indicator of bank’s funding strategy, long term ⇒ ++safe - Due to banks: how much bank relies on funding provided by other banks (less stable source of funding compared to deposits), during crisis interbank funding was close to 0, short term - Securities issued: debt issued by bank bought by investors → higher cost source of funding, medium term P&L Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 PART2 Financial Statement KPI - Business Model & Profitability - Capital & Leverage - Asset Quality 1) Business Model & Profitability ● N et Interest Income Net Interest Income Weight = T otal Operating Income ● and Commissions Income Net Fees and Commissions Weight = N et FTees otal Operating Income ● Net Trading and Other Operating Income Weight = N et T rading and Other Op Income T otal Operating Income ● Loans Loan to Deposit Ratio (LD Ratio)= Customer Direct F unding ​where ​Direct Funding = Customer Deposits + Securities Issued ● Income Positive Yield on Assets (A) = InterestInterest Earning Assets (avg) ● Negative/Cost/ Yield of Liabilities (B) = Interest Bearing Liabilities (avg) ● Interest Spread (Net Interest Margin) =​ Interest Spread (Net Interest Margin) = A - B ● Net Yield on Assets = Interest Expenses Op Expenses ● N et Operating Income T otal Assets (avg) ​where​ Net Operating Income = Tot Op Income - Operating Expenses Cost Income Ratio (excluding D&A) = T otal Operating Income Where ​Operating Expenses = Personal Expenses + Administrative Expense ​ ​ Cost Income Ratio (INCLUDING D&A) same where​ ​Operating Expenses = Personal Expenses + Administrative Expense + D&A P BT Extraordinary Items Contribution = N et Operating Income where : N ​ et Operating Income = Total Operating Income - Operating Expenses ● Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 ● Income Tax Impact = P rofNitetBef ore T ax ● Tangible SH’ Equity ( Not a KPI) = ​Shareholder’s Equity - Intangibles ● Pre Provisions Profit ( Pre tax, not a KPI)= ​Tot Op Income - Op Expenses + Other NetOp Income (Exp) ● I ROE = SH N Equity ● ROE (exLLPs) = ● I ROAE= SE N(avg) ● I ROTE= T angibleNSH Equity ● ROATE = T angible SHN IEquity (avg) ● ROA = T ot Assets ● NI ROAA = T ot Assets (avg) ● NI RORWA = Risk W eighted Assets (RW A) P re P rovisions P rof it pos tax SE NI 2) Capital & Leverage CET 1 Capital RW A ● CET1 Ratio = ● TIER 1 Ratio = ● Total Regulatory Capital Ratio = ● Capital Composition (Tier 1) = T otal Regulatory Capital T ier 1 Capital RW A T ier 1 + T ier 2 Capital RW A) T ier 1 Capital Scaricato da Giovanni Francesco Di Leo ([email protected]) lOMoARcPSD|16455129 CET 1 Capital ● Capital Composition (CET1) = T ier 1 Capital ● RWA Density = T otal Assets ● Leverage 1 = T angible SE T ot A ● Leverage 2 = T ot A SE ● Leverhae 3 = T angible SE ● Leverage 4 = RW A T angible A T angible SE RW A 3) Asset Quality ● Loss Reserve Cash Coverage Ratio = Gross NLoan on P erf orming Exposures ● Gross NPE Ratio = Gross Loans Gross N P E Where ​Gross Loans = Net Customer Loans + Loan Loss Reserve for NPE + Loans Loss Reserve for in-bonis N et N P E ● Net NPE Ratio = N et Loans ● Cost of Risk = ● NPE Texas Ratio = T angible SEGross + | loan loss reserve | ● I P BT ot A ROE Decomposition = PNBT * N et Op * TSE Income * T ot A ROE = ​ Tax Impact * Extra. Items Contribution * Net Yield on Assets * Leverage (2) Loan Loss P rovisions (@P &L)* 10000 Gross Loans ​ *usually in basis points (hence 10000) N et Op Income PARTIAL 2 - Scaricato da Giovanni Francesco Di Leo ([email protected])