Lecture 1 – THE BASIC BUSINESS MODEL (VARIETY IN BANKING, INTRO TO REGULATION)
3 measures of EQUITY:
1) Risk-adjusted equity - compares total adjusted capital to the institutions risk-
weighted assets. Risk-adjusted capital ratios are used to assess the capital adequacy
of a financial institution. How much equity it has for the amount of risk it has?
Analyzing these ratios can help determine whether a bank has enough capital to
withstand a downturn in the economy. Regulators look at this ratio.
2) Leverage (Gross Exposure or Max. Liability) - companies rely on a mixture of owners'
equity and debt to finance their operations. A leverage ratio looks at how much
capital comes in the form of debt (loans), or assesses the ability of a company to
meet financial obligations. It divides the accounting assets by the accounting equity
plus off-balance sheet risk; and because of the big denominator, the leverage ratio is
always lower.
3) Accounting - accounting ratios assist in measuring the efficiency and profitability of a
company based on its financial reports. An example of an accounting ratio is the P/E
ratio. This measures the price paid per share in relation to the profit earned per
share in a given year. Investors look at this ratio because shareholders care only
about returns.
Investors use Accounting Ratio!!!
COMMERCIAL BANKS’ 4 key PRODUCTS:
1) CREDIT PRODUCTS – allocation of resources from those who have to those who
need, and this comes with risk & reward
2) SAVINGS PRODUCTS – requires marketing and differentiation (safe-keeping of funds
= store wealth)
3) SERVICES/OPERATIONS – requires IT investments
4) CROSS-SELLING – sell more bank products to the same customer, and it requires
different channels for delivery of products
BANK BUSINESS MODEL – the plan implemented by a bank to generate revenue and make a
profit from operations. The model includes the components & functions of the business, as
well as the revenues it generates & expenses it incurs:
1) Environment: country, legal system, economy, demographics & culture
2) Banking industry: structure or system
3) Competition in the banking system
4) Government & regulatory strategies (similar or conflicting)
5) Market opportunities
6) Past performance of the bank
7) Governance & management culture
8) Management capability: risk experience, ambition & other personality
KEY Products of COMMERICAL BANKS:
1) CREDIT PRODUCTS – risk management, risk vs. reward
2) SAVINGS PRODUCTS – marketing, product differentiation
3) SERVICES/OPERATIONS – indirect products
4) CROSS-SELLING multiple products – channels for delivery
1
,CBs face challenges in terms of strategy and management. They have to decide whether
they want to be focused or diversified (product range); institutional or retail (customers);
and local or global (geography). Depending which one the banks chooses the risk & reward
will be different. It’s a decision about capital allocation (maximize return & minimize risk).
COMMERCIAL BANKS LOSE MONEY because:
1) OPERATIONS:
POOR COST MANAGEMENT
LOW INVESTMENT in IT – poor information handling system
WEAK SYSTEM
POOR RELIABILITY – low customer trust & confidence
2) RISK:
DECLINING RETURN
INCREASING FUNDING COSTS
EXTENTION TO NEW RISKS
FORBEARANCE – is when a bank provides a measure of support to a
borrower having difficulty meeting its credit obligation. With poor control, it
may result in delaying risk and loss recognition, which may eventually lead
to failure.
COMPETITION – in itself does not make an existing credit product more
risky, however, it is likely to make those products have lower prices. As a
result, (1) the returns may decline within the existing risk, and (2) the bank
extends its risk appetite to the ones that offer higher returns. Either strategy
will increase both the risks of the bank and costs of funding.
BIG vs. SMALL BANKS
BIG:
1. have money to invest in new products and technologies
2. gain efficiency through scale
3. have deeper management and expertise
4. have the ability to service the needs of multinational companies (MNCs)
5. they are better diversified because they serve many different markets with many
different products/services to withstand the risks of fluctuating economy. These
institutions are rarely dependent on the economic conditions of one nation
6. have access to broader funding markets at relatively low cost
7. BUT rely on insurance provided to too-big-to-fail banks
SMALL:
1) they struggle to afford the cost of new equipment and keep pace with new
regulations
2) the operations (and the performance) are monitored by people working in the
various department, and by the vice presidents. They report to senior management,
and the senior management in turn, reports to members of the BODs (selected by
shareholders)
3) significantly impacted by changes in the health of locally based businesses, so when
local sales are depressed, the bank often experiences slowed growth and its
earnings may fall
2
, 4) often limited opportunities for advancement or for the development of new skills.
Nevertheless, they represent attractive employment opportunities because they
place the banker close to customers and give employees the opportunity to see how
their actions can have a real impact on the quality of life in local towns. Unlike some
larger institutions, community bankers usually know their customers well and are
good at monitoring the changing fortunes of households and small businesses
5) committed to attracting smaller household deposits and making household and
small business loans
The general view is that, “BIGGER IS SAFER”, although SMALL BANK can be regarded as safe
if it is well managed.
OPERATING INCOME – FEES = NET INTEREST INCOME
3
3 measures of EQUITY:
1) Risk-adjusted equity - compares total adjusted capital to the institutions risk-
weighted assets. Risk-adjusted capital ratios are used to assess the capital adequacy
of a financial institution. How much equity it has for the amount of risk it has?
Analyzing these ratios can help determine whether a bank has enough capital to
withstand a downturn in the economy. Regulators look at this ratio.
2) Leverage (Gross Exposure or Max. Liability) - companies rely on a mixture of owners'
equity and debt to finance their operations. A leverage ratio looks at how much
capital comes in the form of debt (loans), or assesses the ability of a company to
meet financial obligations. It divides the accounting assets by the accounting equity
plus off-balance sheet risk; and because of the big denominator, the leverage ratio is
always lower.
3) Accounting - accounting ratios assist in measuring the efficiency and profitability of a
company based on its financial reports. An example of an accounting ratio is the P/E
ratio. This measures the price paid per share in relation to the profit earned per
share in a given year. Investors look at this ratio because shareholders care only
about returns.
Investors use Accounting Ratio!!!
COMMERCIAL BANKS’ 4 key PRODUCTS:
1) CREDIT PRODUCTS – allocation of resources from those who have to those who
need, and this comes with risk & reward
2) SAVINGS PRODUCTS – requires marketing and differentiation (safe-keeping of funds
= store wealth)
3) SERVICES/OPERATIONS – requires IT investments
4) CROSS-SELLING – sell more bank products to the same customer, and it requires
different channels for delivery of products
BANK BUSINESS MODEL – the plan implemented by a bank to generate revenue and make a
profit from operations. The model includes the components & functions of the business, as
well as the revenues it generates & expenses it incurs:
1) Environment: country, legal system, economy, demographics & culture
2) Banking industry: structure or system
3) Competition in the banking system
4) Government & regulatory strategies (similar or conflicting)
5) Market opportunities
6) Past performance of the bank
7) Governance & management culture
8) Management capability: risk experience, ambition & other personality
KEY Products of COMMERICAL BANKS:
1) CREDIT PRODUCTS – risk management, risk vs. reward
2) SAVINGS PRODUCTS – marketing, product differentiation
3) SERVICES/OPERATIONS – indirect products
4) CROSS-SELLING multiple products – channels for delivery
1
,CBs face challenges in terms of strategy and management. They have to decide whether
they want to be focused or diversified (product range); institutional or retail (customers);
and local or global (geography). Depending which one the banks chooses the risk & reward
will be different. It’s a decision about capital allocation (maximize return & minimize risk).
COMMERCIAL BANKS LOSE MONEY because:
1) OPERATIONS:
POOR COST MANAGEMENT
LOW INVESTMENT in IT – poor information handling system
WEAK SYSTEM
POOR RELIABILITY – low customer trust & confidence
2) RISK:
DECLINING RETURN
INCREASING FUNDING COSTS
EXTENTION TO NEW RISKS
FORBEARANCE – is when a bank provides a measure of support to a
borrower having difficulty meeting its credit obligation. With poor control, it
may result in delaying risk and loss recognition, which may eventually lead
to failure.
COMPETITION – in itself does not make an existing credit product more
risky, however, it is likely to make those products have lower prices. As a
result, (1) the returns may decline within the existing risk, and (2) the bank
extends its risk appetite to the ones that offer higher returns. Either strategy
will increase both the risks of the bank and costs of funding.
BIG vs. SMALL BANKS
BIG:
1. have money to invest in new products and technologies
2. gain efficiency through scale
3. have deeper management and expertise
4. have the ability to service the needs of multinational companies (MNCs)
5. they are better diversified because they serve many different markets with many
different products/services to withstand the risks of fluctuating economy. These
institutions are rarely dependent on the economic conditions of one nation
6. have access to broader funding markets at relatively low cost
7. BUT rely on insurance provided to too-big-to-fail banks
SMALL:
1) they struggle to afford the cost of new equipment and keep pace with new
regulations
2) the operations (and the performance) are monitored by people working in the
various department, and by the vice presidents. They report to senior management,
and the senior management in turn, reports to members of the BODs (selected by
shareholders)
3) significantly impacted by changes in the health of locally based businesses, so when
local sales are depressed, the bank often experiences slowed growth and its
earnings may fall
2
, 4) often limited opportunities for advancement or for the development of new skills.
Nevertheless, they represent attractive employment opportunities because they
place the banker close to customers and give employees the opportunity to see how
their actions can have a real impact on the quality of life in local towns. Unlike some
larger institutions, community bankers usually know their customers well and are
good at monitoring the changing fortunes of households and small businesses
5) committed to attracting smaller household deposits and making household and
small business loans
The general view is that, “BIGGER IS SAFER”, although SMALL BANK can be regarded as safe
if it is well managed.
OPERATING INCOME – FEES = NET INTEREST INCOME
3
