Lecture Retail and merchant banking – Lecture 18

After studying this chapter you will be able to understand: Basic lending principles, what is asset management banking? asset management banking, what is liability management banking? Profitability, profitability management.

Revise Lecture 18

‘Basic Lending

Principles

- Q: What Is asset management banking?

- Asset management

banking

Basic Lending Principles

Asset management banking

- One of the main challenges to a bank Is ensuring its own liquidity under all

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Basic Lending Principles

Asset management banking

- Excess funds are typically invested In

assets that will provide it with liquidity

- The holding of assets that can readily be turned into cash when needed Is Known as asset management banking

* Q: What Is liability management banking?

‘ Liability management

banking

Basic Lending Principles

Liability management banking

- In contrast, large banks generally lack Sufficient deposits to fund their main

business dealing with large companies, governments, other financial institutions and wealthy individuals

Basic Lending Principles

Liability management banking

- Most of these banks borrow the funds they need from other major lenders in the form

of short-term liabilities which must be

continually rolled over

- This is known as liability management,

A much riskier method than asset

management.

Basic Lending Principles

Liability management banking

- Asmall bank will lose potential income If It gets its asset management wrong

* Alarge bank may fail if it gets its liability

management wrong

Basic Lending Principles

Liability management banking

- The key to liability management is the

ability to borrow always

‘ Therefore, a bank’s most vital asset Is Its creditworthiness If there is any doubt

about Its credit, lenders can easily switch

to another bank

‘ The rate a bank must pay to borrow will go

up rapidly with the slightest suspicion of

trarthin

Basic Lending Principles

Liability management banking

- In recent years, large banks have been

making increasing use of asset

management in order to enhance liquidity, holding a larger part of their assets as

securities as well as securitizing their

loans to recycle borrowed funds

Basic Lending Principles

Liability management banking

* A‘bank run’ is an overwhelming demand for cash by a bank’s depositors

- Alarge depositor assumes a risk and

needs to know something about the bank’s own balance sheet

- However, a healthy balance sheet does

not eliminate all risks

Basic Lending Principles

Liability management banking

- Even if the depositor Knows the bank has adequate liquidity

‘ Large depositors must, therefore, be

concerned about what others are likely to believe Arumour a bank, even though

unfounded, can trigger a run causes a

solvent bank to fall

Basic Lending Principles

Profitability

* Q: What Is profitability and profitability

management?

Basic Lending Principles

Profitability

- A bank generates profit from the

differential between the level of interest it pays for deposits and other sources of

funds and the level of interest it changes

In its lending activities

- This difference ts referred to as the

SPREAD between the cost of funds and the loan interest rate.

Basic Lending Principles

Profitability

* Historically Profitability from lending

activities has been cyclic and dependent

on the needs and strengths of loan

customers

- In recent history, investors have

demanded a more stable revenue stream and banks have therefore, placed more emphasis on transaction fees, primarily

loan fees, but also including services

Basic Lending Principles

Profitability

- However, lending activities still provide the

bulk of a commercial or retail bank’s

Basic Lending Principles

‘ Profitability Management

Basic Lending Principles

Profitability Management

- Profitability management Is a total

management process, rather than just an accounting or analysis procedure

- In contrast to asset and liability

management, it places primary emphasis

on the profit and loss account and

secondary emphasis on the balance

sheet

Basic Lending Principles

Profitability Management

* With profitability management, profitability

is not merely reported; it is planned,

measured and interpreted

- Planning ensures that efforts are directed toward the achievement of corporate

objectives

Basic Lending Principles

Profitability Management

- Measurement checks and adjusts

progress against plan by matching

revenue received with related expense

- Interpretation develops a valid picture of people and businesses, thereby serving

as a basis for the next planning cycle

Basic Lending Principles

Profitability Management

* Profitability management involves the

monitoring of three distinct types of

profitability statistics The profits of bank can be measured in three ways;

- By organization

- By product

- By account

Basic Lending Principles

Profitability Management

* Organizational profitability is the most

familiar type since all banks have some

system for reporting the performance of

their major organizational units

‘ However, an effective profitability

management system will also measure the

Lecture 19

Basic Lending Principles

Safety Issues

Basic Lending Principles

Safety Issues

- The persistent failures of banks to lend sensibly in Pakistan and in many other countries have brought the question of Safety In lending to the fore;

- Why do banks persistently lend so

Imprudently and how should lending be done at minimum risk?

Basic Lending Principles

Safety Issues

‘ One essential problem is the human and managerial challenge of motivating

employees of banks to cater to the interest

of the owners (Shareholders) of the bank

- The history of banking Is replete with

episodes of employees favouring friends and relatives with loans

Basic Lending Principles

Safety Issues

- In some countries, there are well-defined

market rates for bribes for obtaining loans

from banks

- This problem ts also present in Pakistan, though the record of Pakistan’s banking system in this aspect is much better than that of many other countries

Basic Lending Principles

Safety Issues

* Another aspect of the problems of banks concerns prudent levels of leverage

- A bank ts a financial intermediary with

fairly small equity capital, which borrows money from depositors and invest It into risky assets This involves a high degree

of leverage

Basic Lending Principles

Safety Issues

- Leverage, at the level of the bank, is

dangerous regardless of the quality of

credit analysis which has gone into each loan

- High leverage generates high risk and

high returns If high returns are obtained, the bank takes the profits but it Is

protected from high losses by the

government

Basic Lending Principles

Safety Issues

- Regulators have tried many policy

Initiatives aimed at obtaining a banking

system which has controlled leverage,

high quality lending and thus, a reduced

risk of failure

- These include capital adequacy

requirements based on clumsy

measurement of risk, prohibition of lending

against real estate, restrictions on lending

Basic Lending Principles

Safety Issues

* Ariskless loan Is one that Is fully

collateralised using actively traded assets

‘ These assets should be traded objects so that a ‘market to market’ can be done

daily, to ensure that the collateral is always larger than the outstanding loan

- The value of the asset that is measured

when marking to market should be the

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Diversification of Risk

Basic Lending Principles

Diversification of Risk

‘ Diversification in banking has been a topic

of discussion in the literature for decades

- |t effects on performance, risk, efficiency and firm value have been examined

extensively

- Diversification does have a significant

impact on a bank’s risk as well as Its

performance

Basic Lending Principles

Benefits of Diversification

Basic Lending Principles

Benefits of Diversification

- One of the most common benefits

associated with respect to diversification Is

a lower cost of capital

- Banks, with some level of global

diversification have access to different

capital markets which could lead toa

lower cost of funds through a larger

deposit base

Basic Lending Principles

Benefits of Diversification

- Furthermore, the potential for more

efficient internal capital markets Is another

of cited benefit to diversification

- Another benefit associated with activity

diversification is the ability to gain

economies of scale / scope for the

organization

Basic Lending Principles

Benefits of Diversification

- An example might be bank which collects Information credit information on potential borrowers With this information, the bank may be able to offer these potential clients Insurance products or underwriting

services at a lower cost because much of the information needed has already been collected when evaluating the loan

application

Basic Lending Principles

Benefits of Diversification

- Benefits associated with market power

have also been advanced The argument Suggests that banks may diversify their

activities or their operations geographically

to gain or maintain market share

* Finally, an important benefit that has been proposed by some Is the ability for

organizations to reduce earnings volatility

by spreading operations across areas with