Financial Institutions

-- Banking

Functions of Financial Institutions

1. 2. 3. 4. 5. 6. 7. Aids the flow of capital Credit allocation Provides economies of scale and scope Satisfies the needs of general public Provides specialization and expertise Assists asset transformation Offers INTERMEDIATION

Intermediation
The process of transforming a secondary security into a primary security by a financial institution. It relates to financial investments by savors
cash Savors Financial Institutions secondary securities primary securities cash Borrowers

Dis-intermediation
The process of reversing or rejecting the transfer of funds into the financial institutions. This refers to the low deposit interest rates or high operating costs charge to customers.

Illustration of Disintermediation
The removing of Middlemen The dis- or re-channeling funds flow from the FI Changing Role to the Servicing of Markets
Security Investments Mutual Funds Insurance

Types of Intermediation
1. 2. 3. 4. Liquidity Maturity Denomination Risk

Types of Financial Institutions

By Banking Business Nature:
Banks Non-Banks Non-Finance

 By Business Operations: Thrift type Contractual type Investment type Other type

Thrift-type Financial Institutions

Banks:
Commercial Banks Savings Banks Investment Banks (Merchant Banks) etc

Non-Banks:
Deposit-taking Company, Savings and Loan, Home Loans, Building Society, Credit Unions

Contract-type Financial Institutions

Insurance Companies:
Life Insurance Accident and Healthy Insurance

Pension Funds:
Mandatory Providence Funds Retirement Funds/Pension Funds

Investment-type Financial Institutions

Investment Companies:
Closed-end Investment Companies - Investment Brokers Open-end Investment Companies - Mutual Funds/Unit Trust Real Estate Trust Investment Companies

Other Financial Institutions

Finance Companies Factors Companies Lease Companies Mortgage Companies Credit Card Companies Non-finance Financial Institutions:
General Electric, Ford Motors, Toyota Motors wholesalers, Manufactures, Department Stores

Why Financial Institutions?

Fulfill economic goals Reduce transaction and information costs Provide liquidity Prevent risks As transmission of monetary policy Provide payment mechanism Supply credit allocation

Analysis of Financial Institutions

1. 2. 3. 4. Transaction Costs Information Asymmetry -- Moral Hazard Financial Risks Financial Innovation

High Transaction Costs: Solutions

Economy of Scale--to reduce the average unit costs of production as output increase (%Output , AC) Economy of Scope --to generate cost synergies by producing multiple services ( C{x1, x2} < C{x1} +C{x2} ) Specialization: market niche

Solution
Information Asymmetry--Moral Hazard: Information Symmetry and Full Disclosure Regulation Reform Financial Intermediation Financial Risks: Risk Management and Control Burden Administration

Solutions
Financial Innovations: Enhance Internal Control-Planning, Control, and Administration Tighten Asset Management and Quality Modernized Operation System Strengthen Regulation and Monitoring

Duties of the Management of Financial Institutions

1. Determining the optimal capital structure Assets, Liabilities, and Capital 2. Managing interest rate/currency/credit risks 3. electing/Pricing investments and liabilities Maturity Matching, Profit Making 4. Operating effectively Information Processing
Communication Technology

Basic Concept -- Banking

What is a Bank?
A bank is a financial intermediary which provides special types services relating to finance. A bank is a company which carries on banking business with a valid banking license. (Banking Ordinance)

Banking Business
Banking Ordinance - section 2
A. Receiving from the general public money on current deposit, savings deposit or other similar account repayable on demand or within less than three months or at call or notice of less than three months; B Paying or collecting cheques drawn by or paid in by customers.

Universal Definition of A Bank

A Bank is a licensed organization that 1. Accepts Deposits from the general public 2. Grants Loans

Special Features of a Bank

1. It is a regulated organization. 2. It offers checking accounts (Demand Deposit Accounts, or Current Accounts) 3. It acts as payment mechanism. 4. It can create money

Money Creation Feature

1. Assumptions:
No cash outflow (Depositors will not make any drawing) Comply with the Reserves Requirement on Deposits No Excess Reserves set by the Bank Excess Balance on the Deposits will be loaned out All Loans will be re-deposited back to the Bank

 Process of Money Creation: (Minimum Deposit Reserves equal to 20%) 1. Deposits $1,000 into the Banking System
bank will maintain deposit reserves $200 At the same time, $800 will be lent out Borrower will immediately deposit the $800 back to the bank The Bank will then have $1,800 in its Deposit account

 B. The additional $800 deposited into the Bank.

20% of $800 ($160) will be taken out as reserves. The remaining balance of $640 will be lent out. Borrower(s) will not withdraw cash and deposit the $640 into the Bank The Bank will have a total of 2,440 in Deposits. ($1,000+$800+$640)

 C. The process repeats again until the reserves requirement equal to the original deposits amount. The Multiple Effect appears. D = deposits; r= reserves requirement MC=Money Creation MC = D/r)$1,000 x (1/0.2) = $5,000 .. (M1) Minimum Reserves is $5,000 x 0.2 =$1,000

The multiplier is 5 Money creation equals $4,000 r = 0.2; Multiplier = 5 r = 0.1; Multiplier = 10 r = 0.25; Multiplier = 4 r = 0.08; Multiplier = 12.5

 In Reality, the Multiplier may not be exactly the same (as 5 on the reserves requirement is 20%). M1 is always larger than original deposits. Monetary Policy can increase or decrease the reserves requirement to control the money supply.

Bank Organization Structure

Unit Banking Branch Banking Dual Banking Bank Holding Company Multinational Banking Retail Banking Wholesale Banking

HK Banking System
3 tier Banking System: (Structure): 1981: Licensed Banks Licensed Deposit-taking Companies Registered DTC 1989: Licensed Banks Registered Licensed Banks Deposit-taking Companies

Banks in Hong Kong

Source: HKMA Monthly Statistical bulletin, January 2002
Licensed banks IncorIncorporated porated in HK outside HK
31 31 31 31 31 31 29 154 151 149 141 125 123 118

As at end of
1995 1996 1997 1998 1999 2000 2001

Restricted licence banks IncorIncorporated porated in HK outside HK

37 38 39 35 33 28 29 26 24 27 25 25 20 20

Deposit-taking companies IncorIncorporated porated in HK outside HK

129 121 113 99 71 61 54 3 3 2 2 0 0 0

All authorised institutions

380 368 361 333 285 263 250

Balance Sheet of HK Banks

Source:HKMA Monthly Statistical Bulletin, January 2002
Balance Sheet of HK Licensed Banks (Dec.31, 2001) in 000,000 Mill $ HK$ F.C. Total Assets Notes and Coins 12 2 14 Due From AIs 276 166 442 Due from Banks Abroad 110 2,023 2,134 Loans and Advances to Customers 1,508 521 2,029 Negotiable CDs 84 38 122 Negotiable Debt other than CDs 339 516 855 Acceptance and Bills of Exchange 2 32 34 FRNs and CP 44 200 244 Government Bills Bonds and Notes 201 76 277 Other Debt Instruments 92 207 299 Investments in Shareholdings 42 3 45 Land and Buildings 63 1 64 Other Assets 107 67 174 Total Assets 2,880 3,852 6,733 Liabilities Due to AIs Due to Banks Abroad Deposits from Customers Negotiable CDs outstanding Other Debt Instruments Capital Reserves and other Liabilities 343 1,417 3,318 167 43 593 5,881

175 163 1,832 132 1 437 2,740

168 1,254 1,486 35 42 156 3,141

Funds Flow of a Bank

Funds Flow-in:
Deposits Borrowing / NCD Contributed Capital

Funds Flow-out:
Loans and Advances Investments Capital Expenditures

Balance Sheet Presentation

Assets Side: - Cash and Balance due from Depository Institutions - Investments (Short- and Long-term) - Loans and Advances - Plant and Equipment - Investments in Subsidiaries

 Liabilities: - Core Deposits - Certificate Deposits - Borrowings (Short- and Long-term) Equity Capital - Paid-in Capital - Retained Earnings (Reserves)

Bank Assets and Liabilities Structure

Rate Sensitive Assets Rate Sensitive Liab. Fixed Rate Assets Fixed Rate Liab. Non-Rate Assets Equity

Bank Balance Sheet Characteristics

1. Few Fixed Assets -- Low Degree of Operating Leverage 2. Substantial Amount Short-term Liabilities (Deposits) -- Requires High Liquidity 3. Substantial Amount of Assets Relative to Equity Capital -- High Degree of Financial Leverage

Services Provided by Banks

General Areas: - Intermediation: Liquidity, Maturity Risk, Denomination - Cost Reduction - Price Reduction - Information

Special Services Provided by Banks

1. Money Supply Transmissions 2. Credit Allocation

Development Factors in Financial Institutions

1. 2. 3. 4. 5. Crossing Traditional Boundaries Global Competition New Opportunities Deregulation/Re-regulation Corporate Restructuring

The Development in Banking Industry

1. Institutionalization
2. Globalization 3. Securitization

Structural Change in Banking

1. Technological Change 2. Regulation Change 3. Economical Change - Interest Rate Fluctuation 4. Competition Induced Change 5. Bank International Settlement Requirement --Capital (Kapital) Change **TRICK**

Financial Innovation in Banking

TRICK + Rational Self-Interest = Financial Innovation
New financial products and processes that improve the economic efficiency with which financial transactions are conducted, either by serving customers needs in new unregulated ways or by lowering costs.

Examples of Financial Innovations: Negotiable Certificate Deposits ZERO-Coupon Securities Financial Futures Negotiable Order of Withdrawal (NOW a/c) Money Market Deposit Account (MMDA) Euro-Dollar Deposits Securitization

Banking Regulations

Reasons for Banking Regulations

1. 2. 3. 4. 5. 6. 7. 8. Protect Customers Improve Implementation of Monetary Policy Ensure Competitive Markets Prevent from Bank Run Eliminate Prejudice in Supply Pursue Desirable Credit Allocation Protect Taxpayers from Bailouts Reduce Information Asymmetries

What IF There is NO Regulations

Money will be destroyed Payment Mechanism will be Disrupted Credit will be Shrink Risk will be increased Information Flow will be retarded

Objectives of Bank Regulations

1. Safety 2. Stability 3. Structure

Forms of Bank Regulations

Entry Control - Licensed Safety and Soundness Control:
Liquidity Capital Adequacy Concentration Limits

Credit Allocation Control Geographical Expansion Control

Cost/Banefit Analysis of Regulation

Cost
Filing Cost restricted Activities Taxes

Benefits:
Restricted Competition Government Support

Banking Operating Structure

Industry Organization Model: Structure Conducts Performance

Bank Organization Structure

Merge and Acquisition -- Super Size Banks
Efficiency Effectiveness

Multinational Foreign Banks Multinational Bank Holding Companies

Double Leverage

Double Leverage for MBHC

Bank Parent Company: raise funds $10 Billion by issuing bonds or borrowing This amount is then transferred/invested into the subsidiary Bank The funds are used to expand the subsidiary banks capital size. If the subsidiary bank maintain an 20% required ratio of Equity to Asset

 The subsidiary banks assets will be increase by $50 billion while meeting the regulatory capital requirement of 20%. Increase Injected Bank Equity Funds in = Assets Required Reserves Ratio

Increase in Assets = $10b / 0.20 = $50b

Bank Performance

Risks Faced by Bank Operations

Liquidity Risk Credit (Default) Risk Interest Rate Risk Technology/Operational Risk Regulatory Risk Country/Sovereign Risk

 Currency (Foreign Exchange) Risk Political Risk Off-Balance Sheet Risk

Objectives of Bank Performance

To Reduce Risks To Maximize Net Worth To Maximize Profit To Comply with Regulations To Fulfill Bank Policies

Features of Bank Performance

Accepts general publics savings as deposits and grant loans to those who need them. Bank products are mainly services The income and expenses are divided into
Interest Portion Non-interest Portion

Profitability Analysis

Measurement of Profitability
Net Interest Income (NII) = Interest Income Interest Expenses Net Interest Margin (NIM) = Interest Income Interest Expenses Total Earning Assets Spread = (Average Interest Income Rate Average Interest Expense Rate)

Factors Affecting NIM/NII

Credit Risk - Higher Risk; Higher Yields Interest Rate Fluctuation Funding Mix: S/T vs L/T
Sources:wholesale vs retail; savings vs time Uses: commercial vs mortgage vs consumers

Pricing Mix: Fixed Rate vs Floating Rate Non-performance Assets Tax Exempted Investments

Impact of Interest Rate Fluctuation on NIM

Monitoring Rate Sensitive Assets and Liabilities -- Gap Management RSA > RSL .... Positive Gap RSA < RSL Negative Gap RSA = RSL Zero Gap When Interest Rate increases, + Gap: IR > IE + NII ; + NIM Gap: IR < IE NII ; NIM

Measurement Return on Net Worth

Return on New Worth (RONW) = (Total Net Income / Total Equity on MV) Return on Assets (ROA) = (Total Net Income / Total Assets) Return on Equity (ROE) = (Total Net Income / Total Equity on BV)

Asset/Liability Management
Monitoring Assets and Liabilities Mix: Actively Management the Which Assets are funded by What Liabilities The GAP (RSA = RSL) RSA financed by FRL FRA financed by FRL NRA financed by FRL Determine the Amount, Rate Differential and the Expected Earnings of all the items.

Illustration of Active Mgt

Example: RSA 8% FRA11% NRA Total

$ 170 155 30 $ 355

RSL 6% FRL 8.5% Equity Total

$ 150 185 20 $ 355

Rate Differentials (Annual) On RSA and RSL (8% - 6%) On FRA and FRL (11% - 8.5%) On GAP and FRL (8,5% - 8%) On NRA and FRL (8.5% - 0%)

2% 1.5% 0.5% ( 8.5%)

Profitability Analysis RSA financed by RSL ($150 @ 2%) FRA financed by FRL ($155 @ 1.5%) GAP financed by FRL ($20 @ 0.5%) NRA financed by FRL ($10 @ 8.5%) NRA financed by Equity ($20 @ --) Total Pre-tax Profits

$3 2.325 0.1 (0.85) 0 $4.575

RONW (ROE) = $4.575 20 = 0.22875 ~ 22.875%

Liquidity Analysis

Nature of Liquidity
1. The ability to maintain sufficient funds to fulfill the regulatory requirement 2. The ease with which a bank to convert the assets into cash to meet the claims of withdrawals and /or to repay the debts and expenses.

Concepts of Liquidity
Narrow Concept: the ability to maintain sufficient funds or to raise a certain amount of deposits at a certain cost within a certain amount of time to meet the needs by the bank -- Store Liquidity Broad Concept: the ability to include the ease with which the bank can obtain cash by borrowing from external sources -Purchasing Liquidity

Liquidity Requirement by Hong Kong Banking Ordinanace

Any Licensed Bank should maintain the Liquidity Ratio of not less than 25% of Liquefiable Assets to its Qualifying Liabilities for each calendar month, based on the sum of net weighted amount of the liquefiable assets and the sum of the qualifying liabilities for each working day of the month.

Causes of Liquidity
1. Liability-side Causes: Depositors withdraw cash from their accounts or additional deposits do not come as expected 2. Asset-side Causes: Lending commitments or Matured Loans do not pay on time.

Indicators of Liquidity Risk

1. Mis-Matching of maturities of Qualifying Assets to Liquefiable Liabilities 2. Inadequate Liquidity Ratio on Qualifying Assets to Liquefiable Liabilities

Measurement of Liquidity Risk

1. Static Measurement: a. Liquidity Ratio: Qualifying Assets Liquefiable Liabilities b. Net Cash Flows Analysis: Cash In-flows Cash Out-flows

 2. Dynamic Measurement: a. Liquidity Planning: to analyze the deposits withdrawals and additional deposits, and the loans commitments and loans repayments. To determine the net effect on the Liquidity Position.
Liq.Bal Deposits + $140 $50 $75 +Liq Liq Loans Net Change + $100 $80 $??? Liq +Liq

 B. Trends Analysis on Loans and Deposits: $ Deposits Liquidity Gap Loans

Management of Liquidity Risks

1. Store Liquidity a. Maintain sufficient CASH and Near Cash b. Maintain Good Quality Loans c. Retain Deposits in the Bank

 2. Purchase Liquidity: a. Maintain Diversified Borrowing Sources: (I) Inter-bank Loans (ii) Other Borrowings (iii) Discount Windows (LAF) (iv) REPO (v) NCD b. Increase Deposits c. Seek Deposit Sources (Euro$ Deposit)

Lending Analysis

Nature of Lending
Lending is the single and largest categories for banking Lending provides the primary source of revenue for banking Banking business is to grant loans to allocate capital Lending classes: Commercial and Industry, Real Estate (Mortgage). Consumer, and others (leasing, agriculture, govt, etc)

Concepts of Bank Lending

1. The possibility of total loss become less as the number of loans increases 2. The possibility of no losses also become less as number of loans increase 3. As loan portfolio getting larger, number of loans that will go bad can be predicted 4. The Larger the loan portfolio, the possibilities of total loss are very remote 5. In large loan portfolio, some losses are certain

Elements for Lending Policy

Size Maturity Composition Interest Rate: Loan Pricing Fixed Rate or Floating Rate Analyze Loan Loss

Strategies for Lending Policy

Loan Analysis
No Analysis Subjective Analysis
5 Cs Ratio Analysis and Cash Flow Analysis

Objective Analysis
Credit Score Z Score

Credit Score Altmans Z Score Z = 1.2X1 +1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 X1 = Working Capital / Total Assets X2 =Retained Earnings / Total Assets] X3 = EBIT / Total Assets X4 = M. Value of Equity / B. Value of Total Debts X5 = Sales / Total Assets Z Score Probability of Failure 1.8 or less Very High 1.81 2.99 Not Sure 3.0 or Above Unlikely

 Loan Administration
Centralized Approval Decentralized Approval

Loan Authorization
Personnel Authorized Line of Credit

Loan Monitoring

 Loan Delinquency a. Workout Agreement

b. c. d. e. Collateral Liquidation Reducing Debt to Collecting Judgment Charge off Bankruptcy

Capital Analysis

Role of Capital
To Support Operating Asset Commitments To Promote Depositors Confidence To Improve Growth - Loans and Deposits - Earnings To Prevent Morale Hazard

Composition of Capital
Traditional Concept: (GAAP Concept) 1. Contributed Capital: -- Core and Supplementary Capital 2. Book Value Regulatory Concept: (Regulatory Accounting Principles) 1. Contributed Capital plus Debt Capital 2. Market Value

Debt as Source of Capital

Attribute of Debt: (Regulatory point of view) 1. It is legally subordinate to deposits. 2. It does not require immediate repayment. 3. It offers some protection to depositors. 4. It is a sources of funds

Conditions for Debt as Capital

Original maturity of 5 year or more When Issue must Identify as Subordinate to deposits Must be Uninsured

Capital Adequacy
Regulatory Requirement: (Bank of International Settlement Requirement) Capital / Risk Adjusted Assets > 8% Core Capital / Risk Adjusted Assets > 4% Internal Requirement: -Add a Premium onto the BIS requirement -Currently Average Ratio is 20%

Quantitative Analysis of Capital Adequacy

1. Leverage Analysis: NW/ Total Assets NW / Risk Adjusted Assets NW / Average Loans NW / Average Deposits 2. Net Capital Ratio: Capital + R.E. Problem Assets Risk Adjusted Assets NCR < 2.74 ---- Inadequate

Qualitative Analysis of Capital Adequacy

Regulatory Analysis: CAMEL --- Capital size Asset Quality Management Earning History Liquidity Position

Continued
For Bank Holding Company Institutes CAMEL + BOPEC Bank Subsidiary Other Subsidiaries Parent Company Earnings (Consolidated) Capital (Consolidated)