BANK MANAGEMENT
MARTIEN LAMERS
2023-2024
,Table of Contents
1. What are banks? ........................................................................................................ 4
1.1 Balance sheet ................................................................................................................ 4
1.2 Income statement ......................................................................................................... 4
1.3 Types of banks ............................................................................................................... 4
2. Why do banks exist? .................................................................................................. 6
2.1 Financial Intermediation ................................................................................................ 6
2.1.1 Why markets / banks? ................................................................................................................... 6
2.2 Transaction costs ........................................................................................................... 6
2.3 Asymmetric information ................................................................................................ 7
2.4 Adverse selection .......................................................................................................... 7
2.5 Moral Hazard ................................................................................................................. 8
2.6 Regulation ..................................................................................................................... 8
2.7 Recap ............................................................................................................................ 8
3. What is bank management ........................................................................................ 9
3.1 What banks do .............................................................................................................. 9
3.2 Risks .............................................................................................................................. 9
3.2.1 Interest rate risk ............................................................................................................................. 9
3.2.2 Credit risk ..................................................................................................................................... 10
3.2.3 Market risk ................................................................................................................................... 11
3.2.4 Liquidity Risk ................................................................................................................................ 12
3.2.5 Operational Risk ........................................................................................................................... 13
3.3 Risk / return trade-off...................................................................................................13
3.4 Recap ...........................................................................................................................15
4. Interest rate risk ...................................................................................................... 15
4.1 Where does it come from? ...........................................................................................15
4.2 Measuring the interest rate risk ....................................................................................17
4.2.1 Impact on the interest income .......................................................................................................... 17
4.2.2 Impact on equity .......................................................................................................................... 17
4.2.3 Duration ............................................................................................................................................ 17
4.2 Managing interest rates ................................................................................................19
4.3.1 Interest rate managing tools ............................................................................................................. 20
4.2.2 Swaps ........................................................................................................................................... 20
4.3.3 Bancassurance ................................................................................................................................... 20
4.3 Basel Standards ............................................................................................................20
4.4 Recap ...........................................................................................................................21
5. Regulation ............................................................................................................... 21
5.1 Role of regulation .........................................................................................................21
5.1.1 Before 1988 .................................................................................................................................. 21
5.1.2 Basel I ........................................................................................................................................... 22
5.1.3 Basel II .......................................................................................................................................... 23
2
, 5.1.4 Basel III ......................................................................................................................................... 26
5.2 Supervisors ...................................................................................................................27
5.2.1 Supervision ................................................................................................................................... 27
5.3 Recap ...........................................................................................................................28
6. Credit risk................................................................................................................. 29
6.1 Where does credit risk come from? ..............................................................................29
6.2 Regulation for credit risk ..............................................................................................29
6.2.1 Pillar 1: Credit risk capital requirements ...................................................................................... 29
6.2.2 Standardized approach ................................................................................................................ 30
6.2.3 IRB approach ............................................................................................................................... 30
6.2.4 Standardized vs IRB ...................................................................................................................... 31
6.3 Measuring credit risk ....................................................................................................32
6.3.1 Qualitative models ....................................................................................................................... 33
6.3.2 Quantitative / credit scoring models ........................................................................................... 33
6.3.3 Altman Z-score ............................................................................................................................. 33
6.3.4 Regression analysis ...................................................................................................................... 34
6.3.5 Linear probability model .............................................................................................................. 34
6.3.6 Logit / probit model ..................................................................................................................... 34
In a logit model, the linear relationship is adjusted through an exponential transformation ................... 34
6.3.7 Capital market data ...................................................................................................................... 35
6.4 How can credit risk be managed? .................................................................................37
6.4.1 Mitigation..................................................................................................................................... 37
6.5 Recap ...........................................................................................................................37
7. Market, operational and liquidity risk ...................................................................... 38
7.1 Market risk ...................................................................................................................38
7.1.1 5 main categories of market risk .................................................................................................. 39
7.1.2 Capital requirements ................................................................................................................... 39
7.1.3 Measuring risk .............................................................................................................................. 40
7.1.4 Standardized vs internal............................................................................................................... 40
7.2 Operational risk ............................................................................................................40
7.2.1 Capital requirements ................................................................................................................... 41
7.3 Liquidity risk .................................................................................................................42
7.3.1 What happens when depositors run on the bank? ...................................................................... 42
7.3.2 Liquidity risk in the GFC................................................................................................................ 43
7.3.3 Regulatory requirements ............................................................................................................. 43
7.3.4 Liquidity position of Belgian banks .............................................................................................. 44
7.4 Recap ...........................................................................................................................45
3
, 1. What are banks?
à Financial service providers
1.1 Balance sheet
Banks (and other financial institutions) have a different asset and liability structure compared
to other firms
Funded by financial liabilities (passiva): Assets are also mainly financial (Activa):
- Deposits - Cash
- Bonds - Loans
- Subordinated debt - Securities
- (Equity capital) - Fixed assets (branch offices)
1.2 Income statement
Income is derived from:
- Lending
- Investing in other financial assets yielding a return
- Providing services
Expenses
- Funding costs (deposits and non-deposit liabilities)
- Personnel costs
- Costs of running branch network
1.3 Types of banks
Depending on which business/funding is dominant, FIs can be divided into different business
models. Saunders and Cornett define a few:
- Depository institutions
o High proportion of funding from (retail) deposits, and main source of income
real estate loans
o Commercial banks, savings banks, credit unions
- Finance company
o Do not accept deposits, but rely on short- and long-term debt as source of
funds
o Often give riskier (personal) loans
- Securities firms
o Investment banks (originate, underwrite, distribute new securities)
o Brokerage firms (purchase, sale of existing securities)
- Retail bank
o Consumer deposits, consumer loans, mortgages, small business loans
- Wholesale bank (Corporate bank)
o Deposits/loans to large companies, governments, pension funds, etc.
4
MARTIEN LAMERS
2023-2024
,Table of Contents
1. What are banks? ........................................................................................................ 4
1.1 Balance sheet ................................................................................................................ 4
1.2 Income statement ......................................................................................................... 4
1.3 Types of banks ............................................................................................................... 4
2. Why do banks exist? .................................................................................................. 6
2.1 Financial Intermediation ................................................................................................ 6
2.1.1 Why markets / banks? ................................................................................................................... 6
2.2 Transaction costs ........................................................................................................... 6
2.3 Asymmetric information ................................................................................................ 7
2.4 Adverse selection .......................................................................................................... 7
2.5 Moral Hazard ................................................................................................................. 8
2.6 Regulation ..................................................................................................................... 8
2.7 Recap ............................................................................................................................ 8
3. What is bank management ........................................................................................ 9
3.1 What banks do .............................................................................................................. 9
3.2 Risks .............................................................................................................................. 9
3.2.1 Interest rate risk ............................................................................................................................. 9
3.2.2 Credit risk ..................................................................................................................................... 10
3.2.3 Market risk ................................................................................................................................... 11
3.2.4 Liquidity Risk ................................................................................................................................ 12
3.2.5 Operational Risk ........................................................................................................................... 13
3.3 Risk / return trade-off...................................................................................................13
3.4 Recap ...........................................................................................................................15
4. Interest rate risk ...................................................................................................... 15
4.1 Where does it come from? ...........................................................................................15
4.2 Measuring the interest rate risk ....................................................................................17
4.2.1 Impact on the interest income .......................................................................................................... 17
4.2.2 Impact on equity .......................................................................................................................... 17
4.2.3 Duration ............................................................................................................................................ 17
4.2 Managing interest rates ................................................................................................19
4.3.1 Interest rate managing tools ............................................................................................................. 20
4.2.2 Swaps ........................................................................................................................................... 20
4.3.3 Bancassurance ................................................................................................................................... 20
4.3 Basel Standards ............................................................................................................20
4.4 Recap ...........................................................................................................................21
5. Regulation ............................................................................................................... 21
5.1 Role of regulation .........................................................................................................21
5.1.1 Before 1988 .................................................................................................................................. 21
5.1.2 Basel I ........................................................................................................................................... 22
5.1.3 Basel II .......................................................................................................................................... 23
2
, 5.1.4 Basel III ......................................................................................................................................... 26
5.2 Supervisors ...................................................................................................................27
5.2.1 Supervision ................................................................................................................................... 27
5.3 Recap ...........................................................................................................................28
6. Credit risk................................................................................................................. 29
6.1 Where does credit risk come from? ..............................................................................29
6.2 Regulation for credit risk ..............................................................................................29
6.2.1 Pillar 1: Credit risk capital requirements ...................................................................................... 29
6.2.2 Standardized approach ................................................................................................................ 30
6.2.3 IRB approach ............................................................................................................................... 30
6.2.4 Standardized vs IRB ...................................................................................................................... 31
6.3 Measuring credit risk ....................................................................................................32
6.3.1 Qualitative models ....................................................................................................................... 33
6.3.2 Quantitative / credit scoring models ........................................................................................... 33
6.3.3 Altman Z-score ............................................................................................................................. 33
6.3.4 Regression analysis ...................................................................................................................... 34
6.3.5 Linear probability model .............................................................................................................. 34
6.3.6 Logit / probit model ..................................................................................................................... 34
In a logit model, the linear relationship is adjusted through an exponential transformation ................... 34
6.3.7 Capital market data ...................................................................................................................... 35
6.4 How can credit risk be managed? .................................................................................37
6.4.1 Mitigation..................................................................................................................................... 37
6.5 Recap ...........................................................................................................................37
7. Market, operational and liquidity risk ...................................................................... 38
7.1 Market risk ...................................................................................................................38
7.1.1 5 main categories of market risk .................................................................................................. 39
7.1.2 Capital requirements ................................................................................................................... 39
7.1.3 Measuring risk .............................................................................................................................. 40
7.1.4 Standardized vs internal............................................................................................................... 40
7.2 Operational risk ............................................................................................................40
7.2.1 Capital requirements ................................................................................................................... 41
7.3 Liquidity risk .................................................................................................................42
7.3.1 What happens when depositors run on the bank? ...................................................................... 42
7.3.2 Liquidity risk in the GFC................................................................................................................ 43
7.3.3 Regulatory requirements ............................................................................................................. 43
7.3.4 Liquidity position of Belgian banks .............................................................................................. 44
7.4 Recap ...........................................................................................................................45
3
, 1. What are banks?
à Financial service providers
1.1 Balance sheet
Banks (and other financial institutions) have a different asset and liability structure compared
to other firms
Funded by financial liabilities (passiva): Assets are also mainly financial (Activa):
- Deposits - Cash
- Bonds - Loans
- Subordinated debt - Securities
- (Equity capital) - Fixed assets (branch offices)
1.2 Income statement
Income is derived from:
- Lending
- Investing in other financial assets yielding a return
- Providing services
Expenses
- Funding costs (deposits and non-deposit liabilities)
- Personnel costs
- Costs of running branch network
1.3 Types of banks
Depending on which business/funding is dominant, FIs can be divided into different business
models. Saunders and Cornett define a few:
- Depository institutions
o High proportion of funding from (retail) deposits, and main source of income
real estate loans
o Commercial banks, savings banks, credit unions
- Finance company
o Do not accept deposits, but rely on short- and long-term debt as source of
funds
o Often give riskier (personal) loans
- Securities firms
o Investment banks (originate, underwrite, distribute new securities)
o Brokerage firms (purchase, sale of existing securities)
- Retail bank
o Consumer deposits, consumer loans, mortgages, small business loans
- Wholesale bank (Corporate bank)
o Deposits/loans to large companies, governments, pension funds, etc.
4
