Principals and Practice of Banking

Table of Contents

Page 3: Question A
Page 3: Introduction
Page 7: Question B
Page 8: Introduction
Page 9: Conclusion
Page 10: References

Question A: Write a short note explaining each of the following five challenges bank management must address in managing their bank.

Introduction: The role of bank management is to maximise profits form the management of their assets and liabilities, whilst operating in prudent manner that minimises risk from their operations. To achieve these goals the following five challenges must be met:

Asset Management:
The assets of a bank are typically made up of cash, liquid assets, short term instruments, fixed assets (premises, equipment) and loans to customers. These items are generated from the transformation of their liabilities and capital. Loans to the market and customers represent the major portion of these assets held on the balance sheet and are a main component of the profits generated by the bank. Given this role of assets the challenge for bank management is to maximise the returns achieved on these assets while also minimising the risks, as too risk an asset, regardless of interest rate achieved, will be unprofitable should the loan default. This risk or credit assessment of the asset is crucial to ensure not only an appropriate return for the risk is achieved but also that the ultimate default level is minimised.
The challenge for bank management is to keep the profit and return on asset (ROA) as high as possible whilst managing the associated credit risks. This is achieved through processes within the banks credit culture and the associated processes of credit risk assessments, credit screening and ongoing monitoring of assets. It must be kept at an optimal level, at each advance level, as any default will result in loans of many multiples in size being advanced to recoup the default amount through that subsequent interest earned on those subsequent loans. Additionally bank management must ensure that assets are put to best use at a portfolio level also to ensure there is appropriate diversification within the asset portfolio to avoid, as much as possible, the areas of concentration risk (single or narrow advances to individuals or sectors) and unsystematic risk.
Finally within this area bank management also need to consider the liquidity of the assets it holds, as the more liquid the assets the less return and resultant profit earned on those assets but the security these liquid assets give in holding of reserves and potentially reduced risk from these assets.
The management and balance of the above items are a key challenge for bank management as they will ultimate play a pivotal role in the end profit generated for the bank and its shareholders.

Liability Management:
On the opposite side of the banks' balance sheet sit their liabilities, the items used to generate assets and profits. These liabilities are typically, customer (retail and commercial) deposits, other banks deposits, past profits generated and equity issues. Customer deposits, of their various time scales, form the largest piece of the liabilities side of the balance sheet and the challenge for bank management is to acquire these deposits from customers and within the money markets, at the lowest possible rates so as to maximise the profit made through the onward lending of these deposits. The lending of these deposits is undertaken based on the reserve ratio and many multiples of the amounts deposited are lent out. The lower the interest paid on these deposits the greater the margin achieved between the rate charged for lending and that paid for deposits. This net interest margin is a large part of the profit derived for banks from its operations.
The challenge of the management of the assets and liabilities are closely linked and open to similar risks through the refinancing and reinvestment of assets and liabilities respectively. Within this area the size and maturity transformation function of banks needs to ne managed carefully to ensure items such as gap and duration analysis is good and appropriate liquidity and reserves are maintained to meet the demands of customers.
Critically banks must ensure they manage the level of interest paid to entice deposits into the bank, so as to lend out the multiples possible from these (the money or credit multiplier) but also maximise the profit made through the net interest margin between loan and these deposit rates.

Liquidity Management:
Liquidity management involves the decisions regarding the amount of cash and liquid assets, to be retained by banks to service the daily requirements of customers for withdrawals and payments, both for normal and abnormal reasons within their expenditure patterns. A coordinated assets and liabilities management approach is required to balance these requirements and the associated opportunity costs associated with holding these reserves of cash and liquid assets, particularly should these decisions lead to excess reserves being held and not required. The opportunity cost arises are the cash or liquid assets held do not generate as much profit for the bank as could be achieved through more illiquid assets, as cash and liquid assets receive little or no yield. As a result the key challenge is to ensure adequate reserves are maintained to meet the requirements of customers and avoid any bank runs or concerns regarding the solvency of the bank, whilst ensuring profits are maximised on as large a portion of these assets as possible.
Should banks encountered liquidity issues there are options available to manage these to address any shortfall in liquidity. These areas are, borrowing on the money market from other banks, selling some securities or loans to generate liquidity or borrowing from the central bank. The management of liquidity is key as any of the above options may increase the costs to the bank in financial terms or reputationally, which ultimately can impact on the banks' profits and standing. Additionally liquidity is required to continue to advance loans to customers and grow the profits of the bank is this regard also. As with the assets and liabilities the size and maturity transformation roles of banks play a role in creating liquidity risk given the mismatch between the requirements of lenders and borrowers.
Given the impact issues with liquidity can create in both the continued loan advances of banks and the confidence in banks that they can met demands from customers to access their cash, this area is of major importance and needs to be carefully managed through the decisions to hold cash or near cash assets and the associated opportunity costs of these decisions on the profit generation from assets. To this end there are mandatory reserve requirements set by the central bank and additional amounts banks may decide to maintain in excess of this, potentially.

Capital Management:
Relates to the difference between the assets and liabilities on the balance sheet and is a determinant of the solvency of the bank. It differs from liquidity in that it relates to the potential of the bank to ultimately pay its obligations as opposed to paying them on a daily basis as they fall due. As such it is the final view of the solvency of a bank. Similar to the case of liquidity management a key challenges in capital management relates to the trade-off between security and profits based on the levels of capital held, given capital reserves are held in low yield assets. The more capital held in reserves results in the lower the return to shareholders. Similar to the required reserves for liquidity, capital reserves are dictated by regulators, regulatory reserves. Banks can also hold in excess of these levels through economic capital to cover the risks they perceive in their business.
Any negative value of the assets minus liabilities equation will lead to a bank being insolvent, therefore the management of the capital of the bank is key to ensure the continued existence of the bank. Linked to the capital management will also be the asset management process to ensure good quality assets to ensure there is no reduction in the value of assets that may lead to the reduction in the gap between the assets and liabilities of the bank. The allocation of capital, maximising these risk adjusted returns, is key within this process to ensure capital is allocated to the appropriate use and business segment.

Off-Balance Sheet Management:
This area of a bank's management relates to items, unlike those described above, that are held off the balance sheet of the bank. This is due primarily to the nature of the items being contingent assets or liabilities, in that they are items that may be realised in the future or their realisation is dependent on another factor, for example unused overdrafts, letters of credits, securities underwritten or financial derivatives.
The evolution of these non-traditional banking activities in terms of their complexity (securitisation of loans) and their use for both risk reduction and profit generation through hedging, futures, forward, options, interest rates and currency swaps has led to a major challenge for bank management to ensure the exposures entered into are known and well managed. This is critical given that such OBS items are not contained on the balance sheet and covered necessarily by the liquidity and capital reserve management areas and that the exposures from these items can be greatly in excess and multiples of the contracts entered into in certain cases. For example, the mortgage asset backed securities and associated CDO's (collateralized debt obligations) prevalent in the US in the early and mid 2000's contain risks and exposures in financial multiples greatly in excess of the associated contracts and costs known and / or managed correctly by the banks involved. Given this aspect banks need to carefully assess and provision adequate liquidity and capital reserves to ensure they remain solvent. Critically also managing the risks associated with these instruments, balanced with the returns achieved.
Within the context of the current banking environment as its competitive nature, these OBS items also serve to generate profits for banks without the associated costs of pure lending and deposits and there reserve requirements.

As such, through the correct management of these items there are numerous opportunities for banks to diversify their activities and portfolios to achieve greater profitability through OBS activities by generating fee income for the services and containing asset growth thus increasing return on assets and reducing their equity multiplier.

Question B: Banks must be profitable and prudently managed if they are to survive and contribute to the local economy.
Discuss the importance of managing concentration risk in banks and evaluate the contention that the Irish Banking crisis was imported from the US.
The management of a bank to ensure it is as profitable as possible whilst being prudently managed to ensure risks are minimised is key to ongoing stability of the bank and its place with the local economy. A deterioration in either its profitability or risk profile due to excess risks due to non-prudential processes or management can lead to its cessation from operating and removal from the economy. This would impact on the confidence in the banking sector, potentially impacting other banks, and also in the removal of the services it offers within the market to its customers. This could impact on the efficiency of the local economy and banking sector and would be detrimental to the local economy. With this in mind the ongoing prudential management of the bank and generation or risk adjusted profits are key not only to the bank itself but also its customers and wider economy.
Within this area concentration risk is a major factor, both in terms of prudent management and continued profits, that banks must evaluate correctly and take appropriate steps to address should it be deemed to have grown too high.
In the coming section we will review the impact of concentration risk to banks and the actions required to address, whilst also looking at the recent Irish Banking crisis and the impact of centration risk to this, in conjunction with and compared to the US banking crisis on Ireland.
Firstly taking concentration risk, this refers to having large portions of the assets or liabilities of a bank associated with a certain business sector, geographical area or single name customers. For example, within Ireland recently very large parts of the bank's assets were held in property loans or specifically in the case of Anglo Irish Bank, a large concentration of loans were extended to the commercial property sector. Issues within these specific areas or concentrations will therefore have a significant impact on banks portfolio of assets and can be extremely detrimental to the ongoing operations of the bank, as we have seen in Ireland with liquidations of banks, Anglo Irish Bank and on the restriction of activities of the banks impacting the wider economy, AIB and Bank of Ireland restricting credit to customers and the impact on their own share prices. Banks need to ensure that within the credit risk management framework and risk appetite frameworks particularly that concentration risk is analysed and kept within the parameters decided upon to avoid such issues being encountered.
To avoid issues of concentration risk and reduce the associated impact of unsystematic risk banks need to through their risk appetite framework ensure diversification at portfolio level is undertaken to ensure any impacts to a particular customer, sector or location does not adversely impact the profits of the banks in a fatal manner. This diversification policy is the result of prudential management to ensure any localised adverse impact within a particular area are contained and the ongoing profits and operations of the bank continue based on the other areas assets are employed within. Diversification aides the bank in managing this concentration and unsystematic risk and is key to the prudential management of the bank.
The ALCO process and its focus on the minimising of risks and optimal use of its asset and liabilities feed into this by ensuring the asset risk is minimised through diversification and additionally on the liabilities side there is also diversification to ensure one or a small number of clients withdrawing their deposits do not cause liquidity or credit extension problems for the bank that could impact it ongoing operations. In terms of capital management, should a bank correctly assess the associated risk of it having a high concentration risk, this may result in it setting aside a high level of liquidity and capital reserves. Whilst this would be prudent in terms of reserves it would have the impact of greatly reducing its profit generation capabilities.

Concentration risk is a key item to be prudently managed by banks should they wish to avoid adverse impacts, as noted by Regling-Watson (2010:6), 'Credit risk controls failed to prevent severe concentrations in lending on property ' including notably high on commercial property ' as well as high exposure to individual borrowers'.

As such an awareness and management of concentration risk, particularly credit concentration risk, given recent events in Ireland, is key to ensuring a bank is prudently managed and continues to generate the profits required to satisfy shareholders, and remains as the vital part of the efficient local economy through its services to customers.

As noted above concentration risk played a large role in the recent Irish Banking crisis, it is also contended that this crisis was imported from the US. Whilst there is some truth in this contention, the above demonstrates that a large part of the issue was home grown in Ireland's case.
Before looking at the non US imported or home grown issues within Ireland, it is worth noting that whilst Ireland did not import the same issues encountered in the US, for example participation in the subprime mortgage backed securities (MBS) and collateralized debt obligations (CDO) both original and synthetic, there was an associated impact of the US crisis felt in Ireland given that large reliance Irish banks had on the wholesale funding and liquidity markets. As the US crisis developed and spread, it caused a constriction in the wholesale markets of funding, which greatly reduced the funding and options open to Irish banks to continue to fund their operations. This funding constriction had a major impact on Irish banks, as noted by Regling-Watson (2010:16), 'It was at this stage that the full force of the crisis was felt by countries (including Ireland) where banks were heavily exposed to wholesale money markets but did not hold many toxic assets'.
Along with the issues within the wholesale money markets and the large concentration risk demonstrated within the Irish experience there are also other home grown issues that greatly contributed to the Irish experience.
Critically the regulatory and supervisory environment within Ireland was not adequate during the this period, with a 'light touch' approach taken in many instances which failed to adequately assess the risks exposed to the banks and ensure the correct processes were being undertaken to screen and assess the viability of loans advance. This environment was in contrast to have heavier regimes seen in Canadian and Australian banks, who did not suffer to the same extent as our Irish banks. These failures extended across the board in certain cases within Ireland and included internal controls within banks and the credit risk assessments, the adoption and enforcement of appropriate regulations and supervision by regulators and the reviews undertaken by auditors. The combination of these failures once the financial crisis began and spread to Ireland subsequently exposed the banks and wider economy to harsh lessons as a result.

In conclusion, whilst it can be seen that the impact of the US situation had an impact on Ireland through the constriction of the wholesale money markets and the associated reduction in funding available to both domestic and foreign banks operating within Ireland, this was only one factor in a large impact caused by the home grown issues inherent within the Irish banking sector. This is further evidence by the relative impact to Canadian and Australian banks who had a similar exposure to the US but not the same home grown issues as Ireland and those countries reduced experience as a result. These home grown issues related predominantly to the failures of regulation, supervision and accountability within the Irish industry and the concentration risks Irish banks exposed themselves to through lending heavily to the property and commercial property sector and the small pool of property developers loans were advanced to. The impact of these issues was the liquidation of banks, reduction of banks share price and the large scale reduction in business activities within the local economy. This hit hard both the banks themselves and the wider economy and people and businesses within the economy.
From this the lesson of the requirement for profit seeking through prudent management of risks and concentrations has been seen to ensure risk adjusted profits are optimised.

Hamill, P (2013). Principals and Practice of Banking. London: Pearson Education Limited

Honohan, P. (2010). The Irish Banking Crisis Regulatory and Financial Stability Policy 2003-2008

Nyberg. (2011). Misjudging Risk: Causes of the systemic banking crisis in Ireland

Regling-Watson (2010). A Preliminary Report on The Sources of Ireland's Banking Crisis.

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