Business Lines

BANKING BUSINESS LINES The banking industry has a wide array of business lines. These can be grouped into the following main poles: • • • • •

(i) Traditional Commercial Banking (ii) Investment Banking (iii) Trading (iv) Private Banking (v) Others

These poles can be further subdivided into various business lines as shown below: Business Poles Business Lines Commercial Banking Retail financial services Corporate-middle market Large corporates Investment Banking Advisory services Mergers and acquisitions Leveraged buyouts (LBO) Merchant banking Loan syndication Asset financing Commodities Securitization Factoring Forfaiting

Trading

Derivatives Equity Fixed Income securities

Private Banking

Asset management

Others

Custody

Management practices are very different across and within the main poles.

Retail banking is mass oriented and ‘industrial’ because of a large number of transactions. Lending to individuals relies more on statistical techniques. Management reporting on such large number of transactions focuses on large subsets of transactions based on date of origination, type of customer, product family (consumer loans, credit cards, leasing) For medium and large corporate borrowers, individual decisions require more judgement because mechanical rules are not sufficient to assess the actual credit standing of a corporation. For middle market segment to large corporate businesses, relationship banking prevails. The relation is stable based on mutual confidence and generates multiple services. Risk decisions necessitate individual evaluation of transactions. Obligers’ reviws are periodical.

Investment banking is the domain of large transactions, customized to the needs of big corporates or financial institutions. It is also called ‘ structured financing’ implying specific structuring and customization for making large and risky transactions , such as project finance and corporate acquisitions, feasible. Structuring designates the assembling of financial products and derivates plus contractual clauses for monitoring risks (covenants). Without such risk mitigants, transactions would not be feasible. This domain overlaps traditional merchant banking and market business lines.

Trading involves traditional proprietory trading and trading for third parties. In the latter case, traders interact with customers and other banking business units to bundle customized products for large borrowers including professionals of the finance industry, banks, insurance companies, brokers and funds. Other activities such as private banking, asset management or advisory services do not generate directly traditional banking risks. However they generate other risks such as operational risk. All business lines share the common goal of risk-expected return enhancement. For the purpose of differentiating risk management practices and designing risk models, the banking activities can be represented by a matrix of markets and product groups as shown below:

Product Groups

Retail Corporate Off Specilized Financial Lending Balance Finance Services Sheet

Market Transactions

Markets Consumers Corporate Middle Market Large Corporate Firms Financial Institutions Specialized Finance Customers

Specialized Finance refers to structured finance, project finance, LBO or asset financing .

• Within the above broad groups, products vary. Standard lending transactions include overnight loans, short term loans (less than one year), revolving facilities, term loans, committed lines of credit or large corporate general loans. Retail financial services cover all lending activities, from credit card and consumer loans to mortgage loans. Off balance sheet transactions are guarantees and backup lines of credit providing significant revenues to banks. Specialized finance includes project finance, commodity financing, asset financing (from real estate to aircraft) and trade financing. Market transactions cover all basic compartments, fixed income, equity and foreign exchange trading including derivatives from standard swaps and options to exotic and customized products.

Major market segments can also be subdivided. Financial institutions include banks as well as insurance or brokers. Risk management involves risk and expected return measuring, reporting and management for such transactions, for the bank portfolio as a whole and for all couples representing a market-product combination.

COMMERCIAL, INVESTMENT AND UNIVERSAL BANKING Commercial banking is accepting, for the purpose of lending or investment , deposits of money from the public, repayable on demand or otherwise and withdrawable by cheque, draft, order or otherwise. The major functions of a commercial bank are: 1. Accepting deposits: saving, current and fixed 2. Extending loans: overdraft, bill discounting and outright loans and advances. 3. Other functions: transfer of funds, agency function, developmental role

Investment Banking is not a specific service or function. It is an umbrella term for a range of activities: issuing, investing, underwriting, selling and trading securities (stocks and bonds); providing financial advisory services , for example, relating to mergers and acquisitions; and managing assets. Investment banks offer these services to companies, government, nonprofit institutions and individuals. Their main activities include: 1. Corporate Finance: concerned with managing the finances of corporations (including mergers, acquisitions and disposals), often called the investment banking division of the firm. 2. Research: concerned with investigating, valuing and making recommendations to clients, both individual investors and larger entities such as hedge funds, mutual funds- regarding shares, corporate and government bonds.

3. Equities (or sales and trading): concerned with buying and selling on behalf of bank’s clients and sometimes for the bank itself. 4. Proprietory Trading: concerned with management of bank’s own capital. It is often one of the biggest sources of profit for the bank. For example, banks may arbitrage in huge scale if they see a suitable opportunity and/or they may structure their books so that they profit from a fall in bond yields (or rise in bond prices)

Tools of Investment Banking Investment banks can invest money on stock markets or use advanced products such as derivatives. They can also invest money directly into companies, projects etc., either as direct investment for which they carry full risk (known as private equity, venture capital), or as loans with collaterals to reduce risk. Combinations of loans and derivatives also exist such as mezzanines. Some of the major global private investment banks include: ABN Amro Goldman Sachs Barclays Capital JP Morgan Bear Stearns Lazard BNP Paribas Lehman Brothers Brown Brothers Merrill Lynch Citigroup Morgan Stanley Credit Suisse Rothschild Deutsche Bank UBS

Conflict of Interest in Commercial and Investment Banking The conflict between the two may arise from the following: (i) Conflict between the investment banker’s promotional role and the commercial banker’s obligation to provide disinterested advice. (ii) Using the bank’s securities department to issue new securities to repay unprofitable loans. (iii) Placing unsold securities in the bank’s trust account. (iv) Making bank loans to support the price of a security that is underwritten by the bank. (v) Making imprudent loans to issuers of securities that the bank underwrites. (vi) Direct lending by bank to its securities affiliate.

• Conflict of interest was the major reason for he introduction of Glass Steagall Act in the U.S. Three well-defined evils were found to flow from combination of investment and commercial banking: (i) Banks were deploying their own assets in securities with consequential risk to commercial and saving deposits. (ii) Unsound loans were made in order to shore up the prices of securities or the financial position of the companies in which the bank had invested its assets. (iii) A commercial bank’s interest in ownership, price or distribution of securities inevitably tempted bank officials to press their banking customers into investing into securities, which the bank itself was under pressure to sell because of its own pecuniary stake in the transaction. The Glass Steagall Act prohibited banks from offering both commercial and investment services. The Act was repealed by the Gramm-Leach- Bliley Act in 1999.

Universal Banking Universal banking is a combination of commercial banking, investment banking and other activities including insurance. Services provided by Universal Banks Credit/lending business Deposit business Asset management and Securities business investment advice Underwriting business Payment transactions Financial analysis Universal banking usually takes one of the three forms: In house (Germany) , through separately capitalized subsidiaries (U.K.) or through a holding company structure (U.S.A.)

In India, The regulatory environment permits provision of a range of financial services in house in a bank subject to some restrictions. Banks have the option of undertaking investment-banking activity through subsidiaries. Development Financial Institutions (DFIs) have also been permitted to set up banking subsidiaries and also to operate at the short end of the market by performing bank like functions such as providing working capital finance or tapping deposits subject to some restrictions. Thus both banks and DFIs are permitted in a limited way to undertake a range of financial services at their option in house (primary dealership, credit card business, housing finance, securities exchange, securities trading, custodial services etc.) or through subsidiaries (mutual funds, housing finance, insurance, factoring etc.).

It results in greater economic efficiency in the form of lower costs, higher output and better products (economies of scale and economies of scope). Universal banks can more effectively meet shifts in business cycles as diversification reduces the risk of failure. However, the larger the banks, the greater the effects of their failure on the system (high systemic risk). Such institutions may also, by virtue of their size, gain monopoly power in the market that can have undesirable consequences for economic efficiency. Due to large size, there is temptation for greater risk, less flexibility and greater attention towards large and established customers.

It is argued that universal banks are difficult to regulate because their ties with the business world are more complex. In case of specialized institutions, control is easy because their functions are limited. The non-core banking activities may also have an adverse impact on the core banking activities. The public expects that the central bank’s safety net applies to all activities. Failure of the bank in non-core activities can trigger fall of public confidence in banking activities.

THE BANKING AND THE TRADING BOOKS The Banking Book The Banking book groups and records all commercial banking activities. It includes all lending and borrowing usually both for traditional commercial activities and overlaps with investment banking operations. The banking portfolio follows traditional accounting rules of accrued interest income and costs. Customers are mainly nonfinancial corporations or individuals although interbanking transactions occur between professional financial institutions. The banking portfolio generates liquidity and interest rate risks. All assets and liabilities generate accrued revenues and costs of which a large fraction is interest rate driven. Any maturity mismatch between assets and liabilities results in excesses or deficits of funds.

Mismatch also exists between interest references, fixed or variable and results from customers’ demand and banks’ business policy. In general, both mismatches exist in the banking book balance sheet. For example, there are excess funds when collection of deposits and savings is important or a deficit of funds when the lending activities use up more resources than deposits from customers. Financial transactions (on the capital markets) serve to manage the mismatch between commercial assets and liabilities through either investment of excess funds or long term debt by banks. Asset-Liability Management (ALM) applies to the banking portfolio and focuses on interest rate and liquidity risks. The asset side of the banking portfolio also generates credit risk. The liability side contributes to interest rate risk. There is no market risk risk for the banking book.

The Trading Portfolio The market transactions are not subject to the same management rules. The turnover of tradable positions is faster than that of banking portfolio. Earnings are profit and loss equal to changes of the mark-to-market values of traded instruments. Customers include corporate counter parties or other financial players belonging to the banking industry (professional counter parties). The market portfolio generates market risk, defined broadly as the risk of adverse changes in market values over a liquidation period. It is also subject to market liquidity risk, the risk that the volume of transactions is narrow, so much that trades trigger price movements.

. While traditional commercial banking is more ‘local’, the trading portfolio extends beyond geographical borders, just as capital markets do. Many market transactions use nontradable instruments or derivatives such as swaps and options traded over the counter. Such transactions might have a very long maturity. They trigger credit risk, the risk of loss if the counter party fails.

Off Balance Sheet Transactions These are contingencies given and received. For banking transactions, contingencies include guarantees given to third parties, committed credit lines not yet drawn by customers and backup lines of credit. These are contractual commitments which customers use at their initiative. Given contingencies generate revenue as either upfront and/or periodic fees or interest spreads calculated as percentages of outstanding balances. They do not generate immediate exposure since there is no outflow of funds at origination but do trigger interest rate risk, credit risk, funding risk and liquidity risk because of possible future use of contingencies. Off balance sheet items do not appear on the current balance sheet but affect the future shape of the bank’s balance sheet. They have both risk increasing and risk reducing attributes. Banks are induced to enter off balance sheet transactions by squeezing interest rate margins and government regulation in the form of reserve and capital requirement for on balance sheet transactions.

BANKS’ FINANCIAL STATEMENTS Banks’ financial statements consist of a balance sheet and income statement. The balance sheet provides a snapshot view of all assets and liabilities at a given date. The income statement summarizes all revenues and costs to determine the income of a period. Balance Sheet The assets and liabilities emerge out of the various activities of the bank. (i) Treasury and banking transactions give rise to cash and short- term debt. (ii) Intermediation transactions give rise to loans, deposits and off balance sheet items. (iii) Trading activities give rise to financial assets and financial liabilities. (iv) All the above activities necessitate investment in fixed assets and subsidiaries, funds for which are obtained through equity and long term debt.

The relative weights of major components vary from one institution to another depending on their core businesses. Equity is typically low in all banks’ balance sheets. Lending and deposits are traditionally large in retail and commercial banking. Investment banking includes both specialized finance and trading typically funds operations in the market. In European banks, ‘Universal Banking’ allows banking institutions to operate over the entire spectrum of business lines contrasting with the separation between investment banking and commercial banking, which still prevails in the U.S.

The composition of a bank’s balance sheet is normally a result of asset liability and risk management decisions. The risk profile of a bank can be judged simply by analyzing the relative share of various asset items and changes in proportionate share over time. For example, if loan portfolio jumps from 60 percent to 65 percent of on balance sheet assets, one would question if the bank’s credit risk management systems are adequate to enable handling of the increased volume of loan transactions and of the loan portfolio. Such a change will also indicate a shift from another risk area. An increase or decrease in trading securities would indicate a change in the level of market risk to which the institution is exposed. When linked to the amount of net income yielded by each category of assets, this analysis can assess risk versus reward.

Overall liquidity of assets depends on the development of financial markets. Where markets are not well developed, 10 % to 20% of the assets are kept as liquid. The banking environment with well developed markets, liquid assets account for about 5% of total assets. The approval of whether the level of liquid assets is satisfactory is based on a thorough study of money market dynamics in the country. An increase in bank investments and trading portfolios reflects the growing orientation of a bank to nontraditional operations. In risk management terms, such an orientation would mean that a bank has replaced credit risk with market risk and counter party risk.

In case of deposits, some deposits are inherently more risky than others. Large corporate deposits are less stable than household deposits, because they are more actively managed. An analysis of balance sheets can be performed to determine growth rates and the type of structural changes that take place. Shifts in individual components can be examined. Banks that grow too quickly tend to take unjustified risks and often find that their administration and MIS cannot keep up with the rate of expansion. Low earning and non-earning assets can have an adverse effect on net interest margin. Change in the level of these assets over time should be examined. A similar analysis should be made of the off balance sheet items.

Income Statement The income statement of a bank reveals the sources of a bank’s earnings and their quantity and quality and also the quality of a bank’s portfolio and the focus of its expenditure. It also indicates the bank’s business orientation. Income from trading operations, investments and fee based income accounts for an increasingly high percentage of earnings in modern banks. This trend also implies higher volatility of earnings and profits and a different risk profile. Statutory capital requirements, obligatory reserves and taxation also have a bearing on the bank’s profitability. The analysis of profitability starts by considering the structure of a bank’s income- the weightage of interest income, fee income, investment income and trading income. Composition of asset categories should be compared with composition of gross income.