Financial Institutions

1
Financial Institutions

• -- Banking

2
Functions of Financial Institutions

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

3
Intermediation

• The process of transforming a secondary security
  into a primary security by a financial
  institution.
• It relates to financial investments by savors

4
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.

5
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

6
Types of Intermediation

• 1. Liquidity
• 2. Maturity
• 3. Denomination
• 4. Risk

7
Types of Financial Institutions

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

8

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

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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

10
Contract-type Financial Institutions

• Insurance Companies
• Life Insurance
• Accident and Healthy Insurance
• Pension Funds
• Mandatory Providence Funds
• Retirement Funds/Pension Funds

11
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

12
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

13
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

14
Analysis of Financial Institutions

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

15
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 ( Cx1, x2 lt
  Cx1 Cx2 )
• Specialization market niche

16
Solution

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

17
Solutions

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

18
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

19
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)

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Banking BusinessBanking 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.

21
Universal Definition of A Bank

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

22
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

23
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

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• 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

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• 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.
  (1,000800640)

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

27

• 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

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• 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.

29
Bank Organization Structure

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

30
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

31
Banks in Hong KongSource HKMA Monthly
Statistical bulletin, January 2002
32
Balance Sheet of HK Banks SourceHKMA Monthly
Statistical Bulletin, January 2002
33
Funds Flow of a Bank

• Funds Flow-in
• Deposits
• Borrowing / NCD
• Contributed Capital
• Funds Flow-out
• Loans and Advances
• Investments
• Capital Expenditures

34
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

35

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

36
Bank Assets and Liabilities Structure

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

37
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

38
Services Provided by Banks

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

39
Special Services Provided by Banks

• 1. Money Supply Transmissions
• 2. Credit Allocation

40
Development Factors in Financial Institutions

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

41
The Development in Banking Industry

• 1. Institutionalization
• 2. Globalization
• 3. Securitization

42
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

43
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.

44

• 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

45
Banking Regulations
46
Reasons for Banking Regulations

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

47
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

48
Objectives of Bank Regulations

• 1. Safety
• 2. Stability
• 3. Structure

49
Forms of Bank Regulations

• Entry Control - Licensed
• Safety and Soundness Control
• Liquidity
• Capital Adequacy
• Concentration Limits
• Credit Allocation Control
• Geographical Expansion Control

50
Cost/Banefit Analysis of Regulation

• Cost
• Filing Cost
• restricted Activities
• Taxes
• Benefits
• Restricted Competition
• Government Support

51
Banking Operating Structure

• Industry Organization Model
• Structure
• Conducts
• Performance

52
Bank Organization Structure

• Merge and Acquisition -- Super Size Banks
• Efficiency
• Effectiveness
• Multinational Foreign Banks
• Multinational Bank Holding Companies
• Double Leverage

53
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

54

• 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

55
Bank Performance
56
Risks Faced by Bank Operations

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

57

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

58
Objectives of Bank Performance

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

59
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

60
Profitability Analysis
61
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)

62
Factors Affecting NIM/NII

• Credit Risk - Higher Risk Higher Yields
• Interest Rate Fluctuation
• Funding Mix S/T vs L/T
• Sourceswholesale vs retail savings vs time
• Uses commercial vs mortgage vs consumers
• Pricing Mix Fixed Rate vs Floating Rate
• Non-performance Assets
• Tax Exempted Investments

63
Impact of Interest Rate Fluctuation on NIM

• Monitoring Rate Sensitive Assets and
  Liabilities -- Gap Management RSA gt RSL
  .... Positive Gap RSA lt RSL Negative
  Gap RSA RSL Zero Gap When Interest
  Rate increases, Gap ?IR gt ?IE NII
  NIM Gap ?IR lt ?IE NII NIM

64
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)

65
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.

66
Illustration of Active Mgt

• Example
• RSA 8 170 RSL 6 150
• FRA11 155 FRL 8.5 185
• NRA 30 Equity 20
• Total 355 Total 355
• Rate Differentials (Annual)
• On RSA and RSL (8 - 6) 2
• On FRA and FRL (11 - 8.5) 1.5
• On GAP and FRL (8,5 - 8) 0.5
• On NRA and FRL (8.5 - 0) ( 8.5)

67

• Profitability Analysis
• RSA financed by RSL (150 _at_ 2) 3
• FRA financed by FRL (155 _at_ 1.5) 2.325
• GAP financed by FRL (20 _at_ 0.5) 0.1
• NRA financed by FRL (10 _at_ 8.5) (0.85)
• NRA financed by Equity (20 _at_ --) 0
  Total Pre-tax Profits
  4.575
• RONW (ROE) 4.575 ? 20 0.22875
  22.875

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Liquidity Analysis
69
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.

70
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

71
Liquidity Requirement byHong 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.

72
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.

73
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

74
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

75

• 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 Loans Net
  Change
  
  140 50 75 100 80
  ??? Liq Liq Liq Liq

76

• B. Trends Analysis on Loans and Deposits
• Deposits
• Liquidity
• 
  Gap
• Loans
  
• t
  

77
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

78

• 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)

79
Lending Analysis
80
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)

81
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

82
Elements for Lending Policy

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

83
Strategies for Lending Policy

• Loan Analysis
• No Analysis
• Subjective Analysis
• 5 Cs
• Ratio Analysis and Cash Flow Analysis
• Objective Analysis
• Credit Score
• Z Score

84

• 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

85

• Loan Administration
• Centralized Approval
• Decentralized Approval
• Loan Authorization
• Personnel
• Authorized Line of Credit
• Loan Monitoring

86

• Loan Delinquency
• a. Workout Agreement
• b. Collateral Liquidation
• c. Reducing Debt to Collecting Judgment
• d. Charge off
• e. Bankruptcy

87
Capital Analysis
88
Role of Capital

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

89
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

90
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

91
Conditions for Debt as Capital

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

92
Capital Adequacy

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

93
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 lt
  2.74 ---- Inadequate

94
Qualitative Analysis of Capital Adequacy

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

95
Continued

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