Foundations of Financial Risk - Apostolik Richard

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most of the key topics are presented within a risk management framework. A glossary is provided at the end of the book.

       Chapter Outline

      1.1 Banks and Banking

      1.2 Different Bank Types

      1.3 Banking Risks

      1.4 Forces Shaping the Banking Industry

       Key Learning Points

      • Banks provide three core banking services: deposit collection, payment arrangement, and loan underwriting. Banks may also offer financial services such as cash, asset, and risk management.

      • Banks play a central role in facilitating economic activity through three interrelated processes: financial intermediation, asset transformation, and money creation.

      • Retail banks primarily serve retail customers, and wholesale banks primarily serve corporate customers. A country's central bank sets monetary policy on behalf of the country's government, liaises with other central banks, and may act as the bank regulator. Sometimes a body other than the central bank is responsible for the regulation of individual banks.

      • The main risks that banks face are credit, market, operational, and liquidity risks. Other types of risk include business, and reputational risk. As economies, banks, and societies as a whole develop and change, the risks faced by banks may also change, and new risks may emerge.

      • Multiple forces shape the banking industry, including regulation, competition, product innovation, changing technology, and the uncertainty surrounding future interest and inflation rates.

FUNCTIONS AND FORMS OF BANKING 1.1 Banks and Banking

      To understand banking risk and regulation, it is important to understand the range of services banks provide and the key role that banks play in a modern economy.

       1.1.1 Core Bank Services

      Banks offer many products and services. While there is variation among banks and across regions, the core services that banks traditionally provide are:

      • Deposit collection– the process of accepting cash or money (deposits) from individuals and businesses (depositors) for safekeeping in a bank account, available for future use.

      • Payment services– the process of accepting and making payments on behalf of the customers using their bank accounts.

      • Loan underwriting– the process of evaluating and deciding whether a customer (borrower) is eligible to receive credit and then extending a loan or credit to the customer.

      As banking has evolved, the complexity of the three core banking functions has increased. For instance, in early banking, depositors received a certificate stating the amount of money they had deposited with the bank.

Later, deposit certificates could be used to make payments. Initially a cumbersome process, the concept of using deposit certificates for payments further evolved into passbooks, checks, and other methods to conveniently withdraw deposits from the bank. Today, deposits, withdrawals, and payments are instantaneous: withdrawals and payments can now be made through debit cards, and payments are easily made via electronic fund transfers (EFTs). See Figure 1.1 for examples of bank products and the services each provides.

Figure 1.1 Examples of Bank Products and Core Bank Services

      Underwriting has many different meanings in finance and banking. This book focuses on lending or credit. Banks underwrite loans in two steps. First, the bank analyzes the borrower's financial capacity, or the borrower's ability and willingness to repay. This process will be discussed in detail in Chapter 4. Then, the bank pays out, or funds, the loan (cash or other forms of payment) to the borrower.

      Providing all these core services is not enough for an institution to be called a bank in a modern economy, however. In order to provide these services, a modern bank must also hold a banking license and be subject to regulation and supervision by a banking regulator.

       1.1.2 Banks in the Economy

      Through the core bank services mentioned, banks are critical facilitators of economic activity.

      • Banks channel savings from depositors to borrowers, an activity known as financial intermediation.

      • Banks create loans from deposits through asset transformation.

      • Banks, through financial intermediation and asset transformation, engage in money creation.

      When a bank accepts deposits, the depositor in effect lends money to the bank. In exchange, the depositor receives interest payments on the deposits. The bank then uses the deposits to finance loans to borrowers and generates income by charging interest on the loans. The difference between the interest that the bank receives from the borrowers and the interest it pays to the depositors is the main source of revenue and profit to the bank.

      When underwriting a loan, a bank evaluates the credit quality of the borrower – the likelihood that the borrower will repay the loan. However, depositors, who lend money to the bank in the form of deposits, typically do not evaluate the credit quality of the bank or the bank's ability to repay the deposits on demand. Depositors assume that their deposits with the bank are safe and will be returned in full by the bank “on demand.” This puts depositors at risk because, as we will see in later sections, banks occasionally do fail and are not able to repay deposits in full (Section 3.1). To protect depositors against bank failures, governments have created safety nets such as deposit insurance (Section 3.4). These safety nets vary from country to country and generally do not provide unlimited protection, thus leaving a certain percentage of deposits exposed to the risk that a bank will default and the depositors will not be able to receive their deposits in full.

      By collecting funds in the form of deposits and then loaning these funds out, banks engage in financial intermediation. Throughout the world, bank loans are the predominant source of financing for individuals and companies. Other financial intermediaries such as finance companies and the financial markets (such as stock or bond markets) also channel savings and investments. Unlike other financial intermediaries, though, banks alone channel deposits from depositors to borrowers. Hence, banks are also called depository financial intermediaries.

Financial intermediation emphasizes the qualitative differences between bank deposits and bank loans. Bank deposits (e.g., savings accounts, checking accounts) are typically relatively small, consisting of money entrusted to the bank by individuals, companies, and other organizations for safekeeping. Deposits are also comparatively safe and can typically be withdrawn at any time or have relatively short maturities. By contrast, bank loans (e.g., home mortgage loans, car loans, corporate loans) are generally larger and riskier than deposits and have repayment schedules typically extending over several years. The process of creating a new asset (loan) from liabilities (deposits) with different characteristics is called asset transformation (see Figure 1.2).

Figure 1.2 Asset Transformation

       1.1.3 Money Creation

      Banks earn revenues from the financial intermediation/asset transformation process by converting customer deposits into loans. To be profitable, however, the interest rates that the bank earns on its loans must be greater than the rate it pays on the deposits that finance them. Since the majority of deposits can be withdrawn at any time, banks must balance the goal of higher revenues (investing more of the deposits to finance loans) with the need to have cash on hand to meet the withdrawal requests of depositors. To do this, banks “reserve” a relatively small fraction of their deposit funds

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