The success of a bank lies in the management and interplay between a number of important banking concepts. These concepts are manifested in the nature of a bank’s lending and borrowing habits, the quality of investments made by the bank and the conflict that exists between a bank manager’s desire to make profit and their aim to remain resilient to customer reactions on perceived market conditions.
This article explores these concepts which form the key drivers behind decisions made by bank managers and demonstrate their significance to the sustainable long term operation of banks. The article is then concluded with a look at some of the commonly utilised tools for measuring a bank manager’s success in striking a balance between the discussed management drivers.
How Banks Make Money
In simple terms, banks make money by acting as the intermediary between people who want to store their money and people who want to borrow money. Banks offer an incentive for customers to store money with them by offering their customers a fee for holding their cash. This fee is the interest that customers gain for placing their money into bank accounts. Customer’s deposits for this reason are liabilities for the bank, as the bank has to pay an ongoing charge to customers for holding their cash. The deposits which the bank holds are then leant to people who need to borrow money and the people who need the money are required to pay the bank for giving them the money they need. This charge is the interest that the borrowers pay the bank on top of the money they have borrowed. Bank loans are assets to the bank as they generate a profit on top of the money they lend out.
So, banks take deposits from customers and pay the customers interest. Borrowers then take the deposits from the banks and pay the banks interest. ‘How does the bank make any money?’ you may ask. Well, the key to how the bank makes a profit is in the interest rates attached to the money they borrow and lend. The bank makes a profit by charging more interest on the money they lend to borrowers than the interest they originally paid to depositors for storing their money with the bank. At a basic level, this fundamentally is the banking business model.
Lend Long Borrow Short
There is some inherent risk in the way that banks operate as the nature of their assets and the way their assets are financed means that banks tend to borrow over the short term and lend over the long term.
If a person took out a loan, the repayment (or maturity) date would typically be in the region of 5 years. If a Mortgage was taken out on a property, the maturity date can be up to 25 years. As long as the borrower sticks to the terms of their initial agreement with the bank (i.e. keeping up with their repayments), there is nothing the bank can ever do to get their money back any sooner than the initially agreed maturity date.
Deposits on the other hand are quite different. A customer puts money into their current account on the understanding that he can take the money back whenever they like, at very short notice if any at all.
Deposit customers could all demand their money back at the same time (this situation is known as a ‘run on the bank’). In this scenario the bank would take whatever cash it had and would reimburse as many customers as possible with their deposits. The bank would then have to convert its assets into cash (i.e. sell its loans to other banks) to facilitate the reimbursement of outstanding depositor funds once its cash reserves had been utilised. In the unlikely event that the bank managed to reimburse all of its depositors, little money, if any, would remain for the bank to make further investments and cover its operating expenses (i.e. staff salaries, building leases etc.). For this reason the bank would become insolvent.
Asset Liability Management
Asset/ Liability Management (ALM) is a set of techniques used to manage the risks that arise due to mismatches in the time scales of a bank’s debts and liabilities. This strategic management tool aims to minimise this risk by managing the interest rate and liquidity risks that occur as a result of borrowing and lending.
Liquidity Risk arises due to the fact that a loan, once given to a borrower, is no longer a very liquid asset. As mentioned earlier, a bank is unable to suddenly recall the funds loaned to borrowers before the agreed loan maturity date. For this reason, in the event of some unforeseen demand for large sums of money from the bank, the only way that the bank could convert its loans into cash immediately would be to sell them. At this point the bank would be at the mercy of the market since the bank’s ability to sell the loan and the sale-price (and therefore profit, if any) that the bank could achieve would depend purely on the demand for the loan at the time. It is almost guaranteed that a distressed bank aiming to sell their loans quickly would be unable to obtain the value they expected on the original loan so in any case the bank would suffer a loss.
ALM is therefore the process of planning, organizing, and controlling asset and liability volumes, maturities, rates, and yields in order to balance interest rate risk and maintain acceptable profit (and liquidity, as explained later) levels. One of the main ways in which this is done is by adjusting the interest rates on loans and deposits in line with their respective maturities in an aim to reduce interest rate risk and maximise profitability. Banks also achieve this by placing guidelines on the types of loans and deposits the sales and marketing departments have to sell at a moment in time.
Quality of Lending
Another risk that banks are susceptible to is the risk that borrowers could become unable to repay the bank the loans they had taken out. If this was the case, the bank would make no profit and would suffer significant losses in capital. If all of the bank’s capital was wiped out, the bank would be unable to repay its depositors and would therefore become insolvent.
A key aspect of a bank’s operations involves assessing whether people are fit to be given credit. A bank’s profits are purely dependent on how successful they are in accruing the interest and recovering the original cash (known as the ‘Principal’) amount that was loaned to borrowers. The profitability of a loan may be illusive. If a loan of £100 at £5 of interest a year for five years is not repaid at the end of the five years, the bank may have thought it had made £5 a year interest. On the contrary however, in the last year the bank would lose the principal loan amount (i.e. £100), which would vastly outweigh the interest gained up until that point. Banks are constantly faced with a temptation to think short term. Lending money to people who cannot repay the money looks good for a year or two while the interest repayments are made, but looks very bad when the principal has to be paid back and is not. The key to ensuring the long term sustainability of a bank is therefore in determining that potential borrowers are willing and able to repay the loans that they apply for.
A bank’s profits in the short term are directly proportional to the amount of credit they extend. For this reason banks have been known to fixate on their goal of maximising profits while relaxing their selection criteria for who they lend to. Sub-prime lending is the practice of lending to people who don’t have a good credit rating; these people are perceived to pose a higher risk of defaulting on the repayment of their debts. As explained earlier, ALM deals with adjusting interest rates on loans in relation to the risk the borrowers are perceived to carry. Loans to sub-prime borrowers would therefore come with higher interest rates than loans to people with good credit (i.e. prime lenders). Sup-prime loans, with their higher than usual potential profit margins as a result of the higher risks attached to these loans, can be attractive to banks.
The quality of loans is all to do with the risk associated with the borrowers. Loans to borrowers who are highly likely to pay the loans back (i.e. people with good credit ratings) are seen as good quality loans. Loans to sup-prime lenders on the other hand, are seen as poor quality loans.
If a large amount of a bank’s assets were invested in loans to sub-prime borrowers, the bank would be putting itself at significant risk of not being able to realise their projected profits. If this was the case and loans had to be written off, the bank’s capital (i.e. retained profits and/or shareholder equity) would take the hit. The loss that would occur as a result of the defaulted loan would be known as an impairment loss.
Generally an asset is considered to be ‘value impaired’ when its book value exceeds the future cash flows expected to be received from its use. In the case of a bank, a large proportion of the impairment losses would occur as a result of bad debt. Bad debt includes unrecoverable loans, defaulted mortgages and any other unrecoverable assets where credit is extended with interest to a consumer who ends up being unable to meet their agreed repayments for one reason or another. The expected assets that would’ve been recorded as a result of the extension of credit would therefore be incorrect and a loss would occur as a result.
Liquidity vs. Profitability
Figure 1 – Liquidity vs. Profitability
As shown in figure 1, for a given value in customer deposits, the profitability of a bank is directly proportional to the amount of the credit they extend. The more loans a bank gives out, the more interest they will accrue and the higher their potential profits will be over a given time period.
The liquidity, as detailed in figure 1, is related to the amount of cash or near cash assets the bank holds in relation to the customer deposits they hold. The most liquid of all assets, and what everything is compared to, is cash. Cash is the most liquid as it can always be used immediately. The least liquid asset is real estate, as it could take months to convert real estate into cash. Liquidity is relevant as it dictates how much cash is reserved for payment of things such as a bank’s overheads. It is also important as it would determine the effect that a run on the bank would have on the bank’s future solvency.
The liquidity of a bank is inversely proportional to the amount of credit a bank extends to borrowers (i.e. the bank’s profitability). A bank can either be highly profitable, or it could be highly liquid, it cannot be both as the Bank of England give very low interest rates compared to lending to customers and businesses.
In basic terms, at any given time the bank would have a certain amount of cash which would be determined mainly by the amount taken as customer deposits. The bank could either reserve that cash for payment of overheads and to protect against the possible occurrence of a run on the bank, or it could invest most of the cash in assets in an aim to generate profits.
A liquidity buffer describes minimal levels of cash that are deposited within central banks (i.e. Bank of England for UK, Federal Reserve for U.S.A. etc.). This buffer is required to ensure that a bank’s liquidity remains at a sufficient level to protect the bank if a run on the bank were to occur.
It is important to understand that a bank could not ensure its longevity by aiming to align itself with any of the concepts previously discussed in isolation. To ensure a bank’s sustainability, bank managers must appreciate the importance of the constant interplay between the concepts and should understand the consequences of an imbalance between the concepts. There are ways of measuring the quality of a bank’s lending and determining how susceptible a bank is to changes in market conditions. The ‘Net Interest Margin’ and ‘Loan to Deposit ratio’ are two commonly utilised measures for assessing the performance of a bank.
Net Interest Margin (NIM)/ Spread
The Net Interest Margin (NIM) is used to track the profitability of a bank’s investing and lending activities. Also known as the ‘Net Yield’ on interest earning assets, this parameter gives the ‘Net Interest Income’ (NII) as a Percentage of the average interest earning investments made over a time period.
Since NIM is a ratio of NII and average invested assets, the factors and banking practices that affect NIM can be easily determined.
Figure 2 – Factors Affecting Net Interest Margin
The ‘Starting NIM’, as detailed in figure 2 shows the ratio of NII and ‘Average Invested Assets’ that would determine a bank’s NIM. To increase NIM, a bank would have to either increase its NII as shown on the right of the diagram, or reduce its ‘Average Invested Assets’ as shown on the left.
Since this is the difference between the interest gained on assets and the interest paid on liabilities, a bank should aim to maximise the interest gained on its assets and minimise the costs associated with its deposits. Loans to consumers and SMEs will have the highest interest rates compared to loans from the interbank and corporate market, investment securities and other short term investments. Similarly, deposits from consumers and SMEs will generate the smallest interest cost when compared to other forms of borrowed funds. For these reasons, the highest NII is commonly seen in banks where consumer and SME loans make up the majority of their assets and consumer and SME deposits are the main source of funding for their assets.
Loan-Deposit Ratio (LTD)
This term is utilised to assess the liquidity and profit earning potential of a bank at any instant and is given by the formula:
If the ratio is greater than 1, the bank does not have enough deposits to fund its outgoing loans. This is a risky position to be in. If a run on the bank were to occur in these circumstances, the bank would not have enough money in stock to cover the deposits made by its customers. The bank would therefore have to rely on wholesale markets that may or may not be prepared to help the bank at its time of need.
If, on the other hand, the ratio is less than 1, the bank is utilising its own customer’s deposits to finance its loans. This is a better position to be in as there is a surplus of customer deposits which in turn would be held in liquid Bank of England deposits.
The real world consequences of low liquidity
Northern Rock went to administration because the ratio of their loans to deposits fell to an unhealthily low level. They had large sums invested in loans however the amount of deposits they had was very low (meaning their LTD was very high) and they had very low liquidity. For this reason they relied heavily on wholesale markets to balance the capital they had invested in loans. At the start of the recent recession, the wholesale markets decided to stop lending to Northern Rock as a result of the cutbacks that everyone was forced to make. This meant that they didn’t have enough cash reserves to return the deposits to customers that had their savings with the bank. When customers began simultaneously demanding their deposits from the bank they couldn’t pay the customers and for that reason became insolvent.