Banking Operations: Liabilities, Credit Derivatives, & Securitization

Bank Liabilities & Financial Operations

Deposits: Core Bank Liabilities

A deposit is a contract or transaction involving the transfer of money to a bank account.

Types of Deposits:

1. Demand Deposits: Normal deposits for frequent, on-demand access to funds. They are more liquid and less costly for the depositor.
   • Current Accounts: Deposit accounts not primarily for earning interest or savings, but for the convenience of business or personal clients.
   • Money Market Accounts: Less liquid, offering higher interest rates. These are interest-bearing deposit accounts based on current money market rates, typically requiring a higher minimum balance to earn interest or avoid fees.
   • Savings Accounts: Less liquid, offering lower interest rates. These accounts allow customers to set aside a portion of their liquid assets while earning a monetary return. Withdrawals are generally unlimited but can occasionally be costly and more time-consuming.
2. Time Deposits: Funds that cannot be withdrawn for a certain period unless a penalty is paid. Generally, the longer the term, the better the yield. They are less liquid and more costly for the depositor.

Interbank Loans: Short-Term Funding

Interbank loans are liabilities-side operations where banks raise short-term money on the interbank lending market. This market is a global network used by financial institutions to trade currencies and other currency derivatives directly among themselves. The goal of interbank lending markets is to support the fractional reserve banking model by giving banks more flexibility in managing liquidity efficiently and satisfying regulations like reserve requirements.

Repurchase Agreements (Repos): Asset-Backed Funding

Repurchase agreements (Repos) are liabilities-side operations where banks use some of their financial assets to raise short-term funding, agreeing to repurchase the securities later.

Bonds: Medium- to Long-Term Funding

Bonds are fixed-income marketable securities and liabilities-side operations through which banks raise medium- to long-term funds from investors in debt capital markets.

Covered Bonds: Enhanced Debt Securities

Covered bonds are credit-enhanced bonds collateralized by a dedicated pool of assets, providing security against default and reinvestment risks.

• Mortgage Bonds: Secured by the pledge of specific mortgages.
• Public Sector Bonds: Secured by the pledge of specific loans.
• Contingent Convertible Bonds (CoCos): Hybrid securities that convert into a specified number of common stock shares of the issuer when a trigger condition occurs (usually when the bank's capitalization falls below a minimum threshold).

Credit Derivatives & Risk Management

Understanding Credit Derivatives

Credit derivatives are two-sided contracts that enable the buyer and seller to transfer the credit risk of an underlying position. They are traded over-the-counter, treating credit risk as a commodity.

• The counterparty transferring credit risk (the protection buyer) seeks protection from potential losses due to adverse credit events on a position.
• Credit events (e.g., bankruptcy, failure to pay, restructuring) result in a payment from the protection seller to the protection buyer and the termination of the contract.
• The counterparty to whom credit risk is transferred (the protection seller) seeks exposure to credit risk to realize gains based on its credit views (i.e., expectations on credit quality).

Credit Default Swaps (CDS) Defined

Under a Credit Default Swap (CDS), the protection buyer pays a premium to the protection seller and gains the right to either receive a default payment equal to the loss incurred (Cash Settlement: par value – recovery value) or to transfer a deliverable obligation at par value (Physical Settlement) if the reference entity becomes insolvent within the contract's specified period.

Uses of Credit Derivatives

Credit derivatives are utilized for various strategic purposes:

1. Credit Risk Diversification and Management:
   • To hold a credit portfolio with the desired risk-return profile.
   • To reduce or increase exposure of the current credit portfolio to a given sector or region by buying or selling protection.
   • To gain new credit risk exposure to a sector or region by selling protection, based on credit views.
2. Efficient Capital Allocation: To improve the return on absorbed capital for a given level of credit risk.
3. Credit Capacity Enhancement: To gain short-to-medium term exposure to a broader set of customers, sectors, and regions, as excess credit capacity is costly and inefficient.
4. Regulatory Capital Optimization: To free up regulatory capital by buying protection or to employ capital by selling protection.
5. Cost of Funding Reduction: To take positions on credit risk independent of the cost of funding.
6. Bank-Customer Relationships: To manage customer credit risk without breaching the relationship or to free up capital for additional financing.
7. Synthetic Securitizations and Tailored Operations: To manage credit risks while keeping assets on the balance sheet (e.g., synthetic securitization).

Pricing Credit Derivatives

The premium for credit derivatives is quoted as an annual percentage in basis points (b.p.) on the contract’s notional value. Pricing considers several factors:

• Transition Matrices: Reporting the probability for a reference entity in a given rating class to migrate to a different class over a period.
• Probabilities of Default and their Covariances.
• Contingent Claim Analysis: Based on option pricing theory.
• Market Approach: Utilizing the term structure of credit spreads and survival analysis.
• Ratings-Based Approach.
• Recovery Rates in the Event of Default: Determined by trading prices or discounted cash flow approaches.

The Economics of Banking & Financial Institutions

Depository Institutions

Depository institutions accept deposits from the public and provide loans.

Commercial Banks:

Banks that accept deposits and make consumer, commercial, and real estate loans. They are typically more diversified in assets and liabilities, though actual compositions depend on size.

• Generate interest spread income and fee income from on- and off-balance sheet activities.
• Highly leveraged, with little equity compared to total assets.
• Regulators require a minimum level of equity capital as a buffer against losses.
• Subject to annual stress tests to assess capitalization.
• Have a shorter maturity structure of liabilities.
• Can be classified by client type:
  • Retail Banks
  • Corporate Banks
  • Business / Wholesale Banks

Savings Banks:

Depository institutions specializing in residential mortgages, mostly backed by short-term deposits. They originated to serve retail customers' borrowing needs, in response to commercial banks' concentration on corporations.

• Regulators set a floor on the minimum holding of mortgages or mortgage-backed securities.
• Savings deposits are the predominant source of funds.
• Can be established as mutual organizations where depositors are also the bank's owners.
• In Spain: Cajas de Ahorro
  • Controlled by private foundations with a social goal, reinvesting substantial profits into social projects.
  • Localized activity targeted towards households and SMEs.

Credit Unions:

Non-profit depository institutions, owned by members with a common bond, specializing in small consumer loans. Their primary objective is to satisfy members' depository and lending needs.

• High concentration of small consumer loans and small amounts of mortgages.
• No common stocks are issued; members are legally the owners.
• Member savings deposits are the predominant source of funds.
• Earnings from lending activity are tax-exempt and used to pay higher rates on member deposits, charge lower rates on member loans, or finance projects for the cooperative's benefit.

Investment Banks:

Unlike depository institutions, investment banks do not transform securities issued by net users of funds into claims more attractive to net suppliers. Instead, they act as brokers intermediating between suppliers and users of funds by:

• Originating, structuring, and executing (e.g., underwriting, roadshow, and book building) public and private placements of debt and equity securities in primary money and capital markets.
  • ECM (e.g., IPOs, SEOs, ABB, PP)
  • DCM (IG, HY, ABS, PP)
• Assisting trading of securities in secondary markets (brokerage, market-making, research).
• Advising on corporate finance activities and shareholder relations (M&As, joint ventures, leveraged buyouts, takeover defenses, divestitures, spin-offs, loan syndication, and corporate restructurings).
• Investing and lending (proprietary) and asset management (money market funds, pension funds, hedge funds, private equity funds, etc.).

The Investment Bank Business Model:

• More short-term and liquid assets.
• Income derived from commissions and fees.
• Extremely leveraged capital structure.
• Repurchase agreements as the predominant source of funds (no deposits).
• Continuous refinancing of interbank loans.
• Less stringent regulation and supervision.
• Global operations, often organized in a three-dimensional (3D) matrix (area, industry, product), covering sectors like Basic Materials, Healthcare, Communication, Energy, Financial Institutions, Financial Sponsors, Industrials, Power and Utilities, Real Estate, Consumer Products and Retail, Technology and Services, Transportation.

Shadow Banking: Non-Bank Financial Services

Shadow banking refers to non-bank financial service firms performing banking services. They facilitate credit creation across the global financial system and consist of lenders, brokers, and other credit intermediaries outside the traditional regulated banking sector. Generally unregulated (as they do not accept traditional deposits), they are not subject to the same risk, liquidity, and capital restrictions as traditional banks. They played a major role in the expansion of housing credit leading up to the 2008 financial crisis, arising as innovators able to finance real estate and other purposes.

Factors Contributing to the Rise of Shadow Banks:

1. Strict Banking Regulation: Higher burdens in credit access (credit crunch) lead to new entities entering the credit market. Stronger capital requirements (Capital/Risk Weighted Assets) mean banks need to keep higher capital to lend to risky borrowers, thus rationing credit.
2. Regulatory Arbitrage: Highly complex and restrictive banking norms lead non-banks with lighter regulations to satisfy credit demand.
3. Customer Preference: Shadow banks better satisfy some customers (e.g., non-bank lenders like Quicken Loans, P2P platforms).

Drawbacks of Shadow Banking:

• Lack of disclosure and information about asset values.
• Unclear ownership and management structures.
• Little regulatory or supervisory oversight compared to traditional banks (as they do not take deposits).
• A virtual absence of capital to absorb losses or cash for redemptions, and lack of access to formal liquidity support to prevent "liquidations" or forced sales of assets.
• Growth of shadow banking in countries with tightening banking regulation promotes shadow activities, leading to a growing, opaque, and unstable sector, potentially causing the next great financial crisis.
• High interconnection: The bankruptcy of one shadow bank can generate a cascading effect of losses in others without the possibility of controlling or monitoring risks ex ante.

Bank Guarantees & Securitization

Bank Guarantees: Risk Mitigation

A bank guarantee is the bank’s obligation to pay the beneficiary the amount specified in the letter of guarantee if the guaranteed obligation is not fulfilled.

• Claims submitted under a letter of guarantee are paid by the bank on demand.
• Used to essentially insure a buyer or seller from loss or damage due to non-performance by the other party in a contract.

Securitization: Transforming Illiquid Assets

Securitization is the transformation of an illiquid asset into a security (i.e., an asset-backed security).

• The lender sells or assigns certain loans to a Special Purpose Vehicle (SPV), which issues debt (ABS) to investors to finance the transfer.
• The SPV is legally insulated from the originator(s) of the loans.
• Credit quality of the loans is enhanced, and ABS are reviewed by rating agencies.
• Benefits and risks are divided among investors on a pro-rata basis.
• A security is tradable and therefore more liquid than the underlying loans.

Securitization of assets can lower risk, add liquidity, and improve economic efficiency. Sometimes, assets are worth more off the balance sheet than on it.

Reasons for Securitization

Banks embark on securitization for several strategic reasons:

1. Fundraising: To obtain new liquidity to provide new credit (generating new fees) or to repay liabilities.
2. Improved Return on Assets (ROA): By divesting assets that absorb significant capital but offer low returns.
3. Lower Average Cost of Capital.
4. Improved Capitalization Ratios.

Goal and Types of Securitized Assets

The goal of securitization is to identify a homogeneous pool of assets with a definite risk profile, offering stable and frequent cash flow payments.

Types of Assets Suitable for Securitization:

• Mortgages, residential or commercial (MBS, RMBS, or CMBS).
• Loans, performing and non-performing (CLO) or bonds (CBO).
• Credit derivatives, i.e., swaps (CSO).
• Credit card receivables.

Suitability of Assets:

The pool of assets should be large and homogeneous:

• Large enough to facilitate statistical analysis.
• Historically stable in terms of defaults, delinquencies, prepayment, etc.
• Sufficiently diversified.
• Meeting basic credit quality standards, evaluated and approved by rating agencies or specialized financial guaranty companies.
• Composed only of transferable and unencumbered assets.

Risks Involved in Securitization: Cash Flow Waterfall

The risk and return profiles of tranche securities are managed through a cash flow waterfall structure. Notes/securities issued can be subdivided into graduated slices to attract a diverse range of investors with different risk and return requirements. These tranches are sold separately to investors.

Tranches can pay a fixed or floating rate to investors, with interest and principal allocated to the tranches according to their seniority.

Major Sources of Risk:

• Credit Risk: E.g., default rate on loans increases.
• Liquidity Risk: E.g., loan cash flows do not coincide with ABS flows.
• Interest Rate Risk / Currency Risk.
• Basis Risk: E.g., interest rates on loans fall below ABS rates.
• Prepayment Risk: E.g., underlying asset is callable.

Risk Mitigation Strategies:

• Pre-Securitization: Assets for the pool are selected and packaged to make the corresponding ABS attractive. This involves screening assets prior to securitization, subject to criteria like maximum outstanding principal amount.
• Credit Enhancements: Securitized assets are qualitatively transformed to cater to investors' risk-return preferences. ABS are structured to obtain higher credit ratings than the originator or the underlying asset pool.
  • Internal Enhancements: Isolation from the originator, tranche subordination, cash collateral account, excess spread, overcollateralization, replacement of assets.
  • External Enhancements: Third-party credit guarantees.
• Cash Flow Restructuring: Derivative contracts are signed with outside counterparties to hedge risks related to shifts in interest rates or exchange rates.
  • Interest Rate Swaps: To protect ABS investors from the risk that an increase in market interest rates reduces the excess spread for the SPV.
  • Currency Swaps: To protect ABS investors from the risk that a change in exchange rates reduces the excess spread for the SPV.

Cash Flow Waterfall Phases:

Cash inflows from securitized assets can only be used to service debt. The cash flow waterfall structure is characterized by two phases:

1. The Revolving Period: Only interest is paid on ABS. This is the initial period where the originating bank can transfer assets to the SPV up to the maximum nominal amount and according to established eligibility criteria. The bank can also replenish the initial pool as underlying assets amortize.
2. The Amortization Period: Both principal and interest are paid on ABS. This is the period where the asset pool naturally amortizes, and no further replenishments can be made by the originating bank. It can be anticipated if an "early amortization" trigger event occurs.

Off-Balance Sheet Activities

An activity is considered an off-balance sheet asset/liability if, upon a contingent event, the asset/liability moves onto the balance sheet or an income/expense is realized on the income statement.

By moving assets off-balance sheet, banks:

• Earn additional fee income to complement declining margins on loans.
• Improve capitalization coefficients and avoid regulatory costs.

Loan Syndication: Collaborative Financing

Loan Syndication Overview

Loan syndication involves a group of banks formed to jointly provide large and ad hoc financing for a project.

Why Syndicate Loans?

1. To share the risk of a large loan.
2. To create a network between banks.

Bank Roles in a Syndicate

1. Mandated Lead Arranger (MLA): The main actor, designing the operation with the borrower and inviting other banks.
2. Co-Lead Arranger: Works with the MLA to find banks willing to participate in the loan.
3. Participants: Other banks joining the syndicate.
4. Documentation Bank: Organizes the finance documentation.
5. Agent Bank: Acts as the representative of the syndicate.

MLA Syndication Strategies

Traditionally, MLAs have used two primary strategies:

1. Single-Stage Syndication: The MLA alone underwrites the loan and directly allocates portions of it to other banks in the syndicate.
2. Dual-Stage Syndication: The MLA and Co-Lead Arrangers jointly underwrite the loan and then allocate portions of it to other banks participating in the syndicate.