Business Planning: Banking
CHAPTER 1: The function and role of banks
Fractional reserve banking: banks retain small proportion of deposits and lend out rest.
Minimum is set by Central banks to mitigate control risk.
Maturity transformation: banks as part of their role as intermediaries, take short-term deposits
and lend long term.
Market makers: undertake to make firm prices at which the bank will both buy and sell a
particular security or financial instrument. Bid price: price at which the market maker is prepared
to buy. Offer/ask price: price at which market maker is prepared to sell. The spread between the
two is the market maker’s profit.
Loan origination: bank process covering everything from the initial loan application through to
the point of agreeing the amount, terms and pricing of the proposed loan. For
commercial/corporate lending information will be summarized on a term sheet.
Loan underwriting: The appraisal of the lending proposal to assess the credit risk and make a
decision on whether or not to extend the loan. For commercial/corporate lending, information will
be summarized on a credit memo or credit write-up.
Short-term finance:
• Overdraft
• Revolving credit facility (agreed limit)
• Trade finance (i.e. letters of credit)
• Invoice finance (debt factoring) – company sells its receivables to bank
Long-term finance:
• Commercial lending / term loans (common)
• Syndication (several banks lend the borrower)
• Leasing
Advisory services:
• Security/share issuance (arranged by bank for customer)
• Securitisation (cash generating assets sold by bank)
• Investment recommendations: bank provides research and analysis to assist in
investment decisions. Bank receives trading commission which needs to be shown
separately to research and analysis in the FS because of the MiFID II regulation.
Purpose: offer greater protection for investors following the Global Financial Crisis of
2007/08 and to make markets more transparent.
Bank structure:
1) Front office: refers to those functions which are directly responsible for generating revenue
for a bank.
2) Middle office: functions do not initiate revenue but directly support the front office.
3) Back office: functions which are not directly required by front office activities and are part of
the processes of the bank.
-Bank acting on behalf of a customer: agent – broker
-Bank acting on behalf of itself: principal – proprietary trading i.e. trading stocks, currencies,
bonds etc.
,The UK regulatory regime for banks:
1) Financial Conduct Authority (FCA): responsible to HM treasury and promotes
confidence in the financial system by:
- Maintaining and ensuring the integrity of the market
- Ensuring customers get a fair deal
- Ensuring that the financial services market is competitive
(FCA 11 high-level principles handbook)
2) Prudential Regulation Authority (PRA): is a subsidiary of the Bank of England and
promotes the safety and soundness of banks by:
- Requiring banks to hold minimum levels of capital as a buffer against losses
- Ensuring banks have sufficient liquidity
(PRA rulebook: 8 fundamental rules)
Note: the senior manager regime requires that individuals seeking to perform one or
more specified senior mgt functions obtain PRA approval prior to taking up their position.
In determining whether an individual is fit and proper to perform a senior mgt function, the
PRA will consider their:
- Honesty, integrity, reputation
- Competence and capability
- Financial soundness
In order to implement the SMR, banks must allocate prescribed responsibilities across
their senior managers clearly setting out their duties. A governance map must be
produced which clearly delineates key functions within the bank and who performs them,
including a summary of their significant responsibilities and reporting lines. This
governance map must be updated at least quarterly and also whenever there is a
significant change to the governance structure, allocation of significant responsibilities or
relevant reporting lines.
,CHAPTER 2: The financial statements of banks
Net interest income: apply IFRS 9, Financial instruments. Interest income: accrued on loans
and adv held at amortised cost and FVTOCI debt instruments using the EIR method. The EIR
method is the rate that exactly discounts estimated future cash receipts and directly allocates
trans costs incurred to originate the loan through the expected life of the loans and adv, to their
net carrying amt. Interest expense: accrued on financial liabilities held at amortised cost in a
similar way.
Net fee and commission income: IFRS 15, Revenue from Contracts with Customers.
Recognize when performance obligation is satisfied by transferring a promised service to the
customer and the promise to transfer the service is separately identifiable from other promises in
the contract. The performance obligation may be satisfied at a point in time or over a period of
time and fees and commission are recognized accordingly.
Key performance ratios:
Profitability performance:
• Return on equity: Net profit/loss / equity
• Return on assets: Net profit/loss / average interest-bearing assets
• Net interest margin: net interest income / average interest earning assets or average total
assets
• Cost-income ratio: operating costs / total operating income
Risk performance:
• Asset quality ratios:
1) Non-performing loans ratio: (customer) non-performing loans / total gross loans
2) Non-performing coverage ratio: impairment allowance / non-performing loans
• Regulatory capital ratios:
1) Common Equity Tier 1 ratio: common tier 1 / risk-weighted assets
• Funding ratios:
1) Loan-to-deposit ratio: gross customer loans / customer deposits
• Leverage ratio: equity / total assets (minimum 3%)
A UK company can prepare accounts under UK GAAP instead of IFRS if:
o Preparing consolidated accs but does not have securities traded on a regulated
market (i.e. not listed).
o Single company accs even if part of a group with listed securities.
o It has no subsidiaries even if it has securities listed in a regulated market.
Valuation analysis of banks:
The enterprise value problem: forecasting future cashflows discounted at the weighted
average cost of capital. Value of equity then derived after deducting net debt which is hard to
identify. Debt is closer to the raw material of banking.
The forecast future cash flow problem: deducting increases of WC investment from
forecasted free cash flows not possible since banks do not split current/non-current assets or
liabilities.
Best methods:
p/e ratio: market value per share / earning per share
return on equity
price to book: market capitalisation (i.e share capital) / net assets
dividend yield: dividend / share capital
dividend cover: profit/ dividend
, Two important considerations when comparing banks:
1) Impairment loss allowances are judgmental and subjectively arrived at. IFRS 9 requires
banks to calculate “expected credit losses” based on probabilities of default, using both
historic and forward-looking information – some banks will be more prudent than others
making comparative analysis more difficult.
2) Banks will report assets and liabilities at up to data fair value as to a far greater extent
than non-banking entities. This means that a bank’s assets and liabilities and hence
equity is much more closely aligned to market value. This enhances the relevance of the
price to book ratio for bank valuations.
CHAPTER 1: The function and role of banks
Fractional reserve banking: banks retain small proportion of deposits and lend out rest.
Minimum is set by Central banks to mitigate control risk.
Maturity transformation: banks as part of their role as intermediaries, take short-term deposits
and lend long term.
Market makers: undertake to make firm prices at which the bank will both buy and sell a
particular security or financial instrument. Bid price: price at which the market maker is prepared
to buy. Offer/ask price: price at which market maker is prepared to sell. The spread between the
two is the market maker’s profit.
Loan origination: bank process covering everything from the initial loan application through to
the point of agreeing the amount, terms and pricing of the proposed loan. For
commercial/corporate lending information will be summarized on a term sheet.
Loan underwriting: The appraisal of the lending proposal to assess the credit risk and make a
decision on whether or not to extend the loan. For commercial/corporate lending, information will
be summarized on a credit memo or credit write-up.
Short-term finance:
• Overdraft
• Revolving credit facility (agreed limit)
• Trade finance (i.e. letters of credit)
• Invoice finance (debt factoring) – company sells its receivables to bank
Long-term finance:
• Commercial lending / term loans (common)
• Syndication (several banks lend the borrower)
• Leasing
Advisory services:
• Security/share issuance (arranged by bank for customer)
• Securitisation (cash generating assets sold by bank)
• Investment recommendations: bank provides research and analysis to assist in
investment decisions. Bank receives trading commission which needs to be shown
separately to research and analysis in the FS because of the MiFID II regulation.
Purpose: offer greater protection for investors following the Global Financial Crisis of
2007/08 and to make markets more transparent.
Bank structure:
1) Front office: refers to those functions which are directly responsible for generating revenue
for a bank.
2) Middle office: functions do not initiate revenue but directly support the front office.
3) Back office: functions which are not directly required by front office activities and are part of
the processes of the bank.
-Bank acting on behalf of a customer: agent – broker
-Bank acting on behalf of itself: principal – proprietary trading i.e. trading stocks, currencies,
bonds etc.
,The UK regulatory regime for banks:
1) Financial Conduct Authority (FCA): responsible to HM treasury and promotes
confidence in the financial system by:
- Maintaining and ensuring the integrity of the market
- Ensuring customers get a fair deal
- Ensuring that the financial services market is competitive
(FCA 11 high-level principles handbook)
2) Prudential Regulation Authority (PRA): is a subsidiary of the Bank of England and
promotes the safety and soundness of banks by:
- Requiring banks to hold minimum levels of capital as a buffer against losses
- Ensuring banks have sufficient liquidity
(PRA rulebook: 8 fundamental rules)
Note: the senior manager regime requires that individuals seeking to perform one or
more specified senior mgt functions obtain PRA approval prior to taking up their position.
In determining whether an individual is fit and proper to perform a senior mgt function, the
PRA will consider their:
- Honesty, integrity, reputation
- Competence and capability
- Financial soundness
In order to implement the SMR, banks must allocate prescribed responsibilities across
their senior managers clearly setting out their duties. A governance map must be
produced which clearly delineates key functions within the bank and who performs them,
including a summary of their significant responsibilities and reporting lines. This
governance map must be updated at least quarterly and also whenever there is a
significant change to the governance structure, allocation of significant responsibilities or
relevant reporting lines.
,CHAPTER 2: The financial statements of banks
Net interest income: apply IFRS 9, Financial instruments. Interest income: accrued on loans
and adv held at amortised cost and FVTOCI debt instruments using the EIR method. The EIR
method is the rate that exactly discounts estimated future cash receipts and directly allocates
trans costs incurred to originate the loan through the expected life of the loans and adv, to their
net carrying amt. Interest expense: accrued on financial liabilities held at amortised cost in a
similar way.
Net fee and commission income: IFRS 15, Revenue from Contracts with Customers.
Recognize when performance obligation is satisfied by transferring a promised service to the
customer and the promise to transfer the service is separately identifiable from other promises in
the contract. The performance obligation may be satisfied at a point in time or over a period of
time and fees and commission are recognized accordingly.
Key performance ratios:
Profitability performance:
• Return on equity: Net profit/loss / equity
• Return on assets: Net profit/loss / average interest-bearing assets
• Net interest margin: net interest income / average interest earning assets or average total
assets
• Cost-income ratio: operating costs / total operating income
Risk performance:
• Asset quality ratios:
1) Non-performing loans ratio: (customer) non-performing loans / total gross loans
2) Non-performing coverage ratio: impairment allowance / non-performing loans
• Regulatory capital ratios:
1) Common Equity Tier 1 ratio: common tier 1 / risk-weighted assets
• Funding ratios:
1) Loan-to-deposit ratio: gross customer loans / customer deposits
• Leverage ratio: equity / total assets (minimum 3%)
A UK company can prepare accounts under UK GAAP instead of IFRS if:
o Preparing consolidated accs but does not have securities traded on a regulated
market (i.e. not listed).
o Single company accs even if part of a group with listed securities.
o It has no subsidiaries even if it has securities listed in a regulated market.
Valuation analysis of banks:
The enterprise value problem: forecasting future cashflows discounted at the weighted
average cost of capital. Value of equity then derived after deducting net debt which is hard to
identify. Debt is closer to the raw material of banking.
The forecast future cash flow problem: deducting increases of WC investment from
forecasted free cash flows not possible since banks do not split current/non-current assets or
liabilities.
Best methods:
p/e ratio: market value per share / earning per share
return on equity
price to book: market capitalisation (i.e share capital) / net assets
dividend yield: dividend / share capital
dividend cover: profit/ dividend
, Two important considerations when comparing banks:
1) Impairment loss allowances are judgmental and subjectively arrived at. IFRS 9 requires
banks to calculate “expected credit losses” based on probabilities of default, using both
historic and forward-looking information – some banks will be more prudent than others
making comparative analysis more difficult.
2) Banks will report assets and liabilities at up to data fair value as to a far greater extent
than non-banking entities. This means that a bank’s assets and liabilities and hence
equity is much more closely aligned to market value. This enhances the relevance of the
price to book ratio for bank valuations.
