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TrimSize:6.625inx9.625in (cid:2) Choudhry15892 ffirs.tex V1-02/07/2018 10:55am Pagei AN INTRODUCTION TO BANKING PRINCIPLES, STRATEGY AND RISK MANAGEMENT SECOND EDITION (cid:2) (cid:2) (cid:2) TrimSize:6.625inx9.625in (cid:2) Choudhry15892 ffirs.tex V1-02/07/2018 10:55am Pageiii AN INTRODUCTION TO BANKING PRINCIPLES, STRATEGY AND RISK MANAGEMENT SECOND EDITION .......................................................... (cid:2) (cid:2) Moorad Choudhry With contributions from Ed Bace, Polina Bardaeva, Kevin Liddy, Jamie Paris, Soumya Sarkar and Chris Westcott (cid:2) TrimSize:6.625inx9.625in (cid:2) Choudhry15892 ffirs.tex V1-02/07/2018 10:55am Pageiv FirstEditionpublished:April2011 ©2018JohnWiley&Sons,LtdandMooradChoudhry Registeredoffice JohnWiley&SonsLtd,TheAtrium,SouthernGate,Chichester,WestSussex,PO198SQ, UnitedKingdom Fordetailsofourglobaleditorialoffices,forcustomerservicesandforinformationabouthowto applyforpermissiontoreusethecopyrightmaterialinthisbookpleaseseeourwebsiteat www.wiley.com. Allrightsreserved.Nopartofthispublicationmaybereproduced,storedinaretrievalsystem, ortransmitted,inanyformorbyanymeans,electronic,mechanical,photocopying,recordingor otherwise,exceptaspermittedbytheUKCopyright,DesignsandPatentsAct1988,withoutthe priorpermissionofthepublisher. 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Theviews,thoughtsandopinionsexpressedinthisbookrepresentthoseoftheauthorinhis individualprivatecapacity,andshouldnotinanywaybeattributedtoanyemploying institutionortoMooradChoudhryasarepresentative,officer,employee,directoror non-executivedirectorofanyinstitution. LibraryofCongressCataloging-in-PublicationDataisAvailable: ISBN9781119115892(Paperback) ISBN9781119115915(ePDF) ISBN9781119115908(ePub) CoverDesign:Wiley CoverImage:©MaLija/Shutterstock Setin10/12pt,TrumpMediaevalLTStdbySPiGlobal,Chennai,India. PrintedinGreatBritainbyTJInternationalLtd,Padstow,Cornwall,UK 10987654321 (cid:2) TrimSize:6.625inx9.625in (cid:2) Choudhry15892 ffirs.tex V1-02/07/2018 10:55am Pagev For Lindsay UltimateYummyMummy (cid:2) (cid:2) (cid:2) TrimSize:6.625inx9.625in (cid:2) Choudhry15892 ftoc.tex V1-02/02/2018 6:39am Pagevii CONTENTS .......................................................... Foreword ix Preface xi PrefacetotheFirstEdition xv Acknowledgements xvii AbouttheAuthor xix PART I BANK BUSINESS AND THE MARKETS 1 (cid:2) (cid:2) 1 BANKBUSINESSANDCAPITAL 3 2 CUSTOMERSERVICESANDMARKETINGFORBANK PRODUCTS 29 3 CREDITASSESSMENTANDMANAGINGCREDITRISK 49 4 THEMONEYMARKETS 95 5 THEYIELDCURVE 131 6 INTRODUCTIONTOMONEYMARKETDEALINGAND HEDGING 167 PART II ASSET–LIABILITY MANAGEMENT AND LIQUIDITY RISK 205 7 BANKASSETANDLIABILITYMANAGEMENTI 207 8 ASSETANDLIABILITYMANAGEMENTII:THEALCO 247 9 BANKLIQUIDITYRISKMANAGEMENTI 265 (cid:2) TrimSize:6.625inx9.625in (cid:2) Choudhry15892 ftoc.tex V1-02/02/2018 6:39am Pageviii .vi.ii.................................................C..O.N.T.E.N.T.S. 10 LIQUIDITYRISKMANAGEMENTII:BASELIIILIQUIDITY, LIABILITIESSTRATEGY,STRESSTESTING,COLLATERAL MANAGEMENTANDTHEHQLA 287 11 BUSINESSBEST-PRACTICEBANKINTERNALFUNDS TRANSFERPRICINGPOLICY 329 12 NETINTERESTINCOME(NII),NETINTERESTMARGIN (NIM)ANDTHEMANAGEMENTOFINTEREST-RATERISK INTHEBANKINGBOOK 343 13 SECURITISATIONMECHANICSFORBALANCESHEET MANAGEMENT 375 PARTIII STRATEGY, REGULATORY CAPITAL AND CASE STUDIES 391 14 STRATEGYSETTING 393 15 BANKREGULATORYCAPITAL,BASELRULESANDICAAP 419 16 MANAGINGOPERATIONALRISK 493 (cid:2) (cid:2) 17 ADVICEANDPROBLEMSOLVING:CASESTUDIES 505 Appendix A FinancialMarketsArithmetic 531 Appendix B AbbreviationsandAcronyms 549 Index 553 (cid:2) TrimSize:6.625inx9.625in (cid:2) Choudhry15892 fbetw.tex V1-02/02/2018 6:39am Pageix FOREWORD .......................................................... Steen Blaafalk I know Moorad Choudhry as an experienced professional and very strong personally,anditiswithgreatpleasurethatIaccepttowriteashortforeword fortheneweditionofAnIntroductiontoBanking. Akeyroleforabankistotransformshort-termdepositsfrombusinessesand households into long-term loans to businesses and households that want to borrow for investments or consumption. In this way, banks support growth and wealth in society – not only by creating jobs in the banking sector – but alsobysupportinggrowthinmanysectorsoftheeconomy. (cid:2) An integral part of banking is taking calculated risks. A professionally run (cid:2) bank will reserve enough capital to absorb expected as well as unexpected lossesonthelendingbooktocontinueitsbusiness,eveninarecession. Another risk is maturity transformation – borrowing short and lending long. On the one hand, it is a source of income for the bank. On the other hand, it isathreattothesurvivalofthebankifitisfundingitselftooshortorthrough unstablefundingsourcesthatdisappearwhenacrisisoccurs. In the years leading up to the 2008 global financial crisis, banks had become significantlylessconsolidatedasthecapitalrulesallowedthemtohaveavery high gearing of the balance sheet. Moreover, many banks had funded them- selvesveryshortinthecapitalmarketssinceliquiditywasampleandspreads were very low – building up huge customer funding gaps. At the same time, thebankshadcompetedfearlesslyonmarginsinordertoattractnewbusiness. Acocktailthatwouldbedoomedtogowrongatsomepointintime. When the global financial crisis culminated in September 2008 with the col- lapse of Lehman Brothers, all confidence in and among financial institutions disappeared. This resulted in liquidity drying out very fast, and institutions with a short/unstable funding profile found themselves unable to refinance theirdebt.Additionallytothis,manybanksfoundthemselvestoothinlycap- italisedtoabsorbthelossincurringduringthisnextperiod. Theglobalfinancialcrisisspilledoverintotherealeconomysincemanybanks werenotabletofundtheloandemandoftheircustomersandtheydidnothave (cid:2) TrimSize:6.625inx9.625in (cid:2) Choudhry15892 fbetw.tex V1-02/02/2018 6:39am Pagex .x..................................................F.O.R.E.W..O.R.D. theexcesscapitaltogrowtheirbalancesheets.Theauthoritiesreactedtothe situationbydemandingsignificantlyhighercapitalandliquidityratios,which ofcourseinthesituationcatalysedthecrisisintherealeconomy. An Introduction to Banking describes getting the right balance between run- ningasafebankandoptimisingtheuseofcapitalandliquiditytothebenefit oftheshareholdersofthebankforthelongrun. Inthefirstpartofthebook,Mooradintroducesthereadertothebasicconcepts of running a bank. I can recommend this part of the book to bankers who needabroaderinsightintotheinstitutionalsetupandbasictermsinbanking. Understandingthebasicsofbankinghelpsyoutogetthefullbenefitwhenit becomesmoredetailed,dealingwithassetandliabilitymanagement(ALM)as wellascapitalandliquiditymanagementlaterinthebook. Asset&LiabilityManagementistheveryessenceofbanking.Tobesuccess- ful as a bank you need to have professional asset and liability management processes, starting from the top management and flowing down to the differ- entbusinessareasofthebank,includingproperFundsTransferPricing(FTP) for capital and liquidity, to understand and make transparent the drivers for variousbankingproducts. As a Group Chief Financial and Risk Officer, I have had great professional benefit from the description of the role of the Asset & Liability Committee, the risk policy, reporting, and stress testing, as well as the description of the (cid:2) day-to-day management in the risk and treasury departments. It was also (cid:2) rewarding for me to read the final chapters about best practice in capital and funding management and corporate governance, which we should not forget whenweenterintothenextperiodofbullmarkets. Mooradmanagestodescribeacomprehensiveandcomplexareaofbankingin alivelyandreadablelanguage. I can highly recommend the book as a handy reference work for anyone who isinvolvedinbankingstrategy,ALM,andliquidityriskmanagement. SteenBlaafalk GroupChiefFinancialandRiskOfficer SaxoBankA/S Copenhagen 10March2015 (cid:2) TrimSize:6.625inx9.625in (cid:2) Choudhry15892 fpref.tex V1-02/02/2018 7:45am Pagexi PREFACE .......................................................... Who among the world’s population of authors would not love to write a timelesswork?Ideally,atimelessworkoffiction,butfailingthat,something factual that remains the undisputed benchmark for its subject. Somewhat paradoxically, I hold that the latter is actually harder to accomplish. Please don’t get me wrong,only avery small minorityof us(of which Iam not one) haveitinthemtoproduceHamlet,orDune,orTheIliad,orTheAssistant,or CrimeandPunishment,orTheAdventuresofSherlockHolmes,orTheCrab With The Golden Claws, or Seven Pillars of Wisdom, or Peanuts, Featuring Good Ol’ Charlie Brown, or countless other such immortal works. But once one has produced classic art, it lives forever. There is no need ever to update ormodifyit. (cid:2) (cid:2) Practitionertextbooks,ontheotherhand,arerarelytimeless.Inalmostevery fieldoflearning,societydevelopsandaddstoitsknowledgebase,suchthata workofnon-fictionrapidlybecomesoutofdate.Tomaintaincurrencyrequires constant updates and further editions, which means more work. An author ambitiousofproducingaliterarymasterpieceshouldavoidthefactuallearning genre. But there is an apparent paradox when it comes to works of fact concerning banking: in theory, unlike in so many commercial disciplines, the main principles have not changed since the first modern banks came into being in the fifteenth century. Much of what held good for banks in 1808 and 1908 wouldhaveremainedfineforbanksin2008,ifcertainseniorbankexecutives had been competent enough to remember them (or even bothered to learn theminthefirstplace). The traditionally staid and “conservative” field of banking has experienced considerable development and change of late. However, if anything, this “development” has not been all positive. While lauding the introduction of tools and techniques that have enabled borrowers to reduce their risk and assist economic growth worldwide, most of us are now rightly wary of ever-more sophistication and complexity in finance. It really is time for banks, and banking, to revert somewhat to the basics of finance and look to deliver genuine good customer service, and roll back the ever-increasing (cid:2)