Understanding banking:

What do banks do for customers?

How do banks operate?

Overview

Reminder of what actuaries can bring to banking

Big picture of services banking provides:

What do banks do for customers?
What do banks do for society?

Big picture of how banks operate:

At its simplest what do banks do?
What risks does this inherently bring?
How do banks (and regulators) manage these risks?

First the range of actuarial skills still unique

Actuarial training is unique as it crosses siloes:
Credit risk is analgous to underwriting
Provisioning is analgous to reserving
Bank capital management is like solvency
Liquidity risks can be understood through:
behavioural assumptions,
yield curve and duration matching / reinvestment risks

Market risk is a given from asset models

Understand Accounting
Understand Economics

As are actuaries ways of thinking

Automatically want to trade off risk and reward:
Able to develop NPV pricing models
Able to build Customer Value models cross siloes
Seen as a neutral adviser on pricing
Can pick up random problems

Automatically look through time

5 year plus horizon rather than 1 year margin

Consider risk or ruin

Philosophy like older bankers first job is to protect savers,

then think of maximising profits

Overview

Reminder of what actuaries can bring to banking

Big picture of services banking provides:

What do banks do for customers?
What do banks do for society?

Big picture of how banks operate:

At its simplest what do banks do?
What risks does this inherently bring?
How do banks (and regulators) manage these risks?

Banks exist to serve customers needs

Services people need payment transactions
Provide money transmission services:

Services people need - cash flow management

Overdrafts, revolving credit, trade finance
Loans, mortgages (Variable rate / fixed rate)

Safe deposit somewhere to keep savings

Current account, savings accounts, bonds
Long term savings and protection
Pensions, investments, life insurance

Banks have a wider role to help society

Banks matter to society

Multiplier effect

Money transmission
Lend 100
Spend 100
Deposit 100
Lend 90

Investment capital
Maturity transformation

Cashflow management

Zooming in:
Maturity transformation
Each of our current accounts cant do much on their own
Balance is very volatile can change daily

Balance is quite small

Individuals cant usefully lend this to anybody as we dont know when we
will spend it
This is useless money for society

Banks add them together

A few million current accounts add up to a lot of balances
Added up these are much more stable
As these are stable they can be lent out
Used for mortgages, investment in new business etc
Suddenly otherwise useless balances are being used by society

Zooming in:
Multiplier effect
100
Deposit

90

90

Loan

Purchase

90

81

Deposit

Loan

Each time money is deposited assume ~ 90% is lent out

This creates a pattern of deposits . 100, 90, 81, 73 .
This is a geometric series that adds up to 1,000
Our original 100 deposit can be lent out, spent and deposited to make 1,000!
[NOTE: This is an over simplification of the process, but it highlights how banks create
create money by lending. See BOE WP 529]

Great in the good times

Seems like a magical way to create money
Fuels economic growth and expansion
Historically helped Britain defeat France in 1700s 1800s
But problem is when this goes into reverse

What do banks do for society:

Multiplier effect in reverse
Real issue for banking policy makers
When people are worried about the future they start to save more

They borrow less (so money supply falls, money is just an IOU)
They spend less (so less is produced and employment falls)

This means that the multiplier effect we saw above can actually start to go into reverse

Reduced borrowing reduces deposits which can cause money supply to reduce and can
trigger a recession / depression. (Bank money is IOUs, so as IOUs falls so does money).

Policy makers have been trying to avoid this:

Encourage lending (base rate low at 0.5% and asset purchase scheme)
Funding for lending scheme

Overview

Reminder of what actuaries can bring to banking

Big picture of services banking provides:

What do banks do for customers?
What do banks do for society?

Big picture of how banks operate:

At its simplest what do banks do?
What risks does this inherently bring?
How do banks (and regulators) manage these risks?

Understanding what is a bank?

History:
Merchants need somewhere safe to store their gold
Goldsmiths had big safes
Goldsmiths hold gold securely for a fee
Deposits

But other merchants want to borrow the gold smith can

lend out gold in his vault for another fee
Lendin
g

A bank is an intermediary that manages a

balance sheet
Borrowing and lending create a banks balance sheet:
Liability

Asset

(deposits)

(loans)

Lots of Short
term deposits

margin

Long term
mortgages
Short term cards

Pay a rate to depositors to bring in savings

Receive a rate from lenders for lending out mortgages etc
The difference is the margin and this is what all banks strive to manage
Suitable for a 1 year P&L view main difference to insurance

 through different conditions

Borrowing and lending create a banks balance sheet:
Banks manage margin through rate cycles

Liability

Asset

12
10

(deposits)

(loans)

8
6

2%

5%

Margin 3%

2
0

1
25
49
73
97
121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673

margin
3%

Savings Rate

Loan Rate

Need to manage the margin through all interest rate conditions

This is why UK mortgages move onto SVR, it offers a re-price point as the
interest rate world changes.
The US offers > 15 year fixed rate mortgages after the Great Depression and
this caused havoc with the Savings and Loans in the 80s as savings rates
soared

This creates two key risks a bank must manage

History shows risks:

Credit risk: loan not repaid

Liquidity risk: depositors all want their money back

at the same time ... But its been lent out
Id like to
make a
withdrawal

[todays focus]

Credit risk:
Expected and unexpected losses
We allow for expected losses when setting lending rates and fees but losses will
vary over time

Peak losses dont occur every year, but when they do, they can be large
Like insurance companies probability of ruin

Figure 1

Need a buffer in case of unexpected losses

Loss rate

Unexpected
loss (UL)

Day to day business - price and make

decisions on expected losses

Expected
loss (EL)
Tim e

Credit score cards are developed to

manage expected losses
The process is very like insurance underwriting

Probability of default

Score cards bring in a lot of customer data

Score cards built by looking at the correlation of this data against historic loss
Score cards use this past behaviour to rank customers in order of risk

Risk score
Banks make money by taking risk and lending
The more accurately risk and expected loss can be predicted the easier it is to manage

Expected loss will be priced into

credit lending decisions
The loan rate would normally allow for the following:

Sustainable loan rate includes

Expected loss

If we underestimate expected loss

we would underprice lending

Costs to write the loan

Cost of deposits
Profit

Normally bad debts dont arise until a few years after a loan is written (seasoning)
We may not know we have mispriced risks until later

The rate and expected losses decide who banks

can lend to

Given a probability of loss banks can estimate the value fo a loan

This factors in income, costs, expected losses etc
At a certain rate and probability of loss the loan becomes negative value
This sets the minimum cut off the bank should apply
value
Customers with low PD create
positive returns

PD

Break even score

Customers with higher

PDs leads to losses

Risk based pricing as youd expect allows

lending to more customers
If banks charge a higher rate then customers who were unprofitable become
profitable
Banks can therefore lend to more customers at a higher rate.

value
15% Break even score

15% rate
5% rate

PD

6% Break even score

Extra customers who can

get credit with risk based
pricing

Credit risk: Capital protects banks

from unexpected losses

Borrowers:

Savers

Loans
Bank:

~ 90%

Mortgages
Cards

Corporate

Overdrafts

Bank capital

~ 10%

Bank lends funds borrowed from savers and wholesale & its own capital
Banks hold capital to protect savers from unexpected losses

How much capital for two banks?

Banks have same size of balance sheet of 10bn

Asset

Bank A

Bank B

Cash

10%

10%

Mortgages

0%

90%

Loans

90%

0%

Are all risks the same?

How can we get a handle on the riskiness of unexpected losses?

It helps to break losses into 3 parts

Bank Measure

What this measures

PD (Probability
of Default)

The risk a loan is not paid back in full.

EAD (Exposure
at Default)

How much is owed when a loan defaults.

Harder that you think to calculate in advance for credit
cards or overdrafts as customers can borrow right upto
the date they default on.

LGD (Loss
Given Default)

How much of the loan you owe that you cant pay back.
If you owe 1,000 and pay back 300 the LGD is 70%

Credit Loss

Loss = PD * EAD * LGD

Loans are pretty simple to scenario test

The difference between normal (expected) losses and downturn (unexpected)
losses indicates how much capital we may need to hold.

Loans (per 1,000)

Normal

Downturn

PD (lifetime)

4%

12%

EAD

1,000

1,000

LGD

70%

80%

Loss

28

96

Difference for which we would need

capital

68

Secured lending is more complex

The loss given default is strongly influenced by how much the house is worth
relative to the mortgage

In the good times loans are all above water.

LGD is zero when house prices are rising.

Houses are sold for more than the
mortgage and the bank is repaid

75% LTV 85% LTV95% LTV

As prices fall riskier loans are under water
LGD is still zero for low LTV mortgages
It grows rapidly for higher LTV mortgages

75% LTV 85% LTV95% LTV

Changes in mortgage LGDs are very non-linear

in a downturn
Even in good times higher LTV mortgages make a loss as houses are often not
looked after and a quick sale generally requires a haircut.
Expected Loss Given Default for a mortgage
35%

Loss Given Default

30%
25%
20%
15%
10%
5%
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%
44%
48%
52%
56%
60%
64%
68%
72%
76%
80%
84%
88%
92%
96%
100%

0%

Loan to Value

Downturn Loss Given default for a mortgage

35%

25%
20%
15%
10%
5%
0%
1
5
9
13
17
21
25
29
33
37
41
45
49
53
57
61
65
69
73
77
81
85
89
93
97
101

Loss Give Default

30%

Loan to value

The losses are much worse in a

downturn.
More impact on high LTVS.
Even lower LTV mortgages affected

So to estimate losses we need to estimate the

LTV mix of a typical mortgage business
I estimated this using
Lloyds high level split of
its mortgage book and
keeping volumes uniform
in LTV bands

Work out average LGD for

normal conditions

Work out average LGD for

downturn conditions

Complex mortgages become tractable to a

scenario test
Note: because high loan to value mortgages tend to have a higher PD (customers
typically pay more of their post tax income to service the mortgage) I have
adjusted by doubling the effective LGD
Loans (per 1,000)

Normal

Downturn

PD (lifetime)

4%

12%

EAD

1,000

1,000

LGD

0.82%

13.2%

Loss

0.33

13.2

Difference for which we would need

capital

15.8

Relative capital is quite different

Extra loss in downturn

Loans

68

Mortgages

15

=> Loans need 4 times the capital in a downturn

We cant yet answer how much to hold, but it looks like Bank
A would need ~ 4 times more capital than Bank B
Asset

Bank A

Bank B

Cash

10%

10%

Mortgages

0%

90%

Loans

90%

0%

The Basel Rules came in to try and standardise

risk measures between banks
The Bank of International Settlements (BIS) started life as the clearing
bank for Germanys first world war reparations

A convenient location bordering France, Germany and Switzerland later

led to it becoming a central bankers meeting ground

In the 1970s bank risks soared after a benign post war period:
Bretton Woods collapsed and triggered some international bank
collapses (eg Hersatt bank in Germany)
Japan banks were on a capital light fuelled take over of the financial
arena.

BIS introduced Minimum international standards named after its home

town in 1988

Basel I set out a two stage process

First convert lending into relative measures of risk

Relative risk was measured in Risk Weighted Assets

RWAs were set out in standard tables:

Asset

RWA

Cash

0%

Mortgage

50%

Corporate loan

100%

Personal loan

100%

Next convert RWAs into minimum capital requirements

Basel rules define two different types of capital

Tier 1 capital.
The banks own money.
Initial share issues
Rights issues (additional shares issued)
Retained profits
Very loss absorbing

Tier 2 capital.
Like subordinated debt
Not be repaid until depositors get their money back.
Only used if a bank fails. This became a problem with too big to fail

The original minimum capital is pretty low

Regulatory MINIMUM capital calculated from RWAs
4% Tier 1
4% Tier 2
This is a level you stop being a bank
Regulators require more than this minimum

Actual minimum agreed with regulators

Banks now hold > 10% Tier 1 capital
Regulators want to increase further:
Basel III
Stress tests
Leverage ratio (the consultation we are responding to)

Banks have an incentive to minimise capital

Flash bank

Capital
1bn
Capital ratio 8.0%

Steady bank

Capital
1bn
Capital ratio 12.5%

Assume:

The ONLY difference if flash banks adopts a lower capital ratio

Lending by both needs 100% RWAS

This immediately affects the banks profits

Flash bank

Steady bank

Capital
1bn
Capital ratio 8.0%

Capital
1bn
Capital ratio 12.5%

Assets lent 12.5 bn

Profit
125m

Assets lent 8.3 bn

Profit
83m

And growth in profitability

Flash bank

Steady bank

Capital ratio 8.0%

Extra profits 7.8m

Capital ratio 12%

Extra profits 3.46m

Profit
125m
Kept
62.5m
Extra assets 781m
Profit growth 6.25%

Profit
83m
Kept
41.5m
Extra assets 346m
Profit growth 4.16%

Basel I distorted the banking landscape

Basel I ~ 1992
Simple rules focused on credit risk - no other risks included
RWA risk weightings defined for each type of loan
Not specific enough

Implications
Helped standardise capital
RWA do not reflect lending risk Shell Oil needs same capital as a corner
shop
Tends to move banks up risk curve where they can get higher margin for
same RWAs
Danger of going up the risk curve like this may repeat with the proposed
leverage ratio

And clear omissions led to initial tweaks

Basel I ~ update in 1996

Banks security trading was becoming more significant
Basel I 1996 update therefore brought in reference to market risk
Market risk assessment used internal Value at Risk or VAR approach

Implications
Banks were starting to outgrow Basel Is simplicity.
Securitisation allowed credit risk to move off balance sheet. This distorted
business models to exploit capital arbitrage. Eg Northern Rock :
from 1997 to 2006 Assets grew 13 - 87bn (x 6.6)

Equity capital grew 0.7 to 1.7bn ( x2.4)

Tier 1 ratio went from 8.7% to 8.5%
Miracle possible as securitisation left bank with capital deduction for
residual investment only. This was often say ~ 1.5%

This created a very exposed business model reliant on liquid markets

VARs idea of internal assessment was

developed for credit risk with Basel II
Basel II ~ 2004 to 2008
Core idea is for banks capital to reflect bank specific risks.
Calculated RWAs using banks own experience with PD, EAD and LGD.
Also provided increased disclosure in pillars II and III

Internal Ratings (IRB)

Standard Weightings

Loans

Loans

Calculate:
PD
EAD
LGD
By portfolios

Bank specific

RWAs

Loan

RWA

Property

35%

AAA AA-

20%

A+ - A-

50%

BBB BB-

100%

< BB-

150%

More granular
look up

RWAs

IRB, calculating RWAs from PD, EAD and LGD

is rather complex

K is a correlation factor.
It depends on the type of lending, corporate, mortgages, credit cards

Also brought in limited capital requirements for operational risk. Defined

around a percentage of income.

The maths was neat but rather missed a more fundamental flaw.

Banks do this for various reasons

Higher ROE
Number of studies show lower capital for IRB
Design what is best for your bank

Its expected
Regulator expects / demands
Shareholders expect banks to know their own business
Shows confidence in data

But to work well Basel II needs a nice steady

state world

To differentiate
between this risk

Basel II capital became

sensitive to through the cycle
risk

Bank risk through the cycle

Bank A

1.5
Bank B
1
0.5

1
25
49
73
97
121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673

-0.5
-1
-1.5

Or else capital becomes procyclical

In a boom RWAs
and capital shrink

When you are making losses

and need more capital the
models increase the RWAs!

Bank risk through the cycle

Bank A

1.5
Bank B
1
0.5

1
25
49
73
97
121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673

-0.5
-1
-1.5

Quite the opposite of Pharaoh in Genesis

Biblical wisdom save for famine Banking wisdom party on!

Bank risk through the cycle

Bank A

1.5
Bank B
1
0.5

1
25
49
73
97
121
145
169
193
217
241
265
289
313
337
361
385
409
433
457
481
505
529
553
577
601
625
649
673

-0.5
-1
-1.5

This shows clearly in FCA view of ROE

Before Basel II came in, long period of low risks encouraged
leverage to boost ROE
Goldilocks economy

Great moderation

The financial crisis hit before Basel II was

fully implemented
The crisis highlighted various issues
Pricing was too low
Tier 1 capital was too low in level and too low in quality
Tier 2 capital was pointless in a too big to fail world
Too focused on credit risk not liquidity issues

Implications
Central Bankers have started to look at a range of new measures:
Ring fencing retail and investment banking plus living wills

Basel III proposed

Stress testing becoming more serious
New provisioning rules IFRS9
Proposals for a leverage ratio

The crisis highlighted issues with pricing risk

BOE view of UK high yield corporates

Margins falling as
credit expands.
Banks max out on
credit just in time for
major losses!

Sources: Bloomberg, Merrill Lynch, Thomson Datastream and Bank calculations.

BOE April 2007 Financial Stability Report. The decomposition assumes a debt maturity of 20 years. For details, see Churm,
R and Panigirtzoglou, N (2005), Decomposing credit spreads, Bank of England Working Paper no. 253.

The crisis also highlighted a lack of capital

BOE chart for historic US & UK capital ratios

Sources: Berger, A, Herring, R and Szeg, G (1995), The role of capital in financial institutions, Journal of Banking and Finance, pages 393430; United Kingdom:
Billings, M and Capie, F (2007), Capital in British banking 19201970, Business History, Vol. 49(2), pages 13962;
British Bankers Association; and published accounts.
(a) US data show equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets). UK data show
riskweighted Tier 1 capital ratios for a sample of the largest banks.
(b) National Banking Act 1863.
(c) Creation of Federal Reserve 1914.
(d) Creation of Federal Deposit Insurance Corporation 1933.
(e) Implementation of Basel risk-based capital requirements 1990.
(f) From Billings and Capie (2007).
(g) BBA and Bank calculations. This series is not on exactly the same basis as 192070, so comparison of levels is merely indicative.

And declines in quality BOE data on UK bank

Tier 1 make up

Sources: Dealogic, published accounts and Bank calculations.

(a) Includes Abbey, Alliance and Leicester and Bradford and Bingley instead of Banco Santander.
Excludes Northern Rock.

Basel III (2013 2018) seeks to plug some gaps

Better definition of Capital
We have described Tier 1 capital as retained profit
Profit is an accounting concept that includes goodwill, Deferred Tax Assets,
Pension Fund shortfalls etc.
Basel III thus standardises deductions to calculate Tier 1 capital.
This still ignores the issue with accounting profits that assets can be valued in
either the trading book (mark to market) or banking book (face value unless
impaired)

Liquidity issues
Liquidity Coverage Ratio (LCR)
Hold enough liquid assets to cover cash outgoing for 30 days (arrange rescue)
Net Stable Funding ratio (NSFR)

Ratio of sticky deposits to longer term lending

To protect against too great term mismatch to profit from normal yield curve.

Basel III (2013 2018) seeks to plug some gaps

Increase in capital held for trading risks
Capital is held against tail risk
VAR is modelled based on normal conditions so by definition methodology is a
disaster for tail risk!
Basel II.5 has stressed VAR
Basel III may moved to expected short fall approach to try and use realistic
scenarios
Introduces capital fro Counterparty risk (Credit Valuation Adjustment CVA)

Leverage Ratio

Crude ratio of capital to assets

Will affect banks with low RWAs

UK further and faster than most

Some other stuff sits outside

Stress testing
Bigger in US than UK
May end up setting capital floor to pass stress tests
Stresses income, losses and capital

Should capture procyclical risks such as capital or provisions under IFRS9

Attractive as it focuses on need for capital so may focus minds on safety
NOT on arbitrage

IFRS9

Accountants play with probabilistic risks

Increased IBNR versus current provisioning that relies on actually going

bad

Significant operational issues raised by proposals

New rules need to balance out risk of

triggering a problem
Regulators can make banks safer with more capital
Holding more capital reduces risk from lending

Holding Tier 1 capital makes a bank safer

However too much capital will impact the economy
Banks improve capital ratios by cutting back on lending
This impacts the multiplier effect mentioned earlier
Banks reduce riskier lending (eg higher LTV mortgages)

Banks expand lending more slowly as retained profits support

less future lending
Cost of capital may be passed onto customers