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An Introduction to Banking: Liquidity Risk and Asset-Liability Management

ISBN: 978-0-470-68725-3
384 pages
April 2011
An Introduction to Banking: Liquidity Risk and Asset-Liability Management (0470687258) cover image

Description

"A great write-up on the art of banking. Essential reading for anyone working in finance."
Dan Cunningham, Senior Euro Cash & OBS Dealer, KBC Bank NV, London

"Focused and succinct review of the key issues in bank risk management."
Graeme Wolvaardt, Head of Market Risk Control, Europe Arab Bank plc, London

The importance of banks to the world's economic system cannot be overstated. The foundation of consistently successful banking practice remains efficient asset-liability management and liquidity risk management.

This book introduces the key concepts of banking, concentrating on the application of robust risk management principles from a practitioner viewpoint, and how to incorporate these principles into bank strategy.

Detailed coverage includes:

  • Bank strategy and capital
  • Understanding the yield curve
  • Principles of asset-liability management
  • Effective liquidity risk management
  • The role of the bank ALM committee

Written in the author's trademark accessible style, this book is a succinct and focused analysis of the core principles of good banking practice.

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Table of Contents

Foreword xiii

Preface xix

About the author xxiii

1 BANK BUSINESS AND CAPITAL 1

Banking business 2

Interest income 4

Fees and commissions 4

Trading income 4

Costs 5

Capital markets 5

Scope of banking activities 8

Capital 9

Banking and trading books 10

Financial statements and ratios 13

The balance sheet 13

Profit and loss report 14

References 21

2 THE MONEY MARKETS 23

Introduction 25

Securities quoted on a yield basis 27

Money market deposits 27

Certificates of deposit 29

CD yields 30

Securities quoted on a discount basis 34

Treasury bills 36

Banker’s acceptances 37

Eligible banker’s acceptance 38

Commercial paper 39

Commercial paper programmes 40

Commercial paper yields 42

Asset-backed commercial paper 43

Repo 48

Definition 49

The classic repo 50

Examples of classic repo 52

The sell/buyback 56

Examples of sell/buyback 58

Repo collateral 60

Legal treatment 62

Margin 62

Variation margin 64

Currencies using money market year base of 365 days 65

3 THE YIELD CURVE 67

Importance of the yield curve 68

Using the yield curve 69

Yield-to-maturity yield curve 71

Analysing and interpreting the yield curve 72

Theories of the yield curve 73

The zero-coupon yield curve 83

Example calculation illustrations 88

Forward rate calculation for money market term 91

Understanding forward rates 92

Bibliography 93

4 INTRODUCTION TO TRADING AND HEDGING 95

Trading approach 96

The yield curve and interest rate expectations 96

Credit intermediation by the repo desk 98

Specials trading 100

Matched book trading 102

Interest-rate-hedging tools 103

Interest rate futures 103

Forward rate agreements 110

FRA mechanics 112

Overnight interest rate swaps 123

Credit risk hedging 129

Understanding credit risk 130

Credit rating rationale 133

Credit limit setting and rationale 135

Loan origination process standards 139

Bibliography 141

5 ASSET AND LIABILITY MANAGEMENT I 143

Basic concepts 144

Liquidity gap 147

Managing liquidity 153

The liquidity ratio 156

The liquidity portfolio 157

6 ASSET AND LIABILITY MANAGEMENT II 167

Introduction 168

Basic concepts 169

Interest rate risk and source 174

The banking book 180

The ALM desk 181

Traditional ALM 182

Developments in ALM 184

Liquidity and interest rate risk 185

The liquidity gap 185

Gap risk and limits 186

Liquidity management 192

Interest rate gap 194

Portfolio-modified duration gap 197

Critique of the traditional approach 198

The cost of funding 199

Securitization 202

The securitization process 204

Benefits of securitization 206

Generic ALM policy for different-sized banks 212

NPV and value-at-risk 219

Bibliography 220

7 ASSET AND LIABILITY MANAGEMENT III: THE ALCO 223

ALCO policy 224

ALCO reporting 227

8 BANK LIQUIDITY RISK MANAGEMENT 233

The liquidity policy statement 234

Principles of bank liquidity risk management 241

Measuring bank liquidity risk: key metrics 244

Internal funding rate policy 252

Conclusion 259

9 A SUSTAINABLE BANK BUSINESS MODEL: CAPITAL, LIQUIDITY AND LEVERAGE 261

The new bank business model 262

Liquidity risk management 271

The liquid asset buffer 276

Conclusions and recommendations 278

References 279

10 BANK REGULATORY CAPITAL 281

Banking regulatory capital requirements 282

Capital adequacy requirements 284

A primer on Basel II 285

Impact on specific sectors 289

Basel III 304

Bibliography 306

Appendix A Summary of bank product line 307

Appendix B Financial markets arithmetic 317

Appendix C List of abbreviations and acronyms 339

Index 343

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Author Information

Dr Moorad Choudhry is Managing Director, Head of Business Treasury, Global Banking and Markets, at The Royal Bank of Scotland. He is Visiting Professor at London Metropolitan Business School, Visiting Research Fellow at the ICMA Centre, University of Reading, Associate Research Fellow at the School of Information Systems, Computing and Mathematics, Brunel University, a Fellow of the Chartered Institute for Securities and Investment, and a Fellow of the ifs-School of Finance.
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