FREE ELECTRONIC LIBRARY - Books, dissertations, abstract

Pages:   || 2 | 3 | 4 | 5 |

«COPYRIGHT  2002, KMV LLC, SAN FRANCISCO, CALIFORNIA, USA. All rights reserved. Version 1.0. KMV LLC retains all trade secret, copyright, and other ...»

-- [ Page 1 ] --

The Economics of the Bank and of

the Loan Book

Moody’s|KMV Economics of the Bank and of the Loan Book


reserved. Version 1.0.

KMV LLC retains all trade secret, copyright, and other proprietary rights in this document.

Except for individual use, this document should not be copied without the express written

permission of the owner.

Portfolio Manager™, Portfolio Preprocessor™, GCorr™, Global Correlation Model™, Set Analyzer™, Expected Default Frequency™ and EDF™ are trademarks of KMV LLC. KMV, the KMV logo, Credit Monitor®, EDFCalc® and Private Firm Model® are registered trademarks of KMV LLC.

All other trademarks are the property of their respective owners.

Published by: Author(s):

Moody’s|KMV Stephen Kealhofer 1620 Montgomery Street, Suite 140 San Francisco, CA 94111 U.S.A.

Phone: +1 415-296-9669 FAX: +1 415-296-9458 email: support@kmv.com website: http: // www.kmv.com ii Released: 1-May -2002 Moody’s|KMV Economics of the Bank and of the Loan Book Table of Contents Introduction

Franchise and Portfolio

Valuing the Loan: Internal Versus External Benchmarks

Marking the Credit Book to Market



Valuing Credit Risk

Evaluating Optionality and Other Loan Features

The Prepayment Option

The Usage Option



iii Released: 1-May -2002 Moody’s|KMV Economics of the Bank and of the Loan Book Introduction Over the last decade there have been two major developments in commercial banking: the rapid growth of primary and secondary markets for trading credit risk, and active portfolio management of the bank’s loan book. These developments coincide with a long-term change in the perception of the economics of commercial banking. Banks were once viewed as originating relatively safe assets, and earning money by the difference between their short term funding rate and their lending rates. Earnings came from assets. The bank and the portfolio were largely indistinguishable from each other.

Today, banks are viewed as originating riskier assets. Their funding rates are competitive market rates. The differences between funding and lending rates are mostly viewed as compensation for risk. Earnings are primarily generated by activities that explicitly or implicitly earn fees. The portfolio is viewed as a tool to support the bank’s activities.

In this new view, banks earn money from loans by their underwriting or distribution activities. These earnings are represented by the difference in value between the funds lent and the claim created on the borrower. Those earnings can be achieved immediately, via selling the loan, or subsequently, by holding the loan until it matures. However, in the latter case, it is difficult to separate from the subsequent cash flows which ones represent the earnings to underwriting and which the earnings to the portfolio itself.

This problem has been partially addressed by RAROC models. The underlying intent of such models was to determine the profitability of a loan at the time of origination.

However, the definition of profitability was based upon meeting internal hurdle rate returns for capital, without regard for whether the capital was deployed against the portfolio or against the non-portfolio activities of the bank.

It is now better understood that the profitability of a loan can be measured more accurately and more straightforwardly by decomposing the performance of the loan into two parts, one attributable to the underwriting activity, and one attributable to the subsequent performance of the loan. The underwriter’s revenue is determined as the difference between the funds extended and the value of the loan held by the bank. The value of the loan is based primarily upon external market valuations of similar instruments, adjusted to reflect the particular characteristics of the loan. The underwriter’s profitability is this revenue, minus the costs of the underwriting operation.

The second aspect of loan profitability is due to portfolio management. Subsequent to origination, the loan will change in value as external market values change, and as the credit quality of the borrower changes. These changes produce the performance of the portfolio.

The appropriate standard for evaluating the profitability of the portfolio is relative to the performance of a well-constructed portfolio formed from the same universe of potential assets.

This “micro” decomposition of profitability for a single loan can be extended to a “macro” decomposition of the bank as a whole, by separating the portfolio and portfolio

–  –  –

management activities of the bank from the underwriting and non-portfolio services of the bank. This decomposition is very useful in understanding bank performance, as these two parts of the bank have very different characteristics and capital structures.

The remainder of this paper explores the issues raised above. The first part goes into greater detail on the “macro” decomposition of the bank into “portfolio” and “franchise”. The second part looks at the decomposition of loan revenue into “underwriting” and “portfolio” components, and their relationship to RAROC measures, with a discussion on loan valuation approaches. The third part explores the meaning of “mark to market” in the context of the credit portfolio. A brief summary concludes the paper.

A lengthy appendix addresses technical issues around actual loan valuation. The primary motive is to exposit the existing state of the art and, thus, to establish the feasibility of the approaches described in the paper.

Franchise and Portfolio Consider the balance sheet of a large bank, from the standpoint of accounting. Most of the assets on the balance sheet are financial claims, with a relatively small amount of depreciated real assets, as well as intangibles such as goodwill. In this perspective, the portfolio is the dominant aspect of the bank, and the implication is that bank performance flows primarily from portfolio performance.

If we contrast this accounting view with a market value based perspective, the resulting picture of the bank looks different in some significant ways. To get the market view, we need an alternative way to look at the bank’s assets. We can achieve this by shifting our focus from the asset side of the balance sheet to the liability side. The market value of the bank’s liabilities must equal the market value of the bank’s assets; if we owned all the liabilities, we would have an unencumbered claim on all of the bank’s assets.

We can get a decent approximation to this market view if we take the bank’s liabilities to have market values close to their book values, except for the equity, where we can substitute the market value for the book value. When we do this, we discover that many banks have assets whose book value is considerably less than their market value.

Which assets on the balance sheet are the ones that are worth more than their book values?

If we look at the loan book, it would be surprising if it were worth much in excess of its book value. Most individual loan values do not exceed par, and those that do, do so only by a small amount.

The missing market value is attributable to the bank’s non-portfolio business activities. We call this the “franchise”. The franchise is a large, somewhat diversified service business. It represents the underwriting, distribution, fee services, and retail distribution activities of the bank. It is the business we would see if the bank did not retain any of the loans it originated.

–  –  –

The following chart illustrates this decomposition for a generic large bank in the United States. The market values are shown to the left of the each of the accounting balance sheets.

–  –  –

The balance sheet has been decomposed simply by putting all the financial claims into the portfolio, and allocating an appropriate mixture of debt and equity funding against those portfolio assets. The remainder of the assets is assigned to the franchise, along with the remainder of the liabilities and equity.

The market value decomposition is obtained simply by assuming that the portfolio’s market value equals its book value, and assigning the remainder of the book value to the franchise.

Although an approximation, this gives a good idea of the appropriate magnitudes.

Note that the franchise is worth close to $100 billion. Most large bank franchises have market values in the range of $30 billion to $100 billion. These are very large service businesses.

The same decomposition could be applied to a large investment bank, or to a large universal bank, with similar conclusions.

What else do we know about these two parts of the bank? In general, the portfolio has very little risk. For most banks, on a funded basis, the portfolio volatility is about 2% or less per annum. In other words, a one standard deviation move in the value of the portfolio, over a year, would be about 2%. The distribution of outcomes is not symmetric; the possibility of a large down move is economically significant, whereas large up moves are essentially impossible.

The risk of the portfolio can be determined very precisely by a detailed analysis of the portfolio, taking into account the risk of each individual asset, as well as the interrelationships of those risks.

–  –  –

The low volatility means that considerable leverage can be used to finance these assets, and leverage in excess of 90% is common.

The franchise has quite different characteristics. As a service business, it has approximately symmetric upside and downside risks. The risks cannot be readily ascertained from a micro analysis of the component businesses, but can only be approximately measured in the aggregate. Our best estimate of the volatility of the franchise is around 30% per annum for commercial banks and somewhat higher for investment banks. To get some idea of the significance of these values, we can contrast them with the typical volatilities that we observe for businesses of the same size in other industries. In the chart below, the smooth line represents the typical volatility as function of size for other industries; the points represent the values for commercial and investment banks.

–  –  –

For commercial banks, their volatility is consistent with equally large stand-alone nonfinancial business service companies. For investment banks, this volatility lies between those of business service companies and technology companies like software firms. In both cases, these volatilities are above average considering all firms of similar size.

If we look at the capital structure on a market value basis, we discover that unlike the portfolio, the franchise is largely unleveraged, with 20% leverage or less being typical. This is consistent with the relatively high risk profile of the franchise.

–  –  –

The upside potential of the bank resides almost entirely in the franchise. A bank creates franchise value when it figures out how to intermediate more efficiently and build scale as a result. For example, streamlining origination or distribution, and gaining market share results in increased franchise value.

However, there is an important caveat in this picture. Analysts and investors are constantly looking for banks that can produce a steady stream of earnings from their franchise. A bank that is simply taking more risk can produce the false appearance of a steady stream of earnings. Eventually, such risks end up producing significant portfolio losses when there is a downturn in the economy. The portfolio losses lead investors to reassess the value of the franchise, often leading to a fall in the bank’s value that is a multiple of the realized portfolio loss.

Real franchise value cannot be produced simply by taking risk. It can only be produced by taking risks that are worth more than they cost the bank to hold or distribute. The path to franchise profitability lies, first, in understanding the market value of loans at the time of origination.

Pages:   || 2 | 3 | 4 | 5 |

Similar works:

«1 MYRDAL, Gunnar, Swedish economist and first Executive Secretary of the United Nations Economic Commission for Europe (UNECE) 1947-1957, was born 6 December 1898 in Gustafs, Sweden and passed away in Danderyd near Stockholm, Sweden 17 May 1987. He was the son of Karl Adolf Pettersson, farmer and railroad employee, and Anna Sofia Karlsson. On 8 October 1924 he married Alva Reimer, social reformer and politician. They had two daughters and one son. Myrdal was born as Karl Adolf Pettersson and...»

«The Dismeasure of Art. An Interview with Paolo Virno Published at http://www.skor.nl/article-4178-en.html The magazin Open 17 “A Precarious Existence. Vulnerability in the Public Domain” is a publication of SKOR (Foundation Art and Public Space), Amsterdam Open: For a few years now there has been an international discourse surrounding the notion of ‘precarity’ or ‘precariousness’, boosted by European social movements and philosophers such as Paolo Virno: Precarity refers to the...»

«Exploring Project Management by Exploiting Analogy with the Game of Go By E. Grant Kerr A thesis submitted for the degree of Doctor of Philosophy in Strategy, Programme & Project Management SKEMA Business School, Lille December, 2011 © Grant Kerr, 2011 Supervisor Pr. Dr. Christophe N. Bredillet, Centre for Advanced Study and Research in Project, Programme and Portfolio Management Examiners Dr. Derek Walker, Royal Melbourne Institute of Technology Dr. Ginger Levin, SKEMA Business School Jury...»

«Erasmus Journal for Philosophy and Economics, Volume 3, Issue 2, Autumn 2010, pp. 128-135. http://ejpe.org/pdf/3-2-br-5.pdf Review of Nicholas Bardsley, Robin Cubitt, Graham Loomes, Peter Moffatt, Chris Starmer, and Robert Sugden’s Experimental economics: rethinking the rules. Princeton: Princeton University Press, 2009, 384 pp. ANA C. SANTOS University of Coimbra Experimental economics has brought about the most extraordinary changes to economics. Not so long ago the economics profession...»

«Der homo oeconomicus als „happy victimizer“* Strukturen und Prozesse moralischen Funktionierens im verhaltensökonomischen Kontext GERHARD MINNAMEIER ** Ausgehend von einer Kritik am Konzept der „inequity aversion“ wird versucht herauszuarbeiten, wie die situationsspezifische Anpassung moralischer Orientierungen vonstatten geht. Dabei wird auf ein Konzept aus der Moralentwicklungspsychologie zurückgegriffen (den „happy victimizer“), das auf Basis einer moralkognitiven Erklärung...»

«Rich Data, Poor Data Designing Dashboards to Inform by Stephen Few A note about the author Stephen Few has worked for 24 years as an IT innovator, consultant, and educator. Today, as Principal of the consultancy Perceptual Edge, Stephen focuses on data visualization for analyzing and communicating quantitative business information. He provides consulting and training services, writes the monthly data visualization column for the Business Intelligence Network, speaks frequently at conferences...»

«Energy and the state of nations AUTHORS Dietmar Lindenberger Reiner Kümmel* EWI Working Paper, No 11/2011 Institute of Energy Economics at the University of Cologne (EWI) www.ewi.uni-koeln.de The authors are solely responsible for the contents, which therefore do not necessarily represent the opinion of EWI * Corresponding author Energy and the State of Nations Dietmar Lindenbergera, Reiner K¨ mmelb † u a Energiewirtschaftliches Institut an der Universit¨t K¨ln, 50923 K¨ln, Germany ao o...»

«Are PAC Contributions and Lobbying Linked? New Evidence from the 1995 Lobby Disclosure Act ¤ Stephen Ansolabehere Department of Political Science James M. Snyder, Jr. Departments of Political Science and Economics Micky Tripathi Boston Consulting Group August, 2000 1. Introduction House and Senate candidates raise approximately $200 million in campaign contributions from political action committees each election cycle. The lion’s share of this money goes to those already in office,...»

«Journal of Economic Behavior & Organization Vol. 35 (1998) 179±201 Competence and contract in the theory of the firm1 Geoffrey M. Hodgson* The Judge Institute of Management Studies, University of Cambridge, Trumpington Street, Cambridge CB2 1AG, UK Received 8 January 1996; received in revised form 2 December 1996; accepted 20 January 1997 Abstract The Coase±Williamson response to the question ``why do firms exist?'' is based on the idea that transaction costs in viable firms are lower than...»

«Hochschule Hannover Fakultät IV Wirtschaft und Informatik Studiengang: Unternehmensentwicklung Modul: Research Management Intrinsische und extrinsische Motivation von Studierenden der Hochschule Hannover Messung an den Fakultäten III und IV Franziska Badenhop Doris Jeremine Busse Andrea Jonczyk Manuel Schimpf Jörn Siedentopf Inhaltsverzeichnis Inhaltsverzeichnis Abkürzungsverzeichnis Abbildungsverzeichnis Tabellenverzeichnis Kurzfassung Abstract 1 Einführung 1.1 Problemstellung 1.2...»

<<  HOME   |    CONTACTS
2016 www.book.dislib.info - Free e-library - Books, dissertations, abstract

Materials of this site are available for review, all rights belong to their respective owners.
If you do not agree with the fact that your material is placed on this site, please, email us, we will within 1-2 business days delete him.