Introduction

• The traditional role of banks has been to take deposits and make loans. Today, most large banks engage in both commercial and investment banking.
• Commercial banking involves deposit-taking and lending activities, among other things. Commercial banking can be classified as retail banking or wholesale banking. Retail banking, as its name implies, involves taking relatively small deposits from private individuals or small businesses and making relatively small loans to them. Wholesale banking involves the provision of banking services to medium and large corporate clients, fund managers, and other financial institutions. Sometimes banks fund their lending by borrowing in financial markets themselves. Typically the spread between the cost of funds and the lending rate is smaller for wholesale banking than for retail banking. However, this tends to be offset by lower costs. (When a certain dollar amount of wholesale lending is compared to the same dollar amount of retail lending, the expected loan losses and administrative costs are usually much less.) Banks that are heavily involved in wholesale banking and may fund their lending by borrowing in financial markets are referred to as money center banks.
• Investment banking is concerned with assisting companies in raising debt and equity, and providing advice on mergers and acquisitions, major corporate restructurings, and other corporate finance decisions.
• Large banks are also often involved in securities trading (e.g., by providing brokerage services).

The Risks In Banking

• Central bank regulators require banks to hold capital for three types of risk: credit risk, market risk, and operational risk.
• Credit risk is the risk that counterparties in loan transactions and derivatives transactions will default. This has traditionally been the greatest risk facing a bank and is usually the one for which the most regulatory capital is required.
• Market risk arises primarily from the bank’s trading operations. It is the risk relating to the possibility that instruments in the bank’s trading book will decline in value.
• Operational risk, which is often considered to be the biggest risk facing banks, is the risk that losses are made because internal systems fail to work as they are supposed to or because of external events.
• The time horizon used by regulators for considering losses from credit risks and operational risks is one year, whereas the time horizon for considering losses from market risks is usually much shorter.

Market Risk

• Market risks are the risks arising from a bank’s exposure to movements in market variables (e.g., exchange rates, interest rates, commodity prices, and equity prices). These market variables are often referred to as risk factors. The value of a market variable is determined by trading in the financial markets.
• The values of market variables can be affected by many different events. For example, the value of the British pound decreased in June 2016 after the UK voted to leave the European Union (an event that market participants viewed as bad news for the British economy). Another example is the reinstatement of sanctions by the United States government on oil-producer Iran in May 2018. This event led to an increase in the price of oil because market participants thought that it could reduce the supply of oil in global markets.
• Banks provide corporate clients and institutional investors with a wide range of products whose values depend on the prices of market variables. Consider the USD per GBP exchange rate. Among the transactions a corporate client may request are as follows:
  • Spot transactions: where GBP is bought or sold for almost immediate delivery.
  • Forward contracts: where an exchange rate for the purchase or sale of a certain amount of GBP on a future date is agreed.
  • Options: where one side has the right (but not the obligation) to buy or sell GBP at a pre-arranged price (i.e., the exercise price) at a certain future time.

  For many of these contracts, banks act as market makers by quoting both a bid (price at which they are prepared to buy) and an ask (price at which they are prepared to sell). Banks typically ensure that their exposures to market variables are kept within certain limits, but they do not (usually) eliminate those exposures entirely. As a result, banks are always exposed to some market risk.

Credit Risk

• For banks, loans to corporations and individuals are a major source of credit risk. If a borrower defaults, a loss is usually incurred. In a bankruptcy, the size of the loss depends on whether assets have been pledged as collateral and how the bank’s claims rank compared with those of other creditors.
• A bank builds expected losses into the interest rate it charges on loans. For example, suppose the bank’s cost of funds (the average interest rate paid on deposits and on the bank’s debt) is 1.5%. The average interest rate charged on loans might be 4%. The difference between the two interest rates (2.5% in our example) is referred to as the net interest margin. If a bank expects to lose 0.8% of what it lends, it will be left with 1.7% to cover administrative/operational costs and contribute to profits.
• Loan losses show significant variation from year to year. During stressed economic conditions, a bank might experience loan losses as high as 4%, while during good economic times these losses might be as low as 0.2%.
• Current regulations require banks to maintain enough capital to cover losses estimated to occur only once every thousand years.
• Other bank contracts also give rise to credit risk. For example, banks trade a variety of derivatives (e.g., forward contracts and options). As already indicated, these give rise to market risk because the value of a derivatives contract depends on the underlying market variables. Derivatives also give rise to credit risk. This comes from the possibility that the counterparty to a derivatives transaction will default when the transaction has a positive value to the bank (and therefore a negative value to the counterparty).
• Banks typically account for expected losses on transactions as soon as they are initiated. An accounting rule known as IFRS 9 requires banks to estimate expected losses on their loan portfolios and to show the outstanding principal net of expected losses on their balance sheet. In the case of derivatives, banks calculate a credit value adjustment (CVA) reflecting the amount they expect to lose due to counterparty default. This is subtracted from the balance sheet value of the outstanding derivatives. In both cases, expected losses, even though they have not (yet) been incurred, are charged to income.

Operational Risks

• Operational risk is defined by bank regulators as:
  • The risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events. This definition includes all risks that are not market or credit risks (with the exception of strategic and reputational risks). Operational risk is harder to quantify than either market risk or credit risk.
• Examples from seven categories of operational risk identified by regulators include the following.
  1. Internal fraud: Rogue traders intentionally misreporting positions or employees stealing from the bank by creating loans to fictitious companies.
  2. External fraud: Cyberattacks, bank robberies, forgery, and check kiting.
  3. Employment practices and workplace safety: Worker compensation claims, employee discrimination claims, and litigation arising from personal injury claims at bank branches.
  4. Clients, products, and business practices: Money laundering and other actions that are either unlawful or prohibited by regulators.
  5. Damage to physical assets: Terrorism, vandalism, earthquakes, fires, and floods.
  6. Business disruption and system failures: Hardware and software failures, utility outages, and telecommunication problems.
  7. Execution, delivery, and process management: Data entry errors, collateral management issues, and inadequate legal documentation.
• Operational risk is regarded by many to be a greater challenge for banks than either market risk or credit risk. Between 2008 and 2017, banks in North America and Europe have been fined over USD 300 billion for operational risk violations, such as money laundering, market manipulation, terrorist financing, and inappropriate activities in the mortgage market.
• Significant sources of operational risk in banking include cyber risk, legal risk, and compliance risk (i.e., failure to comply with rules and regulations, either accidentally or intentionally).

Economic And Regulatory Capital

• Regulatory capital is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. The objective of regulators is to keep the total capital of a bank sufficiently high that the chance of a bank failure is very low. For example, in the case of credit risk and operational risk, the capital is chosen so that the chance of unexpected losses exceeding the capital in a year is 0.1%.
• In addition to calculating regulatory capital, most large banks have systems in place for calculating what is termed economic capital. This is the capital that the bank, using its own models rather than those prescribed by regulators, thinks it needs. Economic capital is often less than regulatory capital.
• However, banks have no choice but to maintain their capital above the regulatory capital level. The form the capital can take (equity, subordinated debt, etc.) is prescribed by regulators. To avoid having to raise capital at short notice, banks try to keep their capital comfortably above the regulatory minimum.

The Basel Committee

• The Basel Committee for Banking Supervision was established in 1974 to provide a forum where the bank regulators from different countries could exchange ideas. In 1988, there was an international agreement (known as Basel I) that required regulators in all signatory countries to calculate capital requirements in the same manner. Initially, these capital requirements were designed to cover losses arising from defaults on loans and derivatives contracts.
• By the 1990s, however, bank trading activities had significantly increased. In response, the Basel Committee agreed that banks should keep capital for both market risk and credit risk. This modification to Basel I, known as the Market Risk Amendment, was implemented in 1998.
• In 1999, the Basel Committee proposed what has become known as Basel II. This agreement revised the procedure for calculating credit risk capital and introduced a capital requirement for operational risk. It took about eight years for the final Basel II rules to be worked out and implemented. The total capital requirement was then the sum of amounts for
  1. credit risk
  2. market risk
  3. operational risk
• The 2007–2008 crisis led to several bank failures and bailouts. Global bank regulators subsequently determined that the rules for calculating market risk capital were inadequate. Thus, the rules were revised in what is referred to as Basel II.
• The Basel committee also decided that equity capital requirements needed to be increased. This latest set of regulations, called Basel III, includes a large increase in the amount of equity capital that banks are required to keep and is expected to be fully implemented by 2027.
• Meanwhile, the rules for market risk have been revised yet again with the Fundamental Review of the Trading Book, which is due to be implemented in 2022.

Standardized Versus Internal Models

• Models are necessary to determine bank capital. Some models are standardized tools developed by the Basel committee, while others are internal models developed by the banks themselves. Generally, banks need approval from regulators before they can use a specific internal model.
• The Market Risk Amendment included a standardized model approach and an internal model approach. Banks could determine market risk capital using an internal model provided that the model satisfied the requirements laid down by the Basel committee and was approved by national regulators. Basel II allowed internal models to be used to determine both credit risk capital and operational risk capital.
• Since the crisis, the Basel committee has decided to reduce bank reliance on internal models. It now requires that banks use a standardized model for determining operational risk capital. For credit risk and market risk, banks must calculate capital using a standardized model and can (if they receive approval from their national regulators) also calculate capital using an internal model. However, these internal models cannot reduce total capital requirements below a minimum level that is set equal to a certain percentage of the capital given by the standardized approach. By 2027, this percentage will be 72.5%.
• To maintain confidence in banks, government regulators in many countries have introduced guaranty programs. These typically insure depositors against losses up to a certain level.
• The United States with its large number of small banks is particularly prone to bank failures. After the stock market crash of 1929 the United States experienced a major recession and about 10,000 banks failed between 1930 and 1933. Runs on banks and panics were common. In 1933, the United States government created the Federal Deposit Insurance Corporation (FDIC) to provide protection for depositors. Originally, the maximum level of protection provided was $2,500. This has been increased several times and became $250,000 per depositor per bank in October 2008.
• Banks pay an insurance premium that is a percentage of their domestic deposits. Since 2007, the size of the premium paid has depended on the bank’s capital and how safe it is considered to he by regulators. For well-capitalized banks, the premium might be less than 0.1% of the amount insured; for under-capitalized banks, it could be over 0.35% of the amount insured.

Commercial Banking And Deposit Insurance

• To maintain confidence in banks, government regulators in many countries have introduced guaranty programs. These typically insure depositors against losses up to a certain level.
• The United States with its large number of small banks is particularly prone to bank failures. After the stock market crash of 1929 the United States experienced a major recession and about 10,000 banks failed between 1930 and 1933. Runs on banks and panics were common. In 1933, the United States government created the Federal Deposit Insurance Corporation (FDIC) to provide protection for depositors. Originally, the maximum level of protection provided was $2,500. This has been increased several times and became $250,000 per depositor per bank in October 2008.
• Banks pay an insurance premium that is a percentage of their domestic deposits. Since 2007, the size of the premium paid has depended on the bank’s capital and how safe it is considered to he by regulators. For well-capitalized banks, the premium might be less than 0.1% of the amount insured; for under-capitalized banks, it could be over 0.35% of the amount insured.

Deposit Insurance And Moral Hazard

• Up to 1980, the system worked well. There were no runs on banks and few bank failures. However, between 1980 and 1990, bank failures in the United States accelerated with the total number of failures during this decade being over 1,000 (larger than for the whole 1933 to 1979 period).
• One of the reasons for the bank failures was that the existence of deposit insurance allowed banks to follow risky strategies that would not otherwise be feasible. For example, they could increase their deposit base by offering high rates of interest to depositors and use the funds to make risky loans. Without deposit insurance, a bank could not follow this strategy because their depositors would see what they were doing, decide that the bank was too risky, and withdraw their funds. With deposit insurance, it can follow the strategy because depositors know that, if the worst happens, they are protected under FDIC. This is an example of what is known as moral hazard. It can be defined as the possibility that the existence of insurance changes the behavior of the insured party.
  The introduction of risk-based deposit insurance premiums, where the premium might be less for well-capitalized banks, and might be more for under-capitalized banks, has reduced moral hazard to some extent.

Investment Banking

• The main activity of investment banking is raising debt and equity financing for corporations or governments. This involves originating the securities, underwriting them, and then placing them with investors. In a typical arrangement a corporation approaches an investment bank indicating that it wants to raise a certain amount of finance in the form of debt, equity, or hybrid instruments such as convertible bonds.
• There are a number of different types of arrangement between the investment bank and the corporation. Sometimes the financing takes the form of a private placement in which the securities are sold to a small number of large institutional investors, such as life insurance companies or pension funds, and the investment bank receives a fee.
• On other occasions it takes the form of a public offering, where securities are offered to the general public. A public offering may be on a
  • Best efforts basis, where  the investment bank does as well as it can to place the securities with investors and is paid a fee that depends, to some extent, on its success.
  • Firm commitment basis, where the investment bank agrees to buy the securities from the issuer at a particular price and then attempts to sell them in the market for a slightly higher price. It makes a profit equal to the difference between the price at which it sells the securities and the price it pays the issuer. If for any reason it is unable to sell the securities, it ends up owning them itself.

• Best efforts versus firm commitment – example

  A bank has agreed to underwrite an issue of 50 million shares by ABC Corporation. In negotiations between the bank and the corporation the target price to be received by the corporation has been set at $30 per share. This means that the corporation is expecting to raise 30 × 50 million dollars or $1.5 billion in total. The bank can either offer the client a best efforts arrangement where it charges a fee of $0.30 per share sold so that, assuming all shares are sold, it obtains a total fee of 0.3 × 50 = $15 𝑚𝑖𝑙𝑙𝑖𝑜𝑛. Alternatively, it can offer a firm commitment where it agrees to buy the shares from ABC Corporation for $30 per share.
  The bank is confident that it will be able to sell the shares, but is uncertain about the price. As part of its procedures for assessing risk, it considers two alternative scenarios. Under the first scenario, it can obtain a price of $32 per share; under the second scenario, it is able to obtain only $29 per share.
  In a best-efforts deal, the bank obtains a fee of $15 million in both cases. In a firm commitment deal, its profit depends on the price it is able to obtain. If it sells the shares for $32, it makes a profit of (32 − 30) × 50 = $100 million because it has agreed to pay ABC Corporation $30 per share. However, if it can only sell the shares for $29 per share, it loses (30 − 29) × 50 = $50 million because it still has to pay ABC Corporation $30 per share.
  The situation is summarized in the table following. The decision taken is likely to depend on the probabilities assigned by the bank to different outcomes and what is referred to as its “risk appetite.”

  	Profits If Best Efforts	Profits If Firm Commitment
  Can sell at $29	+ $15 million	− $50 million
  Can sell at $32	+ $15 million	+ $100 million

IPOs

• When the company wishing to issue shares is not publicly traded, the share issue is known as an initial public offering (IPO). These types of offering are typically made on a best efforts basis. The correct offering price is difficult to determine and depends on the investment bank’s assessment of the company’s value. The bank’s best estimate of the market price is its estimate of the company’s value divided by the number of shares currently outstanding. However, the bank will typically set the offering price below its best estimate of the market price. This is because it does not want to take the chance that the issue will not sell. (It typically earns the same fee per share sold regardless of the offering price.)
• Often there is a substantial increase in the share price immediately after shares are sold in an IPO (sometimes as much as 40%), indicating that the company could have raised more money if the issue price had been higher. As a result, IPOs are considered attractive buys by many investors. Banks frequently offer IPOs to the fund managers that are their best customers and to senior executives of large companies in the hope that they will provide them with business. (The latter is known as “spinning” and is frowned upon by regulators.)

IPOs – Dutch Option Approach

• A few companies have used a Dutch auction approach for their IPOs. Individuals and companies bid by indicating the number of shares they want and the price they are prepared to pay. Shares are first issued to the highest bidder, then to the next highest bidder, and so on, until all the shares have been sold. The price paid by all successful bidders is the lowest bid that leads to a share allocation.
• Example
  A company wants to sell one million shares in an IPO. It decides to use the Dutch auction approach. The bidders are shown in the table following. In this case, shares are allocated first to C, then to F, then to E, then to H, then to A. At this point, 800,000 shares have been allocated. The next highest bidder is D who has bid for 300,000 shares. Because only 200,000 remain unallocated, D’s order is only two-thirds filled. The price paid by all the investors to whom shares are allocated (A, C, D, E, F, and FI) is the price bid by D, or $29.00

Bidder	Number of Shares	Price
A	100,000	$30.00
B	200,000	$28.00
C	50,000	$33.00
D	300,000	$29.00
E	150,000	$30.50
F	300,000	$31.50
G	400,000	$25.00
H	200,000	$30.25

Dutch Option Approach – Advantages

• Dutch auctions potentially overcome two of the problems with a traditional IPO that we have mentioned.
  • First, the price that clears the market ($29.00 in last example) should be the market price if all potential investors have participated in the bidding process.
  • Second, the situations where investment banks offer IPOs only to their favored clients are avoided. However, the company does not take advantage of the relationships that investment bankers have developed with large investors that usually enable the investment bankers to sell an IPO very quickly.

Dutch Option Approach – Case Study (Optional)

• One high profile IPO that used a Dutch auction was the Google IPO in 2004.Google, developer of the well-known Internet search engine, decided to go public in 2004. It chose the Dutch auction approach. It was assisted by two investment banks, Morgan Stanley and Credit Suisse First Boston. The SEC gave approval for it to raise funds up to a maximum of $2,718,281,828. (Why the odd number? The mathematical constant e is 2.7182818…) The IPO method was not a pure Dutch auction because Google reserved the right to change the number of shares that would be issued and the percentage allocated to each bidder when it saw the bids.Some investors expected the price of the shares to be as high as $120. But when Google saw the bids, it decided that the number of shares offered would be 19,605,052 at a price of $85. This meant that the total value of the offering was 19,605,052 x 85 or $1.67 billion. Investors who had bid $85 or above obtained 74.2% of the shares they had bid for. The date of the IPO was August 19, 2004. Most companies would have given investors who bid $85 or more 100% of the amount they bid for and raised $2.25 billion instead of $1.67 billion. Perhaps Google (stock symbol: GOOG) correctly anticipated it would have no difficulty in selling further shares at a higher price later.The initial market capitalization was $23.1 billion with over 90% of the shares being held by employees. These employees included the founders, Sergei Brin and Larry Page, and the CEO, Eric Schmidt. On the first day of trading, the shares closed at $100.34, 18% above the offer price, and there was a further 7% increase on the second day. Google’s issue therefore proved to be underpriced, but not as underpriced as some other IPOs of technology stocks where traditional IPO methods were used.The cost of Google’s IPO (fees paid to investment banks, etc.) was 2.8% of the amount raised. This compares with an average of about 4% for a regular IPO.

  There were some mistakes made and Google was lucky that these did not prevent the IPO from going ahead as planned. Sergei Brin and Larry Page gave an interview to Playboy magazine in April 2004. The interview appeared in the September issue. This violated SEC requirements that there be a “quiet period” with no promoting of the company’s stock in the period leading up to an IPO. To avoid SEC sanctions, Google had to include the Playboy interview (together with some factual corrections) in its SEC filings. Google also forgot to register 23.2 million shares and 5.6 million stock options.

  Google’s stock price rose rapidly in the period after the IPO. Approximately one year later (in September 2005), it was able to raise a further $4.18 billion by issuing an additional 14,159,265 shares at $295. (Why the odd number? The mathematical constant π is 3.14159265…)

Advisory Services (Optional)

• In addition to assisting companies with new issues of securities, investment banks offer advice to companies on mergers and acquisitions, divestments, major corporate restructurings, and so on. Sometimes they suggest steps they should take to avoid a merger or takeover. These are known as poison pills. Examples of poison pills are:
  • A potential target adds to its charter a provision where, if another company acquires one-third of the shares, other shareholders have the right to sell their shares to that company for twice the recent average share price.
  • A potential target grants to its key employees stock options that vest (i.e., can be exercised) in the event of a takeover. This is liable to create an exodus of key employees immediately after a takeover, leaving an empty shell for the new owner.
  • A potential target adds to its charter provisions making it impossible for a new owner to get rid of existing directors for one or two years after an acquisition.
  • A potential target issues preferred shares that automatically get converted to regular shares when there is a change in control.
  • A potential target adds a provision where existing shareholders have the right to purchase shares at a discounted price during or after a takeover.
  • A potential target changes the voting structure so that some shares have more votes.

Poison Pill – Case (Optional)

• An unusual poison pill, tried by PeopleSoft to fight a takeover by Oracle, is explained in the following box:In 2003, the management of PeopleSoft, Inc., a company that provided human resource management systems, was concerned about a takeover by Oracle, a company specializing in database management systems. It took the unusual step of guaranteeing to its customers that, if it were acquired within two years and product support was reduced within four years, its customers would receive a refund of between two and five times the fees paid for their software licenses. The hypothetical cost to Oracle was estimated at $1.5 billion. The guarantee was opposed by PeopleSoft’s shareholders (It appears to be not in their interests). PeopleSoft discontinued the guarantee in April 2004.Oracle did succeed in acquiring PeopleSoft in December 2004. Although some jobs at PeopleSoft were eliminated, Oracle maintained at least 90% of PeopleSoft’s product development and support staff.

Securities Trading (Optional)

• Banks often get involved in securities trading, providing brokerage services, and making a market in individual securities. In doing so, they compete with smaller securities firms that do not offer other banking services. As mentioned earlier, the Dodd-Frank act in the United States does not allow banks to engage in proprietary trading. In some other countries, proprietary trading is allowed, but it usually has to be organized so that losses do not affect depositors.
• Most large investment and commercial banks have extensive trading activities. Apart from proprietary trading (which may or may not be allowed), banks trade to provide services to their clients. (For example, a bank might enter into a derivatives transaction with a corporate client to help it reduce its foreign exchange risk.) They also trade (typically with other financial institutions) to hedge their risks.
• Banks have in the past been market makers for instruments such as forward contracts, swaps, and options trading in the over-the-counter (OTC) market.

Potential Conflicts Of Interest In Banking

• There are many potential conflicts of interest between commercial banking, securities services, and investment banking when they are all conducted under the same corporate umbrella. For example:
  • When asked for advice by an investor, a bank might be tempted to recommend securities that the investment banking part of its organization is trying to sell. When it has a fiduciary account (i.e., a customer account where the bank can choose trades for the customer), the bank can “stuff” difficult-to-sell securities into the account.
  • A bank, when it lends money to a company, often obtains confidential information about the company. It might be tempted to pass that information to the mergers and acquisitions arm of the investment bank to help it provide advice to one of its clients on potential takeover opportunities.
  • The research end of the securities business might be tempted to recommend a company’s share as a “buy” to please the company’s management and obtain investment banking business.
  • Suppose a commercial bank no longer wants a loan it has made to a company on its books because the confidential information it has obtained from the company leads it to believe that there is an increased chance of bankruptcy. It might be tempted to ask the investmentbank to arrange a bond issue for the company, with the proceeds being used to pay off the loan. This would have the effect of replacing its loan with a loan made by investors who were less well-informed.
• As a result of these types of conflicts of interest, some countries have in the past attempted to separate commercial banking from investment banking. The Glass- Steagall Act of 1933 in the United States limited the ability of commercial banks and investment banks to engage in each other’s activities. But gradually, these have been relaxed, and in 1999, the Financial Services Modernization Act was passed. This effectively eliminated all restrictions on the operations of banks, insurance companies, and securities firms.
• There are internal barriers known as Chinese walls. These internal barriers prohibit the transfer of information from one part of the bank to another when this is not in the best interests of one or more of the bank’s customers. There have been some well-publicized violations of conflict-of-interest rules by large banks leading to hefty fines and lawsuits. Top management has a big incentive to enforce Chinese walls. This is not only because of the fines and lawsuits. A bank’s reputation is its most valuable asset.
• Activities that generate fees, such as most investment banking activities, are straightforward. Accrual accounting rules similar to those that would be used by any other business apply. For other banking activities, there is an important distinction between the “banking book” and the “trading book.”
• Trading book includes all the assets and liabilities the bank has as a result of its trading operations. The values of these assets and liabilities are marked to market daily. This means that the value of the book is adjusted daily to reflect changes in market prices. If a bank trader buys an asset for $100 on one day and the price falls to $60 the next day, the bank records an immediate loss of $40—even if it has no intention of selling the asset in the immediate future. Sometimes it is not easy to estimate the value of a contract that has been entered into because there are no market prices for similar transactions. For example, there might be a lack of liquidity in the market or it might be the case that the transaction is a complex nonstandard derivative that does not trade sufficiently frequently for benchmark market prices to be available. Banks are nevertheless expected to come up with a market price in these circumstances. Often a model has to be assumed. The process of coming up with a “market price” is then sometimes termed marking to model
• The banking book includes loans made to corporations and individuals. These are not marked to market. If a borrower is up-to-date on principal and interest payments on a loan, the loan is recorded in the bank’s books at the principal amount owed plus accrued interest. If payments due from the borrower are more than 90 days past due, the loan is usually classified as a non-performing loan. The bank does not then accrue interest on the loan when calculating its profit. When problems with the loan become more serious and it becomes likely that principal will not be repaid, the loan is classified as a loan loss.
• A bank creates a reserve for loan losses. This is a charge against the income statement for an estimate of the loan losses that will be incurred. Periodically the reserve is increased or decreased. A bank can smooth out its income from one year to the next by overestimating reserves in good years and underestimating them in bad years. Actual loan losses are charged against reserves.

Originate-To-Distribute Model

• Generally, banks take deposits and use them to finance loans. An alternative approach is known as the originate-to-distribute model. This involves the bank originating but not keeping loans. Portfolios of loans are packaged into tranches which are then sold to investors.
• In order to increase the liquidity of the U.S. mortgage market and facilitate the growth of home ownership, three government sponsored entities have been created: the Government National Mortgage Association (GNMA) or “Ginnie Mae,” the Federal National Mortgage Association (FNMA) or “Fannie Mae,” and the Federal Home Loan Mortgage Corporation (FHLMC) or “Freddie Mac.” These agencies buy pools of mortgages from banks and other mortgage originators, guarantee the timely repayment of interest and principal, and then package the cash flow streams and sell them to investors. The investors typically take what is known as prepayment risk. This is the risk that interest rates will decrease and mortgages will be paid off earlier than expected. However, they do not take any credit risk because the mortgages are guaranteed by GNMA, FNMA, or FHLMC. In 1999, FNMA and FHLMC started to guarantee subprime loans and as a result ran into serious financial difficulties.
• The originate-to-distribute model has been used for many types of bank lending, including student loans, commercial loans, commercial mortgages, residential mortgages, and credit card receivables. In many cases there is no guarantee that payment will be made so that it is the investors that bear the credit risk when the loans are packaged and sold.
• Advantage – The originate-to-distribute model is also termed securitization because securities are created from cash flow streams originated by the bank. It is an attractive model for banks. By securitizing its loans it gets them off the balance sheet and frees up funds to enable it to make more loans. It also frees up capital that can be used to cover risks being taken elsewhere in the bank. (This is particularly attractive if the bank feels that the capital required by regulators for a loan is too high.) A bank earns a fee for originating a loan and a further fee if it services the loan after it has been sold.
• Problems Created – The originate-to-distribute model got out of control during the 2000 to 2006 period. Banks relaxed their mortgage lending standards and the credit quality of the instruments being originated declined sharply. This led to a severe credit crisis and a period during which the originate-to-distribute model could not be used by banks because investors had lost confidence in the securities that had been created.