1
Banks operations. Bank business
models. Current Trends in Banking
Oleg Deev
2
Contents
1. Functions of banks.
2. Why banks exist?
3. Types of bank operations.
4. Bank business models.
5. Current trends in banking.
3
What is a Bank?
̶ Banking operations may be varied and complex, but a simple
operational definition of a bank is available (usually used by
regulators):
A bank is an institution whose current operations consist
in granting loans and receiving deposits from the public.
̶ combination of lending and borrowing,
̶ a public good?
Main functions of banks:
̶ Offering liquidity and payment services
̶ Transforming assets
̶ Managing risks
̶ Processing information and monitoring borrowers
4
Liquidity and Payment Services
̶ Management of fiat money:
̶ money change (exchange between different currencies
issued by distinct institutions)
̶ provision of payment services
– management of clients’ accounts
– the finality of payments - the guarantee by the bank that the
debt of the payer (who has received the goods or services
involved in the transaction) has been settled to the payee
through a transfer of money
Checking accounts, credit cards, electronic banking or wire transfers
(CHIPS or Clearing House Interbank Payments System, TARGET or
Trans-European Automated Real-Time Gross Settlement Express
Transfer), international payments (SWIFT or Society for Worldwide
Interbank Financial Tele-communication), etc.
Basic Operations of a Bank
T-account is an accounting tool used to show changes in balance sheet
items.
Example: You open a bank account with 100 at XYZ Bank.
Assets Blank Liabilities Blank
Vault cash +100 Demand deposits +100
Blank Blank Blank Blank
Assets Blank Liabilities Blank
Required reserves +10 Demand deposits +100
Excess reserves +90 Blank Blank
Blank Blank Blank
Assets Blank Liabilities Blank
Reserves +10 Demand deposits +100
Securities +30 Blank Blank
Loans +60 Blank Blank
ABC Bank uses its excess reserves to buy bonds worth 30 and make
a loan worth 60.
6
What is a Bank?
Illiquid
Loans
Liquid
deposits
Liquid
assets
Capital
Assets Liabilities
Bank
Illiquid
Machines,
Products,
Real estate
Debt
(mainly
from
banks)
Liquid assets
Capital
Assets Liabilities
Corporate
Assets Liabilities
Typical bank balance sheet
Cash + Reserves at CB Equity
Loans Deposits
Financial instruments (long) Short-term liabilities
Fixed assets Long-term debt
Off-balance sheet (receivables) Off-balance sheet (liabilities)
7
What is a Bank?
Capital
(to absorb losses from IR-, FX-,
credit mismatches)
Assets Liabilities
3M EUR term deposit, 0.01 mln
1) Interest rate
maturity mismatch
3 months10 years
2) Liquidity
maturity mismatch
3 months10 years
3) FX mismatchEURCZK
4) Credit mismatch1 € paid in => 1 € paid backDefaultable
(PD=1%, LGD=50%)
Amount mismatch0.01 mln1 mln
10Y CZK term loan, 1 mln
Mismatches
Bank1 manages
mismatch risks 1-4
Liquidity reserve
(to cover unexpected outflows from
sudden deposit withdrawals)
1)
More precisely, the Treasury unit within the bank manages these asset-liability mismatches (= ALM risks)
8
Asset Transformation
1. Convenience of denomination - bank chooses the
unit size (denomination) of its products (deposits and
loans) in a way that is convenient for its clients.
2. Quality transformation - occurs when bank deposits
offer better risk-return characteristics than direct
investments (due to impossibility of diversification or
asymmetric information situation).
3. Maturity transformation - banks transforms securities
with short maturities, offered to depositors, into
securities with long maturities, desired by borrowers.
→ liquidity risk
9
Asset Transformation3 Fundamentals of the Banking Business 23
10
Risk Management
̶ Credit risk
̶ Default risk (borrower defaults) and migration risk (borrower’s
credit worthiness deteriorates, but borrower still does not default)
EL (expected loss) = PD (probability of default) ×
×	LGD (loss given default) × EaD (exposure at default)
̶ Credit portfolio models: describe portfolio loss distribution, while
taking into account diversification
̶ Liquidity risks
̶ Funding/ Roll-over risk: risk of not being able to roll-over funding
̶ Market liquidity risk: unable to quickly sell an instrument without
large discount
11
Risk Management
̶ Market risk
̶ Potential losses resulting from movements of market prices like interest
rates, credit spreads, FX-rates, stock prices, and commodity prices.
̶ Reinvestment risk: payments before investor’s horizon such that proceeds
need to be (re-)invested => rate unknown => risk
̶ Pre-payment risk: unexpected early (partial or full) repayments of
mortgages
̶ Model risk: arises if (i) instruments are priced with a model (if nonobservable
market prices) or (ii) risk is measured. Model risk increases
with complexity, number of assumptions, shortage of data
̶ Off-Balance-Sheet Operations
̶ loan commitments, credit lines and guarantees
̶ swaps, hedging contracts, and securities underwriting
̶ Operational risk
̶ Potential losses arising from ‘running the bank’: from internal or external
fraud, system failure, breaking law, selling wrong product to customers,
accidents, ethics, discrimination.
12
Monitoring and Information
Processing
̶ Imperfect information on borrowers
̶ Banks invest in the technologies that allow them to
screen loan applicants and to monitor their projects.
→ Firms and financial intermediaries develop long-term
relationships, thus mitigating the effects of moral hazard.
̶ Compared to security investments, the value of a bank
loan results from this long-term relationship and is a priori
unknown, both to the market and to the regulator.
̶ This enhances economic efficiency and welfare
... but at the cost of inherently unstable banks (bank run).
13
Where do banks sit in the macro
economy?
14
Bank business
Banking
book
Banking
book
Liquid
assets
Capital
Assets Liabilities
Bank
Trading book Trading book
• Comercial banking products (loans, deposits, bonds that are held
to maturity (hedges/ strategic investm.)
• Valued at (initial cost) plus accrued interest
(not valued at market prices, even if instrument had market
prices)
• IFRS: „Held to maturity“
• Main source of the asset-liability mismatch risks
• Items that banks want (have) to trade (buy and sell)
=> often „churn“ rule: to be sold ≤ 180 days)
• Result from market making, proprietary trading, flow trading (for
customers)
• Daily valued at market-(mark-to-market) (or model prices (markto-model)
if market prices are unavailable or not credible because
very illiquid instrument)
• Often derivative instruments
• Note: banking- and trading book exist on both balance sheet
sides!
15
Service or function Balance sheet Revenue generated Risk
Lending
Retail, commercial,
mortgage, project finance
Assets Interest income, fees Credit, Market
Trade finance, credit cards Assets Interest income, fees Credit, Market,
Operat.
Lending, Syndicated Assets Trading, interest incoem, fees Credit, Market
Cash Management
Processing Asset [balance <0],
Liabilities [balance >0]
Fees Operational
Payments Fees Credit, Operational
Custodians --------- Fees Credit, Operational
Private banking --------- Commission income, interest
income, fees
Operational
Asset management ---------- Fees, Performance payments Credit, Market,
Operational
Capital markets
M&A ---------- Fees
Corporate finance Aseets (if banks lends), Fees, Interest income (if bank
lends)
Trading (Equities, Foreign
exchange, Derivatives)
Assets (long, MV > 0)
Liabilities (short, MV<0)
Trading income, fees Credit, Market,
Operational
Trading (Bonds) Assets (long), Liabilities
(short)
Trading income, interest
income, fees
Depositing (Retail, Corporate,
Public sector, Interbank)
Liabilities Interest income Liquidity risk
16
From products to balance sheet
1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions
Borrowing (client’s view) Payment Investment (client’s view) Services & Extras
Government SecuritiesSaving DepositsCurrent account (-)Loans\Overdraft Facility
Certificates of deposits (CDs) Investment funds Saving PlanLoans\Car
Wealth ManagementLoans\CreditCard
CustodyMortgages\Fixed-rate
Mortgages\Variable-rate
Mortgages\Rate Locker
Mortgages\Securitisation Blocker
Mortgages\Pre-payment Option
Unsecured
Deposits from
customers
Securitised
Liabilities
Mortgages
(property-
secured
loans)
Other Claims
Investment fundsTerm DepositsLoans\Consumption Current account (+)
Assets Liabilities
17
From products to balance sheet
1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions
Payment Services & Extras
Capital market financingMoney market depositsCorporate account (-)Bank financing (loans, leases)
Certificates Payment servicesExport and trade finance
Cash pooling
Treasury management
Advisory servicesTerm depositsPromissory note bonds Corporate account (+)
Financing Cash Management Asset Management Risk ManagementInternational Business
Information management
Assets Liabilities
Money market funds
Third party securities
Custody
Company Pension Scheme
Bank’s own debt issuances
Equity
Payment services
Currencies
Promissory
note loans
Trading
assets
Trading
liabilities
Derivatives
Bank’s own equity issuances
Unsecured
Deposits from
customers
Securitised
Liabilities
Mortgages
(property-
secured
loans)
Other Claims
Borrowing (client’s view) Investment (client’s view)
18
From products to balance sheet
Repo (spot purchase)
1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions
Payment Services & Extras
Investment fundsPfandbriefFinance leases (real estate)
Public sector PfandbriefReal estate loans
Ship PfandbriefOperating leases
Asset Mgt & Leasing Real Estate Finance Ship Finance Public Finance
Assets Liabilities
Other assets
Ship loans
Unsecured loans
RE/ infrastructure loans
Repo (spot sale)
Secured
deposits
from
customers
Equity
Promissory
note loans
Unsecured
Deposits from
customers
Securitised
Liabilities
Mortgages
(property-
secured
loans)
Other Claims
Trading
assets
Trading
liabilities
Borrowing (client’s view) Investment (client’s view)
19
From products to balance sheet
1. Retail & SME 2. Corporate 3. Asset-based Finance 4. Financial Institutions
Payment Services & Extras
Advisory servicesRepo (spot sale)Correspondent banks (-)Trade loans
Cash pooling
Payment servicesCorrespondent banks (+)
Currencies
Repo (spot purchase)
Assets Liabilities
Other assets
Secured
deposits
from
customers
Equity
Promissory
note loans
Trading
assets
Trading
liabilities
Unsecured
Deposits from
customers
Securitised
Liabilities
Mortgages
(property-
secured
loans)
Other Claims
UD from
banks
SD from
banks
Claims on
banks
Money market trading
UD from other banks
Deposits to other banks
Liquidity management
Cash reserve
Liquidity reserve
Funding liquidity reserve
Borrowing (client’s view) Investment (client’s view)
Fig. 2.1 Illustrative organization of an archetypical universal bank20
21
Wholesale banking
̶ Large value, low volume part of banking business
̶ Mix of domestic and foreign currency business
̶ Large size of deposits and loans
̶ Tailor made loans
̶ Dependence on inter-bank market
̶ Greater importance of off-balance-sheet facilities
̶ Small proportion of demand deposits
22
Universal banking
̶ Keeps customers in one stop shop
̶ Economies of scale exhausted quickly and constant
returns to scale
̶ Economies of scope
̶ Size allows for risks to be spread and internally diversified
̶ Size also creates danger of Too Big to Fail
23
Islamic banking
̶ Risk sharing – each participant must share in the same risk-return
distribution (removes asymmetric information problem)
̶ Materiality – all financial transactions must be backed by a tangible
asset (no options).
̶ Non-exploitation – neither party can be exploited
̶ No sinful activity – alcohol, gambling, etc
̶ Widely practiced model is 2-tier Mudaraba
̶ Depositors enter into a contract with the bank to share profit
̶ Bank enters into a contract with the borrower to split the profit
̶ Fast rate of growth
̶ Islamic banking assets only constitute up to 2% of global banking
assets
24
Shadow banking
̶ Financial Stability Board definition – ‘credit intermediation involving entities
and activities outside the regular banking system’
̶ Hedge Funds – more aggressive investment strategies than life assurance &
pension funds.
̶ Special Purpose Vehicles – vehicle for securitisation
̶ Money Market Funds – short term high quality securities
̶ Private Equity – investment in private companies
Process takes between 3 and 7 steps:
1. Loan originated by Bank or other FI
2. Loan warehousing financed by ABCP
3. Pooling & structuring loans by broker/dealers
4. ABS warehousing via trading book financed by REPOs
5. Pooling & structuring of ABS into CDOs done by broker dealers.
6. ABS intermediation is carried out by SIVs & hedge funds
7. All steps funded in the wholesale market
desk (i.e., acting as a competitor), or to reduce the maturity gap on their
balance sheet (i.e., acting as a client of yours).
3.1.3 Shadow Banks
Shadow banks6 are market participants providing banking services outside
the scope of regulatory supervision. They include hedge funds, insurance
companies, pension funds and money market funds. Because they don’t have
a banking license that is required to accept retail deposits they are also called
nondepository institutions. Lacking the ability to fund themselves through
deposits, shadow banks tend to use wholesale funding, including repo7
(see Fig. 3.2).
25
International banking
̶ Decision to locate depends on a number of factors
̶ Home Country Characteristics
̶ Home country regulations
̶ Resource costs
̶ Host Country Characteristics
̶ Absence or lack of regulation
̶ Monopolistic characteristics
̶ Information exploitation
̶ Phase 1 – home production, export bank services abroad ACF>ARF>ACD
̶ Phase 2 – bank in home country establishes foreign facilities ARF> ACF>ACD
̶ Phase 3 – foreign production is cheaper than at home (greater foreign share
of business) ARF>ACD> ACF
̶ Phase 4 – home country bank produces banks services abroad and import to
domestic country ACD>ARF>ACF
26
Bank Business Models32
LiabilitiesAssets
Business model
(BM)
Funding
Market/Wholesale
RetailRetail
Market
Activity
BM
Input
BM
Output BMX is the result of a combination “X” of Activity/Funding indicators: BMX =
BMi
.
.
BMn
The Activity/Funding indicators defining a BMX are conceived following an Assets/Liabilities logic:
Customer loans;
R. AYADI
27
Bank Business Models
These features are first-level defining features of what a bank does
(in terms of their assets side) and how it does it (in terms of the
BM
Output BMX is the result of a combination “X” of Activity/Funding indicators: BMX =
.
.
BMn
The Activity/Funding indicators defining a BMX are conceived following an Assets/Liabilities logic:
Retail
Market
Activity
Customer loans;
Corporate and institution loans;
SMEs loans;
Commercial and industrial loans;
Agricultural loans.
Stock market activity (trading
activity, derivative exposure);
Bank loans and other FIs loans;
Central banks loans and other
central FIs loans;
Government loans.
Customer deposits;
Corporate and institution deposits.
Retail
Market/
Wholesale
Funding
Inter-banking
activities
Market borrowings / Stock market
activity;
Government funding.
Other banks deposits;
Other FIs deposits;
Central banks deposits;
Other central FIs deposits.
Fig. 3.1 Bank business model definition. Source: Author. Note: Market and
retail activities and funding are broad categorisations used in this definition.
Market and wholesale are used interchangeably
28
Bank Business Models
Cluster analysis for European banks
Ayadi and de Groen
(2016) define BBMs
distinguishes primarily
between the key banking
activities and the funding
strategy, which broadly
builds on asset-liability
approach. Analysis
covers 147 banking
groups in Europe (80%
of EU bank assets) in
years 2006-2013.
Financial crisis affected
BBMs – banks received
state aid have reoriented
towards focused retail.
Wholesale banks primarily engage in interbank lending and
borrowing.
Investment banks are primarily engaged in trading and derivatives
activities and funded with a mix of retail and market funding (Fig. 4.1).
-2.0
-1.0
0.0
1.0
2.0
3.0
Bank loans
Bank liabilities
Customer deposits
Customer loans
Debt liabilities
Trading assets
Derivative exposures
Tangible common equity
Focused retail Diversified retail (Type 1)
Diversified retail (Type 2) Wholesale
Investment
Fig. 4.1 Identification of bank business models in Europe, standardised scores.
Source: Reproduced from Ayadi et al. (2016). Notes: Indicators marked with an
asterisk (*) were used as instruments in the cluster analysis. The figures represent
the number of standard deviations from the sample mean. Customer loans and
29
Bank Business Models
Model transition matrix
business models transition matrix for banks in Europe, which shows that
business models do not behave similarly.
Figure 7.1 provides the transition matrix for the five models from
2005 to 2014.
Wholesale
80%
1.1%
0.6%
7% 3.8%
Focused
retail
8%
1.7%
90%
0.2% 0.1%
Diversified
retail
(Type 2)
87%8%
0.4%
1.5%
1.1%
Investment
85%
9%
0.1%
4%
6%
Diversified
retail
(Type 1)
89% 0.9%
2.2%
12%
1.1%
30
EU bank’ adjustment to new
business models
31
Competition
Financial
services
D
S
P1
S1
P2
Price of
financial
services
D1
S
Pb1
Pb2
D2
Competition from NBFIs increases supply
of financial services
Increased substitution leads to fall in
demand for bank services
32
33
34
Bank branches per million
inhabitants (EU15)
Bank employees per million
inhabitants (EU15)
Source: ECB Statistical Data Warehouse
35
Core business area IT systems used
Lending IS from external vendors (i.e., SAP ‘‘Commercial
Banking Operations’’ Module)
Taking/managing deposits Branch and ATM network
In-house-developed IS (online and mobile
banking)
SAP software modules
Payments processing and
infrastructure
ATM networks
In-house-developed IS (online and mobile
banking)
Card and digital payment networks
SEPA
Compliance with
regulations
Manual labour
RegTech systems
Marketing and sales CRM technology
Salesforce automation technology
36
AI in Banking
̶ More accurate default predictions can be made with previously
unused data types
̶ A greater variety of algorithms in credit risk estimation
̶ Safer payment networks (detection of fraud and money laundering)
̶ Managing the scale of the business infrastructure (predicting the
amount of cash withdrawals, payments, etc.)
̶ Detection of non-compliance with regulations (analysis of phone
conversations between employees and clients and between
employees in real-time, natural language processing to read and
interpret regulatory documents)
̶ Prediction of financial product purchases
̶ Churn prediction
44
Literature
̶ Choudhry M. (2022). The Principles of Banking, 2nd ed. – Chapter 1
̶ Matthews and Thompson (2015). The Economics of Banking. –
Chapters 1, 3-5.
̶ Ayadi, R. (2019). Bank business models. – Chapters 3-4, 7.