BANKING, INSURANCE AND RISK MANAGEMENT LECTURES
LECTURE 1: INTRODUCTION TO BANKING, PENSION FUNDS AND INSURANCE
This course deals with the risk financial institutions (banks, insurance companies, pension funds, mutual funds,
hedge funds etc.) face, how they can manage and mitigate these risks and what type of regulations they are
subject to. Tip: to study for the exam, practice questions from previous exams and from the book.
WHAT DO FINANCIAL INSTITUTIONS DO?
Financial institutions transform liabilities into assets. As such, they incur risk.
This is their societal function; role in economy. Transformation is the reason
why they earn a profit. The way they transform differs per type of institution:
• Banks: take deposits and transform them into loans.
• Insurance companies: take premiums (monthly, annually) from clients and transform them into assets (real
estate etc.). Their liability is the promise that the insurance company will pay the client an agreed upon
amount of money when a certain event happens.
• Pension fund: take premium (often a particular amount of income) from clients and transform them into
assets. Their liability is the promise that after clients retire, they will provide them a fixed income.
In the process of transformation of liabilities to assets, financial institutions incur different kinds of risks
(depending what is on the asset side of the balance sheet of the financial institutions):
• Credit risk: the risk of the counterparty defaulting. For example, banks face the risk of defaulting loans.
• Market risk: the risk of losing value due to fluctuations in the market. For example, insurance companies
write insurance on tracks and get a premium, however, assets are subject to movements in the market and
they face the risk that the written securities lose value.
• Operational risk: the risk of losses caused by flawed or failed processes, policies, systems or events that
disrupt business operations. For example, not separating the front and back room of a bank.
Financial institutions are critical in economy due to their size (banks are substantially larger than other players
in the economy) and the role they play. Thus, it is crucial that they do not fail.
• Businesses need capital to operate, banks provide this capital for companies to expand. If banks fail this has
effect on the real economy, because companies are not able to get enough capital to expand.
• If old people don’t have access to their pension, then the government needs to step in and provide the
income. So that will also influence young people → young people will consume less and need more saving
as they see that pension funds cannot provide enough income later.
WHAT DOES A FINANCIAL INSTITUTION LOOK LIKE?
Traditional banks:
• Liabilities are divided into three main components:
o Deposits: the (savings) money people deposit at the bank
▪ Deposits have insurance, whereas capital markets have not
o Capital markets: banks are issuing and selling bonds in the market to raise capital. Extremely
important part of liabilities.
o Equity: the bank’s own capital, so capital from its owners.
The equityholders have a residual claim on the assets of the
bank.
• Assets consist of:
o Lending: is divided into wholesale and retail
o Investments: is a very tiny part compared to lending.
,Pension funds:
• The assets consist of investments in capital markets (bonds, stocks, real
estate, and other)
o The liabilities of banks are possibly assets of pension funds.
• The liabilities are claims by pensioners and (former employees)
o The liabilities of pension funds are the assets of employees.
• Equity
WHAT DO BANKS DO?
Commercial banks Universal banks
Take deposits Make loans
Make loans Provide insurance
Investment banking
• Raising debt and equity
• Giving M&A advice, etc. → M&A and valuation advisory is also often done by
non-financial companies, such as accountancy companies, and not just banks.
How do governments access financial markets? Governments borrow from financial markets by issuing bonds.
Their main source of revenue is taxes, their main source of expense is paying bills for hospitals etc. Governments
have to access markets to make up the difference between revenues and expenses. Bonds are sold in the market,
bonds are bought and that is how governments get their money.
Balance sheet of banks: Income statement of banks:
• Interest income and expenses are purely retail banking. To get the income before taxes for retail banks,
also subtract provisions for loan losses (= not all loans will be paid back, some default)!
• Non-interest income and expenses (from investments in stocks and bonds) and provision for loan losses
are the main sources of income for investment banking.
AGGREGATED BALANCE SHEET DUTCH BANKS (LEFT: IN BILLION EUR , ROUNDED; RIGHT: IN %)
• The majority of the assets of Dutch banks are loans. Only 15% is invested in securities.
• Most liabilities of Dutch banks are deposits.
WHAT RISKS DO BANKS FACE?
The Financial Stability Board (FSB) defines four key aspects of financial intermediation:
• Maturity transformation: obtaining short-term funds (deposits) to invest in longer-term assets (loans)
,• Liquidity transformation: a concept similar to maturity transformation that entails using cash-like liabilities
(deposits) to buy harder-to-sell assets (such as loans)
• Credit risk transfer: taking the risk of a borrower’s default and transferring it from the originator of the loan
to another party (riskless deposits to risky loans)
o Saver is bearing the credit risk of the investor doing well with his or her business. Banks can step in
between, taking the credit risk themselves, and protecting the saver/lender. Saver is shielded from
the event that the borrower will default.
• Leverage: employing techniques such as borrowing money to buy fixed assets to magnify the potential gains
(or losses) on an investment
o When your using more capital than your own capital.
o A bank is primarily operating with borrowed capital; they have very little capital from their own
investors in their investments. With borrowed capital, the feature of debt capital is that you have
the pay it back, otherwise you default on debt. Equity is residual, and a bank can never default on
equity. If bank falls short and defaults on their debt they are bankrupt.
TYPES OF RISKS INVOLVED
• Interest rate risk: the probability of a decline in the value of an asset resulting from unexpected fluctuations
in interest rates.
• Credit risk: the possibility of a loss resulting from a borrower’s failure to repay a loan or meet contractual
obligations; so the risk of the counterparty defaulting on their loans.
o The lender may not receive the owned principal and interest, which results in an interruption of
cash flows and increased costs of collection.
• Market risk: the risk of losses in on and off-balance sheet positions arising from adverse movements in
market prices → the value of assets is affected by fluctuations in the value of stocks and investments.
• Liquidity risk: the risk that a company or individual will not have enough cash to meet its financial
obligations (pay its debts) on time.
• Operational risk: the risk of losses caused by flawed or failed processes, policies, systems or events that
disrupt business operations. Employee errors, criminal activity such as fraud, and physical events are among
the factors that can trigger operational risk.
o Barings bank was one of the oldest British banks that had a trader who screwed up. The check
balances that banks put in place to avoid such things nowadays, were not there. The trader was
betting big in Asian markets and was hiding the losses in another account, so the rest of the bank
could not see. He was in charge of front and back office. That was operational failure on the side
of the bank. Extreme losses in Asian market, that was much larger than the equity part of the bank
and bank went bankrupt due to this one guy.
o Any bank has to separate back from front office. Traders will not work in the back office.
• Climate risk: the risk from the consequence likelihoods and responses to the impacts of climate change and
how societal constraints shape adaptation options. If the bank gives a loan to an oil company that will have
a much larger impact than if the bank would give it to other companies.
These risks occur as the properties of the liabilities differ from those of the assets. Need to know how to compute
them for assets and liabilities, and how they differ.
Other risks mentioned in the lecture:
• Liquidity risk: maturity mismatch between deposits and loans → deposits have lower maturity than loans.
If many depositors come to the bank to ask their deposit back, banks do not have the money ready.
• Exchange risk: fluctuations in the market value of currencies
• Inflation risk: value of loan goes down. If inflation is very high (e.g., hyperinflation situation), will be easier
to pay back loan? Liabilities adjust more to inflation than loans will.
,Example 1: What happens in the balance sheet when securities lose 10% of value due to adverse market
conditions? → market risk example
• Securities go down, so total assets go down as well.
• To balance, the total liabilities/equity side goes down.
• Equity is the first to go down, because debt (deposits or other short-
term debt) is something that you have to pay back to debt holders.
Any event that happens that affects the assets of the bank, the first
that is influenced is equity; equity takes the first hit!
Example 2: What happens in the balance sheet when less people repay mortgage due to bad economic
conditions, and the value of loan portfolio drops by 10? → credit risk example
• Loans go down, so total assets go down as well.
• There is not enough equity (equal to 5) to cover the drop in loans
(equal to 10). If equity goes down to -5, there is bankruptcy; there is
not enough capital to pay back the loans. However, debt holders
cannot go to equity holders for further payment, because equity is a
limited liability → equity holders are protected by limited liability;
debt holders cannot ask them to pay more if their liability goes beyond 0.
• The -5 is a loss that the debt holders have to suffer.
• Equity<0, the bank is insolvent!
o Value of the assets does not cover the value of the debt!
Example 3: What happens in the balance sheet when there is a rumour the bank is not safe, and depositors take
out 35? (bank run)
• Depositors take their money out of the bank, so deposits go down.
As a result, the total equity and liabilities goes down. Need to use
assets to pay it back.
• Will first use cash, which goes to zero.
• Then securities are used and also go to zero.
• The bank now has to sell its loans to satisfy the depositors needs of 35 billion euros of payments.
o Selling loans is always bad, because the bank sells it on a discount (firesale of assets): the bank has
no other option but to sell and will get a very bad rate with a very bad discount on its assets. The
value of the assets might be much more than they sell for. Buyer knows there is fair value, but also
knows they get a better deal because the bank has to sell.
• Bank is solvent (equity is positive) but has not enough liquid assets: illiquid!
o Banks will have to liquidate illiquid assets (loans) to cover depositors.
• Bank runs were more common before deposit insurance, but still happened in the US/UK during the crisis.
Illiquidity can slowly go to insolvency.
• But illiquidity is different from insolvency and central banks have a role to play there. Central banks are
known as the lender of last resort, because the central bank can avoid the situation where illiquidity
transforms in insolvency. Banks can borrow from the central bank to have extra cash, which will go to the
deposits. This is a very rare phenomenon, because depositors are insured now and will not rush to get their
deposit back in bad times.
• Banks pay premiums for the deposit insurance to the central bank.
o Since the bank has to pay these securities back, bank is disciplined by the nature of these securities;
the threat of bankruptcy.
o If you fully insure deposits, that reduces the disciplining mechanism on banks → it creates moral
hazard (taking too much risk). If you provide unlimited insurance, that creates reckless behaviour
by banks.
,• Short-term debt is not deposit guaranteed and there could be a run on this side. Banks facing trouble in
raising short term liquidity, because short term liquidity market completely froze, and banks could not raise
capital for their basic operations such as paying salaries. They need to generate short-term capital as they
do not keep a lot of money. Money market mutual funds buy the short term debt.
• In Argentina (2001) there was a fear that even the deposits guarantee was failing.
What is the difference between the originate-to-hold and the originate-to-distribute model of banks (major
contributor to financial crisis):
• Originate to hold is taking a loan and keeping it on balance sheet
• Originate to distribute is taking a loan and selling it off
o Problem with originate-to-distribute: there is incentive to give loans to people who cannot pay it
back. Banks want to generate as much loans as possible as they can sell it by securitization: the
banks do not bear the (credit) risks of the loans but sell it off to someone else, who sells it to
someone, etc. The ones originating the NINJA (No Income, No Job, No Assets) loans had incentives
to generate as many loans as possible as they passed them off to investment banks, who would
sell it to investors. They would make derivatives and give the loans AAA ratings.
o Credits were not checked correctly. The bank was the one paying the credit rating agency, creating
a conflict of interest to credit rating agencies that wrongfully credited loans as AAA.
Why is capital requirement the most key element in bank regulation?
• Basel standards: guidelines for how to regulate banks. Bank for International Settlements (BIS) is a
regulatory body in many countries; they adhere to Basel rules for bank regulations.
o Key element in Basel standards is capital regulation: how much equity the bank has to hold.
▪ The higher the equity, the safer the bank.
• G-SIBs: Global Systematically Important Banks
WHAT DO OTHER INSTITUTIONAL INVESTORS DO?
Pension funds Health, casualty and life insurance
Invest Invest
Insure income after retirement age Insure financial consequences of:
• Bad health
• Loss of property
• Ageing
Business model insurance companies: collect premiums for insuring different kinds of risks (health, life,
property, etc.). They need to collect enough premiums (pool the risks), such that after paying off the claims the
company is left with something to keep – their profit.
• The premium on an insurance is the expected value of a claim in the future – that is when a contract is
written it has 0 value.
o Actuarially fair premium: whatever extra insurance companies charge is their profit. Insurance
companies charge premiums higher than what is actuarially fair.
• Competition among insurance firms brings premiums closer to actuarially fair values.
• They are heavy investors in bonds and stock markets
• Main risk of insurance company: too many people start making claims around the same time (correlated
claims).
• Maintain reserve: conservative actuarial estimates of the present value of the expected pay-outs of the
policies that have been written. Keep reserve, so that they can pay back the extra than normal claims.
Business model pension funds: collect pension for an employee and guarantee a certain income after
retirement age. They invest the amount in assets and after paying off the current claims they keep the profits.
,• Risk of paying out current claims from incoming pensions – the tap running dry
• Longevity risk: people living longer than expected → the pension fund needs to pay the pension for a longer
time than expected.
Explain why/how pension funds and life insurance companies can hedge some of their risks with each other?
• They could write contracts with each other, because longevity is affecting pension companies negatively,
but affecting insurance companies positively. So risks can be hedged by investing in each other. The different
exposures to risks leads to the possibility to hedge the risks.
MUTUAL FUNDS AND HEDGE FUNDS
• Business model: Invest on behalf of individuals and companies, pool money with mutual funds and they
invest it in companies.
o Largest mutual fund is Blackrock. Blackrock takes commission out of investment, which is the main
amount of their income. They take fixed amount of investment (maintenance fee).
• Charge a fee for their service
o Typically higher for hedge funds
• Sometimes also keep a part of the profit
• Hedge funds cater to a more sophisticated clientele and generally there are minimum investment
requirements that are fairly large for retail investors to participate.
Investment strategies
• Mutual funds (bond/equity/hybrid funds) generally go long, by buying bonds.
• Active funds actively try to beat the market. By actively looking for underpriced securities and buying these
securities, they try to outperform a benchmark such as S&P500.
o Higher management fee is charged, because they put more effort and work into their fund.
• Passive funds will blindly follow the benchmark. If the S&P500 is changing, then passive fund is adjusting to
the S&P500. Compositions of shares of passive fund totally mirror the benchmark.
• Hedge funds cater to a more sophisticated clientele and generally there are minimum investment
requirements that are fairly large for retail investors to participate. Hedge funds do all kinds of activities:
o Long/short equity o Merger arbitrage o Emerging markets
o Dedicated short o Convertible arbitrage o Global macro
o Distressed securities o Fixed income arbitrage o Managed futures
Nikola was supposed to do electric trucks. Tesla makes electric cars, Nikola was trying to do the same thing for
trucks, but there was a hedge fund that did extensive research and found out Nikola was fraud and shorted on
their stock. Then reported on the company being a fraud; they claimed to have technology they do not have.
SMALL CASE STUDY: LONG-TERM CAPITAL MANAGEMENT
• Hedge fund founded by star portfolio manager John Meariweather and had two Nobel Laureates: Myron
Scholes and Robert Merton of the Black-Scholes-Merton fame.
• Participated in relative value arbitrage trade.
• LTCM’s main strategy was to make convergence trades: these trades involved finding securities that were
mispriced relative to one another, and then taking long positions in the cheaper ones and short positions in
the dearer ones. This is a highly leveraged strategy! (faces country, market and liquidity risk)
o Based on the principle that two different securities in two different markets, but with the same
underlying asset, should have the same price. However, they often trade with a gap. Due to market
dynamics, prices will converge as they should be sold for same price.
o Issue bonds with maturity bond with 1 year, then 6 months later issue bond with maturity 6
months. Should be priced the same, but there is small difference (something in this trend)
• Rather than converging, pricing were diverging. Led to major losses, because they borrowed from banks to
do these trades. Domino effect on banks themselves.
,LECTURE 2: REGULATION
WHY ARE BANKS REGULATED?
The second wave of the credit crisis of 2007/2008 showed the need for regulation. It became clear that banks
are fragile institutions. Banks have runnable liabilities and insufficient liquid assets to cover these liabilities
(fractional reserve banking system): short time liabilities are not covered by enough liquid assets. The financial
system as a whole is vulnerable to financial crises.
• Interdependence between banks can lead to spreading the problem to other banks.
o Contingent: not interdependence, but a perceived idea that banks are similar. The result between
contingent and interdependence is the same.
• Too big to fail (TBTF) problem: the cost of letting banks fail is much larger than if you would save them.
At the end of 1933, there was need for a lender of last resort. Banks ran out of liquidity, which created awareness
that there should be a lender of last resort. Central banks took this role. The Bagehot principles were developed
that state what to do when there is a bank run (bank can be solvent, but not liquid enough):
1. You should lend generously to solvent banks.
2. They should be able to fulfil their liabilities, it should only be a liquidity problem.
3. Do that against good collateral (high quality collateral)
4. At the penalty of an interest rate (it should not be for free for the bank, because then a bank run is not
a problem for banks).
5. Should provide transparency to the outside world
In the 1930s, the deposit insurance was introduced.
• There is no need for depositors to run to the bank anymore, when the bank is in financial distress.
• Created “moral hazard” problem → There is a need to supervise the banks, due to the lender of last resort
function. Banks take on extra risks, because they know they will be saved or the central bank will repay
depositors. Thus, the central bank needs to know if the bank is solvent, because the bank should only be
illiquid for help. Can no longer rely on retail clients from monetary bank, but need an institution to do it.
The main focus of banking supervision is on the solvency and the liquidity.
• Solvency: the capacity of a bank or institution to meet its liabilities in the longer term; it should have
sufficient assets whatever the maturity to meet its liabilities.
• Liquidity: capacity to service its liabilities falling due at any moment in time; liabilities should be covered by
the assets at any moment.
BANKING REGULATION
Pre “Basel Committee”
• After WW2, the role for supervision emerged. That was in a world where there were lots of restrictions on
capital; the financial sector was very fragmented.
• It became problematic during the 1970s, after Woods system, capital markets became more integrated and
regulated. More room for capital movements. Led to growing number of international banks. Increasing
integration and interdependence, made the system as it was unsustainable (arbitrage, instability of capital
movements).
• Before 1988 banks were regulated with balance sheet measures, e.g., the ratio of capital to assets.
o Definitions and ratios varied from country to country
o Enforcement of regulations varied from county to country
• The growing number of international banks and the increasing integration and interdependence of financial
markets made this unsustainable and led to the establishment in 1988 of the Basel Committee on Banking
Supervision (BCBS) at the BIS (Bank for International Settlements): a place for the major central banks in
the world to discuss issues around capital and monetary policy.
, Basel I (1988)
• The establishment of BCBS led to the first agreement in Basel on what guidelines (not laws) for regulating
banks; now referred to as Basel I. These were long negotiation procedures.
• Enforcement by law in G10 countries in 1992, but more than 100 countries implemented the Basel I
regulation with some small additions and minor customizations for each country.
o G10 was G7, but with 4 countries added. Eleventh country was Switzerland. G7 plus Sweden,
Belgium, Netherlands, and Switzerland.
• Aim to improve the stability of the financial systems by setting minimum reserve requirements for
international banks. Basel I provided a framework for managing credit risk through risk weighting of
different assets. Capital and credit were the important elements.
Risk weighted assets (RWA): assets were classified into four categories (of weights) based on credit risk:
1. 0% for risk-free assets (cash, government bonds (!))
a. Government bonds as we have seen in the euro crisis and many other governments, are not riskless
but for other reasons get a risk weight of zero!!
b. Idea is that you have to hold capital against your risk-weighted assets.
2. 20% for loans to other banks or securities with the highest credit rating
3. 50% for residential mortgages
4. 100% for corporate debt
No need to know these categories explicitly. You will get four types of credits in your balance sheet
(100,200,50,200 these are the assets) and assume they are basket 1, basket 2, basket 3, basket 4. So
100 × 0% + 200 × 20% + 50 × 50% + 200 × 100% = 0 + 40 + 25 + 200 (𝑡ℎ𝑒𝑠𝑒 𝑎𝑟𝑒 𝑡ℎ𝑒 𝑅𝑊𝐴) = 265
𝐶𝑎𝑝𝑖𝑡𝑎𝑙
• Minimum capital requirement ( which is also the leverage ratio) of 4%; capital is capacity to
𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
absorb losses. It is a liability on the balance sheet. Banks do not “hold” capital.
o Capital ratio was to absorb losses. That covers expected losses. If you don’t have the losses, you
will use reserves. Capital is for the unexpected losses, go beyond what you normally expect.
o It is a liability on the bank balance sheet. It is misleading to say that a bank needs to hold capital. It
is on your liability side. It finances your credits. To ensure that you are not going bankrupt when
something unexpected happens. Capital finances your assets like other liabilities. Difference is that
something unexpected happens that go beyond expected losses, the first component that takes
hit is capital.
• Assets included off-balance sheet items that were credit substitutes (e.g., letters of credit or guarantees)
𝐶𝑎𝑝𝑖𝑡𝑎𝑙
• Basel ratio: minimum of 8%
𝑟𝑖𝑠𝑘 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
Minimum capital ratio/Basel ratio of 8%, that was separated into two Tiers:
1. Tier 1: core capital, common stock, high quality capital (minimum of 50% - so 4%)
2. Tier 2: subordinated debt, comes before other stuff on the balance sheet but has less quality than the
tier 1.
Problems with Basel 1:
1. Risk weights not granular enough in the sense that risk management is a core function of banking and
if you impose the rates on the bank, you ask the bank to do something that is far less sophisticated.
a. Leads to undercapitalization of the bank.
2. Only credit risks were covered
Banking regulation Basel II (2004/2007)
Introduction of a three pillar approach:
1. New capital requirements for credit, market, and operational risk
a. Idea is that it is uniform for all banks
2. Supervisory review: more thorough and uniform
