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The Bank Analyst’s
Money, risk and conjuring tricks
Stephen M Frost



The Bank Analyst’s Handbook



The Bank Analyst’s
Money, risk and conjuring tricks
Stephen M Frost





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Library of Congress Cataloging-in-Publication Data
Frost, Stephen M.
The bank analyst’s handbook : money, risk, and conjuring tricks / Stephen M. Frost.
p. cm.
Includes bibliographical references and index.
ISBN 0-470-09118-5 (alk. paper)
1. Banks and banking. I. Title.
HG1601.F76 2004
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
ISBN 0-470-09118-5
Typeset in 10/12pt Times by TechBooks, New Delhi, India
Printed and bound in Great Britain by MPG Limited, Bodmin, Cornwall
This book is printed on acid-free paper responsibly manufactured from sustainable forestry
in which at least two trees are planted for each one used for paper production.


For my children
Natasha, Thomas and Juliet






Part I Financial Systems
1 Securities Markets and Financial Intermediation
2 Introduction to Securities Valuations
3 Central Banks and the Creation of Money


Part II The Spread Business
4 Deposit Taking and Other Funding
5 Corporate Lending
6 Operational Services
7 Mortgage Lending

8 Credit Cards and Other Retail Loans


Part III Risk Management
9 The Controls Cycle
10 Managing Interest Rate and FX Risk
11 Trading
12 Managing Market Risk
13 Managing Credit Risk
14 Capital Management


Part IV Capital Markets
15 Fund Management
16 Stock and Bond Issuance and Brokerage
17 Securitization


Part V Bank Valuations and Acquisitions
18 Bank Valuations
19 Bank Acquisitions


Part VI Problem Loans and Banking Crises
20 Corporate Failures and Problem Loans
21 Banking Crises
22 Dealing with and Valuing Insolvent Banks


Part VII Supervision and Financial Statements
23 Regulation, Supervision and Policing
24 The Balance Sheet
25 The Income Statement





Statistics for Finance
Derivation of Duration and Convexity
Financial Institutions
Appendix I – The Basel Accord
Appendix II – Glossary of Terms
Sources and Further Reading





I have put my sickle into other mens corne, and have laid my building upon other mens foundations.
John Speed, sixteenth century mapmaker, from The Theatre of the Empire of Great Britaine

Financial institutions have few friends. However, despite their poor image, they provide a range
of services without which it is difficult to envisage how a modern economy could operate. It
is also true that banks attract some of the brightest and most highly qualified people of any
industry. Money is one factor, banks pay well for top talent, but many are also attracted by
the intellectual challenges of the business. Banks are difficult to analyze but they also provide
fascinating and challenging problems to solve.
No single person could now write the definitive text on financial systems because the scope
of the subject matter is too broad, the level of detail too deep and it is in a state of constant flux.
One can, for example, go to any large bookshop and buy a 600+ page ‘introductory text’ to value
at risk, techniques used in controlling trading risk. Books that focus on a particular, narrowly
defined subject tend to be very detailed and are usually written for specialist practitioners or
finance academics.
Books that aim to give a general introduction to banking, securities and financial markets
are often rather superficial and most suited to a high-school audience. They tend to be full of
rather boring tables showing such interesting things as international bank rankings by assets
and charts illustrating the growth in the nominal value of interest rate swap agreements. This
book represents an attempt to bridge the gap between the more superficial introductions and
the specialist tomes. In writing this book I have tried to follow these guiding principles:





Scope and detail. That all important functions and subjects related to the financial services
industry be covered. That the key principles related to each subject are clearly identified and
that the level of detail is sufficient for the reader to understand their nature, rationale and
Brevity. That explanations and subjects are covered in a clear and concise manner. Many
specialist finance texts weigh in at an impressive 1000+ pages. The longer a book on
principles is, the less likely it is to be concerned with principles. Einstein’s original paper on
special relativity was a mere 80 pages long. Less is more.
Universality. That the coverage is of universal applicability rather than country specific, and
will date only slowly. This is achieved by focusing on principles and the underlying economic
reality of transactions. Where there are important differences in practices between countries
these are identified.
Motives. That the motives of people and organizations are clearly identified and conflicts of
interest highlighted. Power, greed, fear and corruption all play their parts in financial dealings.

In a very real sense, this is the book that I wish I had had when, fresh out of business school, I
started out as a bank analyst. An important objective is to demystify a vital industry that many
find to be baffling and impenetrable. People who will benefit most from reading this book include
the following:







Business school students and other graduates. MBA and finance students will find that
while the main courses are based on fundamental principles, they come with a pinch of
worldly cynicism. The book also highlights issues such as the failure of financial statements
to provide a true view of banks’ condition and the arbitrary nature of regulatory capital
requirements. Several important areas, such as credit risk management and banking crises,
are also covered that are rarely addressed in general financial works. Anyone who is seriously
considering a career in financial services should find that reading this book helps them in
making their decision.
Finance professionals. Many front-office finance professionals are specialists working in a
narrowly defined field. This book will help them to gain a wider perspective on other parts of
the industry with which they are less familiar. Many other professionals work in back-office,
systems and other support functions. In some cases they have only a limited understanding
of the businesses they are supporting and frequently feel too intimidated to admit their
ignorance. This book will help them to gain a better understanding of the businesses they
support and improve their communications with other people working in the industry.
Analysts and portfolio managers. Financial analysts and portfolio managers are likely to
find the chapters on bank valuation approaches of particular interest. Portfolio managers
apply diversification techniques in the context of fund management but they will gain a new
perspective from seeing how these techniques are also applied in trading, credit risk and in
turn drive bank capital management and requirements.

Consultants, accountants, auditors and legal practitioners. Many external professionals provide a wide range of services to financial institutions. This book will help them to
understand better their clients’ requirements. It will also help to break down the barriers to
communication created by industry jargon.
Financial journalists. Most financial journalists are journalists first and finance specialists
second. This book will give them a solid grounding in theory and practices as they relate
to the financial services industry and help them to understand and interpret bank results,
new developments and regulatory changes better. As Warren Buffett put it “The smarter the
journalists are, the better off society is. People read the press to inform themselves, and the
better the teacher, the better the student body.”
Corporate management. “If you know the enemy and know yourself, you need not fear the
result of a hundred battles. If you know yourself but not the enemy, for every victory gained
you will suffer a defeat. If you know neither the enemy nor yourself, you will succumb in every
battle” (from Sun Tzu’s The Art of War ). Corporate treasuries face many of the same risk
management issues as banks.

I have assumed a basic understanding of accounting and level of numeracy. Some parts of this
work are rather technical but I have tried to keep the level of mathematics in the body of the
text itself relatively low and provided more formal derivations and proofs in stand-alone exhibits
and primers.


The main body of this work is organized around seven relatively discrete parts:







Part I – Financial systems. We start by painting a big picture showing the principal means
whereby capital from investors is channeled to borrowers, and the roles played by commercial
banks, investment banks and fund managers and securities markets in that process. We lay
the foundations for the approaches and methods used to value financial assets. We conclude
by looking at how money is created, the functions of central banks and the tools they have
to influence the supply and price of money.
Part II – The spread business. The main source of commercial banks’ income comes from
the spread they generate between the returns they earn from loans and the costs of attracting
deposits to fund those loans. In the second part of this book we examine deposit taking and
retail and corporate lending. We also cover the most common operational services they
provide to their corporate clients.
Part III – Risk management. Risk management lies at the heart of core bank competencies.
In Part III we focus on interest rate, foreign exchange and credit risk management. We look
at how risk can be measured in terms of volatility of returns and losses and the way in which
portfolio diversification reduces risk. We also explore the fundamental basis for value-at-risk
(VaR) methods for controlling market risk and how this can be used in the context of credit
risk assessment. We conclude by looking at why bank capital should be considered as a
buffer to absorb a level of losses determined by management and how VaR approaches can
be used to define the level of capital that a bank should hold. The Basel Accord on regulatory
capital requirements, in its old and proposed form, is introduced and we take a hard look at
its main features and arbitrary nature.

Part IV – Capital markets. In this part we look at the roles played by fund managers and
investment banks as capital markets intermediaries. We look at the different types of fund
managers and investment products offered and examine the methods used to assess portfolio performance. We look at investment banks’ key capital markets’ intermediation role in
the primary and secondary markets and at their organization and other services offered. We
also examine the nature of asset securitization and how asset backed securities are used
to redistribute risk and returns.
Part V – Bank valuations and acquisitions. The subject of equity valuations is both broad
and complex. We restrict ourselves to the methods used to value commercial banks using
the dividend discount model as the primary tool and show how to approach valuations of
banks with excess capital and how to accommodate short-term explicit earnings forecasts
using multiple-stage models. We look at the worldwide pressures for consolidation and the
fundamental and management incentives for bank acquisitions. We look at the practical
constraints on using cash to make acquisitions and the fundamental constraint imposed by
minimum regulatory capital requirements.
Part VI – Problem loans and banking crises. Under “normal” conditions credit losses
can simply be treated as a cost-of-doing-business. When credit quality starts to deteriorate,
either at individual banks or on a system-wide level, the focus of attention becomes problem
loans. We look at why corporates fail and how banks manage the resultant problem loans.
Banking crises are relatively uncommon but when they do occur their impact is severe. We
examine the major causes of banking crises and the methods most commonly used in their



Part VII – Supervision and financial statements. In the final part of this book we look at
how the financial services industry is policed by regulators and supervisors and the functions

of accounting authorities and audit bodies. We also look at the most important balance
sheet items and income statement lines and their related ratios. We show how to go about
forecasting the balance sheet and income statement looking at loan growth forecasts and
net interest income in particular detail.

There are also three self-contained primers at the back of this book.The first gives a relatively
concise but formal introduction to the various statistical methods referred to in this book. The
second a formal derivation of duration and convexity. The third provides thumbnail sketches of
all of the various institutions that play a part in financial services.
There are very few formal sources in this book, these are well-travelled roads and the foundations of modern financial theory were laid more than a quarter of a century ago. I have included
a list of finance books currently on my bookshelves.


The story behind this book differs from that of most financial texts and this is not the place to tell it in full.
Nor do I have much time, however, for seemingly endless lists of people and platitudes. I met hundreds
of people in my professional capacity, many of whom were very helpful. Two groups of commercial bankers do
stand out, HSBC country managers and ex-Citibankers. So very different and yet so alike. I will concentrate
on those people who actually made a real difference to me. I hope they all know how grateful I am to them.
This book might never have seen the light of day save for an element of serendipity. I first met Chris
Matten when he was appointed CFO of a Singapore bank I covered. He is also the author of an excellent book
ìManaging Bank Capitalî that I had already read. It had given me much food for thought, not least because it
had been written by a practitioner rather than an academic. I donít know what he first thought when my rough
first draft arrived on his desk with a hastily scribbled plea for any feedback or suggestions. It was 18 months
since we had last spoken. The draft (or manuscript as I now know it is called) was posted the day I flew to
the UK for a three-week holiday with my children. This was the first time anyone had had a look at any of
it so I awaited his response with a degree of trepidation.

Chris was very generous with his comments. By e-mail he effectively gave me a crash-course in how
publishers work. I hadnít done any of the things I was supposed to have done. No proposal. No defined
target audience and so on. Iím glad I didnít know what I was supposed to do, the book has life because
I breathed it into it. I am not sure I could have done that if I had followed some tightly structured plan.
He made the critical introduction to Rachael Wilkie, a senior editor with John Wiley in the UK. I was able
to delay my return to Singapore and we met up for my first literary lunch. It was all going much faster than Iíd
planned. I hadnít intended approaching any publisher until the work was completed, still some months away. I
flew back to Singapore if not with a firm commitment then with at least good reason to hope. Other reviews had
to be sought and I had to put together all of those marketing related materials that I had avoided preparing.
Dr Alistair Milne of the Cass Business School in London reviewed the book for John Wiley at this relatively
advanced stage and I took note of his insightful suggestions on book structure. Acting on them meant adding
two new chapters and re-ordering the rest. It was well worth doing. He is not responsible for the rather
pragmatic approach Iíve taken to the application of text-book financial theory.
Rachael had the courage of her convictions and put the proposal forward to Wileyís commissioning committee.
I sent off the completed manuscript a few months later and the contract followed. I thank the team at John
Wiley for their subsequent efforts.
Then there were my friends and family. Most of whom were in the UK and we kept in touch by phone
and email. Alan Spence made a very important contribution. He got me to send him back-ups of the work as
it progressed. As a result, when an incompetent computer repair shop wiped my hard disk it was painful but
possible to recover. He held my hand as the labor progressed and the book began to emerge, albeit from the
distance of 11,500 kilometers. He asks the right questions and that is often more important than having the right
answers. Alan has always been there when it mattered.
Paul Hallas gamely agreed to be the lay guinea pig and made some useful suggestions. Anne Marie,
Mike, Amanda and Suzi in the UK demonstrated that oneís oldest friends are often also the best. My other
great friend, Alan Stewart, died of a brain tumor around the time this book was started. He was so pleased



when, just months before he died, he was awarded his PhD. It is a tribute to his own spirit that he was able
to savor the moment even as he faced death. He does, however, appear in the book in the guise of one of
three young men who bought a house on credit cards. I am sorry that I have not been in a position to give his
widow Karen more support. We all miss him.
I was suffering from acute depression when I started this work. I had cut myself off from the world,
stayed at home with my cat, tuned in to the BBC World Service and thought and wrote. I might never have
written this book if it had been otherwise. My friends and family in the UK were very supportive and very
far away. Ed Manser, Damaris, Gary, Nick, Hugh and Gerry in Singapore defied the cynicís definition of a
friend. Katya Watmore showed great strength of character and compassion when she reached out her hand to
help me pull myself out of the very deep, dark hole into which I had fallen. I am not sure why Katya, in
particular, placed such faith in me but my family and I will be forever indebted.
This book is dedicated to my children, bound for New Zealand, who are far away but close to my heart.
By the time this book is published I will have completed development of a course and workbook that are
intended to complement this book. And after that, who knows. It is a big world out there.
I would welcome any feedback and can be contacted by e-mail at the address below. Please include
the word ìHandbookî in the subject line to avoid being filtered out as spam.
Stephen Frost
February 2004
s m frost@hotmail.com


The love of money is the root of all evil.
The Bible, Timothy, Chapter 12


It is not uncommon to meet professionals in financial services who have only a vague idea about
what their colleagues actually do, even though they work on the same floor. The root cause is
specialization and the subsequent development of languages, or patois, that makes communication between common specialists faster and more precise but are virtually impenetrable to
everybody else.
Some of the terms in these languages can be quite evocative (butterfly spread, fallen angels,
chastity bonds, baked-in-the-cake, sinking funds, double witching day, bottom fishing, concert
party, dressing up, flip-flop notes, ever-greening, barefoot pilgrim) and sound quite fun. Other
terms (collateralized debt obligation, contingent immunization, continuous net settlement, noncumulative preference stocks, death-backed bonds, disintermediation, correlation coefficients,
dynamic asset diversification, subordinated limited irredeemable preference shares) are quite
intimidating and sound as though they should have come from a German-speaking lawyer.
Most lay people have no idea what most of these terms mean but assume quite reasonably
that people who work in finance do. This is like assuming that all Europeans speak the same
language. The terms that we meet in day-to-day life are usually the ones we would rather not
have to think about such as bounced check, over credit limit, minimum payment, bank charges,
commission rates and, at ATMs, service suspended.
General Relativity
It is not necessary to understand Einstein’s theory of general relativity or be able to recall
Newton’s laws to know that if you drop a brick onto your foot it is going to hurt. We only have to
know enough about the effects of gravity to avoid dropping a brick on our toes in the first place.
One does not have to be able to derive the highly complex and very difficult Black–Scholes
model for valuing financial options to be able to understand how they can be used, what factors
determine their price and how changes in these factors will affect a traded option’s price.
Richard Feynman (a jazz-playing, womanizing, fun-loving physicist who won the Nobel prize)
believed that understanding what lies behind a natural phenomenon described by a set of
equations was more important than the ability to write them. He also argued that if one can’t
explain a phenomenon without having to resort to equations, one doesn’t really understand
what is going on. This is how it should be with financial theory.


Much of financial theory tries to formalize what we instinctively believe to be true. We know
that if we back a winning long-shot the payout will be far higher than if it had been the clear
favorite. Risk and reward are inextricably linked. Many of us are experts in liquidity management
and recognize credit and settlement risks when we see them.
Significant advances have been made in finance theory over the past 40 years, particularly
in the areas of asset portfolio management and option valuation techniques. People still joke
about weather forecasting but short-term forecasting is actually pretty good these days, made
possible by very powerful number-crunching computers. I doubt, however, that any progress has
been made in terms of predicting market behaviour reliably and profitably using mathematical
computer models. This lack of progress would be consistent with the fundamental premise that
security price movements are inherently random. An awful lot of people are paid a great deal
of money in the belief that this premise is false.
We also need to maintain a healthy level of skepticism about theories that rely on unrealistic
simplifying assumptions and those that cross the line between science and psychology. An attractive theory may be supported by historic data but fail the acid test of successfully forecasting
future results.
Most of the academic papers on financial theory submitted to journals would lie gathering dust
in various libraries around the world if it had not been for the huge advances in information
technology and data processing that have been made over the past 30 years or so. In 1666
(the same year as the Great Fire of London) Isaac Newton was able to calculate the velocity
required for a rocket to escape earth’s gravity but it took nearly 300 years before the technology
was developed to allow this to be achieved.
Computer hardware, databases, software applications and huge increases in cheap bandwidth and telecommunications capabilities have allowed financial institutions to apply these
advances in financial theory. Academic financial journals are now full of articles seeking
to support or disprove these theories by mining the rich vein of digital financial data now
Few really understand that the world’s financial system has become entirely dependent on
technology. It became fashionable, after the event, to dismiss the warnings of possible Y2K

disasters as hysterical, self-serving hyperbole. If Captain Smith had reduced speed the Titanic
might have escaped from its appointment with destiny. On arrival in New York some would have
criticized him for being too cautious and for failing to meet the promised crossing time. Financial
institutions make huge investments in technology where a successful outcome is one where
nothing happens.
It is difficult to gain a historical perspective of the times through which we live. Each new
paradigm gains its supporters and has its 15 minutes of fame before being casually discarded. In the 1980s there were scores of books extolling the Japanese way of doing things.
American politicians inflamed fears that the Japanese would end up owning most of the
USA. This hysteria reached a peak when Japanese investors bought the symbolic Rockefeller
Center in New York. By the early 1990s most of these books had been remaindered and
were being used for landfill. Many so-called new paradigms are simply the same old ideas

packaged in a different form whose time has come again, and are used to sell consultancy
Liberalization, in all of its forms, has passed into and out of favor many times. The last 25
years of the twentieth century are likely to be viewed by posterity as a period when it was in
ascendancy around the world (despite occasional set-backs). Most industries were affected
and financial services were no exception. A major inflexion point was the collapse in the early
1970s of the fixed exchange rate system between major industrialized economies established
at the end of the Second World War.
Commercial banking and financial brokerage were among the few industries where national
price controls, in the form of regulated deposit and lending rates and commission rates for
buying and selling stocks, still existed. The types of activities that financial institutions could
undertake were also highly restricted. Deposit-taking banks in many countries were prohibited
from stock exchange membership and from owning insurance companies or writing insurance
policies. Significant regulatory barriers had been erected in countries around the world to prevent domestic financial systems falling into the hands of foreigners.

Banking cartels had become well entrenched in many countries. Banks and their regulators
enjoyed a cozy co-existence with incumbents enjoying considerable shelter from the harsh light
of competition. This was at the expense of their customers of course. Liberalization occurred for
a number of reasons. Financial institutions started to shift their international business to those
regimes with the most laissez-faire attitude and lowest taxes and costs. Facing a continuing
loss of jobs and revenues the more highly regulated centers were under relentless pressure to
act to “create a level playing field”. Boundaries between different types of businesses became
increasingly difficult to define. Companies could borrow from a commercial bank or raise funds
from the capital markets. Insurance companies and brokerages sold investment products that
competed head on with bank deposit products.
Progress on World Trade Organization (WTO) agreements on financial services has been
slow and is likely to remain so. Competition and market forces do not stand still, however.
Financial crises have also forced some governments to relax maximum limits on the level of
foreign ownership and lower barriers to entry in order to attract foreign capital.

Historic Perspective
The most basic financial services, such as money lending, date back to the earliest use of money
as a store of value and a means of exchange. Banks, however, have never enjoyed universal
popularity. In the Bible, we read about Jesus Christ throwing out the moneychangers from the
temple two thousand years ago. The Quran prohibits the payment of interest on loans and
deposits. Shakespeare mocked Shylock, a moneylender, in the play The Merchant of Venice.
Banks were blamed widely for the 1930s depression in the US when Gross Domestic Product
(GDP) halved and millions lost their jobs. Thousands of banks failed and many retail depositors
saw their life savings vanish. People who had taken out mortgages to buy their homes, but were
unable to make the required monthly payments, found themselves homeless after banks acted
to seize the property and evict the occupants.


Retail Banking Blues
In more recent years banks around the world have taken action to dissuade low-income retail
customers from using their services. This has been a three-pronged attack. The first prong
involved the introduction of automated teller machines (ATMs) to try to coax retail customers
away from bank branches. The second prong was widespread closures of marginal branches.
The third prong involved the introduction of account and transaction-based fees. In many cases
these fees are waived for customers who maintain a specified minimum balance in their deposit
account. Inevitably it has tended to be the people who can least afford these fees that have
ended up paying them. This has left banks open to continuing political attack and in some
countries legislators have acted to force banks to provide a free basic banking service.
Banks have also been attacked by consumer advocacy groups for offering easy credit and
charging excessive rates of interest to consumers. Inevitably banks have been guilty of misleading advertising. Banks and finance companies may calculate, and highlight, the “interest
rate” charged on installment loans by taking the total interest paid divided by the initial value
of the loan. As this takes no account of the loan’s reducing balance over its term this rate is
well below the effective rate being charged. In many countries lawmakers have had to resort to
legislation to prohibit such practices.
Many banks have also been guilty of selling investment products to ill-informed retail customers without explaining the nature of the underlying downside risks. On occasion when things
have gone badly wrong banks refer complaining customers to the small print in the lengthy
agreement that the customer signed. These “agreements” always seek to indemnify the bank
against any claims or customer losses. As these agreements are usually written in an archaic
form of financial legalese it is not surprising that few members of the general public understand
their detail.

The Pig Trough
Best-selling books and box-office hits have shaped popular perception of investment banking.
Michael Douglas, in his Oscar-winning portrayal of an investment banker in the 1984 movie Wall
Street, caught the public eye with his battle cry that “Greed is good”. There are many books,

both fiction and non-fiction, that have chronicled the excesses of investment bankers, “Masters
of the Universe”. One of the best of these books is Burrough’s Barbarians at the Gate which
gave a riveting account of the takeover of RJR Nabisco, at the time the largest ever such deal,
warts and all.
Any doubts about whether such accounts exaggerated the level of avarice in the 1980s were
probably dispelled by the closure of Drexel Burnham, a US investment bank that pioneered
the issue of ( junk) bonds for companies with a low credit standing. The US District Attorney
prosecuted Michael Milken, its high profile CEO, for criminal and racketeering charges. Milken
pleaded guilty and was sentenced to two years in jail and “agreed” to pay a fine of $850m.
Most insurance companies seem to have been designed to avoid paying out on any claims
and on the rare occasions when they do they never seem to meet the claims in full. Claims
on damage from minor auto accidents always seem to be finely balanced between the costs
of the claim and losing the no-claims bonus. Life insurance policies always seem to cost more
than originally expected and to give worse returns than alternatives. The people selling such
investment products rarely understand how these actually work but follow a script and are
trained to give stock responses to frequently asked questions.

Retail brokers push speculative stocks in order to persuade clients to place buy and sell
orders and hence generate brokerage commission. Many so-called “independent” financial
advisors recommend those investment policies that generate the highest commission for the
advisor rather than those that are in their clients’ best interests. Investors who have bought
mutual funds find that if they try to sell those funds that the amount they actually receive is well
below the value of their investment due to high redemption charges. Nobody likes cold calling
but in many countries such practices are legal and used with high-pressure sales techniques
to persuade unsophisticated investors to buy investment funds that are totally inappropriate to
their needs. Money and morality are words that both start and end with the same letters but
have little else in common.



Financial Systems