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
BRIDGING A GAP
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
shortcomings.

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.
ix
Foreword
TARGET READERSHIP
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 financialworks. 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.
x
Prologue
The love of money is the root of all evil.
The Bible, Timothy, Chapter 12
LANGUAGE, GENERAL RELATIVITY, TECHNOLOGY AND LIBERALIZATION
Language
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.
xv
Prologue
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.
Technology
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
available.
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.
Liberalization
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
xvi
Prologue
packaged in a different form whose time has come again, and are used to sell consultancy
services.
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.
PUBLIC IMAGE LIMITED
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.
xvii
Prologue
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 movieWall
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.
xviii
Prologue
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.
xix
1
Securities Markets and Financial Intermediation
There is no such thing as absolute value in this world. You can only estimate what a thing is worth
to you.
Charles Dudley Warner, US Journalist
RAISON D’Eˆ TRE
Pure capitalist economies are market-based. The allocation and prices of capital, labor, goods
and services are determined by market forces alone, based on supply and demand. This
differs from that of command, or planned, economies where allocation is determined, and
prices set, by a central authority. The former Soviet Union provides an example of a command
economy.
Developed economies today can be viewed as “mixed” economies where private enterprise
and market disciplines are the major determinants of capital allocation and the establishment
of prices but the state also plays a role. Even in those countries where market forces are given
most freedom to act the state usually intervenes to correct the most egregious forms of market
failures and in particular to protect groups, such as individual depositors and investors, from
abuses such as fraud.
Market-based economic systems need financial organizations and structures to facilitate
pricing, market making and redistribution of money and financial risk in order to operate efficiently:

Money. A fundamental requirement of efficient modern economies is that capital is transferred
from those parties with a surplus and allocated to those individuals, companies and
sectors that can generate the highest economic returns. The main mechanism used to determine
this allocation is the action of financial markets.

Risk. All human activities involve a degree of risk. There is, however, a wide range of the
level of risk associated with specific activities. Some institutions and individuals exposed to
a particular form of risk may wish to reduce that exposure and will be prepared to pay to do
so. Others are prepared to accept those risks at a certain price. As a result there is a market
for risk. Financial service organizations help these markets to function by taking such risks
onto their own account, acting in an intermediary role and providing products to redistribute
risks.
In this first chapterwe set the scene by painting a big picture showing the principal flows of money
from investors to borrowers. An impressionist work is created with thousands of brushstrokes
but only makes sense when seen from a distance. Individual brushstrokes have little meaning
in themselves. Readers may come across terms in this chapter with which they are unfamiliar
or whose precise definition is unclear. My advice to readers is to gloss over any such terms.
We will be looking at all of the areas covered here in more detail later.
3
The Bank Analyst’s Handbook
The glossary at the end of this book contains definitions of many of the more important
financial terms. The dictionary definition of a glossary, however, is “a detailed list of specific
terms on a particular subject area that never contains the one you are looking for”.
PRINCIPAL CHANNELS
One of the most important functions of a financial system is to facilitate the flow of capital from
those with excess (the providers of capital) to those with a financing need (the users of capital).
I will tend to use the term investors rather than the unwieldy providers of capital and borrowers
rather than users of capital. Members of the former group are also referred to as savers and
members of the latter group as security issuers.
It is convenient to identify four distinct groups: individuals, private corporations, public sector
entities such asmunicipal authorities and governments. Members of each group may play either
role and at times will play both. There are three principal channels for flows of money between
investors and borrowers:

Direct investment. These are direct flows of money from individual investors to individual
borrowers. Most of these flows are in the formof equity investments and dividends and capital
returns on these investments. Direct investments suffer from a number of fundamental and
practical problems. These flows account for only a very small proportion of the total flows
between investors and borrowers.

Bank intermediation. Banks take deposits from savers and pass these funds on to borrowers.
They pay interest on the deposits and charge interest on the loans. Their profits come
from the spread between the rate they pay for funds and the rate they charge. The pooling
of individual deposits and banks’ ability to lend to many different borrowers eliminate many
of the problems associated with direct investments.

Securities markets intermediation. Using securities markets provides a way to avoid bank
intermediation by bringing together many individual investors to invest in securities, such as
equities and bonds, issued by many different borrowers. Securities market intermediation
also eliminates many of the direct investment problems. By eliminating the banks’ spread
this may provide better returns to investors and lower cost funds to borrowers.
A third type of intermediary exists, not identified explicitly above, that offers investment products
by packaging securities in a number of different ways and selling these to investors. The relative
importance of bank versus securities market intermediation varies significantly from country to
country but we can make these general observations:

Level of development. Securities market intermediation becomes increasingly more important
as the level of development of a country increases. In the most developed economies
securities intermediation to meet corporate financing requirements has become much larger
than bank intermediation. In emerging markets the low level of income is reflected in a limited
demand for investment products and a lower level of domestic institutional investors.
This is one factor in bank intermediation remaining more important than securities markets
intermediation in these countries.
4