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 Topics covered with
me:
• Topic 1: Commercial and investment
banks: Activities and challenges
(2 classes)

• Topic 2: Financial risks (2

classes)

• Topic 3: Liquidity and systemic

risk (2 classes)

• Topic 8: Climate Finance (1 1

classes)
International Banking
- 30178
Academic year 2024-2025

Topic 1
Commercial and investment
banks: activities and
challenges
 Objectives of
Topic 1
• Focus on commercial and
investment banks

• Their activities and sources of

profitability
– Balance sheet
– Income statement
– Financial ratio analysis
Chap. 2 – SC Textbook *Appendix 2B
Chap. 4 – SC Textbook
4
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What are banks for?

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 What are banks for?

• Saver (surplus of Borrower (shortage of funds)

funds)

Financial markets
(direct finance)
 What are banks for?

• Saver (surplus of Borrower (shortage of funds)

funds)

Financial institutions
(indirect finance)
 Why do we need financial
intermediaries (such as banks)?

The two primary functions of FI (such as banks) are

1. Lower Transaction Costs

2. Reduce Asymmetric Info (ex ante: adverse selection; ex post: moral

hazard)

FI are better equipped than financial markets (direct finance) to solve these
problems.
 What are
Banks?
• There are two “types” of banks:

1. commercial banks

2. investment banks

• The Glass-Steagall Act (1933) separated investment and commercial

banking activities in response to the commercial bank involvement
in stock market investment.
 What are
Banks?
- Commercial Banks are institutions that accept deposits (liabilities) and make
loans (assets).
- They are traditionally the largest Financial Intermediary (FI) by asset size.

- Investment Banks are not depository institutions. Mostly they:

1. underwrite the initial sale of stocks and bonds

2. are deal maker in mergers, acquisitions, and
spin-offs
3. are private broker/bank to the very wealthy

Investment banks ‘‘research’’ companies (provide analysts’ forecasts)

 Direct
credit

Firms &
Investors capital
Sovereign

11
Intermediate credit
(Commercial Banks)

Firms &
Investors Sovereign
deposits CB

Families

12
Intermediate credit
(Investment Banks)

IB

Firms &
Investors capital
Sovereign

13
Commercial banks

14
 Commercial
banks
• Major financial intermediaries in the economy

• Main providers of credit to household (mortgages) and corporate

sectors (typically to the SMEs)

• Different size classes

– Smaller banks are more specialized in lending to households
and real estate than larger banks
– Smaller banks collect deposits (retail customers) while large banks
use wholesale sources of liquidity

• Typically joint stock companies

– Publicly listed on the stock exchange
15
– Privately owned
 The two financial
statements
• Balance sheet: it captures the wealth of a bank, that is the
sources and uses of funds at one specific date (end of the
year)

• Income statement: it captures the performance of a bank

between two dates (two ends of the year)

• Appendix: Off Balance Sheet activities

16
Consider the (simplified) balance sheet of a
company (not a FI):
where can you find LOANS and DEPOSITS?
Consider the (simplified) balance sheet
of a company:

You can You can

find find LOANS
DEPOSITS here: the
here: the company
company borrows
keeps some funds
of its
money in a
bank
account
What about a commercial bank’s balance
sheet?
What about a commercial bank’s balance
sheet?

You can You can

find LOANS find
here: the DEPOSITS
bank lends here: the
money to bank always
SME, owes them
households, to
etc depositors
 Balance sheet (b/s)

• It lists sources and uses of banks’ funds

(usually, at the end of the financial year)

• Crucial to understand
– Asset quality and credit risk
– Capital Adequacy and Leverage Funding

21
 The sources of funds (=
liabilities)
The funds come from:

a) general public (retail deposits)

b) companies (small, medium, and large corporate deposits)
c) other banks (interbank deposits)
d) debt issues (bond issues and loans)
e) equity issues (share issues, conferring ownership rights to holders)
f) saving past profits (retained earnings)

22
 The uses of funds (=
assets)
Funds are transformed into financial and, to a lesser extent,
real assets:

a) cash;
b) liquid assets: typically short-term instruments such as
Treasury bills;
c) loans (to SMEs and mortgages);
d) other investments;
e) fixed assets (branch network, computers, premises)

23
 Simplified Balance sheet of a
commercial bank
Assets Liabilities & Equity
- Cash - Retail deposits (households and
- Liquid assets SMEs)
- Loans - Wholesale deposits (large firms/
- Other investments FIs)
- Fixed Assets - Debt (senior/subordinated bonds)

- Equity
- Other capital terms

Total Assets Total Liabilities & Equity

24
 Simplified Balance
sheet (b/s)
Government and
Assets etc. & Equity
Liabilities
corporate bonds,
- Cash 1. Deposits (retails)
- Liquid assets and (wholesale)
2. Deposits
Commercial
- Loans industrial (C&I),
- Other investments mortgage loans
3. Equity
- Fixed Assets 4. Other capital terms

All longer term

securities (bonds and
Total Assets PCs
Branches, other debt Total
instruments)
Liabilities & Equity

25
 What is special about
banks’ (b/s)?
• As we already said, banks’bs are mirror image of the ones
of non-financial corporations:

– Deposits appear on the liability side

– Loans appear on the asset side

The opposite is true for non-financial corporations!

• Moreover, the debt/equity ratio (leverage) is much higher than the

ratio of other kinds of firms (i.e. debt >>equity)
26
 What is the consequence of
high leverage?
• Any firm is solvent as long as its capital is non-negative.
But we just said that banks have less capital!

• When is a manufacturing firm insolvent?

– Assets need to decline by a large percentage

• When is the bank insolvent?

– Assets need to decline only by a small percentage

The bank is much riskier as it has a smaller loss absorption

capacity!
(we will go back to this in details later in the course)
16
 Income statement
(i/s)
It reports costs and revenues, thus bank profitability
(between two year-end balance sheets)

• Crucial to understand
– Banks’ profits
– Banks’ costs and revenues

28
 What is an income
statement? (i/s)
• It measures bank performance between two year-end
balance sheets, and thus bank profitability

• That is, the i/s reports costs and revenues and

Profits = revenues – costs

• Notice the difference:

– balance sheet reports stocks (e.g., amount of outstanding loans)
– income statement represents the cash flow values for a particular year
(e.g., interest received on outstanding loans) 29
 Income
statement
a Interest income
(b) Interest expense
c =a-b Net interest income (or “spread”)
(d) Provision for loan losses (PLL)
e =c-d Net interest income after PLL
f Non-interest income
(g) Non-interest expense
h =f-g Net non-interest income
i =e+h Pre-tax net operating income
l Securities gains (losses)
m =i+l Income before taxes
(n) Taxes
p =m-n Net income
(q) Cash dividends
r =p-q Retained profit 19
 How the b/s links
with the i/s
Assets
Income Statement
1. Loans
Interest income
2. (Loan LossReserves)
3. Other Earning Assets Interest expense
4. Total Earning Assets (1+2+3) Net interest income (or “spread”)
5. Fixed Assets Provision for loan losses (PLL)
6. Non-Earning Assets Net interest income after PLL
7. Total Assets Non-interest income
Non-interest expense
Liabilities & Equity Net non-interest income
1. Deposits Pre-tax net operating income
2. Other interest bearing liabilities
Securities gains (losses)
3. Other non-interest bearing liabilities
4. Total Liabilities (1+2+3) Net income before taxes
5. Retained Earnings Taxes
6. Equity Net income
7. Total Liabilities & Equity (4+5+6) Cash dividends
Retained profit 20
 How the b/s links with
the i/s
Net income (NI):
N M

NI = Σ r n A n − Σ r n L m − PLL + NiI − NiE − T

n=1 n=1

A = Assets (n)
L = Liabilities (m)
PLL = Provisions for loan losses
NiI = Non-interest Income
NiE = Non-interest Expenses
T= Taxes 32
 What drives interest
income?

Yield on Each
Asset Interest Income
(income on all bank
assets such as loans,
Volume on securities and deposits
Earning Assets lent out to other
institutions,
households and other
Composition of borrowers)
Assets

33
 What drives interest
expense?

Interest Cost of
Interest Expense
Each Liability
(expenses on all
interest-bearing
Volume of liabilities such as
Interest-Bearing deposits, ST
Liabilities borrowing and LT
debt)
Composition of
Liabilities

34
 What drives non-
interest income?

Fee Income

Service Charges N on-interest

Income

Other Income

35
 What drives non-
interest expense?
Salaries &
Employee
Benefits

Property and N on-interest

Equipment Expense
Expenses

Other Operating
Expenses

36
 How the b/s links with the i/s
Assets
1. Loans
2. (Loan Loss Reserves) • Income Statement
3. Other Earning Assets • Interest income
4. Total Earning Assets (1+2+3) • Interest expense
5. Fixed Assets • Net interest income (or “spread”)
6. Non-Earning Assets • Provision for loan losses (PLL)
7. Total Assets • Net interest income after PLL
• Non-interest income
Liabilities & Equity • Non-interest expense
1. Deposits • Net non-interest income
2. Other interest bearing liabilities • Pre-tax net operating income
3. Derivatives & trading liabilities • Securities gains (losses)
4. Long-term funding • Net income before taxes
5. Other non-interest bearing liabilities • Taxes
6. Total Liabilities (1+2+3) • Net income
7. Retained Earnings
• Cash dividends
8. Equity
26
9. Total Liabilities & Equity (4+5+6) Retained profit
What drives provisions for
loan losses?

Yield on each
Provision for loan
loan
losses
(amount charged
Volumes of against earnings to
Loans establish a reserve
sufficient to absorb
expected loan losses)
Composition of
Loans

27
 Transition from a current loan
to charge-off
Note: a NPL does not necessarily lead to losses.
If there is adequate collateral, losses might not occur  what is collateral?

Loan is current and accruing interests NPL

Once payment is 30 days late loan is classified as 30-90 days past due

Once payment is 90 days late loan is classified as 90 days past due

If full repayment of loan is uncertain loan is classified as non accrual

Loan is charged off once deemed uncollectible

Cash collection on previously charged-off loans are recorded as recoveries

Loan deterioration
and equity
Reserves

reserves

reserves

reserves
 - initial
situation
Loan deterioration (cntd.)
Reserves

Equity falls
Reserves

Reserves
Management estimates that additional 5k won’t be
paid as promised

Loan deterioration (cntd.)

Reserves

Equity falls
Reserves

Reserves
Management feels there is no chance for
recovering those 5k.
Loan deterioration (cntd.)
It’s the gross loan value now that decreases, as
reserves for loan losses are established back at
theReserves
initial level.

Equity falls
Reserves

Reserves
 Loan deterioration (cntd.)
Reserves

Reserves

Reserves
 Off-Balance-Sheet (OBS)
Activities
• (b/s) and (i/s) do not reflect the total scope of bank
activities

• OBS asset is an asset which moves onto the asset side

of a (b/s) or an income item of a (i/s) only after a
contingent event occurs

• OBS liability….what are they?

45
 Major OBS
Activities
– Loan commitment
– Credit facility with a maximum size and maximum period of time
when the borrower can use funds

– Standby letters of credit

– Guarantees issued to cover contingencies that may occur to a
borrower

– Futures, forwards, options, and swaps

– Derivate instruments – agreements to do something
– E.g. Forward: agreement to exchange assets for cash at a future
date at a pre-specified price 46
 Why do banks engage in OBS
activities?
1. Additional income in the form of fees

2. “Avoid” regulatory costs or “taxes”

– Example: reserve requirements and deposit insurance
premiums are not levied on OBS activities

3. Risk control - hedging

47
Largest banks as
of Nov. 2022
(G-SIFIs)
Source: Financial Stability
Board
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Which of the following drive

interest expenses?

i. Interest Cost of Each Liability

ii. Volume of Interest-Bearing
Liabilities
iii. Composition of Liabilities

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Investment
banks

50
 Main activities of
Investment Banks

– Underwrite securities
– Advising (Mergers and Acquisitions)
– Syndicated loans

IBs deal mainly with corporations and other large institutions

IBs intermediate between fund suppliers and users, while CBs
transform funds into more attractive assets

51
 Underwriting
securities
• Helping customers in issuing new securities (debt
and equity) and distributing them

– Primary issues - IPO (Initial Public Offering)

– Secondary issues of seasoned firms

52
 Underwriting
securities
• In a private placement, the IB acts as an agent for a fee

• In a public placement, the IB can underwrite

– On a best-effort basis
• IB acts as an agent for a fee related to the placing success

– On a firm commitment basis

• IB acts as a principal, purchasing the securities from the issuer at one
price and seeking to place them with public investors at a higher
price: it gains a profit from the intermediation
53
 Best effort vs. firm
commitment
An IB agrees to underwrite an issue of 15 million shares of the
stock of TheBest Corp.

• On a best-efforts basis, it manages to sell 13.6 million shares for

$12.50 per share, and it charges TheBest Corp. $0.275 (fee) per
share sold.

– TheBest Corp. receives

($12.50 - $0.275) x 13,600,000 shares = $166,260,000

– The IB profit is:

$0.275 x 13,600,000 shares = $3,740,000 54
 Best effort vs. firm
commitment
An IB agrees to underwrite an issue of 15 million shares of the
stock of TheBest Corp.

• On a firm commitment basis, it agrees to pay $12.50 per

share and then sell the shares to the public for $13.25 per share.

– TheBest Corp. receives:

$12.50 x 15,000,000 shares = $187,500,000

– The IB profit is:

($13.25 - $12.50) x 15,000,000 shares = $11,250,000
55
 Mergers and
Acquisitions (M&As)
• IBs provide advice or assist in M&As:

– Assist in finding merger partners

– Underwrite new securities issued by the merged firms

– Assess the value of the target firm

– Recommend terms of the merger agreement

– Etc.

56
 Syndicated
loans

• A syndicated loan is provided by a group of financial

intermediaries instead of a single lender

• It is structured by the lead FI and the borrower

• Once the terms (rates, fees, covenants, etc) are set, pieces
of the loan are sold to other FIs

57
Largest IBs by product
group (2021)

Source: Financial Times

58
 To sum
up
• Investment banking is very different from
commercial banking

– Most activities such as securities trading and underwriting, and

M&A advice require no investment in asset or liability funding
• Very different from loan issuance funded through deposits

– Thus, asset value is not a measure of the size of a firm in this

industry

– Rather, equity is used as the most common benchmark of

relative size
59
 Simplified B/S of an
Investment Bank
• Assets Liabilities & Equity
- Cash & other non-earning assets - Commercial paper and other ST
- Trading assets borrowing
- Securities financing transactions- Trading liabilities
- Investment securities - Securities financing transactions
- Loans, notes and mortgages - LT borrowing
- Other investment
- Deposits
- Fixed assets
- Other assets - Equity
- Other capital terms

Total Assets Total Liabilities & Equity

60
 Simplified i/s of an
Investment Bank
Revenues Costs
- Trading and principal investments - Interest expenses
- Investment banking - Operating expenses (staff costs)
- Asset management, portfolio - Communication and technology
service fees and commissions
- Occupancy and related
- Interest income depreciation
- Professional fees
- Marketing
- Other expenses

61
 What is “special”
about IBs?
• There were five major investment banks in the US
prior to 2008…

– Bears Stearns
– Lehman Brothers
– Merrill Lynch
– Goldman Sachs
– Morgan Stanley

62
 What happened to
them?
• After 2008…

• The end of an era for US investment banks!

63
 Bank
performance
and
Financial ratio
analysis

64
 Recall: How to understand bank
performance?

• Balance sheets are crucial to understand

– Asset quality and credit risk
– Capital adequacy and leverage funding

• Income statements (profits and loss account) are crucial to

understand
– Banks’ profits
– Banks’ costs and revenues

65
 Financial Ratio
Analysis (FRA)
• How to construct measures to calculate different aspects
of performance?

• Different ratios measuring

– Profitability
– Asset quality
– Liquidity

66
 Profitabilit
y ratios
• ROE = return on equity = net income/totalequity

– Rate of return to the shareholders or

– The % return on each $ of equity

Often interpreted as a measure of profitability, but…

67
 Profitabilit
y ratios
• ROE = return on equity = net income/totalequity

– Rate of return tothe shareholders or

– The % return on each $ of equity

Often interpreted as a measure of profitability, but…

…it depends crucially on leverage!

If total equity is low (bank much indebted, high leverage)

 ROE high by construction (ceteris paribus)
68
 Profitability
ratios (cont.)
• ROA = return on assets = net income/total assets

– Measure average profit generated relative to the bank’s

assets

– Overall measure of efficiency and operational

performance

69
 Profitability
ratios (cont.)
• NIM = net interest margin (or “spread”)
= net interest income / total assets

– It measures the bank’s spread per unit of assets

– High NIM means that the difference between loan (and

other interest earning assets) and deposit rates is high

– What does it mean if one bank has a higher ratio than

another bank? (Assume the same loan quality)

70
NIM over time – until
2013…

71
 Main challenges of the banking
sector pre-Covid

 Low profitability and low market valuation

 Low interest rate environment (LIRE)

 Deleveraging/Legacy assets from the crisis

 Increased regulation and compliance requirements

 Damaged reputation

 Digital disruption
Bank profitability varies across
jurisdictions
 Bank profitability has been
much higher in US than in the
Euro area or UK after the
financial crisis

Why?
 Sovereign crisis (2011-13) in
addition to financial crisis
 Lower interest rates
 Higher non-performing loans
 Higher regulatory burden
 Different market structure
Price-to-book Ratio: US versus
EU banks

• Euro area banks have lower

valuation than US banks

• IT and ES perform slightly better

than FR and DE
Price-to-book Ratio: US versus
EU banks

• Euro area banks have lower

valuation than US banks

• IT and ES perform slightly better

than FR and DE

market value / book value

= share price X number of outstanding shares / net
assets
Price-to-book ratio: Individual
banks (pre-Covid)

Source: Author’s calculations based on Bloomberg data

• US banks have price-to-book ratios above 1

• European banks have much lower ones
77
Low/negative interest rates
(cont.)

• Pressure on bank profitability because of pressure on NIM

− Difficult to charge negative rates on deposits, in particular retail deposits
(legal or reputation impediments)
− More emphasis on fee income, but difficult to fully compensate
− Potential risk of increased risk taking (i.e., search for yield)
 Still strong resilience with
signs of deterioration
Bank BEAT/ NII Costs CET1 CET1
MISS YoY YoY Fully YoY
Loaded

BNP Paribas BEAT +13% +7.2% 12.2% -0.48%

Deutsche Bank BEAT + +2.1% 13% -0.23%
7.7%
Credit Suisse MISS +4.9% +1.6% 13.5% -0.23%
BBVA BEAT +12.8 +14.6% 12.5% -0.44%
%
Credit Agricole BEAT +4.8% +5.1% 11.1% -1.26%
ING BEAT +0.6% +3% 14.7% -1.01%
Santander MISS +2.5% +12.2% 12.1% -0.05%
Societe Generale BEAT +1.1% +6.9% 12.8% -0.48%
UBS MISS - -3.4% 14.2% -0.33%
Source: Morgan Stanley Research, August 2022
10.7%
80
Unicredit BEAT +6.6% -3.8% 15.7% +0.21%
 Asset Quality
ratios
• Reserves on Loan Losses/Gross Loans
– How much of the total loan portfolio has been provided for, but
not charged off
– Given a similar charge-off policy, the higher the ratio the poorer
the quality of the loan portfolio

• Non-Performing Loans (NPL)/Gross Loans

– The lower the ratio, the higher the quality of the loan
portfolio

• Non-Performing Loans (NPL)/Equity

– The higher the ratio, the greater the concern about the bank’s
solvency 82
 Liquidity
ratios
• Cash ratio: cash and due from other banks/total assets

• Liquidity securities ratio: Government securities/total

assets

• Loans/deposits
– How much of the bank’s loan portfolio is funded bydeposits

83
 Some considerations on
financial ratios
1. One-year’s figures are normally insufficient
– Analysts look at least at five years

2. Comparison across banks may be difficult

– Peer analysis among banks of similar size, operating in similar
geographical markets and perform similar activities

3. Ratios refer to a particular point in time

– Seasonal effects can distort them
– “Window dressing”: financial statements are made up to look better
than they really are
– Possible manipulation and not compliance with recognized
accounting standards
84
The ROE
framework

85
 ROE
decomposition
• The amount of capital is a measure of a bank’s safety but it also
affects the return to shareholder through ROE
• Important decomposition:
ROE = ROA x EM

where
• EM (= equity multiplier) = Total assets/Total equity capital
• ROE = Net income / Total equitycapital
• ROA = Net income / Total assets

• EM measures the extent to which a bank’s assets are funded with equity
relative to debt
86
 Trade-off between
profitability and safety
Consider two banks, Alpha and Beta:

Bank Total assets Total EM= ROA ROE=ROAxEM

(a) capital (b) a/b
Alpha 50.000.000 € 5.000.000€ 10 1.5% 15%

Beta 50.000.000 € 2.500.000€ 20 1.5% 30%

• The two banks have equal total assets and equal ROA,
but Alpha has more capital and lower EM and ROE

 Which bank is safer?

 Which bank is more desirable for shareholders?

87
The ROE
framework

65
 Trends post
Covid19
• Change in supervision  softer supervision on capital and
liquidity regulation to avoid credit crunch (with Elena Carletti)

• Rise in NPLs  are banks equipped to face new defaults?

• Digitalization  the lock down has accelerated the digital

revolution. What will happen to over-extended branch
networks? New IT and cyber risks (more on operative risk in
Topic 2)
66
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Audience Q&A

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