Banks are one of the cornerstones of our financial system and they play a key role in providing liquidity to markets, individuals and businesses. But in order to fulfill their role, these institutions need a strong balance sheet, which is managed through a series of complex activities by the banks’ mainframe: corporate treasury.
The Financial Pipeline sat down with David Wilson, a senior capital markets executive who spent more than 15 years as Managing Director of RBC Corporate Treasury, to untangle how it all works.
FinPipe: What’s the starting point people need to understand about the ways banks work?
David Wilson: At the simplest level, banks make money by doing one of several things: lending at a higher rate than they borrowed. Today there are also many other business lines that are often fee-based, but the origins of banking started with lending. Any loan the bank extends is an asset to them, because when customers take out a loan, they have to pay interest on it. But an important concept to remember at a very high level is that assets don’t exist without funding – that’s the liability side of the balance sheet. Just like customers, banks have to also borrow money themselves in order to be in the lending business.
FP: If that balance between asset and liabilities is so important, how do banks make sure that balance works in their favour?
DW: Banks take in all kinds of funding from deposits, inter-bank loans or by issuing a deposit note, but they don’t have unlimited cash available. If you go to your local bank and take out a mortgage, the bank doesn’t necessarily just dip into a pile of cash and hand you $500,000. Before the bank gives you that loan, it may have to secure a loan itself. Profits occur when it can borrow at a lower rate than the rate clients pay for their loan or mortgage. If you take a mortgage out at 2.5% (asset to bank, liability to customer), the bank may have secured that loan (liability to bank) at 2.0%. That 0.5% difference – the 50 basis points (bps) difference in the interest you pay and the interest the bank pays – is how banks make their money, in its simplest form.
FP: That’s how it works in theory, but markets aren’t static. What do banks do to manage the risk of changing interest rates?
DW: Your ability to make money off a loan’s interest is a combination of the basis point spread and a factor of time. You need to lend out at a higher interest rate than you borrowed, but you also generally want to borrow short term and lend long term, while managing changes in the yield curve. The yield curve moves every day as bond prices move up and down. If the yield curve is positively sloped, RBC can, for example, pay Citibank 2% per cent to borrow money for a week, and lend it to their customer for 2.5% for five years. During that week, the bank earns 50 bps. As time moves on, if the yield curve doesn’t change, and the bank can keep borrowing at 2% every week for 5 years, it will make 50 bps profit every week. But if one year later the yield curve shifts and your loan, which is now a 4 year loan, is now a market rate of 5 per cent interest, the banks earnings will be impacted if it didn’t hedge the difference: It lent out at 2.5 per cent but could have been lending at 5 per cent. That’s an opportunity cost or loss – a difference that happened as a result of a shift in the yield curve. If this were to happen, not only is the market rate for the asset higher, but in all likelihood the cost of funding that loan (the 1 week rate) will also be higher. Keep in mind that the banking regulatory bodies only allow so much short term borrowing against fund long-term assets in order to minimize the risks of a damaging liquidity event, like we saw with Lehman Brothers or Bear Stearns during the 2008 financial crisis.
FP: Who actually manages this risk?
DW: That’s the job of corporate treasury. Corporate treasury (CT) is like the central bank to the rest of the bank. Within a bank, you’ll have retail branch banking, insurance, wealth management, an international division, capital markets, etc. Aside from capital markets, who have risk taking authority, all these other businesses within the bank generally can’t take their own interest rate risk. CT is the centralized function for everything banks do, including commercial loans, deposits … all the risks go into corporate treasury in the form of assets and liabilities and there’s a team of people called balance sheet analysts and managers in a group called ALM (Asset/Liability Management) who look at the exposures in aggregate and determine what the net imbalance is. Typically, whatever is left over in terms of interest rate risk, the treasury group will look to hedge, often in the bond or derivatives markets to lock in interest margins. They can do this because they have expertise in reading bond markets, the economy and future expected monetary policy changes. Ultimately, the Treasurer of the bank and his/her team have authority to position the balance sheet for expected movements (either up or down) in market interest rates.
FP: So how do banks actually make money?
DW: It’s all in the spread between what the banks borrows at and what it lends out at, as well as its management of the yield curve. One of the more important metrics of bank profitability is something called “Net Interest Margin” or NIM. In a very simple sense it measures the difference between what a bank earns on its investment returns on assets less the cost a bank pays on its liabilities (interest expenses) divided by the average earning assets. This is expressed as a percentage. And obviously, the higher percentage the better. But that’s not just happening between a bank like RBC and another bank it borrows from. It’s also happening within one bank – between the bank branch and corporate treasury. The branch that gives you a mortgage will borrow that money from corporate treasury for five years. Your local bank teller isn’t an expert in interest rates and monetary policy; they get their 5 year funding from corporate treasury. That branch pays 2 per cent for 5 years to corporate treasury and then you, the mortgage borrower, pay 2.5% to the branch. That means the branch is making 50 bps off the loan. This way the branch or business unit has “match funded” the loan for the full term of 5 years (or “matched” the term), leaving the retail bank business unit fully hedged from an interest rate and term perspective. This is commonly referred to as “funds transfer pricing” and can help determine which business lines within a bank are the most profitable by isolating spread margins. Corporate treasury, meanwhile, may have hedged that 2.5% asset with a 1.5% liability (receiving 2.5% interest versus paying 1.5% liability; probably a 5 year interest rate swap). Overall, the enterprise is making 100 bps on these transactions: 50 from the branch and 50 from hedging activities by corporate treasury. If that leads to a higher NIM for the bank overall, then typically the market will reward the bank with a higher multiple for its share price.