Chapter 2 Core Banking Systems and The Role of Banks in the Economy

Core Functions of Banks in the Economy

Facilitating Capital Acquisition

Banks provide loans to individuals, businesses, and governments, enabling them to finance investments and consumption, which is crucial for economic growth (Mishkin, 2019) Although there are dozens of types of loans offered by banks, they generally fall into one of two categories of either Commercial Loans or Personal loans. All types of loans typically go through the same process steps.

Commercial Loans

Commercial loans are typically intended for businesses rather than individuals. These loans help companies finance projects, purchase equipment, maintain cash flow, or expand operations. The process used by banks generally include the following steps:

Application —- Underwriting —— Approval/Agreement

• Loan Application Process

Businesses requiring capital to support financing their activities and projects begin the process by submitting a business plan. A Business Plan usually provide a detailed description of the project and its potential benefits. A Typical business plan will include:

An Executive Summary: that identifies the business differentiators and key competitive advantages that should, in theory, spark the interest of the banker in financing the project.

Market analysis: The Business Plan should demonstrate the business’ understanding of the competitive landscape. It should clearly show how the project can competitively succeed.

Products and services: A complete description of the business offerings emphasizing their unique functions and features.

Financial Analysis: Businesses submit comprehensive financial documents that includes income statements, balance sheets, cash flow statements, and tax returns.

 Funding Request: that explains the amount of money the business is requesting from the lender and why they need it (for example to build facilities, buy equipment, hire labor and purchase inventory)

 Financial Projections: that includes forecasted income statements, balance sheets, cash flow statements, and capital expenditure budgets.

• Collateral Requirement: For many commercial loans, businesses need to provide collateral, which could include property, equipment, or inventory. Some loans, however, may be unsecured based on the borrower’s strong credit profile.

The Loan Application is followed by a Credit History Review where the lender reviews the company’s credit history, examining past borrowings and payment records. This helps assess the business’s reliability and creditworthiness.

• Loan Underwriting (guaranteeing) Process.

Banks go through what is known as a loan underwriting process. Business loan underwriting is the process of evaluating a business owner’s risk and their ability to repay the loan. Lenders use underwriting to determine whether to approve a loan and under what terms. The goal of underwriting is to avoid undue risk and ensure that the borrower can afford to repay the loan on time. Other evaluations that underwriting include are:

Evaluation and Risk Assessment: The lender’s underwriting team evaluates the business’s financial health and ability to repay the loan. They look at debt-to-income ratio, liquidity, profitability, and industry conditions.

Loan-to-Value (LTV) Ratio Evaluation: For secured loans, the LTV ratio is calculated to assess the loan amount relative to the collateral’s value. Higher LTV ratios typically mean higher risk for the lender. In essence LTV formula is:

                                                           LTV % = (Loan Amount / Asset Value) * 100

Interest Rate Determination: Interest rates are based on the business’s creditworthiness and market conditions. Rates for commercial loans are usually higher than for large corporations because of higher risk.

Identifying appropriate Loan Terms and Conditions: The lender establishes terms (e.g., repayment schedule, penalties for early payment, and specific uses for the funds).

• Loan Approval and Agreement

Approval: If the underwriting team is satisfied with the borrower’s credentials, they approve the loan and send a commitment letter detailing the terms and conditions.

Disbursement: After signing, the lender disburses the funds, either as a lump sum or through an agreed-upon schedule, depending on the loan type (e.g., term loan, line of credit).

Personal Loans

Personal loans also follow the same process as Commercial loans except they are usually smaller in amounts requested than commercial loans and are meant for individual needs such as home improvements, debt consolidation, medical expenses, or large personal purchases. They can be secured (using some asset as a collateral) or unsecured.

Personal Loans Application Process

Loan Application: The individual submits a loan application to the bank or financial institution, specifying the amount needed and the intended purpose, though the purpose may not always be required.

Personal Financial Information: The borrower provides details such as employment history, monthly income, debt obligations, and bank account balances.

Credit Check: Lenders review the applicant’s credit score and report to assess the risk involved. A good credit score can lead to better interest rates, while a low score may limit loan options or result in higher rates.

Collateral (if required): If the loan is secured (e.g., a home equity loan), the borrower must provide collateral. Unsecured personal loans, however, do not require any assets.

Personal Loans Underwriting Process

Debt-to-Income (DTI) Ratio: The lender calculates the applicant’s DTI ratio by comparing monthly debt payments to gross monthly income. A lower DTI ratio indicates less financial strain and greater loan repayment capacity.

Loan Terms and Rate Determination: Interest rates for personal loans are based on credit score, loan amount, term length, and whether the loan is secured or unsecured. High credit scores generally lead to lower interest rates.

Repayment Plan: Lenders set the repayment schedule, often offering fixed monthly payments over a specific term (e.g., three to five years).

Personal Loans Approval and Agreement

Approval Notification: If the lender is satisfied with the borrower’s financial profile, they approve the loan and inform the borrower of the approved amount, interest rate, and repayment terms.

Signing the Loan Agreement: The borrower signs the loan agreement, acknowledging the terms, including repayment schedule, interest rate, late fees, and penalties for default.

Disbursement: After the agreement is signed, funds are typically disbursed as a lump sum directly to the borrower’s bank account. In some cases (e.g., debt consolidation loans), the lender may send funds directly to creditors.

Example:

A borrower with a steady income applies for a $10,000 personal loan to consolidate credit card debt. They have a credit score of 720 and a DTI ratio of 35%, making them eligible for a favorable rate. The lender approves the loan at a 6% interest rate for a three-year term. After the agreement is signed, the lender disburses the funds to the borrower’s account, and the Borrower uses the funds to pay off higher-interest credit card balances.

Table- 3-1 Comparison between Commercial Vs. Personal Loan

Feature	Commercial Loans	Personal Loans
Purpose	Business financing (e.g., equipment, expansion)	Personal expenses (e.g., debt consolidation)
Documentation	Extensive (financial statements, business plan)	Limited (income, credit report)
Credit Check	Business and sometimes personal credit history	Personal credit score
Collateral	Often required	May be required for secured loans
Approval Criteria	Business financial health, industry outlook	Credit score, income, debt-to-income ratio
Interest Rates	Generally higher and variable	Lower for high credit scores, often fixed
Repayment Terms	Custom terms based on loan type	Typically fixed monthly payments

In both cases, a thorough assessment of the borrower’s ability to repay is central to the lending process, though the specifics differ according to the loan’s purpose and borrower type. Commercial loans usually involve more complex documentation and negotiation, whereas personal loans are often standardized and processed more quickly.

• Intermediating Client Savings and Investments

A core banking function is to provide “safe storage” of money and other financial assets to individuals, as well as, to companies and government entities. These bank functions classify customers as Retail Banking and Institutional Banking (sometimes also called Commercial and Wholesale Banking)

Retail Banking

Retail banking, often referred to as Consumer Banking, involves providing financial services to individual customers and small businesses. Its primary goals are to offer accessible and convenient banking services to the general public in service types that include deposits, loans, credit, and savings accounts.

Checking and Savings Accounts: Enabling customers to securely store and manage money.

Loans and Mortgages: Providing personal loans, auto loans, student loans, and mortgage options.

Credit and Debit Cards: Offering convenient payment methods with credit and debit cards that facilitates quick and easy access to funds.

Personal Financial Management: Access to advisory services for investment, retirement, and financial planning.

Digital Banking: Offering Mobile banking apps, online banking portals, and Automated Teller Machines (ATM) for accessibility and self-service options.

Retail banking clients are primarily individual consumers and small business owners. Retail banking focus is on high volume, low-value transactions that cater to everyday financial needs. Retail banks aim to reach a broad audience through brick & mortar branches, ATMs, and digital channels.

Retail Banking Revenue Model

Retail banks primarily generate revenue through interest income on loans (by lending money at a higher interest rate than they pay on deposits); fees on various banking services like account maintenance; overdraft charges; wire transfers; credit card fees; and cross-selling additional financial products like investment accounts, insurance, and wealth management services.

Key revenue streams for retail banks include:

Net Interest Margin (NIM): The difference between the interest rate earned on loans and the interest rate paid on deposits.

Account fees: Are monthly account maintenance fees, minimum balance fees, overdraft fees, and non-sufficient funds (NSF) charges.

Credit card fees: Annual fees, transaction fees, late payment fees, and foreign transaction fees

Loan origination fees: Fees charged when a new loan is issued

Wire transfer fees: Fees for transferring funds electronically

Investment product fees: Commissions on mutual funds, annuities, and other investment products

Cash management services: Fees for managing business accounts (Accounts Payables, Accounts Receivables), payroll processing, Auditing, etc.

Foreign exchange fees: Fees for converting currencies from one country’s currency to another.

Safe deposit box fees: Rental fees for secure storage of valuables

Wealth management services: Providing investment advice and portfolio management for high-net-worth clients

 Insurance products: Selling life, disability, or home insurance products through the bank

Trading activities: Generating income through securities trading on behalf of clients or with the bank’s own funds

Institutional Banking

Institutional banking sometimes called Wholesale or Commercial banking serves large clients, including corporations, government entities, other financial institutions, and high-net-worth individuals. Institutional banking provides complex financial products, including large loans, underwriting, asset management, and corporate advisory services. The key services offered by Institutional banking includes Commercial Lending, Syndicated Lending requiring substantial financial resources, Wealth Management, Treasury and Cash management, Insurance and Asset Management and Custodial services.

Commercial Lending: Commercial lending is a process where a financial institution, like a bank or loan company, lends money to a business in exchange for interest. The money is used to fund a variety of business expenses, such as: Purchasing real estate or machinery, covering operational costs, paying payroll, and buying supplies.

Syndicated Lending: Loan syndication occurs when two or more lenders come together (resource pooling) to fund one loan for a single borrower. Syndicates are created when a loan is too large for one bank or falls outside the risk tolerance of a bank. The banks in a loan syndicate share the risk and are only exposed to their portion of the loan. There are three types of syndicated loans:

• Leveraged Loans: A leveraged loan is given to a borrower with a poor credit history or a lot of debt. Lenders consider these loans to be riskier, so they have higher interest rates than typical loan.
• Corporate Loan: Is a loan given by the bank to a company instead of an individual. Again, credit checks and other verification methods are used to “Guarantee” the loan.

Project Finance Loan: A loan provided specifically for a project. A project in this case could mean business expansion, new product development, or hiring for specific skill sets.

Bank’s Key Management Processes:

Treasury and Cash Management (TCM):

In a commercial bank, “Treasury Management” refers to a broader strategic function overseeing the bank’s overall financial health, including managing liquidity, investments, and financial risks, while “Cash Management” is a subset focused on the day-to-day movement and monitoring of the bank’s cash flow, ensuring sufficient funds are available to meet operational needs; essentially, cash management is a key component of treasury management, handling the practical aspects of cash flow while treasury management takes a more strategic approach to managing the bank’s overall financial position.. TCM involves:

Cash Positioning and Forecasting

Banks utilize cash positioning and forecasting processes to anticipate future cash needs and to maintain optimal liquidity levels.

Cash Positioning: Involves monitoring real-time cash flows and balances across accounts, both internally and externally, to determine the bank’s cash position at any given time.

Cash Forecasting: Banks project future cash requirements using historical data, expected inflows/outflows, market conditions, and macroeconomic indicators. This forecasting ensures adequate funds are available for operational, investment, and regulatory requirements.

Technologies Used: Real-time data analytics, machine learning models, and treasury management systems (TMS) help banks analyze trends and create accurate forecasts.

Liquidity Management

Liquidity management ensures banks have enough liquidity to meet obligations, optimize capital costs, and comply with regulatory requirements.

Liquidity ratios such as the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are used to ensure regulatory compliance and maintain liquidity buffers (Basel Committee on Banking Supervision, 2019)

Daily Liquidity Management: Banks calculate daily cash balances and compare them with the required minimums to ensure they meet operational needs.

Investment in Liquid Assets: Banks may invest in highly liquid assets (e.g., government securities) that can be easily converted to cash in times of need.

Liquidity Ratios: Metrics like the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) are used to ensure regulatory compliance and maintain liquidity buffers.

Stress Testing: Banks run simulations to test liquidity under various adverse conditions, ensuring preparedness for economic or operational stress.

Payments and Transaction Processing

Efficient payment processing is crucial for TCM, as it enables smooth, timely financial transactions both domestically and internationally.

Payment Systems Integration: Banks integrate with domestic (e.g., ACH, Fedwire) and international payment networks (e.g., SWIFT) to facilitate secure, fast transactions.

Clearing and Settlement: Clearing and settlement processes ensure transactions are completed and funds are transferred as per bank policies and regulatory standards.

Fraud Detection and Prevention: Advanced fraud detection systems using AI and real-time monitoring help prevent unauthorized transactions.

Automation: Robotic Process Automation (RPA) and APIs streamline routine payments, reducing manual intervention and processing times.

Risk Management Process

Risk management is central to TCM, ensuring that financial exposures do not threaten a bank’s capital. Key Risks that impact the TCM process include:

Interest Rate Risk: Banks manage interest rate fluctuations using tools like swaps and options to stabilize income from loans and deposits.

Currency Risk: Foreign exchange (FX) hedging strategies mitigate currency risk exposure for banks involved in cross-border transactions.

Credit Risk: Assessing counterparties’ creditworthiness ensures that banks are not exposed to excessive default risk.

Counterparty Risk: This is monitored and controlled via limits on exposures, especially for derivatives and other financial contracts.

Investment and Portfolio Management

Investment management optimizes excess funds, balancing liquidity requirements with profitability goals.

Portfolio Optimization: Treasury teams work to create portfolios that balance liquidity, yield, and risk, considering factors like duration and credit rating.

Asset-Liability Management (ALM): ALM strategies are used to align the bank’s assets and liabilities, managing interest rate risk and duration mismatches.

Product Diversification: Banks use a diversified portfolio, including government bonds, corporate bonds, and equities, to optimize return on investments.

Bank Reconciliation and Reporting Process

Bank reconciliation ensures that records are accurate, while reporting processes facilitate compliance and inform stakeholders.

Bank Reconciliation: Daily reconciliation of transactions across internal and client accounts helps identify and resolve discrepancies.

Regulatory Reporting: Banks must report liquidity positions, funding structures, and other data to regulators (e.g., Basel III requirements).

Internal Reporting: Real-time dashboards and periodic reports keep management informed about liquidity, investment performance, and risk levels.

Client Services and Relationship Management Process

For corporate clients, treasury services are crucial to optimize cash flow, reduce costs, and manage financial risks. Many banks offer:

Customized Cash Management Solutions: These are tailored services such as cash pooling, notional pooling, and zero-balance accounts to help clients optimize cash flow.

Cash and Investment Advisory Services: Many banks provide advisory services, assisting clients with cash forecasting, investment planning, and hedging strategies.

Client Portals: Creating user-friendly portals that give the bank clients real-time access to account information, transaction history, and cash flow management tools.

Mergers and Acquisitions (M&A) Advisory Process

Mergers and Acquisition’s (M&A) involve one bank acquiring another bank, or a Bank contracted to oversee one company acquiring another company. Banks providing expert guidance on acquisitions, mergers, and other corporate restructuring.

Capital Markets Services Process

Banks assist corporate clients during, or after, an Initial Public Offering (IPO) by facilitating debt and equity issuance to raise capital through bonds or stock offerings.

Asset Management and Custodial Services Process

Asset Management

Asset Management and Custody Services provides bank clients the management of client assets (investments) and safeguarding of the assets. Asset management is a service provided by financial institutions, including banks and investment companies. Asset managers, also known as portfolio managers or financial advisors, use their expertise to help clients achieve their financial goals. They typically charge a management fee, which is usually a percentage of the total value of assets managed. Asset managers charge fees for their services, which can be based on a percentage of the assets under management, a fee per trade, or a commission to upsell securities. It’s important to consider whether the asset management firm is a fiduciary, as this can impact whether the investments and trades recommended are in the client’s best interest.

Asset management is different from wealth management, which is asset management for individuals or families. Wealth management also involves understanding a client’s entire financial situation, including their cash flows, budgets. Key activities in Asset Management include:

• Acquiring assets for clients: Buying investments like stocks, bonds, real estate, businesses, and patents
• Optimizing assets: Monitoring market trends and making investment decisions
• Managing assets: Executing trades and minimizing risks to generate favorable returns

Banks also provide custodial services to clients in a variety of ways, including:

Custodial services

Banks act as custodians for a variety of clients, including investment managers, mutual funds, and retirement plans. Custodians hold and protect client assets, such as cash, stocks, bonds, and other securities, on their behalf. Custodians also perform a number of other services, such as:

• Settling trades 

Trade settlement is the final step in a securities transaction, when the buyer receives the securities and the seller receives payment. It’s a two-way process that ensures the proper transfer of shares and cash.

The settlement date is the date when a trade is considered final. It’s the date when the legal transfer of ownership of an asset occurs. The settlement date is typically two days after the trade date, which is denoted as “T+2”. However, the Securities and Exchange Commission (SEC) announced that the settlement period will be reduced to one business day after the trade date, or “T+1”, starting May 28, 2024.

The settlement date is important for investors who want to receive dividends. To receive dividends, the trade must settle before the company’s record date for allocating dividends. An example of how a trade settlement works:

• Trade date: An investor buys shares of Amazon (AMZN) on Monday, June 3, 2024.
• Settlement date: The investor’s status as a shareholder of Amazon will not be settled in the company’s record books until Tuesday, June 4. On Tuesday, the investor becomes a shareholder of record.

• Investing cash balances

In investment banking, investing cash balances refers to the amount of money a company has available for investments and other financial activities. A company’s cash balance is the amount of money it has on hand or in its bank account at any given time.

A company’s cash balance is important because it helps offset unplanned cash outflows. Without a cash balance, a company may not be able to pay its bills, debt, or return dividends to investors. However, having too much cash can also be detrimental because it can lead to missed investment opportunities.

 A target cash balance is the optimal amount of cash a company or investor should have on hand. Too little cash can lead to liquidity problems and forced asset sales, while too much cash can hurt overall investment performance

• Collecting income 

“Collecting income” at a commercial bank refers to the process of earning money by charging interest on loans they provide to customers, which is primarily generated by the difference between the higher interest rate they charge borrowers and the lower interest rate they pay to depositors on their deposited funds; essentially, banks make profit by collecting interest on the money they lend out, exceeding the interest they pay to account holders.

• Processing corporate actions 

Processing actions at a commercial bank can refer to a number of activities, including:

• Payment Processing. This entails collecting payments from buyers and sending the amounts to sellers. Payment Processing is a series of actions that occur when a person, or a business, initiates a digital payment transaction. This includes authorizing, verifying, and settling transactions, and can involve credit and debit cards, electronic funds transfers (EFTs), and electronic payments (ePay).
• Day 2 Exception Processing.  Exception Processing is the identification and handling of paper, or electronic checks, with exceptions. Most checks are processed without exception, but some exceptions are not recognized until a later date.

• Straight-through processing (STP). Straight-through processing is the electronic processing of secondary market securities trading. STP is used for millions of transactions per day for stocks, bonds, mutual funds, and more.

• Pricing securities positions. Security pricing is the process of determining the value of different types of investment securities such as stocks, bonds, derivatives and commodity futures in the capital markets. Security pricing is influenced by various factors, such as supply and demand, risk and return, market efficiency, and information asymmetry.

• Providing recordkeeping and reporting services. Providing recordkeeping and reporting services at a commercial bank means maintaining detailed records of all customer transactions and generating reports based on that data, which is primarily used to comply with regulations like the Bank Secrecy Act (BSA), track account activity, and provide information to customers about their finances, including details on deposits, withdrawals, and account balances; essentially, it’s the process of documenting and summarizing a customer’s financial activity within the bank.

Institutional Banks Client Base

Institutional banks primarily serve large entities that require sophisticated financial services. Their clients include multinational corporations, government agencies, hedge funds, insurance companies, and pension funds. Unlike retail clients, these customers require high-value, low-volume transactions involving large sums of money.

Institutional Banks Revenue Model

Institutional banks earn revenue from:

Fees and Commissions: Charged for advisory services, asset management, and transactional services.

Interest Income: From large corporate loans, syndicated loans, and credit lines.

Trading and Investments: Profits from securities trading and investment banking activities.

Underwriting Fees: Revenue from helping clients issue debt or equity in capital markets.

Comparing Retail and Institutional Banking

Retail and Institutional banks perform similar financial processes. The Table below summarizes the key similarities and differences between these two functions:

Comparison of Retail Vs. Institutional Banking

Function	Retail Banking	Institutional / Commercial Banking
Client Base	Individual or Small Business	Corporations, Governments, Financial Institutions
Transaction Volume	High Volume, Low-Value Transactions	Low Volume, High-Value Transactions
Service Model	Standardized Services	Customized
Bank Revenue Source	Interest Income and Fees	Interest Income, Fees, Trading Fees, and Insurance Underwriting
Technology Use	Focus on digital channels for customer convenience.	Advanced tech for trading (AI), risk management, and Big Data analytics
Regulatory Burden	Significant but more uniform across markets	Intense regulatory scrutiny and complex compliance

Chapter Summary

Retail and institutional banking play crucial roles in the financial ecosystem, each serving distinct client bases with tailored services. While retail banking focuses on providing accessible services to individuals and small businesses, institutional banking caters to larger clients with complex needs. Both sectors face unique challenges and opportunities amid digital transformation and regulatory pressures. Technological advancements, regulatory compliance, and the drive towards Environmental, Social, and Governance (ESG) are shaping the future of both segments, pushing banks to innovate while ensuring robust risk management and compliance. Technological advancements, regulatory compliance, and the drive towards Environmental, Social, and Governance (ESG) are shaping the future of both segments, pushing banks to innovate while ensuring robust risk management and compliance (McKinsey & Company, 2022).