Wednesday, April 12, 2006

Financial / Banking / Business Model 0 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)

Financial and banking services has always been a mainstay of the Singapore economy since the 1980s, being one of the key service-producing industries and constituting >10% of the Singapore's GDP. The influence extends far beyond that, for the upstream financing and resource allocation activities of banks has knock-on effects on the entire consumption and investment segments of the economy.

Banking income may be primarily divided into interest and non-interest income, which is discussed below. One can also relate to it by looking at a typical bank's financial statement, such as UOB's (simple and easy to understand)

Interest income
This segment is typically more inter-related with retail banking and commercial banking, dealing directly with individuals and small businesses. Its model is simple: receive money from depositors and the capital markets, and lend them out to borrowers(home loans, business and trade financing, at higher rates, thus earning the difference, or the spread. Like arbitraging, the spread is typically minute (1-2% of assets) and that's why banks are seen as one of the (if not the) most capital-intensive industries around.

The business model can be summarised in equation form:
Interest income - Interest expense = Net interest income
--> Net interest income - provisions = Net profit from interest-related segment

Provisions (for bad debts, also known as non-performing loans or NPLs) are due to default of debtors, the primary risk of retail banking. Through diversifying their loan portfolio and pre-empting credit quality problems (constant review of borrowers' credit ratings), banks reduce this risk. Singapore banks are typically conservative with about 5-10% NPL ratio (non-performing loans out of total loans); China banks of the other hand, have been said to have >50% NPL ratio just several years back --- huge black holes if there ever was any. That's why they're rushing to list these state banks and usher in foreign equity and management expertise.

Non-interest income
This segment is typically related to investment banking, which deals with activities on the capital markets. The income is dependent on fees and commissions from clients, and common activities involve underwriting stock and bond issues, advising on M&As (mergers and acquisitions), and asset management (unit trusts, private equity investing etc). Since this segment essentially relies on skilled professionals and builds on intangible assets (trust, reputation), it is especially attractive as a source of income for banks because it is not capital-intensive. The income from this segment is typically recorded as Fee and Commission Income on banks' financial statements.

Conflicts of interest
Given that retail banking serves general individuals while investment banking serves a more elite clientele as well as raising capital for companies, it is not difficult to see that there may arise a conflict of interest between a bank's retail banking operations and investment banking operations. For example, a bank may persuade individuals, against its better judgment, to take up the security issue that it is underwriting. It was for this reason that the Glass-Steagall Act was introduced in the US in the early 20th century to prevent banks from engaging in both commercial and investment banking (the act has since been repealed). No such laws govern the banks of Asia.

(1) The Five Rules for Successful Stock Investing (Pat Dorsey)
(2) Wikipedia entry: Banking




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