An Introductory View to Banking, Development Banking, and Treasury
We have mentioned that our focus is going to be any treasury activity carried out by a traditional financial institution, a development bank, a corporation, or a government. When discussing the issuance of debt we will indeed draw examples from all four types of entities listed; however, when the objective will be a deeper understanding of several concatenated activities, we shall focus on the former two types of institution: investment banks and development banks. Furthermore, our view will narrow toward development banking not only because it is a special concern of ours but also because, in its simpler type of financial activity, it offers an opportunity to isolate clearly the different functions of a bank. A development institution that uses the tools of investment banking (we shall see in Section 1.6.1 that some do not) offers the simplest type of banking activity, a type made up of instruments upon which traditional investment banks have built increasingly more sophisticated ones; the higher level of sophistication, in our situation, does not translate necessarily to a better understanding.
In this chapter we shall introduce the fundamental activities of a financial institution as lending, borrowing, investing, and asset liability management (ALM); we shall try to present them in this order so as to follow the business line that goes from the client's need for a loan, through the bank's need to fund the loan, and then invest the income generated and hedge the potential risks. We shall then conclude with a sketch of the structure of a typical financial institution and a definition of the type of development bank we shall be dealing with.
A REPRESENTATION OF THE CAPITAL FLOW IN A FINANCIAL INSTITUTION
Before offering an introduction to fundamental banking activities, let us focus on a schematic representation of the flow of capital within a financial institution. As we have said before, we shall use a development institution as an example, since it encapsulates at least the fundamental aspects of banking plus a few additional features.
In Figure 1.1 we show the capital inflow and outflow to the treasury of a development institution. In Section 1.6 we describe which type of institutions obtain their funds in which particular way, but here we attempt to describe in a general way how development institutions obtain their funds and what they do with them.
A development institution, like many institutions, has shareholders who have brought a certain initial amount of equity to the institution and own a share of it. The sum of all these contributions constitutes the majority of the institution's equity. Additionally, and this is peculiar to development organizations, there are donors' contributions. These contributions can be made either by the shareholders themselves or by other entities; they can
FIGURE 1.1 A schematic representation of the inflow and outflow of capital to the treasury of a development institution.
actually be given to the institution or they can be pledged, meaning that they remain with the donor until the institution asks for it. These contributions can be offered or, when coming from the shareholders, they can be requested by the collection of shareholders.
An additional inflow of capital, and the main topic of this book, is debt. In Section 1.3 we introduce how borrowing fits within the general activity of an institution and define the varieties of those instruments. Throughout the rest of the book we describe how debt is priced.
The main outflow, and the reason for being a development institution or a commercial bank, is lending. In Section 1.2 we introduce how lending takes place in relation to clients' needs. Income generated by loans is used to repay the debt; any additional return flows into the institution's equity.
The role played by the investment unit of a development institution will be introduced at a general level in Section 1.4 and in more detail in Section 6.4.2. Its main mandate is essentially to prevent depreciation in the institution's equity and to provide emergency liquidity to its lending unit. Investments' returns flow back into the institution's equity.
Finally, the institution's capital is also used for asset liability management, which will be introduced in Section 1.4 at a general level and then in detail in Chapter 7. Its main mandate is to balance debt and income and to hedge high-level exposures. It is an activity that should be more or less return neutral; however, any positive return would flow into the institution's equity.
Having sketched the general movement of capital within a development institution, we can now begin introducing its main activities in more detail before–in the subsequent chapters–getting into even greater detail by adopting more analytical tools.