Banking book
Banking book is one of two main books which hold distinct banking activities. There are no market identifiers in the banking book but there are assets for which corporate, retail and bank counterparties are represented. Accounting treatment for the banking book is in line with the accrual concept, which allows for the accounting of interest flows as they arise. The important thing is that the type of business activity determines whether it will be included in the banking book, not the type of counterparties or the section of the bank that is carring it out[1]. According to M. Choudhry "Assets and liabilities on the banking book generate interest-rate and credit risk exposure for the bank. They also create liquidity and term mismatch risk. Liquidity refers to the ease with which funds can be raised in the market"[2].
Activities of banking book
The banking book usually contains traditional banking activities, which include lending to individuals, companies and other banks. Thus interact with investment operations.
The activities referred to are[3]:
- lending and borrowing money (commercial banking loans),
- holding and issuing securities,
- gathering deposits .
Differences in banking books
In addition to the banking book, there is also a trading book. At first glance, the distinction between banking book and trading book is not exact and clear, but "the primary difference between two books is that the overriding principal of the banking book is one of "buy and hold" - that is, a long term acquisicion. Assets may be held on the book for up to 30 years or longer. The trading book is just that, it employs a trading philosophy so that assets may be held for very short terms, less than 1 day in some cases"[4].
The portfolios of the banking and trading books consist of[5]:
| Banking book | Trading book |
|---|---|
| Bonds | Bonds |
| Term deposits | Term deposits |
| Loans | Interest rate swaps |
| Own bond issues | |
| Interest rate swaps |
A set of these two portfolios may be used to describe the model bank. According to G. Gebhardt, R. Reichardt and C. Wittenbrink "...in order to optimise the bank’s activities in the financial markets, interest rate swaps are only traded externally out of the trading book and internally between the trading book and the banking book. Term deposits, on the other hand, are only traded externally out of the banking book and internally between the banking book and the trading book. Bonds are directly bought into and sold out of both the banking and trading book"[6].
Examples of Banking book
- Loans: Loans are assets which are recorded on the banking book and are measured at their contractual amount. Interest income on loans is recorded when it is earned, rather than when it is collected, and is recognized on a straight-line basis.
- Bank deposits: Bank deposits are liabilities which are recorded on the banking book and are measured at their contractual amount. Interest income on deposits is recorded when it is earned, rather than when it is collected, and is recognized on a straight-line basis.
- Investment securities: Investment securities are assets which are recorded on the banking book and are measured at their fair value. Interest income on investment securities is recorded when it is earned, rather than when it is collected, and is recognized on a straight-line basis.
- Interest rate swaps: Interest rate swaps are derivatives which are recorded on the banking book. Interest income on interest rate swaps is recorded when it is earned, rather than when it is collected, and is recognized on a straight-line basis.
Advantages of Banking book
The banking book offers a number of advantages, including:
- Accurate tracking and recording of cash flows - The banking book allows banks to accurately track and record their cash flows, which makes it easier to monitor, manage and report on their financial performance.
- Simplified accounting - The banking book simplifies accounting for banks by providing an easy-to-follow set of rules and guidelines for recording transactions.
- Reduced risk - The banking book helps to reduce risk by providing a comprehensive view of a bank's financial situation. This allows banks to identify and address potential risks early on.
- Lower costs - The banking book also helps to reduce costs by providing an efficient and streamlined system for managing and recording transactions.
Limitations of Banking book
The banking book is an essential tool for keeping track of banking activities, but it also has some limitations that should be taken into consideration. These limitations include:
- The banking book does not account for any changes in the market prices of assets, nor does it track any related risks. This makes it difficult to accurately assess the value of the investments.
- The accrual concept used in the banking book does not account for any cash flow changes, making it difficult to accurately predict income and expenses.
- The banking book does not account for any regulatory changes, making it difficult to keep up with the latest banking regulations.
- The banking book is also limited in its ability to provide information on the quality of assets, as it does not track any credit ratings or other indicators of asset quality.
- Lastly, the banking book is limited in its ability to track the performance of different asset classes, as it does not provide any detailed analysis or comparison of different investments.
There are several other approaches and strategies that banks may use to manage their banking book.
- Hedging and derivatives: Derivatives are financial contracts that derive their value from underlying assets, such as stocks and commodities. Banks may use derivatives to reduce the risk associated with their banking book by hedging their exposure to fluctuations in interest rates, foreign exchange rates and other financial instruments.
- Capital management: Banks may use capital management strategies to ensure that their banking book is adequately capitalized and that the capital is properly allocated. This includes setting capital requirements, setting risk limits and evaluating the performance of their banking book.
- Risk management: Banks use risk management strategies to identify, monitor and manage the risks associated with their banking book. This includes setting limits on risk exposure, assessing the creditworthiness of counterparties and monitoring liquidity risk.
- Liquidity management: Banks use liquidity management strategies to ensure that they have sufficient liquidity to meet their obligations. This includes setting limits on liquidity, monitoring cash flows and managing collateral.
In summary, there are several other approaches and strategies that banks may use to manage their banking book, including hedging and derivatives, capital management, risk management and liquidity management. Each of these approaches is designed to help banks manage their banking book more effectively and reduce their risk exposure.
Footnotes
| Banking book — recommended articles |
| Trading Book — Collateral management — Bank reference — Quick assets — Held to maturity securities — Normal account balance — Asset base — Brokered deposit — Restricted Cash |
References
- Alexander C. (2009), Market Risk Analysis, Value at Risk Models, John Wiley & Sons
- Choudhry M. (2012), The Principles of Banking, John Wiley & Sons
- Choudhry M. (2018), An Introduction to Banking: Principles, Strategy and Risk management, John Wiley & Sons
- Gebhardt G., Reichardt R., Wittenbrink C. (2004), Accounting for financial instruments in the banking industry: Conclusions from a simulation model European Accounting Review, nr. 21
- Gup B.E. (1999), International Banking Crises: Large-scale Failures, Massive Government Interventions Greenwood Publishing Group, Westport, Connecticut, London
Author: Dominika Kania
