The Principles of Banking

By Moorad Choudhry, Neal Ardley, Sharon Bowles and 4 more

A timely and robust discussion of responsible bank stewardship and practice.

The Second Edition of The Principles of Banking offers banking professionals, regulators, and students from a variety of backgrounds an authoritative and practical discussion of the foundations of modern banking and good banking practice. In the book, you'll find a comprehensive roadmap to a more sustainable business model for your banking organization.

The author draws on his many years' experience as a commercial and investment banker as he explains the original principles of banking—including sound lending policy, capital management, and liquidity risk management—as well as new material covering the impact of COVID-19 on banks, risk management, and balance sheet management.

The Principles of Banking also provides recommendations for bank asset-liability management best practices that enable banks to deliver optimized balance sheets for the benefit of all stakeholders. It also includes new chapters in market risk management, foreign exchange risk management, interest rate risk, and credit risk policy and management.

An essential update to a widely read and taught banking text, The Principles of Banking, Second Edition is an indispensable resource for banking professionals and students everywhere.

• Language: English
• Publisher: Wiley
• Release date: Sep 22, 2022
• ISBN: 9781119755685

Moorad Choudhry

Moorad Choudhry is Chief Executive Officer, Habib Bank Zurich PLC in London, and Visiting Professor at the Department of Mathematical Sciences, Brunel University. Previously he was Head of Treasury of the Corporate Banking Division, Royal Bank of Scotland. Prior to joining RBS, he was a bond trader and structured finance repo trader at KBC Financial Products, ABN Amro Hoare Govett Limited and Hambros Bank Limited. He has a PhD from Birkbeck, University of London and an MBA from Henley Business School. Moorad lives in Surrey, England.

Book preview

The Principles of Banking

Second Edition

MOORAD CHOUDHRY

With contributions from

Polina Bardaeva, Natasha Bourne, Michael Eichhorn, Beata Lubinska, Engelbert Plassmann, Periklis Thivaios and Chris Westcott

Logo: Wiley

This edition first published 2023.

Copyright © 2023 by Moorad Choudhry.

Edition History

John Wiley & Sons Singapore Pte. Ltd. (First Edition, 2012)

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Library of Congress Cataloging-in-Publication Data

Names: Choudhry, Moorad, author.

Title: The principles of banking / Moorad Choudhry.

Description: Second edition. | Hoboken, New Jersey : John Wiley & Sons, Inc., [2023] | Includes index.

Identifiers: LCCN 2022029457 (print) | LCCN 2022029458 (ebook) | ISBN 9781119755647 (paperback) | ISBN 9781119755708 (adobe pdf) | ISBN 9781119755685 (epub)

Subjects: LCSH: Banks and banking. | Finance.

Classification: LCC HG1601 .C495 2022 (print) | LCC HG1601 (ebook) | DDC 332.1068/1—dc23/eng/20220712

LC record available at https://lccn.loc.gov/2022029457

LC ebook record available at https://lccn.loc.gov/2022029458

Cover image: © SkillUp/Shutterstock

Cover design by Wiley

Photograph of Lindsay.Photograph of Lindsay.Photograph of Lindsay.Photograph of Lindsay.

For Lindsay

Who first suggested I write a book called The Principles of Banking…

Foreword

Neal Ardley

Moorad asked me to write a Foreword for his book on banking, which wasn't as surprising as you might think – he'd previously asked me to present at an executive offsite when he was CEO of a bank. Just as he had on that occasion, he invited me to write about Leadership and Teambuilding, as these are as important to achieving success in a bank as they are in a football team.

For me, leadership isn't about being in charge or being the boss, but about being responsible for inspiring everybody around me! The days of managing from the top down are waning, and the bottom-up approach is more rewarding for the creation of good team spirit, employee buy-in, cohesiveness, culture and a rewarding work ethic.

Today's world needs a modern approach and a good leader can be the boss and a decision-maker yet also have the ability to facilitate creativity, opinion and self-worth amongst their staff.

Building relationships is key; this shouldn't be confused with friendships (although friendships can happen), it is more about creating the trust between a leader and the individuals within their team that allow a culture for success, enabling the leader to be demanding and push their staff to be their best whilst still maintaining the belief in the staff that you are with them, wanting them to improve and get even better.

I've always found authenticity is important for a leader. Hard conversations still need to be had with your staff, however the ability to soft land things whilst making your point is crucial. The new generation of younger people need this approach, and react to it a lot more positively.

In my role as Academy Manager and 1st team Manager over the last 13 years I have learnt much that added to what I'd learnt during my 18 years playing professional football. It started in the Cardiff City Academy, and with a clear direction of how I wanted to take things forward. It was important to show my immediate staff my vision whilst adopting a holistic approach that allowed creativity, responsibility and buy-in from them all. This enabled them to work with vigour and passion, often going the extra mile to make the vision a reality.

The same approach helped me to success in my role as First Team Manager at AFC Wimbledon. In my first season we inherited a team that were used to losing, and staring relegation from the football league in the face. As always in life, success doesn't come in a straight upward line! It took until the final game to achieve our immediate goal of survival but the spirit we created amongst the staff and the players gave us the ability to recover from losses, and more importantly going from conceding goals during games to building a belief that it was all in the script and that we would maintain our league status.

We achieved this in several ways. We'd noticed that the players' heads went down every time we conceded a goal, which was most games, as if to say, Here we go again. We needed to change this mindset, to accept that this will happen, and to be able to get past it, so we convinced the players that if we stuck together we would stay up and that every time we conceded a goal, lost a game or had doubts, every player would tell themselves and their team mates, It's in the script, we are staying up! Never was this more apparent than in the last four games of the season, when we came from behind twice, and recovered from conceding an equaliser in our final game, which we had to win to stay up. You could see the players rousing each other, saying It's in the script!, but the most important part, and which made it work, was that all the players genuinely believed it. Also, I made sure that there was no blame culture, and everyone stood up to be counted when under huge pressure.

In our promotion season, which culminated in a final victory at Wembley, things were not going the way we wanted half way through the season. Again, the same principle applied in that we stuck together, without blame culture, and worked hard to find our way through the reasons why we were struggling.

It's at these points that the bottom-up leadership style comes to the fore! The group, to a man, never shied away from responsibility or the fact that we were underachieving, and slowly momentum was built to the point where, as manager, towards the end I could take a step back, knowing the team were ready for whatever came their way.

My belief in this approach was cemented when I took over a club in a similar situation to my first job in senior management, and again staring relegation from the league in the face. However, this time the staff and players didn't buy in to what was needed to create togetherness, and the culture wouldn't change. Sadly, selfishness was rife when it was selflessness that was needed, and unfortunately it took too long to change this as leader. A final day relegation was, harsh as it is to say, deserved in the end!

My experience in both cases confirmed to me that the keys to success in team building must include:

Clear vision

Genuine buy-in from staff

Bottom-up leadership

No blame culture

Building relationships

Inspiring people

The fact that Moorad has asked me to write a Foreword to his book suggests to me that he also likes to try and apply these same principles!

Neal Ardley

Manager, AFC Wimbledon (2012–2018)

Manager, Notts County (2018–2021)

Manager, Solihull Moors FC (2021–)

8 April 2021

Photograph of Neal Ardley.

Foreword

Sharon Bowles

The first edition of this book was published in 2012 in the wake of the financial crisis and was hailed as the book every practitioner should have at their elbow, not least to remind them of the fundamental tenets that had been forgotten in the rapid expansion of wholesale markets.

At that time, I was embroiled in the legislative response to the financial crisis, having a key role as Chair of the Economic and Monetary Affairs Committee of the European Parliament and negotiating the tsunami of EU financial legislation that followed the financial crisis. Meeting daily with Ministers, the Commission, Central Banks, regulators and industry, frequent thoughts on all sides were if only the banking basics had been followed; if only more attention had been given to the big picture; if only there had been a more thoughtful approach.

Now there is no excuse! The Principles of Banking enables everyone to access the big picture, individual specialisations, the thoughtful approach and to understand what happens in all parts of the system. Expressing matters in plain English, Moorad busts myths and fears, allowing you to think properly about concepts not fudged behind the latest jargon. Written with style it is a good read too!

Ten years on, as we wrestle with the economic effects of the Covid-19 pandemic, Moorad has updated his book appraising the regulatory changes and new landscape. Like the original, it is a comprehensive walk through capital markets, assets, liability, liquidity, funding, risk management and governance. It covers not only changes in the trading book, recovery and resolution, stress testing and everything else in Basel IV but also related matters such as IFRS 9 and climate risk management. He also covers the rise of challenger banks and the banking licence application process.

And there is more, including consideration of the effect of negative interest rates, the emergence of FinTech and whether it really is different for regulatory purposes. The governance section is also expanded covering board and committee roles with emphasis on fit for purpose governance, resilience and technology. I know from experience, including being on the Board of the London Stock Exchange Plc, how important these matters are, with increased regulator interest: with politicians such as myself on their case if they are not!

If in doubt about what is best practice, you will probably find it here or understand how to approach the problem and work it out. It lifts the lid on supposed complexity and now it is this second edition that should be kept at the elbow. I wish I had had it.

I was delighted to be asked to write a foreword although I have only known Moorad for a short time, meeting through a shared interest in challenger banks. What I see in his approach and writing is a fellow traveller aiming to practise what they preach. Many do one half – but commenting is not the same as doing and doing is not the same as setting out the rationale. Having done both Moorad shines light from both sides on to where challenges may lie and will help others to cultivate good judgement.

Sharon Bowles

Baroness Bowles of Berkhamsted

Independent NED London Stock Exchange Plc

26 December 2021

Foreword

Henrique Fragelli

As in many fields in history and science, financial markets have evolved based on a continuous interaction of new technological innovations, the temporary disequilibrium that their insertion in the system generates, many times resulting in crisis, and following this process the governance response to handle the learnings of the crisis. As this is a dynamic process, we often have at the same time the governance response being introduced concomitant to new technological innovations. In a world where technological development is accelerating in an exponential way, we have a scenario of constant changes both from the technological and the governance side. This presents governance and risk management challenges.

In the context of the process above described, I believe we've been observing interesting dynamics over the past decade or so. It is often said that the great financial crisis of 2008 was largely exacerbated by the level of leverage in financial markets, and as a response to that regulators increased the level of capital requirements, particularly for systemically important financial institutions. Since that increase in the levels of capital requirement, we can observe that the resiliency of financial markets has materially improved. However, one of the undesired consequences of the new regulations is that financial institutions, particularly the large ones, had to entrench themselves in the more profitable businesses, and as a result financial inclusion retroceded, notably in the periphery of the financial systems.

One measure that many central banks designed to try to compensate for this dynamic was to foster a regulatory environment beneficial for new entrants, particularly for so-called fintechs. In this new reality, regulators have been focusing on creating favourable conditions for new entrants. While they're still small in size, these new entrants don't pose a systemic risk, both with lower cost of capital and also observation costs. But as they become material and increase their systemic risk, new entrants are required to increase capital requirements and observation (i.e., their governance framework). During this journey they fill the vacuum of financial inclusion that was the undesired consequence of the higher levels of capital previously mentioned.

In the last decade, and with growing intensity in the last years, we've been observing a series of fintechs rising and reaching remarkable success, effectively changing the financial markets as we know them. Perhaps one of the most relevant changes we have seen is the capacity for a fintech to occupy a particular market niche, forcing all existing market agents to pursue the best possible offering in that niche. In a market where information costs are reduced dramatically and the end consumer can compare offerings instantaneously, we observe a dynamic where (1) consumers will most of the time choose the best product offering, and (2) financial companies will either offer the best product or be forced out of the market. As a result of these dynamics, most likely no single company will be able to manufacture all products the customers need with the same level of value for customers, and with the new possibilities of integrations and partnerships that the technological development is creating, we now observe some good examples of financial institutions providing a broad product offering, where they manufacture only the products in which they can be best-in-class; for those products that they don't have the same superior capability and experience in, they partner with an institution that does exhibit this capability to then distribute that product.

This recent phenomenon can be regarded as a silent revolution in financial markets. Many of these fintechs explored technological innovations in the transaction services space; some of them went through the more arduous challenges of core banking, in several categories of lending, such as credit cards and BNPL services. But for the latter group, while many things are different in this new form of banking, some components remain critical, and in essence the same, as they have been for more traditional banks. For example, the discipline of Asset and Liability Management (ALM) remains a key pillar for those newer institutions that embrace the fintech world, but who wish to build a scalable and sustainable franchise. Even in this new world, financial companies need to understand, for example, the nature of the banking book, and the need to manage credit risk. They are still faced with the challenges of deploying a funding strategy to support the growth of the asset book. These companies still need to create a Treasury operating model, with a sound understanding of liquidity and funding risk, and with a clear funds transfer price strategy in place. And finally, they need to fully understand all the challenges and implications of regulatory capital requirements and capital management. And those firms wishing to set up a long-term domain in this new world will find invaluable references in this comprehensive book by Moorad Choudhry.

Speaking personally, having navigated throughout my career in the financial markets infrastructure space, in large global banks and more recently in the fintech space, I find it remarkable how these three different worlds are diverse but also how they complement each other in order to form a broad view of the possibilities of modern financial markets. Another interesting point is that in the fintech space, I have the impression that many people focus more attention in the tech component than in the fin side. Perhaps that can explain why in most cases the fintechs end up focusing more on transaction services innovations, as opposed to core banking and lending. In my view, a world of opportunities can be explored for those who master the concepts present in this phenomenal book. And those who can combine the experience of fin with the innovations of the tech will command a leading position in these new uncharted territories.

Henrique Fragelli

Chief Risk Officer

Nubank

São Paulo, 8 January 2022

Foreword

Oldrich Masek III

For the most part, banking's principal purpose has not changed since its formal advent in the 1400s; specifically, it affords a safe means to intermediate savers and borrowers such that underutilised capital can be efficiently recycled within an economy. What has changed, however, is the efficiency and speed by which this optimisation process manifests; each has increased dramatically as a consequence of digital connectivity and the globalisation of world commerce. Digitalisation, in particular, has allowed for alternative forms of financial intermediation to develop, collectively referred to as the Shadow Banking Industry. In its most basic form, the Shadow Banking Industry connects savers and borrowers more directly by bypassing the regulated banking system. While this direct connectivity model can be more efficient as well as provide financial access to individual and corporate borrowers not served by traditional bank lenders, it introduces alternative challenges to the health of the financial system. In many ways, savers should more appropriately be deemed investors given they don't benefit from the safety net afforded by having a regulated bank standing in the middle of the financial intermediation process. Rather, the investor is placing their monies directly with the borrower, consequently taking direct exposure to the creditworthiness of such borrower.

Whilst both financial intermediation models (regulated and unregulated) have economic strengths and weaknesses, their efficacy depends on sound principles of governance. Governance in this regard has many meanings; there are explicit operating principles as well as the implied ones. The explicit operating principles are very eloquently and thoughtfully laid out in this reference book; it frames well key considerations around assessing banking risk (capital, liquidity, and so on) as well as measuring the overall health of the collective system (stress testing concepts). This book also affords a comprehensive context as to why these principles exist, the accepted tools used to manage them, as well as their practical limitations. Like any living organism, however, a bank's overall health depends on the evolutionary interplay of its vital parts; how its well-being is exercised and strengthened through thoughtful leadership and judgement. This is what I refer to as the implied aspects of governance. Whereas the practical operating principles for bank governance are widely accepted and adopted, the judgement used in administering them is shaped by institutional culture and often differs from institution to institution. These institutional differences were best evidenced by the scope of winners and losers in the 2007 financial crisis; despite common regulation and similar sets of operating principals, certain financial institutions got it uniquely wrong. Interestingly, certain financial institution seem to even get their governance wrong consistently; whereby their culture fails to evolve from incident to incident.

Hence, the principles of banking, which titles this reference, warrants some further reflection. Whilst industry practitioners can learn the various accepted models for operating/risk managing a bank's activities, it is more difficult to instil the principles of sound judgement. A banking organisation's commercial behaviour and business choices reflect the culture of its leadership; some cultures tend to operate within the limit of reasonable risk management while others test their precincts. Said differently, better performing financial institutions govern to the spirit of stated regulation and their own control frameworks rather than to their formal regulatory boundaries. In many ways, it is why banks are regulated in the first place; to put guard rails around banking behaviour. Given the importance of the banking system to the economy; regulation is the one governor society can use to shape banking activity over the long term. And like the financial system itself, regulation needs continual revisiting such that it can evolve in parallel with the industry and capture any lessons learned when banking activity goes astray.

With that said, despite the best efforts made by bank regulators to legislate rules prospectively against developing areas of concern, foreshadowing banking problem areas are increasingly challenging. Practically speaking, the accelerated rate of change in global banking activity (as stated above) makes it difficult to stay ahead of incubating risks in the financial system; more often than not, corrective legislation is conceived only after the risk comes to fruition, retrospectively. This practical reality only emphasises further the importance of culture as the ultimate driver of banking self-regulation; banking leadership is in the best position to identify increasing risks real time, be it their own activities or more systemic ones. Banking cultures that promote, action and reward self-discipline in their commercial activity will serve their shareholders, clients as well as the broader society better over the long run. Management judgement and self-discipline by necessity is the real first line of defence against rogue behaviour; current regulatory acceptance of a banking activity is not a catch-all to obfuscate management accountability when things go wrong in this regard. Remember again, regulation is a guard rail, not an operating mandate per se.

Looking forward, as the world moves further into the realm of Shadow Banking, instilling a culture of management accountability becomes even more paramount for the financial industry. Being afforded less regulation, by definition, puts even greater onus on the collective financial system to self-police. Failure to do so only invites new forms of regulation to adjudicate such discipline. Historically, however, regulation born from reaction often over- or under-shoots ist stated aim simply due to timing and information asymmetry. Fortunately, the better banking players realise that fit-for-purpose regulation only manifests through better transparency and cooperation with regulators. As a matter of culture, these organisations proactively share their forward business agendas inclusively with their regulators; be it new product creation, perceived self-governance weakness, and in the extreme, even whistleblowing questionable competitor activity. Institutionalising a culture of collaboration and transparency with regulators (rather than us versus them attitudes) requires multi-year cultivation; they need to be philosophically promoted, as a matter of ideology, through consistent messaging from senior leadership as well as supported through employee education and control frameworks. Again, like any living organism, institutional attitudes need to be evolved and incubated so they become a natural behavioural pattern; it is the only means by which such attitudes can genuinely be entrenched as part of an organisation's operating fabric.

As a general matter, It is hard to argue against a more collaborative and transparent relationship between industry and its regulators. Suffice it to say, regulators appreciate the power they ultimately wield in shaping banking activity; yet they also accept it is difficult to effectively legislate the industry looking outside in. I would also say that they appreciate that an open and shared agenda around governance topics with industry will harvest a healthier banking system. Not only can fit for purpose legislation evolve more real-time, the spirit of any new regulation can be more ubiquitous as it is jointly sponsored and promoted. This is not to say naively that there won't be differences between industry and its regulators when they engage and debate on certain governance topics; rightfully, societal goals often outweigh the immediate commercial goals of any particular industry. Whilst a more collaborative model may seem unrealistic or too aspirational for some, at least the position of each on any given policy matter would have been drawn from information collectively shared; policy decisions and their implementation can only be bettered when contextualised fully.

Interestingly, there are good examples of topics being considered in this collaborative way currently. The industry and its regulators are experimenting with such shared governance approaches as they relate to evolving societal issues like climate change and employee diversity, for instance. Governance topics around climate change for banks focus on the role banks have in financing non-green industries while employee diversity relates to promoting equitable representation of all diversity groups at every level of a bank's organisation. These governance topics are interesting not just in how they are being tabled and considered but that they are now firmly in the regulators' scope; historically, societal goals other than banking failure were outside the purview of banking regulatory oversight. Yet both the industry and its regulators appreciate the extreme importance of addressing such societal goals through governance; such societal goals will move faster to their resolve only if these type of issues are made a collective priority. In this regard, the industry was the first to take the lead on tabling their importance and have worked towards establishing concrete operating goals and deliverables to facilitate the change. Measuring progress against these goals are now firmly part of most banks' performance metrics; not only watched by regulators, but also shareholders and the broader public. So in many ways, the industry's self-initiated response to these historically softer issues can drive constructive change. Interestingly, the regulatory approach to these topics have been more accommodative then prescriptive; regulators have not set hard goals or boundaries per se. Whilst this might change, they have allowed the industry to set its own goals and pace of implementation; what they have done, however, is help call out those industry players that have not taken reasonable action by comparison. Institutions that fail to keep pace with industry or societal goals (be they prescriptive or suggestive) will have their relative shortcomings tabled during their regulatory review; essentially, a documented form of name and shame. So, regulatory suasion, in this regard, can be as effective as hard coded regulation. I would go further and say they may be even more effective at driving change around softer or developing societal issues. By their very nature, their governance is more nuanced and less addressable through hard metrics; unlike setting prescriptive minimum capital requirements, for instance, societal issues are harder to parameter given their multidimensional considerations. So, as an alternative to being formally prescribed, effective governance can be equally instilled through collaborative steering by industry and regulators.

In the end, shared responsibility and ownership of the industry's governance agenda helps ensure that the spirit of any regulatory guard rails (whether formal or through suasion) are prioritised; like most things in life, goals are only achieved when one has a clear plan and roadmap. Collaborative steering of the industry helps ensure its long-term health; otherwise, like a boat without a rudder, the industry can drift in disparate ways. There will always be outlier financial institution that drift from the industry's accepted practices and conventions; but what we don't want is the industry as a whole drifting or at odds with its societal purpose. Through a collective agenda the industry will at least navigate better banking's ever-changing waters; and perhaps, at least minimise the occurrence of rogue activity by some players. In fairness, the complexity of the banking business has made it harder for smaller firms to stay apace with all the infrastructure needed to effectively manage the growing list of governance priorities (be it formal or informal); to me, this is a separate debate from whether they are warranted. They are categorically warranted and are more of a competitive reality for firms to address rather than discount; and like with any industry, an inability to operate completely in this changing competitive environment is a classic form of barrier to entry. The cost of appropriately governing a bank in these complex times necessarily requires scale in order to fund appropriate banking governance (procedures, systems, control personnel, and so on); banks that do not have the scale will necessarily under-fund these important pillars of governance and be more susceptible to operational failure. In many ways, this the biggest argument for industry consolidation which has been long overdue; fewer players, albeit more robust and better controlled in their activities, will better serve society over the long run. Consolidation as a means to reduce bank failure remains open to debate; some argue that concentrating banking risk to fewer larger players unnecessarily increases systemic risk. Whilst there is truth to that, the banking industry would be at least more transparent and manageable from a societal point of view. Whether its insufficient scale or lack of management control culture, the complexity of global banking cannot afford participants with weak governance leadership; through their behaviour, they undermine the industry's overall credibility and good intent.

All in all, like many book forewords, the above may come across as something of a philosophical random walk; I suppose that's what one does with over 25 years of experience in the industry to reflect upon. What I hope most is that future students of banking look beyond the mechanical aspects of the industry and embrace the responsibility afforded them as future leaders of the industry; the responsibility to equitably serve your banking employer, your customers and society as a whole. As future leaders of the industry, use reasonable judgment in your dealings and try to do right by all your constituents; think long-term greedy with your career. The banking industry can be an enjoyable pursuit; it is dynamic, fast moving and highly competitive. Equally, the business leadership and financial engineering skills one can learn are portable to careers in other industries; finance is at the heart of every industry. With that said, banking's complexity and dynamism also makes it easy to go adrift in its choppy waters; so don't let short-term gains or rewards steer one's behaviour or actions. The industry has been plagued by institutions and individuals who lost sight of their responsibility of self-governance; acting outside the most important principles of banking: transparency, fair dealing or ethics generally. Collectively, we can call it personal accountability to do what is right; raising developing risks/issues as they materialise both internally and, if needed, externally as well. Regulators are not your adversaries; they are your partners representing the societal agenda and should be treated as such through transparency and respect. Remember, they help set and define the guard rails by which the industry operates but it is up to individual judgement, behaviour and leadership that ultimately drives the industry forward or sideways; responsible self-regulation and behavioural discipline is the only path to cultivate the trust of society for greater industry latitude to ensue. Perhaps a good complimentary sequel to Moorad's fine reference here would be The Principles of Banking Behaviour.

Oldrich Masek III

Head of Securitized Products – EMEA & ASIA

Managing Director, JP Morgan

8 June 2021

The views expressed in this foreword are those of the author alone, and do not necessarily represent the opinion of JP Morgan.

Foreword

Jason Oakley

I first met Professor Moorad Choudhry at a UK Finance seminar regarding bank capital and liquidity management. I was instantly struck by his passion, but also by his intellect and clarity of thinking. As I have got to know him, as fellow board directors of Recognise Bank, I have come to admire a man of great principles.

I read a lot and often hear a lot about the financial crisis, but for me the rot set in long before this. When I joined the industry in 1985 it was a proud moment for me, offering a career I was excited about. It was made very clear to me that promotion and opportunity were aligned with upskilling, progress with professional exams and mentoring / coaching from senior colleagues.

I set about with great vigour to pass my foundation certificate, then become an Associate by 21 years old, then on to the Financial Studies Diploma, the postgraduate qualification and finally the Lombard MBA – all before I was 30 years old. I learnt a great deal, I interacted with very different bankers, from different cultures, but what we had in common was that we all strived to self-improve. This knowledge and interaction allowed me to join up dots, and to become more ambitious in my thinking and aspirations.

What do I see today?

An industry denuded, the older generation has been prematurely retired off, new recruits have very narrow verticals, they are not taught about old fashioned banking – spreading accounts, debt service, the crucial importance of cash flow and relationship building. This is a great shame, and part of my passion for Recognise Bank is that it is an opportunity to put old-fashioned banking back in vogue.

I am sad that once great banks are a shadow of their former days, they have largely given up being the first port of call for entrepreneurs, and become subservient and much more dependent upon commercial brokers.

Another way?

A shining beacon is Moorad Choudhry – his core beliefs, his passionate behaviour and his engaging style offer some hope. We both firmly believe we can re-educate and re-professionalise our industry.

The Principles of Banking is a herculean achievement and a must-read for all bankers who want to broaden their knowledge, and show their ambition and burn. Mastering the subjects contained in it is a clear statement of intent of one's capability. Moorad's book oozes quality and is rooted in genuine expertise.

As I get older, I have a growing sense of two things: one, never stop learning, growing and challenging yourself. I recently completed a fintech course at Cambridge Judge Business School at 54 years old! And two, I feel a greater obligation to support my younger colleagues and help shine a light to help them become the best they can be.

The Principles of Banking is a foundational building block on that journey.

The best of luck.

Jason Oakley

CEO

Recognise Bank Limited

17 June 2021

Foreword

Helen Sachdev

The Principles of Banking was first published in the aftermath of the 2007–2008 banking crisis. The timing of this second edition coincides with the UK taking its first cautious steps in recovering from the global pandemic of Covid-19 in 2020–2021. What is notable is that since the first edition, and despite the largest shock to GDP since the World Wars in the early 20th century,¹ there have been no UK systemic banking failures.²

Clearly the regulators introducing layers of regulation designed to prevent a repeat of such an occurrence have had a big part to play. But as I got ready to read this book, much as I might reach out for the instruction manual after failing to fix something I rely on, I was intrigued to see whether the author might shed light on what is really different about the current banking system today versus the one back in 2008; what are the root causes of the current crisis not resulting in further systemic banking failures?

As Chair of the Loughborough Building Society, I am proud to work alongside Professor Moorad Choudhry as one of my Non-Executive Directors. His depth of knowledge on balance sheet risk management, Treasury asset–liability management (ALM), liquidity risk management, capital management, and risk governance oversight is invaluable. As well as being a senior practitioner, and having served as Treasurer of various EMEA banks, he is a well-respected academic, and is regularly called upon to lecture and teach on his areas of expertise. And perhaps most importantly in a book that gives equal importance to the ethics and principles, as it does to the mechanics and mathematics, Moorad is one of the world's nicest people – a true gentleman.

One of my favourite quotes from the first half is, It is possible to have an incompetent Board and still survive a market crisis, however, it is not possible for a bank to have an incompetent ALCO and survive the same crisis. The Principles of Banking is at its heart a book which describes both how to build and manage a well-funded and well-managed balance sheet (the very essence of a competent ALCO), and how the right oversight of strategy and good governance needs to provide the necessary wrap arounds (a key role of the Board).

Inclusion of examples such as Lehman Brothers and Northern Rock brings the theory to life, and examples of the proliferation of risky loan products such as 125% LTV advances, which in the rational light of day could never be justified, are a salutary reminder of the dangers of unfettered growth driving bull markets.

In reading this book, I have increased my own depth of understanding of the principles of banking; I will keep this tome close to hand as a key reference guide. My thanks to Professor Choudhry for revising and updating such an important text; relevant both in times of stability, and in times of chaos and uncertainty.

The principles outlined in this book which underpin all banking activity are designed to keep each organisation operating as a going concern. My personal hope is that in the most potentially dangerous times ahead, that is, when stability returns and the next great growth spurt starts, that Boards not only continue to set the right tone in terms of culture and values, but also hold steady and stick to these banking principles which, ultimately, keep our customers' and clients' money safe.

Helen Sachdev

Chair, Loughborough Building Society

Non-Executive Director, McKay Securities Plc

Non-Executive Director, Wilmington Plc

Director and Founder of WOMBA Ltd (Work, Me and the Baby)

16th May 2021

NOTES

1   The magnitude of the recession caused by the pandemic is unprecedented in modern times. GDP declined by 9.8% in 2020, the steepest drop since consistent records began in 1948. Source: UK Parliament House of Commons Library.

2   Correct as at May 2021.

Preface

In his book A Day in the Life: The Music and Artistry of the Beatles, Mark Hertsgaard writes:

Artistic greatness depends not only on aesthetic excellence but also on personal style; there must be something in the art that makes it unique to the artist who created it.

(Dell Publishing, 1995, p. 163)

One might think that an author writing about such dry and dispassionate subjects as banking and finance may struggle to stamp an immediately identifiable and unique imprint on their work, so uniform and plain is the field on which the work is based. But that would be inaccurate: finance, and banking, are much closer to art than science than is generally recognised, and so in theory at least, the artist in this space has an opportunity to create timeless, or at least memorable, work. Very few issues, and fewer problems, in banking have only one solution to them. There is no one size fits all framework, and an approach or business model that works well in one bank may struggle to deliver adequately in another bank. Look closely at any group of firms in question and there is, if not infinite, certainly considerable variety.

So from this author's perspective, finance and banking are not precise sciences. In fact, I would question whether banking is a science at all. There is always more than one feasible solution to practically every problem that arises when running a bank (or working in a bank – many problems one encounters get nowhere near the executive committee, let alone the Board). As my good friend from the City, Colin Johnson, says: Every day is a school day. One is always learning in finance.

But if one is always learning (or should be), how to do that if indeed finance is more art than science? Easy: as with any art, through continuous application and practice, thereby building a capacity to apply good judgement. So much in finance is all about expectations based on assumptions, despite what the financial market quants would tell you. That this is not known universally is itself worrying, with some bankers the world over convinced that the stated gross redemption yield of a bond purchased in the secondary market is indeed what they will actually receive for holding it. The valuation of equities and bonds, the calculation of default probability, the expected life of a loan, the recovery rate of a defaulted loan, the amount of customer deposits that might leave the bank during a stress event, the risk weighting of an asset used to determine its regulatory capital requirement, the expected credit loss on a loan… the values for these are all so much estimation based on assumptions. Which person in their right mind, trying to do the right thing for everyone, would wish to attempt precision on such a foundation?

But in order to be able to execute transactions, so as to enable lending and deposit taking to take place, both of which activities are absolutely vital for development of the economy, we do need to make decisions that are indeed based on estimations and approximations. That's where the good judgement bit comes in; good judgement, and an ability to adapt quickly so as to continue making decisions based on sound principles when market conditions take a turn for the worse.

Economic development is ultimately what this is all about, because without banks performing their vital roles as secure stores of money, maturity transformation specialists and providers of funding to those involved in generating value-added economic output, global social development would take place at a much slower pace. We would all be much worse off, economically as well as socially, without the work undertaken by banks. Of course while it is almost unarguable to state the importance of banks and the good they do for society, all practitioners should know that it is also unarguable to state that the work undertaken by banks must reflect sound risk management principles as well as scrupulous ethics and good intentions.

When this book was first published in 2012, I had a simple ambition for it: that at least one copy should end up in the Boardroom of every bank in the world. Simple, but perhaps slightly unrealistic. My ambition for this second edition is, I think, more focused and hopefully therefore significantly more realistic: that the reader digests its content and concludes with the words, Well, there's food for thought! Because there is always more than one way to approach every issue described in this book. My views are just that, my views. They may not accord with yours, and that is fine – that's what makes a market. That said, I will always provide rationale explaining my view, grounded in logic and based on experience gained across different banks. There is no specific dogma in this book (with the exception of the last sentence in this Preface!). Everything is open to debate and challenge. Markets are dynamic and the environment is constantly changing. Adaptability and an ability to respond quickly and effectively to events, whilst still retaining the long-term view, is the key to maintaining success in banking.

A textbook, as opposed to a work of fiction, is always at risk of being overtaken by events. Ten years after the publication of the first edition of this book, in certain segments the banking industry looks very different compared to what it did in the first decade of this century – different enough to warrant a second edition. But in other areas the discipline and art of banking remain unchanged, not just from the last decade but from the last century, and the century before that. The challenge for practitioners is to adapt to the new whilst retaining the still-relevant and common sense principles of the old.

And so to this second edition. What has changed in the last ten years to warrant the time (and for the reader, the expense) required for a second edition? In one sense, nothing at all. Employees of Banca Monte dei Paschi di Siena S.p.A during the 15th century or of Berenberg Bank in the 16th century would recognise some, indeed many, of the aspects of banking described herein. But in another respect, the very application of banking business, and the activities that banks undertake, has changed significantly since the publication of the first edition. Of course, that does not mean that all banks are doing new things in exciting new digital ways, or old things differently. Some banks around the world (and I have personal experience of one or two of them) might be described as living dinosaurs, so much has their culture and modus operandi remained as it was in the 1970s. That such banks still manage to retain customers in the 21st century is itself telling: banking is not necessarily a difficult industry in which to thrive. The very word bank in a company's name extracts a kind of monopoly rent, implying almost by definition a safe store for customers' deposits and an entity that can handle customers' payment requirements. And that's before we even mention lending! In other words, in many countries around the world it is possible to remain a viable business whilst not necessarily modernising like some other banks have done or new banks are doing. But perhaps not for much longer?

Because that said, a significant number of banks, old and new ones, are doing new things and/or old things differently, compared to just a decade ago. And the level of regulation, already on an intensive level back then, has increased to such a pitch of intensity that one might call it intrusive. Certainly senior executives in banks spend more time addressing regulatory compliance issues than they do on any other area of their responsibility.

So all these factors suggest the need for a second edition.

But there is only so much one can address in a textbook. Ultimately, everyone involved in banking should, I would argue, always take decisions based on what the impact will be for the community, and society, as a whole. The role of banks in a country's economy is too important for there not to be this wider focus from a bank's Board and its executives. Whether moving to a digital customer interface, closing a branch in a town with no other bank branches, introducing a new type of financial markets product, concentrating on form over substance, treating customer service as just one more statement of platitude, or indeed making and implementing any decision in a bank, one should always ask, How is this going to impact the customer, the community, and society as a whole?

That decision should be made from the perspective of all of a bank's stakeholders, that is, its shareholders, its employees, its regulators… and its customers.

Or, put another way, Do good work.

PAPERBACK FORMAT

The first edition of this book was published in hardback, as indeed have been all of the author's books for Wiley Finance.

This second edition has been published in paperback (as well as the usual e-book format). The author's objective has always been, and remains, for his books to be kept within arm's reach and used continuously as ready reference texts for practitioners. This objective is more easily achieved with a paperback book than a hardback book, hence the change in format.

Writing this book has been an interesting and very absorbing experience, and as I have always noted when writing about banking and finance, the work could have continued indefinitely. There is always something extra to write about, something new or some alternative way of describing things. To distil all the relevant subjects into a manageable length, capable of being condensed into a single volume, invariably involves an element of selection, in spite of the frustration that leaving otherwise important facts out may cause one. But the end result has been a second edition that is shorter, not longer, than the first edition. Nonetheless, I hope it still addresses the most important topics in banking. Ideally the contents will remain current, in large part, for many years to come, irrespective of whatever happens in the banking industry.

One of the main differences between this second edition and the first edition is that lower level technical detail, which was for many topics covered in some detail in the first edition, has been dropped or relegated to the book's website in the second edition. This is so that we can focus on higher level principles. The technical detail always needs a separate book in its own right – each chapter subject in this second edition is worthy of a book itself!

Readers who tackle the text from start to finish will forgive some occasional slight repetition of information. This has arisen because of the desire to have self-contained chapters, and to assist those who look up specific individual chapters for reference purposes.

As always, the aim is to remain accessible and practical throughout; we hope this has been achieved. Comments on the text are most welcome and should be sent to the author, care of John Wiley & Sons (Asia) Pte. Ltd.

LAYOUT OF THE BOOK

The book is set out in six parts as follows:

Highlights of this second edition include:

an update on regulatory requirements;

a template risk management framework incorporating risk appetite framework and sample risk appetite statement;

description of the capital adequacy, liquidity adequacy and recovery planning process regulatory submissions;

addressing developments in finance that will impact principles of banking, including sustainable banking and climate change risk management;

real-world case study issues to demonstrate analysis and problem solving;

a review of a textbook published in 1890, demonstrating that the core principles of banking are indeed timeless.

A review of the first edition showed that much of its content was still current and still relevant; only in the detail had certain areas required updating. Hence this book should be read in conjunction with an ongoing review of policy statements and guidelines issued, on a constant basis, by bodies including the Basel Committee, the European Banking Authority and your national banking supervision authority.

COMPANION WEBSITE

Chapter 25 contains full details of the companion website to this book. The website holds policy templates, spreadsheet models and PowerPoint teaching aids, as well as further technical details on the subjects discussed in the book.

Details on how to access the website are given at page 763.

NEWDIGATE FOOTBALL CLUB

I am inspired to continue development in my own professional field by continued membership of an exclusive members club. My everlasting thanks, for their companionship, their team spirit, their good humour, their genuineness and their all-round being 100% fully real, to my chums at Newdigate Football Club. It is a pleasure, a privilege and an honour to count myself as one of you.

Photograph of a team.

Front row (L-R): Bobby Taylor, Jimmy Taylor, Aidan Keeley, Terry Carter, Chris Fox, Ryan Lunn

Back row (L-R): Alex Haigh, Tom Wyatt, Andy Longhurst, Jay Bush, The Author, Matt Dilger, Luke Bartholomew, Liam Fidler, Jay Jenkins

Missing from the picture is Simon Haigh (the gaffer), Jordan Morris (the most handsome player in the team), Leo Hill (the team's talisman), and Ricky Lunn (a true gentleman). My thanks and affection to everyone at the club, in or out of the picture!

Acknowledgements

The historian Ian Kershaw writes at the start of his Acknowledgements in The End: Germany 1944–45 (Penguin Books 2012):

One of the most pleasant parts of finishing a book is to thank those who, in different ways, have contributed to the making of it.

How right he is!

In this instance the names listed in the first edition remain the same for this second edition! I will add some very good friends I have made since then, including Charlie Haswell, Nick West, Daniella Weber, Natalie Horscroft, Helen John, Harish Nair, Ali Andani, Andrew Payton, Julie Kerry, Philip Curtis-Evans, Julie Ashmore Dann, Adrian Golumbina, George Alderwick, Liliana Loata, Sally Baldeh, Antonio Mota Pizarro, Danny Corrigan, David Austen, David Castle, the legendary David Fance (who I hope will be chairing a UK high street bank one day), Eric Khoo, George Littlejohn, the top chaps at ITFC Treasury (Ahmed Jan, Ahmad Hamza and Sharif Alshater), Iain McNay, Jaffar Hussain, Colin Johnson, Chris Blake, Konstantin Nikolaev, Lisa Bamford, Lucy McClements, Mark Williams, Mike Catt, Matt Price, Nathanael Yishak, Michael Georger, Michael Tichareva, Nabiha Akhtar, Tope Fasua, Paula Jaaskelainen, Paul Hale, Paulina Krzyanowska, Philip Allen, Safder Dhirani and Mahdi Dhirani, Silke Waterstraat, Subhamay Bhattacharya, Taha Soomru, Tim Skeet, Vijay Krishnaswamy, Werner Coetzee, Zakaria Salah, Eric Scotto di Rinaldi, Jamel Banda, Mme Yang, Junlan Zhai, Nayan Sthanakiya, and Zia Ishaq. Thank you my friends, for everything!

A real big thanks to everyone at Recognise Bank Limited, everyone at the Loughborough Building Society, everyone at Nubank, everyone at Surya Soft, and everyone at The BTRM. And I mean everyone! It is a great pleasure to work with you all.

My thanks to the Foreword writers, I am humbled and privileged to be able to begin my book with your words.

My thanks to my co-authors for their contributions that one can see throughout this text; the book would have been poorer without them: Polina Bardaeva, Natasha Bourne, Michael Eichhorn, Beata Lubinska, Engelbert Plassmann, Periklis Thivaios and Chris Westcott.

Big, big thanks to the great people at Wiley, easily the best publishers in the world: Syd Ganaden, Purvi Patel and Manikandan Kuppan, and to the copyeditor Elaine Bingham. Terrific job guys! And for one last time, thanks to Nick Wallwork and Zena Deane.

My final thanks are to you, dear reader: my best wishes to you for your studies in banking and in your professional career.

Having attempted to justify the need for a second edition of this book, which I hope you find of value and interest, I assure you that this will be the last. As the peerless Ian MacDonald wrote in the preface to the final update of his majestic work Revolution in the Head, no further editions will be forthcoming.

Or, as the last Oi! album proclaimed, That's yer lot!

Goodbye!

Stay handsome…

Goodbye.

Signature of Moorad.

Moorad Choudhry

Surrey, England

7th July 2022

A Solid Bond in Your Heart

Preface to the First Edition

Aficionados of science fiction will be familiar with Dune, a seminal work in that genre written by the late Frank Herbert. A complex, interwoven tale of imperial rivalry, medieval mysticism, clan fighting and religious hero worship, as well as a more old-fashioned story of good guys versus bad guys, it is set on the desert planet Arrakis. Amongst a range of peculiar geophysical features, this planet exhibits an almost complete lack of water. The native inhabitants of Arrakis, the Fremen, appreciated this lack so much that they took great pains to preserve and recycle every drop of moisture, even to the extent of recycling water from the bodies of their dead. Water was life. Anything that was vital to the maintenance of life itself was known by the Fremen as the water of life.¹

And so to banking. Banks have always been a part of recorded history. Latin texts describe a form of borrowing and lending activity in Roman times, and before that the ancient Babylonians practised an elementary form of banking. In his excellent and thought-provoking book Zero, Charles Seife tells us "before Arabic numerals came around, money [lenders] had to make do with an abacus or counting board. The Germans called the counting board a Rechenbank, which is why we call moneylenders banks." So now we know. Banks are the lifeblood of society, because without them nothing would get done. By that I mean nothing productive. Nothing would get built, nothing would get traded, and very little would get consumed. This would result in all of us being much worse off than we are now. As Simon Johnson and James Kwak note in their book 13 Bankers, because an advancing society in the process of industrialisation requires investments in new technology, it also [requires] credit…long-run prosperity required large-scale commerce and industry, both of which required banks. Banks are vital to societal development and civilisation. And right from the start, banks have always had to rely on the availability of continuous funding, or liquidity. It is a definition of banking. Banks are a lifeblood of society, and for banks, liquidity is the water of life.

Being such an important part of society and human development, it is obvious that banks must be managed properly. That is not as apparent as one might think. During the global financial crisis of 2007–2008 many banks around the world failed, some of them fairly spectacularly. A fair few of these banks were shown to have been managed with quite monumental incompetence, by people who had seemingly been at the top of their game. People boasting Harvard MBAs, feted the world over with knighthoods and invitations to dine at presidential level. People who had in many cases never actually bothered to obtain any professional qualifications in banking, but who would have us believe their self-generated hype that they were the Masters of the Universe. Many of them thought that they could beat the market, that as long as the music was playing they should still be in the game, even as all the indications suggested that a recession was already enveloping them. In the end it was a case of the emperor's new clothes, because it was apparent that many of these star bankers had done what any literate teenager could do: they'd made money in a bull market. Or, as Quentin Letts writes of the former CEO of