Glossary

In this glossary some of the main (banking) concepts which are used in BankManager are explained.

Banking terminology

• Net interest margin
  Net interest margin is a measure of the difference between the average interest rate (charged) for lending and the average interest rate (paid) for deposits and borrowings, relative to the amount of their (interest-earning) assets. Net interest margin is similar to the gross margin (or gross profit margin) of non-financial companies.

  The net interest margin is exposed to interest rate risk due to the fluctuations in the levels of market interest rates. Since a majority of a bank’s lending is done a fixed rate (e.g. mortgages) and a majority of a bank’s borrowings is done at a variable rate (e.g. deposits), the bank run the risk of a narrowing (or even negative) net interest margin if interest rates increase. With increasing interest rates, the lending rate (the income) – which is fixed – stays unchanged, whilst the borrowing rate (the expense) – which is variable – increases with the higher market rates, and thus the net interest margin narrows or becomes negative – at least in the short time perspective.

• Duration
  Duration is the weighted average maturity of a series of future cash flows (and is normally expressed in number of years). Duration is generally seen as a measure of interest rate ‘sensitivity’. The higher the duration, the greater the interest rate sensitivity. In other words, the longer the duration, the longer it takes to adjust interest rates to ‘new’ market interest rates.

• Interest rate gap
  Interest rate gap is the difference between fixed income obligations and fixed-income assets. This interest rate differential is a measure of a bank's exposure to interest rate risk.

• Risk Weighted Assets (RWA)
  The notion of ‘risk-weighted assets’ is taken from the global agreements between banks, known as the Basel accords, and based on the riskiness of a bank's assets (i.e. the riskier the asset, the larger the amount of risk weighted assets).

  Most banks lend to a wide variety of customers, and the risk that a customer cannot repay a loan varies. The greater the risk that a customer cannot repay a loan, the more a bank endangers its own creditworthiness, as credit losses will erode the bank’s equity base. Therefore, banks are restricted to how much risk weighted assets they can take on in relation to their Tier 1 capital (see below).

• Tier 1 capital
  Tier 1 capital is the capital ‘buffer’ which a bank needs to hold – in the perspective of the supervisor – in order to be able to absorb any (credit) losses. Tier 1 capital consists of share capital and not distributed (past) profits.

  The Tier 1 capital ratio is the Tier 1 capital divided by risk weighted assets. The Basel III accord, which has become legally binding in most jurisdictions, stipulates that banks, by 2015, need to meet a Tier 1 capital ratio of minimum 6%. This minimum level will be increased to 8.5% by 2019.

  Example: A bank has equity of 2,000 and takes 10,000 of deposit. The bank lends the whole 10,000 (of deposits) to its customers. If we assume that the lending carries a risk weight of 90%, the risk weighted assets amount to 9,000, and therefore the Tier 1 capital ratio is 2,000/9,000 = 22%.

Macroeconomic indicators

• Consumer Price Index (CPI)
  The Consumer Price Index measures the development of the price level of a basket of goods and services purchased by consumers. This is a widely used measure of inflation.

• Gross Domestic Product (GDP)
  Gross Domestic Product is the total monetary value of all goods and services produced in a country during a specific period (usually a year). Typically, Gross Domestic Product is measured at market prices.

• Surplus/Deficit
  In BankManager, surplus/deficit means the status of the current account of a State budget.

• Yield Curve
  A yield curve is the graphical representation of the relationship between interest rates at different maturities.

  In a ‘normal’ situation, loans with short(er) maturities carry lower interest than loan with long(er) maturities. Therefore we speak of a ‘normal yield curve’ when it is upwards sloping. This is mainly because – all other things equal – at long(er) maturities investors need to be compensated for (increased) risk, uncertainty and possible inflation. Thus, even if the ‘current’ inflation is low, the uncertainty about future inflation normally provides a light increasing yield curve.