Author Queries

AQ1 Please provide incite txt citaion for the Figure 1.7.

Choudhry755647_c01.indd 1 8/23/2022 11:13:31 AM

 CHAPTER 11
Banking, Bank Business and Financial
Statements

F i n a n c i a l Tr a n s a c t i o n s
All financial systems exist to facilitate one basic transaction: the moving of
funds from cash-­rich entities to cash-­poor ones. This transaction involves
the exchange of money for financial assets, or an interest in a financial asset.
This exchange can be undertaken directly between participants, via an inter-
mediary or indirectly.

Direct Finance
This involves two parties, one of which lends funds directly to the other for
an agreed term and rate of interest. This transaction is shown in Figure 1.1.
The funds can be lent in exchange for security (known as collateral) or on
an unsecured basis. Direct financing is the simplest method for undertaking
a financial transaction. Its drawbacks are that parties must know about
each other and each other’s requirements; they must also possess sufficient
information on their counterparties such that they are satisfied in entering
into the transaction. For this reason, direct financing, while very common
among larger institutions or where the central government is involved, often
gives way to financing via intermediaries.

Financing via an Intermediary

In terms of volume, a large proportion of money market transactions are
carried out in semi-­direct form, via intermediaries. We include banks among
our list of intermediaries. These can be distinguished as follows:

1 This section is material from Chapter 1 of the First Edition that has been trans-
ferred to the associated website for this Second Edition.

Choudhry755647_c01.indd 1 8/23/2022 11:13:32 AM

 2 The Principles of Banking

Flow of funds

Lender Borrower
Repayment of loan plus interest
on maturity

FIGURE 1.1 Direct financing.

Loan of
funds Broker

Commission or fees
Lender Borrower

Dealer

Remaining two-way positions

FIGURE 1.2 Intermediary financing.

■■ Brokers: a broker simply acts to bring lenders and borrowers together,

and charges a commission for doing so. However, the involvement of
a broker often introduces greater transparency and information into
the market.
■■ Market-­ makers: known as dealers in the US market, who also serve as
intermediaries between borrowers and lenders, but take the cash posi-
tion onto their own books and charge a two-­way price in this cash to
all other market participants. As such, dealers run a risk exposure posi-
tion in the cash they own directly, as their profit depends on the value
of the cash, which fluctuates in line with market dynamics and supply
and demand.

Of course, the same institution can act in both capacities, according to

who its counterparties are or what market it is trading in. This transaction
is illustrated in Figure 1.2.

Indirect Financing
The existence of an active secondary market in money market securities
reflects the extent of indirect financing. This covers a number of areas, such

Choudhry755647_c01.indd 2 8/23/2022 11:13:32 AM

 Banking, Bank Business and Financial Statements 3

TABLE 1.1 Financial institutions and intermediaries active in the money markets.

Wholesale market
Deposit-­taking institutions Contractual institutions counterparties

Commercial banks Life insurance companies Investment banks

Retail banks Life assurance companies Securities houses
Non-­banking institutions: Pension fund managers (“Broker-­Dealers”)
-­Savings & Loan (“Building Mutual Funds (“Unit Brokers
Societies”) Trusts”) Investment trust
-­Credit Unions companies
Mutual funds (“Unit Trusts”)
-­Money market funds
Finance companies
Government-­lending institu-
tions

as banks issuing their own securities to fund their loans to corporates and
individuals, and the trading of these securities after the initial finance has
been raised. Financial intermediaries that are part of this market include com-
mercial banks, insurance companies, credit institutions such as automobile
manufacturer credit arms, finance companies, savings and loan associations
(known as building societies in the UK), pension funds, mutual funds and so
on. Their role in the market is to act essentially as both borrowers and lend-
ers themselves in a way that serves the market’s ultimate borrowers and
lenders. Table 1.1 lists the types of firms involved in indirect financing.

Characteristics of the Money Market

The money market, worldwide, acts as a channel through which market
participants exchange financial assets for cash, or raise cash on a secured
and unsecured basis. Its key defining point is that it serves short-­term needs.
These are the short-­term financing needs of participants who are short of
cash, and the short-­term investment needs of participants who are long cash.
Figure 1.3 shows a stylised structure of the money market as it would exist
in most countries.
Interest rates set in the money market act as benchmarks and guidelines
for all other rates used. The importance of the money markets to this activ-
ity is often overlooked.
The size of the market means that it, in most countries and certainly in
all developed economies, carries considerable breadth and depth. It is pos-
sible to transact very large volumes of business and for this not to impact

Choudhry755647_c01.indd 3 8/23/2022 11:13:32 AM

 4 The Principles of Banking

Central Bank Main cash flows

Securities
houses Commercial
(dealers and banks
brokers)

Non-bank
The Corporate, financial
government individuals institutions
(finance
companies,
credit unions,
etc.)

FIGURE 1.3 The structure of the money market.

the money market in an observable way. Money market dealing is “OTC”,

(originally “over the counter”), meaning it is not conducted on an exchange
but over the telephone or computer terminal.
Interest rates in the money market – the rates at which participants
borrow and lend funds – are set by the market and reflect a number of fac-
tors, from macroeconomic issues and global supply and demand, to more
market-­specific issues such as liquidity and transparency. There are a large
number of interest rates, for different products and different counterpar-
ties. The cornerstone of the market’s various rates is the T-­bill rate. T-­bills
are issued by the government to raise short-­term cash (the typical maturity
is 90 days). Because the bills are backed by the government, they carry the
lowest default risk in that market. Hence the rates payable on these bills are
the lowest in that market and sometimes referred to as the “risk-­free rate”
despite the fact that in very few countries might the sovereign authority be
considered truly risk-­free! All other rates in the market (and the bond mar-
ket) will be at a positive spread over the T-­bill rate.
Readers interested in detailed coverage of the various instruments that
go to make up the money markets may wish to consult the author’s book
Bank Asset and Liability Management (Choudhry, 2007). This book includes
a primer on financial markets arithmetic, which is necessary required back-
ground for an understanding of interest rate mechanics.

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 Banking, Bank Business and Financial Statements 5

Money Market Conventions

Many money market instruments trade under similar market conventions.
For example, for most currencies the basis used to calculate interest on a
loan assumes a 360-­day year, although sterling is an important exception
to this. Again, while it is the norm for many currencies to float freely –
their exchange rates to other currencies set by market supply and demand –
some other important currencies are pegged to the US dollar and move with
that currency. A small number of currencies are not convertible and cannot
be traded.
Table 1.2 shows the characteristics of a sample of world currencies.
It serves to highlight the individual detail differences that exist in the
market. Terms such as “day-­ count” and “value date” are explained in
Choudhry (2007).

TABLE 1.2 Selected global currency conventions.

Spot FX
Country Currency FX rate Day-­count value date

Argentina Peso Free-­floating ACT/360 T+2

Australia Dollar Free-­floating ACT/365 T+2
Brazil Real Free-­floating ACT/360 T+3
Canada Dollar Free-­floating ACT/365 T+1
(domestic)
ACT/360 (int’l) T+2
China Renminbi Pegged to USD ACT/360 N/A
Czech Republic Koruna Free-­floating ACT/360 T+2
Denmark Krone Free-­floating ACT/360 T+2
Egypt Pound Free-­floating ACT/360 T+2
Euro Areaa Euro Free-­floating ACT/360 T+2
Hong Kong Dollar Pegged to USD, ACT/365 T+2
HKD 7.70 per
USD 1
Hungary Forint Managed floating ACT/360 T+2
Japan Yen Free-­floating ACT/360 T+2
Latvia Lats Pegged to Special ACT/360 T+2
Drawing Right
(SDR)b
Lithuania Litas Pegged to euro, LTL ACT/360 T+2
3.4528 to EUR 1
Malaysia Ringgit Pegged to US dollar ACT/365 T+2
New Zealand Dollar Free-­floating ACT/365 T+2
(Continued)

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 6 The Principles of Banking

TABLE 1.2 (Continued)

Spot FX
Country Currency FX rate Day-­count value date
Norway Krone Free-­floating ACT/360 T+2
Poland Zloty Free-­floating ACT/365 T+2
Singapore Dollar Managed floating ACT/365 T+2
South Africa Rand Free-­floating ACT/365 T+2
South Korea Won Free-­floating ACT/365 T+2
Switzerland Franc Free-­floating ACT/360 T+2
Taiwan Dollar Free-­floating ACT/365 T+2
Thailand Baht Free-­floating ACT/365 T+2
United Kingdom Pound Free-­floating ACT/365 T+2
United States Dollar Free-­floating ACT/360 T+2

a
Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy,
Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain.
b
The “currency” of the International Monetary Fund.
Sources: Bloomberg L.P. and Reuters.

Practitioners with access to Bloomberg can look up individual currency

details by selecting:

[Ticker] [Currency yellow key] DES <Go>.

We show this page for the Australian dollar, Brazilian real and Egyptian
pound in Figures 1.4, 1.5 and 1.6 respectively.

I n t e r e s t -­B e a r i n g a n d N o n -­I n t e r e s t -­B e a r i n g

Current Accounts
These are also known as cheque accounts or (in the US) checking accounts,
and are the simplest form of short-­term deposit or investment instrument.
Customer funds may be withdrawn instantly on demand, and banks
sometimes pay interest on surplus balances, although not often! Current
accounts are a cheap source of funding for banks, as well as a stable one, but
because their balances are instant access, the funds are not as valuable from
a liquidity metrics point of view as fixed term deposits.

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 Banking, Bank Business and Financial Statements 7

FIGURE 1.4 Bloomberg page DES for Australian dollar.

© Bloomberg L.P. All rights reserved. Reproduced with permission.

FIGURE 1.5 Bloomberg page DES for Brazilian real.

© Bloomberg L.P. All rights reserved. Reproduced with permission.

Choudhry755647_c01.indd 7 8/23/2022 11:13:33 AM

 8 The Principles of Banking

FIGURE 1.6 Bloomberg page DES for Egyptian pound.

© Bloomberg L.P. All rights reserved. Reproduced with permission.

Demand Deposits
These are also referred to as sight deposits, similar to a cheque account, but
they are always interest bearing. The funds are available on demand, but
cannot be used for cheques or other similar payments.

Time Deposits
Time or term deposits are interest-­bearing deposit accounts of fixed matu-
AQ1
rity. They are usually offered with a range of maturities ranging from
1 month to 5 years, with the longer dated deposits attracting higher inter-
est. This reflects the positive yield curve, which reflects the funding value to
the bank of longer-­term liabilities. Most time deposits pay a fixed rate of
interest, payable on maturity. Accounts of longer than 1-­year maturity often
capitalise interest on an annual basis.

Choudhry755647_c01.indd 8 8/23/2022 11:13:33 AM

Choudhry755647_c01.indd 9
Retail and wholesale banking Investment banking

Private banking Trust banking Retail personal financial services Commercial lending Mergers and acquisitions Asset management
Wealth management Custody services Loans, deposits, retail products Corporate banking Advisory
Administration Real estate activity Leasing Corporate broking
Servicing Project finance Listing and underwriting
Factoring Structured finance
Securities market making
Proprietary trading

FIGURE 1.7 Banking activities.

8/23/2022 11:13:34 AM
 10 The Principles of Banking

Certificates of Deposit
Certificates of deposit (CDs) are receipts from banks for deposits that have
been placed with them. They were first introduced in the sterling market in
1958. The deposits themselves carry a fixed rate of interest related to market
rates and have a fixed term to maturity, so they cannot be withdrawn before
then. However, the certificates themselves can be traded in a secondary mar-
ket; that is, they are negotiable. CDs are therefore very similar to negotia-
ble money market deposits, although the yields trade below the equivalent
tenor deposit rates because of the added benefit of secondary-­market liquid-
ity. Most CDs issued are of between 1 and 3 months’ maturity, although
they do trade in maturities of 1–5 years. Interest is paid on maturity except
for CDs lasting longer than 1 year, where interest is paid annually or, occa-
sionally, semi-­annually.
Banks, investment banks and building societies issue CDs to raise funds
to finance their business activities. A CD will have a stated interest rate
and fixed maturity date, and can be issued in any denomination. On issue
a CD is sold for face value, so the settlement proceeds of a CD on issue
are always equal to its nominal value. The interest is paid, together with
the face amount, on maturity. The interest rate is sometimes called the cou-
pon, but unless the CD is held to maturity this will not equal the yield,
which is of course the current rate available in the market and varies over
time. The largest group of CD investors are banks, money market funds,
corporates and local authority treasurers.

Commercial Paper
Commercial paper (CP) is a short-­term money market funding instrument
issued by banks and corporates. In most markets, including the US and UK,
it is a discount instrument. Companies’ short-­term capital and working cap-
ital requirement is usually sourced directly from banks, in the form of bank
loans. An alternative short-­term funding instrument is CP, which is available
to corporates that have a sufficiently strong credit rating. CP is a short-­term
unsecured promissory note. The issuer of the note promises to pay its holder
a specified amount on a specified maturity date. CP normally has a zero
coupon and trades at a discount to its face value. The discount represents
interest to the investor in the period to maturity. CP is typically issued in
bearer form, although some issues are in registered form.
CP issued in the US dollar domestic market differs in detail from Euro-
market CP, which is known as EuroCommercial Paper (ECP). We highlight
the main differences in Table 1.3.

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 Banking, Bank Business and Financial Statements 11

TABLE 1.3 Comparison of USCP and ECP.

USCP ECP

Currency US dollar Any Euro currency

Maturity 1–270 days 2–365 days
Common maturity 30–60 days 30–90 days
Interest Zero coupon, issued at Zero-­coupon, issued at discount
discount
Quotation On a discount rate basis On a yield basis
Settlement T + 0 or T + 1 T+2
Registration Bearer form Bearer form
Negotiable Yes Yes

Foreign Exchange
A spot FX trade is an outright purchase or sale of one currency against another
currency, with delivery two working days after the trade date. Note that in
some currencies, generally in the Middle East, markets are closed on Friday but
open on Saturday. A settlement date that falls on a public holiday in the country
of one of the two currencies is delayed for settlement by that day. An FX trans-
action is possible between any two currencies; however, to reduce the number
of quotes that need to be made, the market generally quotes only against the
US dollar or occasionally against sterling or euro, so that the exchange rate
between two non-­dollar currencies is calculated from the rate for each cur-
rency against the dollar. The resulting exchange rate is known as the cross-­rate.
Cross-­rates themselves are also traded between banks in addition to dollar-­
based rates. This is usually because the relationship between two rates is closer
than that of either against the dollar; for example, the Swiss franc moves more
closely in line with the euro than against the dollar, so in practice one observes
that the dollar/Swiss franc rate is more a function of the euro/franc rate.
The spot FX quote is a two-­way bid–offer price and indicates the rate
at which a bank is prepared to buy the base currency against the variable
currency; this is the “bid” for the variable currency, so it is the lower rate.
The other side of the quote is the rate at which the bank is prepared to sell
the base currency against the variable currency. For example, a quote of
1.6245–1.6255 for GBP/USD means that the bank is prepared to buy ster-
ling for $1.6245, and to sell sterling for $1.6255. The convention in the FX
market is uniform across countries, unlike the money markets. Although
the money market convention for bid–offer quotes is, for example, 5½% –
5¼%, meaning that the “bid” for paper – the rate at which the bank will
lend funds, say in the CD market – is the higher rate and always on the left,

Choudhry755647_c01.indd 11 8/23/2022 11:13:34 AM

 12 The Principles of Banking

this convention is reversed in certain countries. In the FX markets the con-

vention is always the same one just described.
The difference between the two sides in a quote is the bank’s dealing
spread. Rates are quoted to 1/100th of a cent, known as a pip. In the quote
above, the spread is 10 pips; however, this amount is a function of the size
of the quote number, so that the rate for USD/JPY at, say, 110.10 – 110.20,
indicates a spread of 0.10 yen. Generally, only the pips in the two rates are
quoted, so that, for example, the quote above would be simply “45–55”.
The “big figure” is not quoted.

EXAMPLE 1.1 EXCHANGE CROSS-­R ATES

Consider the following two spot rates:
EUR / USD 1.0566 1.0571
AUD / USD 0.7034 0.7039

The EUD/USD dealer buys euros and sells dollars at 1.0566 (the
left side), while the AUD/USD dealer sells Australian dollars and buys
US dollars at 0.7039 (the right side). To calculate the rate at which the
bank buys euros and sells Australian dollars, we need to do

1.0566 / 0.7039 1.4997

which is the rate at which the bank buys euros and sells Austral-
ian dollars. In the same way, the rate at which the bank sells euros and
buys Australian dollars is given by:
1.0571 / 0.7034 or 1.5028.

Therefore the spot EUR/AUD rate is 1.4997 – 1.5028.

The derivation of cross-­rates can be depicted in the following
way. If we assume two exchange rates XXX/YYY and XXX/ZZZ, the
cross-­rates are:
YYY / ZZZ XXX / ZZZ XXX / YYY
ZZZ / YYY XXX / YYY XXX / ZZZ

Given two exchange rates, YYY/XXX and XXX/ZZZ, the

cross-­rates are:
YYY / ZZZ YYY / XXX XXX / ZZZ
ZZZ / YYY 1 YYY / XXX / ZZZ

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 Banking, Bank Business and Financial Statements 13

FIGURE 1.8 Bloomberg major currency monitor page, 20 June 2020.

© Bloomberg L.P. All rights reserved. Used with permission

Figure 1.8 shows the Bloomberg major currency FX monitor, page FXC,
as at 20 June 2020.

Government Bonds
Government bonds, also known as sovereign bonds, are issued by gov-
ernments to cover the shortfall in tax revenues compared to public sector
expenditure. The secondary market in government bonds is provided by
banks, those that choose to be market-­makers or primary dealers. Sovereign
debt is essentially a plain vanilla market, with the vast majority of bonds
being fixed coupon and fixed maturity. Governments also issue index-­linked
bonds that offer returns linked to the rate of inflation.

Floating Rate Notes

Floating rate notes (FRNs) are bonds that have variable rates of interest;
the coupon rate is linked to a specified index and changes periodically as
the index changes. An FRN is usually issued with a coupon that pays a
fixed spread over a reference index; for example, the coupon may be 50 bps
over the SONIA rate. Since the value for the reference benchmark index is
not known, it is not possible to calculate the redemption yield for an FRN.
Additional features have been added to FRNs, including floors (the coupon
cannot fall below a specified minimum rate), caps (the coupon cannot rise
above a maximum rate) and callability.

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 14 The Principles of Banking

Generally, the reference interest rate for FRNs is the local market bench-
mark reference rate or “IBOR” rate. For GBP this will be SONIA and for
USD most commonly SOFR, but there are also other benchmarks available
for USD. FRNs denominated in EUR may be linked to EURIBOR.

Repo
Repo is a short-­term secured cash instrument that should always be labelled
as part of the money markets. There is a wide range of uses to which repo
might be put. In the equity market, repo is often conducted in a basket of
stocks, which might be constituent stocks in an index such as the FTSE100
or CAC40, or user-­specified baskets. Market-­makers borrow and lend equi-
ties with differing terms to maturity, and generally the credit rating of the
institution involved in the repo transaction is of more importance than the
quality of the collateral. Central banks’ use of repo also reflects its impor-
tance; it is a key instrument in the implementation of monetary policy in
many countries. Essentially then, repo markets have vital links and rela-
tionships with global money markets, bond markets, futures markets, swap
markets and OTC interest-­rate derivatives.
For practical purposes, repo is essentially a secured loan. The term
comes from sale and repurchase agreement; however, this is not necessarily
the best way to look at it. Although in a classic repo transaction the legal
title of an asset is transferred from the “seller” to the “buyer” during the
term of the repo, this should not detract from the essence of the instrument:
a secured loan of cash. The main value of repo lies in the fact that, for the
lender of cash it provides collateral backing to help mitigate counterparty
credit risk, and for the borrower of cash it enables the financing of asset
positions in the security that is being repo’d out.

Letter of Credit
A letter of credit (LoC) is a standard vanilla product available from a com-
mercial bank. It is an instrument that guarantees that a buyer’s payment to
a seller will be received at the right time and for the specific amount. The
buyer is the customer of the bank. If the buyer is unable to make payment
on the due date, the bank will cover the full amount of the purchase. The
bank therefore takes on the credit risk of the buyer when it writes a LoC
on its behalf. The buyer therefore pays a fee for the LoC that reflects its
credit standing.
LoCs are used in domestic and international trade transactions. Cross-­
border trade transactions involve both parties in issues such as distance,
different legal jurisdictions and lack of due diligence available on the coun-
terparties. A LoC is a valuable tool that eases the process for the buying

Choudhry755647_c01.indd 14 8/23/2022 11:13:40 AM

 Banking, Bank Business and Financial Statements 15

and selling parties. The bank also acts on behalf of the buyer (the purchaser
of the LoC) because it would only make payment when it knows that the
goods have been shipped. For the seller, a LoC substitutes the credit of the
buyer for that of the bank, which is an easier risk exposure for the seller
to take on.
There are essentially two types of LoC: commercial and standby. The
commercial LoC is the primary payment mechanism for a transaction, while
the standby LoC is a secondary payment mechanism.

Commercial Letter of Credit

A commercial LoC is a contract between a bank, known as the issuing bank,
on behalf of one of its customers, authorising another bank, known as the
advising or confirming bank, to make payment to the beneficiary. The issu-
ing bank makes a commitment to guarantee drawings made under the credit.
The beneficiary is normally the provider of goods and/or services. An advis-
ing bank, usually a foreign correspondent bank of the issuing bank, will
advise the beneficiary but otherwise has no other obligation under the LoC.
A LoC is generally negotiable; this means that the issuing bank is
obliged to pay the beneficiary, but also at its request any bank nominated by
the beneficiary. To be negotiable, the LoC features an unconditional promise
to pay on demand at a specified time.

Standby Letter of Credit

The standby LoC is a contract issued by a bank on behalf of a customer to
provide assurances of its ability to perform under the terms of a contract
between it and the beneficiary. In other words, the standby LoC is more of
a guarantee, as both parties to the transaction do not expect that the LoC
will be drawn on. It essentially provides comfort to the beneficiary, as it
enhances the creditworthiness of its customer.

Structured Deposits
A structured deposit is a deposit whose payoff or return profile is structured
to match a specified customer requirement. The structuring results from
the use of an embedded derivative in the product, which links the deposit
to changes in interest rates, FX rates or other market levels. There is a wide
range of different products available that fall in the class of “structured
deposit”. An example is the following: a customer places funds on deposit
at a specified interest rate and fixed term. Under the agreement, if the cen-
tral bank base interest rate remains between 4% and 5%, then the return
is enhanced by 100 bps. If the rate moves below 4% or above 5%, then the

Choudhry755647_c01.indd 15 8/23/2022 11:13:40 AM

 16 The Principles of Banking

deposit forfeits all interest for the remaining term of its life. This is an exam-
ple of a “collared range accrual” deposit.

Liquidity Facilities
Liquidity facility is the generic term for a standing loan agreement, against
which a borrower can draw down funds at any time up to the maximum
value of the line. The borrower pays a fee, even if the line is not used, called
the standing fee, and then pays the agreed rate of interest on any funds that
it does draw.
We distinguish between the following:

■■ Back-­up facility: a facility that is not used in the normal course of busi-
ness. It is generally drawn down if the borrower is experiencing some
difficulty in obtaining funding from its usual sources.
■■ Revolving credit facility (RCF): a commitment from a bank to lend

on a revolving basis under pre-­specified terms. Under an RCF there is

usually a regular drawdown and repayment of funds during the life of
the facility.
■■ Term loan: this is distinct from liquidity lines in that it is a non-­revolving

facility and will be drawn down at execution. It has a fixed repayment

date, although this may be on an amortised basis.

Liquidity facilities require full regulatory capital backing, as the capital

treatment is to assume that they are being fully used at all times.

Syndicated Loans 2
To raise debt capital, companies may issue bonds or loans (as well as other
debt-­like instruments), both of which are associated with a certain seniority
or ranking. In a liquidation or winding-­up, the borrower’s remaining assets
are distributed according to a priority waterfall: debt obligations with the
highest seniority are repaid first, and only if assets remain thereafter are
obligations with lower seniorities repaid. Further, debt instruments may be
secured or unsecured: if a certain number of the borrower’s assets are ring-­
fenced3 to serve as collateral for the lenders under a particular obligation

2This section is an extract from Chapter 11 of Choudhry (2010). It was co-­written

with Timo Schlafer and Marliese Uhrig-­Homburg.
3Ring-­fencing is a legal term that refers to the practice of segregating assets, for the
benefit of one entity, such that they cannot be touched by other creditors during
a bankruptcy or administration proceeding.

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 Banking, Bank Business and Financial Statements 17

TABLE 1.4 Typical priorities of corporate bonds and loans of investment grade
and sub-­investment grade borrowers.

Investment-­grade borrower Sub-­investment-­grade borrower

Bonds ▪▪ Senior unsecured ▪▪ Senior unsecured

▪▪ Senior unsecured ▪▪ Senior secured

(high-­yield bonds)

▪▪ (leveraged loans/syndicated loans)

Loans

Source: Choudhry (2010).

only, this obligation is deemed to be “secured”. Together, seniority and col-

lateral determine the priority of an obligation. As illustrated in Table 1.4,
bonds and loans issued by investment-­grade companies, as well as bonds
issued by sub-­investment grade companies, called “high-­yield bonds”, are
typically senior unsecured. However, loans issued by sub-­investment grade
companies are typically senior secured. Often, these are called “leveraged
loans” or “syndicated secured loans”. The market often uses both terms
interchangeably.
The definition of “leveraged loan” is not universal, however. Vari-
ous market participants define a leveraged loan to be a loan with a sub-­
investment grade rating, while other users view it as one with a certain
spread over RFR (say 100 bps or more) and sometimes a certain debt/earn-
ings before interest, taxes, depreciation and amortisation (EBITDA) ratio of
the borrower. Essentially, the market refers to leveraged loans and high-­yield
bonds as “high-­yield debt”.
Leveraged loans may be arranged either between a borrower and a
single lending bank, or, more commonly, between a borrower and a syn-
dicate of lending banks. In the latter case, one (or more) of the lending
banks acts as lead arranger. Before any other lending banks are involved,
the lead arranger conducts detailed due diligence on the borrower. Also,
lead arranger and borrower agree on the basic transaction terms such as
size of the loan, interest rate, fees, loan structure, covenants and type of syn-
dication. These terms are documented in a “loan agreement”. Based on the
information received in the due diligence process, the lead arranger prepares
an information memorandum – also called “bank book” – which is used
to market the transaction to other potential lending banks or institutional
investors. Together, the lead arranger and the other lenders constitute the
primary market. If the transaction is an “underwritten syndication”, the
lead arranger guarantees the borrower that the entire amount of the loan
will be placed at a predefined price. If the loan is undersubscribed at that
price, the lead arranger is forced to absorb the difference. If the transaction

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 18 The Principles of Banking

TABLE 1.5 Typical structure of leveraged loans.

Lien Lender Repayment

Revolving credit facility Discretionary

Banks
Term loans     A First lien Amortising
        B
        C Institutional Bullet
        D Second lien investors

Source: Choudhry (2010).

is a “best-­efforts syndication”, the lead arranger tries to place the loan at

the predefined terms but will, if investor demand is insufficient, adjust these
terms to achieve full placement.
Leveraged loans typically consist of a revolving credit facility or
“revolver” and “term loans”. The term loans are usually tranched into an
amortising term loan (term loan A), provided by the syndicate banks, and
institutional tranches (term loans B, C and D), provided by institutional
investors. In the US market, amortising term loans have become increas-
ingly rare as institutional investors are now the primary buyers of leveraged
loans. The term loan D may represent a further subdivision, called “second
lien tranche”, which is subordinated to term loans A, B and C, called “first
lien tranches”, but ranks senior to all other debt of the borrower. Histori-
cally, this structure has resulted in significantly higher recovery rates of first
lien tranches compared to second lien tranches.
The term loan A is usually repaid on scheduled repayment dates during
its life, whereas term loans B, C and D are mostly subject to bullet repay-
ment; that is, a one-­off repayment on the maturity date. Once repaid, term
loans cannot be re-­borrowed. This is the principal difference to the revolv-
ing credit facility, usually provided by syndicate lenders, which allows the
borrower to borrow, repay and re-­borrow funds during the life of the loan
in accordance with predetermined conditions. In addition to interest on bor-
rowed funds, borrowers are charged a commitment fee on unused funds.
Revolvers are often used to fund working capital and capital expenditure
requirements that can fluctuate significantly over time. Table 1.5 summarises
the above discussion.

REFERENCES
Choudhry, M. (2007), Bank Asset and Liability Management, Chichester: John
Wiley & Sons.
Choudhry, M. (2010), Structured Credit Products: Credit Derivatives and Synthetic
Securitisation, 2nd edition, Singapore: John Wiley & Sons (Asia) Pte. Ltd.

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