The Hindu Business Line : Benchmark for a bank auditor's knowledge about banks

Lesser minions in the big bank are talking about mergers of small banks with the big, weak ones with the strong, and so on. GTB vanished all of a sudden and morphed as fast as twisting tadpoles become croaking frogs. Hey, what's happening, you wonder.

To understand the industry, here is help: Stephen M. Frost's book, The Bank Analyst's Handbook, from Wiley (www.wiley.com). Let's move from the less respectful subtitle, "money, risk and conjuring tricks", and read the foreword that begins with the reassuring line, "Financial institutions have few friends".

There are two types of books on banking, observes the author: One type `written for specialist practitioners for finance academics', and the other `rather superficial and most suited to a high-school audience'. This book bridges the gap, notes Frost.

Prologue begins with a quote from the Bible: "The love of money is the root of all evil." If that is puzzling, what can be more so is when professionals in financial services exhibit only a vague idea of what their colleagues actually do, `even though they work on the same floor.'

As specialisation grows, language develops to make communication faster between common specialists, but "virtually impenetrable to everybody else."

Almost every profession can be guilty of such blocks, and terms can be `quite evocative' — such as, "butterfly spread, fallen angels, chastity bonds, baked-in-the-cake, sinking funds, double witching day, bottom fishing, concert party, dressing up, flip-flop notes, ever-greening, barefoot pilgrim" and lot of fun!

Even as a small minority mouths hard-hitting phrases like `contingent immunisation, continuous net settlement, dynamic asset diversification, subordinated limited irredeemable preference shares,' and such, making everybody else feel inadequate and ignorant, Frost would comfort you with a simple message: "One does not have to be able to derive the highly complex and very difficult Black-Scholes model for valuing financial options to be able to understand how they can be used, what factors determine their price and how changes in these factors will affect a traded option's price."

Remember what Richard Feynman used to say — that if one can't explain a phenomenon without having to resort to equations, one doesn't really understand what is going on. Similarly, "much of financial theory tries to formalise what we instinctively believe to be true."

So, Frost advises: "Maintain a healthy level of scepticism about theories that rely on unrealistic simplifying assumptions and those that cross the line between science and psychology."

I fast forward to the chapter on `interest rate'. It begins with a Yogi Berra quote: "In theory there is no difference between theory and practice. In practice there is." You'd find inputs on "more exotic interest rate instruments' such as swaptions, interest rate swap futures, basis spread contracts, bond indices futures contracts, caps and collars, strips and synthetic zeroes."

Check your knowledge gap by reading about `gap analysis': A positive interest rate gap means that more assets than liabilities are due to be repriced in a particular time interval."

Part V of the book is on `bank valuations and acquisition' — something relevant to all those weak and strong banks that people are talking about these days. There are four different ways to measure the `value'; two reasons for excess capital; three common methods of goodwill accounting; and so forth.

An important chapter in current context, again, is the one on `banking crises'. No two banking crises have exactly the same root cause or dynamics, points out the author.

Yet, there are common factors that he classifies as micro and macro. In micro, Frost writes: "Banks are run by people.

Some of these people are corrupt, others simply incompetent. Individual bank failures do not usually lead to financial crises but such failures may be indicative of the underlying business and ethical culture and the quality of the banking supervision."

A book to benchmark a bank auditor's knowledge about banks.

BooksOfAccount@TheHindu.co.in

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